On July 18, 2016, the Treasury Department published final regulations (the “Final Regulations”) on arbitrage restrictions under section 148 of the Internal Revenue Code of 1986, as amended (the “Code”). The Final Regulations amend proposed regulations (the “Proposed Regulations”) published on September 26, 2007 and September 16, 2013, and prior existing final regulations under Code Section 148 (the “Prior Regulations”). The Final Regulations address several arbitrage topics that affect issuers of tax‐exempt and other tax‐advantaged bonds, including the topics summarized below. These topics have occasionally been referred to in the past as “non‐issue price” topics. The Final Regulations notably do not provide updated guidance concerning the definition of “issue price,” which continues to be a debated topic and the subject of separate proposed regulations that were published on June 24, 2015.

Working Capital Financing Provisions

Temporary Period Spending Exception to Yield Restriction. The Final Regulations provide a new 13‐month temporary period for investment of bond proceeds for all working capital financings, not just restricted working capital financings. The temporary period is applicable only to proceeds reasonably expected to be allocated to working capital expenditures within 13 months after the issue date.

Anti‐Abuse Factors and Safe Harbors for Working Capital Financings. Working capital financings are viewed by the Internal Revenue Service as very susceptible to the creation of abuses or replacement proceeds. However, the Final Regulations expand the factors listed in the anti‐abuse rules that may be used to justify a working capital bond maturity in excess of 13 months to include the need to finance extraordinary working capital items or an issuer’s long‐term financial distress. This expansion is intended to permit the issuance of long‐term working capital to meet those needs.

The Final Regulations also provide the following two safe harbor exceptions to the creation of replacement proceeds:

• Short‐term Safe Harbor. The regulations shorten the bond maturity necessary to satisfy a safe harbor exception from creation of replacement proceeds for all short‐term working capital financings from two years to 13 months in order to conform to the permitted temporary investment period for working capital expenditures described above.

• Long‐term Safe Harbor. The regulations provide a safe harbor for long‐term working capital financings (and their refundings) if the issuer generally: (1) determines the first year in which it expects to have available amounts for working capital expenditures; (2) monitors for actual available amounts in each year beginning with the year it first expects to have such amounts; and (3) applies such available amounts in each year either to redeem or to invest in (or some combination of redeeming and investing in) certain tax‐exempt bonds (eligible tax‐exempt bonds). The safe harbor would require any amounts invested in eligible tax‐exempt bonds to be invested (or reinvested) continuously, so long as the bonds using the safe harbor remain outstanding. In addition to these general requirements, the long‐term safe harbor has a number of specific definitions and administrative requirements that must be applied and met.

Prior to the Final Regulations, a number of work outs for financially distressed issuers had been the subject of private letter rulings which sanctioned long‐term working capital borrowings with limits on maturity and redemption requirements. The Final Regulations appear to give workable guidance on how such financings may be structured to ensure their tax‐exempt status.

The Final Regulations also remove the restriction against financing a working capital reserve. This should greatly simplify how short‐term working capital financings are sized.

Other than described above, the Preamble to the Final Regulations (the “Preamble”) states that the regulations expressly do not (a) add a new safe harbor to prevent the creation of replacement proceeds specifically for grants and extraordinary working capital financings, (b) redefine “extraordinary working capital” or (3) add new rules for using proceeds to fund working capital reserves. It is not clear from the Preamble whether these points will be the subject of future regulations.

Arbitrage Rebate Rules

Arbitrage Rebate Computation Credit. The Prior Regulations allow an issuer to take a credit against payment of arbitrage rebate to offset at least a portion of the cost of computing rebate. The Final Regulations provide for the amount of this credit to increase based on inflation, using the Consumer Price Index as a guide.

Recovery of Overpayment of Rebate. An example in the Prior Regulations suggested that the calculation of an arbitrage rebate refund could be made by future valuing the payments actually made to the federal government as of a computation date and subtracting the rebate amount that would have been due. The Treasury Department has concluded that the example is contrary to the language of the regulations and, in the Final Regulations, modifies the example to clarify that the calculation of the refund amount should be made without future valuing actual payments. Permitting the future valuing of such payments would have effectively required the federal government to pay interest on arbitrage rebate overpayments, which the Treasury Department believes is contrary to its statutory authority.

Yield on an Issue of Bonds

Joint Bond Yield Authority. The Prior Regulations permitted issuers of qualified mortgage bonds or qualified student loan bonds to request rulings from the Internal Revenue Service to combine two or more issues for purposes of computing a joint bond yield. The Final Regulations eliminate this joint bond yield authority, in part because of its limited application and the factual nature in which a joint bond yield may be appropriate.

Modification of Yield Computation for Yield‐to‐Call Premium Bonds. For yield‐to‐call premium bonds, the Final Regulations simplify yield calculations and focus on the redemption date that results in the lowest yield for a particular premium bond instead of focusing on the lowest yield for an issue.

Qualified Hedges

Cost‐of‐Funds and Taxable Index Hedges. The Final Regulations clarify that a cost‐of‐funds hedge may constitute as a qualified hedge. While taxable index hedges may be integrated, they are generally not capable of super integration unless the bond rate and the off‐setting hedge rate are identical.

Size and Scope of a Qualified Hedge. The size and scope of a qualified hedge is limited under the Final Regulations to a level that is reasonably necessary to hedge the issuer’s risk with respect to interest rate changes on hedged bonds. Such limitation applies to anticipatory hedges based on the reasonably expected terms of the hedged bonds to be issued.

Correspondence of Payments for Simple Integration. The Prior Regulations have always required that, in order for a hedge to be a qualified hedge, the payments under the hedge must correspond closely in time to the specific bond payments being hedged. The Final Regulations treat payments as corresponding closely in time if they are made within 90 days of each other. This represents a liberalization from the Proposed Regulations that required a 60‐day correspondence.

Identification of Qualified Hedges. Under the Final Regulations, in order for a hedge to be identified as a qualified hedge, the identification must take place by the issuer within 15 days from the date on which the parties entered into a binding agreement to enter into such hedge. This is a marked improvement from the three‐day rule of the Prior Regulations.

A new requirement added to the hedge identification process is a certificate from the hedge provider. Such certification must (1) provide that the terms of the hedge were agreed to between a willing buyer and a willing seller in a bona fide, arm’s‐length transaction, (2) provide that the hedge provider has not made, and does not expect to make, any payment to any third party for the benefit of the issuer in connection with the hedge, except for any such third‐party payment that the hedge provider expressly identifies in the documents for the hedge, (3) provide that the amounts payable to the hedge provider pursuant to the hedge do not include any payments for underwriting or other services unrelated to the hedge provider’s obligations under the hedge, except for any such payment that the hedge provider expressly identifies in the documents for the hedge, and (4) contain any other statements that the Commissioner may provide in guidance published in the Internal Revenue Bulletin. It remains to be seen whether the traditional hedge providers who make no such statements in the normal course of their business will balk at making such certifications.

Modifications to Qualified Hedges. A hedge will be considered terminated if it is modified and the modification is material under Code Section 1001. However, the Final Regulations create an exception if the modified hedge is itself a qualified hedge disregarding any off‐market value of the existing hedge at the time of modification. The identification requirement with respect to such exception applies by measuring the time period for identification from the date of modification and without regard to the requirement for a hedge provider’s certification.

Continuations of Qualified Hedges in Connection with Refundings. An existing qualified hedge for refunded bonds that is not terminated in connection with the refunding will be treated as continuing as a qualified hedge for the refunding bonds if the hedge meets the requirements of a qualified hedge for the refunding bonds as of the issue date of the refunding bonds. In determining whether the hedge is a qualified hedge for the refunding bonds, the fact that the hedge is off‐market as of the issue date of the refunding bonds is disregarded. The identification requirement applies by measuring the time period for identification from the issue date of the refunding bonds and without regard to the requirement for a hedge provider’s certification.

Termination of Hedges at Fair Market Value. The Final Regulations provide that the amount of a termination payment that may be taken into account for arbitrage purposes is the fair market value of the qualified hedge on the termination date, based on all of the facts and circumstances.

Yield and Valuation of Investments

Yield Reduction Payment Rules. The Final Regulations expand the availability of yield reduction payments to include circumstances when SLGS are not available, for qualified student loans (previously limited to loans under the FFELP program) and qualified mortgage loans, and for proceeds of a hedged variable yield advance refunding issue.

Valuation of Investments. With respect to the valuation of investments, the Prior Regulations, and in particular Regulation Section 1.148‐5(d), have long been a source of consternation and befuddlement, largely because of their perceived circularity. While not entirely tackling this longstanding confusion, the Final Regulations address this problem by excepting from the mandatory fair market valuation investments that transfer to another issue from an issue that is exclusively tax‐exempt as a result of a refunding or the application of the universal cap, even if the issue to which they transfer is taxable.

The Final Regulations also make a long awaited distinction between purpose and nonpurpose investment valuations. Recognizing in the Preamble that purpose investments are intended to pass on the benefits of the lower borrowing costs of tax‐exempt bond financing to the eligible beneficiaries (e.g., low rate mortgage loans to first‐time homebuyers), the Final Regulations clarify that purpose investments are valued at their present value and nonpurpose investments are valued at fair market value.

Fair Market Value of Treasury Obligations. There was a time when United States Treasury Certificates of Indebtedness, Notes and Bonds—State and Local Government Series (SLGS), which were purchased at par, could be redeemed at par, and the regulations dating back to 1979 have provided that SLGS are to be valued at their purchase price. The formula used to determine the redemption price of SLGS has changed several times and currently is based on a daily estimate of the comparable price of open market Treasuries. The Final Regulations change prior law and treat the purchase price as a SLGS’ fair market value on its purchase date, but use the SLGS’ redemption price as a proxy for fair market value thereafter.

Guaranteed Investment Contracts. In determining the yield on guaranteed investment contracts, the Prior Regulations provided a safe harbor that did not recognize the common use of electronic bidding procedures. The Final Regulations provide that the requirement that bids be “in writing” may be satisfied by being in electronic form including email and internet‐based websites.

External Commingled Investment Funds. The Final Regulations expand and liberalize the class of investors in an external commingled fund to allow additional “smaller investors” to participate.

Definition of Issue

The Prior Regulations did not contemplate the issuance of bonds that provide tax benefits other than tax exemption of interest. With the advent of such types of bonds, clarification was needed to understand how such bonds relate to tax‐exempt bonds. To provide guidance, the Final Regulations introduce the term “tax‐advantaged bonds.” A tax‐advantaged bond includes a tax‐exempt bond, a tax credit bond (e.g., a qualified energy conservation bond), a bond that provides refundable tax credits to issuers (e.g., a build America bond for which an election is made under section 6431 of the Code), and any similar bond that provides a federal tax benefit that reduces an issuer’s borrowing costs. The Final Regulations also provide that each type of tax‐advantaged bond that has a different structure for delivery of the tax benefit or different program eligibility requirements is treated as a different issue for federal income tax purposes. Additionally, tax‐advantaged bonds and bonds that are not tax‐advantaged are treated as different issues.

Definition and Treatment of Grants

The Prior Regulations provide that grants which are funded from bond proceeds are deemed spent for arbitrage purposes at the time that the grant is made to the grantee. This has raised certain issues relating to the use of the grant monies by the grantee, and whether such uses impact the tax‐exemption of the bonds that were the source of the grants. The Final Regulations now define “grants” for all purposes relating to tax‐advantaged bonds. Under the Final Regulations, for certain tax purposes, the use of grant monies by the grantee is traced to determine whether those monies are applied to a proper purpose that is consistent with the requirements for tax‐exemption of the bonds that funded the grant monies. For example, the grant monies will be traced to determine whether bond proceeds are used for a private business use even though, for arbitrage purposes, the grant monies will be deemed spent at the time the grant is made to the grantee. Further, the use of grant proceeds by the grantee to make loans could cause the bonds to be considered private loan bonds.

Applicability Dates

The Final Regulations generally apply to bonds that are sold on and after October 16, 2016, which is 90 days after the Final Regulations were published in the Federal Register. Certain provisions relating to hedges on bonds apply to hedges that are entered into or modified on and after October 16, 2016. The Final Regulations also permit issuers to apply certain of the amended provisions to bonds sold before October 16, 2016.

Kutak Rock LLP

• The Final Regulations referred to in this notice are available online at https://goo.gl/evrVci
• The Proposed Regulations for 2007 are available online at https://goo.gl/x0tTyM
• The Proposed Regulations for 2013 are available online at https://goo.gl/bmK39n

This memorandum was prepared by the following attorneys of Kutak Rock. Questions, comments or corrections to this memorandum may be addressed to any attorney(s) listed below.

This memorandum was prepared for the general informational use of the clients and attorneys of Kutak Rock LLP and reflects our understanding of the matters set forth herein as of the time of its release. The views on the topics presented may change as our experience with the matters discussed herein deepens.