IRS Issues Final Yield Burning Regs

Article excerpt

The Internal Revenue Service (IRS) issued final "yield burning" regulations (T.D.8801) last week, providing guidance for cities that refinance tax-exempt municipal bonds.

The new rules respond to efforts by NLC and other organizations representing state and local governments to provide clear guidance--or a safe harbor--that cities and towns can use to ensure they do not violate federal arbitrage rules when they invest bond proceeds in Treasury securities.

The U.S. Treasury estimates the rules will affect nearly 1,500 cities and towns on an annual basis.

While responsive to municipal concerns, and a significant improvement over the proposed regulations issued in June of 1996, the rules are prospective and provide little, clear relief to the dozens cities already targeted by the IRS. These cities refinanced general obligation and other municipal bonds prior to 1999--most in the early years of the decade when interest rates dropped so sharply. For these cities and towns, the IRS and Treasury continue to maintain that they have the authority to pursue, audit, and take action against them--even when the IRS believes the city is as much a victim as the federal government.

In general, in order for a city's bond issuance to be protected, the city needs to:

* obtain three bona fide bids for its escrow securities,

* determine that the investments or Treasury securities purchased cost less than a portfolio of SLGS or Treasury Department State and Local Government Series securities, and

* pay broker's fees less than $10,000 or .1 percent of the initial principal amount of the investments purchased for the escrow.

The final rules replace the proposed "rebuttable presumption" that cities and states made legitimate deals on refinancings with a set of clear steps which, if taken, guarantee that a city will be in compliance. The rules mark the first time there has been clear guidance from the IRS in this complex area of municipal finance.

The regulations are aimed at putting a stop to what the IRS and Securities and Exchange Commission (SEC) term "yield burning." The two federal agencies believe this occurs when a city, as part of an advance refunding, or refinancing tax-exempt debt before the first call date of the original tax-exempt bonds, invests the proceeds of the new municipal tax-exempt bonds in U. …