In a Technical Advice Memorandum (TAM), IRS has concluded that the residents' entrance fees for a retirement community facility collected by an exempt borrower of bond proceeds weren't replacement proceeds under the arbitrage bond rules of Code Sec. 148 and Reg. §1.148-1(c). Although the borrower “pledged” these fees to pay the borrowed proceeds, it continued to have unrestricted use of these fees. Thus, the bondholders had no reasonable assurance that the fees would be available to pay debt service on the bonds.
Background. Generally, the interest on state or local bonds is exempt from federal income taxation. However, this isn't the case if the bonds are arbitrage bonds. (Code Sec. 103(a), Code Sec. 103(b)(2)
The arbitrage bond rules were enacted to minimize the arbitrage benefits from investing gross proceeds of tax-exempt bonds in higher yielding investments and to remove the arbitrage incentives to issue more bonds, to issue bonds earlier, or to leave bonds outstanding longer than is otherwise reasonably necessary to accomplish the governmental purposes for which the bonds were issued. To do this, the arbitrage bond rules restrict the direct and indirect investment of bond proceeds in higher yielding investments and require that certain earnings on higher yielding investments be rebated to the U.S. Violation of these provisions causes the interest on the bonds to be taxable to the bondholders. (Reg. §1.148-0(a))
An arbitrage bond includes any bond the proceeds of which are used to replace funds which were used directly or indirectly to acquire higher yielding investments. Replacement proceeds of an issue are amounts that have a sufficiently direct nexus to the issue or to the governmental purpose of the issue to conclude that the amounts would have been used for that governmental purpose even if the proceeds of the issue weren't so used. “Governmental purposes” include the expected use of amounts for the payment of debt service on a particular date. The mere availability or preliminary earmarking of amounts for a governmental purpose, however, does not in itself establish a sufficient nexus to cause those amounts to be replacement proceeds. (Reg. §1.148-1(c)(1))
Replacement proceeds include, but aren't limited to, sinking funds, pledged funds, and other replacement proceeds, to the extent that those funds or amounts are held by or derived from a substantial beneficiary of the issue. A substantial beneficiary of an issue includes the issuer and any related party to the issuer, and, if the issuer is not a state, the state in which the issuer is located. A person is not a substantial beneficiary of an issue solely because it is a guarantor under a qualified guarantee. (Reg. §1.148-1(c)(1))
A pledged fund is any amount that is directly or indirectly pledged to pay principal or interest on the issue. A pledge need not be cast in any particular form but, in substance, must provide reasonable assurance that the amount will be available to pay principal or interest on the issue, even if the issuer encounters financial difficulties. A pledge to a guarantor of an issue is an indirect pledge to secure payment of principal or interest on the issue. (Reg. §1.148-1(c)(3))
Rev Rul 78-348, 1978-2 CB 95, provides that, for purposes of determining whether certain collateral constitutes replacement proceeds, a pledge of collateral need not be cast in a particular legal form. Thus, bondholders need not take actual or constructive possession of the collateral. But, there must be a reasonable assurance that the collateral will be available if needed to pay debt service, even if the issuer encounters financial difficulties. For example, an arrangement will not have the effect of a pledge of collateral if the issuer has discretion to defeat the “pledge” merely by liquidating the “collateral” and disposing of the proceeds.
Facts. Issuer issued its bonds and loaned the proceeds to Borrower, an exempt Code Sec. 501(c)(3) organization, which used the proceeds to expand its retirement community facility (Facility) and to refund a prior series of tax-exempt bonds, which were used to construct the initial Facility. Under an indenture and related documents executed in connection with the bond issuance, Borrower granted Trustee a first priority security interest in its revenues, including residents' entrance fees, and certain other collateral.
Before occupying a unit of the Facility, residents are required to remit to Borrower an entrance fee. Borrower isn't required to refund the resident's entrance fee (or the applicable percentage of such) until a resident has left the Facility and the vacated unit is re-occupied by a new resident who has paid an entrance fee. Borrower may decide, in its sole discretion, to refund an entrance fee without these conditions having been met upon a resident's demonstration of a hardship. Borrower isn't required to hold the entrance fees it collects in trust for the residents. Instead, under an agreement with its residents, Borrower may invest the entrance fees or otherwise use these amounts for its own purposes.
Trustee hasn't taken physical possession of, nor does it control, the entrance fees, which are commingled with Borrower's other cash. However, under its security interest filing, Trustee has the ability to take possession of the entrance fees and other commingled moneys to perfect its security interest. Until then, Borrower has unrestricted use of the entrance fees, including use of the fees to pay other creditors. The amount of cash in Borrower's accounts varies with the occupancy of the Facility. Borrower uses its cash, including the entrance fees, to cover operating deficits, the replacement of its facilities, and other capital needs.
At the end of year at issue, the amount of cash that Borrower had invested was approximately one half of the total amount of entrance fee revenue Borrower had received as of the end of the year.
Not replacement proceeds. In the TAM, IRS concluded that, even though there was a nexus between the entrance fees (and other revenues) and the bonds, there was no reasonable assurance that the entrance fees would be available to pay debt service on the bonds in the event that Borrower encountered financial difficulties. Accordingly, the entrance fees weren't properly characterized as replacement proceeds.
The TAM reasoned that since Borrower “pledged” all of its revenues, including the entrance fees, as security for the bonds, there was a nexus between the entrance fees and the bonds. But, the pledge didn't provide reasonable assurance that the entrance fees would be available to pay debt service on the bonds in the event Borrower encountered financial difficulties. Borrower commingled all of its revenues in its accounts and wasn't limited in its ability to spend this money. Borrower apparently spent a substantial portion of its cash, including the entrance fees, after the bonds were issued and continued to expect to spend its cash as necessary on future expenditures, without any interference by Trustee, Borrower's creditors, or the residents. There were no other facts, such as provisions in the indenture or other financing documents (such as financial covenants that require the maintenance of certain asset levels) from which such reasonable assurance could be inferred.
Further, at the end of the year, Borrower's investment balance was approximately one-half of its collected entrance fee revenues. Although there were no facts dealing with the level of cash in Borrower's checking account during the year, it was reasonable to conclude that Borrower would only have transferred cash from its investments to its checking account to the extent necessary to cover its immediately anticipated operating expenses. That is, it was reasonable to conclude that, in the absence of further action by Trustee, the moneys could and would be dissipated to cover operating shortfalls and to finance other items prior to any payment to the bondholders.
There were also no facts to suggest that Borrower's level of cash when the bonds were issued was such that bondholders, considering the nature of the Facility and Borrower's level of operating expenses, could have reasonably relied on this level being maintained while the bonds were outstanding.
References: For replacement proceeds for arbitrage bonds, see FTC 2d/FIN ¶J-3427; United States Tax Reporter ¶1484.04; TaxDesk ¶158,013.