Arbitrage Regulations
The applicable sections of the Internal Revenue Service’s Arbitrage Regulations relating to the investment of bond proceeds in a derivative security are detailed at 26 CFR § 1.148-0 to § 1.148-6.
Section 1.148-0 details the scope of the regulations and table of contents. “Section 148 restricts the direct and indirect investment of bond proceeds in higher yielding investments and requires that certain earnings on higher yielding investments be rebated to the United States. Violation of these provisions causes the bonds in the issue to become arbitrage bonds, the interest on which is not excludable from the gross income of the owners under section 103(a).”
Section 1.148-1 details the definitions used throughout the regulations. Terms such as guaranteed investment contract, rebate amount, proceeds and replacement proceeds are all defined in this section. For the purposes of derivative investments, the definitions of yield, both of the issue and the investment as well as the method for accounting are included in this section.
Section 1.148-2 contains the general arbitrage yield restriction rules. Within this section is delineated the requirements that an issuer act and certify that it is acting pursuant to reasonable expectations. The issuer is required to certify that it will do nothing to cause the bond proceeds to be invested for a profit. This section also imposes a time restriction on when the proceeds of municipal bonds must be spent.
Section 1.148-3 delineates the general arbitrage rebate rules. It imposes the very detailed accounting procedure a municipal bond issuer must follow in calculating the amount of profit it must forfeit to the federal government.
Section 1.148-4 sets forth the method of determining the yield on an issue of municipal bonds. It imposes upon the issuer a requirement that the valuation be done on a present value basis, covers certain hedging transactions and covers the procedure an issuer must follow if it issues floating rate bonds with floors and caps on interest rates.
Section 1.148-5 is the detailed regulations covering the yield and valuation of investments made with bond proceeds. This section imposes a requirement that all investments be combined and the cash flows amalgamated to produce a single investment and that investment must be valued on a present value basis at the yield of the bond issue sold. This section also contains the safe harbor provisions for the creation and valuation of the derivative security municipal bond issuers may purchase.
Section 1.148-6 is the regulation concerning the general allocation and accounting rules. This is a quite technical section involving universal caps on investments, allocation between and among various issues, and the accounting for earnings on a ratable basis.
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