[Federal Register Volume 69, Number 59 (Friday, March 26, 2004)]
[Proposed Rules]
[Pages 15747-15753]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-6623]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-121475-03]
RIN 1545-BC61


Qualified Zone Academy Bonds; Obligations of States and Political 
Subdivisions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that amend the 
final regulations on qualified zone academy bonds. These regulations 
provide guidance to State and local governments that issue qualified 
zone academy bonds and to banks, insurance companies, and other 
taxpayers that hold those bonds. These regulations provide guidance on 
the maximum term, permissible use of proceeds, and remedial actions for 
qualified zone academy bonds. This document also provides notice of a 
public hearing on these proposed regulations.

DATES: Written or electronic comments on this rule must be received by 
June 24, 2004. Requests to speak and outlines of topics to be discussed 
at the public hearing scheduled for July 21, 2004, at 10 a.m., must be 
received by July 12, 2004. Comments on the collection of information 
should be received by May 25, 2004.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-121475-03), room 5203, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-121475-03), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the IRS Internet site at: http://www.irs.gov/regs. 
The public hearing will be held in room 7218, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Timothy L. 
Jones or Zoran Stojanovic, (202) 622-3980; concerning submissions of 
comments, the hearing, and requests to be placed on the building access 
list to attend the meeting, Guy R. Traynor, (202) 622-3693 (not toll-
free numbers).

SUPPLEMENTARY INFORMATION:

[[Page 15748]]

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP; 
Washington, DC 20224. Comments on the collection of information should 
be received by May 25, 2004. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in this proposed regulation is in 
Sec.  1.1397E-1(h). This collection of information is required by the 
IRS to verify compliance with section 1397E. This information will be 
used to identify issuers of qualified zone academy bonds that have 
established a defeasance escrow as a remedial action taken because of 
failure to satisfy certain requirements of section 1397E. The 
collection of information is required to obtain or retain a benefit. 
The likely respondents are states or local governments that issue 
qualified zone academy bonds.
    Estimated total annual reporting burden: 3 hours.
    Estimated average annual burden hours per respondent: 30 minutes.
    Estimated number of respondents: 6.
    Estimated annual frequency of responses: varies.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    Section 1397E(a) of the Internal Revenue Code (Code) provides that 
an eligible taxpayer (within the meaning of section 1397E(d)(6)) that 
holds a qualified zone academy bond on a credit allowance date is 
allowed a credit against Federal income tax for the taxable year that 
includes the credit allowance date. In general, a qualified zone 
academy bond is a bond issued by a State or local government to finance 
certain eligible public school purposes under section 1397E(d). Section 
1397E(b) provides that the amount of the qualified zone academy bond 
credit equals the product of the credit rate and the face amount of the 
bond held by the taxpayer on the credit allowance date. Under section 
1397E(b)(2), the credit rate is determined by the Treasury Department 
and equals the percentage that the Department estimates generally will 
permit the issuance of qualified zone academy bonds without discount 
and without interest cost to the issuer. Section 1397E(f)(1) defines 
credit allowance date as the last day of the one-year period beginning 
on the date of issuance of the issue and the last day of each 
successive one-year period thereafter. Under section 1397E(d)(3), the 
maximum term of a qualified zone academy bond is determined by the 
Treasury Department and equals the term that the Department estimates 
will result in the present value of the obligation to repay the 
principal on the bond being equal to 50 percent of the face amount of 
the bond.
    Section 1397E(g) provides that the amount of the qualified zone 
academy bond credit allowed to the taxpayer is included in the 
taxpayer's gross income.
    Section 1397E(e) imposes a national limitation on the amount of 
qualified zone academy bonds that may be issued for each calendar year. 
The limitation is allocated by the Treasury Department among the States 
on the basis of their respective populations of individuals below the 
poverty line.
    Temporary regulations (TD 8755) interpreting section 1397E were 
published on January 7, 1998 (63 FR 671), and amended on July 1, 1999 
(TD 8826; 64 FR 35573). Final regulations under section 1397E (TD 8903) 
(the final regulations) were published on September 26, 2000 (65 FR 
57732). This document contains proposed regulations (the proposed 
regulations) that would amend the final regulations.

Explanation of Provisions

I. Maximum Term

    Section 1397E(d)(3) provides that the Secretary of the Treasury 
Department shall determine, during each calendar month, the maximum 
term for qualified zone academy bonds issued during the following 
calendar month. Section 1397E(d)(3) states that the maximum term shall 
be the term that the Secretary estimates will result in the present 
value of the obligation to repay the principal on the bond being equal 
to 50 percent of the face amount of the bond. Section 1.1397E-1(d) of 
the final regulations provides that the maximum term for a qualified 
zone academy bond is determined under section 1397E(d)(3) by using a 
discount rate equal to 110 percent of the long-term adjusted applicable 
Federal rate (AFR), compounded semi-annually, for the month in which 
the bond is issued. The IRS publishes the long-term adjusted AFR each 
month in a revenue ruling.
    Section 1397E(b)(2) provides that the Secretary shall determine, 
during each calendar month, a credit rate for qualified zone academy 
bonds issued during the following calendar month. Section 1.1397E-1(b) 
provides that the Secretary shall determine monthly (or more often as 
deemed necessary by the Secretary) the credit rate the Secretary 
estimates generally will permit the issuance of a qualified zone 
academy bond without discount and without interest cost to the issuer. 
Notice 99-35 (1999-2 C.B. 26) indicates that, until further notice, the 
credit rate for a qualified zone academy bond will be published daily 
by the Bureau of Public Debt on its Internet site for State and Local 
Government Series securities (http://www.publicdebt.treas.gov). Notice 
99-35 also provides that the credit rate shall be applied to a 
qualified zone academy bond on the first day on which there is a 
binding contract in writing for the sale or exchange of the bond. 
Notice 99-35 states that the credit rate will be determined by the 
Treasury Department based on its estimate of the yield on outstanding 
AA rated corporate bonds of a similar maturity for the business day 
immediately prior to the date on which there is a binding contract in 
writing for the sale or exchange of the bond.
    Questions have been raised regarding the maximum term of a 
qualified zone

[[Page 15749]]

academy bond that is sold in one month and issued in another month. 
Section 1.1397E-1(d) provides that the maximum term is determined based 
on the month in which the bond is issued. However, under Notice 99-35, 
the credit rate for a qualified zone academy bond is determined based 
on the first day on which there is a binding contract in writing for 
the sale or exchange of the bond. The credit rate and maximum term 
should be determined on the same day because the credit rate for a bond 
depends on its maximum term. Accordingly, the proposed regulations 
amend Sec.  1.1397E-1(d) to provide that the maximum term for a 
qualified zone academy bond is determined based on the first day on 
which there is a binding contract in writing for the sale or exchange 
of the bond.

II. Use of Proceeds and Remedial Actions

A. In General

    Section 1397E(d)(1)(A) provides that a bond issued as part of an 
issue is a qualified zone academy bond only if, among other 
requirements, at least 95 percent of the proceeds of the issue are to 
be used for a qualified purpose with respect to a qualified zone 
academy established by an eligible local education agency (as defined 
in section 1397E(d)(4)(B)). Section 1397E(d)(5) defines qualified 
purpose, with respect to any qualified zone academy, as (i) 
rehabilitating or repairing the public school facility in which such 
academy is established, (ii) providing equipment for use at such 
academy, (iii) developing course materials for education to be provided 
at such academy, and (iv) training teachers and other school personnel 
in such academy. Section 1397E(d)(4)(A) defines qualified zone academy 
as any public school (or academic program within a public school) that 
is established by and operated under the supervision of an eligible 
local education agency to provide education or training below the 
postsecondary level if: (1) The public school or program is designed in 
cooperation with business in accordance with section 1397E(d)(4)(A)(i); 
(2) students in the public school or program will be subject to the 
same academic standards and assessments as other students educated by 
the eligible local education agency; (3) the comprehensive education 
plan of the public school or program is approved by the eligible local 
education agency; and (4) the public school is located in an 
empowerment zone or enterprise community (as defined in section 1393), 
or there is a reasonable expectation (as of the date of issuance of the 
bonds) that at least 35 percent of the students attending the school or 
participating in the program will be eligible for free or reduced-cost 
lunches under the school lunch program established under the Richard B. 
Russell National School Lunch Act.

B. Compliance With 95-Percent Test

1. In General
    Comments have been received requesting guidance on compliance with 
the 95-percent test in section 1397E(d)(1)(A). The proposed regulations 
provide that, in general, an issue must satisfy three requirements to 
comply with section 1397E(d)(1)(A). First, the issuer must reasonably 
expect, as of the date of issuance of the issue, that at least 95 
percent of the proceeds of the issue will be expended with due 
diligence. Second, the issuer must reasonably expect, as of the date of 
issuance of the issue, that at least 95 percent of the proceeds of the 
issue will be used for a qualified purpose with respect to a qualified 
zone academy for the entire term of the issue (without regard to any 
redemption provision). Third, except as otherwise provided in the 
remedial action provisions of the proposed regulations, discussed 
below, at least 95 percent of the proceeds of the issue must actually 
be used for a qualified purpose with respect to a qualified zone 
academy for the entire term of the issue (without regard to any 
redemption provision). For these purposes, any unspent proceeds are 
treated as used for a qualified purpose with respect to a qualified 
zone academy during any period that the issuer reasonably expects that 
those proceeds will be expended with due diligence for a qualified 
purpose with respect to a qualified zone academy.
2. Proceeds Expended for Rehabilitation, Repair or Equipment
    Section 1397E(d)(5)(A) and (B) provides that the term qualified 
purpose with respect to any qualified zone academy includes 
rehabilitating or repairing the public school facility in which such 
academy is established, and providing equipment for use at such 
academy. The proposed regulations specify that, if proceeds of an issue 
are expended for a purpose described in section 1397E(d)(5)(A) or (B) 
with respect to a qualified zone academy, then those proceeds are 
treated as used for a qualified purpose with respect to the academy 
during any period after such expenditure that (1) the property financed 
with those proceeds is used for the purposes of the academy and (2) the 
academy maintains its status as a qualified zone academy. For this 
purpose, the retirement from service of financed property due to normal 
wear or obsolescence does not cause the property not to be used for a 
qualified purpose with respect to a qualified zone academy.
3. Proceeds Expended To Develop Course Materials or Train Teachers
    Section 1397E(d)(5)(C) and (D) provides that the term qualified 
purpose with respect to any qualified zone academy includes developing 
course materials for education to be provided at such academy, and 
training teachers and other school personnel in such academy. The 
proposed regulations provide that, if proceeds of an issue are expended 
for a purpose described in section 1397E(d)(5)(C) or (D) with respect 
to a qualified zone academy, then those proceeds are treated as used 
for a qualified purpose with respect to the academy during any period 
after such expenditure.
4. Special Rule for Determining Status as Qualified Zone Academy
    Section 1397E(d)(4)(A)(iv) provides that a public school (or 
academic program within a public school) is a qualified zone academy 
only if, among other requirements, the public school is located in an 
empowerment zone or enterprise community, or there is a reasonable 
expectation (as of the date of issuance of the bonds) that at least 35 
percent of the students attending the school or participating in the 
program (as the case may be) will be eligible for free or reduced-cost 
lunches under the school lunch program established under the Richard B. 
Russell National School Lunch Act. For purposes of determining whether 
an issue complies with section 1397E(d)(4)(A)(iv), the proposed 
regulations provide that a public school is treated as located in an 
empowerment zone or enterprise community for the entire term of the 
issue if the public school is located in an empowerment zone or 
enterprise community on the date of issuance of the issue.

C. Remedial actions

1. In General
    Comments have been received requesting guidance specifying remedial 
actions that may be taken to cure a violation of the 95-percent test in 
section 1397E(d)(1)(A).
    The proposed regulations specify two remedial actions that may be 
taken in certain circumstances if less than 95 percent of the proceeds 
of an issue is actually used for a qualified purpose

[[Page 15750]]

with respect to a qualified zone academy. These remedial actions are 
available only if the issuer reasonably expected on the date of 
issuance of the issue that: (1) at least 95 percent of the proceeds of 
the issue would be expended with due diligence; and (2) at least 95 
percent of the proceeds of the issue would be used for a qualified 
purpose with respect to a qualified zone academy for the entire term of 
the issue (without regard to any redemption provision).
    As discussed below, the two remedial actions specified in the 
proposed regulations are (1) redemption or defeasance of the 
nonqualified bonds and (2) alternative use of the disposition proceeds. 
If the applicable requirements are met, the redemption or defeasance 
remedial action is available to cure any failure to satisfy the 95-
percent test that was not reasonably expected as of the date of 
issuance. The alternative use of disposition proceeds remedial action 
applies only to certain dispositions of financed property for cash.
2. Redemption or Defeasance of Nonqualified Bonds
    A redemption or defeasance remedial action is taken if: (1) All of 
the nonqualified bonds of the issue (determined by applying the 
principles of Sec.  1.142-2(e)) are redeemed within 90 days after the 
date on which the failure to properly use proceeds occurs; (2) if any 
nonqualified bonds of the issue are not redeemed within 90 days after 
the date on which the failure to properly use proceeds occurs (the 
unredeemed nonqualified bonds), a defeasance escrow is established for 
the unredeemed nonqualified bonds within 90 days after the date on 
which the failure to properly use proceeds occurs; or (3) if the 
failure to properly use proceeds is a disposition of financed property 
described in section 1397E(d)(5)(A) or (B) and the consideration for 
the disposition is exclusively cash, all of the disposition proceeds 
(as defined in Sec.  1.141-12(c)(1)) are used within 90 days after the 
date of the disposition to redeem, or establish a defeasance escrow 
for, a pro rata portion of the nonqualified bonds of the issue.
    For proceeds that are not spent, a failure to properly use proceeds 
occurs on the earlier of: (1) The first date on which the public school 
(or academic program within the public school) does not constitute a 
qualified zone academy; and (2) the first date on which the issuer 
reasonably expects that less than 95 percent of the proceeds of the 
issue will be expended with due diligence for a qualified purpose with 
respect to a qualified zone academy. For proceeds that have been spent 
for rehabilitation, repair or equipment described in section 
1397E(d)(5)(A) or (B) with respect to a qualified zone academy, a 
failure to properly use proceeds occurs on the earlier of: (1) The 
first date on which the public school (or academic program within the 
public school) does not constitute a qualified zone academy; and (2) 
the first date on which an action is taken that causes less than 95 
percent of the proceeds of the issue to be used for a qualified purpose 
with respect to a qualified zone academy. If proceeds have been spent 
for course materials or training described in section 1397E(d)(5)(C) or 
(D) with respect to a qualified zone academy, no event subsequent to 
such expenditure shall constitute a failure to properly use such 
proceeds.
    A defeasance escrow is defined as an irrevocable escrow established 
to retire bonds on the earliest call date after the date on which the 
failure to properly use proceeds occurs in an amount that is sufficient 
to retire the bonds on that call date. At least 90 percent of the 
weighted average amount in a defeasance escrow must be invested in 
investments (as defined in Sec.  1.148-1(b)), except that no amount in 
a defeasance escrow may be invested in any investment the obligor (or 
any person that is a related party with respect to the obligor within 
the meaning of Sec.  1.150-1(b)) of which is a user of proceeds of the 
bonds. All purchases or sales of an investment in a defeasance escrow 
must be made at the fair market value of the investment within the 
meaning of Sec.  1.148-5(d)(6).
    In addition, the issuer must pay to the United States, at the same 
time and in the same manner as rebate amounts are required to be paid 
under Sec.  1.148-3 (or at such other time or in such other manner as 
the Commissioner may prescribe), 100 percent of the investment earnings 
on amounts in the defeasance escrow. For this purpose, the first 
computation period begins on the date on which the failure to properly 
use proceeds occurs.
    Proceeds of qualified zone academy bonds (other than unspent 
proceeds of the issue for which the failure to properly use proceeds 
occurs) are not permitted to be used to redeem or defease the 
nonqualified bonds. The issuer must provide written notice to the 
Commissioner of the establishment of the defeasance escrow within 90 
days of the date the defeasance escrow is established.
3. Alternative Use of the Disposition Proceeds
    The alternative use of disposition proceeds remedial action has 
four requirements. First, the failure to properly use proceeds must be 
a disposition of financed property described in section 1397E(d)(5)(A) 
or (B) and the consideration for the disposition must be exclusively 
cash. Second, the issuer must reasonably expect as of the date of the 
disposition that: (1) All of the disposition proceeds, plus any amounts 
received from investing the disposition proceeds, will be expended 
within two years after the date of the disposition for a qualified 
purpose with respect to a qualified zone academy; or (2) to the extent 
not expected to be so expended, used within 90 days after the date of 
the disposition to take a redemption or defeasance remedial action. 
Third, the disposition proceeds, plus any amounts received from 
investing the disposition proceeds, must be treated as proceeds for 
purposes of section 1397E. Fourth, if all of the disposition proceeds, 
plus any amounts received from investing the disposition proceeds, are 
not actually expended for a qualified purpose within the two-year 
period beginning on the date of the disposition (or used within 90 days 
after the date of the disposition to take a redemption or defeasance 
remedial action), the remainder of such amounts must be used within 90 
days after the end of that two-year period for a redemption or 
defeasance remedial action.

D. Definition of Proceeds

    In general, Sec.  1.148-1(b) defines sale proceeds as any amounts 
actually or constructively received from the sale of an issue, 
including amounts used to pay underwriters' discount or compensation. 
The proposed regulations provide that, for purposes of the qualified 
zone academy bond provisions (other than the private business 
contribution requirement, discussed below), proceeds means sale 
proceeds as defined in Sec.  1.148-1(b), plus any amounts received from 
investing sale proceeds. Thus, under the proposed regulations, the 
requirement in section 1397E(d)(1)(A) that at least 95 percent of the 
proceeds of an issue be used for a qualified purpose with respect to a 
qualified zone academy is applied by taking into account not only the 
sale proceeds of the issue, but also any amounts received from 
investing those sale proceeds.
    Section 1397E(d)(1)(C)(ii) provides that a bond is a qualified zone 
academy bond only if, among other requirements,

[[Page 15751]]

the issuer certifies that it has written assurances that the private 
business contribution requirement of section 1397E(d)(2) will be met 
with respect to the qualified zone academy. Section 1397E(d)(2)(A) 
provides that the private business contribution requirement is met if 
the eligible local education agency that established the qualified zone 
academy has written commitments from private entities to make qualified 
contributions (as defined in section 1397E(d)(2)(B)) having a present 
value (as of the date of issuance of the issue) of not less than ten 
percent of the proceeds of the issue. The proposed regulations provide 
that, for purposes of the private business contribution requirement of 
section 1397E(d)(2), proceeds means sale proceeds as defined in Sec.  
1.148-1(b). Thus, the private business contribution requirement is 
applied by taking into account only the sale proceeds of the issue 
without regard to any amounts received or expected to be received from 
investing those sale proceeds.

E. Payment of Principal, Interest or Redemption Price

    The proposed regulations provide that the use of proceeds of a bond 
to pay principal, interest or redemption price of the bond or another 
bond is not a qualified purpose within the meaning of section 
1397E(d)(5). Thus, the use of proceeds of a bond to refund another bond 
is not a qualified purpose. In addition, the use of proceeds of a bond 
to fund a sinking fund to repay the bond is not a qualified purpose.

Proposed Effective Dates

    The proposed regulations are proposed to apply to bonds sold on or 
after the date that is 60 days after publication of final regulations 
in the Federal Register (the effective date). Issuers may apply the 
proposed regulations in whole, but not in part, to bonds sold before 
the effective date, except that: (1) issuers may apply the proposed 
regulations without regard to Sec.  1.1397E-1(h)(8) (relating to the 
definition of proceeds) to bonds sold before the effective date; and 
(2) Sec.  1.1397E-1(d) (relating to the maximum term of a qualified 
zone academy bond) and Sec.  1.1397E-1(h)(2) (relating to reimbursement 
of expenditures with proceeds of a qualified zone academy bond) may not 
be applied to bonds issued before July 1, 1999.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations. It is hereby 
certified that the collection of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. As previously noted, it is estimated that each year only six 
issuers of qualified zone academy bonds will be required to report the 
establishment of a defeasance escrow, and the estimated burden of each 
such reporting is only 30 minutes. In addition, the establishment of a 
defeasance escrow need only be reported once. Therefore, a regulatory 
flexibility analysis under the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) is not required. Pursuant to section 7805(f) of the Internal 
Revenue Code, this notice of proposed rulemaking will be submitted to 
the Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments that are submitted 
timely (preferably a signed original and eight copies) to the IRS. The 
IRS and Treasury Department request comments on the clarity of the 
proposed regulations and how they may be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for July 21, 2004, at 10 a.m. 
in room 7218, Internal Revenue Building, 1111 Constitution Avenue, NW., 
Washington, DC. Because of access restrictions, visitors will not be 
admitted beyond the lobby more than 30 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons who wish to present oral comments at the hearing must 
submit written comments by June 24, 2004, and submit an outline of the 
topics to be discussed and the amount of time to be devoted to each 
topic by July 12, 2004.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.
    Comments are requested on all aspects of the proposed regulations.

Drafting Information

    The principal authors of these regulations are Timothy L. Jones and 
Zoran Stojanovic, Office of Associate Chief Counsel, IRS (Tax Exempt 
and Governmental Entities), and Stephen J. Watson, Office of Tax 
Policy, Treasury Department. However, other personnel from the IRS and 
the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR Part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.1397E-1 is amended by:
    1. Revising the last sentence in paragraph (a).
    2. Revising paragraphs (d) and (h).
    3. Redesignating the text of paragraph (k) as paragraph (k)(1) and 
adding a heading for newly designated paragraph (k)(1).
    4. Adding paragraph (k)(2).
    The revisions and additions read as follows:


Sec.  1.1397E-1  Qualified zone academy bonds.

    (a) * * * This section also provides other rules for qualified zone 
academy bonds, including rules governing the credit rate, the private 
business contribution requirement, the maximum term, use of proceeds, 
remedial actions, and eligible issuers.
* * * * *
    (d) Maximum term. The maximum term for a qualified zone academy 
bond is determined under section 1397E(d)(3) by using a discount rate 
equal to 110 percent of the long-term adjusted AFR, compounded semi-
annually, for the month in which the bond is sold. The Internal Revenue 
Service publishes this figure each month in a revenue ruling that is 
published in the Internal Revenue Bulletin. See Sec.  
601.601(d)(2)(ii)(b) of this chapter. A bond is sold on the first day 
on which

[[Page 15752]]

there is a binding contract in writing for the sale or exchange of the 
bond.
* * * * *
    (h) Use of proceeds--(1) In general. Section 1397E(d)(1)(A) 
provides that a bond issued as part of an issue is a qualified zone 
academy bond only if, among other requirements, at least 95 percent of 
the proceeds of the issue are to be used for a qualified purpose with 
respect to a qualified zone academy established by an eligible local 
education agency (as defined in section 1397E(d)(4)(B)). Section 
1397E(d)(5) defines qualified purpose, with respect to any qualified 
zone academy, as rehabilitating or repairing the public school facility 
in which such academy is established, providing equipment for use at 
such academy, developing course materials for education to be provided 
at such academy, and training teachers and other school personnel in 
such academy. Section 1397E(d)(4)(A) defines qualified zone academy as 
any public school (or academic program within a public school) that is 
established by and operated under the supervision of an eligible local 
education agency to provide education or training below the 
postsecondary level and that meets the requirements of section 
1397E(d)(4)(A)(i), (ii), (iii) and (iv).
    (2) Use of proceeds requirements. An issue meets the requirements 
of section 1397E(d)(1)(A) only if--
    (i) The issuer reasonably expects, as of the date of issuance of 
the issue, that--
    (A) At least 95 percent of the proceeds of the issue will be 
expended with due diligence; and
    (B) At least 95 percent of the proceeds of the issue will be used 
for a qualified purpose with respect to a qualified zone academy for 
the entire term of the issue (without regard to any redemption 
provision); and
    (ii) Except as otherwise provided in paragraph (h)(7) of this 
section, at least 95 percent of the proceeds of the issue is actually 
used for a qualified purpose with respect to a qualified zone academy 
for the entire term of the issue (without regard to any redemption 
provision).
    (3) Unspent proceeds. For purposes of paragraphs (h)(2)(i)(B) and 
(h)(2)(ii) of this section, unspent proceeds are treated as used for a 
qualified purpose with respect to a qualified zone academy during any 
period that the issuer reasonably expects that those proceeds will be 
expended with due diligence for a qualified purpose with respect to a 
qualified zone academy.
    (4) Proceeds expended for rehabilitation, repair or equipment--(i) 
In general. Section 1397E(d)(5)(A) and (B) provides that the term 
qualified purpose with respect to any qualified zone academy includes 
rehabilitating or repairing the public school facility in which such 
academy is established, and providing equipment for use at such 
academy. If proceeds of an issue are expended for a purpose described 
in section 1397E(d)(5)(A) or (B) with respect to a qualified zone 
academy, then those proceeds are treated as used for a qualified 
purpose with respect to the academy during any period after such 
expenditure that--
    (A) The property financed with those proceeds is used for the 
purposes of the academy; and
    (B) The academy maintains its status as a qualified zone academy 
under section 1397E(d)(4).
    (ii) Retirement from service. The retirement from service of 
financed property due to normal wear or obsolescence does not cause the 
property not to be used for a qualified purpose with respect to a 
qualified zone academy.
    (5) Proceeds expended to develop course materials or train 
teachers. Section 1397E(d)(5)(C) and (D) provides that the term 
qualified purpose with respect to any qualified zone academy includes 
developing course materials for education to be provided at such 
academy, and training teachers and other school personnel in such 
academy. If proceeds of an issue are expended for a purpose described 
in section 1397E(d)(5)(C) or (D) with respect to a qualified zone 
academy, then those proceeds are treated as used for a qualified 
purpose with respect to the academy during any period after such 
expenditure.
    (6) Special rule for determining status as qualified zone academy. 
Section 1397E(d)(4)(A)(iv) provides that a public school (or academic 
program within a public school) is a qualified zone academy only if, 
among other requirements, the public school is located in an 
empowerment zone or enterprise community (as defined in section 1393), 
or there is a reasonable expectation (as of the date of issuance of the 
bonds) that at least 35 percent of the students attending the school or 
participating in the program (as the case may be) will be eligible for 
free or reduced-cost lunches under the school lunch program established 
under the Richard B. Russell National School Lunch Act. For purposes of 
determining whether an issue complies with section 1397E(d)(4)(A)(iv), 
a public school is treated as located in an empowerment zone or 
enterprise community for the entire term of the issue if the public 
school is located in an empowerment zone or enterprise community on the 
date of issuance of the issue.
    (7) Remedial actions--(i) General rule. If less than 95 percent of 
the proceeds of an issue is actually used for a qualified purpose with 
respect to a qualified zone academy, the issue will be treated as 
meeting the requirements of section 1397E(d)(1)(A) if the issue met the 
requirements of paragraph (h)(2)(i) of this section and a remedial 
action is taken under paragraph (h)(7)(ii) or (iii) of this section.
    (ii) Redemption or defeasance--(A) In general. A remedial action is 
taken under this paragraph (h)(7)(ii) if the requirements of paragraphs 
(h)(7)(ii)(B) and (C) of this section are met.
    (B) Retirement of nonqualified bonds--(1) In general. The 
requirements of this paragraph (h)(7)(ii)(B) are met if--
    (i) All of the nonqualified bonds of the issue (determined by 
applying the principles of Sec.  1.142-2(e)) are redeemed within 90 
days after the date on which the failure to properly use proceeds 
occurs (as determined under paragraph (h)(7)(ii)(D) of this section); 
or
    (ii) If any nonqualified bonds of the issue are not redeemed within 
90 days after the date on which the failure to properly use proceeds 
occurs (the unredeemed nonqualified bonds), a defeasance escrow is 
established for the unredeemed nonqualified bonds within 90 days after 
the date on which the failure to properly use proceeds occurs.
    (2) Special rule for dispositions for cash. If the failure to 
properly use proceeds is a disposition of financed property described 
in section 1397E(d)(5)(A) or (B) and the consideration for the 
disposition is exclusively cash, the requirements of this paragraph 
(h)(7)(ii)(B) are met if all of the disposition proceeds (as defined in 
Sec.  1.141-12(c)(1)) are used within 90 days after the date of the 
disposition to redeem, or establish a defeasance escrow for, a pro rata 
portion of the nonqualified bonds of the issue.
    (3) Definition of defeasance escrow. For purposes of this section, 
a defeasance escrow is an irrevocable escrow established to retire 
bonds on the earliest call date after the date on which the failure to 
properly use proceeds occurs in an amount that is sufficient to retire 
the bonds on that call date. At least 90 percent of the weighted 
average amount in a defeasance escrow must be invested in investments 
(as defined in Sec.  1.148-1(b)), except that no amount in a defeasance 
escrow may be invested in any investment the obligor (or any person 
that is a related party with respect to the obligor within the

[[Page 15753]]

meaning of Sec.  1.150-1(b)) of which is a user of proceeds of the 
bonds. All purchases or sales of an investment in a defeasance escrow 
must be made at the fair market value of the investment within the 
meaning of Sec.  1.148-5(d)(6).
    (C) Additional rules--(1) Limitation on source of funding. Proceeds 
of qualified zone academy bonds (other than unspent proceeds of the 
issue for which the failure to properly use proceeds occurs) must not 
be used to redeem or defease nonqualified bonds under paragraph 
(h)(7)(ii)(B) of this section.
    (2) Rebate requirement. The issuer must pay to the United States, 
at the same time and in the same manner as rebate amounts are required 
to be paid under Sec.  1.148-3 (or at such other time or in such other 
manner as the Commissioner may prescribe), 100 percent of the 
investment earnings on amounts in a defeasance escrow established under 
paragraph (h)(7)(ii)(B) of this section. For this purpose, the first 
computation period begins on the date on which the failure to properly 
use proceeds occurs under paragraph (h)(7)(ii)(D) of this section.
    (3) Notice of defeasance. The issuer must provide written notice to 
the Commissioner, at the place designated in Sec.  1.150-5(a), of the 
establishment of the defeasance escrow within 90 days of the date the 
defeasance escrow is established.
    (D) When a failure to properly use proceeds occurs--(1) Proceeds 
not spent. For proceeds that are not spent, a failure to properly use 
proceeds occurs on the earlier of--
    (i) The first date on which the public school (or academic program 
within the public school) does not constitute a qualified zone academy; 
and
    (ii) The first date on which the issuer reasonably expects that 
less than 95 percent of the proceeds of the issue will be expended with 
due diligence for a qualified purpose with respect to a qualified zone 
academy.
    (2) Proceeds spent for rehabilitation, repair or equipment. For 
proceeds that have been spent for a purpose described in section 
1397E(d)(5)(A) or (B) with respect to a qualified zone academy, a 
failure to properly use proceeds occurs on the earlier of--
    (i) The first date on which the public school (or academic program 
within the public school) does not constitute a qualified zone academy; 
and
    (ii) The first date on which an action is taken that causes less 
than 95 percent of the proceeds of the issue to be used for a qualified 
purpose with respect to a qualified zone academy.
    (3) Proceeds spent for course materials or training. If proceeds 
have been spent for a purpose described in section 1397E(d)(5)(C) or 
(D) with respect to a qualified zone academy, no event subsequent to 
such expenditure shall constitute a failure to properly use such 
proceeds.
    (iii) Alternative use of disposition proceeds. A remedial action is 
taken under this paragraph (h)(7)(iii) if all of the requirements of 
paragraphs (h)(7)(iii)(A) through (D) are met--
    (A) The failure to properly use proceeds (as determined under 
paragraph (h)(7)(ii)(D) of this section) is a disposition of financed 
property described in section 1397E(d)(5)(A) or (B) and the 
consideration for the disposition is exclusively cash;
    (B) The issuer reasonably expects as of the date of the disposition 
that--
    (1) All of the disposition proceeds (as defined in Sec.  1.141-
12(c)(1)), plus any amounts received from investing the disposition 
proceeds, will be expended within two years after the date of the 
disposition for a qualified purpose with respect to a qualified zone 
academy; or
    (2) To the extent not expected to be so expended, used within 90 
days after the date of the disposition to redeem or defease bonds in a 
manner that meets the requirements of paragraph (h)(7)(ii) of this 
section;
    (C) The disposition proceeds, plus any amounts received from 
investing the disposition proceeds, are treated as proceeds for 
purposes of section 1397E; and
    (D) If all of the disposition proceeds, plus any amounts received 
from investing the disposition proceeds, are not actually used in the 
manner described in paragraph (h)(7)(iii)(B) of this section, the 
remainder of such amounts are used within 90 days after the end of the 
two-year period described in paragraph (h)(7)(iii)(B)(1) of this 
section for a remedial action that meets the requirements of paragraph 
(h)(7)(ii) of this section.
    (iv) Allocating disposition proceeds among multiple funding 
sources. For purposes of this paragraph (h)(7), if property has been 
financed with an issue of qualified zone academy bonds and one or more 
other funding sources, any disposition proceeds from that property are 
allocated to the issue under the principles of Sec.  1.141-12(c)(3).
    (8) Definition of proceeds--(i) In general. Except as provided in 
paragraph (h)(8)(ii) of this section, for purposes of section 1397E and 
this section, proceeds means sale proceeds as defined in Sec.  1.148-
1(b), plus any amounts received from investing sale proceeds.
    (ii) Private business contribution requirement. For purposes of the 
private business contribution requirement of section 1397E(d)(2), 
proceeds means sale proceeds as defined in Sec.  1.148-1(b).
    (9) Payment of principal, interest or redemption price. The use of 
proceeds of a bond to pay principal, interest or redemption price of 
the bond or another bond is not a qualified purpose within the meaning 
of section 1397E(d)(5).
    (10) Reimbursement. An expenditure for a qualified purpose may be 
reimbursed with proceeds of a qualified zone academy bond. For this 
purpose, rules similar to those in Sec.  1.150-2 shall apply.
* * * * *
    (k) Effective dates--(1) In general. * * *
    (2) Special effective dates for paragraphs (d) and (h)--(i) In 
general. Except as otherwise provided in this paragraph (k)(2), 
paragraphs (d) and (h) of this section apply to bonds sold on or after 
the date that is 60 days after publication of final regulations in the 
Federal Register.
    (ii) Permissive application--(A) In general. Except as provided in 
paragraphs (k)(2)(ii)(B) and (C) of this section, issuers may apply 
paragraphs (d) and (h) of this section in whole, but not in part, to 
bonds sold before the date that is 60 days after publication of final 
regulations in the Federal Register.
    (B) Definition of proceeds. Issuers may apply paragraphs (d) and 
(h) of this section, without regard to the definition of proceeds in 
paragraph (h)(8) of this section, to bonds sold before the date that is 
60 days after publication of final regulations in the Federal Register.
    (C) Bonds issued before July 1, 1999. Paragraphs (d) and (h)(10) of 
this section may not be applied to bonds issued before July 1, 1999.

Mark E. Matthews,
 Deputy Commissioner for Services and Enforcement.
[FR Doc. 04-6623 Filed 3-25-04; 8:45 am]
BILLING CODE 4830-01-P