WASHINGTON – The Treasury Department and Internal Revenue Service are taking action to further the Trump administration’s infrastructure initiatives by clarifying that their arbitrage restrictions on “investment-type property” exclude investments in bond-financed capital projects.

The clarification would mean that if a state or local government pension fund, for example, wanted to invest in a tax-exempt bond-financed highway project then the outstanding bonds or any bonds issued in the future for the project would not be considered as taxable arbitrage bonds.

The Notice of Proposed Rulemaking [REG-106977-18] by the agencies, released on Monday, states that the proposed clarification can be relied upon immediately even though it will not formally take effect until 90 days after the Treasury publishes final rules in the Federal Register.

Meanwhile, the Treasury and IRS have asked that comments and requests for a public hearing on the proposed rules be submitted to them by Sept. 18.

A Treasury official and former IRS official explained the significance of the proposed rules.

“This is a clarification of original legislative intent that’s intended to facilitate investment in public infrastructure,” said John Cross, Treasury associate tax legislative counsel.

Vicky Tsilas has rejoined Ballard Spahr after serving as head of branch 5 in the IRS chief counsel’s office.
Vicky Tsilas, a partner with Ballard Spahr and former chief of Branch 5 of the IRS Office of Associate Chief Counsel for Financial Institutions and Products Brian Tumulty, The Bond Buyer

“This addresses concerns that some investors had about how you define ‘investment-type property’ and it makes it easier to invest in bond-financed facilities,” said Vicky Tsilas, a partner with Ballard Spahr and former chief of Branch 5 of the IRS Office of Associate Chief Counsel for Financial Institutions and Products who worked on the proposal.

Municipal market participants are pleased with the proposal.

“Along with the recent changes to the remedial action rules and the changes to the rules for management contracts, today’s guidance is another positive step by Treasury and the IRS towards facilitating the use of tax-exempt bonds in connection with public-private partnership projects,” said Mitch Rapaport, a partner at Nixon Peabody here.

"IRS and Treasury should be congratulated on the speed and efficiency with which they remedied a gaping hole in the existing arbitrage regulations," said Dave Caprera, a lawyer at Kutak Rock in Denver. "Almost 25 years to the day from when the final arbitrage regulations were issued, the IRS released propsed regulations which would add not one, but two, totally inconsequential and entirely obvious sentences clarifying that state and local governments will not be considered to have acquired investment property when they finance a courthouse."

The Notice of Proposed Rulemaking explained the genesis of the proposal. “Institutional investors have suggested clarification of the scope of the regulatory definition of investment-type property under §1.148-1(e)(1) to ensure that the definition does not impede greater capital investment in public infrastructure,” it stated.

Tax rules generally prohibit the proceeds of tax-exempt bonds from being invested in higher-yielding securities or investments and require issuers or other borrowers to rebate any excess earnings to the federal government. The rules say that bonds are taxable arbitrage bonds if the proceeds are reasonably expected to be used, or intentionally used, to acquire “higher yielding investments.”

The term higher yielding investments is defined to include certain securities, obligations, annuity contracts, residential real property for family units located out of the jurisdiction of the issuer financed with bonds other than private activity bonds, and any “investment-type property.”

Investment-type property is defined to include any property that, in part, “is held principally as a passive vehicle for the production of income.” The production of income includes any benefit based on the time value of money, according to the tax rules.

This definition gave institutional investors pause when considering investing in tax-exempt bond financed infrastructure projects. State and local pension funds were especially concerned because Congress made clear in the Tax Reform Act of 1986 that it did not want public pension funds to be involved in the issuance of tax-exempt bonds, sources said.

The Notice of Proposed Rulemaking said the 1986 act made clear that Congress’ intent was that the definition of investment-type property not extend to investments in capital projects in furtherance of the public purposes of the bonds. In fact, the House report on the act said: “This restriction would not apply … to real or tangible personal property acquired with bond proceeds for reasons other than investment (e.g. courthouse facilities financed with bond proceeds).”

The notice proposed “an express exception to the definition of investment-type property for capital projects that further the public purposes for which the tax-exempt bonds were issued.”

The agencies added, “For example, investment-type property does not include a courthouse financed with governmental bonds or an eligible exempt facility under section 142 [of the Internal Revenue Code], such as a public road, financed with private activity bonds.”

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