Arbitrage & Related Restrictions Applicable to Tax-exempt
Bonds Issued by State & Local Governments, Investment-Type Property

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-113526-98] RIN 1545-AW44

TITLE: Arbitrage and Related Restrictions Applicable to Tax-exempt
Bonds Issued by State and Local Governments, Investment-Type
Property

AGENCY: Internal Revenue Service (IRS), Treasury.

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

SUMMARY: This document contains proposed regulations on the
arbitrage and related restrictions applicable to tax-exempt bonds
issued by State and local governments. The proposed amendments
affect issuers of tax-exempt bonds and provide guidance on the
definition of investment-type property to help issuers comply with
the arbitrage and related restrictions.

DATES: Written comments must be received by December 23, 1999.

Outlines of topics to be discussed at the public hearing scheduled
for January 12, 2000, at 10 a.m. must be received by December 15,
1999.

ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-113526-98), room
5226, 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 5 p.m. to
CC:DOM:CORP:R (REG-113526-98), Courier's Desk, Internal Revenue
Service, 1111 Constitution Avenue, NW., Washington, DC.

Alternatively, taxpayers may submit comments electronically via the
Internet by selecting the A Tax Regs @ option on the IRS Home Page,
or by submitting comments directly to the IRS site at
http://www.irs.ustreas.gov/tax_regs/regslist.html. The public
hearing is in room 2615, Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed
regulations, Barbara Jane League, (202) 622-3980; concerning
submissions of comments, the hearing, and/or requests to be placed
on the building access list to attend the hearing, LaNita Van Dyke,
(202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 148 of the Internal Revenue Code provides rules addressing
the use of proceeds of tax-exempt State and local bonds to acquire
higher-yielding investments. On June 18, 1993, final regulations (TD
8476) relating to the arbitrage restrictions and related rules under
sections 103, 148, 149, and 150 were published in the Federal
Register (58 FR 33510).

Corrections to these regulations were published in the Federal
Register on August 23, 1993 (58 FR 44451), May 11, 1994 (59 FR
24350), and July 9, 1999 (64 FR 37037). On May 9, 1997, additional
final regulations (TD 8718) relating to the arbitrage restrictions
and related rules under sections 103, 148, 149, and 150 were
published in the Federal Register (62 FR 25502). This document
proposes to modify �1.148-1(e) to clarify which prepayments are
investment-type property under section.3 148(b)(2)(D).

Explanation of Provisions

The current regulations, at �1.148-1(e)(2), provide that prepayments
for property or services give rise to investment-type property if a
principal purpose for prepaying is to obtain an investment return
from the time that the payment is made until the time that payment
otherwise would be made. A prepayment does not give rise to
investment-type property if (1) the prepayment is made for a
substantial business purpose other than investment return and the
issuer has no commercially reasonable alternative to the prepayment,
or (2) prepayments on substantially the same terms are made by a
substantial percentage of persons who are similarly situated to the
issuer but who are not beneficiaries of tax-exempt financing.

Recently, an issue arose about whether investment-type property
includes the prepayment of a contract for property or services after
the date that the contract is entered into. In City of Columbus v.
Commissioner, 112 F.3d 1201 (D.C. Cir. 1997), the court held that a
prepayment for property cannot occur after the property is acquired.
The court's holding suggests that an issuer could avoid investment-
type property by entering into a contract for property or services
and, at a later date, prepaying that contract. This result is
inconsistent with the intent of section 148. The legislative history
indicates that Congress intended that the arbitrage rules apply
broadly. For example, the Conference Report to the Tax Reform Act of
1986 provides that investment property includes the acquisition of
any property held for investment (other than another tax-exempt
bond). H.R. Conf.

Rep. No. 841, 99 Cong., 2d Sess. II-747, 1986-3 C.B. (Vol.4) th 747.

This document proposes modifications to the regulations to establish
that prepayments that give rise to investment-type property can
occur after the contract for property or services is entered into
and to make other non-substantive, clarifying changes. It is
intended that these regulations address only the potential issue
created by the City of Columbus opinion as noted above. Comments are
requested on whether the affect of the changes proposed in this
document is broader than intended.

In addition to comments on the proposed regulations, comments are
requested on whether additional guidance is needed to clarify other
aspects of the investment-type property definition. For example,
comments are requested on whether clarification is needed on which
prepayments of an obligation will be treated as a prepayment for
property or services that gives rise to investment-type property,
and whether a contract under which property or services are to be
provided over time and the payments for those property or services
are to be made over time gives rise to investment-type property when
the payment schedule does not match the schedule for the provision
of the property or services.

Finally, Treasury and the IRS have become aware of certain
transactions involving prepayments for the purchase of a commodity.
In these transactions, an issuer generally enters into a long-term
contract with a supplier (for example, a natural gas supply company)
to supply over a number of years a fixed amount of the commodity to
the issuer at a fixed price (the A supply contract @ ).

In return, the issuer makes a single lump-sum prepayment for the
commodity to the supplier. The prepayment is financed through the
issuance of bonds. The amount of the prepayment is determined in a
manner that permits the issuer to obtain an investment return from
the prepayment. The issuer also enters into other agreements,
including one or more swap agreements, that result in the issuer
converting substantially all of the issuer's cost for the commodity
under the supply contract into a variable cost that approximates the
then current price of the commodity when the issuer takes delivery.

Based on the information received, and viewing the transaction as a
whole, it appears that a principal purpose of the prepayment for the
supply contract was to earn an investment return. If so, the supply
contract is investment-type property unless the requirement of
�1.148-1(e)(2)(i) or (ii) are met.

Treasury and the IRS are concerned that the supply contract may be
investment-type property and request comments on these transactions.

The regulations, when finalized, will apply to bonds issued after a
date of applicability that will be set forth in the final
regulations. Treasury and the IRS have not yet determined such date
of applicability other than to have made the determination that the
date of applicability will not be before August 25, 1999. Treasury
and the IRS request comments as to the date of applicability of the
final regulations. No inference is intended as to the treatment of
bonds issued prior to the date of applicability of the final
regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 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, and, because the regulations do not impose a
collection of information on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does not apply. 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 electronic and written comments
(a signed original and eight (8) copies, if written) that are
submitted timely to the IRS. In particular, the IRS and Department
of Treasury specifically request comments on the clarity of the
proposed rule and how it may be made easier to understand. All
comments will be available for public inspection and copying.

A public hearing has been scheduled for Wednesday, January 12, 2000,
beginning at 10 a.m. in room 2615, Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC. Due to building security
procedures, visitors must enter at the 10 th Street entrance,
located between Constitution and Pennsylvania Avenues, NW. In
addition, all visitors must present photo identification to enter
the building. Because of access restrictions, visitors will not be
admitted beyond the immediate entrance area more than 15 minutes
before the hearing starts.

For information about having your name placed on the building access
list to attend the hearing, see the A 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 December 23, 1999, and submit an outline of the
topics to be discussed and the time to be devoted to each topic
(signed original and eight (8) copies) by December 15, 1999. A
period of 10 minutes will be allotted to each person for making
comments. An agenda showing the scheduling of 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.

Drafting Information The principal authors of these proposed
regulations are Rebecca L. Harrigal and Barbara Jane League, Office
of Assistant Chief Counsel (Financial Institutions and Products).
However, other personnel from the IRS and 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 1.148-1(e) is
amended as follows:

1. Paragraph (e)(1) is revised.

2. Paragraphs (e)(2) introductory text, (e)(2)(i) and (e)(2)(ii) are
redesignated as paragraphs (e)(2)(i) introductory text, (e)(2)(i)
(A), and (e)(2)(i)(B), respectively.

3. Paragraph (e)(2) the heading is revised.

4. Newly designated paragraph (e)(2)(i) introductory text is
revised.

5. New paragraph (e)(2)(ii) is added.

The revisions and addition read as follows:

�1.148-1 Definitions and elections.

* * * * *

(e) Investment-type property - (1) In general. Investment-type
property includes any property, other than property described in
section 148(b)(2)(A), (B),(C) or (E), that is held principally as a
passive vehicle for the production of income.

For this purpose, production of income includes any benefit based on
the time value of money.

(2) Prepayments. (i) Except as otherwise provided in this paragraph
(e), a prepayment for property or services, including a prepayment
of a contract for property or services that is made after the date
that the contract is entered into, also gives rise to investment-
type property if a principal purpose for prepaying is to receive an
investment return from the time the prepayment is made until the
time payment otherwise would be made. A prepayment does not give
rise to investment type property if- -*

* * * *

(ii) Example. The following example illustrates an application of
paragraph (e)(2)(i) of this section:

Example. In 1996, City A entered into a ten-year contract with
Company Y. Under the contract, Company Y is to provide services to
City A and in return City A will make fixed annual payments to
Company Y. In 1998, Company Y and City A agree that City A will
prepay its obligation under the contract. To finance the prepayment,
City A will issue bonds. The amount of the prepayment is determined
in a manner that permits City A to obtain an investment return from
the prepayment. A principal purpose for City A agreeing to make the
prepayment is to obtain an investment return from the time of the
prepayment until the time payment otherwise would be made. The
prepayment is not made for a substantial business purpose other than
to obtain the investment return and City A had a commercially
reasonably alternative to the prepayment. In addition, prepayments
on substantially the same terms are not made by a substantial
percentage of persons who are similarly situated to City A but who
are not beneficiaries of tax-exempt financing. When the prepayment
is made, City A will have acquired investment-type property. It does
not matter that the prepayment occurred after the date that the
contract was entered into.

* * * * *

Deputy Commissioner of Internal Revenue.DATE: August 24, 1999
REG-113526-98 (Notice of proposed rulemaking) was forwarded to the
Office of the Federal Register on August 18, 1999.

The filing time was 8:45 a.m. on August 24, 1999.

The publication date is set for August 25, 1999.

FROM: CC:DOM:FI&P

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