The federal government views tax-exempt interest as a subsidy to state and local governments because it is foregoing the income tax revenue that otherwise would have to be paid on taxable interest earnings . As a result , both the Internal Revenue Code of 1986 , as amended ( the “ Code ”) and the Treasury Regulations promulgated thereunder ( the “ Regulations ”) set forth a number of rules meant to ensure that issuers are not , as section 1.148- 10 of the Treasury Regulations provides , “ issuing more bonds , issuing bonds earlier , or allowing bonds to remain outstanding longer than is otherwise reasonably necessary to accomplish the governmental purposes of the bonds , based on all the facts and circumstances .” One way that federal tax law seeks to curb these enumerated abuses is through various provisions that set forth “ spend-down ” requirements for proceeds ( including investment earnings ) of tax-exempt bonds that will be used for capital projects .
◊ Proceeds of bonds are generally “ spent ” on capital projects when they are paid to an unrelated third party .
Qualifications for Temporary Period
The Code and Regulations contain a number of rules relating to “ arbitrage ,” or the investment of tax-exempt proceeds in taxable investments . Generally , these rules require that an issuer restrict its investment of tax-exempt proceeds to a yield that is not materially higher than the yield on the bonds . In a positive arbitrage environment ( one in which investment yields are higher than the bond yield ), it can be administratively challenging for an issuer to manage its investments to remain in compliance with these rules .
Acknowledging this administrative burden , section 1.148-2 ( e )( 2 ) of the Regulations provides for a “ temporary period ” of 3 years ( the “ 3-year temporary period ”) for proceeds of tax-exempt bonds that are reasonably expected to be allocated to capital projects . During the 3-year temporary period , an issuer need not yield restrict such proceeds . To qualify for the 3-year temporary period , however , an issuer must reasonably expect to allocate at least 85 % of the sale proceeds to capital projects within 3 years from the issue date of the bonds . The issuer must also reasonably expect that the projects will proceed with due diligence and that , within 6 months of such issue date , the issuer will enter into a binding obligation with a third party to expend at least 5 % of the net sale proceeds .
If the issuer does not reasonably expect to meet these requirements , the bonds will not necessarily become taxable , but the issuer must more actively monitor and manage its investment yields .