[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2017 Edition]
[From the U.S. Government Publishing Office]



[[Page i]]

          

          Title 26

Internal Revenue


________________________

Part 1 (Secs. 1.140 to 1.169)

                         Revised as of April 1, 2017

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2017
                    Published by the Office of the Federal Register 
                    National Archives and Records Administration as a 
                    Special Edition of the Federal Register

[[Page ii]]

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[[Page iii]]




                            Table of Contents



                                                                    Page
  Explanation.................................................       v

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury (Continued)                                   3
  Finding Aids:
      Table of CFR Titles and Chapters........................     625
      Alphabetical List of Agencies Appearing in the CFR......     645
      Table of OMB Control Numbers............................     655
      List of CFR Sections Affected...........................     673

[[Page iv]]


      


                     ----------------------------

                     Cite this Code:  CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus, 26 CFR 1.141-0 
                       refers to title 26, part 
                       1, section 141-0.

                     ----------------------------

[[Page v]]



                               EXPLANATION

    The Code of Federal Regulations is a codification of the general and 
permanent rules published in the Federal Register by the Executive 
departments and agencies of the Federal Government. The Code is divided 
into 50 titles which represent broad areas subject to Federal 
regulation. Each title is divided into chapters which usually bear the 
name of the issuing agency. Each chapter is further subdivided into 
parts covering specific regulatory areas.
    Each volume of the Code is revised at least once each calendar year 
and issued on a quarterly basis approximately as follows:

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1

    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    The contents of the Federal Register are required to be judicially 
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie 
evidence of the text of the original documents (44 U.S.C. 1510).

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2017), consult the ``List of CFR 
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
List of Parts Affected,'' which appears in the Reader Aids section of 
the daily Federal Register. These two lists will identify the Federal 
Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

    Each volume of the Code contains amendments published in the Federal 
Register since the last revision of that volume of the Code. Source 
citations for the regulations are referred to by volume number and page 
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inserted following the text.

OMB CONTROL NUMBERS

    The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires 
Federal agencies to display an OMB control number with their information 
collection request.

[[Page vi]]

Many agencies have begun publishing numerous OMB control numbers as 
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PAST PROVISIONS OF THE CODE

    Provisions of the Code that are no longer in force and effect as of 
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for 1949-1963, 1964-1972, 1973-1985, and 1986-2000.

``[RESERVED]'' TERMINOLOGY

    The term ``[Reserved]'' is used as a place holder within the Code of 
Federal Regulations. An agency may add regulatory information at a 
``[Reserved]'' location at any time. Occasionally ``[Reserved]'' is used 
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INCORPORATION BY REFERENCE

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This material, like any other properly issued regulation, has the force 
of law.
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Federal Register will approve an incorporation by reference only when 
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    (b) The matter incorporated is in fact available to the extent 
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alphabetical list of agencies publishing in the CFR are also included in 
this volume.

[[Page vii]]

    An index to the text of ``Title 3--The President'' is carried within 
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INQUIRIES

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    The e-CFR is a regularly updated, unofficial editorial compilation 
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available at www.ecfr.gov.

    Oliver A. Potts,
    Director,
    Office of the Federal Register.
    April 1, 2017.

                                
                                      
                            

  

[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty-two volumes. The 
contents of these volumes represent all current regulations issued by 
the Internal Revenue Service, Department of the Treasury, as of April 1, 
2017. The first fifteen volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Secs. 1.0-1.60; 
Secs. 1.61-1.139; Secs. 1.140-1.169; Secs. 1.170-1.300; Secs. 1.301-
1.400; Secs. 1.401-1.409; Secs. 1.410-1.440; Secs. 1.441-1.500; 
Secs. 1.501-1.640; Secs. 1.641-1.850; Secs. 1.851-1.907; Secs. 1.908-
1.1000; Secs. 1.1001-1.1400; Secs. 1.1401-1.1550; and Sec. 1.1551 to end 
of part 1. The sixteenth volume containing parts 2-29, includes the 
remainder of subchapter A and all of Subchapter B--Estate and Gift 
Taxes. The last six volumes contain parts 30-39 (Subchapter C--
Employment Taxes and Collection of Income Tax at Source); parts 40-49; 
parts 50-299 (Subchapter D--Miscellaneous Excise Taxes); parts 300-499 
(Subchapter F--Procedure and Administration); parts 500-599 (Subchapter 
G--Regulations under Tax Conventions); and part 600 to end (Subchapter 
H--Internal Revenue Practice).

    The OMB control numbers for Title 26 appear in Sec. 602.101 of this 
chapter. For the convenience of the user, Sec. 602.101 appears in the 
Finding Aids section of the volumes containing parts 1 to 599.

    For this volume, Cheryl E. Sirofchuck was Chief Editor. The Code of 
Federal Regulations publication program is under the direction of John 
Hyrum Martinez, assisted by Stephen J. Frattini.

[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




            (This book contains part 1, Secs. 1.140 to 1.169)

  --------------------------------------------------------------------
                                                                    Part

chapter i--Internal Revenue Service, Department of the 
  Treasury (Continued)......................................           1

[[Page 3]]



    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)




  --------------------------------------------------------------------


  Editorial Note: IRS published a document at 45 FR 6088, Jan. 25, 1980, 
deleting statutory sections from their regulations. In Chapter I cross-
references to the deleted material have been changed to the 
corresponding sections of the IRS Code of 1954 or to the appropriate 
regulations sections. When either such change produced a redundancy, the 
cross-reference has been deleted. For further explanation, see 45 FR 
20795, Mar. 31, 1980.

                  SUBCHAPTER A--INCOME TAX (CONTINUED)
Part                                                                Page
1               Income taxes (Continued)....................           5

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System, Alcohol and Tobacco Tax Regulations, and 
  Regulations Under Tax Conventions.
  Editorial Note: Treasury Decision 6091, 19 FR 5167, Aug. 17, 1954, 
provides in part as follows:
  Paragraph 1. All regulations (including all Treasury decisions) 
prescribed by, or under authority duly delegated by, the Secretary of 
the Treasury, or jointly by the Secretary and the Commissioner of 
Internal Revenue, or by the Commissioner of Internal Revenue with the 
approval of the Secretary of the Treasury, or jointly by the 
Commissioner of Internal Revenue and the Commissioner of Customs or the 
Commissioner of Narcotics with the approval of the Secretary of the 
Treasury, applicable under any provision of law in effect on the date of 
enactment of the Code, to the extent such provision of law is repealed 
by the Code, are hereby prescribed under and made applicable to the 
provisions of the Code corresponding to the provision of law so repealed 
insofar as any such regulation is not inconsistent with the Code. Such 
regulations shall become effective as regulations under the various 
provisions of the Code as of the dates the corresponding provisions of 
law are repealed by the Code, until superseded by regulations issued 
under the Code.
  Par. 2. With respect to any provision of the Code which depends for 
its application upon the promulgation of regulations or which is to be 
applied in such manner as may be prescribed by regulations, all 
instructions or rules in effect immediately prior to the enactment of 
the Code, to the extent such instructions or rules could be prescribed 
as regulations under authority of such provision of the Code, shall be 
applied as regulations under such provision insofar as such instructions 
or rules are not inconsistent with the Code. Such instructions or rules 
shall be applied as regulations under the applicable provision of the 
Code as of the date such provision takes effect.
  Par. 3. If any election made or other act done pursuant to any 
provision of the Internal Revenue Code of 1939 or prior internal revenue 
laws would (except for the enactment of the Code) be effective for any 
period subsequent to such enactment, and if corresponding provisions are 
contained in the Code, such election or other act shall be given the 
same effect under the corresponding provisions of the Code to the extent 
not inconsistent therewith. The term ``act'' includes, but is not 
limited to, an allocation, identification, declaration, agreement, 
option, waiver, relinquishment, or renunciation.
  Par. 4. The limits of the various internal revenue districts have not 
been changed by the enactment of the Code. Furthermore, delegations of 
authority made pursuant to the provisions of Reorganization Plan No. 26 
of 1950 and Reorganization Plan No. 1 of 1952 (as well as redelegations 
thereunder), including those governing the authority of the Commissioner 
of Internal Revenue, the Regional Commissioners of Internal Revenue, or 
the District Directors of Internal Revenue, are applicable to the 
provisions of the Code to the extent consistent therewith.

[[Page 5]]



                   SUBCHAPTER A_INCOME TAX (CONTINUED)





PART 1_INCOME TAXES (CONTINUED)--Table of Contents



Sec.
1.141-0  Table of contents.

          Tax Exemption Requirements for State and Local Bonds

1.141-1  Definitions and rules of general application.
1.141-2  Private activity bond tests.
1.141-3  Definition of private business use.
1.141-4  Private security or payment test.
1.141-5  Private loan financing test.
1.141-6  Allocation and accounting rules.
1.141-7  Special rules for output facilities.
1.141-8  $15 million limitation for output facilities.
1.141-9  Unrelated or disproportionate use test.
1.141-10  Coordination with volume cap. [Reserved]
1.141-11  Acquisition of nongovernmental output property. [Reserved]
1.141-12  Remedial actions.
1.141-13  Refunding issues.
1.141-14  Anti-abuse rules.
1.141-15  Effective/applicability dates.
1.141-16  Effective dates for qualified private activity bond 
          provisions.
1.142-0  Table of contents.
1.142-1  Exempt facility bonds.
1.142-2  Remedial actions.
1.142-3  Refunding issues. [Reserved]
1.142-4  Use of proceeds to provide a facility.
1.142(a)(5)-1  Exempt facility bonds: Sewage facilities.
1.142(a)(6)-1  Exempt facility bonds: solid waste disposal facilities.
1.142(f)(4)-1  Manner of making election to terminate tax-exempt bond 
          financing.
1.143(g)-1  Requirements related to arbitrage.
1.144-0  Table of contents.
1.144-1  Qualified small issue bonds, qualified student loan bonds, and 
          qualified redevelopment bonds.
1.144-2  Remedial actions.
1.144-3  Standard deduction for individuals choosing income averaging. 
          [Reserved]
1.145-0  Table of contents.
1.145-1  Qualified 501(c)(3) bonds.
1.145-2  Application of private activity bond regulations.
1.147-0  Table of contents.
1.147-1  Other requirements applicable to certain private activity 
          bonds.
1.147-2  Remedial actions.
1.147(b)-1  Bond maturity limitation--treatment of working capital.
1.148-0  Scope and table of contents.
1.148-1  Definitions and elections.
1.148-2  General arbitrage yield restriction rules.
1.148-3  General arbitrage rebate rules.
1.148-4  Yield on an issue of bonds.
1.148-5  Yield and valuation of investments.
1.148-6  General allocation and accounting rules.
1.148-7  Spending exceptions to the rebate requirement.
1.148-8  Small issuer exception to rebate requirement.
1.148-9  Arbitrage rules for refunding issues.
1.148-10  Anti-abuse rules and authority of Commissioner.
1.148-11  Effective/applicability dates.
1.149(b)-1  Federally guaranteed bonds.
1.149(d)-1  Limitations on advance refundings.
1.149(e)-1  Information reporting requirements for tax-exempt bonds.
1.149(g)-1  Hedge bonds.
1.150-1  Definitions.
1.150-2  Proceeds of bonds used for reimbursement.
1.150-4  Change in use of facilities financed with tax-exempt private 
          activity bonds.
1.150-5  Filing notices and elections.

   Regulations Applicable to Certain Bonds Sold Prior to July 8, 1997

1.148-1A  Definitions and elections.
1.148-2A  General arbitrage yield restriction rules.
1.148-3A  General arbitrage rebate rules.
1.148-4A  Yield on an issue of bonds.
1.148-5A  Yield and valuation of investments.
1.148-6A  General allocation and accounting rules.
1.148-9A  Arbitrage rules for refunding issues.
1.148-10A  Anti-abuse rules and authority of Commissioner.
1.148-11A  Effective dates.
1.149(d)-1A  Limitations on advance refundings.
1.150-1A  Definitions.

                   Deductions for Personal Exemptions

1.151-1  Deductions for personal exemptions.
1.151-2  Additional exemptions for dependents.
1.151-3  Definitions.
1.151-4  Amount of deduction for each exemption under section 151.
1.152-1  General definition of a dependent.
1.152-2  Rules relating to general definition of dependent.
1.152-3  Multiple support agreements.
1.152-4  Special rule for a child of divorced or separated parents or 
          parents who live apart.
1.153-1  Determination of marital status.

[[Page 6]]

1.154  Statutory provisions; cross references.

          Itemized Deductions for Individuals and Corporations

1.161-1  Allowance of deductions.
1.162-1  Business expenses.
1.162-2  Traveling expenses.
1.162-3  Materials and supplies.
1.162-4  Repairs.
1.162-5  Expenses for education.
1.162-7  Compensation for personal services.
1.162-8  Treatment of excessive compensation.
1.162-9  Bonuses to employees.
1.162-10  Certain employee benefits.
1.162-10T  Questions and answers relating to the deduction of employee 
          benefits under the Tax Reform Act of 1984; certain limits on 
          amounts deductible (temporary).
1.162-11  Rentals.
1.162-12  Expenses of farmers.
1.162-13  Depositors' guaranty fund.
1.162-14  Expenditures for advertising or promotion of good will.
1.162-15  Contributions, dues, etc.
1.162-16  Cross reference.
1.162-17  Reporting and substantiation of certain business expenses of 
          employees.
1.162-18  Illegal bribes and kickbacks.
1.162-19  Capital contributions to Federal National Mortgage 
          Association.
1.162-20  Expenditures attributable to lobbying, political campaigns, 
          attempts to influence legislation, etc., and certain 
          advertising.
1.162-21  Fines and penalties.
1.162-22  Treble damage payments under the antitrust laws.
1.162-24  Travel expenses of state legislators.
1.162-25  Deductions with respect to noncash fringe benefits.
1.162-25T  Deductions with respect to noncash fringe benefits 
          (temporary).
1.162-27  Certain employee remuneration in excess of $1,000,000.
1.162-28  Allocation of costs to lobbying activities.
1.162-29  Influencing legislation.
1.162-31  The $500,000 deduction limitation for remuneration provided by 
          certain health insurance providers.
1.162-32  Expenses paid or incurred for lodging when not traveling away 
          from home.
1.162(k)-1  Disallowance of deduction for reacquisition payments.
1.162(l)-1T  Deduction for health insurance costs of self-employed 
          individuals (temporary).
1.163-1  Interest deduction in general.
1.163-2  Installment purchases where interest charge is not separately 
          stated.
1.163-3  Deduction for discount on bond issued on or before May 27, 
          1969.
1.163-4  Deduction for original issue discount on certain obligations 
          issued after May 27, 1969. 1
1.163-5  Denial of interest deduction on certain obligations issued 
          after December 31, 1982, unless issued in registered form.
1.163-5T  Denial of interest deduction on certain obligations issued 
          after December 31, 1982, unless issued in registered form 
          (temporary).
1.163-6T  Reduction of deduction where section 25 credit taken 
          (temporary).
1.163-7  Deduction for OID on certain debt instruments.
1.163-8T  Allocation of interest expense among expenditures (temporary).
1.163-9T  Personal interest (temporary).
1.163-10T  Qualified residence interest (temporary).
1.163-11  Allocation of certain prepaid qualified mortgage insurance 
          premiums.
1.163-12  Deduction of original issue discount on instrument held by 
          related foreign person.
1.163-13  Treatment of bond issuance premium.
1.163(d)-1  Time and manner for making elections under the Omnibus 
          Budget Reconciliation Act of 1993 and the Jobs and Growth Tax 
          Relief Reconciliation Act of 2003.
1.164-1  Deduction for taxes.
1.164-2  Deduction denied in case of certain taxes.
1.164-3  Definitions and special rules.
1.164-4  Taxes for local benefits.
1.164-5  Certain retail sales taxes and gasoline taxes.
1.164-6  Apportionment of taxes on real property between seller and 
          purchaser.
1.164-7  Taxes of shareholder paid by corporation.
1.164-8  Payments for municipal services in atomic energy communities.
1.165-1  Losses.
1.165-2  Obsolescence of nondepreciable property.
1.165-3  Demolition of buildings.
1.165-4  Decline in value of stock.
1.165-5  Worthless securities.
1.165-6  Farming losses.
1.165-7  Casualty losses.
1.165-8  Theft losses.
1.165-9  Sale of residential property.
1.165-10  Wagering losses.
1.165-11  Election in respect of losses attributable to a disaster.
1.165-12  Denial of deduction for losses on registration-required 
          obligations not in registered form.
1.165-13T  Questions and answers relating to the treatment of losses on 
          certain straddle transactions entered into before the 
          effective date of the Economic Recovery Tax Act of 1981, under 
          section 108 of the Tax Reform Act of 1984 (temporary).
1.166-1  Bad debts.
1.166-2  Evidence of worthlessness.
1.166-3  Partial or total worthlessness.
1.166-4  Reserve for bad debts.

[[Page 7]]

1.166-5  Nonbusiness debts.
1.166-6  Sale of mortgaged or pledged property.
1.166-7  Worthless bonds issued by an individual.
1.166-8  Losses of guarantors, endorsers, and indemnitors incurred on 
          agreements made before January 1, 1976.
1.166-9  Losses of guarantors, endorsers, and indemnitors incurred, on 
          agreements made after December 31, 1975, in taxable years 
          beginning after such date.
1.166-10  Reserve for guaranteed debt obligations.
1.167(a)-1  Depreciation in general.
1.167(a)-2  Tangible property.
1.167(a)-3  Intangibles.
1.167(a)-4  Leased property.
1.167(a)-5  Apportionment of basis.
1.167(a)-5T  Application of section 1060 to section 167 (temporary).
1.167(a)-6  Depreciation in special cases.
1.167(a)-7  Accounting for depreciable property.
1.167(a)-8  Retirements.
1.167(a)-9  Obsolescence.
1.167(a)-10  When depreciation deduction is allowable.
1.167(a)-11  Depreciation based on class lives and asset depreciation 
          ranges for property placed in service after December 31, 1970.
1.167(a)-12  Depreciation based on class lives for property first placed 
          in service before January 1, 1971.
1.167(a)-13T  Certain elections for intangible property (temporary).
1.167(a)-14  Treatment of certain intangible property excluded from 
          section 197.
1.167(b)-0  Methods of computing depreciation.
1.167(b)-1  Straight line method.
1.167(b)-2  Declining balance method.
1.167(b)-3  Sum of the years-digits method.
1.167(b)-4  Other methods.
1.167(c)-1  Limitations on methods of computing depreciation under 
          section 167(b) (2), (3), and (4).
1.167(d)-1  Agreement as to useful life and rates of depreciation.
1.167(e)-1  Change in method.
1.167(f)-1  Reduction of salvage value taken into account for certain 
          personal property.
1.167(g)-1  Basis for depreciation.
1.167(h)-1  Life tenants and beneficiaries of trusts and estates.
1.167(i)-1  Depreciation of improvements in the case of mines, etc.
1.167(l)-1  Limitations on reasonable allowance in case of property of 
          certain public utilities.
1.167(l)-2  Public utility property; election as to post-1969 property 
          representing growth in capacity.
1.167(l)-3  Multiple regulation, asset acquisitions, reorganizations, 
          etc.
1.167(l)-4  Public utility property; election to use asset depreciation 
          range system.
1.167(m)-1  Class lives.
1.168-5  Special rules.
1.168(a)-1  Modified accelerated cost recovery system.
1.168(b)-1  Definitions.
1.168(d)-0  Table of contents for the applicable convention rules.
1.168(d)-1  Applicable conventions--half-year and mid-quarter 
          conventions.
1.168(f)(8)-1T  Safe-harbor lease information returns concerning 
          qualified mass commuting vehicles (temporary).
1.168(h)-1  Like-kind exchanges involving tax-exempt use property.
1.168(i)-0  Table of contents for the general asset account rules.
1.168(i)-1  General asset accounts.
1.168(i)-2  Lease term.
1.168(i)-3  Treatment of excess deferred income tax reserve upon 
          disposition of deregulated public utility property.
1.168(i)-4  Changes in use.
1.168(i)-5  Table of contents.
1.168(i)-6  Like-kind exchanges and involuntary conversions.
1.168(i)-7  Accounting for MACRS property.
1.168(i)-8  Dispositions of MACRS property.
1.168(j)-1T  Questions and answers concerning tax-exempt entity leasing 
          rules (temporary).
1.168(k)-0  Table of contents.
1.168(k)-1  Additional first year depreciation deduction.
1.168A-1  Amortization of emergency facilities; general rule.
1.168A-2  Election of amortization.
1.168A-3  Election to discontinue amortization.
1.168A-4  Definitions.
1.168A-5  Adjusted basis of emergency facility.
1.168A-6  Depreciation of portion of emergency facility not subject to 
          amortization.
1.168A-7  Payment by United States of unamortized cost of facility.
1.169-1  Amortization of pollution control facilities.
1.169-2  Definitions.
1.169-3  Amortizable basis.
1.169-4  Time and manner of making elections

    Authority: 26 U.S.C. 7805, unless otherwise noted.
    Section 1.148-0 through 1.148-11 also issued under 26 U.S.C. 148(i).
    Section 1.148-6 also issued under 26 U.S.C. 148 (f), (g), and (i).
    Section 1.149(b)-1 also issued under 26 U.S.C. 149(b)(3)(B) (v).
    Section 1.149(d)-1 also issued under 26 U.S.C. 149(d)(7).
    Section 1.149(e)-1 also issued under 26 U.S.C. 149(e).

[[Page 8]]

    Section 1.149(g)-1 also issued under 26 U.S.C. 149(g)(5).
    Section 1.150-4 also issued under 26 U.S.C. 150 (c)(5).
    Section 1.152-4 also issued under 26 U.S.C. 152(e).
    Section 1.162-24 also issued under 26 U.S.C. 162(h).
    Section 1.162(k)-1 is also issued under section 26 U.S.C. 162(k).
    Section 1.163-8T also issued under 26 U.S.C. 469(k)(4).
    Section 1.163-9T also issued under 26 U.S.C. 163(h)(3)(D).
    Section 1.163-11T is also issued under 26 U.S.C. 163(h).
    Section 1.165-12 also issued under 26 U.S.C. 165(j)(3).
    Section 1.166-10 also issued under 26 U.S.C. 166(f).
    Section 1.168(d)-1 also issued under 26 U.S.C. 168(d)(3).
    Section 1.168(f)(8)-1T also added under sec. 112(c), Black Lung 
Benefits Revenue Act of 1981 (Pub. L. 97-119).
    Section 1.168(h)-1 also issued under 26 U.S.C. 168.
    Section 1.168(i)-1 also issued under 26 U.S.C. 168(i)(4).
    Section 1.168(i)-1T also issued under 26 U.S.C. 168(i)(4).
    Section 1.168(i)-2 also issued under 26 U.S.C. 168.
    Section 1.168(i)-4 also issued under 26 U.S.C. 168(i)(5).
    Section 1.168(j)-1T also added under 26 U.S.C. 168(j)(10).

    Source: T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 
1960, unless otherwise noted.



Sec. 1.141-0  Table of contents.

    This section lists the captioned paragraphs contained in 
Secs. 1.141-1 through 1.141-16.

       Sec. 1.141-1  Definitions and rules of general application.

    (a) In general.
    (b) Certain general definitions.
    (c) Elections.
    (d) Related parties.
    (e) Partnerships.

               Sec. 1.141-2  Private activity bond tests.

    (a) Overview.
    (b) Scope.
    (c) General definition of private activity bond.
    (d) Reasonable expectations and deliberate actions.
    (1) In general.
    (2) Reasonable expectations test.
    (3) Deliberate action defined.
    (4) Special rule for dispositions of personal property in the 
ordinary course of an established governmental program.
    (5) Special rule for general obligation bond programs that finance a 
large number of separate purposes.
    (e) When a deliberate action occurs.
    (f) Certain remedial actions.
    (g) Examples.

            Sec. 1.141-3  Definition of private business use.

    (a) General rule.
    (1) In general.
    (2) Indirect use.
    (3) Aggregation of private business use.
    (b) Types of private business use arrangements.
    (1) In general.
    (2) Ownership.
    (3) Leases.
    (4) Management contracts.
    (5) Output contracts.
    (6) Research agreements.
    (7) Other actual or beneficial use.
    (c) Exception for general public use.
    (1) In general.
    (2) Use on the same basis.
    (3) Long-term arrangements not treated as general public use.
    (4) Relation to other use.
    (d) Other exceptions.
    (1) Agents.
    (2) Use incidental to financing arrangements.
    (3) Exceptions for arrangements other than arrangements resulting in 
ownership of financed property by a nongovernmental person.
    (4) Temporary use by developers.
    (5) Incidental use.
    (6) Qualified improvements.
    (e) Special rule for tax assessment bonds.
    (f) Examples.
    (g) Measurement of private business use.
    (1) In general.
    (2) Measurement period.
    (3) Determining average percentage of private business use.
    (4) Determining the average amount of private business use for a 1-
year period.
    (5) Common areas.
    (6) Allocation of neutral costs.
    (7) Commencement of measurement of private business use.
    (8) Examples.

             Sec. 1.141-4  Private security or payment test.

    (a) General rule.
    (1) Private security or payment.
    (2) Aggregation of private payments and security.
    (3) Underlying arrangement.
    (b) Measurement of private payments and security.
    (1) Scope.
    (2) Present value measurement.

[[Page 9]]

    (c) Private payments.
    (1) In general.
    (2) Payments taken into account.
    (3) Allocation of payments.
    (d) Private security.
    (1) In general.
    (2) Security taken into account.
    (3) Pledge of unexpended proceeds.
    (4) Secured by any interest in property or payments.
    (5) Payments in respect of property.
    (6) Allocation of security among issues.
    (e) Generally applicable taxes.
    (1) General rule.
    (2) Definition of generally applicable taxes.
    (3) Special charges.
    (4) Manner of determination and collection.
    (5) Payments in lieu of taxes.
    (f) Certain waste remediation bonds.
    (1) Scope.
    (2) Persons that are not private users.
    (3) Persons that are private users.
    (g) Examples.

               Sec. 1.141-5  Private loan financing test.

    (a) In general.
    (b) Measurement of test.
    (c) Definition of private loan.
    (1) In general.
    (2) Application only to purpose investments.
    (3) Grants.
    (4) Hazardous waste remediation bonds.
    (d) Tax assessment loan exception.
    (1) General rule.
    (2) Tax assessment loan defined.
    (3) Mandatory tax or other assessment.
    (4) Specific essential governmental function.
    (5) Equal basis requirement.
    (6) Coordination with private business tests.
    (e) Examples.

             Sec. 1.141-6  Allocation and accounting rules.

    (a) Allocation of proceeds to expenditures, projects, and uses in 
general.
    (1) Allocations to expenditures.
    (2) Allocations of sources to a project and its uses.
    (3) Definition of project.
    (b) Special allocation rules for eligible mixed-use projects.
    (1) In general.
    (2) Definition of eligible mixed-use project.
    (3) Definition of qualified equity.
    (4) Same plan of financing.
    (c) Allocations of private payments.
    (d) Allocations of proceeds to common costs of an issue.
    (e) Allocations of proceeds to bonds.
    (f) Examples.

           Sec. 1.141-7  Special rules for output facilities.

    (a) Overview.
    (b) Definitions.
    (1) Available output.
    (2) Measurement period.
    (3) Sale at wholesale.
    (4) Take contract and take or pay contract.
    (5) Requirements contract.
    (6) Nonqualified amount.
    (c) Output contracts.
    (1) General rule.
    (2) Take contract or take or pay contract.
    (3) Requirements contract.
    (4) Output contract properly characterized as a lease.
    (d) Measurement of private business use.
    (e) Measurement of private security or payment.
    (f) Exceptions for certain contracts.
    (1) Small purchases of output.
    (2) Swapping and pooling arrangements.
    (3) Short-term output contracts.
    (4) Certain conduit parties disregarded.
    (g) Special rules for electric output facilities used to provide 
open access.
    (1) Operation of transmission facilities by nongovernmental persons.
    (2) Certain use by nongovernmental persons under output contracts.
    (3) Ancillary services.
    (4) Exceptions to deliberate action rules.
    (5) Additional transactions as permitted by the Commissioner.
    (h) Allocations of output facilities and systems.
    (1) Facts and circumstances analysis.
    (2) Illustrations.
    (3) Transmission and distribution contracts.
    (4) Allocation of payments.
    (i) Examples.

       Sec. 1.141-8  $15 million limitation for output facilities.

    (a) In general.
    (1) General rule.
    (2) Reduction in $15 million output limitation for outstanding 
issues.
    (3) Benefits and burdens test applicable.
    (b) Definition of project.
    (1) General rule.
    (2) Separate ownership.
    (3) Generating property.
    (4) Transmission and distribution.
    (5) Subsequent improvements.
    (6) Replacement property.
    (c) Examples.

          Sec. 1.141-9 Unrelated or disproportionate use test.

    (a) General rules.
    (1) Description of test.
    (2) Application of unrelated or disproportionate use test.
    (b) Unrelated use.
    (1) In general.
    (2) Use for the same purpose as government use.
    (c) Disproportionate use.

[[Page 10]]

    (1) Definition of disproportionate use.
    (2) Aggregation of related uses.
    (3) Allocation rule.
    (d) Maximum use taken into account.
    (e) Examples.

         Sec. 1.141-10 Coordination with volume cap. [Reserved]

Sec. 1.141-11 Acquisition of nongovernmental output property. [Reserved]

                     Sec. 1.141-12 Remedial actions.

    (a) Conditions to taking remedial action.
    (1) Reasonable expectations test met.
    (2) Maturity not unreasonably long.
    (3) Fair market value consideration.
    (4) Disposition proceeds treated as gross proceeds for arbitrage 
purposes.
    (5) Proceeds expended on a governmental purpose.
    (b) Effect of a remedial action.
    (1) In general.
    (2) Effect on bonds that have been advance refunded.
    (c) Disposition proceeds.
    (1) Definition.
    (2) Allocating disposition proceeds to an issue.
    (3) Allocating disposition proceeds to different sources of funding.
    (d) Redemption or defeasance of nonqualified bonds.
    (1) In general.
    (2) Special rule for dispositions for cash.
    (3) Anticipatory remedial action.
    (4) Notice of defeasance.
    (5) Special limitation.
    (6) Defeasance escrow defined.
    (e) Alternative use of disposition proceeds.
    (1) In general.
    (2) Special rule for use by 501(c)(3) organizations.
    (f) Alternative use of facility.
    (g) Rules for deemed reissuance.
    (h) Authority of Commissioner to provide for additional remedial 
actions.
    (i) Effect of remedial action on continuing compliance.
    (j) Nonqualified bonds.
    (1) Amount of nonqualified bonds.
    (2) Allocation of nonqualified bonds.
    (k) Examples.

                     Sec. 1.141-13 Refunding issues.

    (a) In general.
    (b) Application of private business use test and private loan 
financing test.
    (1) Allocation of proceeds.
    (2) Determination of amount of private business use.
    (c) Application of private security or payment test.
    (1) Separate issue treatment.
    (2) Combined issue treatment.
    (3) Special rule for arrangements not entered into in contemplation 
of the refunding issue.
    (d) Multipurpose issue allocations.
    (1) In general.
    (2) Exceptions.
    (e) Application of reasonable expectations test to certain refunding 
bonds.
    (f) Special rule for refundings of certain general obligation bonds.
    (g) Examples.

                     Sec. 1.141-14 Anti-abuse rules.

    (a) Authority of Commissioner to reflect substance of transactions.
    (b) Examples.

              Sec. 1.141-15  Effective/applicability dates.

    (a) Scope.
    (b) Effective dates.
    (1) In general.
    (2) Certain short-term arrangements.
    (3) Certain prepayments.
    (4) Certain remedial actions.
    (c) Refunding bonds.
    (d) Permissive application of regulations.
    (e) Permissive retroactive application of certain sections.
    (1) In general.
    (2) Transition rule for pre-effective date bonds.
    (f) Effective dates for certain regulations relating to output 
facilities.
    (1) General rule.
    (2) Transition rule for requirements contracts.
    (g) Refunding bonds for output facilities.
    (h) Permissive retroactive application.
    (i) Permissive application of certain regulations relating to output 
facilities.
    (j) Effective dates for certain regulations relating to refundings.
    (k) Effective/applicability dates for certain regulations relating 
to generally applicable taxes and payments in lieu of tax.
    (l) Applicability date for certain regulations related to allocation 
and accounting.
    (1) In general.
    (2) Refunding bonds.
    (3) Permissive application.
    (m) Permissive retroactive application of certain regulations.
    (n) Effective/applicability dates for certain regulations relating 
to certain definitions.

   Sec. 1.141-16 Effective dates for qualified private activity bond 
                               provisions.

    (a) Scope.
    (b) Effective dates.
    (c) Permissive application.
    (d) Certain remedial actions.
    (1) General rule.

[[Page 11]]

    (2) Special rule for allocations of nonqualified bonds.

[T.D. 8712, 62 FR 2283, Jan. 16, 1997, as amended by T.D. 8757, 63 FR 
3259, Jan. 22, 1998; T.D. 8941, 66 FR 4664, Jan. 18, 2001; T.D. 9016, 67 
FR 59759, Sept. 23, 2002; T.D. 9085, 68 FR 45775, Aug. 4, 2003; T.D. 
9150, 69 FR 50066, Aug. 13, 2004; T.D. 9234, 70 FR 75031, Dec. 19, 2005; 
T.D. 9429, 73 FR 63374, Oct. 24, 2008; T.D. 9741, 80 FR 65642, Oct. 27, 
2015; T.D. 9777, 81 FR 46591, July 18, 2016]

          Tax Exemption Requirements for State and Local Bonds



Sec. 1.141-1  Definitions and rules of general application.

    (a) In general. For purposes of Secs. 1.141-0 through 1.141-16, the 
following definitions and rules apply: The definitions in this section, 
the definitions in Sec. 1.150-1, the definition of placed in service in 
Sec. 1.150-2(c), the definition of reasonably required reserve or 
replacement fund in Sec. 1.148-2(f), and the definitions in Sec. 1.148-1 
of bond year, commingled fund, fixed yield issue, higher yielding 
investments, investment, investment proceeds, issue price, issuer, 
nonpurpose investment, purpose investment, qualified guarantee, 
qualified hedge, reasonable expectations or reasonableness, rebate 
amount, replacement proceeds, sale proceeds, variable yield issue and 
yield.
    (b) Certain general definitions.
    Common areas means portions of a facility that are equally available 
to all users of a facility on the same basis for uses that are 
incidental to the primary use of the facility. For example, hallways and 
elevators generally are treated as common areas if they are used by the 
different lessees of a facility in connection with the primary use of 
that facility.
    Consistently applied means applied uniformly to account for proceeds 
and other amounts.
    Deliberate action is defined in Sec. 1.141-2(d)(3).
    Discrete portion means a portion of a facility that consists of any 
separate and discrete portion of a facility to which use is limited, 
other than common areas. A floor of a building and a portion of a 
building separated by walls, partitions, or other physical barriers are 
examples of a discrete portion.
    Disposition is defined in Sec. 1.141-12(c)(1).
    Disposition proceeds is defined in Sec. 1.141-12(c)(1).
    Essential governmental function is defined in Sec. 1.141-
5(d)(4)(ii).
    Financed means constructed, reconstructed, or acquired with proceeds 
of an issue.
    Governmental bond has the same meaning as in Sec. 1.150-1(b), except 
that, for purposes of Sec. 1.141-13, governmental bond is defined in 
Sec. 1.141-13(b)(2)(iv).
    Governmental person means a state or local governmental unit as 
defined in Sec. 1.103-1 or any instrumentality thereof. It does not 
include the United States or any agency or instrumentality thereof.
    Hazardous waste remediation bonds is defined in Sec. 1.141-4(f)(1).
    Measurement period is defined in Sec. 1.141-3(g)(2).
    Nongovernmental person means a person other than a governmental 
person.
    Output facility means electric and gas generation, transmission, 
distribution, and related facilities, and water collection, storage, and 
distribution facilities.
    Private business tests means the private business use test and the 
private security or payment test of section 141(b).
    Proceeds means the sale proceeds of an issue (other than those sale 
proceeds used to retire bonds of the issue that are not deposited in a 
reasonably required reserve or replacement fund). Proceeds also include 
any investment proceeds from investments that accrue during the project 
period (net of rebate amounts attributable to the project period). 
Disposition proceeds of an issue are treated as proceeds to the extent 
provided in Sec. 1.141-12. The Commissioner may treat any replaced 
amounts as proceeds.
    Project period means the period beginning on the issue date and 
ending on the date that the project is placed in service. In the case of 
a multipurpose issue, the issuer may elect to treat the project period 
for the entire issue as ending on either the expiration of the temporary 
period described in Sec. 1.148-2(e)(2) or the end of the fifth bond year 
after the issue date.

[[Page 12]]

    Public utility property means public utility property as defined in 
section 168(i)(10).
    Qualified bond means a qualified bond as defined in section 141(e).
    Renewal option means a provision under which either party has a 
legally enforceable right to renew the contract. Thus, for example, a 
provision under which a contract is automatically renewed for 1-year 
periods absent cancellation by either party is not a renewal option 
(even if it is expected to be renewed).
    Replaced amounts means replacement proceeds other than amounts that 
are treated as replacement proceeds solely because they are sinking 
funds or pledged funds.
    Weighted average maturity is determined under section 147(b).
    Weighted average reasonably expected economic life is determined 
under section 147(b). The reasonably expected economic life of property 
may be determined by reference to the class life of the property under 
section 168.
    (c) Elections. Elections must be made in writing on or before the 
issue date and retained as part of the bond documents, and, once made, 
may not be revoked without the permission of the Commissioner.
    (d) Related parties. Except as otherwise provided, all related 
parties are treated as one person and any reference to ``person'' 
includes any related party.
    (e) Partnerships. A partnership (as defined in section 7701(a)(2)) 
is treated as an aggregate of its partners, rather than as an entity.

[T.D. 8712, 62 FR 2284, Jan. 16, 1997, as amended by T.D. 9234, 70 FR 
75032, Dec. 19, 2005; T.D. 9741, 80 FR 65643, Oct. 27, 2015; T.D. 9777, 
81 FR 46592, July 18, 2016]



Sec. 1.141-2  Private activity bond tests.

    (a) Overview. Interest on a private activity bond is not excludable 
from gross income under section 103(a) unless the bond is a qualified 
bond. The purpose of the private activity bond tests of section 141 is 
to limit the volume of tax-exempt bonds that finance the activities of 
nongovernmental persons, without regard to whether a financing actually 
transfers benefits of tax-exempt financing to a nongovernmental person. 
The private activity bond tests serve to identify arrangements that have 
the potential to transfer the benefits of tax-exempt financing, as well 
as arrangements that actually transfer these benefits. The regulations 
under section 141 may not be applied in a manner that is inconsistent 
with these purposes.
    (b) Scope. Sections 1.141-0 through 1.141-16 apply generally for 
purposes of the private activity bond limitations under section 141.
    (c) General definition of private activity bond. Under section 141, 
bonds are private activity bonds if they meet either the private 
business use test and private security or payment test of section 141(b) 
or the private loan financing test of section 141(c). The private 
business use and private security or payment tests are described in 
Secs. 1.141-3 and 1.141-4. The private loan financing test is described 
in Sec. 1.141-5.
    (d) Reasonable expectations and deliberate actions--(1) In general. 
An issue is an issue of private activity bonds if the issuer reasonably 
expects, as of the issue date, that the issue will meet either the 
private business tests or the private loan financing test. An issue is 
also an issue of private activity bonds if the issuer takes a deliberate 
action, subsequent to the issue date, that causes the conditions of 
either the private business tests or the private loan financing test to 
be met.
    (2) Reasonable expectations test--(i) In general. In general, the 
reasonable expectations test must take into account reasonable 
expectations about events and actions over the entire stated term of an 
issue.
    (ii) Special rule for issues with mandatory redemption provisions. 
An action that is reasonably expected, as of the issue date, to occur 
after the issue date and to cause either the private business tests or 
the private loan financing test to be met may be disregarded for 
purposes of those tests if--
    (A) The issuer reasonably expects, as of the issue date, that the 
financed property will be used for a governmental purpose for a 
substantial period before the action;
    (B) The issuer is required to redeem all nonqualifying bonds 
(regardless of

[[Page 13]]

the amount of disposition proceeds actually received) within 6 months of 
the date of the action;
    (C) The issuer does not enter into any arrangement with a 
nongovernmental person, as of the issue date, with respect to that 
specific action; and
    (D) The mandatory redemption of bonds meets all of the conditions 
for remedial action under Sec. 1.141-12(a).
    (3) Deliberate action defined--(i) In general. Except as otherwise 
provided in this paragraph (d)(3), a deliberate action is any action 
taken by the issuer that is within its control. An intent to violate the 
requirements of section 141 is not necessary for an action to be 
deliberate.
    (ii) Safe harbor exceptions. An action is not treated as a 
deliberate action if--
    (A) It would be treated as an involuntary or compulsory conversion 
under section 1033; or
    (B) It is taken in response to a regulatory directive made by the 
federal government. See Sec. 1.141-7(g)(4).
    (4) Special rule for dispositions of personal property in the 
ordinary course of an established governmental program--(i) In general. 
Dispositions of personal property in the ordinary course of an 
established governmental program are not treated as deliberate actions 
if--
    (A) The weighted average maturity of the bonds financing that 
personal property is not greater than 120 percent of the reasonably 
expected actual use of that property for governmental purposes;
    (B) The issuer reasonably expects on the issue date that the fair 
market value of that property on the date of disposition will be not 
greater than 25 percent of its cost; and
    (C) The property is no longer suitable for its governmental purposes 
on the date of disposition.
    (ii) Reasonable expectations test. The reasonable expectation that a 
disposition described in paragraph (d)(4)(i) of this section may occur 
in the ordinary course while the bonds are outstanding will not cause 
the issue to meet the private activity bond tests if the issuer is 
required to deposit amounts received from the disposition in a 
commingled fund with substantial tax or other governmental revenues and 
the issuer reasonably expects to spend the amounts on governmental 
programs within 6 months from the date of commingling.
    (iii) Separate issue treatment. An issuer may treat the bonds 
properly allocable to the personal property eligible for this exception 
as a separate issue under Sec. 1.150-1(c)(3).
    (5) Special rule for general obligation bond programs that finance a 
large number of separate purposes. The determination of whether bonds of 
an issue are private activity bonds may be based solely on the issuer's 
reasonable expectations as of the issue date if all of the requirements 
of paragraphs (d)(5)(i) through (vii) of this section are met.
    (i) The issue is an issue of general obligation bonds of a general 
purpose governmental unit that finances at least 25 separate purposes 
(as defined in Sec. 1.150-1(c)(3)) and does not predominantly finance 
fewer than 4 separate purposes.
    (ii) The issuer has adopted a fund method of accounting for its 
general governmental purposes that makes tracing the bond proceeds to 
specific expenditures unreasonably burdensome.
    (iii) The issuer reasonably expects on the issue date to allocate 
all of the net proceeds of the issue to capital expenditures within 6 
months of the issue date and adopts reasonable procedures to verify that 
net proceeds are in fact so expended. A program to randomly spot check 
that 10 percent of the net proceeds were so expended generally is a 
reasonable verification procedure for this purpose.
    (iv) The issuer reasonably expects on the issue date to expend all 
of the net proceeds of the issue before expending proceeds of a 
subsequent issue of similar general obligation bonds.
    (v) The issuer reasonably expects on the issue date that it will not 
make any loans to nongovernmental persons with the proceeds of the 
issue.
    (vi) The issuer reasonably expects on the issue date that the 
capital expenditures that it could make during the 6-month period 
beginning on the issue date with the net proceeds of the issue that 
would not meet the private business tests are not less than 125 percent

[[Page 14]]

of the capital expenditures to be financed with the net proceeds of the 
issue.
    (vii) The issuer reasonably expects on the issue date that the 
weighted average maturity of the issue is not greater than 120 percent 
of the weighted average reasonably expected economic life of the capital 
expenditures financed with the issue. To determine reasonably expected 
economic life for this purpose an issuer may use reasonable estimates 
based on the type of expenditures made from a fund.
    (e) When a deliberate action occurs. A deliberate action occurs on 
the date the issuer enters into a binding contract with a 
nongovernmental person for use of the financed property that is not 
subject to any material contingencies.
    (f) Certain remedial actions. See Sec. 1.141-12 for certain remedial 
actions that prevent a deliberate action with respect to property 
financed by an issue from causing that issue to meet the private 
business use test or the private loan financing test.
    (g) Examples. The following examples illustrate the application of 
this section:

    Example 1 Involuntary action. City B issues bonds to finance the 
purchase of land. On the issue date, B reasonably expects that it will 
be the sole user of the land for the entire term of the bonds. 
Subsequently, the federal government acquires the land in a condemnation 
action. B sets aside the condemnation proceeds to pay debt service on 
the bonds but does not redeem them on their first call date. The bonds 
are not private activity bonds because B has not taken a deliberate 
action after the issue date. See, however, Sec. 1.141-14(b), Example 2.
    Example 2 Reasonable expectations test--involuntary action. The 
facts are the same as in Example 1, except that, on the issue date, B 
reasonably expects that the federal government will acquire the land in 
a condemnation action during the term of the bonds. On the issue date, 
the present value of the amount that B reasonably expects to receive 
from the federal government is greater than 10 percent of the present 
value of the debt service on the bonds. The terms of the bonds do not 
require that the bonds be redeemed within 6 months of the acquisition by 
the federal government. The bonds are private activity bonds because the 
issuer expects as of the issue date that the private business tests will 
be met.
    Example 3 Reasonable expectations test--mandatory redemption. City C 
issues bonds to rehabilitate an existing hospital that it currently 
owns. On the issue date of the bonds, C reasonably expects that the 
hospital will be used for a governmental purpose for a substantial 
period. On the issue date, C also plans to construct a new hospital, but 
the placed in service date of that new hospital is uncertain. C 
reasonably expects that, when the new hospital is placed in service, it 
will sell or lease the rehabilitated hospital to a private hospital 
corporation. The bond documents require that the bonds must be redeemed 
within 6 months of the sale or lease of the rehabilitated hospital 
(regardless of the amount actually received from the sale). The bonds 
meet the reasonable expectations requirement of the private activity 
bond tests if the mandatory redemption of bonds meets all of the 
conditions for a remedial action under Sec. 1.141-12(a).
    Example 4 Dispositions in the ordinary course of an established 
governmental program. City D issues bonds with a weighted average 
maturity of 6 years for the acquisition of police cars. D reasonably 
expects on the issue date that the police cars will be used solely by 
its police department, except that, in the ordinary course of its police 
operations, D sells its police cars to a taxicab corporation after 5 
years of use because they are no longer suitable for police use. 
Further, D reasonably expects that the value of the police cars when 
they are no longer suitable for police use will be no more than 25 
percent of cost. D subsequently sells 20 percent of the police cars 
after only 3 years of actual use. At that time, D deposits the proceeds 
from the sale of the police cars in a commingled fund with substantial 
tax revenues and reasonably expects to spend the proceeds on 
governmental programs within 6 months of the date of deposit. D does not 
trace the actual use of these commingled amounts. The sale of the police 
cars does not cause the private activity bond tests to be met because 
the requirements of paragraph (d)(4) of this section are met.

[T.D. 8712, 62 FR 2284, Jan. 16, 1997, as amended by T.D. 8757, 63 FR 
3260, Jan. 22, 1998; T.D. 9016, 67 FR 59759, Sept. 23, 2002]



Sec. 1.141-3  Definition of private business use.

    (a) General rule--(1) In general. The private business use test 
relates to the use of the proceeds of an issue. The 10 percent private 
business use test of section 141(b)(1) is met if more than 10 percent of 
the proceeds of an issue is used in a trade or business of a 
nongovernmental person. For this purpose, the use of financed property 
is treated as the direct use of proceeds. Any activity

[[Page 15]]

carried on by a person other than a natural person is treated as a trade 
or business. Unless the context or a provision clearly requires 
otherwise, this section also applies to the private business use test 
under sections 141(b)(3) (unrelated or disproportionate use), 141(b)(4) 
($15 million limitation for certain output facilities), and 141(b)(5) 
(the coordination with the volume cap where the nonqualified amount 
exceeds $15 million).
    (2) Indirect use. In determining whether an issue meets the private 
business use test, it is necessary to look to both the indirect and 
direct uses of proceeds. For example, a facility is treated as being 
used for a private business use if it is leased to a nongovernmental 
person and subleased to a governmental person or if it is leased to a 
governmental person and then subleased to a nongovernmental person, 
provided that in each case the nongovernmental person's use is in a 
trade or business. Similarly, the issuer's use of the proceeds to engage 
in a series of financing transactions for property to be used by 
nongovernmental persons in their trades or businesses may cause the 
private business use test to be met. In addition, proceeds are treated 
as used in the trade or business of a nongovernmental person if a 
nongovernmental person, as a result of a single transaction or a series 
of related transactions, uses property acquired with the proceeds of an 
issue.
    (3) Aggregation of private business use. The use of proceeds by all 
nongovernmental persons is aggregated to determine whether the private 
business use test is met.
    (b) Types of private business use arrangements--(1) In general. Both 
actual and beneficial use by a nongovernmental person may be treated as 
private business use. In most cases, the private business use test is 
met only if a nongovernmental person has special legal entitlements to 
use the financed property under an arrangement with the issuer. In 
general, a nongovernmental person is treated as a private business user 
of proceeds and financed property as a result of ownership; actual or 
beneficial use of property pursuant to a lease, or a management or 
incentive payment contract; or certain other arrangements such as a take 
or pay or other output-type contract.
    (2) Ownership. Except as provided in paragraph (d)(1) or (d)(2) of 
this section, ownership by a nongovernmental person of financed property 
is private business use of that property. For this purpose, ownership 
refers to ownership for federal income tax purposes.
    (3) Leases. Except as provided in paragraph (d) of this section, the 
lease of financed property to a nongovernmental person is private 
business use of that property. For this purpose, any arrangement that is 
properly characterized as a lease for federal income tax purposes is 
treated as a lease. In determining whether a management contract is 
properly characterized as a lease, it is necessary to consider all of 
the facts and circumstances, including the following factors--
    (i) The degree of control over the property that is exercised by a 
nongovernmental person; and
    (ii) Whether a nongovernmental person bears risk of loss of the 
financed property.
    (4) Management contracts--(i) Facts and circumstances test. Except 
as provided in paragraph (d) of this section, a management contract 
(within the meaning of paragraph (b)(4)(ii) of this section) with 
respect to financed property may result in private business use of that 
property, based on all of the facts and circumstances. A management 
contract with respect to financed property generally results in private 
business use of that property if the contract provides for compensation 
for services rendered with compensation based, in whole or in part, on a 
share of net profits from the operation of the facility.
    (ii) Management contract defined. For purposes of this section, a 
management contract is a management, service, or incentive payment 
contract between a governmental person and a service provider under 
which the service provider provides services involving all, a portion 
of, or any function of, a facility. For example, a contract for the 
provision of management services for an entire hospital, a contract for 
management services for a specific department of a hospital, and an 
incentive payment

[[Page 16]]

contract for physician services to patients of a hospital are each 
treated as a management contract.
    (iii) Arrangements generally not treated as management contracts. 
The arrangements described in paragraphs (b)(4)(iii)(A) through (D) of 
this section generally are not treated as management contracts that give 
rise to private business use.
    (A) Contracts for services that are solely incidental to the primary 
governmental function or functions of a financed facility (for example, 
contracts for janitorial, office equipment repair, hospital billing, or 
similar services).
    (B) The mere granting of admitting privileges by a hospital to a 
doctor, even if those privileges are conditioned on the provision of de 
minimis services, if those privileges are available to all qualified 
physicians in the area, consistent with the size and nature of its 
facilities.
    (C) A contract to provide for the operation of a facility or system 
of facilities that consists predominantly of public utility property, if 
the only compensation is the reimbursement of actual and direct expenses 
of the service provider and reasonable administrative overhead expenses 
of the service provider.
    (D) A contract to provide for services, if the only compensation is 
the reimbursement of the service provider for actual and direct expenses 
paid by the service provider to unrelated parties.
    (iv) Management contracts that are properly treated as other types 
of private business use. A management contract with respect to financed 
property results in private business use of that property if the service 
provider is treated as the lessee or owner of financed property for 
federal income tax purposes, unless an exception under paragraph (d) of 
this section applies to the arrangement.
    (5) Output contracts. See Sec. 1.141-7 for special rules for 
contracts for the purchase of output of output facilities.
    (6) Research agreements--(i) Facts and circumstances test. Except as 
provided in paragraph (d) of this section, an agreement by a 
nongovernmental person to sponsor research performed by a governmental 
person may result in private business use of the property used for the 
research, based on all of the facts and circumstances.
    (ii) Research agreements that are properly treated as other types of 
private business use. A research agreement with respect to financed 
property results in private business use of that property if the sponsor 
is treated as the lessee or owner of financed property for federal 
income tax purposes, unless an exception under paragraph (d) of this 
section applies to the arrangement.
    (7) Other actual or beneficial use--(i) In general. Any other 
arrangement that conveys special legal entitlements for beneficial use 
of bond proceeds or of financed property that are comparable to special 
legal entitlements described in paragraphs (b)(2), (3), (4), (5), or (6) 
of this section results in private business use. For example, an 
arrangement that conveys priority rights to the use or capacity of a 
facility generally results in private business use.
    (ii) Special rule for facilities not used by the general public. In 
the case of financed property that is not available for use by the 
general public (within the meaning of paragraph (c) of this section), 
private business use may be established solely on the basis of a special 
economic benefit to one or more nongovernmental persons, even if those 
nongovernmental persons have no special legal entitlements to use of the 
property. In determining whether special economic benefit gives rise to 
private business use it is necessary to consider all of the facts and 
circumstances, including one or more of the following factors--
    (A) Whether the financed property is functionally related or 
physically proximate to property used in the trade or business of a 
nongovernmental person;
    (B) Whether only a small number of nongovernmental persons receive 
the special economic benefit; and
    (C) Whether the cost of the financed property is treated as 
depreciable by any nongovernmental person.
    (c) Exception for general public use--(1) In general. Use as a 
member of the general public (general public use) is not private 
business use. Use of financed property by nongovernmental persons in 
their trades or businesses is treated

[[Page 17]]

as general public use only if the property is intended to be available 
and in fact is reasonably available for use on the same basis by natural 
persons not engaged in a trade or business.
    (2) Use on the same basis. In general, use under an arrangement that 
conveys priority rights or other preferential benefits is not use on the 
same basis as the general public. Arrangements providing for use that is 
available to the general public at no charge or on the basis of rates 
that are generally applicable and uniformly applied do not convey 
priority rights or other preferential benefits. For this purpose, rates 
may be treated as generally applicable and uniformly applied even if--
    (i) Different rates apply to different classes of users, such as 
volume purchasers, if the differences in rates are customary and 
reasonable; or
    (ii) A specially negotiated rate arrangement is entered into, but 
only if the user is prohibited by federal law from paying the generally 
applicable rates, and the rates established are as comparable as 
reasonably possible to the generally applicable rates.
    (3) Long-term arrangements not treated as general public use. An 
arrangement is not treated as general public use if the term of the use 
under the arrangement, including all renewal options, is greater than 
200 days. For this purpose, a right of first refusal to renew use under 
the arrangement is not treated as a renewal option if--
    (i) The compensation for the use under the arrangement is 
redetermined at generally applicable, fair market value rates that are 
in effect at the time of renewal; and
    (ii) The use of the financed property under the same or similar 
arrangements is predominantly by natural persons who are not engaged in 
a trade or business.
    (4) Relation to other use. Use of financed property by the general 
public does not prevent the proceeds from being used for a private 
business use because of other use under this section.
    (d) Other exceptions--(1) Agents. Use of proceeds by nongovernmental 
persons solely in their capacity as agents of a governmental person is 
not private business use. For example, use by a nongovernmental person 
that issues obligations on behalf of a governmental person is not 
private business use to the extent the nongovernmental person's use of 
proceeds is in its capacity as an agent of the governmental person.
    (2) Use incidental to financing arrangements. Use by a 
nongovernmental person that is solely incidental to a financing 
arrangement is not private business use. A use is solely incidental to a 
financing arrangement only if the nongovernmental person has no 
substantial rights to use bond proceeds or financed property other than 
as an agent of the bondholders. For example, a nongovernmental person 
that acts solely as an owner of title in a sale and leaseback financing 
transaction with a city generally is not a private business user of the 
property leased to the city, provided that the nongovernmental person 
has assigned all of its rights to use the leased facility to the trustee 
for the bondholders upon default by the city. Similarly, bond trustees, 
servicers, and guarantors are generally not treated as private business 
users.
    (3) Exceptions for arrangements other than arrangements resulting in 
ownership of financed property by a nongovernmental person--(i) 
Arrangements not available for use on the same basis by natural persons 
not engaged in a trade or business. Use by a nongovernmental person 
pursuant to an arrangement, other than an arrangement resulting in 
ownership of financed property by a nongovernmental person, is not 
private business use if--
    (A) The term of the use under the arrangement, including all renewal 
options, is not longer than 100 days;
    (B) The arrangement would be treated as general public use, except 
that it is not available for use on the same basis by natural persons 
not engaged in a trade or business because generally applicable and 
uniformly applied rates are not reasonably available to natural persons 
not engaged in a trade or business; and
    (C) The property is not financed for a principal purpose of 
providing that property for use by that nongovernmental person.

[[Page 18]]

    (ii) Negotiated arm's-length arrangements. Use by a nongovernmental 
person pursuant to an arrangement, other than an arrangement resulting 
in ownership of financed property by a nongovernmental person, is not 
private business use if--
    (A) The term of the use under the arrangement, including all renewal 
options, is not longer than 50 days;
    (B) The arrangement is a negotiated arm's-length arrangement, and 
compensation under the arrangement is at fair market value; and
    (C) The property is not financed for a principal purpose of 
providing that property for use by that nongovernmental person.
    (4) Temporary use by developers. Use during an initial development 
period by a developer of an improvement that carries out an essential 
governmental function is not private business use if the issuer and the 
developer reasonably expect on the issue date to proceed with all 
reasonable speed to develop the improvement and property benefited by 
that improvement and to transfer the improvement to a governmental 
person, and if the improvement is in fact transferred to a governmental 
person promptly after the property benefited by the improvement is 
developed.
    (5) Incidental use--(i) General rule. Incidental uses of a financed 
facility are disregarded, to the extent that those uses do not exceed 
2.5 percent of the proceeds of the issue used to finance the facility. A 
use of a facility by a nongovernmental person is incidental if--
    (A) Except for vending machines, pay telephones, kiosks, and similar 
uses, the use does not involve the transfer to the nongovernmental 
person of possession and control of space that is separated from other 
areas of the facility by walls, partitions, or other physical barriers, 
such as a night gate affixed to a structural component of a building (a 
nonpossessory use);
    (B) The nonpossessory use is not functionally related to any other 
use of the facility by the same person (other than a different 
nonpossessory use); and
    (C) All nonpossessory uses of the facility do not, in the aggregate, 
involve the use of more than 2.5 percent of the facility.
    (ii) Illustrations. Incidental uses may include pay telephones, 
vending machines, advertising displays, and use for television cameras, 
but incidental uses may not include output purchases.
    (6) Qualified improvements. Proceeds that provide a governmentally 
owned improvement to a governmentally owned building (including its 
structural components and land functionally related and subordinate to 
the building) are not used for a private business use if--
    (i) The building was placed in service more than 1 year before the 
construction or acquisition of the improvement is begun;
    (ii) The improvement is not an enlargement of the building or an 
improvement of interior space occupied exclusively for any private 
business use;
    (iii) No portion of the improved building or any payments in respect 
of the improved building are taken into account under section 
141(b)(2)(A) (the private security test); and
    (iv) No more than 15 percent of the improved building is used for a 
private business use.
    (e) Special rule for tax assessment bonds. In the case of a tax 
assessment bond that satisfies the requirements of Sec. 1.141-5(d), the 
loan (or deemed loan) of the proceeds to the borrower paying the 
assessment is disregarded in determining whether the private business 
use test is met. However, the use of the loan proceeds is not 
disregarded in determining whether the private business use test is met.
    (f) Examples. The following examples illustrate the application of 
paragraphs (a) through (e) of this section. In each example, assume that 
the arrangements described are the only arrangements with 
nongovernmental persons for use of the financed property.

    Example 1. Nongovernmental ownership. State A issues 20-year bonds 
to purchase land and equip and construct a factory. A then enters into 
an arrangement with Corporation X to sell the factory to X on an 
installment basis while the bonds are outstanding. The issue meets the 
private business use test because a nongovernmental person owns the 
financed facility. See also Sec. 1.141-2 (relating to the private 
activity bond

[[Page 19]]

tests), and Sec. 1.141-5 (relating to the private loan financing test).
    Example 2 Lease to a nongovernmental person. (i) The facts are the 
same as in Example 1, except that A enters into an arrangement with X to 
lease the factory to X for 3 years rather than to sell it to X. The 
lease payments will be made annually and will be based on the tax-exempt 
interest rate on the bonds. The issue meets the private business use 
test because a nongovernmental person leases the financed facility. See 
also Sec. 1.141-14 (relating to anti-abuse rules).
    (ii) The facts are the same as in Example 2(i), except that the 
annual payments made by X will equal fair rental value of the facility 
and exceed the amount necessary to pay debt service on the bonds for the 
3 years of the lease. The issue meets the private business use test 
because a nongovernmental person leases the financed facility and the 
test does not require that the benefits of tax-exempt financing be 
passed through to the nongovernmental person.
    Example 3. Management contract in substance a lease. City L issues 
30-year bonds to finance the construction of a city hospital. L enters 
into a 15-year contract with M, a nongovernmental person that operates a 
health maintenance organization relating to the treatment of M's members 
at L's hospital. The contract provides for reasonable fixed compensation 
to M for services rendered with no compensation based, in whole or in 
part, on a share of net profits from the operation of the hospital. 
However, the contract also provides that 30 percent of the capacity of 
the hospital will be exclusively available to M's members and M will 
bear the risk of loss of that portion of the capacity of the hospital so 
that, under all of the facts and circumstances, the contract is properly 
characterized as a lease for federal income tax purposes. The issue 
meets the private business use test because a nongovernmental person 
leases the financed facility.
    Example 4. Ownership of title in substance a leasehold interest. 
Nonprofit Corporation R issues bonds on behalf of City P to finance the 
construction of a hospital. R will own legal title to the hospital. In 
addition, R will operate the hospital, but R is not treated as an agent 
of P in its capacity as operator of the hospital. P has certain rights 
to the hospital that establish that it is properly treated as the owner 
of the property for federal income tax purposes. P does not have rights, 
however, to directly control operation of the hospital while R owns 
legal title to it and operates it. The issue meets the private business 
use test because the arrangement provides a nongovernmental person an 
interest in the financed facility that is comparable to a leasehold 
interest. See paragraphs (a)(2) and (b)(7)(i) of this section.
    Example 5. Rights to control use of property treated as private 
business use--parking lot. Corporation C and City D enter into a plan to 
finance the construction of a parking lot adjacent to C's factory. 
Pursuant to the plan, C conveys the site for the parking lot to D for a 
nominal amount, subject to a covenant running with the land that the 
property be used only for a parking lot. In addition, D agrees that C 
will have the right to approve rates charged by D for use of the parking 
lot. D issues bonds to finance construction of the parking lot on the 
site. The parking lot will be available for use by the general public on 
the basis of rates that are generally applicable and uniformly applied. 
The issue meets the private business use test because a nongovernmental 
person has special legal entitlements for beneficial use of the financed 
facility that are comparable to an ownership interest. See paragraph 
(b)(7)(i) of this section.
    Example 6. Other actual or beneficial use--hydroelectric 
enhancements. J, a political subdivision, owns and operates a 
hydroelectric generation plant and related facilities. Pursuant to a 
take or pay contract, J sells 15 percent of the output of the plant to 
Corporation K, an investor-owned utility. K is treated as a private 
business user of the plant. Under the license issued to J for operation 
of the plant, J is required by federal regulations to construct and 
operate various facilities for the preservation of fish and for public 
recreation. J issues its obligations to finance the fish preservation 
and public recreation facilities. K has no special legal entitlements 
for beneficial use of the financed facilities. The fish preservation 
facilities are functionally related to the operation of the plant. The 
recreation facilities are available to natural persons on a short-term 
basis according to generally applicable and uniformly applied rates. 
Under paragraph (c) of this section, the recreation facilities are 
treated as used by the general public. Under paragraph (b)(7) of this 
section, K's use is not treated as private business use of the 
recreation facilities because K has no special legal entitlements for 
beneficial use of the recreation facilities. The fish preservation 
facilities are not of a type reasonably available for use on the same 
basis by natural persons not engaged in a trade or business. Under all 
of the facts and circumstances (including the functional relationship of 
the fish preservation facilities to property used in K's trade or 
business) under paragraph (b)(7)(ii) of this section, K derives a 
special economic benefit from the fish preservation facilities. 
Therefore, K's private business use may be established solely on the 
basis of that special economic benefit, and K's use of the fish 
preservation facilities is treated as private business use.
    Example 7. Other actual or beneficial use--pollution control 
facilities. City B issues obligations to finance construction of a 
specialized pollution control facility on land that it

[[Page 20]]

owns adjacent to a factory owned by Corporation N. B will own and 
operate the pollution control facility, and N will have no special legal 
entitlements to use the facility. B, however, reasonably expects that N 
will be the only user of the facility. The facility will not be 
reasonably available for use on the same basis by natural persons not 
engaged in a trade or business. Under paragraph (b)(7)(ii) of this 
section, because under all of the facts and circumstances the facility 
is functionally related and is physically proximate to property used in 
N's trade or business, N derives a special economic benefit from the 
facility. Therefore, N's private business use may be established solely 
on the basis of that special economic benefit, and N's use is treated as 
private business use of the facility. See paragraph (b)(7)(ii) of this 
section.
    Example 8. General public use--airport runway. (i) City I issues 
bonds and uses all of the proceeds to finance construction of a runway 
at a new city-owned airport. The runway will be available for take-off 
and landing by any operator of an aircraft desiring to use the airport, 
including general aviation operators who are natural persons not engaged 
in a trade or business. It is reasonably expected that most of the 
actual use of the runway will be by private air carriers (both charter 
airlines and commercial airlines) in connection with their use of the 
airport terminals leased by those carriers. These leases for the use of 
terminal space provide no priority rights or other preferential benefits 
to the air carriers for use of the runway. Moreover, under the leases 
the lease payments are determined without taking into account the 
revenues generated by runway landing fees (that is, the lease payments 
are not determined on a ``residual'' basis). Although the lessee air 
carriers receive a special economic benefit from the use of the runway, 
this economic benefit is not sufficient to cause the air carriers to be 
private business users, because the runway is available for general 
public use. The issue does not meet the private business use test. See 
paragraphs (b)(7)(ii) and (c) of this section.
    (ii) The facts are the same as in Example 8(i), except that the 
runway will be available for use only by private air carriers. The use 
by these private air carriers is not for general public use, because the 
runway is not reasonably available for use on the same basis by natural 
persons not engaged in a trade or business. Depending on all of the 
facts and circumstances, including whether there are only a small number 
of lessee private air carriers, the issue may meet the private business 
use test solely because the private air carriers receive a special 
economic benefit from the runway. See paragraph (b)(7)(ii) of this 
section.
    (iii) The facts are the same as in Example 8(i), except that the 
lease payments under the leases with the private air carriers are 
determined on a residual basis by taking into account the net revenues 
generated by runway landing fees. These leases cause the private 
business use test to be met with respect to the runway because they are 
arrangements that convey special legal entitlements to the financed 
facility to nongovernmental persons. See paragraph (b)(7)(i) of this 
section.
    Example 9. General public use--airport parking garage. City S issues 
bonds and uses all of the proceeds to finance construction of a city-
owned parking garage at the city-owned airport. S reasonably expects 
that more than 10 percent of the actual use of the parking garage will 
be by employees of private air carriers (both charter airlines and 
commercial airlines) in connection with their use of the airport 
terminals leased by those carriers. The air carriers' use of the parking 
garage, however, will be on the same basis as passengers and other 
members of the general public using the airport. The leases for the use 
of the terminal space provide no priority rights to the air carriers for 
use of the parking garage, and the lease payments are determined without 
taking into account the revenues generated by the parking garage. 
Although the lessee air carriers receive a special economic benefit from 
the use of the parking garage, this economic benefit is not sufficient 
to cause the air carriers to be private business users, because the 
parking garage is available for general public use. The issue does not 
meet the private business use test. See paragraphs (b)(7)(ii) and (c) of 
this section.
    Example 10. Long-term arrangements not treated as general public 
use--insurance fund. Authority T deposits all of the proceeds of its 
bonds in its insurance fund and invests all of those proceeds in tax-
exempt bonds. The insurance fund provides insurance to a large number of 
businesses and natural persons not engaged in a trade or business. Each 
participant receives insurance for a term of 1 year. The use by the 
participants, other than participants that are natural persons not 
engaged in a trade or business, is treated as private business use of 
the proceeds of the bonds because the participants have special legal 
entitlements to the use of bond proceeds, even though the contractual 
rights are not necessarily properly characterized as ownership, 
leasehold, or similar interests listed in paragraph (b) of this section. 
Use of the bond proceeds is not treated as general public use because 
the term of the insurance is greater than 200 days. See paragraphs 
(b)(7)(i) and (c)(3) of this section.
    Example 11. General public use--port road. Highway Authority W uses 
all of the proceeds of its bonds to construct a 25-mile road

[[Page 21]]

to connect an industrial port owned by Corporation Y with existing roads 
owned and operated by W. Other than the port, the nearest residential or 
commercial development to the new road is 12 miles away. There is no 
reasonable expectation that development will occur in the area 
surrounding the new road. W and Y enter into no arrangement (either by 
contract or ordinance) that conveys special legal entitlements to Y for 
the use of the road. Use of the road will be available without 
restriction to all users, including natural persons who are not engaged 
in a trade or business. The issue does not meet the private business use 
test because the road is treated as used only by the general public.
    Example 12. General public use of governmentally owned hotel. State 
Q issues bonds to purchase land and construct a hotel for use by the 
general public (that is, tourists, visitors, and business travelers). 
The bond documents provide that Q will own and operate the project for 
the term of the bonds. Q will not enter into a lease or license with any 
user for use of rooms for a period longer than 200 days (although users 
may actually use rooms for consecutive periods in excess of 200 days). 
Use of the hotel by hotel guests who are travelling in connection with 
trades or businesses of nongovernmental persons is not a private 
business use of the hotel by these persons because the hotel is intended 
to be available and in fact is reasonably available for use on the same 
basis by natural persons not engaged in a trade or business. See 
paragraph (c)(1) of this section.
    Example 13. General public use with rights of first refusal. 
Authority V uses all of the proceeds of its bonds to construct a parking 
garage. At least 90 percent of the spaces in the garage will be 
available to the general public on a monthly first-come, first-served 
basis. V reasonably expects that the spaces will be predominantly leased 
to natural persons not engaged in a trade or business who have priority 
rights to renew their spaces at then current fair market value rates. 
More than 10 percent of the spaces will be leased to nongovernmental 
persons acting in a trade or business. These leases are not treated as 
arrangements with a term of use greater than 200 days. The rights to 
renew are not treated as renewal options because the compensation for 
the spaces is redetermined at generally applicable, fair market value 
rates that will be in effect at the time of renewal and the use of the 
spaces under similar arrangements is predominantly by natural persons 
who are not engaged in a trade or business. The issue does not meet the 
private business use test because at least 90 percent of the use of the 
parking garage is general public use. See paragraph (c)(3) of this 
section.
    Example 14. General public use with a specially negotiated rate 
agreement with agency of United States. G, a sewage collection and 
treatment district, operates facilities that were financed with its 
bonds. F, an agency of the United States, has a base located within G. 
Approximately 20 percent of G's facilities are used to treat sewage 
produced by F under a specially negotiated rate agreement. Under the 
specially negotiated rate agreement, G uses its best efforts to charge F 
as closely as possible the same amount for its use of G's services as 
its other customers pay for the same amount of services, although those 
other customers pay for services based on standard district charges and 
tax levies. F is prohibited by federal law from paying for the services 
based on those standard district charges and tax levies. The use of G's 
facilities by F is on the same basis as the general public. See 
paragraph (c)(2)(ii) of this section.
    Example 15. Arrangements not available for use by natural persons 
not engaged in a trade or business--federal use of prisons. Authority E 
uses all of the proceeds of its bonds to construct a prison. E contracts 
with federal agency F to house federal prisoners on a space-available, 
first-come, first-served basis, pursuant to which F will be charged 
approximately the same amount for each prisoner as other persons that 
enter into similar transfer agreements. It is reasonably expected that 
other persons will enter into similar agreements. The term of the use 
under the contract is not longer than 100 days, and F has no right to 
renew, although E reasonably expects to renew the contract indefinitely. 
The prison is not financed for a principal purpose of providing the 
prison for use by F. It is reasonably expected that during the term of 
the bonds, more than 10 percent of the prisoners at the prison will be 
federal prisoners. F's use of the facility is not general public use 
because this type of use (leasing space for prisoners) is not available 
for use on the same basis by natural persons not engaged in a trade or 
business. The issue does not meet the private business use test, 
however, because the leases satisfy the exception of paragraph (d)(3)(i) 
of this section.
    Example 16. Negotiated arm's-length arrangements--auditorium 
reserved in advance. (i) City Z issues obligations to finance the 
construction of a municipal auditorium that it will own and operate. The 
use of the auditorium will be open to anyone who wishes to use it for a 
short period of time on a rate-scale basis. Z reasonably expects that 
the auditorium will be used by schools, church groups, sororities, and 
numerous commercial organizations. Corporation H, a nongovernmental 
person, enters into an arm's-length arrangement with Z to use the 
auditorium for 1 week for each year for a 10-year period (a total of 70 
days), pursuant to which H will be charged a specific price reflecting 
fair market value. On the date the contract is entered into, Z has not 
established generally

[[Page 22]]

applicable rates for future years. Even though the auditorium is not 
financed for a principal purpose of providing use of the auditorium to 
H, H is not treated as using the auditorium as a member of the general 
public because its use is not on the same basis as the general public. 
Because the term of H's use of the auditorium is longer than 50 days, 
the arrangement does not meet the exception under paragraph (d)(3)(ii) 
of this section.
    (ii) The facts are the same as in Example 16(i), except that H will 
enter into an arm's-length arrangement with Z to use the auditorium for 
1 week for each year for a 4-year period (a total of 28 days), pursuant 
to which H will be charged a specific price reflecting fair market 
value. H is not treated as a private business user of the auditorium 
because its contract satisfies the exception of paragraph (d)(3)(ii) of 
this section for negotiated arm's-length arrangements.

    (g) Measurement of private business use--(1) In general. In general, 
the private business use of proceeds is allocated to property under 
Sec. 1.141-6. The amount of private business use of that property is 
determined according to the average percentage of private business use 
of that property during the measurement period.
    (2) Measurement period--(i) General rule. Except as provided in this 
paragraph (g)(2), the measurement period of property financed by an 
issue begins on the later of the issue date of that issue or the date 
the property is placed in service and ends on the earlier of the last 
date of the reasonably expected economic life of the property or the 
latest maturity date of any bond of the issue financing the property 
(determined without regard to any optional redemption dates). In 
general, the period of reasonably expected economic life of the property 
for this purpose is based on reasonable expectations as of the issue 
date.
    (ii) Special rule for refundings of short-term obligations. For an 
issue of short-term obligations that the issuer reasonably expects to 
refund with a long-term financing (such as bond anticipation notes), the 
measurement period is based on the latest maturity date of any bond of 
the last refunding issue with respect to the financed property 
(determined without regard to any optional redemption dates).
    (iii) Special rule for reasonably expected mandatory redemptions. If 
an issuer reasonably expects on the issue date that an action will occur 
during the term of the bonds to cause either the private business tests 
or the private loan financing test to be met and is required to redeem 
bonds to meet the reasonable expectations test of Sec. 1.141-2(d)(2), 
the measurement period ends on the reasonably expected redemption date.
    (iv) Special rule for ownership by a nongovernmental person. The 
amount of private business use resulting from ownership by a 
nongovernmental person is the greatest percentage of private business 
use in any 1-year period.
    (v) Special rule for partners that are nongovernmental persons--(A) 
The amount of private business use by a nongovernmental person resulting 
from the use of property by a partnership in which that nongovernmental 
person is a partner is that nongovernmental partner's share of the 
amount of use of the property by the partnership. For this purpose, 
except as otherwise provided in paragraph (g)(2)(v)(B) of this section, 
a nongovernmental partner's share of the partnership's use of the 
property is the nongovernmental partner's greatest percentage share 
under section 704(b) of any partnership item of income, gain, loss, 
deduction, or credit attributable to the period that the partnership 
uses the property during the measurement period. For example, if a 
partnership has a nongovernmental partner and that partner's share of 
partnership items varies, with the greatest share being 25 percent, then 
that nongovernmental partner's share of the partnership's use of 
property is 25 percent.
    (B) An issuer may determine a nongovernmental partner's share of the 
partnership's use of the property under guidance published in the 
Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this 
chapter).
    (vi) Anti-abuse rule. If an issuer establishes the term of an issue 
for a period that is longer than is reasonably necessary for the 
governmental purposes of the issue for a principal purpose of increasing 
the permitted amount of private business use, the Commissioner may 
determine the amount of private business use according to the greatest

[[Page 23]]

percentage of private business use in any 1-year period.
    (3) Determining average percentage of private business use. The 
average percentage of private business use is the average of the 
percentages of private business use during the 1-year periods within the 
measurement period. Appropriate adjustments must be made for beginning 
and ending periods of less than 1 year.
    (4) Determining the average amount of private business use for a 1-
year period--(i) In general. The percentage of private business use of 
property for any 1-year period is the average private business use 
during that year. This average is determined by comparing the amount of 
private business use during the year to the total amount of private 
business use and use that is not private business use (government use) 
during that year. Paragraphs (g)(4) (ii) through (v) of this section 
apply to determine the average amount of private business use for a 1-
year period.
    (ii) Uses at different times. For a facility in which actual 
government use and private business use occur at different times (for 
example, different days), the average amount of private business use 
generally is based on the amount of time that the facility is used for 
private business use as a percentage of the total time for all actual 
use. In determining the total amount of actual use, periods during which 
the facility is not in use are disregarded.
    (iii) Simultaneous use. In general, for a facility in which 
government use and private business use occur simultaneously, the entire 
facility is treated as having private business use. For example, a 
governmentally owned facility that is leased or managed by a 
nongovernmental person in a manner that results in private business use 
is treated as entirely used for a private business use. If, however, 
there is also private business use and actual government use on the same 
basis, the average amount of private business use may be determined on a 
reasonable basis that properly reflects the proportionate benefit to be 
derived by the various users of the facility (for example, reasonably 
expected fair market value of use). For example, the average amount of 
private business use of a garage with unassigned spaces that is used for 
government use and private business use is generally based on the number 
of spaces used for private business use as a percentage of the total 
number of spaces.
    (iv) Discrete portion. For purposes of this paragraph (g), 
measurement of the use of proceeds allocated to a discrete portion of a 
facility is determined by treating that discrete portion as a separate 
facility.
    (v) Relationship to fair market value. For purposes of paragraphs 
(g)(4) (ii) through (iv) of this section, if private business use is 
reasonably expected as of the issue date to have a significantly greater 
fair market value than government use, the average amount of private 
business use must be determined according to the relative reasonably 
expected fair market values of use rather than another measure, such as 
average time of use. This determination of relative fair market value 
may be made as of the date the property is acquired or placed in service 
if making this determination as of the issue date is not reasonably 
possible (for example, if the financed property is not identified on the 
issue date). In general, the relative reasonably expected fair market 
value for a period must be determined by taking into account the amount 
of reasonably expected payments for private business use for the period 
in a manner that properly reflects the proportionate benefit to be 
derived from the private business use.
    (5) Common areas. The amount of private business use of common areas 
within a facility is based on a reasonable method that properly reflects 
the proportionate benefit to be derived by the users of the facility. 
For example, in general, a method that is based on the average amount of 
private business use of the remainder of the entire facility reflects 
proportionate benefit.
    (6) Allocation of neutral costs. Proceeds that are used to pay costs 
of issuance, invested in a reserve or replacement fund, or paid as fees 
for a qualified guarantee or a qualified hedge must be allocated ratably 
among the other purposes for which the proceeds are used.
    (7) Commencement of measurement of private business use. Generally, 
private business use commences on the first

[[Page 24]]

date on which there is a right to actual use by the nongovernmental 
person. However, if an issuer enters into an arrangement for private 
business use a substantial period before the right to actual private 
business use commences and the arrangement transfers ownership or is an 
arrangement for other long-term use (such as a lease for a significant 
portion of the remaining economic life of financed property), private 
business use commences on the date the arrangement is entered into, even 
if the right to actual use commences after the measurement period. For 
this purpose, 10 percent of the measurement period is generally treated 
as a substantial period.
    (8) Examples. The following examples illustrate the application of 
this paragraph (g):

    Example 1. Research facility. University U, a state owned and 
operated university, owns and operates a research facility. U proposes 
to finance general improvements to the facility with the proceeds of an 
issue of bonds. U enters into sponsored research agreements with 
nongovernmental persons that result in private business use because the 
sponsors will own title to any patents resulting from the research. The 
governmental research conducted by U and the research U conducts for the 
sponsors take place simultaneously in all laboratories within the 
research facility. All laboratory equipment is available continuously 
for use by workers who perform both types of research. Because it is not 
possible to predict which research projects will be successful, it is 
not reasonably practicable to estimate the relative revenues expected to 
result from the governmental and nongovernmental research. U contributed 
90 percent of the cost of the facility and the nongovernmental persons 
contributed 10 percent of the cost. Under this section, the 
nongovernmental persons are using the facility for a private business 
use on the same basis as the government use of the facility. The 
portions of the costs contributed by the various users of the facility 
provide a reasonable basis that properly reflects the proportionate 
benefit to be derived by the users of the facility. The nongovernmental 
persons are treated as using 10 percent of the proceeds of the issue.
    Example 2. Stadium. (i) City L issues bonds and uses all of the 
proceeds to construct a stadium. L enters into a long-term contract with 
a professional sports team T under which T will use the stadium 20 times 
during each year. These uses will occur on nights and weekends. L 
reasonably expects that the stadium will be used more than 180 other 
times each year, none of which will give rise to private business use. 
This expectation is based on a feasibility study and historical use of 
the old stadium that is being replaced by the new stadium. There is no 
significant difference in the value of T's uses when compared to the 
other uses of the stadium, taking into account the payments that T is 
reasonably expected to make for its use. Assuming no other private 
business use, the issue does not meet the private business use test 
because not more than 10 percent of the use of the facility is for a 
private business use.
    (ii) The facts are the same as in Example 2(i), except that L 
reasonably expects that the stadium will be used not more than 60 other 
times each year, none of which will give rise to private business use. 
The issue meets the private business use test because 25 percent of the 
proceeds are used for a private business use.
    Example 3. Airport terminal areas treated as common areas. City N 
issues bonds to finance the construction of an airport terminal. Eighty 
percent of the leasable space of the terminal will be leased to private 
air carriers. The remaining 20 percent of the leasable space will be 
used for the term of the bonds by N for its administrative purposes. The 
common areas of the terminal, including waiting areas, lobbies, and 
hallways are treated as 80 percent used by the air carriers for purposes 
of the private business use test.

[T.D. 8712, 62 FR 2286, Jan. 16, 1997, as amended by T.D. 8967, 66 FR 
58062, Nov. 20, 2001; T.D. 9741, 80 FR 65643, Oct. 27, 2015]



Sec. 1.141-4  Private security or payment test.

    (a) General rule--(1) Private security or payment. The private 
security or payment test relates to the nature of the security for, and 
the source of, the payment of debt service on an issue. The private 
payment portion of the test takes into account the payment of the debt 
service on the issue that is directly or indirectly to be derived from 
payments (whether or not to the issuer or any related party) in respect 
of property, or borrowed money, used or to be used for a private 
business use. The private security portion of the test takes into 
account the payment of the debt service on the issue that is directly or 
indirectly secured by any interest in property used or to be used for a 
private business use or payments in respect of property used or to be 
used for a private business use. For additional rules for output 
facilities, see Sec. 1.141-7.

[[Page 25]]

    (2) Aggregation of private payments and security. For purposes of 
the private security or payment test, payments taken into account as 
private payments and payments or property taken into account as private 
security are aggregated. However, the same payments are not taken into 
account as both private security and private payments.
    (3) Underlying arrangement. The security for, and payment of debt 
service on, an issue is determined from both the terms of the bond 
documents and on the basis of any underlying arrangement. An underlying 
arrangement may result from separate agreements between the parties or 
may be determined on the basis of all of the facts and circumstances 
surrounding the issuance of the bonds. For example, if the payment of 
debt service on an issue is secured by both a pledge of the full faith 
and credit of a state or local governmental unit and any interest in 
property used or to be used in a private business use, the issue meets 
the private security or payment test.
    (b) Measurement of private payments and security--(1) Scope. This 
paragraph (b) contains rules that apply to both private security and 
private payments.
    (2) Present value measurement--(i) Use of present value. In 
determining whether an issue meets the private security or payment test, 
the present value of the payments or property taken into account is 
compared to the present value of the debt service to be paid over the 
term of the issue.
    (ii) Debt service--(A) Debt service paid from proceeds. Debt service 
does not include any amount paid or to be paid from sale proceeds or 
investment proceeds. For example, debt service does not include payments 
of capitalized interest funded with proceeds.
    (B) Adjustments to debt service. Debt service is adjusted to take 
into account payments and receipts that adjust the yield on an issue for 
purposes of section 148(f). For example, debt service includes fees paid 
for qualified guarantees under Sec. 1.148-4(f) and is adjusted to take 
into account payments and receipts on qualified hedges under Sec. 1.148-
4(h).
    (iii) Computation of present value--(A) In general. Present values 
are determined by using the yield on the issue as the discount rate and 
by discounting all amounts to the issue date. See, however, Sec. 1.141-
13 for special rules for refunding bonds.
    (B) Fixed yield issues. For a fixed yield issue, yield is determined 
on the issue date and is not adjusted to take into account subsequent 
events.
    (C) Variable yield issues. The yield on a variable yield issue is 
determined over the term of the issue. To determine the reasonably 
expected yield as of any date, the issuer may assume that the future 
interest rate on a variable yield bond will be the then-current interest 
rate on the bonds determined under the formula prescribed in the bond 
documents. A deliberate action requires a recomputation of the yield on 
the variable yield issue to determine the present value of payments 
under that arrangement. In that case, the issuer must use the yield 
determined as of the date of the deliberate action for purposes of 
determining the present value of payments under the arrangement causing 
the deliberate action. See paragraph (g) of this section, Example 3.
    (iv) Application to private security. For purposes of determining 
the present value of debt service that is secured by property, the 
property is valued at fair market value as of the first date on which 
the property secures bonds of the issue.
    (c) Private payments--(1) In general. This paragraph (c) contains 
rules that apply to private payments.
    (2) Payments taken into account--(i) Payments for use--(A) In 
general. Both direct and indirect payments made by any nongovernmental 
person that is treated as using proceeds of the issue are taken into 
account as private payments to the extent allocable to the proceeds used 
by that person. Payments are taken into account as private payments only 
to the extent that they are made for the period of time that proceeds 
are used for a private business use. Payments for a use of proceeds 
include payments (whether or not to the issuer) in respect of property 
financed (directly or indirectly) with those proceeds, even if not made 
by a private business user. Payments are

[[Page 26]]

not made in respect of financed property if those payments are directly 
allocable to other property being directly used by the person making the 
payment and those payments represent fair market value compensation for 
that other use. See paragraph (g) of this section, Example 4 and Example 
5. See also paragraph (c)(3) of this section for rules relating to 
allocation of payments to the source or sources of funding of property.
    (B) Payments not to exceed use. Payments with respect to proceeds 
that are used for a private business use are not taken into account to 
the extent that the present value of those payments exceeds the present 
value of debt service on those proceeds. Payments need not be directly 
derived from a private business user, however, to be taken into account. 
Thus, if 7 percent of the proceeds of an issue is used by a person over 
the measurement period, payments with respect to the property financed 
with those proceeds are taken into account as private payments only to 
the extent that the present value of those payments does not exceed the 
present value of 7 percent of the debt service on the issue.
    (C) Payments for operating expenses. Payments by a person for a use 
of proceeds do not include the portion of any payment that is properly 
allocable to the payment of ordinary and necessary expenses (as defined 
under section 162) directly attributable to the operation and 
maintenance of the financed property used by that person. For this 
purpose, general overhead and administrative expenses are not directly 
attributable to those operations and maintenance. For example, if an 
issuer receives $5,000 rent during the year for use of space in a 
financed facility and during the year pays $500 for ordinary and 
necessary expenses properly allocable to the operation and maintenance 
of that space and $400 for general overhead and general administrative 
expenses properly allocable to that space, $500 of the $5,000 received 
would not be considered a payment for the use of the proceeds allocable 
to that space (regardless of the manner in which that $500 is actually 
used).
    (ii) Refinanced debt service. Payments of debt service on an issue 
to be made from proceeds of a refunding issue are taken into account as 
private payments in the same proportion that the present value of the 
payments taken into account as private payments for the refunding issue 
bears to the present value of the debt service to be paid on the 
refunding issue. For example, if all the debt service on a note is paid 
with proceeds of a refunding issue, the note meets the private security 
or payment test if (and to the same extent that) the refunding issue 
meets the private security or payment test. This paragraph (c)(2)(ii) 
does not apply to payments that arise from deliberate actions that occur 
more than 3 years after the retirement of the prior issue that are not 
reasonably expected on the issue date of the refunding issue. For 
purposes of this paragraph (c)(2)(ii), whether an issue is a refunding 
issue is determined without regard to Sec. 1.150-1(d)(2)(i) (relating to 
certain payments of interest).
    (3) Allocation of payments--(i) In general. Private payments for the 
use of property are allocated to the source or different sources of 
funding of property. The allocation to the source or different sources 
of funding is based on all of the facts and circumstances, including 
whether an allocation is consistent with the purposes of section 141. In 
general, a private payment for the use of property is allocated to a 
source of funding based upon the nexus between the payment and both the 
financed property and the source of funding. For this purpose, different 
sources of funding may include different tax-exempt issues, taxable 
issues, and amounts that are not derived from a borrowing, such as 
revenues of an issuer (equity).
    (ii) Payments for use of discrete property. Payments for the use of 
a discrete facility (or a discrete portion of a facility) are allocated 
to the source or different sources of funding of that discrete property.
    (iii) Allocations among two or more sources of funding. In general, 
except as provided in paragraphs (c)(3)(iv) and (v) of this section, if 
a payment is made for the use of property financed with two or more 
sources of funding (for example, equity and a tax-exempt issue), that 
payment must be allocated to

[[Page 27]]

those sources of funding in a manner that reasonably corresponds to the 
relative amounts of those sources of funding that are expended on that 
property. If an issuer has not retained records of amounts expended on 
the property (for example, records of costs of a building that was built 
30 years before the allocation), an issuer may use reasonable estimates 
of those expenditures. For this purpose, costs of issuance and other 
similar neutral costs are allocated ratably among expenditures in the 
same manner as in Sec. 1.141-3(g)(6). A payment for the use of property 
may be allocated to two or more issues that finance property according 
to the relative amounts of debt service (both paid and accrued) on the 
issues during the annual period for which the payment is made, if that 
allocation reasonably reflects the economic substance of the 
arrangement. In general, allocations of payments according to relative 
debt service reasonably reflect the economic substance of the 
arrangement if the maturity of the bonds reasonably corresponds to the 
reasonably expected economic life of the property and debt service 
payments on the bonds are approximately level from year to year.
    (iv) Payments made under an arrangement entered into in connection 
with issuance of bonds. A private payment for the use of property made 
under an arrangement that is entered into in connection with the 
issuance of the issue that finances that property generally is allocated 
to that issue. Whether an arrangement is entered into in connection with 
the issuance of an issue is determined on the basis of all of the facts 
and circumstances. An arrangement is ordinarily treated as entered into 
in connection with the issuance of an issue if--
    (A) The issuer enters into the arrangement during the 3-year period 
beginning 18 months before the issue date; and
    (B) The amount of payments reflects all or a portion of debt service 
on the issue.
    (v) Allocations to equity. A private payment for the use of property 
may be allocated to equity before payments are allocated to an issue 
only if--
    (A) Not later than 60 days after the date of the expenditure of 
those amounts, the issuer adopts an official intent (in a manner 
comparable to Sec. 1.150-2(e)) indicating that the issuer reasonably 
expects to be repaid for the expenditure from a specific arrangement; 
and
    (B) The private payment is made not later than 18 months after the 
later of the date the expenditure is made or the date the project is 
placed in service.
    (d) Private security--(1) In general. This paragraph (d) contains 
rules that relate to private security.
    (2) Security taken into account. The property that is the security 
for, or the source of, the payment of debt service on an issue need not 
be property financed with proceeds. For example, unimproved land or 
investment securities used, directly or indirectly, in a private 
business use that secures an issue provides private security. Private 
security (other than financed property and private payments) for an 
issue is taken into account under section 141(b), however, only to the 
extent it is provided, directly or indirectly, by a user of proceeds of 
the issue.
    (3) Pledge of unexpended proceeds. Proceeds qualifying for an 
initial temporary period under Sec. 1.148-2(e)(2) or (3) or deposited in 
a reasonably required reserve or replacement fund (as defined in 
Sec. 1.148-2(f)(2)(i)) are not taken into account under this paragraph 
(d) before the date on which those amounts are either expended or loaned 
by the issuer to an unrelated party.
    (4) Secured by any interest in property or payments. Property used 
or to be used for a private business use and payments in respect of that 
property are treated as private security if any interest in that 
property or payments secures the payment of debt service on the bonds. 
For this purpose, the phrase any interest in is to be interpreted 
broadly and includes, for example, any right, claim, title, or legal 
share in property or payments.
    (5) Payments in respect of property. The payments taken into account 
as private security are payments in respect of property used or to be 
used for a private business use. Except as otherwise provided in this 
paragraph (d)(5) and paragraph (d)(6) of this section, the

[[Page 28]]

rules in paragraphs (c)(2)(i)(A) and (B) and (c)(2)(ii) of this section 
apply to determine the amount of payments treated as payments in respect 
of property used or to be used for a private business use. Thus, 
payments made by members of the general public for use of a facility 
used for a private business use (for example, a facility that is the 
subject of a management contract that results in private business use) 
are taken into account as private security to the extent that they are 
made for the period of time that property is used by a private business 
user.
    (6) Allocation of security among issues. In general, property or 
payments from the disposition of that property that are taken into 
account as private security are allocated to each issue secured by the 
property or payments on a reasonable basis that takes into account 
bondholders' rights to the payments or property upon default.
    (e) Generally applicable taxes--(1) General rule. For purposes of 
the private security or payment test, generally applicable taxes are not 
taken into account (that is, are not payments from a nongovernmental 
person and are not payments in respect of property used for a private 
business use).
    (2) Definition of generally applicable taxes. A generally applicable 
tax is an enforced contribution exacted pursuant to legislative 
authority in the exercise of the taxing power that is imposed and 
collected for the purpose of raising revenue to be used for governmental 
or public purposes. A generally applicable tax must have a uniform tax 
rate that is applied to all persons of the same classification in the 
appropriate jurisdiction and a generally applicable manner of 
determination and collection.
    (3) Special charges. A special charge (as defined in this paragraph 
(e)(3)) is not a generally applicable tax. For this purpose, a special 
charge means a payment for a special privilege granted or regulatory 
function (for example, a license fee), a service rendered (for example, 
a sanitation services fee), a use of property (for example, rent), or a 
payment in the nature of a special assessment to finance capital 
improvements that is imposed on a limited class of persons based on 
benefits received from the capital improvements financed with the 
assessment. Thus, a special assessment to finance infrastructure 
improvements in a new industrial park (such as sidewalks, streets, 
streetlights, and utility infrastructure improvements) that is imposed 
on a limited class of persons composed of property owners within the 
industrial park who benefit from those improvements is a special charge. 
By contrast, an otherwise qualified generally applicable tax (such as a 
generally applicable ad valorem tax on all real property within a 
governmental taxing jurisdiction) or an eligible PILOT under paragraph 
(e)(5) of this section that is based on such a generally applicable tax 
is not treated as a special charge merely because the taxes or PILOTs 
received are used for governmental or public purposes in a manner which 
benefits particular property owners.
    (4) Manner of determination and collection--(i) In general. A tax 
does not have a generally applicable manner of determination and 
collection to the extent that one or more taxpayers make any 
impermissible agreements relating to payment of those taxes. An 
impermissible agreement relating to the payment of a tax is taken into 
account whether or not it is reasonably expected to result in any 
payments that would not otherwise have been made. For example, if an 
issuer uses proceeds to make a grant to a taxpayer to improve property, 
agreements that impose reasonable conditions on the use of the grant do 
not cause a tax on that property to fail to be a generally applicable 
tax. If an agreement by a taxpayer causes the tax imposed on that 
taxpayer not to be treated as a generally applicable tax, the entire tax 
paid by that taxpayer is treated as a special charge, unless the 
agreement is limited to a specific portion of the tax.
    (ii) Impermissible agreements. The following are examples of 
agreements that cause a tax to fail to have a generally applicable 
manner of determination and collection: an agreement to be personally 
liable on a tax that does not generally impose personal liability, to 
provide additional credit support such as a third party guarantee, or to 
pay unanticipated shortfalls; an agreement regarding the minimum market 
value

[[Page 29]]

of property subject to property tax; and an agreement not to challenge 
or seek deferral of the tax.
    (iii) Permissible agreements. The following are examples of 
agreements that do not cause a tax to fail to have a generally 
applicable manner of determination and collection: an agreement to use a 
grant for specified purposes (whether or not that agreement is secured); 
a representation regarding the expected value of the property following 
the improvement; an agreement to insure the property and, if damaged, to 
restore the property; a right of a grantor to rescind the grant if 
property taxes are not paid; and an agreement to reduce or limit the 
amount of taxes collected to further a bona fide governmental purpose. 
For example, an agreement to abate taxes to encourage a property owner 
to rehabilitate property in a distressed area is a permissible 
agreement.
    (5) Payments in lieu of taxes. A tax equivalency payment or other 
payment in lieu of a tax (``PILOT'') is treated as a generally 
applicable tax if it meets the requirements of paragraphs (e)(5)(i) 
through (iv) of this section--
    (i) Maximum amount limited by underlying generally applicable tax. 
The PILOT is not greater than the amount imposed by a statute for a 
generally applicable tax in each year.
    (ii) Commensurate with a generally applicable tax. The PILOT is 
commensurate with the amount imposed by a statute for a generally 
applicable tax in each year under the commensurate standard set forth in 
this paragraph (e)(5)(ii). For this purpose, except as otherwise 
provided in this paragraph (e)(5)(ii), a PILOT is commensurate with a 
generally applicable tax only if it is equal to a fixed percentage of 
the generally applicable tax that would otherwise apply in each year or 
it reflects a fixed adjustment to the generally applicable tax that 
would otherwise apply in each year. A PILOT based on a property tax does 
not fail to be commensurate with the property tax as a result of changes 
in the level of the percentage of or adjustment to that property tax for 
a reasonable phase-in period ending when the subject property is placed 
in service (as defined in Sec. 1.150-2(c)). A PILOT based on a property 
tax must take into account the current assessed value of the property 
for property tax purposes for each year in which the PILOT is paid and 
that assessed value must be determined in the same manner and with the 
same frequency as property subject to the property tax. A PILOT is not 
commensurate with a generally applicable tax, however, if the PILOT is 
set at a fixed dollar amount (for example, fixed debt service on a bond 
issue) that cannot vary with changes in the level of the generally 
applicable tax on which it is based.
    (iii) Use of PILOTs for governmental or public purposes. The PILOT 
is to be used for governmental or public purposes for which the 
generally applicable tax on which it is based may be used.
    (iv) No special charges. The PILOT is not a special charge under 
paragraph (e)(3) of this section.
    (f) Certain waste remediation bonds--(1) Scope. This paragraph (f) 
applies to bonds issued to finance hazardous waste clean-up activities 
on privately owned land (hazardous waste remediation bonds).
    (2) Persons that are not private users. Payments from 
nongovernmental persons who are not (other than coincidentally) either 
users of the site being remediated or persons potentially responsible 
for disposing of hazardous waste on that site are not taken into account 
as private security. This paragraph (f)(2) applies to payments that 
secure (directly or indirectly) the payment of principal of, or interest 
on, the bonds under the terms of the bonds. This paragraph (f)(2) 
applies only if the payments are made pursuant to either a generally 
applicable state or local taxing statute or a state or local statute 
that regulates or restrains activities on an industry-wide basis of 
persons who are engaged in generating or handling hazardous waste, or in 
refining, producing, or transporting petroleum, provided that those 
payments do not represent, in substance, payment for the use of 
proceeds. For this purpose, a state or local statute that imposes 
payments that have substantially the same character as those described 
in Chapter 38 of the Code are treated as generally applicable taxes.

[[Page 30]]

    (3) Persons that are private users. If payments from nongovernmental 
persons who are either users of the site being remediated or persons 
potentially responsible for disposing of hazardous waste on that site do 
not secure (directly or indirectly) the payment of principal of, or 
interest on, the bonds under the terms of the bonds, the payments are 
not taken into account as private payments. This paragraph (f)(3) 
applies only if at the time the bonds are issued the payments from those 
nongovernmental persons are not material to the security for the bonds. 
For this purpose, payments are not material to the security for the 
bonds if--
    (i) The payments are not required for the payment of debt service on 
the bonds;
    (ii) The amount and timing of the payments are not structured or 
designed to reflect the payment of debt service on the bonds;
    (iii) The receipt or the amount of the payment is uncertain (for 
example, as of the issue date, no final judgment has been entered into 
against the nongovernmental person);
    (iv) The payments from those nongovernmental persons, when and if 
received, are used either to redeem bonds of the issuer or to pay for 
costs of any hazardous waste remediation project; and
    (v) In the case when a judgment (but not a final judgment) has been 
entered by the issue date against a nongovernmental person, there are, 
as of the issue date, costs of hazardous waste remediation other than 
those financed with the bonds that may be financed with the payments.
    (g) Examples. The following examples illustrate the application of 
this section:

    Example 1. Aggregation of payments. State B issues bonds with 
proceeds of $10 million. B uses $9.7 million of the proceeds to 
construct a 10-story office building. B uses the remaining $300,000 of 
proceeds to make a loan to Corporation Y. In addition, Corporation X 
leases 1 floor of the building for the term of the bonds. Under all of 
the facts and circumstances, it is reasonable to allocate 10 percent of 
the proceeds to that 1 floor. As a percentage of the present value of 
the debt service on the bonds, the present value of Y's loan repayments 
is 3 percent and the present value of X's lease payments is 8 percent. 
The bonds meet the private security or payment test because the private 
payments taken into account are more than 10 percent of the present 
value of the debt service on the bonds.
    Example 2. Indirect private payments. J, a political subdivision of 
a state, will issue several series of bonds from time to time and will 
use the proceeds to rehabilitate urban areas. Under all of the facts and 
circumstances, the private business use test will be met with respect to 
each issue that will be used for the rehabilitation and construction of 
buildings that will be leased or sold to nongovernmental persons for use 
in their trades or businesses. Nongovernmental persons will make 
payments for these sales and leases. There is no limitation either on 
the number of issues or the aggregate amount of bonds that may be 
outstanding. No group of bondholders has any legal claim prior to any 
other bondholders or creditors with respect to specific revenues of J, 
and there is no arrangement whereby revenues from a particular project 
are paid into a trust or constructive trust, or sinking fund, or are 
otherwise segregated or restricted for the benefit of any group of 
bondholders. There is, however, an unconditional obligation by J to pay 
the principal of, and the interest on, each issue. Although not directly 
pledged under the terms of the bond documents, the leases and sales are 
underlying arrangements. The payments relating to these leases and sales 
are taken into account as private payments to determine whether each 
issue of bonds meets the private security or payment test.
    Example 3. Computation of payment in variable yield issues. (i) City 
M issues general obligation bonds with proceeds of $10 million to 
finance a 5-story office building. The bonds bear interest at a variable 
rate that is recomputed monthly according to an index that reflects 
current market yields. The yield that the interest index would produce 
on the issue date is 6 percent. M leases 1 floor of the office building 
to Corporation T, a nongovernmental person, for the term of the bonds. 
Under all of the facts and circumstances, T is treated as using more 
than 10 percent of the proceeds. Using the 6 percent yield as the 
discount rate, M reasonably expects on the issue date that the present 
value of lease payments to be made by T will be 8 percent of the present 
value of the total debt service on the bonds. After the issue date of 
the bonds, interest rates decline significantly, so that the yield on 
the bonds over their entire term is 4 percent. Using this actual 4 
percent yield as the discount rate, the present value of lease payments 
made by T is 12 percent of the present value of the actual total debt 
service on the bonds. The bonds are not private activity bonds because M 
reasonably expected on the issue

[[Page 31]]

date that the bonds would not meet the private security or payment test 
and because M did not take any subsequent deliberate action to meet the 
private security or payment test.
    (ii) The facts are the same as Example 3(i), except that 5 years 
after the issue date M leases a second floor to Corporation S, a 
nongovernmental person, under a long-term lease. Because M has taken a 
deliberate action, the present value of the lease payments must be 
computed. On the date this lease is entered into, M reasonably expects 
that the yield on the bonds over their entire term will be 5.5 percent, 
based on actual interest rates to date and the then-current rate on the 
variable yield bonds. M uses this 5.5 percent yield as the discount 
rate. Using this 5.5 percent yield as the discount rate, as a percentage 
of the present value of the debt service on the bonds, the present value 
of the lease payments made by S is 3 percent. The bonds are private 
activity bonds because the present value of the aggregate private 
payments is greater than 10 percent of the present value of debt 
service.
    Example 4. Payments not in respect of financed property. In order to 
further public safety, City Y issues tax assessment bonds the proceeds 
of which are used to move existing electric utility lines underground. 
Although the utility lines are owned by a nongovernmental utility 
company, that company is under no obligation to move the lines. The debt 
service on the bonds will be paid using assessments levied by City Y on 
the customers of the utility. Although the utility lines are privately 
owned and the utility customers make payments to the utility company for 
the use of those lines, the assessments are payments in respect of the 
cost of relocating the utility line. Thus, the assessment payments are 
not made in respect of property used for a private business use. Any 
direct or indirect payments to Y by the utility company for the 
undergrounding are, however, taken into account as private payments.
    Example 5. Payments from users of proceeds that are not private 
business users taken into account. City P issues general obligation 
bonds to finance the renovation of a hospital that it owns. The hospital 
is operated for P by D, a nongovernmental person, under a management 
contract that results in private business use under Sec. 1.141-3. P will 
use the revenues from the hospital (after the required payments to D and 
the payment of operation and maintenance expenses) to pay the debt 
service on the bonds. The bonds meet the private security or payment 
test because the revenues from the hospital are payments in respect of 
property used for a private business use.
    Example 6. Limitation of amount of payments to amount of private 
business use not determined annually. City Q issues bonds with a term of 
15 years and uses the proceeds to construct an office building. The debt 
service on the bonds is level throughout the 15-year term. Q enters into 
a 5-year lease with Corporation R under which R is treated as a user of 
11 percent of the proceeds. R will make lease payments equal to 20 
percent of the annual debt service on the bonds for each year of the 
lease. The present value of R's lease payments is equal to 12 percent of 
the present value of the debt service over the entire 15-year term of 
the bonds. If, however, the lease payments taken into account as private 
payments were limited to 11 percent of debt service paid in each year of 
the lease, the present value of these payments would be only 8 percent 
of the debt service on the bonds over the entire term of the bonds. The 
bonds meet the private security or payment test, because R's lease 
payments are taken into account as private payments in an amount not to 
exceed 11 percent of the debt service of the bonds.
    Example 7. Allocation of payments to funds not derived from a 
borrowing. City Z purchases property for $1,250,000 using $1,000,000 of 
proceeds of its tax increment bonds and $250,000 of other revenues that 
are in its redevelopment fund. Within 60 days of the date of purchase, Z 
declared its intent to sell the property pursuant to a redevelopment 
plan and to use that amount to reimburse its redevelopment fund. The 
bonds are secured only by the incremental property taxes attributable to 
the increase in value of the property from the planned redevelopment of 
the property. Within 18 months after the issue date, Z sells the 
financed property to Developer M for $250,000, which Z uses to reimburse 
the redevelopment fund. The property that M uses is financed both with 
the proceeds of the bonds and Z's redevelopment fund. The payments by M 
are properly allocable to the costs of property financed with the 
amounts in Z's redevelopment fund. See paragraphs (c)(3) (i) and (v) of 
this section.
    Example 8. Allocation of payments to different sources of funding--
improvements. In 1997, City L issues bonds with proceeds of $8 million 
to finance the acquisition of a building. In 2002, L spends $2 million 
of its general revenues to improve the heating system and roof of the 
building. At that time, L enters into a 10-year lease with Corporation M 
for the building providing for annual payments of $1 million to L. The 
lease payments are at fair market value, and the lease payments do not 
otherwise have a significant nexus to either the issue or to the 
expenditure of general revenues. Eighty percent of each lease payment is 
allocated to the issue and is taken into account under the private 
payment test because each lease payment is properly allocated to the 
sources of funding in a manner that reasonably corresponds to the 
relative amounts of the sources of funding that are expended on the 
building.

[[Page 32]]

    Example 9. Security not provided by users of proceeds not taken into 
account. County W issues certificates of participation in a lease of a 
building that W owns and covenants to appropriate annual payments for 
the lease. A portion of each payment is specified as interest. More than 
10 percent of the building is used for private business use. None of the 
proceeds of the obligations are used with respect to the building. W 
uses the proceeds of the obligations to make a grant to Corporation Y 
for the construction of a factory that Y will own. Y makes no payments 
to W, directly or indirectly, for its use of proceeds, and Y has no 
relationship to the users of the leased building. If W defaults under 
the lease, the trustee for the holders of the certificates of 
participation has a limited right of repossession under which the 
trustee may not foreclose but may lease the property to a new tenant at 
fair market value. The obligations are secured by an interest in 
property used for a private business use. However, because the property 
is not provided by a private business user and is not financed property, 
the obligations do not meet the private security or payment test.
    Example 10. Allocation of payments among issues. University L, a 
political subdivision, issued three separate series of revenue bonds 
during 1989, 1991, and 1993 under the same bond resolution. L used the 
proceeds to construct facilities exclusively for its own use. Bonds 
issued under the resolution are equally and ratably secured and payable 
solely from the income derived by L from rates, fees, and charges 
imposed by L for the use of the facilities. The bonds issued in 1989, 
1991, and 1993 are not private activity bonds. In 1997, L issues another 
series of bonds under the resolution to finance additional facilities. L 
leases 20 percent of the new facilities for the term of the 1997 bonds 
to nongovernmental persons who will use the facilities in their trades 
or businesses. The present value of the lease payments from the 
nongovernmental users will equal 15 percent of the present value of the 
debt service on the 1997 bonds. L will commingle all of the revenues 
from all its bond-financed facilities in its revenue fund. The present 
value of the portion of the lease payments from nongovernmental lessees 
of the new facilities allocable to the 1997 bonds under paragraph (d) of 
this section is less than 10 percent of the present value of the debt 
service on the 1997 bonds because the bond documents provide that the 
bonds are equally and ratably secured. Accordingly, the 1997 bonds do 
not meet the private security test. The 1997 bonds meet the private 
payment test, however, because the private lease payments for the new 
facility are properly allocated to those bonds (that is, because none of 
the proceeds of the prior issues were used for the new facilities). See 
paragraph (c) of this section.
    Example 11. Generally applicable tax. (i) Authority N issues bonds 
to finance the construction of a stadium. Under a long-term lease, 
Corporation X, a professional sports team, will use more than 10 percent 
of the stadium. X will not, however, make any payments for this private 
business use. The security for the bonds will be a ticket tax imposed on 
each person purchasing a ticket for an event at the stadium. The portion 
of the ticket tax attributable to tickets purchased by persons attending 
X's events will, on a present value basis, exceed 10 percent of the 
present value of the debt service on N's bonds. The bonds meet the 
private security or payment test. The ticket tax is not a generally 
applicable tax and, to the extent that the tax receipts relate to X's 
events, the taxes are payments in respect of property used for a private 
business use.
    (ii) The facts are the same as Example 11(i), except that the ticket 
tax is imposed by N on tickets purchased for events at a number of large 
entertainment facilities within the N's jurisdiction (for example, other 
stadiums, arenas, and concert halls), some of which were not financed 
with tax-exempt bonds. The ticket tax is a generally applicable tax and 
therefore the revenues from this tax are not payments in respect of 
property used for a private business use. The receipt of the ticket tax 
does not cause the bonds to meet the private security or payment test.

[T.D. 8712, 62 FR 2291, Jan. 16, 1997, as amended by T.D. 9429, 73 FR 
63374, Oct. 24, 2008]



Sec. 1.141-5  Private loan financing test.

    (a) In general. Bonds of an issue are private activity bonds if more 
than the lesser of 5 percent or $5 million of the proceeds of the issue 
is to be used (directly or indirectly) to make or finance loans to 
persons other than governmental persons. Section 1.141-2(d) applies in 
determining whether the private loan financing test is met. In 
determining whether the proceeds of an issue are used to make or finance 
loans, indirect, as well as direct, use of the proceeds is taken into 
account.
    (b) Measurement of test. In determining whether the private loan 
financing test is met, the amount actually loaned to a nongovernmental 
person is not discounted to reflect the present value of the loan 
repayments.
    (c) Definition of private loan--(1) In general. Any transaction that 
is generally characterized as a loan for federal income tax purposes is 
a loan for purposes of this section. In addition, a loan may arise from 
the direct lending of bond proceeds or may arise from

[[Page 33]]

transactions in which indirect benefits that are the economic equivalent 
of a loan are conveyed. Thus, the determination of whether a loan is 
made depends on the substance of a transaction rather than its form. For 
example, a lease or other contractual arrangement (for example, a 
management contract or an output contract) may in substance constitute a 
loan if the arrangement transfers tax ownership of the facility to a 
nongovernmental person. Similarly, an output contract or a management 
contract with respect to a financed facility generally is not treated as 
a loan of proceeds unless the agreement in substance shifts significant 
burdens and benefits of ownership to the nongovernmental purchaser or 
manager of the facility.
    (2) Application only to purpose investments--(i) In general. A loan 
may be either a purpose investment or a nonpurpose investment. A loan 
that is a nonpurpose investment does not cause the private loan 
financing test to be met. For example, proceeds invested in loans, such 
as obligations of the United States, during a temporary period, as part 
of a reasonably required reserve or replacement fund, as part of a 
refunding escrow, or as part of a minor portion (as each of those terms 
are defined in Sec. 1.148-1 or Sec. 1.148-2) are generally not treated 
as loans under the private loan financing test.
    (ii) Certain prepayments treated as loans. Except as otherwise 
provided, a prepayment for property or services, including a prepayment 
for property or services that is made after the date that the contract 
to buy the property or services is entered into, is treated as a loan 
for purposes of the private loan financing test if a principal purpose 
for prepaying is to provide a benefit of tax-exempt financing to the 
seller. A prepayment is not treated as a loan for purposes of the 
private loan financing test if--
    (A) Prepayments on substantially the same terms are made by a 
substantial percentage of persons who are similarly situated to the 
issuer but who are not beneficiaries of tax-exempt financing;
    (B) The prepayment is made within 90 days of the reasonably expected 
date of delivery to the issuer of all of the property or services for 
which the prepayment is made; or
    (C) The prepayment meets the requirements of Sec. 1.148-
1(e)(2)(iii)(A) or (B) (relating to certain prepayments to acquire a 
supply of natural gas or electricity).
    (iii) Customary prepayments. The determination of whether a 
prepayment satisfies paragraph (c)(2)(ii)(A) of this section is 
generally made based on all the facts and circumstances. In addition, a 
prepayment is deemed to satisfy paragraph (c)(2)(ii)(A) of this section 
if--
    (A) The prepayment is made for--
    (1) Maintenance, repair, or an extended warranty with respect to 
personal property (for example, automobiles or electronic equipment); or
    (2) Updates or maintenance or support services with respect to 
computer software; and
    (B) The same maintenance, repair, extended warranty, updates or 
maintenance or support services, as applicable, are regularly provided 
to nongovernmental persons on the same terms.
    (iv) Additional prepayments as permitted by the Commissioner. The 
Commissioner may, by published guidance, set forth additional 
circumstances in which a prepayment is not treated as a loan for 
purposes of the private loan financing test.
    (3) Grants--(i) In general. A grant of proceeds is not a loan. 
Whether a transaction may be treated as a grant or a loan depends on all 
of the facts and circumstances.
    (ii) Tax increment financing--(A) In general. Generally, a grant 
using proceeds of an issue that is secured by generally applicable taxes 
attributable to the improvements to be made with the grant is not 
treated as a loan, unless the grantee makes any impermissible agreements 
relating to the payment that results in the taxes imposed on that 
taxpayer not to be treated as generally applicable taxes under 
Sec. 1.141-4(e).
    (B) Amount of loan. If a grant is treated as a loan under this 
paragraph (c)(3), the entire grant is treated as a loan unless the 
impermissible agreement is limited to a specific portion of the tax. For 
this purpose, an arrangement with

[[Page 34]]

each unrelated grantee is treated as a separate grant.
    (4) Hazardous waste remediation bonds. In the case of an issue of 
hazardous waste remediation bonds, payments from nongovernmental persons 
that are either users of the site being remediated or persons 
potentially responsible for disposing of hazardous waste on that site do 
not establish that the transaction is a loan for purposes of this 
section. This paragraph (c)(4) applies only if those payments do not 
secure the payment of principal of, or interest on, the bonds (directly 
or indirectly), under the terms of the bonds and those payments are not 
taken into account under the private payment test pursuant to 
Sec. 1.141-4(f)(3).
    (d) Tax assessment loan exception--(1) General rule. For purposes of 
this section, a tax assessment loan that satisfies the requirements of 
this paragraph (d) is not a loan for purposes of the private loan 
financing test.
    (2) Tax assessment loan defined. A tax assessment loan is a loan 
that arises when a governmental person permits or requires property 
owners to finance any governmental tax or assessment of general 
application for an essential governmental function that satisfies each 
of the requirements of paragraphs (d) (3) through (5) of this section.
    (3) Mandatory tax or other assessment. The tax or assessment must be 
an enforced contribution that is imposed and collected for the purpose 
of raising revenue to be used for a specific purpose (that is, to defray 
the capital cost of an improvement). Taxes and assessments do not 
include fees for services. The tax or assessment must be imposed 
pursuant to a state law of general application that can be applied 
equally to natural persons not acting in a trade or business and persons 
acting in a trade or business. For this purpose, taxes and assessments 
that are imposed subject to protest procedures are treated as enforced 
contributions.
    (4) Specific essential governmental function--(i) In general. A 
mandatory tax or assessment that gives rise to a tax assessment loan 
must be imposed for one or more specific, essential governmental 
functions.
    (ii) Essential governmental functions. For purposes of paragraph (d) 
of this section, improvements to utilities and systems that are owned by 
a governmental person and that are available for use by the general 
public (such as sidewalks, streets and street-lights; electric, 
telephone, and cable television systems; sewage treatment and disposal 
systems; and municipal water facilities) serve essential governmental 
functions. For other types of facilities, the extent to which the 
service provided by the facility is customarily performed (and financed 
with governmental bonds) by governments with general taxing powers is a 
primary factor in determining whether the facility serves an essential 
governmental function. For example, parks that are owned by a 
governmental person and that are available for use by the general public 
serve an essential governmental function. Except as otherwise provided 
in this paragraph (d)(4)(ii), commercial or industrial facilities and 
improvements to property owned by a nongovernmental person do not serve 
an essential governmental

function. Permitting installment payments of property taxes or other 
taxes is not an essential governmental function.
    (5) Equal basis requirement--(i) In general. Owners of both business 
and nonbusiness property benefiting from the financed improvements must 
be eligible, or required, to make deferred payments of the tax or 
assessment giving rise to a tax assessment loan on an equal basis (the 
equal basis requirement). A tax or assessment does not satisfy the equal 
basis requirement if the terms for payment of the tax or assessment are 
not the same for all taxed or assessed persons. For example, the equal 
basis requirement is not met if certain property owners are permitted to 
pay the tax or assessment over a period of years while others must pay 
the entire tax or assessment immediately or if only certain property 
owners are required to prepay the tax or assessment when the property is 
sold.
    (ii) General rule for guarantees. A guarantee of debt service on 
bonds, or of taxes or assessments, by a person that is treated as a 
borrower of bond proceeds violates the equal basis requirement if it is 
reasonable to expect on the date the guarantee is entered

[[Page 35]]

into that payments will be made under the guarantee.
    (6) Coordination with private business tests. See Secs. 1.141-3 and 
1.141-4 for rules for determining whether tax assessment loans cause the 
bonds financing those loans to be private activity bonds under the 
private business use and the private security or payment tests.
    (e) Examples. The following examples illustrate the application of 
this section:

    Example 1. Turnkey contract not treated as a loan. State agency Z 
and federal agency H will each contribute to rehabilitate a project 
owned by Z. H can only provide its funds through a contribution to Z to 
be used to acquire the rehabilitated project on a turnkey basis from an 
approved developer. Under H's turnkey program, the developer must own 
the project while it is rehabilitated. Z issues its notes to provide 
funds for construction. A portion of the notes will be retired using the 
H contribution, and the balance of the notes will be retired through the 
issuance by Z of long-term bonds. Z lends the proceeds of its notes to 
Developer B as construction financing and transfers title to B for a 
nominal amount. The conveyance is made on condition that B rehabilitate 
the property and reconvey it upon completion, with Z retaining the right 
to force reconveyance if these conditions are not satisfied. B must name 
Z as an additional insured on all insurance. Upon completion, B must 
transfer title to the project back to Z at a set price, which price 
reflects B's costs and profit, not fair market value. Further, this 
price is adjusted downward to reflect any cost-underruns. For purposes 
of section 141(c), this transaction does not involve a private loan.
    Example 2. Essential government function requirement not met. City D 
creates a special taxing district consisting of property owned by 
nongovernmental persons that requires environmental clean-up. D imposes 
a special tax on each parcel within the district in an amount that is 
related to the expected environmental clean-up costs of that parcel. The 
payment of the tax over a 20-year period is treated as a loan by the 
property owners for purposes of the private loan financing test. The 
special district issues bonds, acting on behalf of D, that are payable 
from the special tax levied within the district, and uses the proceeds 
to pay for the costs of environmental clean-up on the property within 
the district. The bonds meet the private loan financing test because 
more than 5 percent of the proceeds of the issue are loaned to 
nongovernmental persons. The issue does not meet the tax assessment loan 
exception because the improvements to property owned by a 
nongovernmental person are not an essential governmental function under 
section 141(c)(2). The issue also meets the private business tests of 
section 141(b).

[T.D. 8712, 62 FR 2296, Jan. 16, 1997, as amended by T.D. 9085, 68 FR 
45775, Aug. 4, 2003]



Sec. 1.141-6  Allocation and accounting rules.

    (a) Allocations of proceeds to expenditures, projects, and uses in 
general--(1) Allocations to expenditures. The allocations of proceeds 
and other sources of funds to expenditures under Sec. 1.148-6(d) apply 
for purposes of Secs. 1.141-1 through 1.141-15.
    (2) Allocations of sources to a project and its uses. Except as 
provided in paragraph (b) of this section (regarding an eligible mixed-
use project), if two or more sources of funding (including two or more 
tax-exempt issues) are allocated to capital expenditures (as defined in 
Sec. 1.150-1(b)) for a project (as defined in paragraph (a)(3) of this 
section), those sources are allocated throughout that project to the 
governmental use and private business use of the project in proportion 
to the relative amounts of those sources of funding spent on the 
project.
    (3) Definition of project--(i) In general. For purposes of this 
section, project means one or more facilities or capital projects, 
including land, buildings, equipment, or other property, financed in 
whole or in part with proceeds of the issue.
    (ii) Output facilities. If an output facility has multiple undivided 
ownership interests (respectively owned by governmental persons or by 
both governmental and nongovernmental persons), each owner's interest in 
the facility is treated as a separate facility for purposes of this 
section, provided that all owners of the undivided ownership interests 
share the ownership and output in proportion to their contributions to 
the capital costs of the output facility.
    (b) Special allocation rules for eligible mixed-use projects--(1) In 
general. The sources of funding allocated to capital expenditures for an 
eligible mixed-use project (as defined in paragraph (b)(2) of this 
section) are allocated to undivided portions of the eligible mixed-use 
project and the governmental use and private business use of the 
eligible mixed-use project in accordance with

[[Page 36]]

this paragraph (b). Qualified equity (as defined in paragraph (b)(3) of 
this section) is allocated first to the private business use of the 
eligible mixed-use project and then to governmental use, and proceeds 
are allocated first to the governmental use and then to private business 
use, using the percentages of the eligible mixed-use project financed 
with the respective sources and the percentages of the respective uses. 
Thus, if the percentage of the eligible mixed-use project financed with 
qualified equity is less than the percentage of private business use of 
the project, all of the qualified equity is allocated to the private 
business use. Proceeds are allocated to the balance of the private 
business use of the project. Similarly, if the percentage of the 
eligible mixed-use project financed with proceeds is less than the 
percentage of governmental use of the project, all of the proceeds are 
allocated to the governmental use, and qualified equity is allocated to 
the balance of the governmental use of the project. Further, if proceeds 
of more than one issue finance the eligible mixed-use project, proceeds 
of each issue are allocated ratably to the uses to which proceeds are 
allocated in proportion to the relative amounts of the proceeds of such 
issues allocated to the eligible mixed-use project. For private business 
use measured under Sec. 1.141-3(g), qualified equity and proceeds are 
allocated to the uses of the eligible mixed-use project in each one-year 
period under Sec. 1.141-3(g)(4). See Example 1 of paragraph (f) of this 
section.
    (2) Definition of eligible mixed-use project. Eligible mixed-use 
project means a project (as defined in paragraph (a)(3) of this section) 
that is financed with proceeds of bonds that, when issued, purported to 
be governmental bonds (as defined in Sec. 1.150-1(b)) (the applicable 
bonds) and with qualified equity pursuant to the same plan of financing 
(within the meaning of Sec. 1.150-1(c)(1)(ii)). An eligible mixed-use 
project must be wholly owned by one or more governmental persons or by a 
partnership in which at least one governmental person is a partner.
    (3) Definition of qualified equity. For purposes of this section, 
qualified equity means proceeds of bonds that are not tax-advantaged 
bonds and funds that are not derived from proceeds of a borrowing that 
are spent on the same eligible mixed-use project as the proceeds of the 
applicable bonds. Qualified equity does not include equity interests in 
real property or tangible personal property. Further, qualified equity 
does not include funds used to redeem or repay governmental bonds. See 
Secs. 1.141-2(d)(2)(ii) and 1.141-12(i) (regarding the effects of 
certain redemptions as remedial actions).
    (4) Same plan of financing. Qualified equity finances a project 
under the same plan of financing that includes the applicable bonds if 
the qualified equity pays for capital expenditures of the project on a 
date that is no earlier than a date on which such expenditures would be 
eligible for reimbursement by proceeds of the applicable bonds under 
Sec. 1.150-2(d)(2) (regardless of whether the applicable bonds are 
reimbursement bonds) and, except for a reasonable retainage (within the 
meaning of Sec. 1.148-7(h)), no later than the date on which the 
measurement period begins.
    (c) Allocations of private payments. Except as provided in this 
paragraph (c), private payments for a project are allocated in 
accordance with Sec. 1.141-4. Payments under an output contract that 
result in private business use of an eligible mixed-use project are 
allocated to the same source of funding (notwithstanding Sec. 1.141-
4(c)(3)(v) (regarding certain allocations of private payments to 
equity)) allocated to the private business use from such contract under 
paragraph (b) of this section.
    (d) Allocations of proceeds to common costs of an issue. Proceeds 
used for expenditures for common costs (for example, issuance costs, 
qualified guarantee fees, or reasonably required reserve or replacement 
funds) are allocated in accordance with Sec. 1.141-3(g)(6). Proceeds, as 
allocated under Sec. 1.141-3(g)(6) to an eligible mixed-use project, are 
allocated to the uses of the project in the same proportions as the 
proceeds allocated to the uses under paragraph (b) of this section.
    (e) Allocations of proceeds to bonds. In general, proceeds are 
allocated to bonds in accordance with the rules for allocations of 
proceeds to bonds for separate purposes of multipurpose

[[Page 37]]

issues in Sec. 1.141-13(d). For an issue that is not a multipurpose 
issue (or is a multipurpose issue for which the issuer has not made a 
multipurpose allocation), proceeds are allocated to bonds ratably in a 
manner similar to the allocation of proceeds to projects under paragraph 
(a)(2) of this section.
    (f) Examples. The following examples illustrate the application of 
this section:

    Example 1. Mixed-use project. City A issues $70x of bonds (the 
Bonds) and finances the construction of a 10-story office building 
costing $100x (the Project) with proceeds of the Bonds and $30x of 
qualified equity (the Qualified Equity). To the extent that the private 
business use of the Project does not exceed 30 percent in any particular 
year, the Qualified Equity is allocated to the private business use. If 
private business use of the Project were, for example, 44 percent in a 
year, the Qualified Equity would be allocated to 30 percent ($30x) 
private business use and proceeds of the Bonds would be allocated to the 
excess (that is, 14 percent or $14x), resulting in private business use 
of the Bonds in that year of 20 percent ($14x/$70x). Conversely, if 
private business use of the Project were 20 percent, Qualified Equity 
would be allocated to that 20 percent. The remaining Qualified Equity 
(that is, 10 percent or $10x) would be allocated to the governmental use 
in excess of the 70 percent to which the proceeds of the Bonds would be 
allocated.
    Example 2. Mixed-use output facility. Authority A is a governmental 
person that owns and operates an electric transmission facility. Several 
years ago, Authority A used its equity to pay capital expenditures of 
$1000x for the facility. Authority A wants to make capital improvements 
to the facility in the amount of $100x (the Project). Authority A 
reasonably expects that, after completion of the Project, it will sell 
46 percent of the available output of the facility, as determined under 
Sec. 1.141-7, under output contracts that result in private business use 
and it will sell 54 percent of the available output of the facility for 
governmental use. On January 1, 2017, Authority A issues $60x of bonds 
(the Bonds) and uses the proceeds of the Bonds and $40x of qualified 
equity (the Qualified Equity) to finance the Project. The Qualified 
Equity is allocated to 40 of the 46 percent private business use 
resulting from the output contracts. Proceeds of the Bonds are allocated 
to the 54 percent governmental use and thereafter to the remaining 6 
percent private business use.
    Example 3. Subsequent improvements and replacements. County A owns a 
hospital, which opened in 2001, that it financed entirely with proceeds 
of bonds it issued in 1998 (the 1998 Bonds). In 2017, County A finances 
the cost of an addition to the hospital with proceeds of bonds (the 2017 
Bonds) and qualified equity (the 2017 Qualified Equity). The original 
hospital is a project (the 1998 Project) and the addition is a project 
(the 2017 Project). Proceeds of the 2017 Bonds and the 2017 Qualified 
Equity are allocated to the 2017 Project. The 2017 Qualified Equity is 
allocated first to the private business use of the 2017 Project and then 
to the governmental use of the 2017 Project. Proceeds of the 2017 Bonds 
are allocated first to the governmental use of the 2017 Project and then 
to the private business use of that project. Neither proceeds of the 
2017 Bonds nor 2017 Qualified Equity is allocated to the uses of the 
1998 Project. Proceeds of the 1998 Bonds are not allocated to uses of 
the 2017 Project.

[T.D. 9741, 80 FR 65643, Oct. 27, 2015]



Sec. 1.141-7  Special rules for output facilities.

    (a) Overview. This section provides special rules to determine 
whether arrangements for the purchase of output from an output facility 
cause an issue of bonds to meet the private business tests. For this 
purpose, unless otherwise stated, water facilities are treated as output 
facilities. Sections 1.141-3 and 1.141-4 generally apply to determine 
whether other types of arrangements for use of an output facility cause 
an issue to meet the private business tests.
    (b) Definitions. For purposes of this section and Sec. 1.141-8, the 
following definitions and rules apply:
    (1) Available output. The available output of a facility financed by 
an issue is determined by multiplying the number of units produced or to 
be produced by the facility in one year by the number of years in the 
measurement period of that facility for that issue.
    (i) Generating facilities. The number of units produced or to be 
produced by a generating facility in one year is determined by reference 
to its nameplate capacity or the equivalent (or where there is no 
nameplate capacity or the equivalent, its maximum capacity), which is 
not reduced for reserves, maintenance or other unutilized capacity.
    (ii) Transmission and other output facilities--(A) In general. For 
transmission, distribution, cogeneration, and other output facilities, 
available

[[Page 38]]

output must be measured in a reasonable manner to reflect capacity.
    (B) Electric transmission facilities. Measurement of the available 
output of all or a portion of electric transmission facilities may be 
determined in a manner consistent with the reporting rules and 
requirements for transmission networks promulgated by the Federal Energy 
Regulatory Commission (FERC). For example, for a transmission network, 
the use of aggregate load and load share ratios in a manner consistent 
with the requirements of the FERC may be reasonable. In addition, 
depending on the facts and circumstances, measurement of the available 
output of transmission facilities using thermal capacity or transfer 
capacity may be reasonable.
    (iii) Special rule for facilities with significant unutilized 
capacity. If an issuer reasonably expects on the issue date that persons 
that are treated as private business users will purchase more than 30 
percent of the actual output of the facility financed with the issue, 
the Commissioner may determine the number of units produced or to be 
produced by the facility in one year on a reasonable basis other than by 
reference to nameplate or other capacity, such as the average expected 
annual output of the facility. For example, the Commissioner may 
determine the available output of a financed peaking electric generating 
unit by reference to the reasonably expected annual output of that unit 
if the issuer reasonably expects, on the issue date of bonds that 
finance the unit, that an investor-owned utility will purchase more than 
30 percent of the actual output of the facility during the measurement 
period under a take or pay contract, even if the amount of output 
purchased is less than 10 percent of the available output determined by 
reference to nameplate capacity. The reasonably expected annual output 
of the generating facility must be consistent with the capacity reported 
for prudent reliability purposes.
    (iv) Special rule for facilities with a limited source of supply. If 
a limited source of supply constrains the output of an output facility, 
the number of units produced or to be produced by the facility must be 
determined by reasonably taking into account those constraints. For this 
purpose, a limited source of supply shall include a physical limitation 
(for example, flow of water), but not an economic limitation (for 
example, cost of coal or gas). For example, the available output of a 
hydroelectric unit must be determined by reference to the reasonably 
expected annual flow of water through the unit.
    (2) Measurement period. The measurement period of an output facility 
financed by an issue is determined under Sec. 1.141-3(g).
    (3) Sale at wholesale. A sale at wholesale means a sale of output to 
any person for resale.
    (4) Take contract and take or pay contract. A take contract is an 
output contract under which a purchaser agrees to pay for the output 
under the contract if the output facility is capable of providing the 
output. A take or pay contract is an output contract under which a 
purchaser agrees to pay for the output under the contract, whether or 
not the output facility is capable of providing the output.
    (5) Requirements contract. A requirements contract is an output 
contract, other than a take contract or a take or pay contract, under 
which a nongovernmental person agrees to purchase all or part of its 
output requirements.
    (6) Nonqualified amount. The nonqualified amount with respect to an 
issue is determined under section 141(b)(8).
    (c) Output contracts--(1) General rule. The purchase pursuant to a 
contract by a nongovernmental person of available output of an output 
facility (output contract) financed with proceeds of an issue is taken 
into account under the private business tests if the purchase has the 
effect of transferring the benefits of owning the facility and the 
burdens of paying the debt service on bonds used (directly or 
indirectly) to finance the facility (the benefits and burdens test). See 
paragraph (c)(4) of this section for the treatment of an output contract 
that is properly characterized as a lease for Federal income tax 
purposes. See paragraphs (d) and (e) of this section for rules regarding 
measuring the use of, and payments of debt service for, an output 
facility for

[[Page 39]]

determining whether the private business tests are met. See also 
Sec. 1.141-8 for rules for when an issue that finances an output 
facility (other than a water facility) meets the private business tests 
because the nonqualified amount of the issue exceeds $15 million.
    (2) Take contract or take or pay contract. The benefits and burdens 
test is met if a nongovernmental person agrees pursuant to a take 
contract or a take or pay contract to purchase available output of a 
facility.
    (3) Requirements contract--(i) In general. A requirements contract 
may satisfy the benefits and burdens test under paragraph (c)(3)(ii) or 
(iii) of this section. See Sec. 1.141-15(f)(2) for special effective 
dates for the application of this paragraph (c)(3) to issues financing 
facilities subject to requirements contracts.
    (ii) Requirements contract similar to take contract or take or pay 
contract. A requirements contract generally meets the benefits and 
burdens test to the extent that it contains contractual terms that 
obligate the purchaser to make payments that are not contingent on the 
output requirements of the purchaser or that obligate the purchaser to 
have output requirements. For example, a requirements contract with an 
industrial purchaser meets the benefits and burdens test if the 
purchaser enters into additional contractual obligations with the issuer 
or another governmental unit not to cease operations. A requirements 
contract does not meet the benefits and burdens test, however, by reason 
of a provision that requires the purchaser to pay reasonable and 
customary damages (including liquidated damages) in the event of a 
default, or a provision that permits the purchaser to pay a specified 
amount to terminate the contract while the purchaser has requirements, 
in each case if the amount of the payment is reasonably related to the 
purchaser's obligation to buy requirements that is discharged by the 
payment.
    (iii) Wholesale requirements contract--(A) In general. A 
requirements contract that is a sale at wholesale (a wholesale 
requirements contract) may satisfy the benefits and burdens test, 
depending on all the facts and circumstances.
    (B) Significant factors. Significant factors that tend to establish 
that a wholesale requirements contract meets the benefits and burdens 
test include, but are not limited to--
    (1) The term of the contract is substantial relative to the term of 
the issue or issues that finance the facility; and
    (2) The amount of output to be purchased under the contract 
represents a substantial portion of the available output of the 
facility.
    (C) Safe harbors. A wholesale requirements contract does not meet 
the benefits and burdens test if--
    (1) The term of the contract, including all renewal options, does 
not exceed the lesser of 5 years or 30 percent of the term of the issue; 
or
    (2) The amount of output to be purchased under the contract (and any 
other requirements contract with the same purchaser or a related party 
with respect to the facility) does not exceed 5 percent of the available 
output of the facility.
    (iv) Retail requirements contract. Except as otherwise provided in 
this paragraph (c)(3), a requirements contract that is not a sale at 
wholesale does not meet the benefits and burdens test.
    (4) Output contract properly characterized as a lease. 
Notwithstanding any other provision of this section, an output contract 
that is properly characterized as a lease for Federal income tax 
purposes shall be tested under the rules contained in Secs. 1.141-3 and 
1.141-4 to determine whether it is taken into account under the private 
business tests.
    (d) Measurement of private business use. If an output contract 
results in private business use under this section, the amount of 
private business use generally is the amount of output purchased under 
the contract.
    (e) Measurement of private security or payment. The measurement of 
payments made or to be made by nongovernmental persons under output 
contracts as a percent of the debt service of an issue is determined 
under the rules provided in Sec. 1.141-4.
    (f) Exceptions for certain contracts--(1) Small purchases of output. 
An output contract for the use of a facility is not taken into account 
under the private

[[Page 40]]

business tests if the average annual payments to be made under the 
contract do not exceed 1 percent of the average annual debt service on 
all outstanding tax-exempt bonds issued to finance the facility, 
determined as of the effective date of the contract.
    (2) Swapping and pooling arrangements. An agreement that provides 
for swapping or pooling of output by one or more governmental persons 
and one or more nongovernmental persons does not result in private 
business use of the output facility owned by the governmental person to 
the extent that--
    (i) The swapped output is reasonably expected to be approximately 
equal in value (determined over periods of three years or less); and
    (ii) The purpose of the agreement is to enable each of the parties 
to satisfy different peak load demands, to accommodate temporary 
outages, to diversify supply, or to enhance reliability in accordance 
with prudent reliability standards.
    (3) Short-term output contracts. An output contract with a 
nongovernmental person is not taken into account under the private 
business tests if--
    (i) The term of the contract, including all renewal options, is not 
longer than 3 years;
    (ii) The contract either is a negotiated, arm's-length arrangement 
that provides for compensation at fair market value, or is based on 
generally applicable and uniformly applied rates; and
    (iii) The output facility is not financed for a principal purpose of 
providing that facility for use by that nongovernmental person.
    (4) Certain conduit parties disregarded. A nongovernmental person 
acting solely as a conduit for the exchange of output among 
governmentally owned and operated utilities is disregarded in 
determining whether the private business tests are met with respect to 
financed facilities owned by a governmental person.
    (g) Special rules for electric output facilities used to provide 
open access--(1) Operation of transmission facilities by nongovernmental 
persons--(i) In general. The operation of an electric transmission 
facility by a nongovernmental person may result in private business use 
of the facility under Sec. 1.141-3 and this section based on all the 
facts and circumstances. For example, a transmission facility is 
generally used for a private business use if a nongovernmental person 
enters into a contract to operate the facility and receives compensation 
based, in whole or in part, on a share of net profits from the operation 
of the facility.
    (ii) Certain use by independent transmission operators. A contract 
for the operation of an electric transmission facility by an independent 
entity, such as a regional transmission organization or an independent 
system operator (independent transmission operator), does not constitute 
private business use of the facility if--
    (A) The facility is owned by a governmental person;
    (B) The operation of the facility by the independent transmission 
operator is approved by the FERC under one or more provisions of the 
Federal Power Act (16 U.S.C. 791a through 825r) (or by a state authority 
under comparable provisions of state law);
    (C) No portion of the compensation of the independent transmission 
operator is based on a share of net profits from the operation of the 
facility; and
    (D) The independent transmission operator does not bear risk of loss 
of the facility.
    (2) Certain use by nongovernmental persons under output contracts--
(i) Transmission facilities. The use of an electric transmission 
facility by a nongovernmental person pursuant to an output contract does 
not constitute private business use of the facility if--
    (A) The facility is owned by a governmental person;
    (B) The facility is operated by an independent transmission operator 
in a manner that satisfies paragraph (g)(1)(ii) of this section; and
    (C) The facility is not financed for a principal purpose of 
providing that facility for use by that nongovernmental person.
    (ii) Distribution facilities. The use of an electric distribution 
facility by a nongovernmental person pursuant to an output contract does 
not constitute private business use of the facility if--

[[Page 41]]

    (A) The facility is owned by a governmental person;
    (B) The facility is available for use on a nondiscriminatory, open 
access basis by buyers and sellers of electricity in accordance with 
rates that are generally applicable and uniformly applied within the 
meaning of Sec. 1.141-3(c)(2); and
    (C) The facility is not financed for a principal purpose of 
providing that facility for use by that nongovernmental person (other 
than a retail end-user).
    (3) Ancillary services. The use of an electric output facility to 
provide ancillary services required to be offered as part of an open 
access transmission tariff under rules promulgated by the FERC under the 
Federal Power Act (16 U.S.C. 791a through 825r) (or by a state 
regulatory authority under comparable provisions of state law) does not 
result in private business use.
    (4) Exceptions to deliberate action rules--(i) Mandated wheeling. 
Entering into a contract for the use of electric transmission or 
distribution facilities is not treated as a deliberate action under 
Sec. 1.141-2(d) if--
    (A) The contract is entered into in response to (or in anticipation 
of) an order by the United States under sections 211 and 212 of the 
Federal Power Act (16 U.S.C. 824j and 824k) (or a state regulatory 
authority under comparable provisions of state law); and
    (B) The terms of the contract are bona fide and arm's-length, and 
the consideration paid is consistent with the provisions of section 
212(a) of the Federal Power Act.
    (ii) Actions taken to implement non-discriminatory, open access. An 
action is not treated as a deliberate action under Sec. 1.141-2(d) if it 
is taken to implement the offering of non-discriminatory, open access 
tariffs for the use of electric transmission or distribution facilities 
in a manner consistent with rules promulgated by the FERC under sections 
205 and 206 of the Federal Power Act (16 U.S.C. 824d and 824e) (or 
comparable provisions of state law). This paragraph (g)(4)(ii) does not 
apply, however, to the sale, exchange, or other disposition (within the 
meaning of section 1001(a)) of transmission or distribution facilities 
to a nongovernmental person.
    (iii) Application of reasonable expectations test to certain current 
refunding bonds. An action taken or to be taken with respect to electric 
transmission or distribution facilities refinanced by an issue is not 
taken into account under the reasonable expectations test of Sec. 1.141-
2(d) if--
    (A) The action is described in paragraph (g)(4)(i) or (ii) of this 
section;
    (B) The bonds of the issue are current refunding bonds that refund 
bonds originally issued before February 23, 1998; and
    (C) The weighted average maturity of the refunding bonds is not 
greater than the remaining weighted average maturity of the prior bonds.
    (5) Additional transactions as permitted by the Commissioner. The 
Commissioner may, by published guidance, set forth additional 
circumstances in which the use of electric output facilities in a 
restructured electric industry does not constitute private business use.
    (h) Allocations of output facilities and systems--(1) Facts and 
circumstances analysis. Whether output sold under an output contract is 
allocated to a particular facility (for example, a generating unit), to 
the entire system of the seller of that output (net of any uses of that 
system output allocated to a particular facility), or to a portion of a 
facility is based on all the facts and circumstances. Significant 
factors to be considered in determining the allocation of an output 
contract to financed property are the following:
    (i) The extent to which it is physically possible to deliver output 
to or from a particular facility or system.
    (ii) The terms of a contract relating to the delivery of output 
(such as delivery limitations and options or obligations to deliver 
power from additional sources).
    (iii) Whether a contract is entered into as part of a common plan of 
financing for a facility.
    (iv) The method of pricing output under the contract, such as the 
use of market rates rather than rates designed to pay debt service of 
tax-exempt bonds used to finance a particular facility.
    (2) Illustrations. The following illustrate the factors set forth in 
paragraph (h)(1) of this section:

[[Page 42]]

    (i) Physical possibility. Output from a generating unit that is fed 
directly into a low voltage distribution system of the owner of that 
unit and that cannot physically leave that distribution system generally 
must be allocated to those receiving electricity through that 
distribution system. Output may be allocated without regard to physical 
limitations, however, if exchange or similar agreements provide output 
to a purchaser where, but for the exchange agreements, it would not be 
possible for the seller to provide output to that purchaser.
    (ii) Contract terms relating to performance. A contract to provide a 
specified amount of electricity from a system, but only when at least 
that amount of electricity is being generated by a particular unit, is 
allocated to that unit. For example, a contract to buy 20 MW of system 
power with a right to take up to 40 percent of the actual output of a 
specific 50 MW facility whenever total system output is insufficient to 
meet all of the seller's obligations generally is allocated to the 
specific facility rather than to the system.
    (iii) Common plan of financing. A contract entered into as part of a 
common plan of financing for a facility generally is allocated to the 
facility if debt service for the issue of bonds is reasonably expected 
to be paid, directly or indirectly, from payments under the contract.
    (iv) Pricing method. Pricing based on the capital and generating 
costs of a particular turbine tends to indicate that output under the 
contract is properly allocated to that turbine.
    (3) Transmission and distribution contracts. Whether use under an 
output contract for transmission or distribution is allocated to a 
particular facility or to a transmission or distribution network is 
based on all the facts and circumstances, in a manner similar to 
paragraphs (h)(1) and (2) of this section. In general, the method used 
to determine payments under a contract is a more significant contract 
term for this purpose than nominal contract path. In general, if 
reasonable and consistently applied, the determination of use of 
transmission or distribution facilities under an output contract may be 
based on a method used by third parties, such as reliability councils.
    (4) Allocation of payments. Payments for output provided by an 
output facility financed with two or more sources of funding are 
generally allocated under the rules in Sec. 1.141-4(c).
    (i) Examples. The following examples illustrate the application of 
this section:

    Example 1 Joint ownership. Z, an investor-owned electric utility, 
and City H agree to construct an electric generating facility of a size 
sufficient to take advantage of the economies of scale. H will issue $50 
million of its 24-year bonds, and Z will use $100 million of its funds 
for construction of a facility they will jointly own as tenants in 
common. Each of the participants will share in the ownership, output, 
and operating expenses of the facility in proportion to its contribution 
to the cost of the facility, that is, one-third by H and two-thirds by 
Z. H's bonds will be secured by H's ownership interest in the facility 
and by revenues to be derived from its share of the annual output of the 
facility. H will need only 50 percent of its share of the annual output 
of the facility during the first 20 years of operations. It agrees to 
sell 10 percent of its share of the annual output to Z for a period of 
20 years pursuant to a contract under which Z agrees to take that power 
if available. The facility will begin operation, and Z will begin to 
receive power, 4 years after the H bonds are issued. The measurement 
period for the property financed by the issue is 20 years. H also will 
sell the remaining 40 percent of its share of the annual output to 
numerous other private utilities under contracts of three years or less 
that satisfy the exception under paragraph (f)(3) of this section. No 
other contracts will be executed obligating any person to purchase any 
specified amount of the power for any specified period of time. No 
person (other than Z) will make payments that will result in a transfer 
of the burdens of paying debt service on bonds used directly or 
indirectly to provide H's share of the facilities. The bonds are not 
private activity bonds, because H's one-third interest in the facility 
is not treated as used by the other owners of the facility. Although 10 
percent of H's share of the annual output of the facility will be used 
in the trade or business of Z, a nongovernmental person, under this 
section, that portion constitutes not more than 10 percent of the 
available output of H's ownership interest in the facility.
    Example 2 Wholesale requirements contract. (i) City J issues 20-year 
bonds to acquire an electric generating facility having a reasonably 
expected economic life substantially

[[Page 43]]

greater than 20 years and a nameplate capacity of 100 MW. The available 
output of the facility under paragraph (b)(1) of this section is 
approximately 17,520,000 MWh (100 MW  x  24 hours  x  365 days  x  20 
years). On the issue date, J enters into a contract with T, an investor-
owned utility, to provide T with all of its power requirements for a 
period of 10 years, commencing on the issue date. J reasonably expects 
that T will actually purchase an average of 30 MW over the 10-year 
period. The contract is taken into account under the private business 
tests pursuant to paragraph (c)(3) of this section because the term of 
the contract is substantial relative to the term of the issue and the 
amount of output to be purchased is a substantial portion of the 
available output.
    (ii) Under paragraph (d) of this section, the amount of reasonably 
expected private business use under this contract is approximately 15 
percent (30 MW  x  24 hours  x  365 days  x  10 years, or 2,628,000 MWh) 
of the available output. Accordingly, the issue meets the private 
business use test. J reasonably expects that the amount to be paid for 
an average of 30 MW of power (less the operation and maintenance costs 
directly attributable to generating that 30 MW of power), will be more 
than 10 percent of debt service on the issue on a present-value basis. 
Accordingly, the issue meets the private security or payment test 
because J reasonably expects that payment of more than 10 percent of the 
debt service will be indirectly derived from payments by T. The bonds 
are private activity bonds under paragraph (c) of this section. Further, 
if 15 percent of the sale proceeds of the issue is greater than $15 
million and the issue meets the private security or payment test with 
respect to the $15 million output limitation, the bonds are also private 
activity bonds under section 141(b)(4). See Sec. 1.141-8.
    Example 3 Retail contracts. (i) State Agency M, a political 
subdivision, issues bonds in 2003 to finance the construction of a 
generating facility that will be used to furnish electricity to M's 
retail customers. In 2007, M enters into a 10-year contract with 
industrial corporation I. Under the contract, M agrees to supply I with 
all of its power requirements during the contract term, and I agrees to 
pay for that power at a negotiated price as it is delivered. The 
contract does not require I to pay for any power except to the extent I 
has requirements. In addition, the contract requires I to pay reasonable 
and customary liquidated damages in the event of a default by I, and 
permits I to terminate the contract while it has requirements by paying 
M a specified amount that is a reasonable and customary amount for 
terminating the contract. Any damages or termination payment by I will 
be reasonably related to I's obligation to buy requirements that is 
discharged by the payment. Under paragraph (c)(3) of this section, the 
contract does not meet the benefits and burdens test. Thus, it is not 
taken into account under the private business tests.
    (ii) The facts are the same as in paragraph (i) of this Example 3, 
except that the contract requires I to make guaranteed minimum payments, 
regardless of I's requirements, in an amount such that the contract does 
not meet the exception for small purchases in paragraph (f)(1) of this 
section. Under paragraph (c)(3)(ii) of this section, the contract meets 
the benefits and burdens test because it obligates I to make payments 
that are not contingent on its output requirements. Thus, it is taken 
into account under the private business tests.
    Example 4 Allocation of existing contracts to new facilities. Power 
Authority K, a political subdivision created by the legislature in State 
X to own and operate certain power generating facilities, sells all of 
the power from its existing facilities to four private utility systems 
under contracts executed in 1999, under which the four systems are 
required to take or pay for specified portions of the total power output 
until the year 2029. Existing facilities supply all of the present needs 
of the four utility systems, but their future power requirements are 
expected to increase substantially beyond the capacity of K's current 
generating system. K issues 20-year bonds in 2004 to construct a large 
generating facility. As part of the financing plan for the bonds, a 
fifth private utility system contracts with K to take or pay for 15 
percent of the available output of the new facility. The balance of the 
output of the new facility will be available for sale as required, but 
initially it is not anticipated that there will be any need for that 
power. The revenues from the contract with the fifth private utility 
system will be sufficient to pay less than 10 percent of the debt 
service on the bonds (determined on a present value basis). The balance, 
which will exceed 10 percent of the debt service on the bonds, will be 
paid from revenues derived from the contracts with the four systems 
initially from sale of power produced by the old facilities. The output 
contracts with all the private utilities are allocated to K's entire 
generating system. See paragraphs (h)(1) and (2) of this section. Thus, 
the bonds meet the private business use test because more than 10 
percent of the proceeds will be used in the trade or business of a 
nongovernmental person. In addition, the bonds meet the private security 
or payment test because payment of more than 10 percent of the debt 
service, pursuant to underlying arrangements, will be derived from 
payments in respect of property used for a private business use.
    Example 5 Allocation to displaced resource. Municipal utility MU, a 
political subdivision, purchases all of the electricity required to meet 
the needs of its customers (1,000 MW)

[[Page 44]]

from B, an investor-owned utility that operates its own electric 
generating facilities, under a 50-year take or pay contract. MU does not 
anticipate that it will require additional electric resources, and any 
new resources would produce electricity at a higher cost to MU than its 
cost under its contract with B. Nevertheless, B encourages MU to 
construct a new generating plant sufficient to meet MU's requirements. 
MU issues obligations to construct facilities that will produce 1,000 MW 
of electricity. MU, B, and I, another investor-owned utility, enter into 
an agreement under which MU assigns to I its rights under MU's take or 
pay contract with B. Under this arrangement, I will pay MU, and MU will 
continue to pay B, for the 1,000 MW. I's payments to MU will at least 
equal the amounts required to pay debt service on MU's bonds. In 
addition, under paragraph (h)(1)(iii) of this section, the contract 
among MU, B, and I is entered into as part of a common plan of financing 
of the MU facilities. Under all the facts and circumstances, MU's 
assignment to I of its rights under the original take or pay contract is 
allocable to MU's new facilities under paragraph (h) of this section. 
Because I is a nongovernmental person, MU's bonds are private activity 
bonds.
    Example 6 Operation of transmission facilities by regional 
transmission organization. (i) Public Power Agency D is a political 
subdivision that owns and operates electric generation, transmission and 
distribution facilities. In 2003, D transfers operating control of its 
transmission system to a regional transmission organization (RTO), a 
nongovernmental person, pursuant to an operating agreement that is 
approved by the FERC under sections 205 and 206 of the Federal Power 
Act. D retains ownership of its facilities. No portion of the RTO's 
compensation is based on a share of net profits from the operation of 
D's facilities, and the RTO does not bear any risk of loss of those 
facilities. Under paragraph (g)(1)(ii) of this section, the RTO's use of 
D's facilities does not constitute a private business use.
    (ii) Company A is located in D's service territory. In 2004, Power 
Supplier E, a nongovernmental person, enters into a 10-year contract 
with A to supply A's electricity requirements. The electricity supplied 
by E to A will be transmitted over D's transmission and distribution 
facilities. D's distribution facilities are available for use on a 
nondiscriminatory, open access basis by buyers and sellers of 
electricity in accordance with rates that are generally applicable and 
uniformly applied within the meaning of Sec. 1.141-3(c)(2). D's 
facilities are not financed for a principal purpose of providing the 
facilities for use by E. Under paragraph (g)(2) of this section, the 
contract between A and E does not result in private business use of D's 
facilities.
    Example 7 Certain actions not treated as deliberate actions. The 
facts are the same as in Example 6 of this paragraph (i), except that 
the RTO's compensation is based on a share of net profits from operating 
D's facilities. In addition, D had issued bonds in 1994 to finance 
improvements to its transmission system. At the time D transfers 
operating control of its transmission system to the RTO, D chooses to 
apply the private activity bond regulations of Secs. 1.141-1 through 
1.141-15 to the 1994 bonds. The operation of D's facilities by the RTO 
results in private business use under Sec. 1.141-3 and paragraph 
(g)(1)(i) of this section. Under the special exception in paragraph 
(g)(4)(ii) of this section, however, the transfer of control is not 
treated as a deliberate action. Accordingly, the transfer of control 
does not cause the 1994 bonds to meet the private activity bond tests.
    Example 8 Current refunding. The facts are the same as in Example 7 
of this paragraph (i), and in addition D issues bonds in 2004 to 
currently refund the 1994 bonds. The weighted average maturity of the 
2004 bonds is not greater than the remaining weighted average maturity 
of the 1994 bonds. D chooses to apply the private activity bond 
regulations of Secs. 1.141-1 through 1.141-15 to the refunding bonds. In 
general, reasonable expectations must be separately tested on the date 
that refunding bonds are issued under Sec. 1.141-2(d). Under the special 
exception in paragraph (g)(4)(iii) of this section, however, the 
transfer of the financed facilities to the RTO need not be taken into 
account in applying the reasonable expectations test to the refunding 
bonds.

[T.D. 9016, 67 FR 59759, Sept. 23, 2002; 67 FR 70845, Nov. 27, 2002]



Sec. 1.141-8  $15 million limitation for output facilities.

    (a) In general--(1) General rule. Section 141(b)(4) provides a 
special private activity bond limitation (the $15 million output 
limitation) for issues 5 percent or more of the proceeds of which are to 
be used to finance output facilities (other than a facility for the 
furnishing of water). Under this rule, an issue consists of private 
activity bonds under the private business tests of section 141(b)(1) and 
(2) if the nonqualified amount with respect to output facilities 
financed by the proceeds of the issue exceeds $15 million. The $15 
million output limitation applies in addition to the private business 
tests of section 141(b)(1) and (2). Under section 141(b)(4) and 
paragraph (a)(2) of this

[[Page 45]]

section, the $15 million output limitation is reduced in certain cases. 
Specifically, an issue meets the test in section 141(b)(4) if both of 
the following tests are met:
    (i) More than $15 million of the proceeds of the issue to be used 
with respect to an output facility are to be used for a private business 
use. Investment proceeds are disregarded for this purpose if they are 
not allocated disproportionately to the private business use portion of 
the issue.
    (ii) The payment of the principal of, or the interest on, more than 
$15 million of the sale proceeds of the portion of the issue used with 
respect to an output facility is (under the terms of the issue or any 
underlying arrangement) directly or indirectly--
    (A) Secured by any interest in an output facility used or to be used 
for a private business use (or payments in respect of such an output 
facility); or
    (B) To be derived from payments (whether or not to the issuer) in 
respect of an output facility used or to be used for a private business 
use.
    (2) Reduction in $15 million output limitation for outstanding 
issues--(i) General rule. In determining whether an issue 5 percent or 
more of the proceeds of which are to be used with respect to an output 
facility consists of private activity bonds under the $15 million output 
limitation, the $15 million limitation on private business use and 
private security or payments is applied by taking into account the 
aggregate nonqualified amounts of any outstanding bonds of other issues 
5 percent or more of the proceeds of which are or will be used with 
respect to that output facility or any other output facility that is 
part of the same project.
    (ii) Bonds taken into account. For purposes of this paragraph 
(a)(2), in applying the $15 million output limitation to an issue (the 
later issue), a tax-exempt bond of another issue (the earlier issue) is 
taken into account if--
    (A) That bond is outstanding on the issue date of the later issue;
    (B) That bond will not be redeemed within 90 days of the issue date 
of the later issue in connection with the refunding of that bond by the 
later issue; and
    (C) 5 percent or more of the sale proceeds of the earlier issue 
financed an output facility that is part of the same project as the 
output facility that is financed by 5 percent or more of the sale 
proceeds of the later issue.
    (3) Benefits and burdens test applicable--(i) In general. In 
applying the $15 million output limitation, the benefits and burdens 
test of Sec. 1.141-7 applies, except that ``$15 million'' is applied in 
place of ``10 percent'', or ``5 percent'' as appropriate.
    (ii) Earlier issues for the project. If bonds of an earlier issue 
are outstanding and must be taken into account under paragraph (a)(2) of 
this section, the nonqualified amount for that earlier issue is 
multiplied by a fraction, the numerator of which is the adjusted issue 
price of the earlier issue as of the issue date of the later issue, and 
the denominator of which is the issue price of the earlier issue. Pre-
issuance accrued interest as defined in Sec. 1.148-1(b) is disregarded 
for this purpose.
    (b) Definition of project--(1) General rule. For purposes of 
paragraph (a)(2) of this section, project has the meaning provided in 
this paragraph. Facilities that are functionally related and subordinate 
to a project are treated as part of that same project. Facilities having 
different purposes or serving different customer bases are not 
ordinarily part of the same project. For example, the following are 
generally not part of the same project--
    (i) Generation, transmission and distribution facilities;
    (ii) Separate facilities designed to serve wholesale customers and 
retail customers; and
    (iii) A peaking unit and a baseload unit (regardless of the location 
of the units).
    (2) Separate ownership. Except as otherwise provided in this 
paragraph (b)(2), facilities that are not owned by the same person are 
not part of the same project. If different governmental persons act in 
concert to finance a project, however (for example as participants in a 
joint powers authority), their interests are aggregated with respect to 
that project to determine whether the $15 million output limitation is 
met. In the case of undivided

[[Page 46]]

ownership interests in a single output facility, property that is not 
owned by different persons is treated as separate projects only if the 
separate interests are financed--
    (i) With bonds of different issuers; and
    (ii) Without a principal purpose of avoiding the limitation in this 
section.
    (3) Generating property--(i) Property on same site. In the case of 
generation and related facilities, project means property located at the 
same site.
    (ii) Special rule for generating units. Separate generating units 
are not part of the same project if one unit is reasonably expected, on 
the issue date of each issue that finances the units, to be placed in 
service more than 3 years before the other. Common facilities or 
property that will be functionally related to more than one generating 
unit must be allocated on a reasonable basis. If a generating unit 
already is constructed or is under construction (the first unit) and 
bonds are to be issued to finance an additional generating unit (the 
second unit), all costs for any common facilities paid or incurred 
before the earlier of the issue date of bonds to finance the second unit 
or the commencement of construction of the second unit are allocated to 
the first unit. At the time that bonds are issued to finance the second 
unit (or, if earlier, upon commencement of construction of that unit), 
any remaining costs of the common facilities may be allocated between 
the first and second units so that in the aggregate the allocation is 
reasonable.
    (4) Transmission and distribution. In the case of transmission or 
distribution facilities, project means functionally related or 
contiguous property. Separate transmission or distribution facilities 
are not part of the same project if one facility is reasonably expected, 
on the issue date of each issue that finances the facilities, to be 
placed in service more than 2 years before the other.
    (5) Subsequent improvements--(i) In general. An improvement to 
generation, transmission or distribution facilities that is not part of 
the original design of those facilities (the original project) is not 
part of the same project as the original project if the construction, 
reconstruction, or acquisition of that improvement commences more than 3 
years after the original project was placed in service and the bonds 
issued to finance that improvement are issued more than 3 years after 
the original project was placed in service.
    (ii) Special rule for transmission and distribution facilities. An 
improvement to transmission or distribution facilities that is not part 
of the original design of that property is not part of the same project 
as the original project if the issuer did not reasonably expect the need 
to make that improvement when it commenced construction of the original 
project and the construction, reconstruction, or acquisition of that 
improvement is mandated by the federal government or a state regulatory 
authority to accommodate requests for wheeling.
    (6) Replacement property. For purposes of this section, property 
that replaces existing property of an output facility is treated as part 
of the same project as the replaced property unless--
    (i) The need to replace the property was not reasonably expected on 
the issue date or the need to replace the property occurred more than 3 
years before the issuer reasonably expected (determined on the issue 
date of the bonds financing the property) that it would need to replace 
the property; and
    (ii) The bonds that finance (and refinance) the output facility have 
a weighted average maturity that is not greater than 120 percent of the 
reasonably expected economic life of the facility.
    (c) Example. The application of the provisions of this section is 
illustrated by the following example:

    Example. (i) Power Authority K, a political subdivision, intends to 
issue a single issue of tax-exempt bonds at par with a stated principal 
amount and sale proceeds of $500 million to finance the acquisition of 
an electric generating facility. No portion of the facility will be used 
for a private business use, except that L, an investor-owned utility, 
will purchase 10 percent of the output of the facility under a take 
contract and will pay 10 percent of the debt service on the bonds. The 
nonqualified amount with respect to the bonds is $50 million.
    (ii) The maximum amount of tax-exempt bonds that may be issued for 
the acquisition of an interest in the facility in paragraph (i) of this 
Example is $465 million (that is, $450

[[Page 47]]

million for the 90 percent of the facility that is governmentally owned 
and used plus a nonqualified amount of $15 million).

[T.D. 9016, 67 FR 59763, Sept. 23, 2002]



Sec. 1.141-9  Unrelated or disproportionate use test.

    (a) General rules--(1) Description of test. Under section 141(b)(3) 
(the unrelated or disproportionate use test), an issue meets the private 
business tests if the amount of private business use and private 
security or payments attributable to unrelated or disproportionate 
private business use exceeds 5 percent of the proceeds of the issue. For 
this purpose, the private business use test is applied by taking into 
account only use that is not related to any government use of proceeds 
of the issue (unrelated use) and use that is related but 
disproportionate to any government use of those proceeds 
(disproportionate use).
    (2) Application of unrelated or disproportionate use test--(i) Order 
of application. The unrelated or disproportionate use test is applied by 
first determining whether a private business use is related to a 
government use. Next, private business use that relates to a government 
use is examined to determine whether it is disproportionate to that 
government use.
    (ii) Aggregation of unrelated and disproportionate use. All the 
unrelated use and disproportionate use financed with the proceeds of an 
issue are aggregated to determine compliance with the unrelated or 
disproportionate use test. The amount of permissible unrelated and 
disproportionate private business use is not reduced by the amount of 
private business use financed with the proceeds of an issue that is 
neither unrelated use nor disproportionate use.
    (iii) Deliberate actions. A deliberate action that occurs after the 
issue date does not result in unrelated or disproportionate use if the 
issue meets the conditions of Sec. 1.141-12(a).
    (b) Unrelated use--(1) In general. Whether a private business use is 
related to a government use financed with the proceeds of an issue is 
determined on a case-by-case basis, emphasizing the operational 
relationship between the government use and the private business use. In 
general, a facility that is used for a related private business use must 
be located within, or adjacent to, the governmentally used facility.
    (2) Use for the same purpose as government use. Use of a facility by 
a nongovernmental person for the same purpose as use by a governmental 
person is not treated as unrelated use if the government use is not 
insignificant. Similarly, a use of a facility in the same manner both 
for private business use that is related use and private business use 
that is unrelated use does not result in unrelated use if the related 
use is not insignificant. For example, a privately owned pharmacy in a 
governmentally owned hospital does not ordinarily result in unrelated 
use solely because the pharmacy also serves individuals not using the 
hospital. In addition, use of parking spaces in a garage by a 
nongovernmental person is not treated as unrelated use if more than an 
insignificant portion of the parking spaces are used for a government 
use (or a private business use that is related to a government use), 
even though the use by the nongovernmental person is not directly 
related to that other use.
    (c) Disproportionate use--(1) Definition of disproportionate use. A 
private business use is disproportionate to a related government use 
only to the extent that the amount of proceeds used for that private 
business use exceeds the amount of proceeds used for the related 
government use. For example, a private use of $100 of proceeds that is 
related to a government use of $70 of proceeds results in $30 of 
disproportionate use.
    (2) Aggregation of related uses. If two or more private business 
uses of the proceeds of an issue relate to a single government use of 
those proceeds, those private business uses are aggregated to apply the 
disproportionate use test.
    (3) Allocation rule. If a private business use relates to more than 
a single use of the proceeds of the issue (for example, two or more 
government uses of the proceeds of the issue or a government use and a 
private use), the amount of any disproportionate use may be determined 
by--

[[Page 48]]

    (i) Reasonably allocating the proceeds used for the private business 
use among the related uses;
    (ii) Aggregating government uses that are directly related to each 
other; or
    (iii) Allocating the private business use to the government use to 
which it is primarily related.
    (d) Maximum use taken into account. The determination of the amount 
of unrelated use or disproportionate use of a facility is based on the 
maximum amount of reasonably expected government use of a facility 
during the measurement period. Thus, no unrelated use or 
disproportionate use arises solely because a facility initially has 
excess capacity that is to be used by a nongovernmental person if the 
facility will be completely used by the issuer during the term of the 
issue for more than an insignificant period.
    (e) Examples. The following examples illustrate the application of 
this section:

    Example 1. School and remote cafeteria. County X issues bonds with 
proceeds of $20 million and uses $18.1 million of the proceeds for 
construction of a new school building and $1.9 million of the proceeds 
for construction of a privately operated cafeteria in its administrative 
office building, which is located at a remote site. The bonds are 
secured, in part, by the cafeteria. The $1.9 million of proceeds is 
unrelated to the government use (that is, school construction) financed 
with the bonds and exceeds 5 percent of $20 million. Thus, the issue 
meets the private business tests.
    Example 2. Public safety building and courthouse. City Y issues 
bonds with proceeds of $50 million for construction of a new public 
safety building ($32 million) and for improvements to an existing 
courthouse ($15 million). Y uses $3 million of the bond proceeds for 
renovations to an existing privately operated cafeteria located in the 
courthouse. The bonds are secured, in part, by the cafeteria. Y's use of 
the $3 million for the privately operated cafeteria does not meet the 
unrelated or disproportionate use test because these expenditures are 
neither unrelated use nor disproportionate use.
    Example 3. Unrelated garage. City Y issues bonds with proceeds of 
$50 million for construction of a new public safety building ($30.5 
million) and for improvements to an existing courthouse ($15 million). Y 
uses $3 million of the bond proceeds for renovations to an existing 
privately operated cafeteria located in the courthouse. The bonds are 
secured, in part, by the cafeteria. Y also uses $1.5 million of the 
proceeds to construct a privately operated parking garage adjacent to a 
private office building. The private business use of the parking garage 
is unrelated to any government use of proceeds of the issue. Since the 
proceeds used for unrelated uses and disproportionate uses do not exceed 
5 percent of the proceeds, the unrelated or disproportionate use test is 
not met.
    Example 4. Disproportionate use of garage. County Z issues bonds 
with proceeds of $20 million for construction of a hospital with no 
private business use ($17 million); renovation of an office building 
with no private business use ($1 million); and construction of a garage 
that is entirely used for a private business use ($2 million). The use 
of the garage is related to the use of the office building but not to 
the use of the hospital. The private business use of the garage results 
in $1 million of disproportionate use because the proceeds used for the 
garage ($2 million) exceed the proceeds used for the related government 
use ($1 million). The bonds are not private activity bonds, however, 
because the disproportionate use does not exceed 5 percent of the 
proceeds of the issue.
    Example 5. Bonds for multiple projects. (i) County W issues bonds 
with proceeds of $80 million for the following purposes: (1) $72 million 
to construct a County-owned and operated waste incinerator; (2) $1 
million for a County-owned and operated facility for the temporary 
storage of hazardous waste prior to final disposal; (3) $1 million to 
construct a privately owned recycling facility located at a remote site; 
and (4) $6 million to build a garage adjacent to the County-owned 
incinerator that will be leased to Company T to store and repair trucks 
that it owns and uses to haul County W refuse. Company T uses 75 percent 
of its trucks to haul materials to the incinerator and the remaining 25 
percent of its trucks to haul materials to the temporary storage 
facility.
    (ii) The $1 million of proceeds used for the recycling facility is 
used for an unrelated use. The garage is related use. In addition, 75 
percent of the use of the $6 million of proceeds used for the garage is 
allocable to the government use of proceeds at the incinerator. The 
remaining 25 percent of the proceeds used for the garage ($1.5 million) 
relates to the government use of proceeds at the temporary storage 
facility. Thus, this portion of the proceeds used for the garage exceeds 
the proceeds used for the temporary storage facility by $0.5 million and 
this excess is disproportionate use (but not unrelated use). Thus, the 
aggregate amount of unrelated use and disproportionate use financed with 
the proceeds of the issue is $1.5 million. Alternatively, under 
paragraph (c)(3)(iii) of this section, the entire garage may be treated 
as related to the government use of the incinerator and, under that 
allocation, the garage is not disproportionate use.

[[Page 49]]

In either event, section 141(b)(3) limits the aggregate unrelated use 
and disproportionate use to $4 million. Therefore, the bonds are not 
private activity bonds under this section.

[T.D. 8712, 62 FR 2297, Jan. 16, 1997]



Sec. 1.141-10  Coordination with volume cap. [Reserved]



Sec. 1.141-11  Acquisition of nongovernmental output property.[Reserved]
                       



Sec. 1.141-12  Remedial actions.

    (a) Conditions to taking remedial action. An action that causes an 
issue to meet the private business tests or the private loan financing 
test is not treated as a deliberate action if the issuer takes a 
remedial action described in paragraph (d), (e), or (f) of this section 
with respect to the nonqualified bonds and if all of the requirements in 
paragraphs (a) (1) through (5) of this section are met.
    (1) Reasonable expectations test met. The issuer reasonably expected 
on the issue date that the issue would meet neither the private business 
tests nor the private loan financing test for the entire term of the 
bonds. For this purpose, if the issuer reasonably expected on the issue 
date to take a deliberate action prior to the final maturity date of the 
issue that would cause either the private business tests or the private 
loan financing test to be met, the term of the bonds for this purpose 
may be determined by taking into account a redemption provision if the 
provisions of Sec. 1.141-2(d)(2)(ii) (A) through (C) are met.
    (2) Maturity not unreasonably long. The term of the issue must not 
be longer than is reasonably necessary for the governmental purposes of 
the issue (within the meaning of Sec. 1.148-1(c)(4)). Thus, this 
requirement is met if the weighted average maturity of the bonds of the 
issue is not greater than 120 percent of the average reasonably expected 
economic life of the property financed with the proceeds of the issue as 
of the issue date.
    (3) Fair market value consideration. Except as provided in paragraph 
(f) of this section, the terms of any arrangement that results in 
satisfaction of either the private business tests or the private loan 
financing test are bona fide and arm's-length, and the new user pays 
fair market value for the use of the financed property. Thus, for 
example, fair market value may be determined in a manner that takes into 
account restrictions on the use of the financed property that serve a 
bona fide governmental purpose.
    (4) Disposition proceeds treated as gross proceeds for arbitrage 
purposes. The issuer must treat any disposition proceeds as gross 
proceeds for purposes of section 148. For purposes of eligibility for 
temporary periods under section 148(c) and exemptions from the 
requirement of section 148(f) the issuer may treat the date of receipt 
of the disposition proceeds as the issue date of the bonds and disregard 
the receipt of disposition proceeds for exemptions based on expenditure 
of proceeds under Sec. 1.148-7 that were met before the receipt of the 
disposition proceeds.
    (5) Proceeds expended on a governmental purpose. Except for a 
remedial action under paragraph (d) of this section, the proceeds of the 
issue that are affected by the deliberate action must have been expended 
on a governmental purpose before the date of the deliberate action.
    (b) Effect of a remedial action--(1) In general. The effect of a 
remedial action is to cure use of proceeds that causes the private 
business use test or the private loan financing test to be met. A 
remedial action does not affect application of the private security or 
payment test.
    (2) Effect on bonds that have been advance refunded. If proceeds of 
an issue were used to advance refund another bond, a remedial action 
taken with respect to the refunding bond proportionately reduces the 
amount of proceeds of the advance refunded bond that is taken into 
account under the private business use test or the private loan 
financing test.
    (c) Disposition proceeds--(1) Definition. Disposition proceeds are 
any amounts (including property, such as an agreement to provide 
services) derived from the sale, exchange, or other disposition 
(disposition) of property (other than investments) financed with the 
proceeds of an issue.
    (2) Allocating disposition proceeds to an issue. In general, if the 
requirements of

[[Page 50]]

paragraph (a) of this section are met, after the date of the 
disposition, the proceeds of the issue allocable to the transferred 
property are treated as financing the disposition proceeds rather than 
the transferred property. If a disposition is made pursuant to an 
installment sale, the proceeds of the issue continue to be allocated to 
the transferred property. If an issue does not meet the requirements for 
remedial action in paragraph (a) of this section or the issuer does not 
take an appropriate remedial action, the proceeds of the issue are 
allocable to either the transferred property or the disposition 
proceeds, whichever allocation produces the greater amount of private 
business use and private security or payments.
    (3) Allocating disposition proceeds to different sources of funding. 
If property has been financed by different sources of funding, for 
purposes of this section, the disposition proceeds from that property 
are first allocated to the outstanding bonds that financed that property 
in proportion to the principal amounts of those outstanding bonds. In no 
event may disposition proceeds be allocated to bonds that are no longer 
outstanding or to a source of funding not derived from a borrowing (such 
as revenues of the issuer) if the disposition proceeds are not greater 
than the total principal amounts of the outstanding bonds that are 
allocable to that property. For purposes of this paragraph (c)(3), 
principal amount has the same meaning as in Sec. 1.148-9(b)(2) and 
outstanding bonds do not include advance refunded bonds.
    (d) Redemption or defeasance of nonqualified bonds--(1) In general. 
The requirements of this paragraph (d) are met if all of the 
nonqualified bonds of the issue are redeemed. Proceeds of tax-exempt 
bonds must not be used for this purpose, unless the tax-exempt bonds are 
qualified bonds, taking into account the purchaser's use of the 
facility. Except as provided in paragraph (d)(3) of this section, if the 
bonds are not redeemed within 90 days of the date of the deliberate 
action, a defeasance escrow must be established for those bonds within 
90 days of the deliberate action.
    (2) Special rule for dispositions for cash. If the consideration for 
the disposition of financed property is exclusively cash, the 
requirements of this paragraph (d) are met if the disposition proceeds 
are used to redeem a pro rata portion of the nonqualified bonds at the 
earliest call date after the deliberate action. If the bonds are not 
redeemed within 90 days of the date of the deliberate action, the 
disposition proceeds must be used to establish a defeasance escrow for 
those bonds within 90 days of the deliberate action.
    (3) Anticipatory remedial action. The requirements of paragraphs 
(d)(1) and (2) of this section for redemption or defeasance of the 
nonqualified bonds within 90 days of the deliberate action are met if 
the issuer declares its official intent to redeem or defease all of the 
bonds that would become nonqualified bonds in the event of a subsequent 
deliberate action that would cause the private business tests or the 
private loan financing test to be met and redeems or defeases such bonds 
prior to that deliberate action. The issuer must declare its official 
intent on or before the date on which it redeems or defeases such bonds, 
and the declaration of intent must identify the financed property or 
loan with respect to which the anticipatory remedial action is being 
taken and describe the deliberate action that potentially may result in 
the private business tests being met (for example, sale of financed 
property that the buyer may then lease to a nongovernmental person). 
Rules similar to those in Sec. 1.150-2(e) (regarding official intent for 
reimbursement bonds) apply to declarations of intent under this 
paragraph (d)(3), including deviations in the descriptions of the 
project or loan and deliberate action and the reasonableness of the 
official intent.
    (4) Notice of defeasance. The issuer must provide written notice to 
the Commissioner of the establishment of the defeasance escrow within 90 
days of the date the defeasance escrow is established.
    (5) Special limitation. The establishment of a defeasance escrow 
does not satisfy the requirements of this paragraph (d) if the period 
between the issue date and the first call date of the bonds is more than 
10\1/2\ years.

[[Page 51]]

    (6) Defeasance escrow defined. A defeasance escrow is an irrevocable 
escrow established to redeem bonds on their earliest call date in an 
amount that, together with investment earnings, is sufficient to pay all 
the principal of, and interest and call premium on, bonds from the date 
the escrow is established to the earliest call date. The escrow may not 
be invested in higher yielding investments or in any investment under 
which the obligor is a user of the proceeds of the bonds.
    (e) Alternative use of disposition proceeds--(1) In general. The 
requirements of this paragraph (e) are met if--
    (i) The deliberate action is a disposition for which the 
consideration is exclusively cash;
    (ii) The issuer reasonably expects to expend the disposition 
proceeds within two years of the date of the deliberate action;
    (iii) The disposition proceeds are treated as proceeds for purposes 
of section 141 and are used in a manner that does not cause the issue to 
meet either the private business tests or the private loan financing 
test, and the issuer does not take any action subsequent to the date of 
the deliberate action to cause either of these tests to be met; and
    (iv) If the issuer does not use all of the disposition proceeds for 
an alternative use described in paragraph (e)(1)(iii) of this section, 
the issuer uses those remaining disposition proceeds for a remedial 
action that meets paragraph (d) of this section.
    (2) Special rule for use by 501(c)(3) organizations. If the 
disposition proceeds are to be used by a 501(c)(3) organization, the 
nonqualified bonds must in addition be treated as reissued for purposes 
of sections 141, 145, 147, 149, and 150 and, under this treatment, 
satisfy all of the applicable requirements for qualified 501(c)(3) 
bonds. Thus, beginning on the date of the deliberate action, 
nonqualified bonds that satisfy these requirements must be treated as 
qualified 501(c)(3) bonds for all purposes, including sections 145(b) 
and 150(b).
    (f) Alternative use of facility. The requirements of this paragraph 
(f) are met if--
    (1) The facility with respect to which the deliberate action occurs 
is used in an alternative manner (for example, used for a qualifying 
purpose by a nongovernmental person or used by a 501(c)(3) organization 
rather than a governmental person);
    (2) The nonqualified bonds are treated as reissued, as of the date 
of the deliberate action, for purposes of sections 55 through 59 and 
141, 142, 144, 145, 146, 147, 149 and 150, and under this treatment, the 
nonqualified bonds satisfy all the applicable requirements for qualified 
bonds throughout the remaining term of the nonqualified bonds;
    (3) The deliberate action does not involve a disposition to a 
purchaser that finances the acquisition with proceeds of another issue 
of tax-exempt bonds; and
    (4) Any disposition proceeds other than those arising from an 
agreement to provide services (including disposition proceeds from an 
installment sale) resulting from the deliberate action are used to pay 
the debt service on the bonds on the next available payment date or, 
within 90 days of receipt, are deposited into an escrow that is 
restricted to the yield on the bonds to pay the debt service on the 
bonds on the next available payment date.
    (g) Rules for deemed reissuance. For purposes of determining whether 
bonds that are treated as reissued under paragraphs (e) and (f) of this 
section are qualified bonds--
    (1) The provisions of the Code and regulations thereunder in effect 
as of the date of the deliberate action apply; and
    (2) For purposes of paragraph (f) of this section, section 147(d) 
(relating to the acquisition of existing property) does not apply.
    (h) Authority of Commissioner to provide for additional remedial 
actions. The Commissioner may, by publication in the Federal Register or 
the Internal Revenue Bulletin, provide additional remedial actions, 
including making a remedial payment to the United States, under which a 
subsequent action will not be treated as a deliberate action for 
purposes of Sec. 1.141-2.
    (i) Effect of remedial action on continuing compliance. Solely for 
purposes

[[Page 52]]

of determining whether deliberate actions that are taken after a 
remedial action cause an issue to meet the private business tests or the 
private loan financing test--
    (1) If a remedial action is taken under paragraph (d) of this 
section, the amount of private business use or private loans resulting 
from the deliberate action that is taken into account for purposes of 
determining whether the bonds are private activity bonds is that portion 
of the remaining bonds that is used for private business use or private 
loans (as calculated under paragraph (j) of this section);
    (2) If a remedial action is taken under paragraph (e) or (f) of this 
section, the amount of private business use or private loans resulting 
from the deliberate action is not taken into account for purposes of 
determining whether the bonds are private activity bonds; and
    (3) After a remedial action is taken, the amount of disposition 
proceeds is treated as equal to the proceeds of the issue that had been 
allocable to the transferred property immediately prior to the 
disposition. See paragraph (k) of this section, Example 5.
    (j) Nonqualified bonds--(1) Amount of nonqualified bonds. The 
nonqualified bonds are a portion of the outstanding bonds in an amount 
that, if the remaining bonds were issued on the date on which the 
deliberate action occurs, the remaining bonds would not meet the private 
business use test or private loan financing test, as applicable. For 
this purpose, the amount of private business use is the greatest 
percentage of private business use in any one-year period commencing 
with the one-year period in which the deliberate action occurs.
    (2) Allocation of nonqualified bonds. Allocations of nonqualified 
bonds must be made on a pro rata basis, except that, for purposes of 
paragraph (d) of this section (relating to redemption or defeasance), an 
issuer may treat any bonds of an issue as the nonqualified bonds so long 
as--
    (i) The remaining weighted average maturity of the issue, determined 
as of the date on which the nonqualified bonds are redeemed or defeased 
(determination date), and excluding from the determination the 
nonqualified bonds redeemed or defeased by the issuer in accordance with 
this section, is not greater than
    (ii) The remaining weighted average maturity of the issue, 
determined as of the determination date, but without regard to the 
redemption or defeasance of any bonds (including the nonqualified bonds) 
occurring on the determination date.
    (k) Examples. The following examples illustrate the application of 
this section:

    Example 1 Disposition proceeds less than outstanding bonds used to 
retire bonds. On June 1, 1997, City C issues 30-year bonds with an issue 
price of $10 million to finance the construction of a hospital building. 
The bonds have a weighted average maturity that does not exceed 120 
percent of the reasonably expected economic life of the building. On the 
issue date, C reasonably expects that it will be the only user of the 
building for the entire term of the bonds. Six years after the issue 
date, C sells the building to Corporation P for $5 million. The sale 
price is the fair market value of the building, as verified by an 
independent appraiser. C uses all of the $5 million disposition proceeds 
to immediately retire a pro rata portion of the bonds. The sale does not 
cause the bonds to be private activity bonds because C has taken a 
remedial action described in paragraph (d) of this section so that P is 
not treated as a private business user of bond proceeds.
    Example 2. Lease to nongovernmental person. The facts are the same 
as in Example 1, except that instead of selling the building, C, 6 years 
after the issue date, leases the building to P for 7 years and uses 
other funds to redeem all of the $10 million outstanding bonds within 90 
days of the deliberate act. The bonds are not treated as private 
activity bonds because C has taken the remedial action described in 
paragraph (d) of this section.
    Example 3. Sale for less than fair market value. The facts are the 
same as in Example 1, except that the fair market value of the building 
at the time of the sale to P is $6 million. Because the transfer was for 
less than fair market value, the bonds are ineligible for the remedial 
actions under this section. The bonds are private activity bonds because 
P is treated as a user of all of the proceeds and P makes a payment ($6 
million) for this use that is greater than 10 percent of the debt 
service on the bonds, on a present value basis.
    Example 4. Fair market value determined taking into account 
governmental restrictions. The facts are the same as in Example 1, 
except

[[Page 53]]

that the building was used by C only for hospital purposes and C 
determines to sell the building subject to a restriction that it be used 
only for hospital purposes. After conducting a public bidding procedure 
as required by state law, the best price that C is able to obtain for 
the building subject to this restriction is $4.5 million from P. C uses 
all of the $4.5 million disposition proceeds to immediately retire a pro 
rata portion of the bonds. The sale does not cause the bonds to be 
private activity bonds because C has taken a remedial action described 
in paragraph (d) of this section so that P is not treated as a private 
business user of bond proceeds.
    Example 5. Alternative use of disposition proceeds. The facts are 
the same as in Example 1, except that C reasonably expects on the date 
of the deliberate action to use the $5 million disposition proceeds for 
another governmental purpose (construction of governmentally owned 
roads) within two years of receipt, rather than using the $5 million to 
redeem outstanding bonds. C treats these disposition proceeds as gross 
proceeds for purposes of section 148. The bonds are not private activity 
bonds because C has taken a remedial action described in paragraph (e) 
of this section. After the date of the deliberate action, the proceeds 
of all of the outstanding bonds are treated as used for the construction 
of the roads, even though only $5 million of disposition proceeds was 
actually used for the roads.
    Example 6. Alternative use of financed property. The facts are the 
same as in Example 1, except that C determines to lease the hospital 
building to Q, an organization described in section 501(c)(3), for a 
term of 10 years rather than to sell the building to P. In order to 
induce Q to provide hospital services, C agrees to lease payments that 
are less than fair market value. Before entering into the lease, an 
applicable elected representative of C approves the lease after a 
noticed public hearing. As of the date of the deliberate action, the 
issue meets all the requirements for qualified 501(c)(3) bonds, treating 
the bonds as reissued on that date. For example, the issue meets the two 
percent restriction on use of proceeds of finance issuance costs of 
section 147(g) because the issue pays no costs of issuance from 
disposition proceeds in connection with the deemed reissuance. C and Q 
treat the bonds as qualified 501(c)(3) bonds for all purposes commencing 
with the date of the deliberate action. The bonds are treated as 
qualified 501(c)(3) bonds commencing with the date of the deliberate 
action.
    Example 7. Deliberate action before proceeds are expended on a 
governmental purpose. County J issues bonds with proceeds of $10 million 
that can be used only to finance a correctional facility. On the issue 
date of the bonds, J reasonably expects that it will be the sole user of 
the bonds for the useful life of the facility. The bonds have a weighted 
average maturity that does not exceed 120 percent of the reasonably 
expected economic life of the facility. After the issue date of the 
bonds, but before the facility is placed in service, J enters into a 
contract with the federal government pursuant to which the federal 
government will make a fair market value, lump sum payment equal to 25 
percent of the cost of the facility. In exchange for this payment, J 
provides the federal government with priority rights to use of 25 
percent of the facility. J uses the payment received from the federal 
government to defease the nonqualified bonds. The agreement does not 
cause the bonds to be private activity bonds because J has taken a 
remedial action described in paragraph (d) of this section. See 
paragraph (a)(5) of this section.
    Example 8. Compliance after remedial action. In 2007, City G issues 
bonds with proceeds of $10 million to finance a courthouse. The bonds 
have a weighted average maturity that does not exceed 120 percent of the 
reasonably expected economic life of the courthouse. City G enters into 
contracts with nongovernmental persons that result in private business 
use of 10 percent of the courthouse per year. More than 10 percent of 
the debt service on the issue is secured by private security or 
payments. In 2019, in a bona fide and arm's length arrangement, City G 
enters into a management contract with a nongovernmental person that 
results in private business use of an additional 40 percent of the 
courthouse per year during the remaining term of the bonds. City G 
immediately redeems the nonqualified bonds, or 44.44 percent of the 
outstanding bonds. This is the portion of the outstanding bonds that, if 
the remaining bonds were issued on the date on which the deliberate 
action occurs, the remaining bonds would not meet the private business 
use test, treating the amount of private business use as the greatest 
percentage of private business use in any one-year period commencing 
with the one-year period in which the deliberate action occurs (50 
percent). This percentage is computed by dividing the percentage of the 
facility used for a government use (50 percent) by the minimum amount of 
government use required (90 percent), and subtracting the resulting 
percentage (55.56 percent) from 100 percent (44.44 percent). For 
purposes of subsequently applying section 141 to the issue, City G may 
continue to use all of the proceeds of the outstanding bonds in the same 
manner (that is, for the courthouse and the private business use) 
without causing the issue to meet the private business use test. The 
issue continues to meet the private security or payment test. The result 
would be the same if City G, instead of redeeming the bonds, established 
a defeasance escrow for those bonds, provided that the requirement of 
paragraph (d)(5) of

[[Page 54]]

this section is met. If City G takes a subsequent deliberate action that 
results in further private business use, it must take into account 10 
percent of private business use in addition to that caused by the second 
deliberate act.

[T.D. 8712, 62 FR 2298, Jan. 16, 1997, as amended by T.D. 9741, 80 FR 
65644, Oct. 27, 2015]



Sec. 1.141-13  Refunding issues.

    (a) In general. Except as provided in this section, a refunding 
issue and a prior issue are tested separately under section 141. Thus, 
the determination of whether a refunding issue consists of private 
activity bonds generally does not depend on whether the prior issue 
consists of private activity bonds.
    (b) Application of private business use test and private loan 
financing test--(1) Allocation of proceeds. In applying the private 
business use test and the private loan financing test to a refunding 
issue, the proceeds of the refunding issue are allocated to the same 
expenditures and purpose investments as the proceeds of the prior issue.
    (2) Determination of amount of private business use--(i) In general. 
Except as provided in paragraph (b)(2)(ii) of this section, the amount 
of private business use of a refunding issue is determined under 
Sec. 1.141-3(g), based on the measurement period for that issue (for 
example, without regard to any private business use that occurred prior 
to the issue date of the refunding issue).
    (ii) Refundings of governmental bonds. In applying the private 
business use test to a refunding issue that refunds a prior issue of 
governmental bonds, the amount of private business use of the refunding 
issue is the amount of private business use--
    (A) During the combined measurement period; or
    (B) At the option of the issuer, during the period described in 
paragraph (b)(2)(i) of this section, but only if, without regard to the 
reasonable expectations test of Sec. 1.141-2(d), the prior issue does 
not satisfy the private business use test, based on a measurement period 
that begins on the first day of the combined measurement period and ends 
on the issue date of the refunding issue.
    (iii) Combined measurement period--(A) In general. Except as 
provided in paragraph (b)(2)(iii)(B) of this section, the combined 
measurement period is the period that begins on the first day of the 
measurement period (as defined in Sec. 1.141-3(g)) for the prior issue 
(or, in the case of a series of refundings of governmental bonds, the 
first issue of governmental bonds in the series) and ends on the last 
day of the measurement period for the refunding issue.
    (B) Transition rule for refundings of bonds originally issued before 
May 16, 1997. If the prior issue (or, in the case of a series of 
refundings of governmental bonds, the first issue of governmental bonds 
in the series) was issued before May 16, 1997, then the issuer, at its 
option, may treat the combined measurement period as beginning on the 
date (the transition date) that is the earlier of December 19, 2005 or 
the first date on which the prior issue (or an earlier issue in the case 
of a series of refundings of governmental bonds) became subject to the 
1997 regulations (as defined in Sec. 1.141-15(b)). If the issuer treats 
the combined measurement period as beginning on the transition date in 
accordance with this paragraph (b)(2)(iii)(B), then paragraph (c)(2) of 
this section shall be applied by treating the transition date as the 
issue date of the earliest issue, by treating the bonds as reissued on 
the transition date at an issue price equal to the value of the bonds 
(as determined under Sec. 1.148-4(e)) on that date, and by disregarding 
any private security or private payments before the transition date.
    (iv) Governmental bond. For purposes of this section, the term 
governmental bond means any bond that, when issued, purported to be a 
governmental bond, as defined in Sec. 1.150-1(b), or a qualified 
501(c)(3) bond, as defined in section 145(a).
    (v) Special rule for refundings of qualified 501(c)(3) bonds with 
governmental bonds. For purposes of applying this paragraph (b)(2) to a 
refunding issue that refunds a qualified 501(c)(3) bond, any use of the 
property refinanced by the refunding issue before the issue date of the 
refunding issue by a 501(c)(3) organization with respect to its 
activities that do not constitute an unrelated trade or business under 
section 513(a) is treated as government use.

[[Page 55]]

    (c) Application of private security or payment test--(1) Separate 
issue treatment. If the amount of private business use of a refunding 
issue is determined based on the measurement period for that issue in 
accordance with paragraph (b)(2)(i) or (b)(2)(ii)(B) of this section, 
then the amount of private security and private payments allocable to 
the refunding issue is determined under Sec. 1.141-4 by treating the 
refunding issue as a separate issue.
    (2) Combined issue treatment. If the amount of private business use 
of a refunding issue is determined based on the combined measurement 
period for that issue in accordance with paragraph (b)(2)(ii)(A) of this 
section, then the amount of private security and private payments 
allocable to the refunding issue is determined under Sec. 1.141-4 by 
treating the refunding issue and all earlier issues taken into account 
in determining the combined measurement period as a combined issue. For 
this purpose, the present value of the private security and private 
payments is compared to the present value of the debt service on the 
combined issue (other than debt service paid with proceeds of any 
refunding bond). Present values are computed as of the issue date of the 
earliest issue taken into account in determining the combined 
measurement period (the earliest issue). Except as provided in paragraph 
(c)(3) of this section, present values are determined by using the yield 
on the combined issue as the discount rate. The yield on the combined 
issue is determined by taking into account payments on the refunding 
issue and all earlier issues taken into account in determining the 
combined measurement period (other than payments made with proceeds of 
any refunding bond), and based on the issue price of the earliest issue. 
In the case of a refunding of only a portion of the original principal 
amount of a prior issue, the refunded portion of the prior issue is 
treated as a separate issue and any private security or private payments 
with respect to the prior issue are allocated ratably between the 
combined issue and the unrefunded portion of the prior issue in a 
consistent manner based on relative debt service. See paragraph 
(b)(2)(iii)(B) of this section for special rules relating to certain 
refundings of governmental bonds originally issued before May 16, 1997.
    (3) Special rule for arrangements not entered into in contemplation 
of the refunding issue. In applying the private security or payment test 
to a refunding issue that refunds a prior issue of governmental bonds, 
the issuer may use the yield on the prior issue to determine the present 
value of private security and private payments under arrangements that 
were not entered into in contemplation of the refunding issue. For this 
purpose, any arrangement that was entered into more than 1 year before 
the issue date of the refunding issue is treated as not entered into in 
contemplation of the refunding issue.
    (d) Multipurpose issue allocations--(1) In general. For purposes of 
section 141, unless the context clearly requires otherwise, Sec. 1.148-
9(h) applies to allocations of multipurpose issues (as defined in 
Sec. 1.148-1(b)), including allocations involving the refunding purposes 
of the issue. An allocation under this paragraph (d) may be made at any 
time, but once made, may not be changed. An allocation is not reasonable 
under this paragraph (d) if it achieves more favorable results under 
section 141 than could be achieved with actual separate issues. Each of 
the separate issues under the allocation must consist of one or more 
tax-exempt bonds. Allocations made under this paragraph (d) and 
Sec. 1.148-9(h) must be consistent for purposes of sections 141 and 148.
    (2) Exceptions. This paragraph (d) does not apply for purposes of 
sections 141(c)(1) and 141(d)(1).
    (e) Application of reasonable expectations test to certain refunding 
bonds. An action that would otherwise cause a refunding issue to satisfy 
the private business tests or the private loan financing test is not 
taken into account under the reasonable expectations test of Sec. 1.141-
2(d) if--
    (1) The action is not a deliberate action within the meaning of 
Sec. 1.141-2(d)(3); and
    (2) The weighted average maturity of the refunding bonds is not 
greater than the weighted average reasonably expected economic life of 
the property financed by the prior bonds.

[[Page 56]]

    (f) Special rule for refundings of certain general obligation bonds. 
Notwithstanding any other provision of this section, a refunding issue 
does not consist of private activity bonds if--
    (1) The prior issue meets the requirements of Sec. 1.141-2(d)(5) 
(relating to certain general obligation bond programs that finance a 
large number of separate purposes); or
    (2) The refunded portion of the prior issue is part of a series of 
refundings of all or a portion of an issue that meets the requirements 
of Sec. 1.141-2(d)(5).
    (g) Examples. The following examples illustrate the application of 
this section:

    Example 1. Measuring private business use. In 2002, Authority A 
issues tax-exempt bonds that mature in 2032 to acquire an office 
building. The measurement period for the 2002 bonds under Sec. 1.141-
3(g) is 30 years. At the time A acquires the building, it enters into a 
10-year lease with a nongovernmental person under which the 
nongovernmental person will use 5 percent of the building in its trade 
or business during each year of the lease term. In 2007, A issues bonds 
to refund the 2002 bonds. The 2007 bonds mature on the same date as the 
2002 bonds and have a measurement period of 25 years under Sec. 1.141-
3(g). Under paragraph (b)(2)(ii)(A) of this section, the amount of 
private business use of the proceeds of the 2007 bonds is 1.67 percent, 
which equals the amount of private business use during the combined 
measurement period (5 percent of \1/3\ of the 30-year combined 
measurement period). In addition, the 2002 bonds do not satisfy the 
private business use test, based on a measurement period beginning on 
the first day of the measurement period for the 2002 bonds and ending on 
the issue date of the 2007 bonds, because only 5 percent of the proceeds 
of the 2002 bonds are used for a private business use during that 
period. Thus, under paragraph (b)(2)(ii)(B) of this section, A may treat 
the amount of private business use of the 2007 bonds as 1 percent (5 
percent of \1/5\ of the 25-year measurement period for the 2007 bonds). 
The 2007 bonds do not satisfy the private business use test.
    Example 2. Combined issue yield computation. (i) On January 1, 2000, 
County B issues 20-year bonds to finance the acquisition of a municipal 
auditorium. The 2000 bonds have a yield of 7.7500 percent, compounded 
annually, and an issue price and par amount of $100 million. The debt 
service payments on the 2000 bonds are as follows:

------------------------------------------------------------------------
                         Date                             Debt service
------------------------------------------------------------------------
1/1/01...............................................         $9,996,470
1/1/02...............................................          9,996,470
1/1/03...............................................          9,996,470
1/1/04...............................................          9,996,470
1/1/05...............................................          9,996,470
1/1/06...............................................          9,996,470
1/1/07...............................................          9,996,470
1/1/08...............................................          9,996,470
1/1/09...............................................          9,996,470
1/1/10...............................................          9,996,470
1/1/11...............................................          9,996,470
1/1/12...............................................          9,996,470
1/1/13...............................................          9,996,470
1/1/14...............................................          9,996,470
1/1/15...............................................          9,996,470
1/1/16...............................................          9,996,470
1/1/17...............................................          9,996,470
1/1/18...............................................          9,996,470
1/1/19...............................................          9,996,470
1/1/20...............................................          9,996,470
                                                      ------------------
                                                             199,929,400
------------------------------------------------------------------------

    (ii) On January 1, 2005, B issues 15-year bonds to refund all of the 
outstanding 2000 bonds maturing after January 1, 2005 (in the aggregate 
principal amount of $86,500,000). The 2005 bonds have a yield of 6.0000 
percent, compounded annually, and an issue price and par amount of 
$89,500,000. The debt service payments on the 2005 bonds are as follows:

------------------------------------------------------------------------
                         Date                             Debt service
------------------------------------------------------------------------
1/1/06...............................................         $9,215,167
1/1/07...............................................          9,215,167
1/1/08...............................................          9,215,167
1/1/09...............................................          9,215,167
1/1/10...............................................          9,215,167
1/1/11...............................................          9,215,167
1/1/12...............................................          9,215,167
1/1/13...............................................          9,215,167
1/1/14...............................................          9,215,167
1/1/15...............................................          9,215,167
1/1/16...............................................          9,215,167
1/1/17...............................................          9,215,167
1/1/18...............................................          9,215,167
1/1/19...............................................          9,215,167
1/1/20...............................................          9,215,167
                                                      ------------------
                                                             138,227,511
------------------------------------------------------------------------

    (iii) In accordance with Sec. 1.141-15(h), B chooses to apply 
Sec. 1.141-13 (together with the other provisions set forth in 
Sec. 1.141-15(h)), to the 2005 bonds. For purposes of determining the 
amount of private security and private payments with respect to the 2005 
bonds, the 2005 bonds and the refunded portion of the 2000 bonds are 
treated as a combined issue under paragraph (c)(2) of this section. The 
yield on the combined issue is determined in accordance with 
Secs. 1.148-4, 1.141-4(b)(2)(iii) and 1.141-13(c)(2). Under this 
methodology, the yield on the combined issue is 7.1062 percent per year 
compounded annually, illustrated as follows:

[[Page 57]]



----------------------------------------------------------------------------------------------------------------
                                             Previous debt
                                              service on
                   Date                        refunded     Refunding debt      Total debt      Present value on
                                              portion of        service          service             1/1/00
                                              prior issue
----------------------------------------------------------------------------------------------------------------
1/1/00....................................  ..............  ..............  .................   ($86,500,000.00)
1/1/01....................................       6,689,793  ..............          6,689,793       6,245,945.33
1/1/02....................................       6,689,793  ..............          6,689,793       5,831,545.62
1/1/03....................................       6,689,793  ..............          6,689,793       5,444,640.09
1/1/04....................................       6,689,793  ..............          6,689,793       5,083,404.58
1/1/05....................................       6,689,793  ..............          6,689,793       4,746,135.95
1/1/06....................................  ..............       9,215,167          9,215,167       6,104,023.84
1/1/07....................................  ..............       9,215,167          9,215,167       5,699,040.20
1/1/08....................................  ..............       9,215,167          9,215,167       5,320,926.00
1/1/09....................................  ..............       9,215,167          9,215,167       4,967,898.55
1/1/10....................................  ..............       9,215,167          9,215,167       4,638,293.40
1/1/11....................................  ..............       9,215,167          9,215,167       4,330,556.57
1/1/12....................................  ..............       9,215,167          9,215,167       4,043,237.15
1/1/13....................................  ..............       9,215,167          9,215,167       3,774,980.51
1/1/14....................................  ..............       9,215,167          9,215,167       3,524,521.90
1/1/15....................................  ..............       9,215,167          9,215,167       3,290,680.46
1/1/16....................................  ..............       9,215,167          9,215,167       3,072,353.70
1/1/17....................................  ..............       9,215,167          9,215,167       2,868,512.26
1/1/18....................................  ..............       9,215,167          9,215,167       2,678,195.09
1/1/19....................................  ..............       9,215,167          9,215,167       2,500,504.89
1/1/20....................................  ..............       9,215,167          9,215,167       2,334,603.90
                                           ---------------------------------------------------------------------
                                                33,448,965     138,227,511    171,676,4760.00               0.00
----------------------------------------------------------------------------------------------------------------

    Example 3. Determination of private payments allocable to combined 
issue. The facts are the same as in Example 2. In addition, on January 
1, 2001, B enters into a contract with a nongovernmental person for the 
use of the auditorium. The contract results in a private payment in the 
amount of $500,000 on each January 1 beginning on January 1, 2001, and 
ending on January 1, 2020. Under paragraph (c)(2) of this section, the 
amount of the private payments allocable to the combined issue is 
determined by treating the refunded portion of the 2000 bonds 
($86,500,000 principal amount) as a separate issue, and by allocating 
the total private payments ratably between the combined issue and the 
unrefunded portion of the 2000 bonds ($13,500,000 principal amount) 
based on relative debt service, as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                         Percentage   Amount of
                                                            Debt                         of private    private
                                             Private     service on   Debt service on     payments     payments
                   Date                      payments    unrefunded    combined issue    allocable    allocable
                                                         portion of                     to combined  to combined
                                                        prior issue                        issue        issue
----------------------------------------------------------------------------------------------------------------
1/1/01...................................     $500,000   $3,306,677         $6,689,793        66.92     $334,608
1/1/02...................................      500,000    3,306,677          6,689,793        66.92      334,608
1/1/03...................................      500,000    3,306,677          6,689,793        66.92      334,608
1/1/04...................................      500,000    3,306,677          6,689,793        66.92      334,608
1/1/05...................................      500,000    3,306,677          6,689,793        66.92      334,608
1/1/06...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/07...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/08...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/09...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/10...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/11...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/12...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/13...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/14...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/15...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/16...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/17...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/18...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/19...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/20...................................      500,000  ...........          9,215,167       100.00      500,000
                                          ----------------------------------------------------------------------
                                           $10,000,000  $16,533,385       $171,676,476  ...........   $9,173,039
----------------------------------------------------------------------------------------------------------------


[[Page 58]]

    Example 4. Refunding taxable bonds and qualified bonds. (i) In 1999, 
City C issues taxable bonds to finance the construction of a facility 
for the furnishing of water. The bonds are secured by revenues from the 
facility. The facility is managed pursuant to a management contract with 
a nongovernmental person that gives rise to private business use. In 
2007, C terminates the management contract and takes over the operation 
of the facility. In 2009, C issues bonds to refund the 1999 bonds. On 
the issue date of the 2009 bonds, C reasonably expects that the facility 
will not be used for a private business use during the term of the 2009 
bonds. In addition, during the term of the 2009 bonds, the facility is 
not used for a private business use. Under paragraph (b)(2)(i) of this 
section, the 2009 bonds do not satisfy the private business use test 
because the amount of private business use is based on the measurement 
period for those bonds and therefore does not take into account any 
private business use that occurred pursuant to the management contract.
    (ii) The facts are the same as in paragraph (i) of this Example 4, 
except that the 1999 bonds are issued as exempt facility bonds under 
section 142(a)(4). The 2009 bonds do not satisfy the private business 
use test.
    Example 5. Multipurpose issue. (i) In 2017, State D issues bonds to 
finance the construction of two office buildings, Building 1 and 
Building 2. D expends an equal amount of the proceeds on each building. 
D enters into arrangements that result in private business use of 8 
percent of Building 1 and 12 percent of Building 2 during the 
measurement period under Sec. 1.141-3(g) and private payments of 4 
percent of the 2017 bonds in respect of Building 1 and 6 percent of the 
2017 bonds in respect of Building 2. These arrangements result in a 
total of 10 percent of the proceeds of the 2017 bonds being used for a 
private business use and total private payments of 10 percent. In 2022, 
D purports to make a multipurpose issue allocation under paragraph (d) 
of this section of the outstanding 2017 bonds, allocating the issue into 
two separate issues of equal amounts with one issue allocable to 
Building 1 and the second allocable to Building 2. An allocation is 
unreasonable under paragraph (d) of this section if it achieves more 
favorable results under section 141 than could be achieved with actual 
separate issues. D's allocation is unreasonable because, if permitted, 
it would allow more favorable results under section 141 for the 2017 
bonds (that is, private business use and private payments that exceed 10 
percent for the 2017 bonds allocable to Building 2) than could be 
achieved with actual separate issues. In addition, if D's purported 
allocation was intended to result in two separate issues of tax-exempt 
governmental bonds (versus tax-exempt private activity bonds), the 
allocation would violate paragraph (d) of this section in the first 
instance because the allocation to the separate issue for Building 2 
would fail to qualify separately as an issue of tax-exempt governmental 
bonds as a result of its 12 percent of private business use and private 
payments.
    (ii) The facts are the same as in paragraph (i) of this Example 5, 
except that D enters into arrangements only for Building 1, and it 
expects no private business use of Building 2. In 2022, D allocates an 
equal amount of the outstanding 2017 bonds to Building 1 and Building 2. 
D selects particular bonds for each separate issue such that the 
allocation does not achieve a more favorable result than could have been 
achieved by issuing actual separate issues. D uses the same allocation 
for purposes of both sections 141 and 148. D's allocation is reasonable.
    (iii) The facts are the same as in paragraph (ii) of this Example 5, 
except that as part of the same issue, D issues bonds for a privately 
used airport. The airport bonds, if issued as a separate issue, would be 
qualified private activity bonds. The remaining bonds, if issued 
separately from the airport bonds, would be governmental bonds. Treated 
as one issue, however, the bonds are taxable private activity bonds. 
Therefore, D makes its allocation of the bonds under paragraph (d) of 
this section and Sec. 1.150-1(c)(3) into 3 separate issues on or before 
the issue date. Assuming all other applicable requirements are met, the 
bonds of the respective issues will be tax-exempt qualified private 
activity bonds or governmental bonds.
    Example 6. Non-deliberate action. In 1998, City E issues bonds to 
finance the purchase of land and construction of a building (the prior 
bonds). On the issue date of the prior bonds, E reasonably expects that 
it will be the sole user of the financed property for the entire term of 
the bonds. In 2003, the federal government acquires the financed 
property in a condemnation action. In 2006, E issues bonds to refund the 
prior bonds (the refunding bonds). The weighted average maturity of the 
refunding bonds is not greater than the reasonably expected economic 
life of the financed property. In general, under Sec. 1.141-2(d) and 
this section, reasonable expectations must be separately tested on the 
issue date of a refunding issue. Under paragraph (e) of this section, 
however, the condemnation action is not taken into account in applying 
the reasonable expectations test to the refunding bonds because the 
condemnation action is not a deliberate action within the meaning of 
Sec. 1.141-2(d)(3) and the weighted average maturity of the refunding 
bonds is not greater than the weighted average reasonably expected 
economic life of the property financed by the prior bonds. Thus, the 
condemnation action does not cause the refunding bonds to be private 
activity bonds.
    Example 7. Non-transitioned refunding of bonds subject to 1954 Code. 
In 1985, County F

[[Page 59]]

issues bonds to finance a court house. The 1985 bonds are subject to the 
provisions of the Internal Revenue Code of 1954. In 2006, F issues bonds 
to refund all of the outstanding 1985 bonds. The weighted average 
maturity of the 2006 bonds is longer than the remaining weighted average 
maturity of the 1985 bonds. In addition, the 2006 bonds do not satisfy 
any transitional rule for refundings in the Tax Reform Act of 1986, 100 
Stat. 2085 (1986). Section 141 and this section apply to determine 
whether the 2006 bonds are private activity bonds including whether, for 
purposes of Sec. 1.141-13(b)(2)(ii)(B), the 1985 bonds satisfy the 
private business use test based on a measurement period that begins on 
the first day of the combined measurement period for the 2006 bonds and 
ends on the issue date of the 2006 bonds.

[T.D. 9234, 70 FR 75032, Dec. 19, 2006, as amended by T.D. 9741, 80 FR 
65645, Oct. 27, 2015]



Sec. 1.141-14  Anti-abuse rules.

    (a) Authority of Commissioner to reflect substance of transactions. 
If an issuer enters into a transaction or series of transactions with 
respect to one or more issues with a principal purpose of transferring 
to nongovernmental persons (other than as members of the general public) 
significant benefits of tax-exempt financing in a manner that is 
inconsistent with the purposes of section 141, the Commissioner may take 
any action to reflect the substance of the transaction or series of 
transactions, including--
    (1) Treating separate issues as a single issue for purposes of the 
private activity bond tests;
    (2) Reallocating proceeds to expenditures, property, use, or bonds;
    (3) Reallocating payments to use or proceeds;
    (4) Measuring private business use on a basis that reasonably 
reflects the economic benefit in a manner different than as provided in 
Sec. 1.141-3(g); and
    (5) Measuring private payments or security on a basis that 
reasonably reflects the economic substance in a manner different than as 
provided in Sec. 1.141-4.
    (b) Examples. The following examples illustrate the application of 
this section:
    Example 1. Reallocating proceeds to indirect use. City C issues 
bonds with proceeds of $20 million for the stated purpose of financing 
improvements to roads that it owns. As a part of the same plan of 
financing, however, C also agrees to make a loan of $7 million to 
Corporation M from its general revenues that it otherwise would have 
used for the road improvements. The interest rate of the loan 
corresponds to the interest rate on a portion of the issue. A principal 
purpose of the financing arrangement is to transfer to M significant 
benefits of the tax-exempt financing. Although C actually allocates all 
of the proceeds of the bonds to the road improvements, the Commissioner 
may reallocate a portion of the proceeds of the bonds to the loan to M 
because a principal purpose of the financing arrangement is to transfer 
to M significant benefits of tax-exempt financing in a manner that is 
inconsistent with the purposes of section 141. The bonds are private 
activity bonds because the issue meets the private loan financing test. 
The bonds also meet the private business tests. See also Secs. 1.141-
3(a)(2), 1.141-4(a)(1), and 1.141-5(a), under which indirect use of 
proceeds and payments are taken into account.
    Example 2. Taking into account use of amounts derived from proceeds 
that would be otherwise disregarded. County B issues bonds with proceeds 
of $10 million to finance the purchase of land. On the issue date, B 
reasonably expects that it will be the sole user of the land. 
Subsequently, the federal government acquires the land for $3 million in 
a condemnation action. B uses this amount to make a loan to Corporation 
M. In addition, the interest rate on the loan reflects the tax-exempt 
interest rate on the bonds and thus is substantially less than a current 
market rate. A principal purpose of the arrangement is to transfer to M 
significant benefits of the tax-exempt financing. Although the 
condemnation action is not a deliberate action, the Commissioner may 
treat the condemnation proceeds as proceeds of the issue because a 
principal purpose of the arrangement is to transfer to M significant 
benefits of tax-exempt financing in a manner inconsistent with the 
purposes of section 141. The bonds are private activity bonds.
    Example 3. Measuring private business use on an alternative basis. 
City F issues bonds with a 30-year term to finance the acquisition of an 
industrial building having a remaining reasonably expected useful 
economic life of more than 30 years. On the issue date, F leases the 
building to Corporation G for 3 years. F reasonably expects that it will 
be the sole user of the building for the remaining term of the bonds. 
Because of the local market conditions, it is reasonably expected that 
the fair rental value of the industrial building will be significantly 
greater during the early years of the term of the bonds than in the 
later years. The annual rental payments are significantly less than fair 
market value, reflecting the interest rate on the

[[Page 60]]

bonds. The present value of these rental payments (net of operation and 
maintenance expenses) as of the issue date, however, is approximately 25 
percent of the present value of debt service on the issue. Under 
Sec. 1.141-3, the issue does not meet the private business tests, 
because only 10 percent of the proceeds are used in a trade or business 
by a nongovernmental person. A principal purpose of the issue is to 
transfer to G significant benefits of tax-exempt financing in a manner 
inconsistent with the purposes of section 141. The method of measuring 
private business use over the reasonably expected useful economic life 
of financed property is for the administrative convenience of issuers of 
state and local bonds. In cases where this method is used in a manner 
inconsistent with the purposes of section 141, the Commissioner may 
measure private business use on another basis that reasonably reflects 
economic benefit, such as in this case on an annual basis. If the 
Commissioner measures private business use on an annual basis, the bonds 
are private activity bonds because the private payment test is met and 
more than 10 percent of the proceeds are used in a trade or business by 
a nongovernmental person.
    Example 4. Treating separate issues as a single issue. City D enters 
into a development agreement with Corporation T to induce T to locate 
its headquarters within D's city limits. Pursuant to the development 
agreement, in 1997 D will issue $20 million of its general obligation 
bonds (the 1997 bonds) to purchase land that it will grant to T. The 
development agreement also provides that, in 1998, D will issue $20 
million of its tax increment bonds (the 1998 bonds), secured solely by 
the increase in property taxes in a special taxing district. 
Substantially all of the property within the special taxing district is 
owned by T or D. T will separately enter into an agreement to guarantee 
the payment of tax increment to D in an amount sufficient to retire the 
1998 bonds. The proceeds of the 1998 bonds will be used to finance 
improvements owned and operated by D that will not give rise to private 
business use. Treated separately, the 1997 issue meets the private 
business use test, but not the private security or payment test; the 
1998 issue meets the private security or payment test, but not the 
private business use test. A principal purpose of the financing plan, 
including the two issues, is to transfer significant benefits of tax-
exempt financing to T for its headquarters. Thus, the 1997 issue and the 
1998 issue may be treated by the Commissioner as a single issue for 
purposes of applying the private activity bond tests. Accordingly, the 
bonds of both the 1997 issue and the 1998 issue may be treated as 
private activity bonds.
    Example 5. Reallocating proceeds. City E acquires an electric 
generating facility with a useful economic life of more than 40 years 
and enters into a 30-year take or pay contract to sell 30 percent of the 
available output to investor-owned utility M. E plans to use the 
remaining 70 percent of available output for its own governmental 
purposes. To finance the entire cost of the facility, E issues $30 
million of its series A taxable bonds at taxable interest rates and $70 
million series B bonds, which purport to be tax-exempt bonds, at tax-
exempt interest rates. E allocates all of M's private business use to 
the proceeds of the series A bonds and all of its own government use to 
the proceeds of the series B bonds. The series A bonds have a weighted 
average maturity of 15 years, while the series B bonds have a weighted 
average maturity of 26 years. M's payments under the take or pay 
contract are expressly determined by reference to 30 percent of M's 
total costs (that is, the sum of the debt service required to be paid on 
both the series A and the series B bonds and all other operating costs). 
The allocation of all of M's private business use to the series A bonds 
does not reflect economic substance because the series of transactions 
transfers to M significant benefits of the tax-exempt interest rates 
paid on the series B bonds. A principal purpose of the financing 
arrangement is to transfer to M significant benefits of the tax-exempt 
financing. Accordingly, the Commissioner may allocate M's private 
business use on a pro rata basis to both the series B bonds as well as 
the series A bonds, in which case the series B bonds are private 
activity bonds.
    Example 6. Allocations respected. The facts are the same as in 
Example 5, except that the debt service component of M's payments under 
the take or pay contract is based exclusively on the amounts necessary 
to pay the debt service on the taxable series A bonds. E's allocation of 
all of M's private business use to the series A bonds is respected 
because the series of transactions does not actually transfer benefits 
of tax-exempt interest rates to M. Accordingly, the series B bonds are 
not private activity bonds. The result would be the same if M's payments 
under the take or pay contract were based exclusively on fair market 
value pricing, rather than the tax-exempt interest rates on E's bonds. 
The result also would be the same if the series A bonds and the series B 
bonds had substantially equivalent weighted average maturities and E and 
M had entered into a customary contract providing for payments based on 
a ratable share of total debt service. E would not be treated by the 
Commissioner in any of these cases as entering into the contract with a 
principal purpose of transferring the benefits of tax-exempt financing 
to M in a manner inconsistent with the purposes of section 141.

[T.D. 8712, 62 FR 2301, Jan. 16, 1997]

[[Page 61]]



Sec. 1.141-15  Effective/applicability dates.

    (a) Scope. The effective dates of this section apply for purposes of 
Secs. 1.141-1 through 1.141-14, 1.145-1 through 1.145-2, and 1.150-
1(a)(3) and the definition of bond documents contained in Sec. 1.150-
1(b).
    (b) Effective dates--(1) In general. Except as otherwise provided in 
this section, Secs. 1.141-0 through 1.141-6(a), 1.141-9 through 1.141-
12, 1.141-14, 1.145-1 through 1.145-2(c), and the definition of bond 
documents contained in Sec. 1.150-1(b) (the 1997 regulations) apply to 
bonds issued on or after May 16, 1997, that are subject to section 1301 
of the Tax Reform Act of 1986 (100 Stat. 2602).
    (2) Certain short-term arrangements. The provisions of Sec. 1.141-3 
that refer to arrangements for 200 days, 100 days, or 50 days apply to 
any bond sold on or after November 20, 2001 and may be applied to any 
bond outstanding on November 20, 2001 to which Sec. 1.141-3 applies.
    (3) Certain prepayments. Except as provided in paragraph (c) of this 
section, paragraphs (c)(2)(ii), (c)(2)(iii) and (c)(2)(iv) of 
Sec. 1.141-5 apply to bonds sold on or after October 3, 2003. Issuers 
may apply paragraphs (c)(2)(ii), (c)(2)(iii) and (c)(2)(iv) of 
Sec. 1.141-5, in whole but not in part, to bonds sold before October 3, 
2003 that are subject to Sec. 1.141-5.
    (4) Certain remedial actions--(i) General rule. For bonds subject to 
Sec. 1.141-12, the provisions of Sec. 1.141-12(d)(3), (i), (j), and (k), 
Example 8, apply to deliberate actions that occur on or after January 
25, 2016.
    (ii) Special rule for allocations of nonqualified bonds. For 
purposes of Sec. 1.141-12(j)(2), in addition to the allocation methods 
permitted in Sec. 1.141-12(j)(2), an issuer may treat bonds with the 
longest maturities (determined on a bond-by-bond basis) as the 
nonqualified bonds, but only for bonds sold before January 25, 2016.
    (c) Refunding bonds. Except as otherwise provided in this section, 
the 1997 regulations (defined in paragraph (b)(1) of this section) do 
not apply to any bonds issued on or after May 16, 1997, to refund a bond 
to which those regulations do not apply unless--
    (1) The refunding bonds are subject to section 1301 of the Tax 
Reform Act of 1986 (100 Stat. 2602); and
    (2)(i) The weighted average maturity of the refunding bonds is 
longer than--
    (A) The weighted average maturity of the refunded bonds; or
    (B) In the case of a short-term obligation that the issuer 
reasonably expects to refund with a long-term financing (such as a bond 
anticipation note), 120 percent of the weighted average reasonably 
expected economic life of the facilities financed; or
    (ii) A principal purpose for the issuance of the refunding bonds is 
to make one or more new conduit loans.
    (d) Permissive application of regulations. Except as provided in 
paragraph (e) of this section, the 1997 regulations (defined in 
paragraph (b)(1) of this section) may be applied in whole, but not in 
part, to actions taken before February 23, 1998, with respect to--
    (1) Bonds that are outstanding on May 16, 1997, and subject to 
section 141; or
    (2) Refunding bonds issued on or after May 16, 1997, that are 
subject to 141.
    (e) Permissive application of certain sections--(1) In general. The 
following sections may each be applied by issuers to any bonds:
    (i) Section 1.141-3(b)(4);
    (ii) Section 1.141-3(b)(6); and
    (iii) Section 1.141-12.
    (2) Transition rule for pre-effective date bonds. For purposes of 
paragraphs (e)(1) and (h) of this section, issuers may apply Sec. 1.141-
12 to bonds issued before May 16, 1997, without regard to paragraph 
(d)(5) thereof with respect to deliberate actions that occur on or after 
April 21, 2003.
    (f) Effective dates for certain regulations relating to output 
facilities--(1) General rule. Except as otherwise provided in this 
section, Secs. 1.141-7 and 1.141-8 apply to bonds sold on or after 
November 22, 2002, that are subject to section 1301 of the Tax Reform 
Act of 1986 (100 Stat. 2602).
    (2) Transition rule for requirements contracts. For bonds otherwise 
subject to Secs. 1.141-7 and 1.141-8, Sec. 1.141-7(c)(3) applies to 
output contracts entered into on or after September 19, 2002. An output 
contract is treated as entered into on or after that date if it is 
amended on or after that date, but only if the amendment results in a 
change in the parties to the contract or increases the

[[Page 62]]

amount of requirements covered by the contract by reason of an extension 
of the contract term or a change in the method for determining such 
requirements. For purposes of this paragraph (f)(2)--
    (i) The extension of the term of a contract causes the contract to 
be treated as entered into on the first day of the additional term;
    (ii) The exercise by a party of a legally enforceable right that was 
provided under a contract before September 19, 2002, on terms that were 
fixed and determinable before such date, is not treated as an amendment 
of the contract. For example, the exercise by a purchaser after 
September 19, 2002 of a renewal option that was provided under a 
contract before that date, on terms identical to the original contract, 
is not treated as an amendment of the contract; and
    (iii) An amendment that increases the amount of requirements covered 
by the contract by reason of a change in the method for determining such 
requirements is treated as a separate contract that is entered into as 
of the effective date of the amendment, but only with respect to the 
increased output to be provided under the contract.
    (g) Refunding bonds for output facilities. Except as otherwise 
provided in paragraph (h) or (i) of this section, Secs. 1.141-7 and 
1.141-8 do not apply to any bonds sold on or after November 22, 2002, to 
refund a bond to which Secs. 1.141-7 and 1.141-8 do not apply unless--
    (1) The refunding bonds are subject to section 1301 of the Tax 
Reform Act of 1986 (100 Stat. 2602); and
    (2)(i) The weighted average maturity of the refunding bonds is 
longer than--
    (A) The weighted average maturity of the refunded bonds; or
    (B) In the case of a short-term obligation that the issuer 
reasonably expects to refund with a long-term financing (such as a bond 
anticipation note), 120 percent of the weighted average reasonably 
expected economic life of the facilities financed; or
    (ii) A principal purpose for the issuance of the refunding bonds is 
to make one or more new conduit loans.
    (h) Permissive retroactive application. Except as provided in 
paragraphs (d), (e) or (i) of this section, Secs. 1.141-1 through 1.141-
6(a), 1.141-7 through 1.141-14, 1.145-1 through 1.145-2, 1.149(d)-1(g), 
1.150-1(a)(3), the definition of bond documents contained in Sec. 1.150-
1(b) and Sec. 1.150-1(c)(3)(ii) may be applied by issuers in whole, but 
not in part, to--
    (1) Outstanding bonds that are sold before February 17, 2006, and 
subject to section 141; or
    (2) Refunding bonds that are sold on or after February 17, 2006, and 
subject to section 141.
    (i) Permissive application of certain regulations relating to output 
facilities. Issuers may apply each of the following sections to any 
bonds used to finance output facilities:
    (1) Section 1.141-6;
    (2) Section 1.141-7(f)(3); and
    (3) Section 1.141-7(g).
    (j) Effective dates for certain regulations relating to refundings. 
Except as otherwise provided in this section, Secs. 1.141-13, 1.145-
2(d), 1.149(d)-1(g), 1.150-1(a)(3) and 1.150-1(c)(3)(ii) apply to bonds 
that are sold on or after February 17, 2006, and that are subject to the 
1997 regulations (defined in paragraph (b)(1) of this section).
    (k) Effective/applicability dates for certain regulations relating 
to generally applicable taxes and payments in lieu of tax--(1) In 
general. Except as otherwise provided in paragraphs (k)(2) and (k)(3) of 
this section, revised Secs. 1.141-4(e)(2), 1.141-4(e)(3) and 1.141-
4(e)(5) apply to bonds sold on or after October 24, 2008 that are 
otherwise subject to the 1997 Regulations (defined in paragraph (b)(1) 
of this section).
    (2) Transitional rule for certain refundings. Paragraph (k)(1) does 
not apply to bonds that are issued to refund bonds if--
    (i) Either--
    (A) The refunded bonds (or the original bonds in a series of 
refundings) were sold before October 24, 2008, or
    (B) The refunded bonds (or the original bonds in a series of 
refundings) satisfied the transitional rule for projects substantially 
in progress under paragraph (k)(3) of this section; and
    (ii) The weighted average maturity of the refunding bonds does not 
exceed the remaining weighted average maturity of the refunded bonds.
    (3) Transitional rule for certain projects substantially in 
progress. Paragraph

[[Page 63]]

(k)(1) of this section does not apply to bonds issued for projects for 
which all of the following requirements are met:
    (i) A governmental person (as defined in Sec. 1.141-1) took official 
action evidencing its preliminary approval of the project before October 
19, 2006, and the plan of finance for the project in place at that time 
contemplated financing the project with tax-exempt bonds to be paid or 
secured by PILOTs.
    (ii) Before October 19, 2006, significant expenditures were paid or 
incurred with respect to the project or a contract was entered into to 
pay or incur significant expenditures with respect to the project.
    (iii) The bonds for the project (excluding refunding bonds) are 
issued on or before December 31, 2009.
    (l) Applicability date for certain regulations relating to 
allocation and accounting--(1) In general. Except as otherwise provided 
in this section, Secs. 1.141-1(e), 1.141-3(g)(2)(v), 1.141-6, 1.141-
13(d), and 1.145-2(b)(4), (b)(5), and (c)(2) apply to bonds that are 
sold on or after January 25, 2016, and to which the 1997 regulations (as 
defined in paragraph (b)(1) of this section) apply.
    (2) Refunding bonds. Except as otherwise provided in this section, 
Secs. 1.141-1(e), 1.141-3(g)(2)(v), 1.141-6, and 1.145-2(b)(4), (5), and 
(c)(2) do not apply to any bonds sold on or after January 25, 2016, to 
refund a bond to which these sections do not apply, provided that the 
weighted average maturity of the refunding bonds is no longer than--
    (i) The remaining weighted average maturity of the refunded bonds; 
or
    (ii) In the case of a short-term obligation that the issuer 
reasonably expects to refund with a long-term financing (such as a bond 
anticipation note), 120 percent of the weighted average reasonably 
expected economic life of the facilities financed.
    (3) Permissive application. Except as otherwise provided in this 
section, issuers may apply Secs. 1.141-1(e), 1.141-3(g)(2)(v), 1.141-6, 
and 1.145-2(b)(4), (b)(5), and (c)(2), in whole but not in part, to 
bonds to which the 1997 regulations apply.
    (m) Permissive retroactive application of certain regulations. 
Issuers may apply Sec. 1.141-13(d) to bonds to which Sec. 1.141-13 
applies.
    (n) Effective/applicability dates for certain regulations relating 
to certain definitions. Sec. 1.141-1(a) applies to bonds that are sold 
on or after October 17, 2016.

[T.D. 8757, 63 FR 3265, Jan. 22, 1998, as amended by T.D. 8941, 66 FR 
4670, Jan. 18, 2001; T.D. 8967, 66 FR 58062, Nov. 20, 2001; T.D. 9016, 
67 FR 59765, Sept. 23, 2002; T.D. 9085, 68 FR 45775, Aug. 4, 2003; T.D. 
9234, 70 FR 75035, Dec. 19, 2005; 71 FR 1971, Jan. 12, 2006; T.D. 9429, 
73 FR 63375, Oct. 24, 2008; T.D. 9741, 80 FR 65645, Oct. 27, 2015; 80 FR 
74678, Nov. 30, 2015; T.D. 9777, 81 FR 46592, July 18, 2016]



Sec. 1.141-16  Effective dates for qualified private activity bond 
provisions.

    (a) Scope. The effective dates of this section apply for purposes of 
Secs. 1.142-0 through 1.142-2, 1.144-0 through 1.144-2, 1.147-0 through 
1.147-2, and 1.150-4.
    (b) Effective dates. Except as otherwise provided in this section, 
the regulations designated in paragraph (a) of this section apply to 
bonds issued on or after May 16, 1997 (the effective date).
    (c) Permissive application. The regulations designated in paragraph 
(a) of this section may be applied by issuers in whole, but not in part, 
to bonds outstanding on the effective date. For this purpose, issuers 
may apply Sec. 1.142-2 without regard to paragraph (c)(3) thereof to 
failures to properly use proceeds that occur on or after April 21, 2003.
    (d) Certain remedial actions--(1) General rule. The provisions of 
Sec. 1.142-2(e) apply to failures to properly use proceeds that occur on 
or after August 13, 2004 and may be applied by issuers to failures to 
properly use proceeds that occur on or after May 14, 2004, provided that 
the bonds are subject to Sec. 1.142-2.
    (2) Special rule for allocations of nonqualified bonds. For purposes 
of Sec. 1.142-2(e)(2), in addition to the allocation methods permitted 
in Sec. 1.142-2(e)(2), an issuer may treat bonds with the longest 
maturities (determined on a bond-by-bond basis) as the nonqualified 
bonds, but only with respect to failures to properly use proceeds that 
occur on or after May 14, 2004, with respect to bonds sold before August 
13, 2004.

[T.D. 8712, 62 FR 2302, Jan. 16, 1997, as amended by T.D. 9150, 69 FR 
50066, Aug. 13, 2004]

[[Page 64]]



Sec. 1.142-0  Table of contents.

    This section lists the captioned paragraphs contained in 
Secs. 1.142-1 through 1.142-3.

                  Sec. 1.142-1  Exempt facility bonds.

    (a) Overview.
    (b) Scope.
    (c) Effective dates.

                     Sec. 1.142-2  Remedial actions.

    (a) General rule.
    (b) Reasonable expectations requirement.
    (c) Redemption or defeasance.
    (1) In general.
    (2) Notice of defeasance.
    (3) Special limitation.
    (4) Special rule for dispositions of personal property.
    (5) Definitions.
    (d) When a failure to properly use proceeds occurs.
    (1) Proceeds not spent.
    (2) Proceeds spent.
    (e) Nonqualified bonds.
    (1) Amount of nonqualified bonds.
    (2) Allocation of nonqualified bonds.

               Sec. 1.142-3  Refunding issues. [Reserved]

[T.D. 8712, 62 FR 2302, Jan. 16, 1997, as amended by T.D. 9150, 69 FR 
50066, Aug. 13, 2004]



Sec. 1.142-1  Exempt facility bonds.

    (a) Overview. Interest on a private activity bond is not excludable 
from gross income under section 103(a) unless the bond is a qualified 
bond. Under section 141(e)(1)(A), an exempt facility bond issued under 
section 142 may be a qualified bond.
    Under section 142(a), an exempt facility bond is any bond issued as 
a part of an issue using 95 percent or more of the proceeds for certain 
exempt facilities.
    (b) Scope. Sections 1.142-0 through 1.142-3 apply for purposes of 
the rules for exempt facility bonds under section 142, except that, with 
respect to net proceeds that have been spent, Sec. 1.142-2 does not 
apply to bonds issued under section 142(d) (relating to bonds issued to 
provide qualified residential rental projects) and section 142(f) (2) 
and (4) (relating to bonds issued to provide local furnishing of 
electric energy or gas).
    (c) Effective dates. For effective dates of Secs. 1.142-0 through 
1.142-2, see Sec. 1.141-16.

[T.D. 8712, 62 FR 2302, Jan. 16, 1997]



Sec. 1.142-2  Remedial actions.

    (a) General rule. If less than 95 percent of the net proceeds of an 
exempt facility bond are actually used to provide an exempt facility, 
and for no other purpose, the issue will be treated as meeting the use 
of proceeds requirement of section 142(a) if the issue meets the 
condition of paragraph (b) of this section and the issuer takes the 
remedial action described in paragraph (c) of this section.
    (b) Reasonable expectations requirement. The issuer must have 
reasonably expected on the issue date that 95 percent of the net 
proceeds of the issue would be used to provide an exempt facility and 
for no other purpose for the entire term of the bonds (disregarding any 
redemption provisions). To meet this condition the amount of the issue 
must have been based on reasonable estimates about the cost of the 
facility.
    (c) Redemption or defeasance--(1) In general. The requirements of 
this paragraph (c) are met if all of the nonqualified bonds of the issue 
are redeemed on the earliest call date after the date on which the 
failure to properly use the proceeds occurs under paragraph (d) of this 
section. Proceeds of tax-exempt bonds (other than those described in 
paragraph (d)(1) of this section) must not be used for this purpose. If 
the bonds are not redeemed within 90 days of the date on which the 
failure to properly use proceeds occurs, a defeasance escrow must be 
established for those bonds within 90 days of that date.
    (2) Notice of defeasance. The issuer must provide written notice to 
the Commissioner of the establishment of the defeasance escrow within 90 
days of the date the escrow is established.
    (3) Special limitation. The establishment of a defeasance escrow 
does not satisfy the requirements of this paragraph (c) if the period 
between the issue date and the first call date is more than 10\1/2\ 
years.
    (4) Special rule for dispositions of personal property. For 
dispositions of personal property exclusively for cash, the requirements 
of this paragraph (c) are met if the issuer expends the disposition 
proceeds within 6 months of the

[[Page 65]]

date of the disposition to acquire replacement property for the same 
qualifying purpose of the issue under section 142.
    (5) Definitions. For purposes of paragraph (c)(4) of this section, 
disposition proceeds means disposition proceeds as defined in 
Sec. 1.141-12(c).
    (d) When a failure to properly use proceeds occurs--(1) Proceeds not 
spent. For net proceeds that are not spent, a failure to properly use 
proceeds occurs on the earlier of the date on which the issuer 
reasonably determines that the financed facility will not be completed 
or the date on which the financed facility is placed in service.
    (2) Proceeds spent. For net proceeds that are spent, a failure to 
properly use proceeds occurs on the date on which an action is taken 
that causes the bonds not to be used for the qualifying purpose for 
which the bonds were issued.
    (e) Nonqualified bonds--(1) Amount of nonqualified bonds. For 
purposes of this section, the nonqualified bonds are a portion of the 
outstanding bonds in an amount that, if the remaining bonds were issued 
on the date on which the failure to properly use the proceeds occurs, at 
least 95 percent of the net proceeds of the remaining bonds would be 
used to provide an exempt facility. If no proceeds have been spent to 
provide an exempt facility, all of the outstanding bonds are 
nonqualified bonds.
    (2) Allocation of nonqualified bonds. Allocations of nonqualified 
bonds must be made on a pro rata basis, except that an issuer may treat 
any bonds of an issue as the nonqualified bonds so long as--
    (i) The remaining weighted average maturity of the issue, determined 
as of the date on which the nonqualified bonds are redeemed or defeased 
(determination date), and excluding from the determination the 
nonqualified bonds redeemed or defeased by the issuer to meet the 
requirements of paragraph (c) of this section, is not greater than
    (ii) The remaining weighted average maturity of the issue, 
determined as of the determination date, but without regard to the 
redemption or defeasance of any bonds (including the nonqualified bonds) 
occurring on the determination date.

[T.D. 8712, 62 FR 2302, Jan. 16, 1997, as amended by T.D. 9150, 69 FR 
50067, Aug. 13, 2004]



Sec. 1.142-3  Refunding Issues. [Reserved]



Sec. 1.142-4  Use of proceeds to provide a facility.

    (a) In general. [Reserved]
    (b) Reimbursement allocations. If an expenditure for a facility is 
paid before the issue date of the bonds to provide that facility, the 
facility is described in section 142(a) only if the expenditure meets 
the requirements of Sec. 1.150-2 (relating to reimbursement 
allocations). For purposes of this paragraph (b), if the proceeds of an 
issue are used to pay principal of or interest on an obligation other 
than a State or local bond (for example, temporary construction 
financing of the conduit borrower), that issue is not a refunding issue, 
and, thus, Sec. 1.150-2(g) does not apply.
    (c) Limitation on use of facilities by substantial users--(1) In 
general. If the original use of a facility begins before the issue date 
of the bonds to provide the facility, the facility is not described in 
section 142(a) if any person that was a substantial user of the facility 
at any time during the 5-year period before the issue date or any 
related person to that user receives (directly or indirectly) 5 percent 
or more of the proceeds of the issue for the user's interest in the 
facility and is a substantial user of the facility at any time during 
the 5-year period after the issue date, unless--
    (i) An official intent for the facility is adopted under Sec. 1.150-
2 within 60 days after the date on which acquisition, construction, or 
reconstruction of that facility commenced; and
    (ii) For an acquisition, no person that is a substantial user or 
related person after the acquisition date was also a substantial user 
more than 60 days before the date on which the official intent was 
adopted.
    (2) Definitions. For purposes of paragraph (c)(1) of this section, 
substantial user has the meaning used in section 147(a)(1), related 
person has the meaning used in section 144(a)(3), and a user that is a 
governmental unit within the meaning of Sec. 1.103-1 is disregarded.

[[Page 66]]

    (d) Effective date--(1) In general. This section applies to bonds 
sold on or after July 8, 1997. See Sec. 1.103-8(a)(5) for rules 
applicable to bonds sold before that date.
    (2) Elective retroactive application. An issuer may apply this 
section to any bond sold before July 8, 1997.

[T.D. 8718, 62 FR 25506, May 9, 1997]



Sec. 1.142(a)(5)-1  Exempt facility bonds: Sewage facilities.

    (a) In general. Under section 103(a), a private activity bond is a 
tax-exempt bond only if it is a qualified bond. A qualified bond 
includes an exempt facility bond, defined as any bond issued as part of 
an issue 95 percent or more of the net proceeds of which are used to 
provide a facility specified in section 142. One type of facility 
specified in section 142(a) is a sewage facility. This section defines 
the term sewage facility for purposes of section 142(a).
    (b) Definitions--(1) Sewage facility defined. A sewage facility is 
property--
    (i) Except as provided in paragraphs (b)(2) and (d) of this section, 
used for the secondary treatment of wastewater; however, for property 
treating wastewater reasonably expected to have an average daily raw 
wasteload concentration of biochemical oxygen demand (BOD) that exceeds 
350 milligrams per liter as oxygen (measured at the time the influent 
enters the facility) (the BOD limit), this paragraph (b)(1)(i) applies 
only to the extent the treatment is for wastewater having an average 
daily raw wasteload concentration of BOD that does not exceed the BOD 
limit;
    (ii) Used for the preliminary and/or primary treatment of wastewater 
but only to the extent used in connection with secondary treatment 
(without regard to the BOD limit described in paragraph (b)(1)(i) of 
this section);
    (iii) Used for the advanced or tertiary treatment of wastewater but 
only to the extent used in connection with and after secondary 
treatment;
    (iv) Used for the collection, storage, use, processing, or final 
disposal of--
    (A) Wastewater, which property is necessary for such preliminary, 
primary, secondary, advanced, or tertiary treatment; or
    (B) Sewage sludge removed during such preliminary, primary, 
secondary, advanced, or tertiary treatment (without regard to the BOD 
limit described in paragraph (b)(1)(i) of this section);
    (v) Used for the treatment, collection, storage, use, processing, or 
final disposal of septage (without regard to the BOD limit described in 
paragraph (b)(1)(i) of this section); and
    (vi) Functionally related and subordinate to property described in 
this paragraph (b)(1), such as sewage disinfection property.
    (2) Special rules and exceptions--(i) Exception to BOD limit. A 
facility treating wastewater with an average daily raw wasteload 
concentration of BOD exceeding the BOD limit will not fail to qualify as 
a sewage facility described in paragraph (b)(1) of this section to the 
extent that the failure to satisfy the BOD limit results from the 
implementation of a federal, state, or local water conservation program 
(for example, a program designed to promote water use efficiency that 
results in BOD concentrations beyond the BOD limit).
    (ii) Anti-abuse rule for BOD limit. A facility does not satisfy the 
BOD limit if there is any intentional manipulation of the BOD level to 
circumvent the BOD limit (for example, increasing the volume of water in 
the wastewater before the influent enters the facility with the 
intention of reducing the BOD level).
    (iii) Authority of Commissioner. In appropriate cases upon 
application to the Commissioner, the Commissioner may determine that 
facilities employing technologically advanced or innovative treatment 
processes qualify as sewage facilities if it is demonstrated that these 
facilities perform functions that are consistent with the definition of 
sewage facilities described in paragraph (b)(1) of this section.
    (3) Other applicable definitions--(i) Advanced or tertiary treatment 
means the treatment of wastewater after secondary treatment. Advanced or 
tertiary treatment ranges from biological treatment extensions to 
physical-chemical separation techniques such as denitrification, ammonia 
stripping, carbon adsorption, and chemical precipitation.

[[Page 67]]

    (ii) Nonconventional pollutants are any pollutants that are not 
listed in 40 CFR 401.15, 401.16, or appendix A to part 423.
    (iii) Preliminary treatment means treatment that removes large 
extraneous matter from incoming wastewater and renders the incoming 
wastewater more amenable to subsequent treatment and handling.
    (iv) Pretreatment means a process that preconditions wastewater to 
neutralize or remove toxic, priority, or nonconventional pollutants that 
could adversely affect sewers or inhibit a preliminary, primary, 
secondary, advanced, or tertiary treatment operation.
    (v) Primary treatment means treatment that removes material that 
floats or will settle, usually by screens or settling tanks.
    (vi) Priority pollutants are those pollutants listed in appendix A 
to 40 CFR part 423.
    (vii) Secondary treatment means the stage in sewage treatment in 
which a bacterial process (or an equivalent process) consumes the 
organic parts of wastes, usually by trickling filters or an activated 
sludge process.
    (viii) Sewage sludge is defined in 40 CFR 122.2 and includes 
septage.
    (ix) Toxic pollutants are those pollutants listed in 40 CFR 401.15.
    (c) Other property not included in the definition of a sewage 
facility. Property other than property described in paragraph (b)(1) of 
this section is not a sewage facility. Thus, for example, property is 
not a sewage facility, or functionally related and subordinate property, 
if the property is used for pretreatment of wastewater (whether or not 
this treatment is necessary to perform preliminary, primary, secondary, 
advanced, or tertiary treatment), or the related collection, storage, 
use, processing, or final disposal of the wastewater. In addition, 
property used to treat, process, or use wastewater subsequent to the 
time the wastewater can be discharged into navigable waters, as defined 
in 33 U.S.C. 1362, is not a sewage facility.
    (d) Allocation of costs. In the case of property that has both a use 
described in paragraph (b)(1) of this section (a sewage treatment 
function) and a use other than sewage treatment, only the portion of the 
cost of the property allocable to the sewage treatment function is taken 
into account as an expenditure to provide sewage facilities. The portion 
of the cost of property allocable to the sewage treatment function is 
determined by allocating the cost of that property between the 
property's sewage treatment function and any other uses by any method 
which, based on all the facts and circumstances, reasonably reflects a 
separation of costs for each use of the property.
    (e) Effective date--(1) In general. This section applies to issues 
of bonds issued after February 21, 1995.
    (2) Refundings. In the case of a refunding bond issued to refund a 
bond to which this section does not apply, the issuer need not apply 
this section to that refunding bond. This paragraph (e)(2) applies only 
if the weighted average maturity of the refunding bonds, as described in 
section 147(b), is not greater than the remaining weighted average 
maturity of the refunded bonds.

[T.D. 8576, 59 FR 66163, Dec. 23, 1994, as amended by T.D. 9546, Aug. 
19, 2011]



Sec. 1.142(a)(6)-1  Exempt facility bonds: solid waste disposal
facilities.

    (a) In general. This section defines the term solid waste disposal 
facility for purposes of section 142(a)(6).
    (b) Solid waste disposal facility. The term solid waste disposal 
facility means a facility to the extent that the facility--
    (1) Processes solid waste (as defined in paragraph (c) of this 
section) in a qualified solid waste disposal process (as defined in 
paragraph (d) of this section);
    (2) Performs a preliminary function (as defined in paragraph (f) of 
this section); or
    (3) Is functionally related and subordinate (within the meaning of 
Sec. 1.103-8(a)(3)) to a facility described in paragraph (b)(1) or 
(b)(2) of this section.
    (c) Solid waste--(1) In general. Except to the extent excluded under 
paragraph (c)(2) of this section, for purposes of section 142(a)(6), the 
term solid waste means garbage, refuse, and other solid

[[Page 68]]

material derived from any agricultural, commercial, consumer, 
governmental, or industrial operation or activity if the material meets 
the requirements of both paragraph (c)(1)(i) and paragraph (c)(1)(ii) of 
this section. For purposes of this section, material is solid if it is 
solid at ambient temperature and pressure.
    (i) Used material or residual material. Material meets the 
requirements of this paragraph (c)(1)(i) if it is either used material 
(as defined in paragraph (c)(1)(i)(A)) of this section or residual 
material (as defined in paragraph (c)(1)(i)(B) of this section).
    (A) Used material. The term used material means any material that is 
a product of any agricultural, commercial, consumer, governmental, or 
industrial operation or activity, or a component of any such product or 
activity, and that has been used previously. Used material also includes 
animal waste produced by animals from a biological process.
    (B) Residual material. The term residual material means material 
that meets the requirements of this paragraph (c)(1)(i)(B). The material 
must be a residual byproduct or excess raw material that results from or 
remains after the completion of any agricultural, commercial, consumer, 
governmental, or industrial production process or activity or from the 
provision of any service. In the case of multiple processes constituting 
an integrated manufacturing or industrial process, the material must 
result from or remain after the completion of such integrated process. 
As of the issue date of the bonds used to finance the solid waste 
disposal facility, the material must be reasonably expected to have a 
fair market value that is lower than the value of all of the products 
made in that production process or lower than the value of the service 
that produces such residual material.
    (ii) Reasonably expected introduction into a qualified solid waste 
disposal process. Material meets the requirements of this paragraph 
(c)(1)(ii) if it is reasonably expected by the person who generates, 
purchases, or otherwise acquires it to be introduced within a reasonable 
time after such generation, purchase or acquisition into a qualified 
solid waste disposal process described in paragraph (d) of this section.
    (2) Exclusions from solid waste. The following materials do not 
constitute solid waste:
    (i) Virgin material. Except to the extent that virgin material 
constitutes an input to a final disposal process or residual material, 
solid waste excludes any virgin material. The term virgin material means 
material that has not been processed into an agricultural, commercial, 
consumer, governmental, or industrial product, or a component of any 
such product. Further, for this purpose, material continues to be virgin 
material after it has been grown, harvested, mined, or otherwise 
extracted from its naturally occurring location and cleaned, divided 
into component elements, modified, or enhanced, as long as further 
processing is required before it becomes an agricultural, commercial, 
consumer, or industrial product, or a component of any such product.
    (ii) Solids within liquids and liquid waste. Solid waste excludes 
any solid or dissolved material in domestic sewage or other significant 
pollutant in water resources, such as silt, dissolved or suspended 
solids in industrial waste water effluents, dissolved materials in 
irrigation return flows or other common water pollutants, and liquid or 
gaseous waste.
    (iii) Precious metals. Except to the extent that a precious metal 
constitutes an input to a final disposal process and/or an unrecoverable 
trace of the particular precious metal, solid waste excludes gold, 
silver, ruthenium, rhodium, palladium, osmium, iridium, platinum, 
gallium, rhenium, and any other precious metal material as may be 
identified by the Internal Revenue Service in future public 
administrative guidance.
    (iv) Hazardous material. Solid waste excludes any hazardous material 
that must be disposed of at a facility that is subject to final permit 
requirements under subtitle C of title II of the Solid Waste Disposal 
Act as in effect on the date of the enactment of the Tax Reform Act of 
1986 (which is October 22, 1986). See section 142(h)(1) of the Internal 
Revenue Code for the definition of qualified hazardous waste facilities.

[[Page 69]]

    (v) Radioactive material. Solid waste excludes any radioactive 
material subject to regulation under the Nuclear Regulatory Act (10 CFR 
1.1 et seq.), as in effect on the issue date of the bonds.
    (d) Qualified solid waste disposal process. The term qualified solid 
waste disposal process means the processing of solid waste in a final 
disposal process (as defined in paragraph (d)(1) of this section), an 
energy conversion process (as defined in paragraph (d)(2) of this 
section), or a recycling process (as defined in paragraph (d)(3) of this 
section). Absent an express restriction to the contrary in this section, 
a qualified solid waste disposal process may employ any biological, 
engineering, industrial, or technological method.
    (1) Final disposal process. The term final disposal process means 
the placement of solid waste in a landfill (including, for this purpose, 
the spreading of solid waste over land in an environmentally compliant 
and safe manner with no intent to remove such solid waste), the 
incineration of solid waste without capturing any useful energy, or the 
containment of solid waste with a reasonable expectation as of the date 
of issue of the bonds that the containment will continue indefinitely 
and that the solid waste has no current or future beneficial use.
    (2) Energy conversion process. The term energy conversion process 
means a thermal, chemical, or other process that is applied to solid 
waste to create and capture synthesis gas, heat, hot water, steam, or 
other useful energy. The energy conversion process begins at the point 
of the first application of such process. The energy conversion process 
ends at the point at which the useful energy is first created, captured, 
or incorporated into the form of synthesis gas, heat, hot water, or 
other useful energy and before any transfer or distribution of such 
synthesis gas, heat, hot water or other useful energy, regardless of 
whether such synthesis gas, heat, hot water, or other useful energy 
constitutes a first useful product within the meaning of paragraph (e) 
of this section.
    (3) Recycling process--(i) In general. The term recycling process 
means reconstituting, transforming, or otherwise processing solid waste 
into a useful product. The recycling process begins at the point of the 
first application of a process to reconstitute or transform the solid 
waste into a useful product, such as decontamination, melting, re-
pulping, shredding, or other processing of the solid waste to accomplish 
this purpose. The recycling process ends at the point of completion of 
production of the first useful product from the solid waste.
    (ii) Refurbishment, repair, or similar activities. The term 
recycling process does not include refurbishment, repair, or similar 
activities. The term refurbishment means the breakdown and reassembly of 
a product if such activity is done on a product-by-product basis and if 
the finished product contains more than 30 percent of its original 
materials or components.
    (e) First useful product. The term first useful product means the 
first product produced from the processing of solid waste in a solid 
waste disposal process that is useful for consumption in agricultural, 
consumer, commercial, governmental, or industrial operation or activity 
and that could be sold for such use, whether or not actually sold. A 
useful product includes both a product useful to an individual consumer 
as an ultimate end-use consumer product and a product useful to an 
industrial user as a material or input for processing in some stage of a 
manufacturing or production process to produce a different end-use 
consumer product. The determination of whether a useful product has been 
produced may take into account operational constraints that affect the 
point in production when a useful product reasonably can be extracted or 
isolated and sold independently. For this purpose, the costs of 
extracting, isolating, storing, and transporting the product to a market 
may only be taken into account as operational constraints if the product 
is not to be used as part of an integrated manufacturing or industrial 
process in the same location as that in which the product is produced.
    (f) Preliminary function. A preliminary function is a function to 
collect, separate, sort, store, treat, process, disassemble, or handle 
solid waste that is preliminary to and directly related to a qualified 
solid waste disposal process.

[[Page 70]]

    (g) Mixed-use facilities--(1) In general. If a facility is used for 
both a qualified solid waste disposal function (including a qualified 
solid waste disposal process or a preliminary function) and a 
nonqualified function (a mixed-use facility), then the costs of the 
facility allocable to the qualified solid waste disposal function are 
determined using any reasonable method, based on all the facts and 
circumstances. See Sec. 1.103-8(a)(1) for allocation rules on amounts 
properly allocable to an exempt facility. Facilities qualify as 
functionally related and subordinate to a qualified solid waste disposal 
function only to the extent that they are functionally related and 
subordinate to the portion of the mixed-use facility that is used for 
one or more qualified solid waste disposal functions (including a 
qualified solid waste disposal process or a preliminary function).
    (2) Mixed inputs--(i) In general. Except as otherwise provided in 
paragraph (g)(2)(ii) of this section, for each facility (or a portion of 
a mixed-use facility) performing a qualified solid waste disposal 
process or a preliminary function, the percentage of the costs of the 
property used for such process that are allocable to a qualified solid 
waste disposal process or a preliminary function cannot exceed the 
average annual percentage of solid waste processed in that qualified 
solid waste disposal process or that preliminary function while the 
issue is outstanding. The annual percentage of solid waste processed in 
that qualified solid waste disposal process or preliminary function for 
any year is the percentage, by weight or volume, of the total materials 
processed in that qualified solid waste disposal process or preliminary 
function that constitute solid waste for that year.
    (ii) Special rule for mixed-input processes if at least 65 percent 
of the materials processed are solid waste--(A) In general. Except as 
otherwise provided in paragraph (g)(2)(ii)(B) of this section, for each 
facility (or a portion of a mixed-use facility) performing a qualified 
solid waste disposal process or preliminary function, if the annual 
percentage of solid waste processed in that qualified solid waste 
disposal process or preliminary function for each year that the issue is 
outstanding (beginning with the date such facility is placed in service 
within the meaning of Sec. 1.150-2(c)) equals at least 65 percent of the 
materials processed in that qualified solid waste disposal process or 
preliminary function, then all of the costs of the property used for 
such process are treated as allocable to a qualified solid waste 
disposal process. The annual percentage of solid waste processed in such 
qualified solid waste disposal process or preliminary function for any 
year is the percentage, by weight or volume, of the total materials 
processed in that qualified solid waste disposal process or preliminary 
function that constitute solid waste for that year.
    (B) Special rule for extraordinary events. In the case of an 
extraordinary event that is beyond the control of the operator of a 
solid waste disposal facility (such as a natural disaster, strike, major 
utility disruption, or governmental intervention) and that causes a 
solid waste disposal facility to be unable to meet the 65 percent test 
under paragraph (g)(2)(ii)(A) of this section for a particular year, the 
percentage of solid waste processed for that year equals--
    (1) The sum of the amount of solid waste processed in the solid 
waste disposal facility for the year affected by the extraordinary event 
and the amount of solid waste processed in the solid waste disposal 
facility during the following two years in excess of the amount required 
to meet the general 65 percent threshold for the facility during each of 
such two years; divided by
    (2) The total materials processed in the solid waste disposal 
facility during the year affected by the extraordinary event. If the 
resulting measure of solid waste processed for the year affected by the 
extraordinary event equals at least 65 percent, then the facility is 
treated as meeting the requirements of the 65 percent test under 
paragraph (g)(2)(ii)(A) of this section for such year.
    (iii) Facilities functionally related and subordinate to mixed-input 
facilities. Except to the extent that facilities are functionally 
related and subordinate to a mixed-input facility that meets the 65 
percent test under paragraph

[[Page 71]]

(g)(2)(ii) of this section, facilities qualify as functionally related 
and subordinate to a mixed-input facility only to the extent that they 
are functionally related and subordinate to the qualified portion of the 
mixed-input facility that is used for one or more qualified solid waste 
disposal functions (including a qualified solid waste disposal process 
or a preliminary function).
    (h) Examples. The following examples illustrate the application of 
this section:

    Example 1. Nonqualified Unused Material--Cloth. Company A takes wool 
and weaves it into cloth and then sells the cloth to a manufacturer to 
manufacture clothing. The cloth is material that has not been used 
previously as a product of or otherwise used in an agricultural, 
commercial, consumer, governmental, or industrial operation or activity, 
or as a component of any such product or activity. Accordingly, the 
cloth is not solid waste.
    Example 2. Residual Material--Waste Coal. Company B mines coal. Some 
of the ore mined is a low quality byproduct of coal mining commonly 
known as waste coal, which cannot be converted to energy under a normal 
energy-production process because the BTU content is too low. Waste coal 
has the lowest fair market value of any product produced in Company B's 
coal mining process. Waste coal is solid waste because it is residual 
material within the meaning of paragraph (c)(1)(i)(B) of this section 
and Company B reasonably expects to introduce the waste coal into a 
solid waste disposal process.
    Example 3. Virgin Material--Logs. Company C cuts down trees and 
sells the logs to another company, which further processes the logs into 
lumber. In order to facilitate shipping, Company C cuts the trees into 
uniform logs. The trees are not solid waste because they are virgin 
material within the meaning of paragraph (c)(2)(i) of this section that 
are not being introduced into a final disposal process within the 
meaning of paragraph (d)(1) of this section. The division of such trees 
into uniform logs does not change the status of the trees as virgin 
material.
    Example 4. Qualified Solid Waste Disposal Process--Landfill. Company 
D plans to construct a landfill. The landfill will not be subject to the 
final permit requirements under subtitle C of title II of the Solid 
Waste Disposal Act (as in effect on the date of enactment of the Tax 
Reform Act of 1986). As of the issue date, Company D expects that the 
landfill will be filled entirely with material that will qualify as 
solid waste within the meaning of paragraph (c) of this section. Placing 
solid waste into a landfill is a qualified solid waste disposal process. 
The landfill is a qualified solid waste disposal facility.
    Example 5. Qualified Solid Waste Disposal Process--Recycling Tires. 
Company E owns a facility that converts used tires into roadbed 
material. The used tires are used material within the meaning of 
paragraph (c)(1)(i)(A) of this section that qualifies as solid waste. 
Between the introduction of the old tires into the roadbed manufacturing 
process and the completion of the roadbed material, the facility does 
not create any interim useful products. The process for the 
manufacturing of the roadbed material from the old tires is a qualified 
solid waste disposal process as a recycling process and the facility 
that converts the tires into roadbed material is a qualified solid waste 
disposal facility. This conclusion would be the same if the recycling 
process took place at more than one plant.
    Example 6. Qualified Solid Waste Disposal Process--Energy Conversion 
Process. Company F receives solid waste from a municipal garbage 
collector. Company F burns that solid waste in an incinerator to remove 
exhaust gas and to produce heat. Company F further processes the heat in 
a heat exchanger to produce steam. Company F further processes the steam 
to generate electricity. The energy conversion process ends with the 
production of steam. The facilities used to burn the solid waste and to 
capture the steam as useful energy are qualified solid waste disposal 
facilities because they process solid waste in an energy conversion 
process. The generating facilities used to process the steam further to 
generate electricity are not engaged in the energy conversion process 
and are not qualified solid waste disposal facilities.
    Example 7. Nonqualified Refurbishment. Company G purchases used cars 
and restores them. This restoration process includes disassembly, 
cleaning, and repairing of the cars. Parts that cannot be repaired are 
replaced. The restored cars contain at least 30 percent of the original 
parts. While the cars are used material, the refurbishing process is not 
a qualified solid waste disposal process. Accordingly, Company G's 
facility is not a qualified solid waste disposal facility.
    Example 8. Qualified Solid Waste Disposal Facility--First Useful 
Product Rule--Paper Recycling. (i) Company H employs an integrated 
process to re-pulp discarded magazines, clean the pulp, and produce 
retail paper towel products. Operational constraints on Company H's 
process do not allow for reasonable extraction, isolation, and sale of 
the cleaned paper pulp independently without degradation of the pulp. 
Company H further processes the paper pulp into large industrial-sized 
rolls of paper which are approximately 12 feet in diameter. At this 
point in the process, Company H could either sell such industrial-sized 
rolls of paper to another company

[[Page 72]]

for further processing to produce retail paper products or it could 
produce those retail products itself. In general, paper pulp is a useful 
product that is bought and sold on the market as a material for input 
into manufacturing or production processes. The discarded magazines are 
used material within the meaning of paragraph (c)(1)(i)(A) of this 
section. Company H's facility is engaged in a recycling process within 
the meaning of paragraph (d)(3) of this section to the extent that it 
repulps and cleans the discarded magazines generally and further to the 
extent that it produces industrial-sized rolls of paper under the 
particular circumstances here. Specifically, taking into account the 
operational constraints on Company H's facility that limit its ability 
reasonably to extract, isolate, and sell the paper pulp independently, 
the first useful products within the meaning of paragraph (e) of this 
section from Company H's recycling process are the industrial-sized 
rolls of paper. The portion of Company H's facility that processes the 
discarded magazines and produces industrial-sized rolls of paper is a 
qualified solid waste disposal facility, and the portion of Company H's 
facility that further processes the industrial-sized rolls of paper into 
retail paper towels is not a qualified solid waste facility.
    (ii) The facts are the same as in paragraph (i) of this Example 8, 
except that Company H is able reasonably to extract the cleaned paper 
pulp from the process without degradation of the pulp and to sell the 
cleaned paper pulp at its dock for a price that exceeds its costs of 
extracting the pulp from the process. Therefore, the paper pulp is the 
first useful product within the meaning of paragraph (e) of this 
section. As a result, the portion of Company H's facility that processes 
the discarded magazines is a qualified solid waste disposal facility, 
and the portion of Company H's facility that produces industrial-sized 
rolls of paper is not a qualified solid waste disposal facility. If, 
however, the only reasonable way Company H could sell the pulp was to 
transport the pulp to a distant market, then the costs of storing and 
transporting the pulp to the market may be taken into account in 
determining whether the pulp is the first useful product.
    Example 9. Preliminary Function--Energy Conversion Process. (i) 
Company I owns a paper mill. At the mill, logs from nearby timber 
operations are processed through a machine that removes bark. The 
stripped logs are used to manufacture paper. The stripped bark has the 
lowest fair market value of any product produced from the paper mill. 
The stripped bark falls onto a conveyor belt that transports the bark to 
a storage bin that is used to store the bark briefly until Company I 
feeds the bark into a boiler. The conveyor belt and storage bin are used 
only for these purposes. The boiler is used only to create steam by 
burning the bark, and the steam is used to generate electricity. The 
stripped bark is solid waste because it is residual material within the 
meaning of paragraph (c)(1)(i)(B) of this section and Company I expects 
to introduce the bark into an energy conversion process within a 
reasonable period of time. The creation of steam from the stripped bark 
is an energy conversion process that starts with the incineration of the 
stripped bark. The energy conversion process is a qualified solid waste 
disposal process. The conveyor belt performs a collection activity that 
is preliminary and that is directly related to the solid waste disposal 
function. The storage bin performs a storage function that is 
preliminary and that is directly related to the solid waste disposal 
function. Thus, the conveyor belt and storage bin are solid waste 
disposal facilities. The bark removal process is not a preliminary 
function because it is not directly related to the energy conversion 
process and it does not become so related merely because it results in 
material that is solid waste.
    (ii) The facts are the same as in paragraph (i) of this Example 9, 
except that the stripped bark represents only 55 percent by weight and 
volume of the materials that are transported by the conveyor belt. The 
remaining 45 percent of the materials transported by the conveyor belt 
are not solid waste and these other materials are sorted from the 
conveyor belt by a sorting machine immediately before the stripped bark 
arrives at the storage bin. Fifty-five percent of the costs of the 
conveyor belt and the sorting machine are allocable to solid waste 
disposal functions.
    Example 10. Preliminary Function--Final Disposal Process. Company J 
owns a waste transfer station and uses it to collect, sort, and process 
solid waste. Company J uses its trucks to haul the solid waste to the 
nearest landfill. At least 65 percent by weight and volume of the 
material brought to the transfer station is solid waste. The waste 
transfer station and the trucks perform functions that are preliminary 
and directly related to the solid waste disposal function of the 
landfill. Thus, the waste transfer station and the trucks qualify as 
solid waste disposal facilities.
    Example 11. Mixed-Input Facility. Company K owns an incinerator 
financed by an issue and uses the incinerator exclusively to burn coal 
and other solid material to create steam. Each year while the issue is 
outstanding, 40 percent by volume and 45 percent by weight of the solid 
material that Company K processes in the conversion process is coal. The 
remainder of the solid material is either used material or residual 
material within the meaning of paragraph (c)(1)(i) of this section. 
Sixty percent of the costs of

[[Page 73]]

the property used to perform the energy conversion process are allocable 
to a solid waste disposal function.

    (i) Effective/Applicability Dates--(1) In general. Except as 
otherwise provided in this paragraph (i), this section applies to bonds 
to which section 142 applies that are sold on or after October 18, 2011.
    (2) Elective retroactive application. Issuers may apply this 
section, in whole, but not in part, to outstanding bonds to which 
section 142 applies and which were sold before October 18, 2011.
    (3) Certain refunding bonds. An issuer need not apply this section 
to bonds that are issued in a current refunding to refund bonds to which 
this section does not apply if the weighted average maturity of the 
refunding bonds is no longer than the remaining weighted average 
maturity of the refunded bonds.

[T.D. 9546, 76 FR 51881, Aug. 19, 2011; 76 FR 55255, Sept. 7, 2011]



Sec. 1.142(f)(4)-1  Manner of making election to terminate tax-exempt
bond financing.

    (a) Overview. Section 142(f)(4) permits a person engaged in the 
local furnishing of electric energy or gas (a local furnisher) that uses 
facilities financed with exempt facility bonds under section 142(a)(8) 
and that expands its service area in a manner inconsistent with the 
requirements of sections 142(a)(8) and (f) to make an election to ensure 
that those bonds will continue to be treated as exempt facility bonds. 
The election must meet the requirements of paragraphs (b) and (c) of 
this section.
    (b) Time for making election--(1) In general. An election under 
section 142(f)(4)(B) must be filed with the Internal Revenue Service on 
or before 90 days after the date of the service area expansion that 
causes bonds to cease to meet the requirements of sections 142(a)(8) and 
(f).
    (2) Date of service area expansion. For the purposes of this 
section, the date of the service area expansion is the first date on 
which the local furnisher is authorized to collect revenue for the 
provision of service in the expanded area.
    (c) Manner of making election. An election under section 
142(f)(4)(B) must be captioned ``ELECTION TO TERMINATE TAX-EXEMPT BOND 
FINANCING'', must be signed under penalties of perjury by a person who 
has authority to sign on behalf of the local furnisher, and must contain 
the following information--
    (1) The name of the local furnisher;
    (2) The tax identification number of the local furnisher;
    (3) The complete address of the local furnisher;
    (4) The date of the service area expansion;
    (5) Identification of each bond issue subject to the election, 
including the complete name of each issue, the tax identification number 
of each issuer, the report number of the information return filed under 
section 149(e) for each issue, the issue date of each issue, the CUSIP 
number (if any) of the bond with the latest maturity of each issue, the 
issue price of each issue, the adjusted issue price of each issue as of 
the date of the election, the earliest date on which the bonds of each 
issue may be redeemed, and the principal amount of bonds of each issue 
to be redeemed on the earliest redemption date;
    (6) A statement that the local furnisher making the election agrees 
to the conditions stated in section 142(f)(4)(B); and
    (7) A statement that each issuer of the bonds subject to the 
election has received written notice of the election.
    (d) Effect on section 150(b). Except as provided in paragraph (e) of 
this section, if a local furnisher files an election within the period 
specified in paragraph (b) of this section, section 150(b) does not 
apply to bonds identified in the election during and after that period.
    (e) Effect of failure to meet agreements. If a local furnisher fails 
to meet any of the conditions stated in an election pursuant to 
paragraph (c)(6) of this section, the election is invalid.
    (f) Corresponding provisions of the Internal Revenue Code of 1954. 
Section 103(b)(4)(E) of the Internal Revenue Code of 1954 set forth 
corresponding requirements for the exclusion from gross income of the 
interest on bonds issued for facilities for the local furnishing of 
electric energy or gas. For

[[Page 74]]

the purposes of this section any reference to sections 142(a)(8) and (f) 
of the Internal Revenue Code of 1986 includes a reference to the 
corresponding portion of section 103(b)(4)(E) of the Internal Revenue 
Code of 1954.
    (g) Effective dates. This section applies to elections made on or 
after January 19, 2001.

[T.D. 8941, 66 FR 4671, Jan. 18, 2001]



Sec. 1.143(g)-1  Requirements related to arbitrage.

    (a) In general. Under section 143, for an issue to be an issue of 
qualified mortgage bonds or qualified veterans' mortgage bonds 
(together, mortgage revenue bonds), the requirements of section 143(g) 
must be satisfied. An issue satisfies the requirements of section 143(g) 
only if such issue meets the requirements of paragraph (b) of this 
section and, in the case of an issue 95 percent or more of the net 
proceeds of which are to be used to provide residences for veterans, 
such issue also meets the requirements of paragraph (c) of this section. 
The requirements of section 143(g) and this section are applicable in 
addition to the requirements of section 148 and Secs. 1.148-0 through 
1.148-11.
    (b) Effective rate of mortgage interest not to exceed bond yield by 
more than 1.125 percentage points--(1) Maximum yield. An issue shall be 
treated as meeting the requirements of this paragraph (b) only if the 
excess of the effective rate of interest on the mortgages financed by 
the issue, over the yield on the issue, is not greater over the term of 
the issue than 1.125 percentage points.
    (2) Effective rate of interest. (i) In determining the effective 
rate of interest on any mortgage for purposes of this paragraph (b), 
there shall be taken into account all fees, charges, and other amounts 
borne by the mortgagor that are attributable to the mortgage or to the 
bond issue. Such amounts include points, commitment fees, origination 
fees, servicing fees, and prepayment penalties paid by the mortgagor.
    (ii) Items that shall be treated as borne by the mortgagor and shall 
be taken into account in calculating the effective rate of interest also 
include--
    (A) All points, commitment fees, origination fees, or similar 
charges borne by the seller of the property; and
    (B) The excess of any amounts received from any person other than 
the mortgagor by any person in connection with the acquisition of the 
mortgagor's interest in the property over the usual and reasonable 
acquisition costs of a person acquiring like property when owner-
financing is not provided through the use of mortgage revenue bonds.
    (iii) The following items shall not be treated as borne by the 
mortgagor and shall not be taken into account in calculating the 
effective rate of interest--
    (A) Any expected rebate of arbitrage profit under paragraph (c) of 
this section; and
    (B) Any application fee, survey fee, credit report fee, insurance 
charge or similar settlement or financing cost to the extent such amount 
does not exceed amounts charged in the area in cases when owner-
financing is not provided through the use of mortgage revenue bonds. For 
example, amounts paid for Federal Housing Administration, Veterans' 
Administration, or similar private mortgage insurance on an individual's 
mortgage, or amounts paid for pool mortgage insurance on a pool of 
mortgages, are not taken into account so long as such amounts do not 
exceed the amounts charged in the area with respect to a similar 
mortgage, or pool of mortgages, that is not financed with mortgage 
revenue bonds. For this purpose, amounts paid for pool mortgage 
insurance include amounts paid to an entity (for example, the Government 
National Mortgage Association, the Federal National Mortgage Association 
(FNMA), the Federal Home Loan Mortgage Corporation, or other mortgage 
insurer) to directly guarantee the pool of mortgages financed with the 
bonds, or to guarantee a pass-through security backed by the pool of 
mortgages financed with the bonds.
    (C) The following example illustrates the provisions of this 
paragraph (b)(2)(iii):

    Example. Housing Authority X issues bonds intended to be qualified 
mortgage bonds under section 143(a). At the time the bonds are issued, X 
enters into an agreement with a group of mortgage lending institutions

[[Page 75]]

(lenders) under which the lenders agree to originate and service 
mortgages that meet certain specified requirements. After originating a 
specified amount of mortgages, each lender issues a ``pass-though 
security'' (each, a PTS) backed by the mortgages and sells the PTS to X. 
Under the terms of the PTS, the lender pays X an amount equal to the 
regular monthly payments on the mortgages (less certain fees), whether 
or not received by the lender (plus any prepayments and liquidation 
proceeds in the event of a foreclosure or other disposition of any 
mortgages). FNMA guarantees the timely payment of principal and interest 
on each PTS. From the payments received from each mortgagor, the lender 
pays a fee to FNMA for its guarantee of the PTS. The amounts paid to 
FNMA do not exceed the amounts charged in the area with respect to a 
similar pool of mortgages that is not financed with mortgage revenue 
bonds. Under this paragraph (b)(2)(iii), the fees for the guarantee 
provided by FNMA are an insurance charge because the guarantee is pool 
mortgage insurance. Because the amounts charged for the guarantee do not 
exceed the amounts charged in the area with respect to a similar pool of 
mortgages that is not financed with mortgage revenue bonds, the amounts 
charged for the guarantee are not taken into account in computing the 
effective rate of interest on the mortgages financed with X's bonds.

    (3) Additional rules. To the extent not inconsistent with the Tax 
Reform Act of 1986, Public Law 99-514 (the 1986 Act), or subsequent law, 
Sec. 6a.103A-2(i)(2) (other than paragraphs (i)(2)(i) and (i)(2)(ii)(A) 
through (C)) of this chapter applies to provide additional rules 
relating to compliance with the requirement that the effective rate of 
mortgage interest not exceed the bond yield by more than 1.125 
percentage points.
    (c) Arbitrage and investment gains to be used to reduce costs of 
owner-financing. As provided in section 143(g)(3), certain earnings on 
nonpurpose investments must either be paid or credited to mortgagors, or 
paid to the United States, in certain circumstances. To the extent not 
inconsistent with the 1986 Act or subsequent law, Sec. 6a.103A-2(i)(4) 
of this chapter applies to provide guidance relating to compliance with 
this requirement.
    (d) Effective dates--(1) In general. Except as otherwise provided in 
this section, Sec. 1.143(g)-1 applies to bonds sold on or after May 23, 
2005, that are subject to section 143.
    (2) Permissive retroactive application in whole. Except as provided 
in paragraph (d)(4) of this section, issuers may apply Sec. 1.143(g)-1, 
in whole, but not in part, to bonds sold before May 23, 2005, that are 
subject to section 143.
    (3) Bonds subject to the Internal Revenue Code of 1954. Except as 
provided in paragraph (d)(4) of this section and subject to the 
applicable effective dates for the corresponding statutory provisions, 
an issuer may apply Sec. 1.143(g)-1, in whole, but not in part, to bonds 
that are subject to section 103A(i) of the Internal Revenue Code of 
1954.
    (4) Special rule for pre-July 1, 1993 bonds. To the extent that an 
issuer applies this section to bonds issued before July 1, 1993, 
Sec. 6a.103A-2(i)(3) of this chapter also applies to the bonds.

[T.D. 9204, 70 FR 29449, May 23, 2005]



Sec. 1.144-0  Table of contents.

    This section lists the captioned paragraphs contained in 
Secs. 1.144-1 and 1.144-2.

Sec. 1.144-1  Qualified small issue bonds, qualified student loan bonds, 
                   and qualified redevelopment bonds.

    (a) Overview.
    (b) Scope.
    (c) Effective dates.

                     Sec. 1.144-2  Remedial actions.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997]



Sec. 1.144-1  Qualified small issue bonds, qualified student loan 
bonds, and qualified redevelopment bonds.

    (a) Overview. Interest on a private activity bond is not excludable 
from gross income under section 103(a) unless the bond is a qualified 
bond. Under section 141(e)(1)(D), a qualified small issue bond issued 
under section 144(a) may be a qualified bond. Under section 144(a), any 
qualified small issue bond is any bond issued as a part of an issue 95 
percent or more of the proceeds of which are to be used to provide 
certain manufacturing facilities or certain depreciable farm property 
and which meets other requirements. Under section 141(e)(1)(F) a 
qualified redevelopment bond issued under section 144(c) is a qualified 
bond. Under section 144(c), a qualified redevelopment bond is any bond 
issued as a part of an issue

[[Page 76]]

95 percent or more of the net proceeds of which are to be used for one 
or more redevelopment purposes and which meets certain other 
requirements.
    (b) Scope. Sections 1.144-0 through 1.144-2 apply for purposes of 
the rules for small issue bonds under section 144(a) and qualified 
redevelopment bonds under section 144(c), except that Sec. 1.144-2 does 
not apply to the requirements for qualified small issue bonds under 
section 144(a)(4) (relating to the limitation on capital expenditures) 
or under section 144(a)(10) (relating to the aggregate limit of tax-
exempt bonds per taxpayer).
    (c) Effective dates. For effective dates of Secs. 1.144-0 through 
1.144-2, see Sec. 1.141-16.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997]



Sec. 1.144-2  Remedial actions.

    The remedial action rules of Sec. 1.142-2 apply to qualified small 
issue bonds issued under section 144(a) and to qualified redevelopment 
bonds issued under section 144(c), for this purpose treating those bonds 
as exempt facility bonds and the qualifying purposes for those bonds as 
exempt facilities.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997]



Sec. 1.145-0  Table of contents.

    This section lists the captioned paragraphs contained in 
Secs. 1.145-1 and 1.145-2.

                Sec. 1.145-1  Qualified 501(c)(3) bonds.

    (a) Overview.
    (b) Scope.
    (c) Effective dates.

     Sec. 1.145-2  Application of private activity bond regulations.

    (a) In general.
    (b) Modification of private business tests.
    (c) Exceptions.
    (1) Certain provisions relating to governmental programs.
    (2) Costs of issuance.
    (d) Issuance costs financed by prior issue.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997, as amended by T.D. 9234, 70 FR 
75035, Dec. 19, 2005]



Sec. 1.145-1  Qualified 501(c)(3) bonds.

    (a) Overview. Interest on a private activity bond is not excludable 
from gross income under section 103(a) unless the bond is a qualified 
bond. Under section 141(e)(1)(G), a qualified 501(c)(3) bond issued 
under section 145 is a qualified bond. Under section 145, a qualified 
501(c)(3) bond is any bond issued as a part of an issue that satisfies 
the requirements of sections 145(a) through (d).
    (b) Scope. Sections 1.145-0 through 1.145-2 apply for purposes of 
section 145(a).
    (c) Effective dates. For effective dates of Secs. 1.145-0 through 
1.145-2, see Sec. 1.141-15.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997]



Sec. 1.145-2  Application of private activity bond regulations.

    (a) In general. Except as provided in this section, Secs. 1.141-0 
through 1.141-15 apply to section 145(a). For example, under this 
section, Sec. 1.141-1, and Sec. 1.141-2, an issue ceases to be an issue 
of qualified 501(c)(3) bonds if the issuer or a conduit borrower 
501(c)(3) organization takes a deliberate action, subsequent to the 
issue date, that causes the issue to fail to comply with the 
requirements of sections 141(e) and 145 (such as an action that results 
in revocation of exempt status of the 501(c)(3) organization).
    (b) Modification of private business tests. In applying Secs. 1.141-
0 through 1.141-15 to section 145(a)--
    (1) References to governmental persons include 501(c)(3) 
organizations with respect to their activities that do not constitute 
unrelated trades or businesses under section 513(a);
    (2) References to ``10 percent'' and ``proceeds'' in the context of 
the private business use test and the private security or payment test 
mean ``5 percent'' and ``net proceeds''; and
    (3) References to the private business use test in Secs. 1.141-2 and 
1.141-12 include the ownership test of section 145(a)(1).
    (4) References to governmental bonds in Sec. 1.141-6 mean qualified 
501(c)(3) bonds.
    (5) References to ownership by governmental persons in Sec. 1.141-6 
mean ownership by governmental persons or 501(c)(3) organizations.
    (c) Exceptions--(1) Certain provisions relating to governmental 
programs. The following provisions do not apply to section 145: 
Sec. 1.141-2(d)(4) (relating to

[[Page 77]]

the special rule for dispositions of personal property in the ordinary 
course of an established governmental program) and Sec. 1.141-2(d)(5) 
(relating to the special rule for general obligation bond programs that 
finance a large number of separate purposes).
    (2) Costs of issuance. Sections 1.141-3(g)(6) and 1.141-6(d) do not 
apply to the extent costs of issuance are allocated among the other 
purposes for which the proceeds are used or to portions of a project. 
For purposes of section 145(a)(2), costs of issuance are treated as 
private business use.
    (d) Issuance costs financed by prior issue. Solely for purposes of 
applying the private business use test to a refunding issue under 
Sec. 1.141-13, the use of proceeds of the prior issue (or any earlier 
issue in a series of refundings) to pay issuance costs of the prior 
issue (or the earlier issue) is treated as a government use.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997, as amended by T.D. 9234, 70 FR 
75035, Dec. 19, 2005; T.D. 9741, 80 FR 65646, Oct. 27, 2015]



Sec. 1.147-0  Table of contents.

    This section lists the captioned paragraphs contained in 
Secs. 1.147-1 and 1.147-2.

Sec. 1.147-1  Other requirements applicable to certain private activity 
                                 bonds.

    (a) Overview.
    (b) Scope.
    (c) Effective dates.

                     Sec. 1.147-2  Remedial actions.

[T.D. 8712, 62 FR 2304, Jan. 16, 1997]



Sec. 1.147-1  Other requirements applicable to certain private
activity bonds.

    (a) Overview. Interest on a private activity bond is not excludable 
from gross income under section 103(a) unless the bond is a qualified 
bond. Under section 147, certain requirements must be met for a private 
activity bond to qualify as a qualified bond.
    (b) Scope. Sections 1.147-0 through 1.147-2 apply for purposes of 
the rules in section 147 for qualified private activity bonds that 
permit use of proceeds to acquire land for environmental purposes 
(section 147(c)(3)), permit use of proceeds for certain rehabilitations 
(section 147(d) (2) and (3)), prohibit use of proceeds to finance 
skyboxes, airplanes, gambling establishments and similar facilities 
(section 147(e)), and require public approval (section 147(f)), but not 
for the rules limiting use of proceeds to acquire land or existing 
property under sections 147(c) (1) and (2), and (d)(1).
    (c) Effective dates. For effective dates of Secs. 1.147-0 through 
1.147-2, see Sec. 1.141-16.

[T.D. 8712, 62 FR 2304, Jan. 16, 1997]



Sec. 1.147-2  Remedial actions.

    The remedial action rules of Sec. 1.142-2 apply to the rules in 
section 147 for qualified private activity bonds that permit use of 
proceeds to acquire land for environmental purposes (section 147(c)(3)), 
permit use of proceeds for certain rehabilitations (section 147(d) (2) 
and (3)), prohibit use of proceeds to finance skyboxes, airplanes, 
gambling establishments and similar facilities (section 147(e)), and 
require public approval (section 147(f)), for this purpose treating 
those private activity bonds subject to the rules under section 147 as 
exempt facility bonds and the qualifying purposes for those bonds as 
exempt facilities.

[T.D. 8712, 62 FR 2304, Jan. 16, 1997]



Sec. 1.147(b)-1  Bond maturity limitation-treatment of working capital.

    Section 147(b) does not apply to proceeds of a private activity bond 
issue used to finance working capital expenditures.

[T.D. 8476, 58 FR 33515, June 18, 1993]



Sec. 1.148-0  Scope and table of contents.

    (a) Overview. Under section 103(a), interest on certain obligations 
issued by States and local governments is excludable from the gross 
income of the owners. Section 148 was enacted to minimize the arbitrage 
benefits from investing gross proceeds of tax-exempt bonds in higher 
yielding investments and to remove the arbitrage incentives to issue 
more bonds, to issue bonds earlier, or to leave bonds outstanding longer 
than is otherwise reasonably necessary to accomplish the governmental 
purposes for which the bonds

[[Page 78]]

were issued. To accomplish these purposes, 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). The regulations in Secs. 1.148-1 through 1.148-11 
apply in a manner consistent with these purposes.
    (b) Scope. Sections 1.148-1 through 1.148-11 apply generally for 
purposes of the arbitrage restrictions on State and local bonds under 
section 148.
    (c) Table of contents. This paragraph (c) lists the table of 
contents for Secs. 1.148-1, 1.148-2, 1.148-3, 1.148-4, 1.148-5, 1.148-6, 
1.148-7, 1.148-8, 1.148-9, 1.148-10 and 1.148-11.

                Sec. 1.148-1  Definitions and elections.

    (a) In general.
    (b) Certain definitions.
    (c) Definition of replacement proceeds.
    (1) In general.
    (2) Sinking fund.
    (3) Pledged fund.
    (4) Other replacement proceeds.
    (d) Elections.
    (e) Investment-type property.
    (1) In general.
    (2) Prepayments.
    (3) Certain hedges.
    (f) Definition of issue price.
    (1) In general.
    (2) Bonds issued for money.
    (3) Definitions.
    (4) Other special rules.

        Sec. 1.148-2  General arbitrage yield restriction rules.

    (a) In general.
    (b) Reasonable expectations.
    (1) In general.
    (2) Certification of expectations.
    (c) Intentional acts.
    (d) Materially higher yielding investments.
    (1) In general.
    (2) Definitions of materially higher yield.
    (3) Mortgage loans.
    (e) Temporary periods.
    (1) In general.
    (2) General 3-year temporary period for capital projects and 
qualified mortgage loans.
    (3) Temporary period for working capital expenditures.
    (4) Temporary period for pooled financings.
    (5) Temporary period for replacement proceeds.
    (6) Temporary period for investment proceeds.
    (7) Other amounts.
    (f) Reserve or replacement funds.
    (1) General 10 percent limitation on funding with sale proceeds.
    (2) Exception from yield restriction for reasonably required reserve 
or replacement funds.
    (3) Certain parity reserve funds.
    (g) Minor portion.
    (h) Certain waivers permitted.

              Sec. 1.148-3  General arbitrage rebate rules.

    (a) In general.
    (b) Definition of rebate amount.
    (c) Computation of future value of a payment or receipt.
    (d) Payments and receipts.
    (1) Definition of payments.
    (2) Definition of receipts.
    (3) Special rules for commingled funds.
    (4) Cost-of-living adjustment.
    (e) Computation dates.
    (1) In general.
    (2) Final computation date.
    (f) Amount of required rebate installment payment.
    (1) Amount of interim rebate payments.
    (2) Amount of final rebate payment.
    (3) Future value of rebate payments.
    (g) Time and manner of payment.
    (h) Penalty in lieu of loss of tax exemption.
    (1) In general.
    (2) Interest on underpayments.
    (3) Waivers of the penalty.
    (4) Application to alternative penalty under Sec. 1.148-7.
    (i) Recovery of overpayment of rebate.
    (1) In general.
    (2) Limitations on recovery.
    (3) Time and manner for requesting refund.
    (j) Examples.
    (k) Bona fide debt service fund exception.

                Sec. 1.148-4  Yield on an issue of bonds.

    (a) In general.
    (b) Computing yield on a fixed yield issue.
    (1) In general.
    (2) Yield on certain fixed yield bonds subject to mandatory or 
contingent early redemption.
    (3) Yield on certain fixed yield bonds subject to optional early 
redemption.
    (4) Yield recomputed upon transfer of certain rights associated with 
the bond.
    (5) Special aggregation rule treating certain bonds as a single 
fixed yield bond.
    (6) Examples.
    (c) Computing yield on a variable yield issue.
    (1) In general.
    (2) Payments on bonds included in yield for a computation period.
    (3) Example.
    (d) Conversion from variable yield issue to fixed yield issue.

[[Page 79]]

    (e) Value of bonds.
    (1) Plain par bonds.
    (2) Other bonds.
    (f) Qualified guarantees.
    (1) In general.
    (2) Interest savings.
    (3) Guarantee in substance.
    (4) Reasonable charge.
    (5) Guarantee of purpose investments.
    (6) Allocation of qualified guarantee payments.
    (7) Refund or reduction of guarantee payments.
    (g) Yield on certain mortgage revenue and student loan bonds.
    (h) Qualified hedging transactions.
    (1) In general.
    (2) Qualified hedge defined.
    (3) Accounting for qualified hedges.
    (4) Certain variable yield bonds treated as fixed yield bonds.
    (5) Contracts entered into before issue date of hedged bond.
    (6) Authority of the Commissioner.

            Sec. 1.148-5  Yield and valuation of investments.

    (a) In general.
    (b) Yield on an investment.
    (1) In general.
    (2) Yield on a separate class of investments.
    (3) Investments to be held beyond issue's maturity or beyond 
temporary period.
    (4) Consistent redemption assumptions on purpose investments.
    (5) Student loan special allowance payments included in yield.
    (c) Yield reduction payments to the United States.
    (1) In general.
    (2) Manner of payment.
    (3) Applicability of special yield reduction rule.
    (d) Value of investments.
    (1) In general.
    (2) Mandatory valuation of certain yield restricted investments at 
present value.
    (3) Mandatory valuation of certain investments at fair market value.
    (4) Special transition rule for transferred proceeds.
    (5) Definition of present value of an investment.
    (6) Definition of fair market value.
    (e) Administrative costs of investments.
    (1) In general.
    (2) Qualified administrative costs on nonpurpose investments.
    (3) Qualified administrative costs on purpose investments.

         Sec. 1.148-6  General allocation and accounting rules.

    (a) In general.
    (1) Reasonable accounting methods required.
    (2) Bona fide deviations from accounting method.
    (b) Allocation of gross proceeds to an issue.
    (1) One-issue rule and general ordering rules.
    (2) Universal cap on value of nonpurpose investments allocated to an 
issue.
    (c) Fair market value limit on allocations to nonpurpose 
investments.
    (d) Allocation of gross proceeds to expenditures.
    (1) Expenditures in general.
    (2) Treatment of gross proceeds invested in purpose investments.
    (3) Expenditures for working capital purposes.
    (4) Expenditures for grants.
    (5) Expenditures for reimbursement purposes.
    (6) Expenditures of certain commingled investment proceeds of 
governmental issues.
    (7) Payments to related parties.
    (e) Special rules for commingled funds.
    (1) In general.
    (2) Investments held by a commingled fund.
    (3) Certain expenditures involving a commingled fund.
    (4) Fiscal periods.
    (5) Unrealized gains and losses on investments of a commingled fund.
    (6) Allocations of commingled funds serving as common reserve funds 
or sinking funds.

      Sec. 1.148-7  Spending exceptions to the rebate requirement.

    (a) Scope of section.
    (1) In general.
    (2) Relationship of spending exceptions.
    (3) Spending exceptions not mandatory.
    (b) Rules applicable for all spending exceptions.
    (1) Special transferred proceeds rules.
    (2) Application of multipurpose issue rules.
    (3) Expenditures for governmental purposes of the issue.
    (4) De minimis rule.
    (5) Special definition of reasonably required reserve or replacement 
fund.
    (6) Pooled financing issue.
    (c) 6-month exception.
    (1) General rule.
    (2) Additional period for certain bonds.
    (3) Amounts not included in gross proceeds.
    (4) Series of refundings.
    (d) 18-month exception.
    (1) General rule.
    (2) Extension for reasonable retainage.
    (3) Gross proceeds.
    (4) Application to multipurpose issues.
    (e) 2-year exception.
    (1) General rule.
    (2) Extension for reasonable retainage.
    (3) Definitions.
    (f) Construction issue.
    (1) Definition.

[[Page 80]]

    (2) Use of actual facts.
    (3) Ownership requirement.
    (g) Construction expenditures.
    (1) Definition.
    (2) Certain acquisitions under turnkey contracts treated as 
construction expenditures.
    (3) Constructed personal property.
    (4) Specially developed computer software.
    (5) Examples.
    (h) Reasonable retainage definition.
    (i) Available construction proceeds.
    (1) Definition in general.
    (2) Earnings on a reasonably required reserve or replacement fund.
    (3) Reasonable expectations test for future earnings.
    (4) Issuance costs.
    (5) One and one-half percent penalty in lieu of arbitrage rebate.
    (6) Payments on purpose investments and repayments of grants.
    (7) Examples.
    (j) Election to treat portion of issue used for construction as 
separate issue.
    (1) In general.
    (2) Example.
    (k) One and one-half percent penalty in lieu of arbitrage rebate.
    (1) In general.
    (2) Application to reasonable retainage.
    (3) Coordination with rebate requirement.
    (l) Termination of 1\1/2\ percent penalty.
    (1) Termination after initial temporary period.
    (2) Termination before end of initial temporary period.
    (3) Application to reasonable retainage.
    (4) Example.
    (m) Payment of penalties.

       Sec. 1.148-8  Small issuer exception to rebate requirement.

    (a) Scope.
    (b) General taxing powers.
    (c) Size limitation.
    (1) In general.
    (2) Aggregation rules.
    (3) Certain refunding bonds not taken into account.
    (d) Pooled financings--treatment of conduit borrowers.
    (e) Refunding issues.
    (1) In general.
    (2) Multipurpose issues.

           Sec. 1.148-9  Arbitrage rules for refunding issues.

    (a) Scope of application.
    (b) Transferred proceeds allocation rule.
    (1) In general.
    (2) Special definition of principal amount.
    (3) Relation of transferred proceeds rule to universal cap rule.
    (4) Limitation on multi-generational transfers.
    (c) Special allocation rules for refunding issues.
    (1) Allocations of investments.
    (2) Allocations of mixed escrows to expenditures for principal, 
interest, and redemption prices on a prior issue.
    (d) Temporary periods in refundings.
    (1) In general.
    (2) Types of temporary periods in refundings.
    (e) Reasonably required reserve or replacement funds in refundings.
    (f) Minor portions in refundings.
    (g) Certain waivers permitted.
    (h) Multipurpose issue allocations.
    (1) Application of multipurpose issue allocation rules.
    (2) Rules on allocations of multipurpose issues.
    (3) Separate purposes of a multipurpose issue.
    (4) Allocations of bonds of a multipurpose issue.
    (5) Limitation on multi-generation allocations.
    (i) Operating rules for separation of prior issues into refunded and 
unrefunded portions.
    (1) In general.
    (2) Allocations of proceeds and investments in a partial refunding.
    (3) References to prior issue.

     Sec. 1.148-10  Anti-abuse rules and authority of Commissioner.

    (a) Abusive arbitrage device.
    (1) In general.
    (2) Abusive arbitrage device defined.
    (3) Exploitation of tax-exempt interest rates.
    (4) Overburdening the tax-exempt market.
    (b) Consequences of overburdening the tax-exempt bond market.
    (1) In general.
    (2) Application.
    (c) Anti-abuse rules on excess gross proceeds of advance refunding 
issues.
    (1) In general.
    (2) Definition of excess gross proceeds.
    (3) Special treatment of transferred proceeds.
    (4) Special rule for crossover refundings.
    (5) Special rule for gross refundings.
    (d) Examples.
    (e) Authority of the Commissioner to prevent transactions that are 
inconsistent with the purpose of the arbitrage investment restrictions.
    (f) Authority of the Commissioner to require an earlier date for 
payment of rebate.
    (g) Authority of the Commissioner to waive regulatory limitations.

              Sec. 1.148-11  Effective/applicability dates.

    (a) In general.
    (b) Elective retroactive application in whole.
    (1) In general.

[[Page 81]]

    (2) No elective retroactive application for 18-month spending 
exception.
    (3) No elective retroactive application for hedges of fixed rate 
issues.
    (4) No elective retroactive application for safe harbor for 
establishing fair market value for guaranteed investment contracts and 
investments purchased for a yield restricted defeasance escrow.
    (c) Elective retroactive application of certain provisions.
    (1) Retroactive application of overpayment recovery provisions.
    (2) Certain allocations of multipurpose issues.
    (3) Special limitation.
    (d) Transition rule excepting certain state guarantee funds from the 
definition of replacement proceeds.
    (1) Certain perpetual trust funds.
    (2) Permanent University Fund.
    (e) Transition rule regarding special allowance payments.
    (f) Transition rule regarding applicability of yield reduction rule.
    (g) Provisions applicable to certain bonds sold before effective 
date.
    (h) Safe harbor for establishing fair market value for guaranteed 
investment contracts and investments purchased for a yield restricted 
defeasance escrow.
    (i) Special rule for certain broker's commissions and similar fees.
    (j) Certain prepayments.
    (k) Certain arbitrage guidance updates.
    (1) In general.
    (2) Valuation of investments in refunding transactions.
    (3) Rebate overpayment recovery.
    (4) Hedge identification.
    (5) Hedge modifications and termination.
    (6) Small issuer exception to rebate requirement for conduit 
borrowers of pooled financings.
    (l) Permissive application of certain arbitrage updates.
    (1) In general.
    (2) Computation credit.
    (3) Yield reduction payments.
    (4) External commingled funds.
    (m) Definition of issue price.

[T.D. 8476, 58 FR 33515, June 18, 1993, as amended by T.D. 8538, 59 FR 
24041, May 10, 1994; T.D. 8718, 62 FR 25506, May 9, 1997; T.D. 9085, 68 
FR 45775, Aug. 4, 2003; T.D. 9097, 68 FR 69022, Dec. 11, 2003; T.D. 
9701, 79 FR 67351, Nov. 13, 2014; T.D. 9777, 81 FR 46592, July 18, 2016; 
T.D. 9801, 81 FR 89003, Dec. 9, 2016]



Sec. 1.148-1  Definitions and elections.

    (a) In general. The definitions in this section and the definitions 
under section 150 apply for purposes of section 148 and Secs. 1.148-1 
through 1.148-11.
    (b) Certain definitions. The following definitions apply:
    Accounting method means both the overall method used to account for 
gross proceeds of an issue (e.g., the cash method or a modified accrual 
method) and the method used to account for or allocate any particular 
item within that overall accounting method (e.g., accounting for 
investments, expenditures, allocations to and from different sources, 
and particular items of the foregoing).
    Annuity contract means annuity contract as defined in section 72.
    Available amount means available amount as defined in Sec. 1.148-
6(d)(3)(iii).
    Bona fide debt service fund means a fund, which may include proceeds 
of an issue, that--
    (1) Is used primarily to achieve a proper matching of revenues with 
principal and interest payments within each bond year; and
    (2) Is depleted at least once each bond year, except for a 
reasonable carryover amount not to exceed the greater of:
    (i) the earnings on the fund for the immediately preceding bond 
year; or
    (ii) one-twelfth of the principal and interest payments on the issue 
for the immediately preceding bond year.
    Bond year means, in reference to an issue, each 1-year period that 
ends on the day selected by the issuer. The first and last bond years 
may be short periods. If no day is selected by the issuer before the 
earlier of the final maturity date of the issue or the date that is 5 
years after the issue date, bond years end on each anniversary of the 
issue date and on the final maturity date.
    Capital project or capital projects means all capital expenditures, 
plus related working capital expenditures to which the de minimis rule 
under Sec. 1.148-6(d)(3)(ii)(A) applies, that carry out the governmental 
purposes of an issue. For example, a capital project may include capital 
expenditures for one or more buildings, plus related start-up operating 
costs.
    Commingled fund means any fund or account containing both gross 
proceeds of an issue and amounts in excess of $25,000 that are not gross 
proceeds of that issue if the amounts in the fund or account are 
invested and accounted for collectively, without regard to the

[[Page 82]]

source of funds deposited in the fund or account. An open-end regulated 
investment company under section 851, however, is not a commingled fund.
    Computation date means each date on which the rebate amount for an 
issue is computed under Sec. 1.148-3(e).
    Computation period means the period between computation dates. The 
first computation period begins on the issue date and ends on the first 
computation date. Each succeeding computation period begins on the date 
immediately following the computation date and ends on the next 
computation date.
    Consistently applied means applied uniformly within a fiscal period 
and between fiscal periods to account for gross proceeds of an issue and 
any amounts that are in a commingled fund.
    De minimis amount means--
    (1) In reference to original issue discount (as defined in section 
1273(a)(1)) or premium on an obligation--
    (i) An amount that does not exceed 2 percent multiplied by the 
stated redemption price at maturity; plus
    (ii) Any original issue premium that is attributable exclusively to 
reasonable underwriters' compensation; and
    (2) In reference to market discount (as defined in section 
1278(a)(2)(A)) or premium on an obligation, an amount that does not 
exceed 2 percent multiplied by the stated redemption price at maturity.
    Economic accrual method (also known as the constant interest method 
or actuarial method) means the method of computing yield that is based 
on the compounding of interest at the end of each compounding period.
    Fair market value means fair market value as defined in Sec. 1.148-
5(d)(6).
    Fixed rate investment means any investment whose yield is fixed and 
determinable on the issue date.
    Fixed yield bond means any bond whose yield is fixed and 
determinable on the issue date using the assumptions and rules provided 
in Sec. 1.148-4(b).
    Fixed yield issue means any issue if each bond that is part of the 
issue is a fixed yield bond.
    Gross proceeds means any proceeds and replacement proceeds of an 
issue.
    Guaranteed investment contract includes any nonpurpose investment 
that has specifically negotiated withdrawal or reinvestment provisions 
and a specifically negotiated interest rate, and also includes any 
agreement to supply investments on two or more future dates (e.g., a 
forward supply contract).
    Higher yielding investments means higher yielding investments as 
defined in section 148(b)(1).
    Investment means any investment property as defined in sections 
148(b)(2) and 148(b)(3), and any other tax-exempt bond.
    Investment proceeds means any amounts actually or constructively 
received from investing proceeds of an issue.
    Investment-type property is defined in paragraph (e) of this 
section.
    Issue price means issue price as defined in paragraph (f) of this 
section.
    Issuer generally means the entity that actually issues the issue, 
and, unless the context or a provision clearly requires otherwise, each 
conduit borrower of the issue. For example, rules imposed on issuers to 
account for gross proceeds of an issue apply to a conduit borrower to 
account for any gross proceeds received under a purpose investment. 
Provisions regarding elections, filings, liability for the rebate 
amount, and certifications of reasonable expectations apply only to the 
actual issuer.
    Multipurpose issue means an issue the proceeds of which are used for 
two or more separate purposes determined in accordance with Sec. 1.148-
9(h).
    Net sale proceeds means sale proceeds, less the portion of those 
sale proceeds invested in a reasonably required reserve or replacement 
fund under section 148(d) and as part of a minor portion under section 
148(e).
    Nonpurpose investment means any investment property, as defined in 
section 148(b), that is not a purpose investment.
    Payment means a payment as defined in Sec. 1.148-3(d) for purposes 
of computing the rebate amount, and a payment as defined in Sec. 1.148-
5(b) for purposes of computing the yield on an investment.
    Plain par bond means a qualified tender bond or a bond--
    (1) Issued with not more than a de minimis amount of original issue 
discount or premium;

[[Page 83]]

    (2) Issued for a price that does not include accrued interest other 
than pre-issuance accrued interest;
    (3) That bears interest from the issue date at a single, stated, 
fixed rate or that is a variable rate debt instrument under section 
1275, in each case with interest unconditionally payable at least 
annually; and
    (4) That has a lowest stated redemption price that is not less than 
its outstanding stated principal amount.
    Plain par investment means an investment that is an obligation--
    (1) Issued with not more than a de minimis amount of original issue 
discount or premium, or, if acquired on a date other than the issue 
date, acquired with not more than a de minimis amount of market discount 
or premium;
    (2) Issued for a price that does not include accrued interest other 
than pre-issuance accrued interest;
    (3) That bears interest from the issue date at a single, stated, 
fixed rate or that is a variable rate debt instrument under section 
1275, in each case with interest unconditionally payable at least 
annually; and
    (4) That has a lowest stated redemption price that is not less than 
its outstanding stated principal amount.
    Pre-issuance accrued interest means amounts representing interest 
that accrued on an obligation for a period not greater than one year 
before its issue date but only if those amounts are paid within one year 
after the issue date.
    Proceeds means any sale proceeds, investment proceeds, and 
transferred proceeds of an issue. Proceeds do not include, however, 
amounts actually or constructively received with respect to a purpose 
investment that are properly allocable to the immaterially higher yield 
under Sec. 1.148-2(d) or section 143(g) or to qualified administrative 
costs recoverable under Sec. 1.148-5(e).
    Program investment means a purpose investment that is part of a 
governmental program in which--
    (1) The program involves the origination or acquisition of purpose 
investments;
    (2) At least 95 percent (90 percent for qualified student loans 
under section 144(b)(1)(A)) of the cost of the purpose investments 
acquired under the program represents one or more loans to a substantial 
number of persons representing the general public, States or political 
subdivisions, 501(c)(3) organizations, persons who provide housing and 
related facilities, or any combination of the foregoing;
    (3) At least 95 percent of the receipts from the purpose investments 
are used to pay principal, interest, or redemption prices on issues that 
financed the program, to pay or reimburse administrative costs of those 
issues or of the program, to pay or reimburse anticipated future losses 
directly related to the program, to finance additional purpose 
investments for the same general purposes of the program, or to redeem 
and retire governmental obligations at the next earliest possible date 
of redemption;
    (4) The program documents prohibit any obligor on a purpose 
investment financed by the program or any related party to that obligor 
from purchasing bonds of an issue that finance the program in an amount 
related to the amount of the purpose investment acquired from that 
obligor; and
    (5) The issuer has not waived the right to treat the investment as a 
program investment.
    Purpose investment means an investment that is acquired to carry out 
the governmental purpose of an issue.
    Qualified administrative costs means qualified administrative costs 
as defined in Sec. 1.148-5(e).
    Qualified guarantee means a qualified guarantee as defined in 
Sec. 1.148-4(f).
    Qualified hedge means a qualified hedge as defined in Sec. 1.148-
4(h)(2).
    Reasonable expectations or reasonableness. An issuer's expectations 
or actions are reasonable only if a prudent person in the same 
circumstances as the issuer would have those same expectations or take 
those same actions, based on all the objective facts and circumstances. 
Factors relevant to a determination of reasonableness include the 
issuer's history of conduct concerning stated expectations made in 
connection with the issuance of obligations, the level of inquiry by the 
issuer into factual matters, and the existence of covenants, enforceable 
by bondholders, that require implementation of specific expectations. 
For a conduit

[[Page 84]]

financing issue, factors relevant to a determination of reasonableness 
include the reasonable expectations of the conduit borrower, but only 
if, under the circumstances, it is reasonable and prudent for the issuer 
to rely on those expectations.
    Rebate amount means 100 percent of the amount owed to the United 
States under section 148(f)(2), as further described in Sec. 1.148-3.
    Receipt means a receipt as defined in Sec. 1.148-3(d) for purposes 
of computing the rebate amount, and a receipt as defined in Sec. 1.148-
5(b) for purposes of computing yield on an investment.
    Refunding escrow means one or more funds established as part of a 
single transaction or a series of related transactions, containing 
proceeds of a refunding issue and any other amounts to provide for 
payment of principal or interest on one or more prior issues. For this 
purpose, funds are generally not so established solely because of--
    (1) The deposit of proceeds of an issue and replacement proceeds of 
the prior issue in an escrow more than 6 months apart, or
    (2) The deposit of proceeds of completely separate issues in an 
escrow.
    Replacement proceeds is defined in paragraph (c) of this section.
    Restricted working capital expenditures means working capital 
expenditures that are subject to the proceeds-spent-last rule in 
Sec. 1.148-6(d)(3)(i) and are ineligible for any exception to that rule.
    Sale proceeds means any amounts actually or constructively received 
from the sale of the issue, including amounts used to pay underwriters' 
discount or compensation and accrued interest other than pre-issuance 
accrued interest. Sale proceeds also include, but are not limited to, 
amounts derived from the sale of a right that is associated with a bond, 
and that is described in Sec. 1.148-4(b)(4). See also Sec. 1.148-4(h)(5) 
treating amounts received upon the termination of certain hedges as sale 
proceeds.
    Stated redemption price means the redemption price of an obligation 
under the terms of that obligation, including any call premium.
    Transferred proceeds means transferred proceeds as defined in 
Sec. 1.148-9 (or the applicable corresponding provision of prior law).
    Unconditionally payable means payable under terms in which--
    (1) Late payment or nonpayment results in a significant penalty to 
the borrower or reasonable remedies to the lender, and
    (2) It is reasonably certain on the issue date that the payment will 
actually be made.
    Value means value determined under Sec. 1.148-4(e) for a bond, and 
value determined under Sec. 1.148-5(d) for an investment.
    Variable yield bond means any bond that is not a fixed yield bond.
    Variable yield issue means any issue that is not a fixed yield 
issue.
    Yield means yield computed under Sec. 1.148-4 for an issue, and 
yield computed under Sec. 1.148-5 for an investment.
    Yield restricted means required to be invested at a yield that is 
not materially higher than the yield on the issue under section 148(a) 
and Sec. 1.148-2.
    (c) Definition of replacement proceeds--(1) In general. Amounts are 
replacement proceeds of an issue if the amounts have a sufficiently 
direct nexus to the issue or to the governmental purpose of the issue to 
conclude that the amounts would have been used for that governmental 
purpose if the proceeds of the issue were not used or to be used for 
that governmental purpose. For this purpose, governmental purposes 
include the expected use of amounts for the payment of debt service on a 
particular date. The mere availability or preliminary earmarking of 
amounts for a governmental purpose, however, does not in itself 
establish a sufficient nexus to cause those amounts to be replacement 
proceeds. Replacement proceeds include, but are not limited to, sinking 
funds, pledged funds, and other replacement proceeds described in 
paragraph (c)(4) of this section, to the extent that those funds or 
amounts are held by or derived from a substantial beneficiary of the 
issue. A substantial beneficiary of an issue includes the issuer and any 
related party to the issuer, and, if the issuer is not a state, the 
state in which the issuer is located. A person is not a substantial 
beneficiary of an issue solely

[[Page 85]]

because it is a guarantor under a qualified guarantee.
    (2) Sinking fund. Sinking fund includes a debt service fund, 
redemption fund, reserve fund, replacement fund, or any similar fund, to 
the extent reasonably expected to be used directly or indirectly to pay 
principal or interest on the issue.
    (3) Pledged fund--(i) In general. A pledged fund is any amount that 
is directly or indirectly pledged to pay principal or interest on the 
issue. A pledge need not be cast in any particular form but, in 
substance, must provide reasonable assurance that the amount will be 
available to pay principal or interest on the issue, even if the issuer 
encounters financial difficulties. A pledge to a guarantor of an issue 
is an indirect pledge to secure payment of principal or interest on the 
issue. A pledge of more than 50 percent of the outstanding stock of a 
corporation that is a conduit borrower of the issue is not treated as a 
pledge for this purpose, unless the corporation is formed or availed of 
to avoid the creation of replacement proceeds.
    (ii) Negative pledges. An amount is treated as pledged to pay 
principal or interest on an issue if it is held under an agreement to 
maintain the amount at a particular level for the direct or indirect 
benefit of the bondholders or a guarantor of the bonds. An amount is not 
treated as pledged under this paragraph (c)(3)(ii), however, if--
    (A) The issuer or a substantial beneficiary may grant rights in the 
amount that are superior to the rights of the bondholders or the 
guarantor; or
    (B) The amount does not exceed reasonable needs for which it is 
maintained, the required level is tested no more frequently than every 6 
months, and the amount may be spent without any substantial restriction 
other than a requirement to replenish the amount by the next testing 
date.
    (4) Other replacement proceeds--(i) Bonds outstanding longer than 
necessary--(A) In general. Replacement proceeds arise to the extent that 
the issuer reasonably expects as of the issue date that--
    (1) The term of an issue will be longer than is reasonably necessary 
for the governmental purposes of the issue, and
    (2) There will be available amounts during the period that the issue 
remains outstanding longer than necessary. Whether an issue is 
outstanding longer than necessary is determined under Sec. 1.148-10. 
Replacement proceeds are created under this paragraph (c)(4)(i)(A) at 
the beginning of each fiscal year during which an issue remains 
outstanding longer than necessary in an amount equal to available 
amounts of the issuer as of that date.
    (B) Safe harbor against creation of replacement proceeds. As a safe 
harbor, replacement proceeds do not arise under paragraph (c)(4)(i)(A) 
of this section--
    (1) For the portion of an issue that is to be used to finance 
working capital expenditures, if that portion is not outstanding longer 
than the temporary period under Sec. 1.148-2(e)(3) for which the 
proceeds qualify;
    (2) For the portion of an issue (including a refunding issue) that 
is to be used to finance or refinance capital projects, if that portion 
has a weighted average maturity that does not exceed 120 percent of the 
average reasonably expected economic life of the financed capital 
projects, determined in the same manner as under section 147(b);
    (3) For the portion of an issue that is a refunding issue, if that 
portion has a weighted average maturity that does not exceed the 
remaining weighted average maturity of the prior issue, and the issue of 
which the prior issue is a part satisfies paragraph (c)(4)(i)(B) (1) or 
(2) of this section; or
    (4) For the portion of an issue (including a refunding issue) that 
is to be used to finance working capital expenditures, if that portion 
satisfies paragraph (c)(4)(ii) of this section.
    (ii) Safe harbor for longer-term working capital financings. A 
portion of an issue used to finance working capital expenditures 
satisfies this paragraph (c)(4)(ii) if the issuer meets the requirements 
of paragraphs (c)(4)(ii)(A) through (E) of this section.
    (A) Determine first testing year. On the issue date, the issuer must 
determine the first fiscal year following the applicable temporary 
period under Sec. 1.148-2(e) in which it reasonably expects to have 
available amounts (first testing

[[Page 86]]

year), but in no event can the first day of the first testing year be 
later than five years after the issue date.
    (B) Application of available amount to reduce burden on tax-exempt 
bond market. Beginning with the first testing year and for each 
subsequent fiscal year for which the portion of the issue that is the 
subject of this safe harbor remains outstanding, the issuer must 
determine the available amount as of the first day of each fiscal year. 
Then, except as provided in paragraph (c)(4)(ii)(D) of this section, 
within the first 90 days of that fiscal year, the issuer must apply that 
amount (or if less, the available amount on the date of the required 
redemption or investment) to redeem or to invest in eligible tax-exempt 
bonds (as defined in paragraph (c)(4)(ii)(E) of this section). For this 
purpose, available amounts in a bona fide debt service fund are not 
treated as available amounts.
    (C) Continuous investment requirement. Except as provided in this 
paragraph (c)(4)(ii)(C), any amounts invested in eligible tax-exempt 
bonds under paragraph (c)(4)(ii)(B) of this section must be invested 
continuously in such tax-exempt bonds to the extent provided in 
paragraph (c)(4)(ii)(D) of this section.
    (1) Exception for reinvestment period. Amounts previously invested 
in eligible tax-exempt bonds under paragraph (c)(4)(ii)(B) of this 
section that are held for not more than 30 days in a fiscal year pending 
reinvestment in eligible tax-exempt bonds are treated as invested in 
eligible tax-exempt bonds.
    (2) Limited use of invested amounts. An issuer may spend amounts 
previously invested in eligible tax-exempt bonds under paragraph 
(c)(4)(ii)(B) of this section within 30 days of the date on which they 
cease to be so invested to make expenditures for a governmental purpose 
on any date on which the issuer has no other available amounts for such 
purpose, or to redeem eligible tax-exempt bonds.
    (D) Cap on applied or invested amounts. The maximum amount that an 
issuer is required to apply under paragraph (c)(4)(ii)(B) of this 
section or to invest continuously under paragraph (c)(4)(ii)(C) of this 
section with respect to the portion of an issue that is the subject of 
this safe harbor is the outstanding principal amount of such portion. 
For purposes of this cap, an issuer receives credit towards its 
requirement to invest available amounts in eligible tax-exempt bonds for 
amounts previously invested under paragraph (c)(4)(ii)(B) of this 
section that remain continuously invested under paragraph (c)(4)(ii)(C) 
of this section.
    (E) Definition of eligible tax-exempt bonds. For purposes of 
paragraph (c)(4)(ii) of this section, eligible tax-exempt bonds means 
any of the following:
    (1) A bond the interest on which is excludable from gross income 
under section 103 and that is not a specified private activity bond (as 
defined in section 57(a)(5)(C)) subject to the alternative minimum tax;
    (2) An interest in a regulated investment company to the extent that 
at least 95 percent of the income to the holder of the interest is 
interest on a bond that is excludable from gross income under section 
103 and that is not interest on a specified private activity bond (as 
defined in section 57(a)(5)(C)) subject to the alternative minimum tax; 
or
    (3) A certificate of indebtedness issued by the United States 
Treasury pursuant to the Demand Deposit State and Local Government 
Series program described in 31 CFR part 344.
    (d) Elections. Except as otherwise provided, any required elections 
must be made in writing, and, once made, may not be revoked without the 
permission of the Commissioner.
    (e) Investment-type property--(1) In general. Investment-type 
property includes any property, other than property described in section 
148(b)(2)(A), (B), (C) or (E), that is held principally as a passive 
vehicle for the production of income. For this purpose, production of 
income includes any benefit based on the time value of money.
    (2) Prepayments--(i) In general--(A) Generally. Except as otherwise 
provided in this paragraph (e)(2), a prepayment for property or 
services, including a prepayment for property or services that is made 
after the date that the contract to buy the property or services is 
entered into, also gives rise to investment-type property if a principal 
purpose for prepaying is to receive an investment return from the time 
the

[[Page 87]]

prepayment is made until the time payment otherwise would be made. A 
prepayment does not give rise to investment-type property if--
    (1) Prepayments on substantially the same terms are made by a 
substantial percentage of persons who are similarly situated to the 
issuer but who are not beneficiaries of tax-exempt financing;
    (2) The prepayment is made within 90 days of the reasonably expected 
date of delivery to the issuer of all of the property or services for 
which the prepayment is made; or
    (3) The prepayment meets the requirements of paragraph 
(e)(2)(iii)(A) or (B) of this section.
    (B) Example. The following example illustrates an application of 
this paragraph (e)(2)(i):

    Example. Prepayment after contract is executed. In 1998, City A 
enters into a ten-year contract with Company Y. Under the contract, 
Company Y is to provide services to City A over the term of the contract 
and in return City A will pay Company Y for its services as they are 
provided. In 2004, City A issues bonds to finance a lump sum payment to 
Company Y in satisfaction of City A's obligation to pay for Company Y's 
services to be provided over the remaining term of the contract. The use 
of bond proceeds to make the lump sum payment constitutes a prepayment 
for services under paragraph (e)(2)(i) of this section, even though the 
payment is made after the date that the contract is executed.

    (ii) Customary prepayments. The determination of whether a 
prepayment satisfies paragraph (e)(2)(i)(A)(1) of this section is 
generally made based on all the facts and circumstances. In addition, a 
prepayment is deemed to satisfy paragraph (e)(2)(i)(A)(1) of this 
section if--
    (A) The prepayment is made for--
    (1) Maintenance, repair, or an extended warranty with respect to 
personal property (for example, automobiles or electronic equipment); or
    (2) Updates or maintenance or support services with respect to 
computer software; and
    (B) The same maintenance, repair, extended warranty, updates or 
maintenance or support services, as applicable, are regularly provided 
to nongovernmental persons on the same terms.
    (iii) Certain prepayments to acquire a supply of natural gas or 
electricity--(A) Natural gas prepayments. A prepayment meets the 
requirements of this paragraph (e)(2)(iii)(A) if--
    (1) It is made by or for one or more utilities that are owned by a 
governmental person, as defined in Sec. 1.141-1(b) (each of which is 
referred to in this paragraph (e)(2)(iii)(A) as the issuing municipal 
utility), to purchase a supply of natural gas; and
    (2) At least 90 percent of the prepaid natural gas financed by the 
issue is used for a qualifying use. Natural gas is used for a qualifying 
use if it is to be--
    (i) Furnished to retail gas customers of the issuing municipal 
utility who are located in the natural gas service area of the issuing 
municipal utility, provided, however, that gas used to produce 
electricity for sale shall not be included under this paragraph 
(e)(2)(iii)(A)(2)(i);
    (ii) Used by the issuing municipal utility to produce electricity 
that will be furnished to retail electric customers of the issuing 
municipal utility who are located in the electricity service area of the 
issuing municipal utility;
    (iii) Used by the issuing municipal utility to produce electricity 
that will be sold to a utility that is owned by a governmental person 
and furnished to retail electric customers of the purchaser who are 
located in the electricity service area of the purchaser;
    (iv) Sold to a utility that is owned by a governmental person if the 
requirements of paragraph (e)(2)(iii)(A)(2)(i), (ii) or (iii) of this 
section are satisfied by the purchaser (treating the purchaser as the 
issuing municipal utility); or
    (v) Used to fuel the pipeline transportation of the prepaid gas 
supply acquired in accordance with this paragraph (e)(2)(iii)(A).
    (B) Electricity prepayments. A prepayment meets the requirements of 
this paragraph (e)(2)(iii)(B) if--
    (1) It is made by or for one or more utilities that are owned by a 
governmental person (each of which is referred to in this paragraph 
(e)(2)(iii)(B) as the issuing municipal utility) to purchase a supply of 
electricity; and

[[Page 88]]

    (2) At least 90 percent of the prepaid electricity financed by the 
issue is used for a qualifying use. Electricity is used for a qualifying 
use if it is to be--
    (i) Furnished to retail electric customers of the issuing municipal 
utility who are located in the electricity service area of the issuing 
municipal utility; or
    (ii) Sold to a utility that is owned by a governmental person and 
furnished to retail electric customers of the purchaser who are located 
in the electricity service area of the purchaser.
    (C) Service area. For purposes of this paragraph (e)(2)(iii), the 
service area of a utility owned by a governmental person consists of--
    (1) Any area throughout which the utility provided, at all times 
during the 5-year period ending on the issue date--
    (i) In the case of a natural gas utility, natural gas transmission 
or distribution service; and
    (ii) In the case of an electric utility, electricity distribution 
service; and
    (2) Any area recognized as the service area of the utility under 
state or Federal law.
    (D) Retail customer. For purposes of this paragraph (e)(2)(iii), a 
retail customer is a customer that purchases natural gas or electricity, 
as applicable, other than for resale.
    (E) Commodity swaps. A prepayment does not fail to meet the 
requirements of this paragraph (e)(2)(iii) by reason of any commodity 
swap contract that may be entered into between the issuer and an 
unrelated party (other than the gas or electricity supplier), or between 
the gas or electricity supplier and an unrelated party (other than the 
issuer), so long as each swap contract is an independent contract. A 
swap contract is an independent contract if the obligation of each party 
to perform under the swap contract is not dependent on performance by 
any person (other than the other party to the swap contract) under 
another contract (for example, a gas or electricity supply contract or 
another swap contract); provided, however, that a commodity swap 
contract will not fail to be an independent contract solely because the 
swap contract may terminate in the event of a failure of a gas or 
electricity supplier to deliver gas or electricity for which the swap 
contract is a hedge.
    (F) Remedial action. Issuers may apply principles similar to the 
rules of Sec. 1.141-12, including Sec. 1.141-12(d) (relating to 
redemption or defeasance of nonqualified bonds) and Sec. 1.141-12(e) 
(relating to alternative use of disposition proceeds), to cure a 
violation of paragraph (e)(2)(iii)(A)(2) or (e)(2)(iii)(B)(2) of this 
section. For this purpose, the amount of nonqualified bonds is 
determined in the same manner as for output contracts taken into account 
under the private business tests, including the principles of 
Sec. 1.141-7(d), treating nonqualified sales of gas or electricity under 
this paragraph (e)(2)(iii) as satisfying the benefits and burdens test 
under Sec. 1.141-7(c)(1).
    (iv) Additional prepayments as permitted by the Commissioner. The 
Commissioner may, by published guidance, set forth additional 
circumstances in which a prepayment does not give rise to investment-
type property.
    (f) Definition of issue price--(1) In general. Except as otherwise 
provided in this paragraph (f), ``issue price'' is defined in sections 
1273 and 1274 and the regulations under those sections.
    (2) Bonds issued for money--(i) General rule. Except as otherwise 
provided in this paragraph (f)(2), the issue price of bonds issued for 
money is the first price at which a substantial amount of the bonds is 
sold to the public. If a bond is issued for money in a private placement 
to a single buyer that is not an underwriter or a related party (as 
defined in Sec. 1.150-1(b)) to an underwriter, the issue price of the 
bond is the price paid by that buyer. Issue price is not reduced by any 
issuance costs (as defined in Sec. 1.150-1(b)).
    (ii) Special rule for use of initial offering price to the public. 
The issuer may treat the initial offering price to the public as of the 
sale date as the issue price of the bonds if the requirements of 
paragraphs (f)(2)(ii)(A) and (B) of this section are met.
    (A) The underwriters offered the bonds to the public for purchase at 
a specified initial offering price on or before the sale date, and the 
lead underwriter in the underwriting syndicate or selling group (or, if 
applicable, the sole underwriter) provides, on or before the

[[Page 89]]

issue date, a certification to that effect to the issuer, together with 
reasonable supporting documentation for that certification, such as a 
copy of the pricing wire or equivalent communication.
    (B) Each underwriter agrees in writing that it will neither offer 
nor sell the bonds to any person at a price that is higher than the 
initial offering price to the public during the period starting on the 
sale date and ending on the earlier of the following:
    (1) The close of the fifth (5th) business day after the sale date; 
or
    (2) The date on which the underwriters have sold a substantial 
amount of the bonds to the public at a price that is no higher than the 
initial offering price to the public.
    (iii) Special rule for competitive sales. For bonds issued for money 
in a competitive sale, an issuer may treat the reasonably expected 
initial offering price to the public as of the sale date as the issue 
price of the bonds if the issuer obtains from the winning bidder a 
certification of the bonds' reasonably expected initial offering price 
to the public as of the sale date upon which the price in the winning 
bid is based.
    (iv) Choice of rule for determining issue price. If more than one 
rule for determining the issue price of the bonds is available under 
this paragraph (f)(2), at any time on or before the issue date, the 
issuer may select the rule it will use to determine the issue price of 
the bonds. On or before the issue date of the bonds, the issuer must 
identify the rule selected in its books and records maintained for the 
bonds.
    (3) Definitions. For purposes of this paragraph (f), the following 
definitions apply:
    (i) Competitive sale means a sale of bonds by an issuer to an 
underwriter that is the winning bidder in a bidding process in which the 
issuer offers the bonds for sale to underwriters at specified written 
terms, if that process meets the following requirements:
    (A) The issuer disseminates the notice of sale to potential 
underwriters in a manner that is reasonably designed to reach potential 
underwriters (for example, through electronic communication that is 
widely circulated to potential underwriters by a recognized publisher of 
municipal bond offering documents or by posting on an Internet-based Web 
site or other electronic medium that is regularly used for such purpose 
and is widely available to potential underwriters);
    (B) All bidders have an equal opportunity to bid (within the meaning 
of Sec. 1.148-5(d)(6)(iii)(A)(6));
    (C) The issuer receives bids from at least three underwriters of 
municipal bonds who have established industry reputations for 
underwriting new issuances of municipal bonds; and
    (D) The issuer awards the sale to the bidder who submits a firm 
offer to purchase the bonds at the highest price (or lowest interest 
cost).
    (ii) Public means any person (as defined in section 7701(a)(1)) 
other than an underwriter or a related party (as defined in Sec. 1.150-
1(b)) to an underwriter.
    (iii) Underwriter means:
    (A) Any person (as defined in section 7701(a)(1)) that agrees 
pursuant to a written contract with the issuer (or with the lead 
underwriter to form an underwriting syndicate) to participate in the 
initial sale of the bonds to the public; and
    (B) Any person that agrees pursuant to a written contract directly 
or indirectly with a person described in paragraph (f)(3)(iii)(A) of 
this section to participate in the initial sale of the bonds to the 
public (for example, a retail distribution agreement between a national 
lead underwriter and a regional firm under which the regional firm 
participates in the initial sale of the bonds to the public).
    (4) Other special rules. For purposes of this paragraph (f), the 
following special rules apply:
    (i) Separate determinations. The issue price of bonds in an issue 
that do not have the same credit and payment terms is determined 
separately. The issuer need not apply the same rule to determine issue 
price for all of the bonds in the issue.
    (ii) Substantial amount. Ten percent is a substantial amount.
    (iii) Bonds issued for property. If a bond is issued for property, 
the adjusted applicable Federal rate, as determined under section 1288 
and

[[Page 90]]

Sec. 1.1288-1, is used in lieu of the applicable Federal rate to 
determine the bond's issue price under section 1274.

[T.D. 8476, 58 FR 33517, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24041, May 10, 1994; T.D. 8718, 62 FR 25507, 
May 9, 1997; T.D. 9085, 68 FR 45775, Aug. 4, 2003; T.D. 9777, 81 FR 
46592, July 18, 2016; T.D. 9801, 81 FR 89003, Dec. 9, 2016]



Sec. 1.148-2  General arbitrage yield restriction rules.

    (a) In general. Under section 148(a), the direct or indirect 
investment of the gross proceeds of an issue in higher yielding 
investments causes the bonds of the issue to be arbitrage bonds. The 
investment of proceeds in higher yielding investments, however, during a 
temporary period described in paragraph (e) of this section, as part of 
a reasonably required reserve or replacement fund described in paragraph 
(f) of this section, or as part of a minor portion described in 
paragraph (g) of this section does not cause the bonds of the issue to 
be arbitrage bonds. Bonds are not arbitrage bonds under this section as 
a result of an inadvertent, insubstantial error.
    (b) Reasonable expectations--(1) In general. Except as provided in 
paragraph (c) of this section, the determination of whether an issue 
consists of arbitrage bonds under section 148(a) is based on the 
issuer's reasonable expectations as of the issue date regarding the 
amount and use of the gross proceeds of the issue.
    (2) Certification of expectations--(i) In general. An officer of the 
issuer responsible for issuing the bonds must, in good faith, certify 
the issuer's expectations as of the issue date. The certification must 
state the facts and estimates that form the basis for the issuer's 
expectations. The certification is evidence of the issuer's 
expectations, but does not establish any conclusions of law or any 
presumptions regarding either the issuer's actual expectations or their 
reasonableness.
    (ii) Exceptions to certification requirement. An issuer is not 
required to make a certification for an issue under paragraph (b)(2)(i) 
of this section if--
    (A) The issuer reasonably expects as of the issue date that there 
will be no unspent gross proceeds after the issue date, other than gross 
proceeds in a bona fide debt service fund (e.g., equipment lease 
financings in which the issuer purchases equipment in exchange for an 
installment payment note); or
    (B) The issue price of the issue does not exceed $1,000,000.
    (c) Intentional acts. The taking of any deliberate, intentional 
action by the issuer or person acting on its behalf after the issue date 
in order to earn arbitrage causes the bonds of the issue to be arbitrage 
bonds if that action, had it been expected on the issue date, would have 
caused the bonds to be arbitrage bonds. An intent to violate the 
requirements of section 148 is not necessary for an action to be 
intentional.
    (d) Materially higher yielding investments--(1) In general. The 
yield on investments is materially higher than the yield on the issue to 
which the investments are allocated if the yield on the investments over 
the term of the issue exceeds the yield on the issue by an amount in 
excess of the applicable definition of materially higher set forth in 
paragraph (d)(2) of this section. If yield restricted investments in the 
same class are subject to different definitions of materially higher, 
the applicable definition of materially higher that produces the lowest 
permitted yield applies to all the investments in the class. The yield 
on the issue is determined under Sec. 1.148-4. The yield on investments 
is determined under Sec. 1.148-5.
    (2) Definitions of materially higher yield--(i) General rule for 
purpose and nonpurpose investments. For investments that are not 
otherwise described in this paragraph (d)(2), materially higher means 
one-eighth of 1 percentage point.
    (ii) Refunding escrows and replacement proceeds. For investments in 
a refunding escrow or for investments allocable to replacement proceeds, 
materially higher means one-thousandth of 1 percentage point.
    (iii) Program investments. For program investments that are not 
described in paragraph (d)(2)(iv) of this section, materially higher 
means 1 and one-half percentage points.

[[Page 91]]

    (iv) Student loans. For qualified student loans that are program 
investments, materially higher means 2 percentage points.
    (v) Tax-exempt investments. For investments that are tax-exempt 
bonds and are not investment property under section 148(b)(3), no yield 
limitation applies.
    (3) Mortgage loans. Qualified mortgage loans that satisfy the 
requirements of section 143(g) are treated as meeting the requirements 
of this paragraph (d).
    (e) Temporary periods--(1) In general. During the temporary periods 
set forth in this paragraph (e), the proceeds and replacement proceeds 
of an issue may be invested in higher yielding investments without 
causing bonds in the issue to be arbitrage bonds. This paragraph (e) 
does not apply to refunding issues (see Sec. 1.148-9).
    (2) General 3-year temporary period for capital projects and 
qualified mortgage loans--(i) In general. The net sale proceeds and 
investment proceeds of an issue reasonably expected to be allocated to 
expenditures for capital projects qualify for a temporary period of 3 
years beginning on the issue date (the 3-year temporary period). The 3-
year temporary period also applies to the proceeds of qualified mortgage 
bonds and qualified veterans' mortgage bonds by substituting qualified 
mortgage loans in each place that capital projects appears in this 
paragraph (e)(2). The 3-year temporary period applies only if the issuer 
reasonably expects to satisfy the expenditure test, the time test, and 
the due diligence test. These rules apply separately to each conduit 
loan financed by an issue (other than qualified mortgage loans), with 
the expenditure and time tests measured from the issue date of the 
issue.
    (A) Expenditure test. The expenditure test is met if at least 85 
percent of the net sale proceeds of the issue are allocated to 
expenditures on the capital projects by the end of the 3-year temporary 
period.
    (B) Time test. The time test is met if the issuer incurs within 6 
months of the issue date a substantial binding obligation to a third 
party to expend at least 5 percent of the net sale proceeds of the issue 
on the capital projects. An obligation is not binding if it is subject 
to contingencies within the issuer's or a related party's control.
    (C) Due diligence test. The due diligence test is met if completion 
of the capital projects and the allocation of the net sale proceeds of 
the issue to expenditures proceed with due diligence.
    (ii) 5-year temporary period. In the case of proceeds expected to be 
allocated to a capital project involving a substantial amount of 
construction expenditures (as defined in Sec. 1.148-7), a 5-year 
temporary period applies in lieu of the 3-year temporary period if the 
issuer satisfies the requirements of paragraph (e)(2)(i) of this section 
applied by substituting ``5 years'' in each place that ``3 years'' 
appears, and both the issuer and a licensed architect or engineer 
certify that the longer period is necessary to complete the capital 
project.
    (3) Temporary period for working capital expenditures--(i) General 
rule. The proceeds of an issue that are reasonably expected to be 
allocated to working capital expenditures within 13 months after the 
issue date qualify for a temporary period of 13 months beginning on the 
issue date. Paragraph (e)(2) of this section contains additional 
temporary period rules for certain working capital expenditures that are 
treated as part of a capital project.
    (ii) Longer temporary period for certain tax anticipation issues. If 
an issuer reasonably expects to use tax revenues arising from tax levies 
for a single fiscal year to redeem or retire an issue, and the issue 
matures by the earlier of 2 years after the issue date or 60 days after 
the last date for payment of those taxes without interest or penalty, 
the temporary period under paragraph (e)(3)(i) of this section is 
extended until the maturity date of the issue.
    (4) Temporary period for pooled financings--(i) In general. Proceeds 
of a pooled financing issue reasonably expected to be used to finance 
purpose investments qualify for a temporary period of 6 months while 
held by the issuer before being loaned to a conduit borrower. Any 
otherwise available temporary period for proceeds held by a conduit 
borrower, however, is reduced by the period of time during which those 
proceeds were held by the issuer

[[Page 92]]

before being loaned. For example, if the proceeds of a pooled financing 
issue loaned to a conduit borrower would qualify for a 3-year temporary 
period, and the proceeds are held by the issuer for 5 months before 
being loaned to the conduit borrower, the proceeds qualify for only an 
additional 31-month temporary period after being loaned to the conduit 
borrower. Except as provided in paragraph (e)(4)(iv) of this section, 
this paragraph (e)(4) does not apply to any qualified mortgage bond or 
qualified veterans' mortgage bond under section 143.
    (ii) Loan repayments--(A) Amount held by the issuer. The temporary 
period under this paragraph (e)(4) for proceeds from the sale or 
repayment of any loan that are reasonably expected to be used to make or 
finance new loans is 3 months.
    (B) Amounts re-loaned to conduit borrowers. Any temporary period for 
proceeds held by a conduit borrower under a new loan from amounts 
described in paragraph (e)(4)(ii)(A) of this section is determined by 
treating the date the new loan is made as the issue date and by reducing 
the temporary period by the period the amounts were held by the issuer 
following the last repayment.
    (iii) Construction issues. If all or a portion of a pooled financing 
issue qualifies as a construction issue under Sec. 1.148-7(b)(6), 
paragraph (e)(4)(i) of this section is applied by substituting ``2 
years'' for ``6 months.''
    (iv) Amounts re-loaned for qualified mortgage loans. The temporary 
period under this paragraph (e)(4) for proceeds from the sale, 
prepayment, or repayment of any qualified mortgage loan that are 
reasonably expected to be used to make or finance new qualified mortgage 
loans is 3 years.
    (5) Temporary period for replacement proceeds--(i) In general. 
Except as otherwise provided, replacement proceeds qualify for a 
temporary period of 30 days beginning on the date that the amounts are 
first treated as replacement proceeds.
    (ii) Temporary period for bona fide debt service funds. Amounts in a 
bona fide debt service fund for an issue qualify for a temporary period 
of 13 months. If only a portion of a fund qualifies as a bona fide debt 
service fund, only that portion qualifies for this temporary period.
    (6) Temporary period for investment proceeds. Except as otherwise 
provided in this paragraph (e), investment proceeds qualify for a 
temporary period of 1 year beginning on the date of receipt.
    (7) Other amounts. Gross proceeds not otherwise eligible for a 
temporary period described in this paragraph (e) qualify for a temporary 
period of 30 days beginning on the date of receipt.
    (f) Reserve or replacement funds--(1) General 10 percent limitation 
on funding with sale proceeds. An issue consists of arbitrage bonds if 
sale proceeds of the issue in excess of 10 percent of the stated 
principal amount of the issue are used to finance any reserve or 
replacement fund, without regard to whether those sale proceeds are 
invested in higher yielding investments. If an issue has more than a de 
minimis amount of original issue discount or premium, the issue price 
(net of pre-issuance accrued interest) is used to measure the 10-percent 
limitation in lieu of stated principal amount. This rule does not limit 
the use of amounts other than sale proceeds of an issue to fund a 
reserve or replacement fund.
    (2) Exception from yield restriction for reasonably required reserve 
or replacement funds--(i) In general. The investment of amounts that are 
part of a reasonably required reserve or replacement fund in higher 
yielding investments will not cause an issue to consist of arbitrage 
bonds. A reasonably required reserve or replacement fund may consist of 
all or a portion of one or more funds, however labelled, derived from 
one or more sources. Amounts in a reserve or replacement fund in excess 
of the amount that is reasonably required are not part of a reasonably 
required reserve or replacement fund.
    (ii) Size limitation. The amount of gross proceeds of an issue that 
qualifies as a reasonably required reserve or replacement fund may not 
exceed an amount equal to the least of 10 percent of the stated 
principal amount of the issue, the maximum annual principal and interest 
requirements on the issue, or 125 percent of the average annual 
principal and interest requirements on

[[Page 93]]

the issue. If an issue has more than a de minimis amount of original 
issue discount or premium, the issue price of the issue (net of pre-
issuance accrued interest) is used to measure the 10 percent limitation 
in lieu of its stated principal amount. For a reserve or replacement 
fund that secures more than one issue (e.g. a parity reserve fund), the 
size limitation may be measured on an aggregate basis.
    (iii) Valuation of investments. Investments in a reasonably required 
reserve or replacement fund may be valued in any reasonable, 
consistently applied manner that is permitted under Sec. 1.148-5.
    (iv) 150 percent debt service limitation on investment in nonpurpose 
investments for certain private activity bonds. Section 148(d)(3) 
contains additional limits on the amount of gross proceeds of an issue 
of private activity bonds, other than qualified 501(c)(3) bonds, that 
may be invested in higher yielding nonpurpose investments without 
causing the bonds to be arbitrage bonds. For purposes of these rules, 
initial temporary period means the temporary periods under paragraphs 
(e)(2), (e)(3), and (e)(4) of this section and under Sec. 1.148-
9(d)(2)(i), (ii), and (iii).
    (3) Certain parity reserve funds. The limitation contained in 
paragraph (f)(1) of this section does not apply to an issue if the 
master legal document authorizing the issuance of the bonds (e.g., a 
master indenture) was adopted before August 16, 1986, and that 
document--
    (i) Requires a reserve or replacement fund in excess of 10 percent 
of the sale proceeds, but not more than maximum annual principal and 
interest requirements;
    (ii) Is not amended after August 31, 1986 (other than to permit the 
issuance of additional bonds as contemplated in the master legal 
document); and
    (iii) Provides that bonds having a parity of security may not be 
issued by or on behalf of the issuer for the purposes provided under the 
document without satisfying the reserve fund requirements of the 
indenture.
    (g) Minor portion. Under section 148(e), a bond of an issue is not 
an arbitrage bond solely because of the investment in higher yielding 
investments of gross proceeds of the issue in an amount not exceeding 
the lesser of--
    (1) 5 percent of the sale proceeds of the issue; or
    (2) $100,000.
    (h) Certain waivers permitted. On or before the issue date, an 
issuer may elect to waive the right to invest in higher yielding 
investments during any temporary period under paragraph (e) of this 
section or as part of a reasonably required reserve or replacement fund 
under paragraph (f) of this section. At any time, an issuer may waive 
the right to invest in higher yielding investments as part of a minor 
portion under paragraph (g) of this section.

[T.D. 8476, 58 FR 33520, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24042, May 10, 1994; T.D. 8718, 62 FR 25507, 
May 9, 1997; T.D. 9777, 81 FR 46593, July 18, 2016]



Sec. 1.148-3  General arbitrage rebate rules.

    (a) In general. Section 148(f) requires that certain earnings on 
nonpurpose investments allocable to the gross proceeds of an issue be 
paid to the United States to prevent the bonds in the issue from being 
arbitrage bonds. The arbitrage that must be rebated is based on the 
difference between the amount actually earned on nonpurpose investments 
and the amount that would have been earned if those investments had a 
yield equal to the yield on the issue.
    (b) Definition of rebate amount. As of any date, the rebate amount 
for an issue is the excess of the future value, as of that date, of all 
receipts on nonpurpose investments over the future value, as of that 
date, of all payments on nonpurpose investments.
    (c) Computation of future value of a payment or receipt. The future 
value of a payment or receipt at the end of any period is determined 
using the economic accrual method and equals the value of that payment 
or receipt when it is paid or received (or treated as paid or received), 
plus interest assumed to be earned and compounded over the period at a 
rate equal to the yield on the issue, using the same compounding 
interval and financial conventions used to compute that yield.

[[Page 94]]

    (d) Payments and receipts--(1) Definition of payments. For purposes 
of this section, payments are--
    (i) Amounts actually or constructively paid to acquire a nonpurpose 
investment (or treated as paid to a commingled fund);
    (ii) For a nonpurpose investment that is first allocated to an issue 
on a date after it is actually acquired (e.g., an investment that 
becomes allocable to transferred proceeds or to replacement proceeds) or 
that becomes subject to the rebate requirement on a date after it is 
actually acquired (e.g., an investment allocated to a reasonably 
required reserve or replacement fund for a construction issue at the end 
of the 2-year spending period), the value of that investment on that 
date;
    (iii) For a nonpurpose investment that was allocated to an issue at 
the end of the preceding computation period, the value of that 
investment at the beginning of the computation period;
    (iv) On the last day of each bond year during which there are 
amounts allocated to gross proceeds of an issue that are subject to the 
rebate requirement, and on the final maturity date, a computation credit 
of $1,400 for any bond year ending in 2007 and, for bond years ending 
after 2007, a computation credit in the amount determined under 
paragraph (d)(4) of this section; and
    (v) Yield reduction payments on nonpurpose investments made pursuant 
to Sec. 1.148-5(c).
    (2) Definition of receipts. For purposes of this section, receipts 
are--
    (i) Amounts actually or constructively received from a nonpurpose 
investment (including amounts treated as received from a commingled 
fund), such as earnings and return of principal;
    (ii) For a nonpurpose investment that ceases to be allocated to an 
issue before its disposition or redemption date (e.g., an investment 
that becomes allocable to transferred proceeds of another issue or that 
ceases to be allocable to the issue pursuant to the universal cap under 
Sec. 1.148-6) or that ceases to be subject to the rebate requirement on 
a date earlier than its disposition or redemption date (e.g., an 
investment allocated to a fund initially subject to the rebate 
requirement but that subsequently qualifies as a bona fide debt service 
fund), the value of that nonpurpose investment on that date; and
    (iii) For a nonpurpose investment that is held at the end of a 
computation period, the value of that investment at the end of that 
period.
    (3) Special rules for commingled funds. Section 1.148-6(e) provides 
special rules to limit certain of the required determinations of 
payments and receipts for investments of a commingled fund.
    (4) Cost-of-living adjustment. For any calendar year after 2007, the 
$1,400 computation credit set forth in paragraph (d)(1)(iv) of this 
section shall be increased by an amount equal to such dollar amount 
multiplied by the cost-of-living adjustment determined under section 
1(f)(3) for such year, as modified by this paragraph (d)(4). In applying 
section 1(f)(3) to determine this cost-of-living adjustment, the 
reference to ``calendar year 1992'' in section 1(f)(3)(B) shall be 
changed to ``calendar year 2006.'' If any such increase determined under 
this paragraph (d)(4) is not a multiple of $10, such increase shall be 
rounded to the nearest multiple thereof.
    (e) Computation dates--(1) In general. For a fixed yield issue, an 
issuer may treat any date as a computation date. For a variable yield 
issue, an issuer:
    (i) May treat the last day of any bond year ending on or before the 
latest date on which the first rebate amount is required to be paid 
under paragraph (f) of this section (the first required payment date) as 
a computation date but may not change that treatment after the first 
payment date; and
    (ii) After the first required payment date, must consistently treat 
either the end of each bond year or the end of each fifth bond year as 
computation dates and may not change these computation dates after the 
first required payment date.
    (2) Final computation date. The date that an issue is discharged is 
the final computation date. For an issue retired within 3 years of the 
issue date, however, the final computation date need not occur before 
the end of 8 months

[[Page 95]]

after the issue date or during the period in which the issuer reasonably 
expects that any of the spending exceptions under Sec. 1.148-7 will 
apply to the issue.
    (f) Amount of required rebate installment payment--(1) Amount of 
interim rebate payments. The first rebate installment payment must be 
made for a computation date that is not later than 5 years after the 
issue date. Subsequent rebate installment payments must be made for a 
computation date that is not later than 5 years after the previous 
computation date for which an installment payment was made. A rebate 
installment payment must be in an amount that, when added to the future 
value, as of the computation date, of previous rebate payments made for 
the issue, equals at least 90 percent of the rebate amount as of that 
date.
    (2) Amount of final rebate payment. For the final computation date, 
a final rebate payment must be paid in an amount that, when added to the 
future value of previous rebate payments made for the issue, equals 100 
percent of the rebate amount as of that date.
    (3) Future value of rebate payments. The future value of a rebate 
payment is determined under paragraph (c) of this section. This value is 
computed by taking into account recoveries of overpayments.
    (g) Time and manner of payment. Each rebate payment must be paid no 
later than 60 days after the computation date to which the payment 
relates. Any rebate payment paid within this 60-day period may be 
treated as paid on the computation date to which it relates. A rebate 
payment is paid when it is filed with the Internal Revenue Service at 
the place or places designated by the Commissioner. A payment must be 
accompanied by the form provided by the Commissioner for this purpose.
    (h) Penalty in lieu of loss of tax exemption--(1) In general. The 
failure to pay the correct rebate amount when required will cause the 
bonds of the issue to be arbitrage bonds, unless the Commissioner 
determines that the failure was not caused by willful neglect and the 
issuer promptly pays a penalty to the United States. If no bond of the 
issue is a private activity bond (other than a qualified 501(c)(3) 
bond), the penalty equals 50 percent of the rebate amount not paid when 
required to be paid, plus interest on that amount. Otherwise, the 
penalty equals 100 percent of the rebate amount not paid when required 
to be paid, plus interest on that amount.
    (2) Interest on underpayments. Interest accrues at the underpayment 
rate under section 6621, beginning on the date the correct rebate amount 
is due and ending on the date 10 days before it is paid.
    (3) Waivers of the penalty. The penalty is automatically waived if 
the rebate amount that the issuer failed to pay plus interest is paid 
within 180 days after discovery of the failure, unless, the Commissioner 
determines that the failure was due to willful neglect, or the issue is 
under examination by the Commissioner at any time during the period 
beginning on the date the failure first occurred and ending on the date 
90 days after the receipt of the rebate amount. Generally, extensions of 
this 180-day period and waivers of the penalty in other cases will be 
granted by the Commissioner only in unusual circumstances. For purposes 
of this paragraph (h)(3), willful neglect does not include a failure 
that is attributable solely to the permissible retroactive selection of 
a short first bond year if the rebate amount that the issuer failed to 
pay is paid within 60 days of the selection of that bond year.
    (4) Application to alternative penalty under Sec. 1.148-7. 
Paragraphs (h) (1), (2), and (3) of this section apply to failures to 
pay penalty payments under Sec. 1.148-7 (alternative penalty amounts) by 
substituting alternative penalty amounts for rebate amount and the last 
day of each spending period for computation date.
    (i) Recovery of overpayment of rebate--(1) In general. An issuer may 
recover an overpayment for an issue of tax-exempt bonds by establishing 
to the satisfaction of the Commissioner that the overpayment occurred. 
An overpayment is the excess of the amount paid to the United States for 
an issue under section 148 over the sum of the rebate amount for the 
issue as of the most recent computation date and all amounts that are 
otherwise required to be paid under section 148 as of the date the 
recovery is requested.

[[Page 96]]

    (2) Limitations on recovery. (i) An overpayment may be recovered 
only to the extent that a recovery on the date that it is first 
requested would not result in an additional rebate amount if that date 
were treated as a computation date.
    (ii) Except for overpayments of penalty in lieu of rebate under 
section 148(f)(4)(C)(vii) and Sec. 1.148-7(k), an overpayment of less 
than $5,000 may not be recovered before the final computation date.
    (3) Time and manner for requesting refund. (i) An issuer must 
request a refund of an overpayment (claim) no later than the date that 
is two years after the final computation date for the issue to which the 
overpayment relates (the filing deadline). The claim must be made using 
the form provided by the Commissioner for this purpose.
    (ii) The Commissioner may request additional information to support 
a claim. The issuer must file the additional information by the date 
specified in the Commissioner's request, which date may be extended by 
the Commissioner if unusual circumstances warrant. An issuer will be 
given at least 21 calendar days to respond to a request for additional 
information.
    (iii) A claim described in either paragraph (i)(3)(iii)(A) or (B) of 
this section that has been denied by the Commissioner may be appealed to 
the Office of Appeals under this paragraph (i)(3)(iii). Upon a 
determination in favor of the issuer, the Office of Appeals must return 
the undeveloped case to the Commissioner for further consideration of 
the substance of the claim.
    (A) A claim is described in this paragraph (i)(3)(iii)(A) if the 
Commissioner asserts that the claim was filed after the filing deadline.
    (B) A claim is described in this paragraph (i)(3)(iii)(B) if the 
Commissioner asserts that additional information to support the claim 
was not submitted within the time specified in the request for 
information or in any extension of such specified time period.
    (j) Examples. The provisions of this section may be illustrated by 
the following examples.

    Example 1. Calculation and payment of rebate for a fixed yield 
issue. (i) Facts. On January 1, 1994, City A issues a fixed yield issue 
and invests all the sale proceeds of the issue ($49 million). There are 
no other gross proceeds. The issue has a yield of 7.0000 percent per 
year compounded semiannually (computed on a 30 day month/360 day year 
basis). City A receives amounts from the investment and immediately 
expends them for the governmental purpose of the issue as follows:

------------------------------------------------------------------------
                          Date                                Amount
------------------------------------------------------------------------
2/1/94..................................................      $3,000,000
5/1/94..................................................       5,000,000
1/1/95..................................................       5,000,000
9/1/95..................................................      20,000,000
3/1/96..................................................      22,000,000
------------------------------------------------------------------------

    (ii) First computation date. (A) City A chooses January 1, 1999, as 
its first computation date. This date is the latest date that may be 
used to compute the first required rebate installment payment. The 
rebate amount as of this date is computed by determining the future 
value of the receipts and the payments for the investment. The 
compounding interval is each 6-month (or shorter) period and the 30 day 
month/360 day year basis is used because these conventions were used to 
compute yield on the issue. The future value of these amounts, plus the 
computation credit, as of January 1, 1999, is:

------------------------------------------------------------------------
                                            Receipts        FV (7.0000
                 Date                      (payments)        percent)
------------------------------------------------------------------------
1/1/94................................    ($49,000,000)    ($69,119,339)
2/1/94................................       3,000,000        4,207,602
5/1/94................................       5,000,000        6,893,079
1/1/95................................       5,000,000        6,584,045
1/1/95................................          (1,000)          (1,317)
9/1/95................................      20,000,000       25,155,464
1/1/96................................          (1,000)           1,229)
3/1/96................................      22,000,000       26,735,275
1/1/97................................          (1,000)          (1,148)
                                       ---------------------------------
Rebate amount (1/01/99)...............  ...............         452,432
------------------------------------------------------------------------

    (B) City A pays 90 percent of the rebate amount ($407,189) to the 
United States within 60 days of January 1, 1999.
    (iii) Second computation date. (A) On the next required computation 
date, January 1, 2004, the future value of the payments and receipts is:

------------------------------------------------------------------------
                                                  Receipts    FV (7.0000
                     Date                        (payments)    percent)
------------------------------------------------------------------------
1/1/99........................................     $452,432     $638,200
                                               -------------------------
Rebate amount (1/01/04).......................  ...........      638,200
------------------------------------------------------------------------

    (B) As of this computation date, the future value of the payment 
treated as made on January 1, 1999, is $574,380, which equals at least 
90 percent of the rebate amount as of this computation date ($638,200 
x  0.9), and thus no additional rebate payment is due as of this date.

[[Page 97]]

    (iv) Final computation date. (A) On January 1, 2009, City A redeems 
all the bonds, and thus this date is the final computation date. The 
future value of the receipts and payments as of this date is:

------------------------------------------------------------------------
                                                Receipts     FV (7.0000
                    Date                       (payments)     percent)
------------------------------------------------------------------------
1/1/04......................................     $638,200      $900,244
1/1/09......................................       (1,000)       (1,000)
                                             ---------------------------
Rebate amount (1/01/09).....................  ............      899,244
------------------------------------------------------------------------

    (B) As of this computation date, the future value of the payment 
made on January 1, 1999, is $810,220 and thus an additional rebate 
payment of $89,024 is due. This payment reflects the future value of the 
10 percent unpaid portion, and thus would not be owed had the issuer 
paid the full rebate amount as of any prior computation date.
    Example 2. Calculation and payment of rebate for a variable yield 
issue. (i) Facts. On July 1, 1994, City B issues a variable yield issue 
and invests all of the sale proceeds of the issue ($30 million). There 
are no other gross proceeds. As of July 1, 1999, there are nonpurpose 
investments allocated to the issue. Prior to July 1, 1999, City B 
receives amounts from nonpurpose investments and immediately expends 
them for the governmental purpose of the issue as follows:

------------------------------------------------------------------------
                           Date                                Amount
------------------------------------------------------------------------
8/1/1994..................................................    $5,000,000
7/1/1995..................................................     8,000,000
12/1/1995.................................................    17,000,000
7/1/1999..................................................       650,000
------------------------------------------------------------------------

    (ii) First computation date. (A) City B treats the last day of the 
fifth bond year (July 1, 1999) as a computation date. The yield on the 
variable yield issue during the first computation period (the period 
beginning on the issue date and ending on the first computation date) is 
6.0000 percent per year compounded semiannually. The value of the 
nonpurpose investments allocated to the issue as of July 1, 1999, is $3 
million. The rebate amount as of July 1, 1999, is computed by 
determining the future value of the receipts and the payments for the 
nonpurpose investments. The compounding interval is each 6-month (or 
shorter) period and the 30 day month/360 day year basis is used because 
these conventions were used to compute yield on the issue. The future 
value of these amounts and of the computation date credits as of July 1, 
1999, is:

------------------------------------------------------------------------
                                          Receipts         FV (6.0000
                 Date                    (payments)         percent)
------------------------------------------------------------------------
7/1/1994.............................   ($30,000,000)      ($40,317,491)
8/1/1994.............................       5,000,000          6,686,560
7/1/1995.............................         (1,000)            (1,267)
7/1/1995.............................       8,000,000         10,134,161
12/1/1995............................      17,000,000         21,011,112
7/1/1996.............................         (1,000)            (1,194)
7/1/1997.............................         (1,000)            (1,126)
7/1/1998.............................         (1,000)            (1,061)
7/1/1999.............................       3,000,000          3,000,000
7/1/1999.............................         650,000            650,000
7/1/1999.............................         (1,000)            (1,000)
                                      ----------------------------------
Rebate amount (7/01/1999)............                          1,158,694
------------------------------------------------------------------------


    (B) City B pays 90 percent of the rebate amount ($1,042,824.60) to 
the United States within 60 days of July 1, 1999.
    (iii) Next computation date. (A) On July 1, 2004, City B redeems all 
of the bonds. Thus, the next computation date is July 1, 2004. On July 
30, 1999, City B chose to compute rebate for periods following the first 
computation period by treating the end of each fifth bond year as a 
computation date. The yield during the second computation period is 
5.0000 percent per year compounded semiannually. The computation of the 
rebate amount as of this date reflects the value of the nonpurpose 
investments allocated to the issue at the end of the prior computation 
period. On July 1, 2004, City B sells those nonpurpose investments for 
$3,925,000 and expends that amount for the governmental purpose of the 
issue.
    (B) As of July 1, 2004, the future value of the rebate amount 
computed as of July 1, 1999, and of all other payments and receipts is:

------------------------------------------------------------------------
                                                 Receipts    FV (5.0000
                     Date                       (payments)    percent)
------------------------------------------------------------------------
7/1/1999.....................................   $1,158,694    $1,483,226
7/1/1999.....................................  (3,000,000)   (3,840,254)
7/1/2000.....................................      (1,000)       (1,218)
7/1/2001.....................................      (1,000)       (1,160)
7/1/2002.....................................      (1,000)       (1,104)
7/1/2003.....................................      (1,000)       (1,051)
7/1/2004.....................................      (2,000)       (2,000)
7/1/2004.....................................    3,925,000     3,925,000
                                              --------------------------
                                                               1,561,439
------------------------------------------------------------------------

    (C) As of this computation date, the future value of the payment 
made on July 1, 1999, is $1,334,904 and thus an additional rebate 
payment of $226,535 is due.
    (D) If the yield during the second computation period were, instead, 
7.0000 percent, the rebate amount computed as of July 1, 2004, would be 
$1,320,891. The future value of the payment made on July 1, 1999, would 
be $1,471,007. Although the future value of the payment made on July 1, 
1999 ($1,471,007), exceeds the rebate amount computed as of July 1, 2004 
($1,320,891), Sec. 1.148-3(i) limits the amount recoverable as a defined 
overpayment of rebate under section 148 to the excess of the total 
``amount paid'' over the sum of the amount determined under the future 
value method to be the ``rebate amount'' as of the most recent 
computation date and all

[[Page 98]]

other amounts that are otherwise required to be paid under section 148 
as of the date the recovery is requested. Because the total amount that 
the issuer paid on July 1, 1999 ($1,042,824.60), does not exceed the 
rebate amount as of July 1, 2004 ($1,320,891), the issuer would not be 
entitled to recover any overpayment of rebate in this case.

    (k) Bona fide debt service fund exception. Under section 
148(f)(4)(A), the rebate requirement does not apply to amounts in 
certain bona fide debt service funds. An issue with an average annual 
debt service that is not in excess of $2,500,000 may be treated as 
satisfying the $100,000 limitation in section 148(f)(4)(A)(ii).

[T.D. 8476, 58 FR 33522, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24042, May 10, 1994; T.D. 8476, 59 FR 24350, 
May 11, 1994; T.D. 8718, 62 FR 25507, May 9, 1997; T.D. 9701, 79 FR 
67351, Nov. 13, 2014; T.D. 9777, 81 FR 46593, July 18, 2016]



Sec. 1.148-4  Yield on an issue of bonds.

    (a) In general. The yield on an issue of bonds is used to apply 
investment yield restrictions under section 148(a) and to compute rebate 
liability under section 148(f). Yield is computed under the economic 
accrual method using any consistently applied compounding interval of 
not more than one year. A short first compounding interval and a short 
last compounding interval may be used. Yield is expressed as an annual 
percentage rate that is calculated to at least four decimal places (for 
example, 5.2525 percent). Other reasonable, standard financial 
conventions, such as the 30 days per month/360 days per year convention, 
may be used in computing yield but must be consistently applied. The 
yield on an issue that would be a purpose investment (absent section 
148(b)(3)(A)) is equal to the yield on the conduit financing issue that 
financed that purpose investment.
    (b) Computing yield on a fixed yield issue--(1) In general--(i) 
Yield on an issue. The yield on a fixed yield issue is the discount rate 
that, when used in computing the present value as of the issue date of 
all unconditionally payable payments of principal, interest, and fees 
for qualified guarantees on the issue and amounts reasonably expected to 
be paid as fees for qualified guarantees on the issue, produces an 
amount equal to the present value, using the same discount rate, of the 
aggregate issue price of bonds of the issue as of the issue date. 
Further, payments include certain amounts properly allocable to a 
qualified hedge. Yield on a fixed yield issue is computed as of the 
issue date and is not affected by subsequent unexpected events, except 
to the extent provided in paragraphs (b)(4) and (h)(3) of this section.
    (ii) Yield on a bond. Yield on a fixed yield bond is computed in the 
same manner as yield on a fixed yield issue.
    (2) Yield on certain fixed yield bonds subject to mandatory or 
contingent early redemption--(i) In general. The yield on a fixed yield 
issue that includes a bond subject to mandatory early redemption or 
expected contingent redemption is computed by treating that bond as 
redeemed on its reasonably expected early redemption date for an amount 
equal to its value on that date. Reasonable expectations are determined 
on the issue date. A bond is subject to mandatory early redemption if it 
is unconditionally payable in full before its final maturity date. A 
bond is subject to a contingent redemption if it must be, or is 
reasonably expected to be, redeemed prior to final maturity upon the 
occurrence of a contingency. A contingent redemption is taken into 
account only if the contingency is reasonably expected to occur, in 
which case the date of occurrence of the contingency must be reasonably 
estimated. For example, if bonds are reasonably expected to be redeemed 
early using excess revenues from general or special property taxes or 
benefit assessments or similar amounts, the reasonably expected 
redemption schedule is used to determine yield. For purposes of this 
paragraph (b)(2)(i), excess proceeds calls for issues for which the 
requirements of Sec. 1.148-2(e) (2) or (3) are satisfied, calamity 
calls, and refundings do not cause a bond to be subject to early 
redemption. The value of a bond is determined under paragraph (e) of 
this section.
    (ii) Substantially identical bonds subject to mandatory early 
redemption. If substantially identical bonds of an issue are subject to 
specified mandatory redemptions prior to final maturity (e.g., a 
mandatory sinking fund redemption requirement), yield on that

[[Page 99]]

issue is computed by treating those bonds as redeemed in accordance with 
the redemption schedule for an amount equal to their value. Generally, 
bonds are substantially identical if the stated interest rate, maturity, 
and payment dates are the same. In computing the yield on an issue 
containing bonds described in this paragraph (b)(2)(ii), each of those 
bonds must be treated as redeemed at its present value, unless the 
stated redemption price at maturity of the bond does not exceed the 
issue price of the bond by more than one-fourth of one percent 
multiplied by the product of the stated redemption price at maturity and 
the number of years to the weighted average maturity date of the 
substantially identical bonds, in which case each of those bonds must be 
treated as redeemed at its outstanding stated principal amount, plus 
accrued, unpaid interest. Weighted average maturity is determined by 
taking into account the mandatory redemption schedule.
    (3) Yield on certain fixed yield bonds subject to optional early 
redemption--(i) In general. If a fixed yield bond is subject to optional 
early redemption and is described in paragraph (b)(3)(ii) of this 
section, the yield on the issue containing the bond is computed by 
treating the bond as redeemed at its stated redemption price on the 
optional redemption date that would produce the lowest yield on that 
bond.
    (ii) Fixed yield bonds subject to special yield calculation rule. A 
fixed yield bond is described in this paragraph (b)(3)(ii) only if it--
    (A) Is subject to optional redemption within five years of the issue 
date, but only if the yield on the issue computed by assuming all bonds 
in the issue subject to redemption within 5 years of the issue date are 
redeemed at maturity is more than one-eighth of one percentage point 
higher than the yield on that issue computed by assuming all bonds 
subject to optional redemption within 5 years of the issue date are 
redeemed at the earliest date for their redemption;
    (B) Is issued at an issue price that exceeds the stated redemption 
price at maturity by more than one-fourth of one percent multiplied by 
the product of the stated redemption price at maturity and the number of 
complete years to the first optional redemption date for the bond; or
    (C) Bears interest at increasing interest rates (i.e., a stepped 
coupon bond).
    (4) Yield recomputed upon transfer of certain rights associated with 
the bond. For purposes of Sec. 1.148-3, as of the date of any transfer, 
waiver, modification, or similar transaction (collectively, a transfer) 
of any right that is part of the terms of a bond or is otherwise 
associated with a bond (e.g., a redemption right), in a transaction that 
is separate and apart from the original sale of the bond, the issue is 
treated as if it were retired and a new issue issued on the date of the 
transfer (reissued). The redemption price of the retired issue and the 
issue price of the new issue equal the aggregate values of all the bonds 
of the issue on the date of the transfer. In computing yield on the new 
issue, any amounts received by the issuer as consideration for the 
transfer are taken into account.
    (5) Special aggregation rule treating certain bonds as a single 
fixed yield bond. Two variable yield bonds of an issue are treated in 
the aggregate as a single fixed yield bond if--
    (i) Aggregate treatment would result in the single bond being a 
fixed yield bond; and
    (ii) The terms of the bonds do not contain any features that could 
distort the aggregate fixed yield from what the yield would be if a 
single fixed yield bond were issued. For example, if an issue contains a 
bond bearing interest at a floating rate and a related bond bearing 
interest at a rate equal to a fixed rate minus that floating rate, those 
two bonds are treated as a single fixed yield bond only if neither bond 
may be redeemed unless the other bond is also redeemed at the same time.
    (6) Examples. The provisions of this paragraph (b) may be 
illustrated by the following examples.

    Example 1. No early call--(i) Facts. On January 1, 1994, City A 
issues an issue consisting of four identical fixed yield bonds. The 
stated final maturity date of each bond is January 1, 2004, and no bond 
is subject to redemption before this date. Interest is payable on 
January 1 of each year at a rate of 6.0000 percent per year on the 
outstanding principal amount. The total stated principal amount

[[Page 100]]

of the bonds is $20 million. The issue price of the bonds $20,060,000.
    (ii) Computation. The yield on the issue is computed by treating the 
bonds as retired at the stated maturity under the general rule of 
Sec. 1.148-4(b)(1). The bonds are treated as redeemed for their stated 
redemption prices. The yield on the issue is 5.8731 percent per year 
compounded semiannually, computed as follows:

------------------------------------------------------------------------
                                                             PV (5.8731
                     Date                        Payments     percent)
------------------------------------------------------------------------
1/1/1995.....................................   $1,200,000    $1,132,510
1/1/1996.....................................    1,200,000     1,068,816
1/1/1997.....................................    1,200,000     1,008,704
1/1/1998.....................................    1,200,000       951,973
1/1/1999.....................................    1,200,000       898,433
1/1/2000.....................................    1,200,000       847,903
1/1/2001.....................................    1,200,000       800,216
1/1/2002.....................................    1,200,000       755,210
1/1/2003.....................................    1,200,000       712,736
1/1/2004.....................................   21,200,000    11,883,498
                                                           -------------
                                                              20,060,000
------------------------------------------------------------------------

    Example 2. Mandatory calls. (i) Facts. The facts are the same as in 
Example 1. In this case, however, the bonds are subject to mandatory 
sinking fund redemption on January 1 of each year, beginning January 1, 
2001. On each sinking fund redemption date, one of the bonds is chosen 
by lottery and is required to be redeemed at par plus accrued interest.
    (ii) Computation. Because the bonds are subject to specified 
redemptions, yield on the issue is computed by treating the bonds as 
redeemed in accordance with the redemption schedule under Sec. 1.148-
4(b)(2)(ii). Because the bonds are not sold at a discount, the bonds are 
treated as retired at their stated redemption prices. The yield on the 
issue is 5.8678 percent per year compounded semiannually, computed as 
follows:

------------------------------------------------------------------------
                                                             PV (5.8678
                     Date                        Payments     percent)
------------------------------------------------------------------------
1/1/1995.....................................   $1,200,000    $1,132,569
1/1/1996.....................................    1,200,000     1,068,926
1/1/1997.....................................    1,200,000     1,008,860
1/1/1998.....................................    1,200,000       952,169
1/1/1999.....................................    1,200,000       898,664
1/1/2000.....................................    1,200,000       848,166
1/1/2001.....................................    6,200,000     4,135,942
1/1/2002.....................................    5,900,000     3,714,650
1/1/2003.....................................    5,600,000     3,327,647
1/1/2004.....................................    5,300,000     2,972,407
                                                           -------------
                                                             $20,060,000
------------------------------------------------------------------------

    Example 3. Optional early call. (i) Facts. On January 1, 1994, City 
C issues an issue consisting of three bonds. Each bond has a stated 
principal amount of $10 million dollars and is issued for par. Bond X 
bears interest at 5 percent per year and matures on January 1, 1999. 
BondY bears interest at 6 percent per year and matures on January 1, 
2002. Bond Z bears interest at 7 percent per year and matures on January 
1, 2004. Bonds Y and Z are callable by the issuer at par plus accrued 
interest after December 31, 1998.
    (ii) Computation. (A) The yield on the issue computed as if each 
bond is outstanding to its maturity is 6.0834 percent per year 
compounded semiannually, computed as follows:

------------------------------------------------------------------------
                                                             PV (6.0834
                     Date                        Payments     percent)
------------------------------------------------------------------------
1/1/1995.....................................   $1,800,000    $1,695,299
1/1/1996.....................................    1,800,000     1,596,689
1/1/1997.....................................    1,800,000     1,503,814
1/1/1998.....................................    1,800,000     1,416,342
1/1/1999.....................................   11,800,000     8,744,830
1/1/2000.....................................    1,300,000       907,374
1/1/2001.....................................    1,300,000       854,595
1/1/2002.....................................   11,300,000     6,996,316
1/1/2003.....................................      700,000       408,190
1/1/2004.....................................   10,700,000     5,876,551
                                                           -------------
                                                              30,000,000
------------------------------------------------------------------------

    (B) The yield on the issue computed as if all bonds are called at 
the earliest date for redemption is 5.9126 percent per year compounded 
semiannually, computed as follows:

------------------------------------------------------------------------
                                                             PV (5.9126
                     Date                        Payments     percent)
------------------------------------------------------------------------
1/1/1995.....................................   $1,800,000    $1,698,113
1/1/1996.....................................    1,800,000     1,601,994
1/1/1997.....................................    1,800,000     1,511,315
1/1/1998.....................................    1,800,000     1,425,769
1/1/1999.....................................   31,800,000    23,762,809
                                                           -------------
                                                              30,000,000
------------------------------------------------------------------------

    (C) Because the yield on the issue computed by assuming all bonds in 
the issue subject to redemption within 5 years of the issue date are 
redeemed at maturity is more than one-eighth of one percentage point 
higher than the yield on the issue computed by assuming all bonds 
subject to optional redemption within 5 years of the issue date are 
redeemed at the earliest date for their redemption, each bond is treated 
as redeemed on the date that would produce the lowest yield for the 
issue. The lowest yield on the issue would result from a redemption of 
all the bonds on January 1, 1999. Thus, the yield on the issue is 5.9126 
percent per year compounded semiannually.

    (c) Computing yield on a variable yield issue--(1) In general. The 
yield on a variable yield issue is computed separately for each 
computation period. The yield for each computation period is the 
discount rate that, when used in computing the present value as of the 
first day of the computation period of all the payments of principal and 
interest and fees for qualified guarantees that are attributable to the 
computation period, produces an amount equal

[[Page 101]]

to the present value, using the same discount rate, of the aggregate 
issue price (or deemed issue price, as determined in paragraph 
(c)(2)(iv) of this section) of the bonds of the issue as of the first 
day of the computation period. The yield on a variable yield bond is 
computed in the same manner as the yield on a variable yield issue. 
Except as provided in paragraph (c)(2) of this section, yield on any 
fixed yield bond in a variable yield issue is computed in the same 
manner as the yield on a fixed yield issue as provided in paragraph (b) 
of this section.
    (2) Payments on bonds included in yield for a computation period--
(i) Payments in general. The payments on a bond that are attributable to 
a computation period include any amounts actually paid during the period 
for principal on the bond. Payments also include any amounts paid during 
the current period both for interest accruing on the bond during the 
current period and for interest accruing during the prior period that 
was included in the deemed issue price of the bond as accrued unpaid 
interest at the start of the current period under this paragraph (c)(2). 
Further, payments include any amounts properly allocable to fees for a 
qualified guarantee of the bond for the period and to any amounts 
properly allocable to a qualified hedge for the period.
    (ii) Payments at actual redemption. If a bond is actually redeemed 
during a computation period, an amount equal to the greater of its value 
on the redemption date or the actual redemption price is a payment on 
the actual redemption date.
    (iii) Payments for bonds outstanding at end of computation period. 
If a bond is outstanding at the end of a computation period, a payment 
equal to the bond's value is taken into account on the last day of that 
period.
    (iv) Issue price for bonds outstanding at beginning of next 
computation period. A bond outstanding at the end of a computation 
period is treated as if it were immediately reissued on the next day for 
a deemed issue price equal to the value from the day before as 
determined under paragraph (c)(2)(iii) of this section.
    (3) Example. The provisions of this paragraph (c) may be illustrated 
by the following example.

    Example. On January 1, 1994, City A issues an issue of identical 
plain par bonds in an aggregate principal amount of $1,000,000. The 
bonds pay interest at a variable rate on each June 1 throughout the term 
of the issue. The entire principal amount of the bonds plus accrued, 
unpaid interest is payable on the final maturity date of January 1, 
2000. No bond year is selected. On June 1, 1994, 1995, 1996, 1997, and 
1998, interest in the amounts of $30,000, $55,000, $57,000, $56,000, and 
$45,000 is paid on the bonds. From June 1, 1998, to January 1, 1999, 
$30,000 of interest accrues on the bonds. From January 1, 1999, to June 
1, 1999, another $35,000 of interest accrues. On June 1, 1999, the 
issuer actually pays $65,000 of interest. On January 1, 2000, $1,000,000 
of principal and $38,000 of accrued interest are paid. The payments for 
the computation period starting on the issue date and ending on January 
1, 1999, include all annual interest payments paid from the issue date 
to June 1, 1998. Because the issue is outstanding on January 1, 1999, it 
is treated as redeemed on that date for amount equal to its value 
($1,000,000 plus accrued, unpaid interest of $30,000 under paragraph 
(e)(1) of this section). Thus, $1,030,000 is treated as paid on January 
1, 1999. The issue is then treated as reissued on January 1, 1999, for 
$1,030,000. The payments for the next computation period starting on 
January 1, 1999, and ending on January 1, 2000, include the interest 
actually paid on the bonds during that period ($65,000 on June 1, 1999, 
plus $38,000 paid on January 1, 2000). Because the issue was actually 
redeemed on January 1, 2000, an amount equal to its stated redemption 
price is also treated as paid on January 1, 2000.

    (d) Conversion from variable yield issue to fixed yield issue. For 
purposes of determining yield under this section, as of the first day on 
which a variable yield issue would qualify as a fixed yield issue if it 
were newly issued on that date (a conversion date), that issue is 
treated as if it were reissued as a fixed yield issue on the conversion 
date. The redemption price of the variable yield issue and the issue 
price of the fixed yield issue equal the aggregate values of all the 
bonds on the conversion date. Thus, for example, for plain par bonds 
(e.g., tender bonds), the deemed issue price would be the outstanding 
principal amount, plus accrued unpaid interest. If the conversion date 
occurs on a date other than a computation date, the issuer may continue 
to treat the issue as a variable

[[Page 102]]

yield issue until the next computation date, at which time it must be 
treated as converted to a fixed yield issue.
    (e) Value of bonds--(1) Plain par bonds. Except as otherwise 
provided, the value of a plain par bond is its outstanding stated 
principal amount, plus accrued unpaid interest. The value of a plain par 
bond that is actually redeemed or treated as redeemed is its stated 
redemption price on the redemption date, plus accrued, unpaid interest.
    (2) Other bonds. The value of a bond other than a plain par bond on 
a date is its present value on that date. The present value of a bond is 
computed under the economic accrual method taking into account all the 
unconditionally payable payments of principal, interest, and fees for a 
qualified guarantee to be paid on or after that date and using the yield 
on the bond as the discount rate, except that for purposes of 
Sec. 1.148-6(b)(2) (relating to the universal cap), these values may be 
determined by consistently using the yield on the issue of which the 
bonds are a part. To determine yield on fixed yield bonds, see paragraph 
(b)(1) of this section. The rules contained in paragraphs (b)(2) and 
(b)(3) of this section apply for this purpose. In the case of bonds 
described in paragraph (b)(2)(ii) of this section, the present value of 
those bonds on any date is computed using the yield to the final 
maturity date of those bonds as the discount rate. In determining the 
present value of a variable yield bond under this paragraph (e)(2), the 
initial interest rate on the bond established by the interest index or 
other interest rate setting mechanism is used to determine the interest 
payments on that bond.
    (f) Qualified guarantees--(1) In general. Fees properly allocable to 
payments for a qualified guarantee for an issue (as determined under 
paragraph (f)(6) of this section) are treated as additional interest on 
that issue under section 148. A guarantee is a qualified guarantee if it 
satisfies each of the requirements of paragraphs (f)(2) through (f)(4) 
of this section.
    (2) Interest savings. As of the date the guarantee is obtained, the 
issuer must reasonably expect that the present value of the fees for the 
guarantee will be less than the present value of the expected interest 
savings on the issue as a result of the guarantee. For this purpose, 
present value is computed using the yield on the issue, determined with 
regard to guarantee payments, as the discount rate.
    (3) Guarantee in substance. The arrangement must create a guarantee 
in substance. The arrangement must impose a secondary liability that 
unconditionally shifts substantially all of the credit risk for all or 
part of the payments, such as payments for principal and interest, 
redemption prices, or tender prices, on the guaranteed bonds. Reasonable 
procedural or administrative requirements of the guarantee do not cause 
the guarantee to be conditional. In the case of a guarantee against 
failure to remarket a qualified tender bond, commercially reasonable 
limitations based on credit risk, such as limitations on payment in the 
event of default by the primary obligor or the bankruptcy of a long-term 
credit guarantor, do not cause the guarantee to be conditional. The 
guarantee may be in any form. The guarantor may not be a co-obligor. 
Thus, the guarantor must not expect to make any payments other than 
under a direct-pay letter of credit or similar arrangement for which the 
guarantor will be reimbursed immediately. The guarantor and any related 
parties together must not use more than 10 percent of the proceeds of 
the portion of the issue allocable to the guaranteed bonds.
    (4) Reasonable charge--(i) In general. Fees for a guarantee must not 
exceed a reasonable, arm's-length charge for the transfer of credit 
risk. In complying with this requirement, the issuer may not rely on the 
representations of the guarantor.
    (ii) Fees for services other than transfer of credit risk must be 
separately stated. A fee for a guarantee must not include any payment 
for any direct or indirect services other than the transfer of credit 
risk, unless the compensation for those other services is separately 
stated, reasonable, and excluded from the guarantee fee. Fees for the 
transfer of credit risk include fees for the guarantor's overhead and 
other costs relating to the transfer of credit risk. For example, a fee 
includes payment for

[[Page 103]]

services other than transfer of credit risk if--
    (A) It includes payment for the cost of underwriting or remarketing 
bonds or for the cost of insurance for casualty to bond-financed 
property;
    (B) It is refundable upon redemption of the guaranteed bond before 
the final maturity date and the amount of the refund would exceed the 
portion of the fee that had not been earned; or
    (C) The requirements of Sec. 1.148-2(e)(2) (relating to temporary 
periods for capital projects) are not satisfied, and the guarantor is 
not reasonably assured that the bonds will be repaid if the project to 
be financed is not completed.
    (5) Guarantee of purpose investments. Except for guarantees of 
qualified mortgage loans and qualified student loans, a guarantee of 
payments on a purpose investment is a qualified guarantee of the issue 
if all payments on the purpose investment reasonably coincide with 
payments on the related bonds and the payments on the purpose investment 
are unconditionally payable no more than 6 months before the 
corresponding interest payment and 12 months before the corresponding 
principal payments on the bonds. This paragraph (f)(5) only applies if, 
in addition to satisfying the other requirements of this paragraph (f), 
the guarantee is, in substance, a guarantee of the bonds allocable to 
that purpose investment and to no other bonds except for bonds that are 
equally and ratably secured by purpose investments of the same conduit 
borrower.
    (6) Allocation of qualified guarantee payments--(i) In general. 
Payments for a qualified guarantee must be allocated to bonds and to 
computation periods in a manner that properly reflects the proportionate 
credit risk for which the guarantor is compensated. Proportionate credit 
risk for bonds that are not substantially identical may be determined 
using any reasonable, consistently applied method. For example, this 
risk may be based on the ratio of the total principal and interest paid 
and to be paid on a guaranteed bond to the total principal and interest 
paid and to be paid on all bonds of the guaranteed issue. An allocation 
method generally is not reasonable, for example, if a substantial 
portion of the fee is allocated to the construction portion of the issue 
and a correspondingly insubstantial portion is allocated to the later 
years covered by the guarantee. Reasonable letter of credit set up fees 
may be allocated ratably during the initial term of the letter of 
credit. Upon an early redemption of a variable yield bond, fees 
otherwise allocable to the period after the redemption are allocated to 
remaining outstanding bonds of the issue or, if none remain outstanding, 
to the period before the redemption.
    (ii) Safe harbor for allocation of qualified guarantee fees for 
variable yield issues. An allocation of non-level payments for a 
qualified guarantee for variable yield bonds is treated as meeting the 
requirements of paragraph (f)(6)(i) of this section if, for each bond 
year for which the guarantee is in effect, an equal amount (or for any 
short bond year, a proportionate amount of the equal amount) is treated 
as paid as of the beginning of that bond year. The present value of the 
annual amounts must equal the fee for the guarantee allocated to that 
bond, with present value computed as of the first day the guarantee is 
in effect by using as the discount rate the yield on the variable yield 
bonds covered by the guarantee, determined without regard to any fee 
allocated under this paragraph (f)(6)(ii).
    (7) Refund or reduction of guarantee payments. If as a result of an 
investment of proceeds of a refunding issue in a refunding escrow, there 
will be a reduction in, or refund of, payments for a guarantee 
(savings), the savings must be treated as a reduction in the payments on 
the refunding issue.
    (g) Yield on certain mortgage revenue and student loan bonds. For 
purposes of section 148 and this section, section 143(g)(2)(C)(ii) 
applies to the computation of yield on an issue of qualified mortgage 
bonds or qualified veterans' mortgage bonds. For purposes of applying 
section 148 and section 143(g) with respect to purpose investments 
allocable to a variable yield issue of qualified mortgage bonds, 
qualified veterans' mortgage bonds, or qualified student loan bonds that 
is reasonably expected as of the issue date to convert to a fixed yield 
issue, the yield may be

[[Page 104]]

computed over the term of the issue, and, if the yield is so computed, 
paragraph (d) of this section does not apply to the issue. As of any 
date, the yield over the term of the issue is based on--
    (1) With respect to any bond of the issue that has not converted to 
a fixed and determinable yield on or before that date, the actual 
amounts paid or received to that date and the amounts that are 
reasonably expected (as of that date) to be paid or received with 
respect to that bond over the remaining term of the issue (taking into 
account prepayment assumptions under section 143(g)(2)(B)(iv), if 
applicable); and
    (2) With respect to any bond of the issue that has converted to a 
fixed and determinable yield on or before that date, the actual amounts 
paid or received before that bond converted, if any, and the amount that 
was reasonably expected (on the date that bond converted) to be paid or 
received with respect to that bond over the remaining term of the issue 
(taking into account prepayment assumptions under section 
143(g)(2)(B)(iv), if applicable).
    (h) Qualified hedging transactions--(1) In general. Payments made or 
received by an issuer under a qualified hedge (as defined in paragraph 
(h)(2) of this section) relating to bonds of an issue are taken into 
account (as provided in paragraph (h)(3) of this section) to determine 
the yield on the issue. Except as provided in paragraphs (h)(4) and 
(h)(5)(ii)(E) of this section, the bonds to which a qualified hedge 
relates are treated as variable yield bonds from the issue date of the 
bonds. This paragraph (h) applies solely for purposes of sections 
143(g), 148, and 149(d).
    (2) Qualified hedge defined. Except as provided in paragraph (h)(5) 
of this section, the term qualified hedge means a contract that 
satisfies each of the following requirements:
    (i) Hedge--(A) In general. The contract is entered into primarily to 
modify the issuer's risk of interest rate changes with respect to a bond 
(a hedge). For example, the contract may be an interest rate swap, an 
interest rate cap, a futures contract, a forward contract, or an option.
    (B) Special rule for fixed rate issues. If the contract modifies the 
issuer's risk of interest rate changes with respect to a bond that is 
part of an issue that, absent the contract, would be a fixed rate issue, 
the contract must be entered into--
    (1) No later than 15 days after the issue date (or the deemed issue 
date under paragraph (d) of this section) of the issue; or
    (2) No later than the expiration of a qualified hedge with respect 
to bonds of that issue that satisfies paragraph (h)(2)(i)(B)(1) of this 
section; or
    (3) No later than the expiration of a qualified hedge with respect 
to bonds of that issue that satisfies either paragraph (h)(2)(i)(B)(2) 
of this section or this paragraph (h)(2)(i)(B)(3).
    (C) Contracts with certain acquisition payments. If a hedge provider 
makes a single payment to the issuer (e.g., a payment for an off-market 
swap) in connection with the acquisition of a contract, the issuer may 
treat a portion of that contract as a hedge provided--
    (1) The hedge provider's payment to the issuer and the issuer's 
payments under the contract in excess of those that it would make if the 
contract bore rates equal to the on-market rates for the contract 
(determined as of the date the parties enter into the contract) are 
separately identified in a certification of the hedge provider; and
    (2) The payments described in paragraph (h)(2)(i)(C)(1) of this 
section are not treated as payments on the hedge.
    (ii) No significant investment element--(A) In general. The contract 
does not contain a significant investment element. Except as provided in 
paragraph (h)(2)(ii)(B) of this section, a contract contains a 
significant investment element if a significant portion of any payment 
by one party relates to a conditional or unconditional obligation by the 
other party to make a payment on a different date. Examples of contracts 
that contain a significant investment element are a debt instrument held 
by the issuer; an interest rate swap requiring any payments other than 
periodic payments, within the meaning of Sec. 1.446-3 (periodic 
payments) (e.g., a payment for an off-market swap or prepayment of part 
or all of one leg of a swap); and an interest rate cap requiring the 
issuer's premium for the cap to

[[Page 105]]

be paid in a single, up-front payment. Solely for purposes of 
determining if a hedge is a qualified hedge under this section, payments 
that an issuer receives pursuant to the terms of a hedge that are equal 
to the issuer's cost of funds are treated as periodic payments under 
Sec. 1.446-3 without regard to whether the payments are calculated by 
reference to a ``specified index'' described in Sec. 1.446-3(c)(2). 
Accordingly, a hedge does not have a significant investment element 
under this paragraph (h)(2)(ii)(A) solely because an issuer receives 
payments pursuant to the terms of a hedge that are computed to be equal 
to the issuer's cost of funds, such as the issuer's actual market-based 
tax-exempt variable interest rate on its bonds.
    (B) Special level payment rule for interest rate caps. An interest 
rate cap does not contain a significant investment element if--
    (1) All payments to the issuer by the hedge provider are periodic 
payments;
    (2) The issuer makes payments for the cap at the same time as 
periodic payments by the hedge provider must be made if the specified 
index (within the meaning of Sec. 1.446-3) of the cap is above the 
strike price of the cap; and
    (3) Each payment by the issuer bears the same ratio to the notional 
principal amount (within the meaning of Sec. 1.446-3) that is used to 
compute the hedge provider's payment, if any, on that date.
    (iii) Parties. The contract is entered into between the issuer or 
the political subdivision on behalf of which the issuer issues the bonds 
(collectively referred to in this paragraph (h) as the issuer) and a 
provider that is not a related party (the hedge provider).
    (iv) Hedged bonds. The contract covers, in whole or in part, all of 
one or more groups of substantially identical bonds in the issue (i.e., 
all of the bonds having the same interest rate, maturity, and terms). 
Thus, for example, a qualified hedge may include a hedge of all or a pro 
rata portion of each interest payment on the variable rate bonds in an 
issue for the first 5 years following their issuance. For purposes of 
this paragraph (h), unless the context clearly requires otherwise, 
hedged bonds means the specific bonds or portions thereof covered by a 
hedge.
    (v) Interest-based contract and size and scope of hedge. The 
contract is primarily interest-based (for example, a hedge based on a 
debt index, including a tax-exempt debt index or a taxable debt index, 
rather than an equity index). In addition, the size and scope of the 
hedge under the contract is limited to that which is reasonably 
necessary to hedge the issuer's risk with respect to interest rate 
changes on the hedged bonds. For example, a contract is limited to 
hedging an issuer's risk with respect to interest rate changes on the 
hedged bonds if the hedge is based on the principal amount and the 
reasonably expected interest payments of the hedged bonds. For 
anticipatory hedges under paragraph (h)(5) of this section, the size and 
scope limitation applies based on the reasonably expected terms of the 
hedged bonds to be issued. A contract is not primarily interest based 
unless--
    (A) The hedged bond, without regard to the contract, is either a 
fixed rate bond, a variable rate debt instrument within the meaning of 
Sec. 1.1275-5 provided the rate is not based on an objective rate other 
than a qualified inverse floating rate or a qualified inflation rate, a 
tax-exempt obligation described in Sec. 1.1275-4(d)(2), or an inflation-
indexed debt instrument within the meaning of Sec. 1.1275-7; and
    (B) As a result of treating all payments on (and receipts from) the 
contract as additional payments on (and receipts from) the hedged bond, 
the resulting bond would be substantially similar to either a fixed rate 
bond, a variable rate debt instrument within the meaning of Sec. 1.1275-
5 provided the rate is not based on an objective rate other than a 
qualified inverse floating rate or a qualified inflation rate, a tax-
exempt obligation described in Sec. 1.1275-4(d)(2), or an inflation-
indexed debt instrument within the meaning of Sec. 1.1275-7. For this 
purpose, differences that would not prevent the resulting bond from 
being substantially similar to another type of bond include: a 
difference between the interest rate used to compute payments on the 
hedged bond and the interest rate used to compute payments on the hedge 
where one

[[Page 106]]

interest rate is substantially similar to the other; the difference 
resulting from the payment of a fixed premium for a cap (for example, 
payments for a cap that are made in other than level installments); and 
the difference resulting from the allocation of a termination payment 
where the termination was not expected as of the date the contract was 
entered into.
    (vi) Payments closely correspond. The payments received by the 
issuer from the hedge provider under the contract correspond closely in 
time to either the specific payments being hedged on the hedged bonds or 
specific payments required to be made pursuant to the bond documents, 
regardless of the hedge, to a sinking fund, debt service fund, or 
similar fund maintained for the issue of which the hedged bond is a 
part. For this purpose, such payments will be treated as corresponding 
closely in time under this paragraph (h)(2)(vi) if they are made within 
90 calendar days of each other.
    (vii) Source of payments. Payments to the hedge provider are 
reasonably expected to be made from the same source of funds that, 
absent the hedge, would be reasonably expected to be used to pay 
principal and interest on the hedged bonds.
    (viii) Identification--(A) In general. The actual issuer must 
identify the contract on its books and records maintained for the hedged 
bonds not later than 15 calendar days after the date on which there is a 
binding agreement to enter into a hedge contract (for example, the date 
of a hedge pricing confirmation, as distinguished from the closing date 
for the hedge or start date for payments on the hedge, if different). 
The identification must specify the name of the hedge provider, the 
terms of the contract, the hedged bonds, and include a hedge provider's 
certification as described in paragraph (h)(2)(viii)(B) of this section. 
The identification must contain sufficient detail to establish that the 
requirements of this paragraph (h)(2) and, if applicable, paragraph 
(h)(4) of this section are satisfied. In addition, the existence of the 
hedge must be noted on the first form relating to the issue of which the 
hedged bonds are a part that is filed with the Internal Revenue Service 
on or after the date on which the contract is identified pursuant to 
this paragraph (h)(2)(viii).
    (B) Hedge provider's certification. The hedge provider's 
certification must--
    (1) Provide that the terms of the hedge were agreed to between a 
willing buyer and 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. See 
Sec. 601.601(d)(2)(ii) of this chapter.
    (3) Accounting for qualified hedges--(i) In general. Except as 
otherwise provided in paragraph (h)(4) of this section, payments made or 
received by the issuer under a qualified hedge are treated as payments 
made or received, as appropriate, on the hedged bonds that are taken 
into account in determining the yield on those bonds. These payments are 
reasonably allocated to the hedged bonds in the period to which the 
payments relate, as determined under paragraph (h)(3)(iii) of this 
section. Payments made or received by the issuer include payments deemed 
made or received when a contract is terminated or deemed terminated 
under this paragraph (h)(3). Payments reasonably allocable to the 
modification of risk of interest rate changes and to the hedge 
provider's overhead under this paragraph (h) are included as payments 
made or received under a qualified hedge.
    (ii) Exclusions from hedge. If any payment for services or other 
items under the contract is not expressly treated by paragraph (h)(3)(i) 
of this section as a

[[Page 107]]

payment under the qualified hedge, the payment is not a payment with 
respect to a qualified hedge.
    (iii) Timing and allocation of payments. Except as provided in 
paragraphs (h)(3)(iv) and (h)(5) of this section, payments made or 
received by the issuer under a qualified hedge are taken into account in 
the same period in which those amounts would be treated as income or 
deductions under Sec. 1.446-4 (without regard to Sec. 1.446-4(a)(2)(iv)) 
and are adjusted as necessary to reflect the end of a computation period 
and the start of a new computation period.
    (iv) Termination payments--(A) Modification defined. A modification 
of a qualified hedge includes, without limitation, a change in the terms 
of the hedge or an issuer's acquisition of another hedge with terms that 
have the effect of modifying an issuer's risk of interest rate changes 
or other terms of an existing qualified hedge. For example, if the 
issuer enters into a qualified hedge that is an interest rate swap under 
which it receives payments based on the Securities Industry and 
Financial Market Association (SIFMA) Municipal Swap Index and 
subsequently enters a second hedge (with the same or different provider) 
that limits the issuer's exposure under the existing qualified hedge to 
variations in the SIFMA Municipal Swap Index, the new hedge modifies the 
qualified hedge.
    (B) Termination defined. A termination means either an actual 
termination or a deemed termination of a qualified hedge. Except as 
otherwise provided, an actual termination of a qualified hedge occurs to 
the extent that the issuer sells, disposes of, or otherwise actually 
terminates all or a portion of the hedge. A deemed termination of a 
qualified hedge occurs if the hedge ceases to meet the requirements for 
a qualified hedge; the issuer makes a modification (as defined in 
paragraph (h)(3)(iv)(A) of this section) that is material either in kind 
or in extent and, therefore, results in a deemed exchange of the hedge 
and a realization event to the issuer under section 1001; or the issuer 
redeems all or a portion of the hedged bonds.
    (C) Special rules for certain modifications when the hedge remains 
qualified. A modification of a qualified hedge that otherwise would 
result in a deemed termination under paragraph (h)(3)(iv)(B) of this 
section does not result in such a termination if the modified hedge is 
re-tested for qualification as a qualified hedge as of the date of the 
modification, the modified hedge meets the requirements for a qualified 
hedge as of such date, and the modified hedge is treated as a qualified 
hedge prospectively in determining the yield on the hedged bonds. For 
purposes of this paragraph (h)(3)(iv)(C), when determining whether the 
modified hedge is qualified, the fact that the existing qualified hedge 
is off-market as of the date of the modification is disregarded and the 
identification requirement in paragraph (h)(2)(viii) of this section 
applies by measuring the time period for identification from the date of 
the modification and without regard to the requirement for a hedge 
provider's certification.
    (D) Continuations of certain qualified hedges in refundings. If 
hedged bonds are redeemed using proceeds of a refunding issue, the 
qualified hedge for the refunded bonds is not actually terminated, and 
the hedge meets the requirements for a qualified hedge for the refunding 
bonds as of the issue date of the refunding bonds, then no termination 
of the hedge occurs and the hedge instead is treated as a qualified 
hedge for the refunding bonds. For purposes of this paragraph 
(h)(3)(iv)(D), when determining whether the hedge is a qualified hedge 
for the refunding bonds, the fact that the hedge is off-market with 
respect to the refunding bonds as of the issue date of the refunding 
bonds is disregarded and the identification requirement in paragraph 
(h)(2)(viii) of this section 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.
    (E) General allocation rules for hedge termination payments. Except 
as otherwise provided in paragraphs (h)(3)(iv)(F), (G), and (H) of this 
section, a payment made or received by an issuer to terminate a 
qualified hedge, or a payment deemed made or received for a deemed 
termination, is treated as

[[Page 108]]

a payment made or received, as appropriate, on the hedged bonds. Upon an 
actual termination or a deemed termination of a qualified hedge, the 
amount that an issuer may treat as a termination payment made or 
received on the hedged bonds is the fair market value of the qualified 
hedge on its termination date, based on all of the facts and 
circumstances. Except as otherwise provided, a termination payment is 
reasonably allocated to the remaining periods originally covered by the 
terminated hedge in a manner that reflects the economic substance of the 
hedge.
    (F) Special rule for terminations when bonds are redeemed. Except as 
otherwise provided in this paragraph (h)(3)(iv)(F) and in paragraph 
(h)(3)(iv)(G) of this section, when a qualified hedge is deemed 
terminated because the hedged bonds are redeemed, the termination 
payment as determined under paragraph (h)(3)(iv)(E) of this section is 
treated as made or received on that date. When hedged bonds are 
redeemed, any payment received by the issuer on termination of a hedge, 
including a termination payment or a deemed termination payment, 
reduces, but not below zero, the interest payments made by the issuer on 
the hedged bonds in the computation period ending on the termination 
date. The remainder of the payment, if any, is reasonably allocated over 
the bond years in the immediately preceding computation period or 
periods to the extent necessary to eliminate the excess.
    (G) Special rules for refundings. When there is a termination of a 
qualified hedge because there is a refunding of the hedged bonds, to the 
extent that the hedged bonds are redeemed using the proceeds of a 
refunding issue, the termination payment is accounted for under 
paragraph (h)(3)(iv)(E) of this section by treating it as a payment on 
the refunding issue, rather than the hedged bonds. In addition, to the 
extent that the refunding issue is redeemed during the period to which 
the termination payment has been allocated to that issue, paragraph 
(h)(3)(iv)(F) of this section applies to the termination payment by 
treating it as a payment on the redeemed refunding issue.
    (H) Safe harbor for allocation of certain termination payments. A 
payment to terminate a qualified hedge does not result in that hedge 
failing to satisfy the applicable provisions of paragraph (h)(3)(iv)(E) 
of this section if that payment is allocated in accordance with this 
paragraph (h)(3)(iv)(H). For an issue that is a variable yield issue 
after termination of a qualified hedge, an amount must be allocated to 
each date on which the hedge provider's payment, if any, would have been 
made had the hedge not been terminated. The amounts allocated to each 
date must bear the same ratio to the notional principal amount (within 
the meaning of Sec. 1.446-3) that would have been used to compute the 
hedge provider's payment, if any, on that date, and the sum of the 
present values of those amounts must equal the present value of the 
termination payment. Present value is computed as of the day the 
qualified hedge is terminated, using the yield on the hedged bonds, 
determined without regard to the termination payment. The yield used for 
this purpose is computed for the period beginning on the first date the 
qualified hedge is in effect and ending on the date the qualified hedge 
is terminated. On the other hand, for an issue that is a fixed yield 
issue after termination of a qualified hedge, the termination payment is 
taken into account as a single payment on the date it is paid.
    (4) Certain variable yield bonds treated as fixed yield bonds--(i) 
In general. Except as otherwise provided in this paragraph (h)(4), if 
the issuer of variable yield bonds enters into a qualified hedge, the 
hedged bonds are treated as fixed yield bonds paying a fixed interest 
rate if:
    (A) Maturity. The term of the hedge is equal to the entire period 
during which the hedged bonds bear interest at variable interest rates, 
and the issuer does not reasonably expect that the hedge will be 
terminated before the end of that period.
    (B) Payments closely correspond. Payments to be received under the 
hedge correspond closely in time to the hedged portion of payments on 
the hedged bonds. Hedge payments received within 15 days of the related

[[Page 109]]

payments on the hedged bonds generally so correspond.
    (C) Aggregate payments fixed. Taking into account all payments made 
and received under the hedge and all payments on the hedged bonds (i.e., 
after netting all payments), the issuer's aggregate payments are fixed 
and determinable as of a date not later than 15 days after the issue 
date of the hedged bonds. Payments on bonds are treated as fixed for 
purposes of this paragraph (h)(4)(i)(C) if payments on the bonds are 
based, in whole or in part, on one interest rate, payments on the hedge 
are based, in whole or in part, on a second interest rate that is 
substantially the same as, but not identical to, the first interest rate 
and payments on the bonds would be fixed if the two rates were 
identical. Rates are treated as substantially the same if they are 
reasonably expected to be substantially the same throughout the term of 
the hedge. For example, an objective 30-day tax-exempt variable rate 
index or other objective index may be substantially the same as an 
issuer's individual 30-day interest rate. A hedge based on a taxable 
interest rate or taxable interest index cannot meet the requirements of 
this paragraph (h)(4)(i)(C) unless either--
    (1) The hedge is an anticipatory hedge that is terminated or 
otherwise closed substantially contemporaneously with the issuance of 
the hedged bond in accordance with paragraph (h)(5)(ii) or (iii) of this 
section; or
    (2) The issuer's payments on the hedged bonds and the hedge 
provider's payments on the hedge are based on identical interest rates.
    (ii) Accounting. Except as otherwise provided in this paragraph 
(h)(4)(ii), in determining yield on the hedged bonds, all the issuer's 
payments on the hedged bonds and all payments made and received on a 
hedge described in paragraph (h)(4)(i) of this section are taken into 
account. If payments on the bonds and payments on the hedge are based, 
in whole or in part, on variable interest rates that are substantially 
the same within the meaning of paragraph (h)(4)(i)(C) of this section 
(but not identical), yield on the issue is determined by treating the 
variable interest rates as identical. For example, if variable rate 
bonds bearing interest at a weekly rate equal to the rate necessary to 
remarket the bonds at par are hedged with an interest rate swap under 
which the issuer receives payments based on a short-term floating rate 
index that is substantially the same as, but not identical to, the 
weekly rate on the bonds, the interest payments on the bonds are treated 
as equal to the payments received by the issuer under the swap for 
purposes of computing the yield on the bonds.
    (iii) Effect of termination--(A) In general. Except as otherwise 
provided in this paragraph (h)(4)(iii) and paragraph (h)(5) of this 
section, the issue of which the hedged bonds are a part is treated as if 
it were reissued as of the termination date of the qualified hedge 
covered by paragraph (h)(4)(i) of this section in determining yield on 
the hedged bonds for purposes of Sec. 1.148-3. The redemption price of 
the retired issue and the issue price of the new issue equal the 
aggregate values of all the bonds of the issue on the termination date. 
In computing the yield on the new issue for this purpose, any 
termination payment is accounted for under paragraph (h)(3)(iv) of this 
section, applied by treating the termination payment as made or received 
on the new issue under this paragraph (h)(4)(iii).
    (B) Effect of early termination. Except as otherwise provided in 
this paragraph (h)(4)(iii), the general rules of paragraph (h)(4)(i) of 
this section do not apply in determining the yield on the hedged bonds 
for purposes of Sec. 1.148-3 if the hedge is terminated or deemed 
terminated within 5 years after the issue date of the issue of which the 
hedged bonds are a part. Thus, the hedged bonds are treated as variable 
yield bonds for purposes of Sec. 1.148-3 from the issue date.
    (C) Certain terminations disregarded. This paragraph (h)(4)(iii) 
does not apply to a termination if, based on the facts and circumstances 
(e.g., taking into account both the termination and any qualified hedge 
that immediately replaces the terminated hedge), there is no change in 
the yield.

[[Page 110]]

    (iv) Consequences of certain modifications. The special rules under 
paragraph (h)(4)(iii) of this section regarding the effects of 
termination of a qualified hedge of fixed yield hedged bonds apply to a 
modification described in paragraph (h)(3)(iv)(C) of this section. Thus, 
such a modification is treated as a termination for purposes of 
paragraph (h)(4)(iii) of this section unless the rule in paragraph 
(h)(4)(iii)(C) applies.
    (5) Contracts entered into before issue date of hedged bond--(i) In 
general. A contract does not fail to be a hedge under paragraph 
(h)(2)(i) of this section solely because it is entered into before the 
issue date of the hedged bond. However, that contract must be one to 
which either paragraph (h)(5)(ii) or (h)(5)(iii) of this section 
applies.
    (ii) Contracts expected to be closed substantially contemporaneously 
with the issue date of hedged bond--(A) Application. This paragraph 
(h)(5)(ii) applies to a contract if, on the date the contract is 
identified, the issuer reasonably expects to terminate or otherwise 
close (terminate) the contract substantially contemporaneously with the 
issue date of the hedged bond.
    (B) Contract terminated. If a contract to which this paragraph 
(h)(5)(ii) applies is terminated substantially contemporaneously with 
the issue date of the hedged bond, the amount paid or received, or 
deemed to be paid or received, by the issuer in connection with the 
issuance of the hedged bond to terminate the contract is treated as an 
adjustment to the issue price of the hedged bond and as an adjustment to 
the sale proceeds of the hedged bond for purposes of section 148. 
Amounts paid or received, or deemed to be paid or received, before the 
issue date of the hedged bond are treated as paid or received on the 
issue date in an amount equal to the future value of the payment or 
receipt on that date. For this purpose, future value is computed using 
yield on the hedged bond without taking into account amounts paid or 
received (or deemed paid or received) on the contract.
    (C) Contract not terminated. If a contract to which this paragraph 
(h)(5)(ii) applies is not terminated substantially contemporaneously 
with the issue date of the hedged bond, the contract is deemed 
terminated for its fair market value as of the issue date of the hedged 
bond. Once a contract has been deemed terminated pursuant to this 
paragraph (h)(5)(ii)(C), payments on and receipts from the contract are 
no longer taken into account under this paragraph (h) for purposes of 
determining yield on the hedged bond.
    (D) Relation to other requirements of a qualified hedge. Payments 
made in connection with the issuance of a bond to terminate a contract 
to which this paragraph (h)(5)(ii) applies do not prevent the contract 
from satisfying the requirements of paragraph (h)(2)(vi) of this 
section.
    (E) Fixed yield treatment. A bond that is hedged with a contract to 
which this paragraph (h)(5)(ii) applies does not fail to be a fixed 
yield bond if, taking into account payments on the contract and the 
payments to be made on the bond, the bond satisfies the definition of 
fixed yield bond. See also paragraph (h)(4) of this section.
    (iii) Contracts expected not to be closed substantially 
contemporaneously with the issue date of hedged bond--(A) Application. 
This paragraph (h)(5)(iii) applies to a contract if, on the date the 
contract is identified, the issuer does not reasonably expect to 
terminate the contract substantially contemporaneously with the issue 
date of the hedge bond.
    (B) Contract terminated. If a contract to which this paragraph 
(h)(5)(iii) applies is terminated in connection with the issuance of the 
hedged bond, the amount paid or received, or deemed to be paid or 
received, by the issuer to terminate the contract is treated as an 
adjustment to the issue price of the hedged bond and as an adjustment to 
the sale proceeds of the hedged bond for purposes of section 148.
    (C) Contract not terminated. If a contract to which this paragraph 
(h)(5)(iii) applies is not terminated substantially contemporaneously 
with the issue date of the hedged bond, no payments with respect to the 
hedge made by the issuer before the issue date of the hedged bond are 
taken into account under this section.
    (iv) Identification. The identification required under paragraph 
(h)(2)(viii) of

[[Page 111]]

this section must specify the reasonably expected governmental purpose, 
issue price, maturity, and issue date of the hedged bond, the manner in 
which interest is reasonably expected to be computed, and whether 
paragraph (h)(5)(ii) or (h)(5)(iii) of this section applies to the 
contract. If an issuer identifies a contract under this paragraph 
(h)(5)(iv) that would be a qualified hedge with respect to the 
anticipated bond, but does not issue the anticipated bond on the 
identified issue date, the contract is taken into account as a qualified 
hedge of any bond of the issuer that is issued for the identified 
governmental purpose within a reasonable interval around the identified 
issue date of the anticipated bond.
    (6) Authority of the Commissioner. The Commissioner, by publication 
of a revenue ruling or revenue procedure (see Sec. 601.601(d)(2) of this 
chapter), may specify contracts that, although they do not meet the 
requirements of paragraph (h)(2) of this section, are qualified hedges 
or, although they do not meet the requirements of paragraph (h)(4) of 
this section, cause the hedged bonds to be treated as fixed yield bonds.

[T.D. 8476, 58 FR 33524, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24042, May 10, 1994; T.D. 8718, 62 FR 25507, 
May 9, 1997; T.D. 8838, 64 FR 48547, Sept. 7, 1999; T.D. 9777, 81 FR 
46593, July 18, 2016]



Sec. 1.148-5  Yield and valuation of investments.

    (a) In general. This section provides rules for computing the yield 
and value of investments allocated to an issue for various purposes 
under section 148.
    (b) Yield on an investment--(1) In general. Except as otherwise 
provided, the yield on an investment allocated to an issue is computed 
under the economic accrual method, using the same compounding interval 
and financial conventions used to compute the yield on the issue. The 
yield on an investment allocated to an issue is the discount rate that, 
when used in computing the present value as of the date the investment 
is first allocated to the issue of all unconditionally payable receipts 
from the investment, produces an amount equal to the present value of 
all unconditionally payable payments for the investment. For this 
purpose, payments means amounts to be actually or constructively paid to 
acquire the investment, and receipts means amounts to be actually or 
constructively received from the investment, such as earnings and return 
of principal. The yield on a variable rate investment is determined in a 
manner comparable to the determination of the yield on a variable rate 
issue. For an issue of qualified mortgage bonds, qualified veterans' 
mortgage bonds, or qualified student loan bonds on which interest is 
paid semiannually, all regular monthly loan payments to be received 
during a semiannual debt service period may be treated as received at 
the end of that period. In addition, for any conduit financing issue, 
payments made by the conduit borrower are not treated as paid until the 
conduit borrower ceases to receive the benefit of earnings on those 
amounts.
    (2) Yield on a separate class of investments--(i) In general. For 
purposes of the yield restriction rules of section 148(a) and 
Sec. 1.148-2, yield is computed separately for each class of 
investments. For this purpose, in determining the yield on a separate 
class of investments, the yield on each individual investment within the 
class is blended with the yield on other individual investments within 
the class, whether or not held concurrently, by treating those 
investments as a single investment. The yields on investments that are 
not within the same class are not blended.
    (ii) Separate classes of investments. Each of the following is a 
separate class of investments--
    (A) Each category of yield restricted purpose investment and program 
investment that is subject to a different definition of materially 
higher under Sec. 1.148-2(d)(2);
    (B) Yield-restricted nonpurpose investments; and
    (C) All other nonpurpose investments;
    (iii) Permissive application of single investment rules to certain 
yield restricted investments for all purposes of section 148. For all 
purposes of section 148, if an issuer reasonably expects as of the issue 
date to establish and maintain a

[[Page 112]]

sinking fund solely to reduce the yield on the investments in a 
refunding escrow, then the issuer may treat all of the yield restricted 
nonpurpose investments in the refunding escrow and that sinking fund as 
a single investment having a single yield, determined under this 
paragraph (b)(2). Thus, an issuer may not treat the nonpurpose 
investments in a reasonably required reserve fund and a refunding escrow 
as a single investment having a single yield under this paragraph 
(b)(2)(iii).
    (iv) Mandatory application of single investment rules for refunding 
escrows for all purposes of section 148. For all purposes of section 
148, in computing the yield on yield restricted investments allocable to 
proceeds (i.e., sale proceeds, investment proceeds, and transferred 
proceeds) of a refunding issue that are held in one or more refunding 
escrows, the individual investments are treated as a single investment 
having a single yield, whether or not held concurrently. For example, 
this single investment includes both the individual investments 
allocable to sale and investment proceeds of a refunding issue that are 
held in one refunding escrow for a prior issue and the investments 
allocable to transferred proceeds of that refunding issue that are held 
in another refunding escrow.
    (3) Investments to be held beyond issue's maturity or beyond 
temporary period. In computing the yield on investments allocable to an 
issue that are to be held beyond the reasonably expected redemption date 
of the issue, those investments are treated as sold for an amount equal 
to their value on that date. In computing the yield on investments that 
are held beyond an applicable temporary period under Sec. 1.148-2, for 
purposes of Sec. 1.148-2 those investments may be treated as purchased 
for an amount equal to their fair market value as of the end of the 
temporary period.
    (4) Consistent redemption assumptions on purpose investments. The 
yield on purpose investments allocable to an issue is computed using the 
same redemption assumptions used to compute the yield on the issue. 
Yield on purpose investments allocable to an issue of qualified mortgage 
bonds and qualified veterans' mortgage bonds must be determined in a 
manner that is consistent with, and using the assumptions required by, 
section 143(g)(2)(B).
    (5) Student loan special allowance payments included in yield. 
Except as provided in Sec. 1.148-11(e), the yield on qualified student 
loans is computed by including as receipts any special allowance 
payments made by the Secretary of Education pursuant to section 438 of 
the Higher Education Act of 1965.
    (c) Yield reduction payments to the United States--(1) In general. 
In determining the yield on an investment to which this paragraph (c) 
applies, any amount paid to the United States in accordance with this 
paragraph (c), including a rebate amount, is treated as a payment for 
that investment that reduces the yield on that investment.
    (2) Manner of payment--(i) In general. Except as otherwise provided 
in paragraph (c)(2)(ii) of this section, an amount is paid under this 
paragraph (c) if it is paid to the United States at the same time and in 
the same manner as rebate amounts are required to be paid or at such 
other time or in such manner as the Commissioner may prescribe. For 
example, yield reduction payments must be made on or before the date of 
required rebate installment payments as described in Secs. 1.148-3(f), 
(g), and (h). The provisions of Sec. 1.148-3(i) apply to payments made 
under this paragraph (c).
    (ii) Special rule for purpose investments. For purpose investments 
allocable to an issue--
    (A) No amounts are required to be paid to satisfy this paragraph (c) 
until the earlier of the end of the tenth bond year after the issue date 
of the issue or 60 days after the date on which the issue is no longer 
outstanding; and
    (B) For payments made prior to the date on which the issue is 
retired, the issuer need not pay more than 75 percent of the amount 
otherwise required to be paid as of the date to which the payment 
relates.
    (3) Applicability of special yield reduction rule. Paragraph (c) 
applies only to investments that are described in at least one of 
paragraphs (c)(3)(i) through (ix) of this section and, except as 
otherwise expressly provided in paragraphs (c)(3)(i) through (ix) of 
this section, that are allocated to proceeds of an

[[Page 113]]

issue other than gross proceeds of an advance refunding issue.
    (i) Nonpurpose investments allocated to proceeds of an issue that 
qualified for certain temporary periods. Nonpurpose investments 
allocable to proceeds of an issue that qualified for one of the 
temporary periods available for capital projects, working capital 
expenditures, pooled financings, or investment proceeds under 
Sec. 1.148-2(e)(2), (3), (4), or (6), respectively.
    (ii) Investments allocable to certain variable yield issues. 
Investments allocable to a variable yield issue during any computation 
period in which at least 5 percent of the value of the issue is 
represented by variable yield bonds, unless the issue is an issue of 
hedge bonds (as defined in section 149(g)(3)(A)).
    (iii) Nonpurpose investments allocable to certain transferred 
proceeds. Nonpurpose investments allocable to transferred proceeds of--
    (A) A current refunding issue to the extent necessary to reduce the 
yield on those investments to satisfy yield restrictions under section 
148(a); or
    (B) An advance refunding issue to the extent that investment of the 
refunding escrows allocable to the proceeds, other than transferred 
proceeds, of the refunding issue in zero-yielding nonpurpose investments 
is insufficient to satisfy yield restrictions under section 148(a).
    (iv) Purpose investments allocable to qualified student loans and 
qualified mortgage loans. Purpose investments allocable to qualified 
student loans and qualified mortgage loans.
    (v) Nonpurpose investments allocable to gross proceeds in certain 
reserve funds. Nonpurpose investments allocable to gross proceeds of an 
issue in a reasonably required reserve or replacement fund or a fund 
that, except for its failure to satisfy the size limitation in 
Sec. 1.148-2(f)(2)(ii), would qualify as a reasonably required reserve 
or replacement fund, but only to the extent the requirements in 
paragraphs (c)(3)(v)(A) or (B) of this section are met. This paragraph 
(c)(3)(v) includes nonpurpose investments described in this paragraph 
that are allocable to transferred proceeds of an advance refunding 
issue, but only to the extent necessary to satisfy yield restriction 
under section 148(a) on those proceeds treating all investments 
allocable to those proceeds as a separate class.
    (A) The value of the nonpurpose investments in the fund is not 
greater than 15 percent of the stated principal amount of the issue, as 
computed under Sec. 1.148-2(f)(2)(ii).
    (B) The amounts in the fund (other than investment earnings) are not 
reasonably expected to be used to pay debt service on the issue other 
than in connection with reductions in the amount required to be in that 
fund (for example, a reserve fund for a revolving fund loan program).
    (vi) Nonpurpose investments allocable to certain replacement 
proceeds of refunded issues. Nonpurpose investments allocated to 
replacement proceeds of a refunded issue, including a refunded issue 
that is an advance refunding issue, as a result of the application of 
the universal cap to amounts in a refunding escrow.
    (vii) Investments allocable to replacement proceeds under a certain 
transition rule. Investments described in Sec. 1.148-11(f).
    (viii) Nonpurpose investments allocable to proceeds when State and 
Local Government Series Securities are unavailable. Nonpurpose 
investments allocable to proceeds of an issue, including an advance 
refunding issue, that an issuer purchases if, on the date the issuer 
enters into the agreement to purchase such investments, the issuer is 
unable to subscribe for State and Local Government Series Securities 
because the U.S. Department of the Treasury, Bureau of the Fiscal 
Service, has suspended sales of those securities.
    (ix) Nonpurpose investments allocable to proceeds of certain 
variable yield advance refunding issues. Nonpurpose investments 
allocable to proceeds of the portion of a variable yield issue used for 
advance refunding purposes that are deposited in a yield restricted 
defeasance escrow if--
    (A) The issuer has entered into a qualified hedge under Sec. 1.148-
4(h)(2) with respect to all of the variable yield bonds of the issue 
allocable to the yield restricted defeasance escrow and that hedge is in 
the form of a variable-to-fixed interest rate swap under which

[[Page 114]]

the issuer pays the hedge provider a fixed interest rate and receives 
from the hedge provider a floating interest rate;
    (B) Such qualified hedge covers a period beginning on the issue date 
of the hedged bonds and ending on or after the date on which the final 
payment is to be made from the yield restricted defeasance escrow; and
    (C) The issuer restricts the yield on the yield restricted 
defeasance escrow to a yield that is not greater than the yield on the 
issue, determined by taking into account the issuer's fixed payments to 
be made under the hedge and by assuming that the issuer's variable yield 
payments to be paid on the hedged bonds are equal to the floating 
payments to be received by the issuer under the qualified hedge and are 
paid on the same dates (that is, such yield reduction payments can only 
be made to address basis risk differences between the variable yield 
payments on the hedged bonds and the floating payments received on the 
hedge).
    (d) Value of investments--(1) In general. Except as otherwise 
provided, the value of an investment (including a payment or receipt on 
the investment) on a date must be determined using one of the following 
valuation methods consistently for all purposes of section 148 to that 
investment on that date:
    (i) Plain par investment--outstanding principal amount. A plain par 
investment may be valued at its outstanding stated principal amount, 
plus any accrued unpaid interest on that date.
    (ii) Fixed rate investment--present value. A fixed rate investment 
may be valued at its present value on that date.
    (iii) Any investment--fair market value. An investment may be valued 
at its fair market value on that date.
    (2) Mandatory valuation of certain yield restricted investments at 
present value. A purpose investment must be valued at present value, and 
except as otherwise provided in paragraphs (b)(3) and (d)(3) of this 
section, a yield restricted nonpurpose investment must be valued at 
present value.
    (3) Mandatory valuation of certain investments at fair market 
value--(i) In general. Except as otherwise provided in paragraphs 
(d)(3)(ii) and (d)(4) of this section, a nonpurpose investment must be 
valued at fair market value on the date that it is first allocated to an 
issue or first ceases to be allocated to an issue as a consequence of a 
deemed acquisition or deemed disposition. For example, if an issuer 
deposits existing nonpurpose investments into a sinking fund for an 
issue, those investments must be valued at fair market value as of the 
date first deposited into the fund.
    (ii) Exception to fair market value requirement for transferred 
proceeds allocations, certain universal cap allocations, and commingled 
funds. Paragraph (d)(3)(i) of this section does not apply if the 
investment is allocated from one issue to another as a result of the 
transferred proceeds allocation rule under Sec. 1.148-9(b) or is 
deallocated from one issue as a result of the universal cap rule under 
Sec. 1.148-6(b)(2) and reallocated to another issue as a result of a 
preexisting pledge of the investment to secure that other issue, 
provided that, in either circumstance (that is, transferred proceeds 
allocations or universal cap deallocations), the issue from which the 
investment is allocated (that is, the first issue in an allocation from 
one issue to another issue) consists of tax-exempt bonds. In addition, 
paragraph (d)(3)(i) of this section does not apply to investments in a 
commingled fund (other than a bona fide debt service fund) unless it is 
an investment being initially deposited in or withdrawn from a 
commingled fund described in Sec. 1.148-6(e)(5)(iii).
    (4) Special transition rule for transferred proceeds. The value of a 
nonpurpose investment that is allocated to transferred proceeds of a 
refunding issue on a transfer date may not exceed the value of that 
investment on the transfer date used for purposes of applying the 
arbitrage restrictions to the refunded issue.
    (5) Definition of present value of an investment. Except as 
otherwise provided, present value of an investment is computed under the 
economic accrual method, using the same compounding interval and 
financial conventions used to compute the yield on the issue. The 
present value of an investment on a date is equal to the present value 
of all unconditionally payable receipts to be

[[Page 115]]

received from and payments to be paid for the investment after that 
date, using the yield on the investment as the discount rate.
    (6) Definition of fair market value--(i) In general. The fair market 
value of an investment is the price at which a willing buyer would 
purchase the investment from a willing seller in a bona fide, arm's-
length transaction. Fair market value generally is determined on the 
date on which a contract to purchase or sell the nonpurpose investment 
becomes binding (i.e., the trade date rather than the settlement date). 
Except as otherwise provided in this paragraph (d)(6), an investment 
that is not of a type traded on an established securities market, within 
the meaning of section 1273, is rebuttably presumed to be acquired or 
disposed of for a price that is not equal to its fair market value. On 
the purchase date, the fair market value of a United States Treasury 
obligation that is purchased directly from the United States Treasury, 
including a State and Local Government Series Security, is its purchase 
price. The fair market value of a State and Local Government Series 
Security on any date other than the purchase date is the redemption 
price for redemption on that date.
    (ii) Safe harbor for establishing fair market value for certificates 
of deposit. This paragraph (d)(6)(ii) applies to a certificate of 
deposit that has a fixed interest rate, a fixed payment schedule, and a 
substantial penalty for early withdrawal. The purchase price of such a 
certificate of deposit is treated as its fair market value on the 
purchase date if the yield on the certificate of deposit is not less 
than--
    (A) The yield on reasonably comparable direct obligations of the 
United States; and
    (B) The highest yield that is published or posted by the provider to 
be currently available from the provider on reasonably comparable 
certificates of deposit offered to the public.
    (iii) Safe harbor for establishing fair market value for guaranteed 
investment contracts and investments purchased for a yield restricted 
defeasance escrow. The purchase price of a guaranteed investment 
contract and the purchase price of an investment purchased for a yield 
restricted defeasance escrow will be treated as the fair market value of 
the investment on the purchase date if all of the following requirements 
are satisfied:
    (A) The issuer makes a bona fide solicitation for the purchase of 
the investment. A bona fide solicitation is a solicitation that 
satisfies all of the following requirements:
    (1) The bid specifications are in writing and are timely 
disseminated to potential providers. For purposes of this paragraph 
(d)(6)(iii)(A)(1), a writing may be in electronic form and may be 
disseminated by fax, email, an internet-based Web site, or other 
electronic medium that is similar to an internet-based Web site and 
regularly used to post bid specifications.
    (2) The bid specifications include all material terms of the bid. A 
term is material if it may directly or indirectly affect the yield or 
the cost of the investment.
    (3) The bid specifications include a statement notifying potential 
providers that submission of a bid is a representation that the 
potential provider did not consult with any other potential provider 
about its bid, that the bid was determined without regard to any other 
formal or informal agreement that the potential provider has with the 
issuer or any other person (whether or not in connection with the bond 
issue), and that the bid is not being submitted solely as a courtesy to 
the issuer or any other person for purposes of satisfying the 
requirements of paragraph (d)(6)(iii)(B)(1) or (2) of this section.
    (4) The terms of the bid specifications are commercially reasonable. 
A term is commercially reasonable if there is a legitimate business 
purpose for the term other than to increase the purchase price or reduce 
the yield of the investment. For example, for solicitations of 
investments for a yield restricted defeasance escrow, the hold firm 
period must be no longer than the issuer reasonably requires.
    (5) For purchases of guaranteed investment contracts only, the terms 
of the solicitation take into account the issuer's reasonably expected 
deposit and drawdown schedule for the amounts to be invested.

[[Page 116]]

    (6) All potential providers have an equal opportunity to bid. If the 
bidding process affords any opportunity for a potential provider to 
review other bids before providing a bid, then providers have an equal 
opportunity to bid only if all potential providers have an equal 
opportunity to review other bids. Thus, no potential provider may be 
given an opportunity to review other bids that is not equally given to 
all potential providers (that is, no exclusive ``last look'').
    (7) At least three reasonably competitive providers are solicited 
for bids. A reasonably competitive provider is a provider that has an 
established industry reputation as a competitive provider of the type of 
investments being purchased.
    (B) The bids received by the issuer meet all of the following 
requirements:
    (1) The issuer receives at least three bids from providers that the 
issuer solicited under a bona fide solicitation meeting the requirements 
of paragraph (d)(6)(iii)(A) of this section and that do not have a 
material financial interest in the issue. A lead underwriter in a 
negotiated underwriting transaction is deemed to have a material 
financial interest in the issue until 15 days after the issue date of 
the issue. In addition, any entity acting as a financial advisor with 
respect to the purchase of the investment at the time the bid 
specifications are forwarded to potential providers has a material 
financial interest in the issue. A provider that is a related party to a 
provider that has a material financial interest in the issue is deemed 
to have a material financial interest in the issue.
    (2) At least one of the three bids described in paragraph 
(d)(6)(iii)(B)(1) of this section is from a reasonably competitive 
provider, within the meaning of paragraph (d)(6)(iii)(A)(7) of this 
section.
    (3) If the issuer uses an agent to conduct the bidding process, the 
agent did not bid to provide the investment.
    (C) The winning bid meets the following requirements:
    (1) Guaranteed investment contracts. If the investment is a 
guaranteed investment contract, the winning bid is the highest yielding 
bona fide bid (determined net of any broker's fees).
    (2) Other investments. If the investment is not a guaranteed 
investment contract, the following requirements are met:
    (i) The winning bid is the lowest cost bona fide bid (including any 
broker's fees). The lowest cost bid is either the lowest cost bid for 
the portfolio or, if the issuer compares the bids on an investment-by-
investment basis, the aggregate cost of a portfolio comprised of the 
lowest cost bid for each investment. Any payment received by the issuer 
from a provider at the time a guaranteed investment contract is 
purchased (e.g., an escrow float contract) for a yield restricted 
defeasance escrow under a bidding procedure meeting the requirements of 
this paragraph (d)(6)(iii) is taken into account in determining the 
lowest cost bid.
    (ii) The lowest cost bona fide bid (including any broker's fees) is 
not greater than the cost of the most efficient portfolio comprised 
exclusively of State and Local Government Series Securities from the 
United States Department of the Treasury, Bureau of Public Debt. The 
cost of the most efficient portfolio of State and Local Government 
Series Securities is to be determined at the time that bids are required 
to be submitted pursuant to the terms of the bid specifications.
    (iii) If State and Local Government Series Securities from the 
United States Department of the Treasury, Bureau of Public Debt are not 
available for purchase on the day that bids are required to be submitted 
pursuant to terms of the bid specifications because sales of those 
securities have been suspended, the cost comparison of paragraph 
(d)(6)(iii) (C)(2)(ii) of this section is not required.
    (D) The provider of the investments or the obligor on the guaranteed 
investment contract certifies the administrative costs that it pays (or 
expects to pay, if any) to third parties in connection with supplying 
the investment.
    (E) The issuer retains the following records with the bond documents 
until three years after the last outstanding bond is redeemed:
    (1) For purchases of guaranteed investment contracts, a copy of the 
contract, and for purchases of investments

[[Page 117]]

other than guaranteed investment contracts, the purchase agreement or 
confirmation.
    (2) The receipt or other record of the amount actually paid by the 
issuer for the investments, including a record of any administrative 
costs paid by the issuer, and the certification under paragraph 
(d)(6)(iii)(D) of this section.
    (3) For each bid that is submitted, the name of the person and 
entity submitting the bid, the time and date of the bid, and the bid 
results.
    (4) The bid solicitation form and, if the terms of the purchase 
agreement or the guaranteed investment contract deviated from the bid 
solicitation form or a submitted bid is modified, a brief statement 
explaining the deviation and stating the purpose for the deviation. For 
example, if the issuer purchases a portfolio of investments for a yield 
restricted defeasance escrow and, in order to satisfy the yield 
restriction requirements of section 148, an investment in the winning 
bid is replaced with an investment with a lower yield, the issuer must 
retain a record of the substitution and how the price of the substitute 
investment was determined. If the issuer replaces an investment in the 
winning bid portfolio with another investment, the purchase price of the 
new investment is not covered by the safe harbor unless the investment 
is bid under a bidding procedure meeting the requirements of this 
paragraph (d)(6)(iii).
    (5) For purchases of investments other than guaranteed investment 
contracts, the cost of the most efficient portfolio of State and Local 
Government Series Securities, determined at the time that the bids were 
required to be submitted pursuant to the terms of the bid 
specifications.
    (e) Administrative costs of investments--(1) In general. Except as 
otherwise provided in this paragraph (e), an allocation of gross 
proceeds of an issue to a payment or a receipt on an investment is not 
adjusted to take into account any costs or expenses paid, directly or 
indirectly, to purchase, carry, sell, or retire the investment 
(administrative costs). Thus, these administrative costs generally do 
not increase the payments for, or reduce the receipts from, investments.
    (2) Qualified administrative costs on nonpurpose investments--(i) In 
general. In determining payments and receipts on nonpurpose investments, 
qualified administrative costs are taken into account. Thus, qualified 
administrative costs increase the payments for, or decrease the receipts 
from, the investments. Qualified administrative costs are reasonable, 
direct administrative costs, other than carrying costs, such as 
separately stated brokerage or selling commissions, but not legal and 
accounting fees, recordkeeping, custody, and similar costs. General 
overhead costs and similar indirect costs of the issuer such as employee 
salaries and office expenses and costs associated with computing the 
rebate amount under section 148(f) are not qualified administrative 
costs. In general, administrative costs are not reasonable unless they 
are comparable to administrative costs that would be charged for the 
same investment or a reasonably comparable investment if acquired with a 
source of funds other than gross proceeds of tax-exempt bonds.
    (ii) Special rule for administrative costs of nonpurpose investments 
in certain regulated investment companies and commingled funds. 
Qualified administrative costs include all reasonable administrative 
costs, without regard to the limitation on indirect costs under 
paragraph (e)(2)(i) of this section, incurred by:
    (A) Regulated investment companies. A publicly offered regulated 
investment company (as defined in section 67(c)(2)(B)); and
    (B) External commingled funds. A widely held commingled fund in 
which no investor in the fund owns more than 10 percent of the 
beneficial interest in the fund. For purposes of this paragraph 
(e)(2)(ii)(B), a fund is treated as widely held only if, during the 
immediately preceding fixed, semiannual period chosen by the fund (for 
example, semiannual periods ending June 30 and December 31), the fund 
had a daily average of more than 15 investors that were not related 
parties, and at least 16 of the unrelated investors each maintained a 
daily average amount invested in the fund that was not less than the 
lesser of $500,000 and one percent (1%) of the daily average of the 
total

[[Page 118]]

amount invested in the fund (with it being understood that additional 
smaller investors will not disqualify the fund). For purposes of this 
paragraph (e)(2)(ii)(B), an investor will be treated as owning not more 
than 10 percent of the beneficial interest in the fund if, on the date 
of each deposit by the investor into the fund, the total amount the 
investor and any related parties have on deposit in the fund is not more 
than 10 percent of the total amount that all investors have on deposit 
in the fund. For purposes of the preceding sentence, the total amount 
that all investors have on deposit in the fund is equal to the sum of 
all deposits made by the investor and any related parties on the date of 
those deposits and the closing balance in the fund on the day before 
those deposits. If any investor in the fund owns more than 10 percent of 
the beneficial interest in the fund, the fund does not qualify under 
this paragraph (e)(2)(ii)(B) until that investor makes sufficient 
withdrawals from the fund to reduce its beneficial interest in the fund 
to 10 percent or less.
    (iii) Special rule for guaranteed investment contracts and 
investments purchased for a yield restricted defeasance escrow--(A) In 
general. An amount paid for a broker's commission or similar fee with 
respect to a guaranteed investment contract or investments purchased for 
a yield restricted defeasance escrow is a qualified administrative cost 
if the fee is reasonable within the meaning of paragraph (e)(2)(i) of 
this section.
    (B) Safe harbor--(1) In general. A broker's commission or similar 
fee with respect to the acquisition of a guaranteed investment contract 
or investments purchased for a yield restricted defeasance escrow is 
reasonable within the meaning of paragraph (e)(2)(i) of this section to 
the extent that--
    (i) The amount of the fee that the issuer treats as a qualified 
administrative cost does not exceed the lesser of:
    (A) $30,000 and
    (B) 0.2% of the computational base or, if more, $3,000; and
    (ii) For any issue, the issuer does not treat as qualified 
administrative costs more than $85,000 in brokers' commissions or 
similar fees with respect to all guaranteed investment contracts and 
investments for yield restricted defeasance escrows purchased with gross 
proceeds of the issue.
    (2) Computational base. For purposes of paragraph (e)(2)(iii)(B)(1) 
of this section, computational base shall mean--
    (i) For a guaranteed investment contract, the amount of gross 
proceeds the issuer reasonably expects, as of the date the contract is 
acquired, to be deposited in the guaranteed investment contract over the 
term of the contract, and
    (ii) For investments (other than guaranteed investment contracts) to 
be deposited in a yield restricted defeasance escrow, the amount of 
gross proceeds initially invested in those investments.
    (3) Cost-of-living adjustment. In the case of a calendar year after 
2004, each of the dollar amounts in paragraph (e)(2)(iii)(B)(1) of this 
section shall be increased by an amount equal to--
    (i) Such dollar amount; multiplied by
    (ii) The cost-of-living adjustment determined under section 1(f)(3) 
for such calendar year by using the language ``calendar year 2003'' 
instead of ``calendar year 1992'' in section 1(f)(3)(B).
    (4) Rounding. If any increase determined under paragraph 
(e)(2)(iii)(B)(3) of this section is not a multiple of $1,000, such 
increase shall be rounded to the nearest multiple thereof.
    (5) Applicable year for cost-of-living adjustment. The cost-of-
living adjustments under paragraph (e)(2)(iii)(B)(3) of this section 
shall apply to the safe harbor amounts under paragraph (e)(2)(iii)(B)(1) 
of this section based on the year the guaranteed investment contract or 
the investments for the yield restricted defeasance escrow, as 
applicable, are acquired.
    (6) Cost-of-living adjustment to determine remaining amount of per-
issue safe harbor--(i) In general. This paragraph (e)(2)(iii)(B)(6) 
applies to determine the portion of the safe harbor amount under 
paragraph (e)(2)(iii)(B)(1)(ii) of this section, as modified by 
paragraph (e)(2)(iii)(B)(3) of this section (the per-issue safe harbor), 
that is available (the remaining amount) for any year (the determination 
year) if the per-issue safe harbor was partially used in one or more 
prior years.

[[Page 119]]

    (ii) Remaining amount of per-issue safe harbor. The remaining amount 
of the per-issue safe harbor for any determination year is equal to the 
per-issue safe harbor for that year, reduced by the portion of the per-
issue safe harbor used in one or more prior years.
    (iii) Portion of per-issue safe harbor used in prior years. The 
portion of the per-issue safe harbor used in any prior year (the prior 
year) is equal to the total amount of broker's commissions or similar 
fees paid in connection with guaranteed investment contracts or 
investments for a yield restricted defeasance escrow acquired in the 
prior year that the issuer treated as qualified administrative costs for 
the issue, multiplied by a fraction the numerator of which is the per-
issue safe harbor for the determination year and the denominator of 
which is the per-issue safe harbor for the prior year. See paragraph 
(e)(2)(iii)(C) Example 2 of this section.
    (C) Examples. The following examples illustrate the application of 
the safe harbor in paragraph (e)(2)(iii)(B) of this section:

    Example 1. Multipurpose issue. In 2003, the issuer of a multipurpose 
issue uses brokers to acquire the following investments with gross 
proceeds of the issue: a guaranteed investment contract for amounts to 
be deposited in a construction fund (construction GIC), Treasury 
securities to be deposited in a yield restricted defeasance escrow 
(Treasury investments) and a guaranteed investment contract that will be 
used to earn a return on what otherwise would be idle cash balances from 
maturing investments in the yield restricted defeasance escrow (the 
float GIC). The issuer deposits $22,000,000 into the construction GIC 
and reasonably expects that no further deposits will be made over its 
term. The issuer uses $8,040,000 of the proceeds to purchase the 
Treasury investments. The issuer reasonably expects that it will make 
aggregate deposits of $600,000 to the float GIC over its term. The 
brokers' fees are $30,000 for the construction GIC, $16,080 for the 
Treasury investments and $3,000 for the float GIC. The issuer has not 
previously treated any brokers' commissions or similar fees as qualified 
administrative costs. The issuer may claim all $49,080 in brokers' fees 
for these investments as qualified administrative costs because the fees 
do not exceed the safe harbors in paragraph (e)(2)(iii)(B) of this 
section. Specifically, each of the brokers' fees equals the lesser of 
$30,000 and 0.2% of the computational base (or, if more, $3,000) (i.e., 
lesser of $30,000 and 0.2%  x  $22,000,000 for the construction GIC; 
lesser of $30,000 and 0.2%  x  $8,040,000 for the Treasury investments; 
and lesser of $30,000 and $3,000 for the float GIC). In addition, the 
total amount of brokers' fees claimed by the issuer as qualified 
administrative costs ($49,080) does not exceed the per-issue safe harbor 
of $85,000.
    Example 2. Cost-of-living adjustment. In 2003, an issuer issues 
bonds and uses gross proceeds of the issue to acquire two guaranteed 
investment contracts. The issuer pays a total of $50,000 in brokers' 
fees for the two guaranteed investment contracts and treats these fees 
as qualified administrative costs. In a year subsequent to 2003 (Year 
Y), the issuer uses gross proceeds of the issue to acquire two 
additional guaranteed investment contracts, paying a total of $20,000 in 
broker's fees for the two guaranteed investment contracts, and treats 
those fees as qualified administrative costs. For Year Y, applying the 
cost-of-living adjustment under paragraph (e)(2)(iii)(B)(3) of this 
section, the safe harbor dollar limits under paragraph (e)(2)(iii)(B)(1) 
of this section are $3,000, $32,000 and $90,000. The remaining amount of 
the per-issue safe harbor for Year Y is $37,059 ($90,000-[$50,000  x  
$90,000/$85,000]). The broker's fees in Year Y do not exceed the per-
issue safe harbor under paragraph (e)(2)(iii)(B)(1)(ii) (as modified by 
paragraph (e)(2)(iii)(B)(3)) of this section because the broker's fees 
do not exceed the remaining amount of the per-issue safe harbor 
determined under paragraph (e)(2)(iii)(B)(6) of this section for Year Y. 
In a year subsequent to Year Y (Year Z), the issuer uses gross proceeds 
of the issue to acquire an additional guaranteed investment contract, 
pays a broker's fee of $15,000 for the guaranteed investment contract, 
and treats the broker's fee as a qualified administrative cost. For Year 
Z, applying the cost-of-living adjustment under paragraph 
(e)(2)(iii)(B)(3) of this section, the safe harbor dollar limits under 
paragraph (e)(2)(iii)(B)(1) of this section are $3,000, $33,000 and 
$93,000. The remaining amount of the per-issue safe harbor for Year Z is 
$17,627 ($93,000--[($50,000  x  $93,000/$85,000) + ($20,000  x  $93,000/
$90,000)]). The broker's fee incurred in Year Z does not exceed the per-
issue safe harbor under paragraph (e)(2)(iii)(B)(1)(ii) (as modified by 
paragraph (e)(2)(iii)(B)(3)) of this section because the broker's fee 
does not exceed the remaining amount of the per-issue safe harbor 
determined under paragraph (e)(2)(iii)(B)(6) of this section for Year Z. 
See paragraph (e)(2)(iii)(B)(6) of this section.

    (3) Qualified administrative costs on purpose investments--(i) In 
general. In determining payments and receipts on

[[Page 120]]

purpose investments, qualified administrative costs described in this 
paragraph (e)(3) paid by the conduit borrower are taken into account. 
Thus, these costs increase the payments for, or decrease the receipts 
from, the purpose investments. This rule applies even if those payments 
merely reimburse the issuer. Although the actual payments by the conduit 
borrower may be made at any time, for this purpose, a pro rata portion 
of each payment made by a conduit borrower is treated as a reimbursement 
of reasonable administrative costs, if the present value of those 
payments does not exceed the present value of the reasonable 
administrative costs paid by the issuer, using the yield on the issue as 
the discount rate.
    (ii) Definition of qualified administrative costs of purpose 
investments--(A) In general. Except as otherwise provided in this 
paragraph (e)(3)(ii), qualified administrative costs of a purpose 
investment means--
    (1) Costs or expenses paid, directly or indirectly, to purchase, 
carry, sell, or retire the investment; and
    (2) Costs of issuing, carrying, or repaying the issue, and any 
underwriters' discount.
    (B) Limitation on program investments. For a program investment, 
qualified administrative costs include only those costs described in 
paragraph (e)(3)(ii)(A)(2) of this section.

[T.D. 8476, 58 FR 33529, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24044, May 10, 1994; T.D. 8718, 62 FR 25511, 
May 9, 1997; T.D. 8801, 63 FR 71751, Dec. 30, 1998; T.D. 9097, 68 FR 
69022, Dec. 11, 2003; T.D. 9777, 81 FR 46595, July 17, 2016]



Sec. 1.148-6  General allocation and accounting rules.

    (a) In general--(1) Reasonable accounting methods required. An 
issuer may use any reasonable, consistently applied accounting method to 
account for gross proceeds, investments, and expenditures of an issue.
    (2) Bona fide deviations from accounting method. An accounting 
method does not fail to be reasonable and consistently applied solely 
because a different accounting method is used for a bona fide 
governmental purpose to consistently account for a particular item. Bona 
fide governmental purposes may include special State law restrictions 
imposed on specific funds or actions to avoid grant forfeitures.
    (3) Absence of allocation and accounting methods. If an issuer fails 
to maintain books and records sufficient to establish the accounting 
method for an issue and the allocation of the proceeds of that issue, 
the rules of this section are applied using the specific tracing method. 
This paragraph (a)(3) applies to bonds issued on or after May 16, 1997.
    (b) Allocation of gross proceeds to an issue--(1) One-issue rule and 
general ordering rules. Except as otherwise provided, amounts are 
allocable to only one issue at a time as gross proceeds, and if amounts 
simultaneously are proceeds of one issue and replacement proceeds of 
another issue, those amounts are allocable to the issue of which they 
are proceeds. Amounts cease to be allocated to an issue as proceeds only 
when those amounts are allocated to an expenditure for a governmental 
purpose, are allocated to transferred proceeds of another issue, or 
cease to be allocated to that issue at retirement of the issue or under 
the universal cap of paragraph (b)(2) of this section. Amounts cease to 
be allocated to an issue as replacement proceeds only when those amounts 
are allocated to an expenditure for a governmental purpose, are no 
longer used in a manner that causes those amounts to be replacement 
proceeds of that issue, or cease to be allocated to that issue because 
of the retirement of the issue or the application of the universal cap 
under paragraph (b)(2) of this section. Amounts that cease to be 
allocated to an issue as gross proceeds are eligible for allocation to 
another issue. Under Sec. 1.148-10(a), however, the rules in this 
paragraph (b)(1) do not apply in certain cases involving abusive 
arbitrage devices.
    (2) Universal cap on value of nonpurpose investments allocated to an 
issue--(i) Application. The rules in this paragraph (b)(2) provide an 
overall limitation on the amount of gross proceeds allocable to an 
issue. Although the universal cap generally may be applied at any time 
in the manner described in this paragraph (b)(2), it need not be applied 
on any otherwise required date of application if its application on that 
date

[[Page 121]]

would not result in a reduction or reallocation of gross proceeds of an 
issue. For this purpose, if an issuer reasonably expects as of the issue 
date that the universal cap will not reduce the amount of gross proceeds 
allocable to the issue during the term of the issue, the universal cap 
need not be applied on any date on which an issue actually has all of 
the following characteristics--
    (A) No replacement proceeds are allocable to the issue, other than 
replacement proceeds in a bona fide debt service fund or a reasonably 
required reserve or replacement fund;
    (B) The net sale proceeds of the issue--
    (1) Qualified for one of the temporary periods available for capital 
projects, restricted working capital expenditures, or pooled financings 
under Sec. 1.148-2 (e)(2), (e)(3), or (e)(4), and those net sales 
proceeds were in fact allocated to expenditures prior to the expiration 
of the longest applicable temporary period; or
    (2) were deposited in a refunding escrow and expended as originally 
expected;
    (C) The issue does not refund a prior issue that, on any transfer 
date, has unspent proceeds allocable to it;
    (D) None of the bonds are retired prior to the date on which those 
bonds are treated as retired in computing the yield on the issue; and
    (E) No proceeds of the issue are invested in qualified student loans 
or qualified mortgage loans.
    (ii) General rule. Except as otherwise provided below, amounts that 
would otherwise be gross proceeds allocable to an issue are allocated 
(and remain allocated) to the issue only to the extent that the value of 
the nonpurpose investments allocable to those gross proceeds does not 
exceed the value of all outstanding bonds of the issue. For this 
purpose, gross proceeds allocable to cash, tax-exempt bonds that would 
be nonpurpose investments (absent section 148(b)(3)(A)), qualified 
student loans, and qualified mortgage loans are treated as nonpurpose 
investments. The values of bonds and investments are determined under 
Sec. 1.148-4(e) and Sec. 1.148-5(d), respectively. The value of all 
outstanding bonds of the issue is referred to as the universal cap. 
Thus, for example, the universal cap for an issue of plain par bonds is 
equal to the outstanding stated principal amount of those bonds plus 
accrued interest.
    (iii) Determination and application of the universal cap. Except as 
otherwise provided, beginning with the first bond year that commences 
after the second anniversary of the issue date, the amount of the 
universal cap and the value of the nonpurpose investments must be 
determined as of the first day of each bond year. For refunding and 
refunded issues, the cap and values must be determined as of each date 
that, but for this paragraph (b)(2), proceeds of the refunded issue 
would become transferred proceeds of the refunding issue, and need not 
otherwise be determined in the bond year in which that date occurs. All 
values are determined as of the close of business on each determination 
date, after giving effect to all payments on bonds and payments for and 
receipts on investments on that date.
    (iv) General ordering rule for allocations of amounts in excess of 
the universal cap--(A) In general. If the value of all nonpurpose 
investments allocated to the gross proceeds of an issue exceeds the 
universal cap for that issue on a date as of which the cap is determined 
under paragraph (b)(2)(iii) of this section, nonpurpose investments 
allocable to gross proceeds necessary to eliminate that excess cease to 
be allocated to the issue, in the following order of priority--
    (1) First, nonpurpose investments allocable to replacement proceeds;
    (2) Second, nonpurpose investments allocable to transferred 
proceeds; and
    (3) Third, nonpurpose investments allocable to sale proceeds and 
investment proceeds.
    (B) Re-allocation of certain amounts. Except as provided in 
Sec. 1.148-9(b)(3), amounts that cease to be allocated to an issue as a 
result of the application of the universal cap may only be allocated to 
another issue as replacement proceeds.
    (C) Allocations of portions of investments. Portions of investments 
to which this paragraph (b)(2)(iv) applies are allocated under either 
the ratable method or the representative method

[[Page 122]]

in the same manner as allocations of portions of investments to 
transferred proceeds under Sec. 1.148-9(c).
    (v) Nonpurpose investments in a bona fide debt service fund not 
counted. For purposes of this paragraph (b)(2), nonpurpose investments 
allocated to gross proceeds in a bona fide debt service fund for an 
issue are not taken into account in determining the value of the 
nonpurpose investments, and those nonpurpose investments remain 
allocated to the issue.
    (c) Fair market value limit on allocations to nonpurpose 
investments. Upon a purchase or sale of a nonpurpose investment, gross 
proceeds of an issue are not allocated to a payment for that nonpurpose 
investment in an amount greater than, or to a receipt from that 
nonpurpose investment in an amount less than, the fair market value of 
the nonpurpose investment as of the purchase or sale date. For purposes 
of this paragraph (c) only, the fair market value of a nonpurpose 
investment is adjusted to take into account qualified administrative 
costs allocable to the investment.
    (d) Allocation of gross proceeds to expenditures--(1) Expenditures 
in general--(i) General rule. Reasonable accounting methods for 
allocating funds from different sources to expenditures for the same 
governmental purpose include any of the following methods if 
consistently applied: a specific tracing method; a gross proceeds spent 
first method; a first-in, first-out method; or a ratable allocation 
method.
    (ii) General limitation. An allocation of gross proceeds of an issue 
to an expenditure must involve a current outlay of cash for a 
governmental purpose of the issue. A current outlay of cash means an 
outlay reasonably expected to occur not later than 5 banking days after 
the date as of which the allocation of gross proceeds to the expenditure 
is made.
    (iii) Timing. An issuer must account for the allocation of proceeds 
to expenditures not later than 18 months after the later of the date the 
expenditure is paid or the date the project, if any, that is financed by 
the issue is placed in service. This allocation must be made in any 
event by the date 60 days after the fifth anniversary of the issue date 
or the date 60 days after the retirement of the issue, if earlier. This 
paragraph (d)(1)(iii) applies to bonds issued on or after May 16, 1997.
    (2) Treatment of gross proceeds invested in purpose investments--(i) 
In general. Gross proceeds of an issue invested in a purpose investment 
are allocated to an expenditure on the date on which the conduit 
borrower under the purpose investment allocates the gross proceeds to an 
expenditure in accordance with this paragraph (d).
    (ii) Exception for qualified mortgage loans and qualified student 
loans. If gross proceeds of an issue are allocated to a purpose 
investment that is a qualified mortgage loan or a qualified student 
loan, those gross proceeds are allocated to an expenditure for the 
governmental purpose of the issue on the date on which the issuer 
allocates gross proceeds to that purpose investment.
    (iii) Continuing allocation of gross proceeds to purpose 
investments. Regardless of whether gross proceeds of a conduit financing 
issue invested in a purpose investment have been allocated to an 
expenditure under paragraph (d)(2) (i) or (ii) of this section, with 
respect to the actual issuer those gross proceeds continue to be 
allocated to the purpose investment until the sale, discharge, or other 
disposition of the purpose investment.
    (3) Expenditures for working capital purposes--(i) In general. 
Except as otherwise provided in this paragraph (d)(3) or paragraph 
(d)(4) of this section, proceeds of an issue may only be allocated to 
working capital expenditures as of any date to the extent that those 
working capital expenditures exceed available amounts (as defined in 
paragraph (d)(3)(iii) of this section) as of that date (i.e., a 
``proceeds-spent-last'' method). For this purpose, proceeds include 
replacement proceeds described in Sec. 1.148-1(c)(4).
    (ii) Exceptions--(A) General de minimis exception. Paragraph 
(d)(3)(i) of this section does not apply to expenditures to pay--
    (1) Any issuance costs of the issue or any qualified administrative 
costs within the meaning of Secs. 1.148-5(e)(2) (i) or (ii), or 
Sec. 1.148-5(e)(3)(ii)(A);

[[Page 123]]

    (2) Fees for qualified guarantees of the issue or payments for a 
qualified hedge for the issue;
    (3) Interest on the issue for a period commencing on the issue date 
and ending on the date that is the later of three years from the issue 
date or one year after the date on which the project is placed in 
service;
    (4) Amounts paid to the United States under Secs. 1.148-3, 1.148-
5(c), or 1.148-7 for the issue;
    (5) Costs, other than those described in paragraphs (d)(3)(ii)(A) 
(1) through (4) of this section, that do not exceed 5 percent of the 
sale proceeds of an issue and that are directly related to capital 
expenditures financed by the issue (e.g., initial operating expenses for 
a new capital project);
    (6) Principal or interest on an issue paid from unexpected excess 
sale or investment proceeds; and
    (7) Principal or interest on an issue paid from investment earnings 
on a reserve or replacement fund that are deposited in a bona fide debt 
service fund.
    (B) Exception for extraordinary items. Paragraph (d)(3)(i) of this 
section does not apply to expenditures for extraordinary, nonrecurring 
items that are not customarily payable from current revenues, such as 
casualty losses or extraordinary legal judgments in amounts in excess of 
reasonable insurance coverage. If, however, an issuer or a related party 
maintains a reserve for such items (e.g., a self-insurance fund) or has 
set aside other available amounts for such expenses, gross proceeds 
within that reserve must be allocated to expenditures only after all 
other available amounts in that reserve are expended.
    (C) Exception for payment of principal and interest on prior issues. 
Paragraph (d)(3)(i) of this section does not apply to expenditures for 
payment of principal, interest, or redemption prices on a prior issue 
and, for a crossover refunding issue, interest on that issue.
    (D) No exceptions if replacement proceeds created. The exceptions 
provided in this paragraph (d)(3)(ii) do not apply if the allocation 
merely substitutes gross proceeds for other amounts that would have been 
used to make those expenditures in a manner that gives rise to 
replacement proceeds. For example, if a purported reimbursement 
allocation of proceeds of a reimbursement bond does not result in an 
expenditure under Sec. 1.150-2, those proceeds may not be allocated to 
pay interest on an issue that, absent this allocation, would have been 
paid from the issuer's current revenues.
    (iii) Definition of available amount--(A) In general. For purposes 
of this paragraph (d)(3), available amount means any amount that is 
available to an issuer for working capital expenditure purposes of the 
type financed by an issue. Except as otherwise provided, available 
amount excludes proceeds of any issue but includes cash, investments, 
and other amounts held in accounts or otherwise by the issuer or a 
related party if those amounts may be used by the issuer for working 
capital expenditures of the type being financed by an issue without 
legislative or judicial action and without a legislative, judicial, or 
contractual requirement that those amounts be reimbursed.
    (B) Reasonable working capital reserve treated as unavailable. A 
reasonable working capital reserve is treated as unavailable. Any 
working capital reserve is reasonable if it does not exceed 5 percent of 
the actual working capital expenditures of the issuer in the fiscal year 
before the year in which the determination of available amounts is made. 
For this purpose only, in determining the working capital expenditures 
of an issuer for a prior fiscal year, any expenditures (whether capital 
or working capital expenditures) that are paid out of current revenues 
may be treated as working capital expenditures.
    (C) Qualified endowment funds treated as unavailable. For a 
501(c)(3) organization, a qualified endowment fund is treated as 
unavailable. A fund is a qualified endowment fund if--
    (1) The fund is derived from gifts or bequests, or the income 
thereon, that were neither made nor reasonably expected to be used to 
pay working capital expenditures;
    (2) Pursuant to reasonable, established practices of the 
organization, the governing body of the 501(c)(3) organization 
designates and consistently

[[Page 124]]

operates the fund as a permanent endowment fund or quasi-endowment fund 
restricted as to use; and
    (3) There is an independent verification that the fund is reasonably 
necessary as part of the organization's permanent capital.
    (D) Application to statutory safe harbor for tax and revenue 
anticipation bonds. For purposes of section 148(f)(4)(B)(iii)(II), 
available amount has the same meaning as in paragraph (d)(3)(iii) of 
this section, except that the otherwise-permitted reasonable working 
capital reserve is treated as part of the available amount.
    (4) Expenditures for grants--(i) In general. Gross proceeds of an 
issue that are used to make a grant are allocated to an expenditure on 
the date on which the grant is made.
    (ii) Characterization of repayments of grants. If any amount of a 
grant financed by gross proceeds of an issue is repaid to the grantor, 
the repaid amount is treated as unspent proceeds of the issue as of the 
repayment date unless expended within 60 days of repayment.
    (5) Expenditures for reimbursement purposes. In allocating gross 
proceeds of issues of reimbursement bonds (as defined in Sec. 1.150-2)) 
to certain expenditures, Sec. 1.150-2 applies. In allocating gross 
proceeds to an expenditure to reimburse a previously paid working 
capital expenditure, paragraph (d)(3) of this section applies. Thus, if 
the expenditure is described in paragraph (d)(3)(ii) of this section or 
there are no available amounts on the date a working capital expenditure 
is made and there are no other available amounts on the date of the 
reimbursement of that expenditure, gross proceeds are allocated to the 
working capital expenditure as of the date of the reimbursement.
    (6) Expenditures of certain commingled investment proceeds of 
governmental issues. This paragraph (d)(6) applies to any issue of 
governmental bonds, any issue of private activity bonds issued to 
finance a facility that is required by section 142 to be owned by a 
governmental unit, and any portion of an issue that is not treated as 
consisting of private activity bonds under section 141(b)(9). Investment 
proceeds of the issue (other than investment proceeds held in a 
refunding escrow) are treated as allocated to expenditures for a 
governmental purpose when the amounts are deposited in a commingled fund 
with substantial tax or other revenues from governmental operations of 
the issuer and the amounts are reasonably expected to be spent for 
governmental purposes within 6 months from the date of the commingling. 
In establishing these reasonable expectations, an issuer may use any 
reasonable accounting assumption and is not bound by the proceeds-spent-
last assumption generally required for working capital expenditures 
under paragraph (d)(3) of this section.
    (7) Payments to related parties. Any payment of gross proceeds of 
the issue to a related party of the payor is not an expenditure of those 
gross proceeds.
    (e) Special rules for commingled funds--(1) In general. An 
accounting method for gross proceeds of an issue in a commingled fund, 
other than a bona fide debt service fund, is reasonable only if it 
satisfies the requirements of paragraphs (e)(2) through (6) of this 
section in addition to the other requirements of this section.
    (2) Investments held by a commingled fund--(i) Required ratable 
allocations. Not less frequently than as of the close of each fiscal 
period, all payments and receipts (including deemed payments and 
receipts) on investments held by a commingled fund must be allocated 
(but not necessarily distributed) among the different investors in the 
fund. This allocation must be based on a consistently applied, 
reasonable ratable allocation method.
    (ii) Safe harbors for ratable allocation methods. Reasonable ratable 
allocation methods include, without limitation, methods that allocate 
these items in proportion to either--
    (A) The average daily balances of the amounts in the commingled fund 
from different investors during a fiscal period (as described in 
paragraph (e)(4) of this section); or
    (B) The average of the beginning and ending balances of the amounts 
in the commingled fund from different investors for a fiscal period that 
does not exceed one month.

[[Page 125]]

    (iii) Definition of investor. For purposes of this paragraph (e), 
the term investor means each different source of funds invested in a 
commingled fund. For example, if a city invests gross proceeds of an 
issue and tax revenues in a commingled fund, it is treated as two 
different investors.
    (3) Certain expenditures involving a commingled fund. If a ratable 
allocation method is used under paragraph (d) of this section to 
allocate expenditures from the commingled fund, the same ratable 
allocation method must be used to allocate payments and receipts on 
investments in the commingled fund under paragraph (e)(2) of this 
section.
    (4) Fiscal periods. The fiscal year of a commingled fund is the 
calendar year unless the fund adopts another fiscal year. A commingled 
fund may use any consistent fiscal period that does not exceed three 
months (e.g., a daily, weekly, monthly, or quarterly fiscal period).
    (5) Unrealized gains and losses on investments of a commingled 
fund--(i) Mark-to-market requirement for internal commingled funds with 
longer-term investment portfolios. Except as otherwise provided in this 
paragraph (e), in the case of a commingled fund in which the issuer and 
any related party own more than 25 percent of the beneficial interests 
in the fund (an internal commingled fund), the fund must treat all its 
investments as if sold at fair market value either on the last day of 
the fiscal year or the last day of each fiscal period. The net gains or 
losses from these deemed sales of investments must be allocated to all 
investors of the commingled fund during the period since the last 
allocation.
    (ii) Exception for internal commingled funds with shorter-term 
investment portfolios. If the remaining weighted average maturity of all 
investments held by a commingled fund during a particular fiscal year 
does not exceed 18 months, and the investments held by the commingled 
fund during that fiscal year consist exclusively of obligations, the 
mark-to-market requirement of paragraph (e)(5)(i) of this section does 
not apply.
    (iii) Exception for commingled reserve funds and sinking funds. The 
mark-to-market requirement of paragraph (e)(5)(i) of this section does 
not apply to a commingled fund that operates exclusively as a reserve 
fund, sinking fund, or replacement fund for two or more issues of the 
same issuer.
    (6) Allocations of commingled funds serving as common reserve funds 
or sinking funds--(i) Permitted ratable allocation methods. If a 
commingled fund serves as a common reserve fund, replacement fund, or 
sinking fund for two or more issues (a commingled reserve), after making 
reasonable adjustments to account for proceeds allocated under paragraph 
(b)(1) or (b)(2) of this section, investments held by that commingled 
fund must be allocated ratably among the issues served by the commingled 
fund in accordance with one of the following methods--
    (A) The relative values of the bonds of those issues under 
Sec. 1.148-4(e);
    (B) The relative amounts of the remaining maximum annual debt 
service requirements on the outstanding principal amounts of those 
issues; or
    (C) The relative original stated principal amounts of the 
outstanding issues.
    (ii) Frequency of allocations. An issuer must make any allocations 
required by this paragraph (e)(6) as of a date at least every 3 years 
and as of each date that an issue first becomes secured by the 
commingled reserve. If relative original principal amounts are used to 
allocate, allocations must also be made on the retirement of any issue 
secured by the commingled reserve.

[T.D. 8476, 58 FR 33532, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24045, May 10, 1994; T.D. 8712, 62 FR 2304, 
Jan. 16, 1997; T.D. 8718, 62 FR 25512, May 9, 1997; T.D. 9777, 81 FR 
46597, July 18, 2016]



Sec. 1.148-7  Spending exceptions to the rebate requirement.

    (a) Scope of section--(1) In general. This section provides guidance 
on the spending exceptions to the arbitrage rebate requirement of 
section 148(f)(2). These exceptions are the 6-month exception in section 
148(f)(4)(B) (the 6-month exception), the 18-month exception under 
paragraph (d) of this section (the 18-month exception), and the 2-year 
construction exception under section 148(f)(4)(C) (the 2-year exception) 
(collectively, the spending exceptions).

[[Page 126]]

    (2) Relationship of spending exceptions. Each of the spending 
exceptions is an independent exception to arbitrage rebate. For example, 
a construction issue may qualify for the 6-month exception or the 18-
month exception even though the issuer makes one or more elections under 
the 2-year exception with respect to the issue.
    (3) Spending exceptions not mandatory. Use of the spending 
exceptions is not mandatory. An issuer may apply the arbitrage rebate 
requirement to an issue that otherwise satisfies a spending exception. 
If an issuer elects to pay penalty in lieu of rebate under the 2-year 
exception, however, the issuer must apply those penalty provisions.
    (b) Rules applicable for all spending exceptions. The provisions of 
this paragraph (b) apply for purposes of applying each of the spending 
exceptions.
    (1) Special transferred proceeds rules--(i) Application to prior 
issues. For purposes of applying the spending exceptions to a prior 
issue only, proceeds of the prior issue that become transferred proceeds 
of the refunding issue continue to be treated as unspent proceeds of the 
prior issue. If the prior issue satisfies one of the spending 
exceptions, the proceeds of the prior issue that are excepted from 
rebate under that spending exception are not subject to rebate either as 
proceeds of the prior issue or as transferred proceeds of the refunding 
issue.
    (ii) Application to refunding issues--(A) In general. The only 
spending exception applicable to refunding issues is the 6-month 
exception. For purposes of applying the 6-month exception to a refunding 
issue only, proceeds of the prior issue that become transferred proceeds 
of the refunding issue generally are not treated as proceeds of the 
refunding issue and need not be spent for the refunding issue to satisfy 
that spending exception. Even if the refunding issue qualifies for that 
spending exception, those transferred proceeds are subject to rebate as 
proceeds of the refunding issue unless an exception to rebate applied to 
those proceeds as proceeds of the prior issue.
    (B) Exception. For purposes of applying the 6-month exception to 
refunding issues, those transferred proceeds of the refunding issue 
excluded from the gross proceeds of the prior issue under the special 
definition of gross proceeds in paragraph (c)(3) of this section, and 
those that transferred from a prior taxable issue, are generally treated 
as gross proceeds of the refunding issue. Thus, for the refunding issue 
to qualify for the 6-month exception, those proceeds must be spent 
within 6 months of the issue date of the refunding issue, unless those 
amounts continue to be used in a manner that does not cause those 
amounts to be gross proceeds under paragraph (c)(3) of this section.
    (2) Application of multipurpose issue rules. Except as otherwise 
provided, if any portion of an issue is treated as a separate issue 
allocable to refunding purposes under Sec. 1.148-9(h) (relating to 
multipurpose issues), for purposes of this section, that portion is 
treated as a separate issue.
    (3) Expenditures for governmental purposes of the issue. For 
purposes of this section, expenditures for the governmental purpose of 
an issue include payments for interest, but not principal, on the issue, 
and for principal or interest on another issue of obligations. The 
preceding sentence does not apply for purposes of the 18-month and 2-
year exceptions if those payments cause the issue to be a refunding 
issue.
    (4) De minimis rule. Any failure to satisfy the final spending 
requirement of the 18-month exception or the 2-year exception is 
disregarded if the issuer exercises due diligence to complete the 
project financed and the amount of the failure does not exceed the 
lesser of 3 percent of the issue price of the issue or $250,000.
    (5) Special definition of reasonably required reserve or replacement 
fund. For purposes of this section only, a reasonably required reserve 
or replacement fund also includes any fund to the extent described in 
Sec. 1.148-5(c)(3)(i)(E) or (G).
    (6) Pooled financing issue--(i) In general. Except as otherwise 
provided in this paragraph (b)(6), the spending exceptions apply to a 
pooled financing issue as a whole, rather than to each loan separately.
    (ii) Election to apply spending exceptions separately to each loan--
(A) In general. At the election (made on or before the issue date) of 
the issuer of a pooled

[[Page 127]]

financing issue, the spending exceptions are applied separately to each 
conduit loan, and the applicable spending requirements for a loan begin 
on the earlier of the date the loan is made, or the first day following 
the 1-year period beginning on the issue date of the pooled financing 
issue. If this election is made, the rebate requirement applies to, and 
none of the spending exceptions are available for, gross proceeds of the 
pooled financing bonds before the date on which the spending 
requirements for those proceeds begin.
    (B) Application of spending exceptions. If the issuer makes the 
election under this paragraph (b)(6)(ii), the rebate requirement is 
satisfied for proceeds used to finance a particular conduit loan to the 
extent that the loan satisfies a spending exception or the small issuer 
exception under Sec. 1.148-8, regardless of whether any other conduit 
loans allocable to the issue satisfy such an exception. A pooled 
financing issue is an issue of arbitrage bonds, however, unless the 
entire issue satisfies the requirements of section 148. An issuer may 
pay rebate for some conduit loans and 1\1/2\ percent penalty for other 
conduit loans from the same pooled financing issue. The 1\1/2\ percent 
penalty is computed separately for each conduit loan.
    (C) Elections under 2-year exception. If the issuer makes the 
election under this paragraph (b)(6)(ii), the issuer may make all 
elections under the 2-year exception separately for each loan. Elections 
regarding a loan that otherwise must be made by the issuer on or before 
the issue date instead may be made on or before the date the loan is 
made (but not later than 1 year after the issue date).
    (D) Example. The operation of this paragraph (b)(6) is illustrated 
by the following example:

    Example. Pooled financing issue. On January 1, 1994, Authority J 
issues bonds. As of the issue date, J reasonably expects to use the 
proceeds of the issue to make loans to City K, County L, and City M. J 
does not reasonably expect to use more than 75 percent of the available 
construction proceeds of the issue for construction expenditures. On or 
before the issue date, J elects to apply the spending exceptions 
separately for each loan, with spending requirements beginning on the 
earlier of the date the loan is made or the first day following the 1-
year period beginning on the issue date. On February 1, 1994, J loans a 
portion of the proceeds to K, and K reasonably expects that 45 percent 
of those amounts will be used for construction expenditures. On the date 
this loan is made, J elects under paragraph (j) of this section to treat 
60 percent of the amount loaned to K as a separate construction issue, 
and also elects the 1\1/2\ percent penalty under paragraph (k) of this 
section for the separate construction issue. On March 1, 1994, J loans a 
portion of the proceeds to L, and L reasonably expects that more than 75 
percent of those amounts will be used for construction expenditures. On 
March 1, 1995, J loans the remainder of the proceeds to M, and none of 
those amounts will be used for construction expenditures. J must satisfy 
the rebate requirement for all gross proceeds before those amounts are 
loaned. For the loan to K, the spending periods begin on February 1, 
1994, and the 1\1/2\ percent penalty must be paid for any failure to 
meet a spending requirement for the portion of the loan to K that is 
treated as a separate construction issue. Rebate must be paid on the 
remaining portion of the loan to K, unless that portion qualifies for 
the 6-month exception. For the loan to L, the spending periods begin on 
March 1, 1994, and the rebate requirement must be satisfied unless the 
6-month, 18-month, or the 2-year exception is satisfied with respect to 
those amounts. For the loan to M, the spending periods begin on January 
2, 1995, and the rebate requirement must be satisfied for those amounts 
unless the 6-month or 18-month exception is satisfied.

    (c) 6-month exception--(1)General rule. An issue is treated as 
meeting the rebate requirement if--
    (i) The gross proceeds (as modified by paragraph (c)(3) of this 
section) of the issue are allocated to expenditures for the governmental 
purposes of the issue within the 6-month period beginning on the issue 
date (the 6-month spending period); and
    (ii) The rebate requirement is met for amounts not required to be 
spent within the 6-month spending period (excluding earnings on a bona 
fide debt service fund).
    (2) Additional period for certain bonds. The 6-month spending period 
is extended for an additional 6 months in certain circumstances 
specified under section 148(f)(4)(B)(ii).
    (3) Amounts not included in gross proceeds. For purposes of 
paragraph (c)(1)(i) of this section only, gross proceeds has the meaning 
used in Sec. 1.148-1, except it does not include amounts--

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    (i) In a bona fide debt service fund;
    (ii) In a reasonably required reserve or replacement fund (see 
Sec. 1.148-7(b)(5));
    (iii) That, as of the issue date, are not reasonably expected to be 
gross proceeds but that become gross proceeds after the end of the 6-
month spending period;
    (iv) Representing sale or investment proceeds derived from payments 
under any purpose investment of the issue; and
    (v) Representing repayments of grants (as defined in Sec. 1.150-
1(f)) financed by the issue.
    (4) Series of refundings. If a principal purpose of a series of 
refunding issues is to exploit the difference between taxable and tax-
exempt interest rates by investing proceeds during the temporary periods 
provided in Sec. 1.148-9(d), the 6-month spending period for all issues 
in the series begins on the issue date of the first issue in the series.
    (d) 18-month exception--(1) General rule. An issue is treated as 
meeting the rebate requirement if all of the following requirements are 
satisfied--
    (i) 18-month expenditure schedule met. The gross proceeds (as 
defined in paragraph (d)(3) of this section) are allocated to 
expenditures for a governmental purpose of the issue in accordance with 
the following schedule (the 18-month expenditure schedule) measured from 
the issue date--
    (A) At least 15 percent within 6 months (the first spending period);
    (B) At least 60 percent within 12 months (the second spending 
period); and
    (C) 100 percent within 18 months (the third spending period).
    (ii) Rebate requirement met for amounts not required to be spent. 
The rebate requirement is met for all amounts not required to be spent 
in accordance with the 18-month expenditure schedule (other than 
earnings on a bona fide debt service fund).
    (iii) Issue qualifies for initial temporary period. All of the gross 
proceeds (as defined in paragraph (d)(3)(i) of this section) of the 
issue qualify for the initial temporary period under Sec. 1.148-2(e)(2).
    (2) Extension for reasonable retainage. An issue does not fail to 
satisfy the spending requirement for the third spending period as a 
result of a reasonable retainage if the reasonable retainage is 
allocated to expenditures within 30 months of the issue date. Reasonable 
retainage has the meaning under paragraph (h) of this section, as 
modified to refer to net sale proceeds on the date 18 months after the 
issue date.
    (3) Gross proceeds--(i) Definition of gross proceeds. For purposes 
of paragraph (d)(1) of this section only, gross proceeds means gross 
proceeds as defined in paragraph (c)(3) of this section, as modified to 
refer to ``18 months'' in paragraph (c)(3)(iii) of this section in lieu 
of ``6 months.''
    (ii) Estimated earnings. For purposes of determining compliance with 
the first two spending periods under paragraph (d)(1)(i) of this 
section, the amount of investment proceeds included in gross proceeds of 
the issue is determined based on the issuer's reasonable expectations on 
the issue date.
    (4) Application to multipurpose issues. This paragraph (d) does not 
apply to an issue any portion of which is treated as meeting the rebate 
requirement under paragraph (e) of this section (relating to the 2-year 
exception).
    (e) 2-year exception--(1) General rule. A construction issue is 
treated as meeting the rebate requirement for available construction 
proceeds if those proceeds are allocated to expenditures for 
governmental purposes of the issue in accordance with the following 
schedule (the 2-year expenditure schedule), measured from the issue 
date--
    (i) At least 10 percent within 6 months (the first spending period);
    (ii) At least 45 percent within 1 year (the second spending period);
    (iii) At least 75 percent within 18 months (the third spending 
period); and
    (iv) 100 percent within 2 years (the fourth spending period).
    (2) Extension for reasonable retainage. An issue does not fail to 
satisfy the spending requirement for the fourth spending period as a 
result of unspent amounts for reasonable retainage (as defined in 
paragraph (h) of this section) if those amounts are allocated to 
expenditures within 3 years of the issue date.
    (3) Definitions. For purposes of the 2-year exception, the following 
definitions apply:

[[Page 129]]

    (i) Real property means land and improvements to land, such as 
buildings or other inherently permanent structures, including interests 
in real property. For example, real property includes wiring in a 
building, plumbing systems, central heating or air-conditioning systems, 
pipes or ducts, elevators, escalators installed in a building, paved 
parking areas, roads, wharves and docks, bridges, and sewage lines.
    (ii) Tangible personal property means any tangible property other 
than real property, including interests in tangible personal property. 
For example, tangible personal property includes machinery that is not a 
structural component of a building, subway cars, fire trucks, 
automobiles, office equipment, testing equipment, and furnishings.
    (iii) Substantially completed. Construction may be treated as 
substantially completed when the issuer abandons construction or when at 
least 90 percent of the total costs of the construction reasonably 
expected, as of that date, to be financed with the available 
construction proceeds have been allocated to expenditures.
    (f) Construction issue--(1) Definition. Construction issue means any 
issue that is not a refunding issue if--
    (i) The issuer reasonably expects, as of the issue date, that at 
least 75 percent of the available construction proceeds of the issue 
will be allocated to construction expenditures (as defined in paragraph 
(g) of this section) for property owned by a governmental unit or a 
501(c)(3) organization; and
    (ii) Any private activity bonds that are part of the issue are 
qualified 501(c)(3) bonds or private activity bonds issued to finance 
property to be owned by a governmental unit or a 501(c)(3) organization.
    (2) Use of actual facts. For the provisions of paragraphs (e) 
through (m) of this section that apply based on the issuer's reasonable 
expectations, an issuer may elect on or before the issue date to apply 
all of those provisions based on actual facts, except that this election 
does not apply for purposes of determining whether an issue is a 
construction issue under paragraph (f)(1) of this section if the 1\1/2\ 
percent penalty election is made under paragraph (k) of this section.
    (3) Ownership requirement--(i) In general. A governmental unit or 
501(c)(3) organization is treated as the owner of property if it would 
be treated as the owner for Federal income tax purposes. For obligations 
issued on behalf of a State or local governmental unit, the entity that 
actually issues the bonds is treated as a governmental unit.
    (ii) Safe harbor for leases and management contracts. Property 
leased by a governmental unit or a 501(c)(3) organization is treated as 
owned by the governmental unit or 501(c)(3) organization if the lessee 
complies with the requirements of section 142(b)(1)(B). For a bond 
described in section 142(a)(6), the requirements of section 142(b)(1)(B) 
apply as modified by section 146(h)(2).
    (g) Construction expenditures--(1) Definition. Except as otherwise 
provided, construction expenditures means capital expenditures (as 
defined in Sec. 1.150-1) that are allocable to the cost of real property 
or constructed personal property (as defined in paragraph (g)(3) of this 
section). Except as provided in paragraph (g)(2) of this section, 
construction expenditures do not include expenditures for acquisitions 
of interests in land or other existing real property.
    (2) Certain acquisitions under turnkey contracts treated as 
construction expenditures. Expenditures are not for the acquisition of 
an interest in existing real property other than land if the contract 
between the seller and the issuer requires the seller to build or 
install the property (e.g., a turnkey contract), but only to the extent 
that the property has not been built or installed at the time the 
parties enter into the contract.
    (3) Constructed personal property. Constructed personal property 
means tangible personal property (or, if acquired pursuant to a single 
acquisition contract, properties) or specially developed computer 
software if--
    (i) A substantial portion of the property or properties is completed 
more than 6 months after the earlier of the date construction or 
rehabilitation commenced and the date the issuer entered into an 
acquisition contract;

[[Page 130]]

    (ii) Based on the reasonable expectations of the issuer, if any, or 
representations of the person constructing the property, with the 
exercise of due diligence, completion of construction or rehabilitation 
(and delivery to the issuer) could not have occurred within that 6-month 
period; and
    (iii) If the issuer itself builds or rehabilitates the property, not 
more than 75 percent of the capitalizable cost is attributable to 
property acquired by the issuer (e.g., components, raw materials, and 
other supplies).
    (4) Specially developed computer software. Specially developed 
computer software means any programs or routines used to cause a 
computer to perform a desired task or set of tasks, and the 
documentation required to describe and maintain those programs, provided 
that the software is specially developed and is functionally related and 
subordinate to real property or other constructed personal property.
    (5) Examples. The operation of this paragraph (g) is illustrated by 
the following examples:

    Example 1. Purchase of construction materials. City A issues bonds 
to finance a new office building. A uses proceeds of the bonds to 
purchase materials to be used in constructing the building, such as 
bricks, pipes, wires, lighting, carpeting, heating equipment, and 
similar materials. Expenditures by A for the construction materials are 
construction expenditures because those expenditures will be 
capitalizable to the cost of the building upon completion, even though 
they are not initially capitalizable to the cost of existing real 
property. This result would be the same if A hires a third-party to 
perform the construction, unless the office building is partially 
constructed at the time that A contracts to purchase the building.
    Example 2. Turnkey contract. City B issues bonds to finance a new 
office building. B enters into a turnkey contract with developer D under 
which D agrees to provide B with a completed building on a specified 
completion date on land currently owned by D. Under the agreement, D 
holds title to the land and building and assumes any risk of loss until 
the completion date, at which time title to the land and the building 
will be transferred to B. No construction has been performed by the date 
that B and D enter into the agreement. All payments by B to D for 
construction of the building are construction expenditures because all 
the payments are properly capitalized to the cost of the building, but 
payments by B to D allocable to the acquisition of the land are not 
construction expenditures.
    Example 3. Right-of-way. P, a public agency, issues bonds to finance 
the acquisition of a right-of-way and the construction of sewage lines 
through numerous parcels of land. The right-of-way is acquired primarily 
through P' s exercise of its powers of eminent domain. As of the issue 
date, P reasonably expects that it will take approximately 2 years to 
acquire the entire right-of-way because of the time normally required 
for condemnation proceedings. No expenditures for the acquisition of the 
right-of-way are construction expenditures because they are costs 
incurred to acquire an interest in existing real property.
    Example 4. Subway cars. City C issues bonds to finance new subway 
cars. C reasonably expects that it will take more than 6 months for the 
subway cars to be constructed to C's specifications. The subway cars are 
constructed personal property. Alternatively, if the builder of the 
subway cars informs C that it will only take 3 months to build the 
subway cars to C's specifications, no payments for the subway cars are 
construction expenditures.
    Example 5. Fractional interest in property. U, a public agency, 
issues bonds to finance an undivided fractional interest in a newly 
constructed power-generating facility. U contributes its ratable share 
of the cost of building the new facility to the project manager for the 
facility. U's contributions are construction expenditures in the same 
proportion that the total expenditures for the facility qualify as 
construction expenditures.
    Example 6. Park land. City D issues bonds to finance the purchase of 
unimproved land and the cost of subsequent improvements to the land, 
such as grading and landscaping, necessary to transform it into a park. 
The costs of the improvements are properly capitalizable to the cost of 
the land, and therefore, are construction expenditures, but expenditures 
for the acquisition of the land are not.

    (h) Reasonable retainage definition. Reasonable retainage means an 
amount, not to exceed 5 percent of available construction proceeds as of 
the end of the fourth spending period, that is retained for reasonable 
business purposes relating to the property financed with the proceeds of 
the issue. For example, a reasonable retainage may include a retention 
to ensure or promote compliance with a construction contract in 
circumstances in which the retained amount is not yet payable, or in 
which the issuer reasonably determines that a dispute exists regarding 
completion or payment.

[[Page 131]]

    (i) Available construction proceeds--(1) Definition in general. 
Available construction proceeds has the meaning used in section 
148(f)(4)(C)(vi). For purposes of this definition, earnings include 
earnings on any tax-exempt bond. Pre-issuance accrued interest and 
earnings thereon may be disregarded. Amounts that are not gross proceeds 
as a result of the application of the universal cap under Sec. 1.148-
6(b)(2) are not available construction proceeds.
    (2) Earnings on a reasonably required reserve or replacement fund. 
Earnings on any reasonably required reserve or replacement fund are 
available construction proceeds only to the extent that those earnings 
accrue before the earlier of the date construction is substantially 
completed or the date that is 2 years after the issue date. An issuer 
may elect on or before the issue date to exclude from available 
construction proceeds the earnings on such a fund. If the election is 
made, the rebate requirement applies to the excluded amounts from the 
issue date.
    (3) Reasonable expectations test for future earnings. For purposes 
of determining compliance with the spending requirements as of the end 
of each of the first three spending periods, available construction 
proceeds include the amount of future earnings that the issuer 
reasonably expected as of the issue date.
    (4) Issuance costs. Available construction proceeds do not include 
gross proceeds used to pay issuance costs financed by an issue, but do 
include earnings on such proceeds. Thus, an expenditure of gross 
proceeds of an issue for issuance costs does not count toward meeting 
the spending requirements. The expenditure of earnings on gross proceeds 
used to pay issuance costs does count toward meeting those requirements. 
If the spending requirements are met and the proceeds used to pay 
issuance costs are expended by the end of the fourth spending period, 
those proceeds and the earnings thereon are treated as having satisfied 
the rebate requirement.
    (5) One and one-half percent penalty in lieu of arbitrage rebate. 
For purposes of the spending requirements of paragraph (e) of this 
section, available construction proceeds as of the end of any spending 
period are reduced by the amount of penalty in lieu of arbitrage rebate 
(under paragraph (k) of this section) that the issuer has paid from 
available construction proceeds before the last day of the spending 
period.
    (6) Payments on purpose investments and repayments of grants. 
Available construction proceeds do not include--
    (i) Sale or investment proceeds derived from payments under any 
purpose investment of the issue; or
    (ii) Repayments of grants (as defined in Sec. 1.150-1(f)) financed 
by the issue.
    (7) Examples. The operation of this paragraph (i) is illustrated by 
the following examples:

    Example 1. Treatment of investment earnings. City F issues bonds 
having an issue price of $10,000,000. F deposits all of the proceeds of 
the issue into a construction fund to be used for expenditures other 
than costs of issuance. F estimates on the issue date that, based on 
reasonably expected expenditures and rates of investment, earnings on 
the construction fund will be $800,000. As of the issue date and the end 
of each of the first three spending periods, the amount of available 
construction proceeds is $10,800,000. To qualify as a construction 
issue, F must reasonably expect on the issue date that at least 
$8,100,000 (75 percent of $10,800,000) will be used for construction 
expenditures. In order to meet the 10 percent spending requirement at 
the end of the first spending period, F must spend at least $1,080,000. 
As of the end of the fourth spending period, F has received $1,100,000 
in earnings. In order to meet the spending requirement at the end of the 
fourth spending period, however, F must spend all of the $11,100,000 of 
actual available construction proceeds (except for reasonable retainage 
not exceeding $555,000).
    Example 2. Treatment of investment earnings without a reserve fund. 
City G issues bonds having an issue price of $11,200,000. G does not 
elect to exclude earnings on the reserve fund from available 
construction proceeds. G uses $200,000 of proceeds to pay issuance costs 
and deposits $1,000,000 of proceeds into a reasonably required reserve 
fund. G deposits the remaining $10,000,000 of proceeds into a 
construction fund to be used for construction expenditures. On the issue 
date, G reasonably expects that, based on the reasonably expected date 
of substantial completion and rates of investment, total earnings on the 
construction fund will be $800,000, and total earnings on the reserve 
fund to the date of substantial completion will be $150,000. G 
reasonably expects that substantial completion will occur during the 
fourth spending period. As of the issue date, the amount of available 
construction proceeds is

[[Page 132]]

$10,950,000 ($10,000,000 originally deposited into the construction fund 
plus $800,000 expected earnings on the construction fund and $150,000 
expected earnings on the reserve fund). To qualify as a construction 
issue, G must reasonably expect on the issue date that at least 
$8,212,500 will be used for construction expenditures.
    Example 3. Election to exclude earnings on a reserve fund. The facts 
are the same as Example 2, except that G elects on the issue date to 
exclude earnings on the reserve fund from available construction 
proceeds. The amount of available construction proceeds as of the issue 
date is $10,800,000.

    (j) Election to treat portion of issue used for construction as 
separate issue--(1) In general. For purposes of paragraph (e) of this 
section, if any proceeds of an issue are to be used for construction 
expenditures, the issuer may elect on or before the issue date to treat 
the portion of the issue that is not a refunding issue as two, and only 
two, separate issues, if--
    (i) One of the separate issues is a construction issue as defined in 
paragraph (f) of this section;
    (ii) The issuer reasonably expects, as of the issue date, that this 
construction issue will finance all of the construction expenditures to 
be financed by the issue; and
    (iii) The issuer makes an election to apportion the issue under this 
paragraph (j)(1) in which it identifies the amount of the issue price of 
the issue allocable to the construction issue.
    (2) Example. The operation of this paragraph (j) is illustrated by 
the following example.

    Example. City D issues bonds having an issue price of $19,000,000. 
On the issue date, D reasonably expects to use $10,800,000 of bond 
proceeds (including investment earnings) for construction expenditures 
for the project being financed. D deposits $10,000,000 in a construction 
fund to be used for construction expenditures and $9,000,000 in an 
acquisition fund to be used for acquisition of equipment not qualifying 
as construction expenditures. D estimates on the issue date, based on 
reasonably expected expenditures and rates of investment, that total 
earnings on the construction fund will be $800,000 and total earnings on 
the acquisition fund will be $200,000. Because the total construction 
expenditures to be financed by the issue are expected to be $10,800,000, 
the maximum available construction proceeds for a construction issue is 
$14,400,000 ($10,800,000 divided by 0.75). To determine the maximum 
amount of the issue price allocable to a construction issue, the 
estimated investment earnings allocable to the construction issue are 
subtracted. The entire $800,000 of earnings on the construction fund are 
allocable to the construction issue. Only a portion of the $200,000 of 
earnings on the acquisition fund, however, are allocable to the 
construction issue. The total amount of the available construction 
proceeds that is expected to be used for acquisition is $3,600,000 
($14,400,000-$10,800,000). The portion of earnings on the acquisition 
fund that is allocable to the construction issue is $78,261 ($200,000 
x  $3,600,000/$9,200,000). Accordingly, D may elect on or before the 
issue date to treat up to $13,521,739 of the issue price as a 
construction issue ($14,400,000-$800,000-$78,261). D's election must 
specify the amount of the issue price treated as a construction issue. 
The balance of the issue price is treated as a separate nonconstruction 
issue that is subject to the rebate requirement unless it meets another 
exception to arbitrage rebate. Because the financing of a construction 
issue is a separate governmental purpose under Sec. 1.148-9(h), the 
election causes the issue to be a multipurpose issue under that section.

    (k) One and one-half percent penalty in lieu of arbitrage rebate--
(1) In general. Under section 148(f)(4)(C)(vii), an issuer of a 
construction issue may elect on or before the issue date to pay a 
penalty (the 1\1/2\ percent penalty) to the United States in lieu of the 
obligation to pay the rebate amount on available construction proceeds 
upon failure to satisfy the spending requirements of paragraph (e) of 
this section. The 1\1/2\ percent penalty is calculated separately for 
each spending period, including each semiannual period after the end of 
the fourth spending period, and is equal to 1.5 percent times the 
underexpended proceeds as of the end of the spending period. For each 
spending period, underexpended proceeds equal the amount of available 
construction proceeds required to be spent by the end of the spending 
period, less the amount actually allocated to expenditures for the 
governmental purposes of the issue by that date. The 1\1/2\ percent 
penalty must be paid to the United States no later than 90 days after 
the end of the spending period to which it relates. The 1\1/2\ percent 
penalty continues to apply at the end of each spending period and each 
semiannual period thereafter until the earliest of the following--

[[Page 133]]

    (i) The termination of the penalty under paragraph (l) of this 
section;
    (ii) The expenditure of all of the available construction proceeds; 
or
    (iii) The last stated final maturity date of bonds that are part of 
the issue and any bonds that refund those bonds.
    (2) Application to reasonable retainage. If an issue meets the 
exception for reasonable retainage except that all retainage is not 
spent within 3 years of the issue date, the issuer must pay the 1\1/2\ 
percent penalty to the United States for any reasonable retainage that 
was not so spent as of the close of the 3-year period and each later 
spending period.
    (3) Coordination with rebate requirement. The rebate requirement is 
treated as met with respect to available construction proceeds for a 
period if the 1\1/2\ percent penalty is paid in accordance with this 
section.
    (l) Termination of 1\1/2\ percent penalty--(1)Termination after 
initial temporary period. The issuer may terminate the 1\1/2\ percent 
penalty after the initial temporary period (a section 148(f)(4)(C)(viii) 
penalty termination) if--
    (i) Not later than 90 days after the earlier of the end of the 
initial temporary period or the date construction is substantially 
completed, the issuer elects to terminate the 1\1/2\ percent penalty; 
provided that solely for this purpose, the initial temporary period may 
be extended by the issuer to a date ending 5 years after the issue date;
    (ii) Within 90 days after the end of the initial temporary period, 
the issuer pays a penalty equal to 3 percent of the unexpended available 
construction proceeds determined as of the end of the initial temporary 
period, multiplied by the number of years (including fractions of years 
computed to 2 decimal places) in the initial temporary period;
    (iii) For the period beginning as of the close of the initial 
temporary period, the unexpended available construction proceeds are not 
invested in higher yielding investments; and
    (iv) On the earliest date on which the bonds may be called or 
otherwise redeemed, with or without a call premium, the unexpended 
available construction proceeds as of that date (not including any 
amount earned after the date on which notice of the redemption was 
required to be given) must be used to redeem the bonds. Amounts used to 
pay any call premium are treated as used to redeem bonds. This 
redemption requirement may be met by purchases of bonds by the issuer on 
the open market at prices not exceeding fair market value. A portion of 
the annual principal payment due on serial bonds of a construction issue 
may be paid from the unexpended amount, but only in an amount no greater 
than the amount that bears the same ratio to the annual principal due 
that the total unexpended amount bears to the issue price of the 
construction issue.
    (2) Termination before end of initial temporary period. If the 
construction to be financed by the construction issue is substantially 
completed before the end of the initial temporary period, the issuer may 
elect to terminate the 1\1/2\ percent penalty before the end of the 
initial temporary period (a section 148(f)(4)(C)(ix) penalty 
termination) if--
    (i) Before the close of the initial temporary period and not later 
than 90 days after the date the construction is substantially completed, 
the issuer elects to terminate the 1\1/2\ percent penalty;
    (ii) The election identifies the amount of available construction 
proceeds that will not be spent for the governmental purposes of the 
issue; and
    (iii) The issuer has met all of the conditions for a section 
148(f)(4)(C)(viii) penalty termination, applied as if the initial 
temporary period ended as of the date the required election for a 
section 148(f)(4)(C)(ix) penalty termination is made. That penalty 
termination election satisfies the required election for a section 
148(f)(4)(C)(viii) termination.
    (3) Application to reasonable retainage. Solely for purposes of 
determining whether the conditions for terminating the 1\1/2\ percent 
penalty are met, reasonable retainage may be treated as spent for a 
governmental purpose of the construction issue. Reasonable retainage 
that is so treated continues to be subject to the 1\1/2\ percent 
penalty.
    (4) Example. The operation of this paragraph (l) is illustrated by 
the following example.


[[Page 134]]


    Example. City I issues a construction issue having a 20-year 
maturity and qualifying for a 3-year initial temporary period. The bonds 
are first subject to optional redemption 10 years after the issue date 
at a premium of 3 percent. I elects, on or before the issue date, to pay 
the 1\1/2\ percent penalty in lieu of arbitrage rebate. At the end of 
the 3-year temporary period, the project is not substantially completed, 
and $1,500,000 of available construction proceeds of the issue are 
unspent. At that time, I reasonably expects to need $500,000 to complete 
the project. I may terminate the 1\1/2\ percent penalty in lieu of 
arbitrage rebate with respect to the excess $1,500,000 by electing to 
terminate within 90 days of the end of the initial temporary period; 
paying a penalty to the United States of $135,000 (3 percent of 
$1,500,000 multiplied by 3 years); restricting the yield on the 
investment of unspent available construction proceeds for 7 years until 
the first call date, although any portion of these proceeds may still be 
spent on the project prior to that call date; and using the available 
construction proceeds that, as of the first call date, have not been 
allocated to expenditures for the governmental purposes of the issue to 
redeem bonds on that call date. If I fails to make the termination 
election, I is required to pay the 1\1/2\ percent penalty on unspent 
available construction proceeds every 6 months until the latest maturity 
date of bonds of the issue (or any bonds of another issue that refund 
such bonds).

    (m) Payment of penalties. Each penalty payment under this section 
must be paid in the manner provided in Sec. 1.148-3(g). See Sec. 1.148-
3(h) for rules on failures to pay penalties under this section.

[T.D. 8476, 58 FR 33535, June 18, 1993; 58 FR 44452, Aug. 23, 1993; T.D. 
9777, 81 FR 46597, July 18, 2016]



Sec. 1.148-8  Small issuer exception to rebate requirement.

    (a) Scope. Under section 148(f)(4)(D), bonds issued to finance 
governmental activities of certain small issuers are treated as meeting 
the arbitrage rebate requirement of section 148(f)(2) (the ``small 
issuer exception''). This section provides guidance on the small issuer 
exception.
    (b) General taxing powers. The small issuer exception generally 
applies only to bonds issued by governmental units with general taxing 
powers. A governmental unit has general taxing powers if it has the 
power to impose taxes (or to cause another entity to impose taxes) of 
general applicability which, when collected, may be used for the general 
purposes of the issuer. The taxing power may be limited to a specific 
type of tax, provided that the applicability of the tax is not limited 
to a small number of persons. The governmental unit's exercise of its 
taxing power may be subject to procedural limitations, such as voter 
approval requirements, but may not be contingent on approval by another 
governmental unit. See, also, section 148(f)(4)(D)(iv).
    (c) Size limitation--(1) In general. An issue (other than a 
refunding issue) qualifies for the small issuer exception only if the 
issuer reasonably expects, as of the issue date, that the aggregate face 
amount of all tax-exempt bonds (other than private activity bonds) 
issued by it during that calendar year will not exceed $5,000,000; or 
the aggregate face amount of all tax-exempt bonds of the issuer (other 
than private activity bonds) actually issued during that calendar year 
does not exceed $5,000,000. For this purpose, if an issue has more than 
a de minimis amount of original issue discount or premium, aggregate 
face amount means the aggregate issue price of that issue (determined 
without regard to pre-issuance accrued interest).
    (2) Aggregation rules. The following aggregation rules apply for 
purposes of applying the $5,000,000 size limitation under paragraph 
(c)(1) of this section.
    (i) On-behalf-of issuers. An issuer and all entities (other than 
political subdivisions) that issue bonds on behalf of that issuer are 
treated as one issuer.
    (ii) Subordinate entities--(A) In general. Except as otherwise 
provided in paragraph (d) of this section and section 148(f)(4)(D)(iv), 
all bonds issued by a subordinate entity are also treated as issued by 
each entity to which it is subordinate. An issuer is subordinate to 
another governmental entity if it is directly or indirectly controlled 
by the other entity within the meaning of Sec. 1.150-1(e).
    (B) Exception for allocations of size limitation. If an entity 
properly makes an allocation of a portion of its $5,000,000 size 
limitation to a subordinate entity (including an on behalf of issuer) 
under section 148(f)(4)(D)(iv), the portion of bonds issued by the 
subordinate entity

[[Page 135]]

under the allocation is treated as issued only by the allocating entity 
and not by any other entity to which the issuing entity is subordinate. 
These allocations are irrevocable and must bear a reasonable 
relationship to the benefits received by the allocating unit from issues 
issued by the subordinate entity. The benefits to be considered include 
the manner in which--
    (1) Proceeds are to be distributed;
    (2) The debt service is to be paid;
    (3) The facility financed is to be owned;
    (4) The use or output of the facility is to be shared; and
    (5) Costs of operation and maintenance are to be shared.
    (iii) Avoidance of size limitation. An entity formed or availed of 
to avoid the purposes of the $5,000,000 size limitation and all entities 
that would benefit from the avoidance are treated as one issuer. 
Situations in which an entity is formed or availed of to avoid the 
purposes of the $5,000,000 size limitation include those in which the 
issuer--
    (A) Issues bonds which, but for the $5,000,000 size limitation, 
would have been issued by another entity; and
    (B) Does not receive a substantial benefit from the project financed 
by the bonds.
    (3) Certain refunding bonds not taken into account. In applying the 
$5,000,000 size limitation, there is not taken into account the portion 
of an issue that is a current refunding issue to the extent that the 
stated principal amount of the refunding bond does not exceed the 
portion of the outstanding stated principal amount of the refunded bond 
paid with proceeds of the refunding bond. For this purpose, principal 
amount means, in reference to a plain par bond, its stated principal 
amount plus accrued unpaid interest, and in reference to any other bond, 
its present value.
    (d) Pooled financings--treatment of conduit borrowers. A loan to a 
conduit borrower in a pooled financing qualifies for the small issuer 
exception, regardless of the size of either the pooled financing or of 
any loan to other conduit borrowers, only if--
    (1) The bonds of the pooled financing are not private activity 
bonds;
    (2) None of the loans to conduit borrowers are private activity 
bonds; and
    (3) The loan to the conduit borrower meets all the requirements of 
the small issuer exception.
    (e) Refunding issues--(1) In general. Sections 148(f)(4)(D) (v) and 
(vi) provide restrictions on application of the small issuer exception 
to refunding issues.
    (2) Multipurpose issues. The multipurpose issue allocation rules of 
Sec. 1.148-9(h) apply for purposes of determining whether refunding 
bonds meet the requirements of section 148(f)(4)(D)(v).

[T.D. 8476, 58 FR 33540, June 18, 1993, as amended by T.D. 9777, 81 FR 
46597, July 18, 2016]



Sec. 1.148-9  Arbitrage rules for refunding issues.

    (a) Scope of application. This section contains special arbitrage 
rules for refunding issues. These rules apply for all purposes of 
section 148 and govern allocations of proceeds, bonds, and investments 
to determine transferred proceeds, temporary periods, reasonably 
required reserve or replacement funds, minor portions, and separate 
issue treatment of certain multipurpose issues.
    (b) Transferred proceeds allocation rule--(1) In general. When 
proceeds of the refunding issue discharge any of the outstanding 
principal amount of the prior issue, proceeds of the prior issue become 
transferred proceeds of the refunding issue and cease to be proceeds of 
the prior issue. The amount of proceeds of the prior issue that becomes 
transferred proceeds of the refunding issue is an amount equal to the 
proceeds of the prior issue on the date of that discharge multiplied by 
a fraction--
    (i) The numerator of which is the principal amount of the prior 
issue discharged with proceeds of the refunding issue on the date of 
that discharge; and
    (ii) The denominator of which is the total outstanding principal 
amount of the prior issue on the date immediately before the date of 
that discharge.
    (2) Special definition of principal amount. For purposes of this 
section, principal amount means, in reference to a plain par bond, its 
stated principal amount, and in reference to any other bond, its present 
value.
    (3) Relation of transferred proceeds rule to universal cap rule--(i) 
In general.

[[Page 136]]

Paragraphs (b)(1) and (c) of this section apply to allocate transferred 
proceeds and corresponding investments to a refunding issue on any date 
required by those paragraphs before the application of the universal cap 
rule of Sec. 1.148-6(b)(2) to reallocate any of those amounts. To the 
extent nonpurpose investments allocable to proceeds of a refunding issue 
exceed the universal cap for the issue on the date that amounts become 
transferred proceeds of the refunding issue, those transferred proceeds 
and corresponding investments are reallocated back to the issue from 
which they transferred on that same date to the extent of the unused 
universal cap on that prior issue.
    (ii) Example. The following example illustrates the application of 
this paragraph of (b)(3):

    Example. On January 1, 1995, $100,000 of nonpurpose investments 
allocable to proceeds of issue A become transferred proceeds of issue B 
under Sec. 1.148-9, but the unused portion of issue B' s universal cap 
is $75,000 as of that date. On January 1, 1995, issue A has unused 
universal cap in excess of $25,000. Thus, $25,000 of nonpurpose 
investments representing the transferred proceeds are immediately 
reallocated back to issue A on January 1, 1995, and are proceeds of 
issue A. On the next transfer date under Sec. 1.148-9, the $25,000 
receives no priority in determining transferred proceeds as of that date 
but is treated the same as all other proceeds of issue A subject to 
transfer.

    (4) Limitation on multi-generational transfers. This paragraph 
(b)(4) contains limitations on the manner in which proceeds of a first 
generation issue that is refunded by a refunding issue (a second 
generation issue) become transferred proceeds of a refunding issue (a 
third generation issue) that refunds the second generation issue. 
Proceeds of the first generation issue that become transferred proceeds 
of the third generation issue are treated as having a yield equal to the 
yield on the refunding escrow allocated to the second generation issue 
(i.e., as determined under Sec. 1.148-5(b)(2)(iv)). The determination of 
the transferred proceeds of the third generation issue does not affect 
compliance with the requirements of section 148, including the 
determination of the amount of arbitrage rebate with respect to or the 
yield on the refunding escrow, of the second generation issue.
    (c) Special allocation rules for refunding issues--(1) Allocations 
of investments--(i) In general. Except as otherwise provided in this 
paragraph (c), investments purchased with sale proceeds or investment 
proceeds of a refunding issue must be allocated to those proceeds, and 
investments not purchased with those proceeds may not be allocated to 
those proceeds (i.e., a specific tracing method).
    (ii) Allocations to transferred proceeds. When proceeds of a prior 
issue become transferred proceeds of a refunding issue, investments (and 
the related payments and receipts) of proceeds of the prior issue that 
are held in a refunding escrow for another issue are allocated to the 
transferred proceeds under the ratable allocation method described in 
paragraph (c)(1)(iii) of this section. Investments of proceeds of the 
prior issue that are not held in a refunding escrow for another issue 
are allocated to the transferred proceeds by application of the 
allocation methods described in paragraph (c)(1) (iii) or (iv) of this 
section, consistently applied to all investments on a transfer date.
    (iii) Ratable allocation method. Under the ratable allocation 
method, a ratable portion of each nonpurpose and purpose investment of 
proceeds of the prior issue is allocated to transferred proceeds of the 
refunding issue.
    (iv) Representative allocation method--(A) In general. Under the 
representative allocation method, representative portions of the 
portfolio of nonpurpose investments and the portfolio of purpose 
investments of proceeds of the prior issue are allocated to transferred 
proceeds of the refunding issue. Unlike the ratable allocation method, 
this representative allocation method permits an allocation of 
particular whole investments. Whether a portion is representative is 
based on all the facts and circumstances, including, without limitation, 
whether the current yields, maturities, and current unrealized gains or 
losses on the particular allocated investments are reasonably comparable 
to those of the unallocated investments in the aggregate. In addition, 
if a portion of nonpurpose investments is otherwise representative, it 
is within the issuer's discretion to allocate the portion from whichever 
source

[[Page 137]]

of funds it deems appropriate, such as a reserve fund or a construction 
fund for a prior issue.
    (B) Mark-to-market safe harbor for representative allocation method. 
In addition to other representative allocations, a specific allocation 
of a particular nonpurpose investment to transferred proceeds (e.g., of 
lower yielding investments) is treated as satisfying the representative 
allocation method if that investment is valued at fair market value on 
the transfer date in determining the payments and receipts on that date, 
but only if the portion of the nonpurpose investments that transfers is 
based on the relative fair market value of all nonpurpose investments.
    (2) Allocations of mixed escrows to expenditures for principal, 
interest, and redemption prices on a prior issue--(i) In general. Except 
for amounts required or permitted to be accounted for under paragraph 
(c)(2)(ii) of this section, proceeds of a refunding issue and other 
amounts that are not proceeds of a refunding issue that are deposited in 
a refunding escrow (a mixed escrow) must be accounted for under this 
paragraph (c)(2)(i). Those proceeds and other amounts must be allocated 
to expenditures for principal, interest, or stated redemption prices on 
the prior issue so that the expenditures of those proceeds do not occur 
faster than ratably with expenditures of the other amounts in the mixed 
escrow. During the period that the prior issue has unspent proceeds, 
however, these allocations must be ratable (with reasonable adjustments 
for rounding) both between sources for expenditures (i.e., proceeds and 
other amounts) and between uses (i.e., principal, interest, and stated 
redemption prices on the prior issue).
    (ii) Exceptions--(A) Mandatory allocation of certain non-proceeds to 
earliest expenditures. If amounts other than proceeds of the refunding 
issue are deposited in a mixed escrow, but before the issue date of the 
refunding issue those amounts had been held in a bona fide debt service 
fund or a fund to carry out the governmental purpose of the prior issue 
(e.g., a construction fund), those amounts must be allocated to the 
earliest maturing investments in the mixed escrow.
    (B) Permissive allocation of non-proceeds to earliest expenditures. 
Excluding amounts covered by paragraph (c)(2)(ii)(A) of this section and 
subject to any required earlier expenditure of those amounts, any 
amounts in a mixed escrow that are not proceeds of a refunding issue may 
be allocated to the earliest maturing investments in the mixed escrow, 
provided that those investments mature and the proceeds thereof are 
expended before the date of any expenditure from the mixed escrow to pay 
any principal of the prior issue.
    (d) Temporary periods in refundings--(1) In general. Proceeds of a 
refunding issue may be invested in higher yielding investments under 
section 148(c) only during the temporary periods described in paragraph 
(d)(2) of this section.
    (2) Types of temporary periods in refundings. The available 
temporary periods for proceeds of a refunding issue are as follows:
    (i) General temporary period for refunding issues. Except as 
otherwise provided in this paragraph (d)(2), the temporary period for 
proceeds (other than transferred proceeds) of a refunding issue is the 
period ending 30 days after the issue date of the refunding issue.
    (ii) Temporary periods for current refunding issues--(A) In general. 
Except as otherwise provided in paragraph (d)(2)(ii)(B) of this section, 
the temporary period for proceeds (other than transferred proceeds) of a 
current refunding issue is 90 days.
    (B) Temporary period for short-term current refunding issues. The 
temporary period for proceeds (other than transferred proceeds) of a 
current refunding issue that has an original term to maturity of 270 
days or less may not exceed 30 days. The aggregate temporary periods for 
proceeds (other than transferred proceeds) of all current refunding 
issues described in the preceding sentence that are part of the same 
series of refundings is 90 days. An issue is part of a series of 
refundings if it finances or refinances the same expenditures for a 
particular governmental purpose as another issue.
    (iii) Temporary periods for transferred proceeds--(A) In general. 
Except as otherwise provided in paragraph

[[Page 138]]

(d)(2)(iii)(B) of this section, each available temporary period for 
transferred proceeds of a refunding issue begins on the date those 
amounts become transferred proceeds of the refunding issue and ends on 
the date that, without regard to the discharge of the prior issue, the 
available temporary period for those proceeds would have ended had those 
proceeds remained proceeds of the prior issue.
    (B) Termination of initial temporary period for prior issue in an 
advance refunding. The initial temporary period under Sec. 1.148-2(e) 
(2) and (3) for the proceeds of a prior issue that is refunded by an 
advance refunding issue (including transferred proceeds) terminates on 
the issue date of the advance refunding issue.
    (iv) Certain short-term gross proceeds. Except for proceeds of a 
refunding issue held in a refunding escrow, proceeds otherwise 
reasonably expected to be used to pay principal or interest on the prior 
issue, replacement proceeds not held in a bona fide debt service fund, 
and transferred proceeds, the temporary period for gross proceeds of a 
refunding issue is the 13-month period beginning on the date of receipt.
    (e) Reasonably required reserve or replacement funds in refundings. 
In addition to the requirements of Sec. 1.148-2(f), beginning on the 
issue date of a refunding issue, a reserve or replacement fund for a 
refunding issue or a prior issue is a reasonably required reserve or 
replacement fund under section 148(d) that may be invested in higher 
yielding investments only if the aggregate amount invested in higher 
yielding investments under this paragraph (e) for both the refunding 
issue and the prior issue does not exceed the size limitations under 
Sec. 1.148-2 (f)(2) and (f)(3), measured by reference to the refunding 
issue only (regardless of whether proceeds of the prior issue have 
become transferred proceeds of the refunding issue).
    (f) Minor portions in refundings. Beginning on the issue date of the 
refunding issue, gross proceeds not in excess of a minor portion of the 
refunding issue qualify for investment in higher yielding investments 
under section 148(e), and gross proceeds not in excess of a minor 
portion of the prior issue qualify for investment in higher yielding 
investments under either section 148(e) or section 149(d)(3)(A)(v), 
whichever is applicable. Minor portion is defined in Sec. 1.148-2(g).
    (g) Certain waivers permitted. On or before the issue date, an 
issuer may waive the right to invest in higher yielding investments 
during any temporary period or as part of a reasonably required reserve 
or replacement fund. At any time, an issuer may waive the right to 
invest in higher yielding investments as part of a minor portion.
    (h) Multipurpose issue allocations--(1) Application of multipurpose 
issue allocation rules. The portion of the bonds of a multipurpose issue 
reasonably allocated to any separate purpose under this paragraph (h) is 
treated as a separate issue for all purposes of section 148 except the 
following--
    (i) Arbitrage yield. Except to the extent that the proceeds of an 
issue are allocable to two or more conduit loans that are tax-exempt 
bonds, determining the yield on a multipurpose issue and the yield on 
investments for purposes of the arbitrage yield restrictions of section 
148 and the arbitrage rebate requirement of section 148(f);
    (ii) Rebate amount. Except as provided in paragraph (h)(1)(i) of 
this section, determining the rebate amount for a multipurpose issue, 
including subsidiary matters with respect to that determination, such as 
the computation date credit under Sec. 1.148-3(d)(1), the due date for 
payments, and the $100,000 bona fide debt service fund exception under 
section 148(f)(4)(A)(ii);
    (iii) Minor portion. Determining the minor portion of an issue under 
section 148(e);
    (iv) Reasonably required reserve or replacement fund. Determining 
the portion of an issue eligible for investment in higher yielding 
investments as part of a reasonably required reserve or replacement fund 
under section 148(d); and
    (v) Effective date. Applying the provisions of Sec. 1.148-11(b) 
(relating to elective retroactive application of Secs. 1.148-1 through 
1.148-10 to certain issues).
    (2) Rules on allocations of multipurpose issues--(i) In general. 
This paragraph (h) applies to allocations of multipurpose issues, 
including allocations involving

[[Page 139]]

the refunding purposes of the issue. Except as otherwise provided in 
this paragraph (h), proceeds, investments, and bonds of a multipurpose 
issue may be allocated among the various separate purposes of the issue 
using any reasonable, consistently applied allocation method. An 
allocation is not reasonable if it achieves more favorable results under 
section 148 or 149(d) than could be achieved with actual separate 
issues. An allocation under this paragraph (h) may be made at any time, 
but once made may not be changed.
    (ii) Allocations involving certain common costs. A ratable 
allocation of common costs (as described in paragraph (h)(3)(ii) of this 
section) among the separate purposes of the multipurpose issue is 
generally reasonable. If another allocation method more accurately 
reflects the extent to which any separate purpose of a multipurpose 
issue enjoys the economic benefit or bears the economic burden of 
certain common costs, that allocation method may be used.
    (3) Separate purposes of a multipurpose issue--(i) In general. 
Separate purposes of a multipurpose issue include refunding a separate 
prior issue, financing a separate purpose investment, financing a 
construction issue (as defined in Sec. 1.148-7(f)), and any clearly 
discrete governmental purpose reasonably expected to be financed by that 
issue. In general, all integrated or functionally related capital 
projects that qualify for the same initial temporary period under 
Sec. 1.148-2(e)(2) are treated as having a single governmental purpose. 
The separate purposes of a refunding issue include the separate purposes 
of the prior issue, if any. Separate purposes may be treated as a single 
purpose if the proceeds used to finance those purposes are eligible for 
the same initial temporary period under section 148(c). For example, the 
use of proceeds of a multipurpose issue to finance separate qualified 
mortgage loans may be treated as a single purpose.
    (ii) Financing common costs. Common costs of a multipurpose issue 
are not separate purposes. Common costs include issuance costs, accrued 
interest, capitalized interest on the issue, a reserve or replacement 
fund, qualified guarantee fees, and similar costs properly allocable to 
the separate purposes of the issue.
    (iii) Example. The following example illustrates the application of 
this paragraph (h)(3).

    Example. On January 1, 1994, Housing Authority of State A issues a 
$10 million issue (the 1994 issue) at an interest rate of 10 percent to 
finance qualified mortgage loans for owner-occupied residences under 
section 143. During 1994, A originates $5 million in qualified mortgage 
loans at an interest rate of 10 percent. In 1995, the market interest 
rates for housing loans falls to 8 percent and A is unable to originate 
further loans from the 1994 issue. On January 1, 1996, A issues a $5 
million issue (the 1996 issue) at an interest rate of 8 percent to 
refund partially the 1994 issue. Under paragraph (h) of this section, A 
treats the portion of the 1994 issue used to originate $5 million in 
loans as a separate issue comprised of that group of purpose 
investments. A allocates those purpose investments representing those 
loans to that separate unrefunded portion of the issue. In addition, A 
treats the unoriginated portion of the 1994 issue as a separate issue 
and allocates the nonpurpose investments representing the unoriginated 
proceeds of the 1994 issue to the refunded portion of the issue. Thus, 
when proceeds of the 1996 issue are used to pay principal on the 
refunded portion of the 1994 issue that is treated as a separate issue 
under paragraph (h) of this section, only the portion of the 1994 issue 
representing unoriginated loan funds invested in nonpurpose investments 
transfer to become transferred proceeds of the 1996 issue.

    (4) Allocations of bonds of a multipurpose issue--(i) Reasonable 
allocation of bonds to portions of issue. After reasonable adjustment of 
the issue price of a multipurpose issue to account for common costs, the 
portion of the bonds of a multipurpose issue allocated to a separate 
purpose must have an issue price that bears the same ratio to the 
aggregate issue price of the multipurpose issue as the portion of the 
sale proceeds of the multipurpose issue used for that separate purpose 
bears to the aggregate sale proceeds of the multipurpose issue. For a 
refunding issue used to refund two or more prior issues, the portion of 
the sales proceeds allocated to the refunding of a separate prior issue 
is based on the present value of the refunded debt service on that prior 
issue, using the yield on investments in the refunding escrow allocable 
to the entire refunding issue as the discount rate.

[[Page 140]]

    (ii) Safe harbor for pro rata allocation method for bonds. The use 
of the relative amount of sales proceeds used for each separate purpose 
to ratably allocate each bond or a ratable number of substantially 
identical whole bonds is a reasonable method for allocating bonds of a 
multipurpose issue.
    (iii) Safe harbor for allocations of bonds used to finance separate 
purpose investments. An allocation of a portion of the bonds of a 
multipurpose issue to a particular purpose investment is generally 
reasonable if that purpose investment has principal and interest 
payments that reasonably coincide in time and amount to principal and 
interest payments on the bonds allocated to that purpose investment.
    (iv) Rounding of bond allocations to next whole bond denomination 
permitted. An allocation that rounds each resulting fractional bond up 
or down to the next integral multiple of a permitted denomination of 
bonds of that issue not in excess of $100,000 does not prevent the 
allocation from satisfying this paragraph (h)(4).
    (v) Restrictions on allocations of bonds to refunding purposes. For 
each portion of a multipurpose issue that is used to refund a separate 
prior issue, a method of allocating bonds of that issue is reasonable 
under this paragraph (h) only if, in addition to the requirements of 
paragraphs (h)(1) and (h)(2) of this section, the portion of the bonds 
allocated to the refunding of that prior issue--
    (A) Results from a pro rata allocation under paragraph (h)(4)(ii) of 
this section;
    (B) Reflects aggregate principal and interest payable in each bond 
year that is less than, equal to, or proportionate to, the aggregate 
principal and interest payable on the prior issue in each bond year;
    (C) Results from an allocation of all the bonds of the entire 
multipurpose issue in proportion to the remaining weighted average 
economic life of the capital projects financed or refinanced by the 
issue, determined in the same manner as under section 147(b); or
    (D) Results from another reasonable allocation method, but only to 
the extent that the application of the allocation methods provided in 
this paragraph (h)(4)(v) is not permitted under state law restrictions 
applicable to the bonds, reasonable terms of bonds issued before, or 
subject to a master indenture that became effective prior to, July 1, 
1993, or other similar restrictions or circumstances. This paragraph 
(h)(4)(v)(D) shall be strictly construed and is available only if it 
does not result in a greater burden on the market for tax-exempt bonds 
than would occur using one of the other allocation methods provided in 
this paragraph (h)(4)(v). (See also Sec. 1.148-11(c)(2).)
    (vi) Exception for refundings of interim notes. Paragraph (h)(4)(v) 
of this section need not be applied to refunding bonds issued to provide 
permanent financing for one or more projects if the prior issue had a 
term of less than 3 years and was sold in anticipation of permanent 
financing, but only if the aggregate term of all prior issues sold in 
anticipation of permanent financing was less than 3 years.
    (5) Limitation on multi-generation allocations. This paragraph (h) 
does not apply to allocations of a multipurpose refunded issue unless 
that refunded issue is refunded directly by an issue to which this 
paragraph (h) applies. For example, if a 1994 issue refunds a 1984 
multipurpose issue, which in turn refunded a 1980 multipurpose issue, 
this paragraph (h) applies to allocations of the 1984 issue for purposes 
of allocating the refunding purposes of the 1994 issue, but does not 
permit allocations of the 1980 issue.
    (i) Operating rules for separation of prior issue into refunded and 
unrefunded portions--(1) In general. For purposes of paragraph (h)(3)(i) 
of this section, the separate purposes of a prior issue include the 
refunded and unrefunded portions of the prior issue. Thus, the refunded 
and unrefunded portions are treated as separate issues under paragraph 
(h)(1) of this section. Those separate issues must satisfy the 
requirements of paragraphs (h) and (i) of this section. The refunded 
portion of the bonds of a prior issue is based on a fraction the 
numerator of which is the principal amount of the prior issue to be paid 
with proceeds of the refunding issue and the denominator of which is the 
outstanding principal amount of

[[Page 141]]

the bonds of the prior issue, each determined as of the issue date of 
the refunding issue. (See also paragraph (b)(2) of this section.)
    (2) Allocations of proceeds and investments in a partial refunding. 
As of the issue date of a partial refunding issue under this paragraph 
(i), unspent proceeds of the prior issue are allocated ratably between 
the refunded and unrefunded portions of the prior issue and the 
investments allocable to those unspent proceeds are allocated in the 
manner required for the allocation of investments to transferred 
proceeds under paragraph (c)(1)(ii) of this section.
    (3) References to prior issue. If the refunded and unrefunded 
portions of a prior issue are treated as separate issues under this 
paragraph (i), then, except to the extent that the context clearly 
requires otherwise (e.g., references to the aggregate prior issue in the 
mixed escrow rule in paragraph (c)(2) of this section), all references 
in this section to a prior issue refer only to the refunded portion of 
that prior issue.

[T.D. 8476, 58 FR 33541, June 18, 1993; 58 FR 44453, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24045, May 10, 1994; T.D. 8718, 62 FR 25512, 
May 9, 1997]



Sec. 1.148-10  Anti-abuse rules and authority of Commissioner.

    (a) Abusive arbitrage device--(1) In general. Bonds of an issue are 
arbitrage bonds under section 148 if an abusive arbitrage device under 
paragraph (a)(2) of this section is used in connection with the issue. 
This paragraph (a) is to be applied and interpreted broadly to carry out 
the purposes of section 148, as further described in Sec. 1.148-0. 
Except as otherwise provided in paragraph (c) of this section, any 
action that is expressly permitted by section 148 or Secs. 1.148-1 
through 1.148-11 is not an abusive arbitrage device (e.g., investment in 
higher yielding investments during a permitted temporary period under 
section 148(c)).
    (2) Abusive arbitrage device defined. Any action is an abusive 
arbitrage device if the action has the effect of--
    (i) Enabling the issuer to exploit the difference between tax-exempt 
and taxable interest rates to obtain a material financial advantage; and
    (ii) Overburdening the tax-exempt bond market.
    (3) Exploitation of tax-exempt interest rates. An action may exploit 
tax-exempt interest rates under paragraph (a)(2) of this section as a 
result of an investment of any portion of the gross proceeds of an issue 
over any period of time, notwithstanding that, in the aggregate, the 
gross proceeds of the issue are not invested in higher yielding 
investments over the term of the issue.
    (4) Overburdening the tax-exempt market. An action overburdens the 
tax-exempt bond market under paragraph (a)(2)(ii) of this section if it 
results in 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. Whether an action is reasonably necessary to 
accomplish the governmental purposes of the bonds depends on whether the 
primary purpose of the transaction is a bona fide governmental purpose 
(e.g., an issue of refunding bonds to achieve a debt service 
restructuring that would be issued independent of any arbitrage 
benefit). An important factor bearing on this determination is whether 
the action would reasonably be taken to accomplish the governmental 
purpose of the issue if the interest on the issue were not excludable 
from gross income under section 103(a) (assuming that the hypothetical 
taxable interest rate would be the same as the actual tax-exempt 
interest rate). Factors evidencing an overissuance include the issuance 
of an issue the proceeds of which are reasonably expected to exceed by 
more than a minor portion the amount necessary to accomplish the 
governmental purposes of the issue, or an issue the proceeds of which 
are, in fact, substantially in excess of the amount of sale proceeds 
allocated to expenditures for the governmental purposes of the issue. 
One factor evidencing an early issuance is the issuance of bonds that do 
not qualify for a temporary period under Sec. 1.148-2(e)(2), (e)(3), or 
(e)(4). One factor evidencing that bonds may remain outstanding longer 
than necessary is a

[[Page 142]]

term that exceeds the safe harbors against the creation of replacement 
proceeds under Sec. 1.148-1(c)(4)(i)(B). These factors may be outweighed 
by other factors, such as bona fide cost underruns, an issuer's bona 
fide need to finance extraordinary working capital items, or an issuer's 
long-term financial distress.
    (b) Consequences of overburdening the tax-exempt bond market--(1) In 
general. An issue that overburdens the tax-exempt bond market (within 
the meaning of paragraph (a)(4) of this section) is subject to the 
following special limitations--
    (i) Special yield restriction. Investments are subject to the 
definition of materially higher yield under Sec. 1.148-2(d) that is 
equal to one-thousandth of 1 percent. In addition, each investment is 
treated as a separate class of investments under Sec. 1.148-5(b)(2)(ii), 
the yield on which may not be blended with that of other investments.
    (ii) Certain regulatory provisions inapplicable. The provisions of 
Sec. 1.148-5(c) (relating to yield reduction payments) and Sec. 1.148-
5(e) (2) and (3) (relating to recovery of qualified administrative 
costs) do not apply.
    (iii) Restrictive expenditure rule. Proceeds are not allocated to 
expenditures unless the proceeds-spent-last rule under Sec. 1.148-
6(d)(3)(i) is satisfied, applied by treating those proceeds as proceeds 
to be used for restricted working capital expenditures. For this 
purpose, available amount includes a reasonable working capital reserve 
as defined in Sec. 1.148-6(d)(3)(iii)(B).
    (2) Application. The provisions of this paragraph (b) only apply to 
the portion of an issue that, as a result of actions taken (or actions 
not taken) after the issue date, overburdens the market for tax-exempt 
bonds, except that for an issue that is reasonably expected as of the 
issue date to overburden the market, those provisions apply to all of 
the gross proceeds of the issue.
    (c) Anti-abuse rules on excess gross proceeds of advance refunding 
issues--(1) In general. Except as otherwise provided in this paragraph 
(c), an abusive arbitrage device is used and bonds of an advance 
refunding issue are arbitrage bonds if the issue has excess gross 
proceeds.
    (2) Definition of excess gross proceeds. Excess gross proceeds means 
all gross proceeds of an advance refunding issue that exceed an amount 
equal to 1 percent of sale proceeds of the issue, other than gross 
proceeds allocable to--
    (i) Payment of principal, interest, or call premium on the prior 
issue;
    (ii) Payment of pre-issuance accrued interest on the refunding 
issue, and interest on the refunding issue that accrues for a period up 
to the completion date of any capital project for which the prior issue 
was issued, plus one year;
    (iii) A reasonably required reserve or replacement fund for the 
refunding issue or investment proceeds of such a fund;
    (iv) Payment of costs of issuance of the refunding issue;
    (v) Payment of administrative costs allocable to repaying the prior 
issue, carrying and repaying the refunding issue, or investments of the 
refunding issue;
    (vi) Transferred proceeds that will be used or maintained for the 
governmental purpose of the prior issue;
    (vii) Interest on purpose investments;
    (viii) Replacement proceeds in a sinking fund for the refunding 
issue;
    (ix) Qualified guarantee fees for the refunding issue or the prior 
issue; and
    (x) Fees for a qualified hedge for the refunding issue.
    (3) Special treatment of transferred proceeds. For purposes of this 
paragraph (c), all unspent proceeds of the prior issue as of the issue 
date of the refunding issue are treated as transferred proceeds of the 
advance refunding issue.
    (4) Special rule for crossover refundings. An advance refunding 
issue is not an issue of arbitrage bonds under this paragraph (c) if all 
excess gross proceeds of the refunding issue are used to pay interest 
that accrues on the refunding issue before the prior issue is 
discharged, and no gross proceeds of any refunding issue are used to pay 
interest on the prior issue or to replace funds used directly or 
indirectly to pay such interest (other than transferred proceeds used to 
pay interest on the prior issue that accrues for a period up to the 
completion date of the project for which the prior issue was issued, 
plus one year, or proceeds used to pay

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principal that is attributable to accrued original issue discount).
    (5) Special rule for gross refundings. This paragraph (c)(5) applies 
if an advance refunding issue (the series B issue) is used together with 
one or more other advance refunding issues (the series A issues) in a 
gross refunding of a prior issue, but only if the use of a gross 
refunding method is required under bond documents that were effective 
prior to November 6, 1992. These advance refunding issues are not 
arbitrage bonds under this paragraph (c) if--
    (i) All excess gross proceeds of the series B issue and each series 
A issue are investment proceeds used to pay principal and interest on 
the series B issue;
    (ii) At least 99 percent of all principal and interest on the series 
B issue is paid with proceeds of the series B and series A issues or 
with the earnings on other amounts in the refunding escrow for the prior 
issue;
    (iii) The series B issue is discharged not later than the prior 
issue; and
    (iv) As of any date, the amount of gross proceeds of the series B 
issue allocated to expenditures does not exceed the aggregate amount of 
expenditures before that date for principal and interest on the series B 
issue, and administrative costs of carrying and repaying the series B 
issue, or of investments of the series B issue.
    (d) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. Mortgage sale. In 1982, City issued its revenue issue 
(the 1982 issue) and lent the proceeds to Developer to finance a low-
income housing project under former section 103(b)(4)(A) of the 1954 
Code. In 1994, Developer encounters financial difficulties and 
negotiates with City to refund the 1982 issue. City issues $10 million 
in principal amount of its 8 percent bonds (the 1994 issue). City lends 
the proceeds of the 1994 issue to Developer. To evidence Developer's 
obligation to repay that loan, Developer, as obligor, issues a note to 
City (the City note). Bank agrees to provide Developer with a direct-pay 
letter of credit pursuant to which Bank will make all payments to the 
trustee for the 1994 issue necessary to meet Developer's obligations 
under the City note. Developer pays Bank a fee for the issuance of the 
letter of credit and issues a note to Bank (the Bank note). The Bank 
note is secured by a mortgage on the housing project and is guaranteed 
by FHA. The Bank note and the 1994 issue have different prepayment 
terms. The City does not reasonably expect to treat prepayments of the 
Bank note as gross proceeds of the 1994 issue. At the same time or 
pursuant to a series of related transactions, Bank sells the Bank note 
to Investor for $9.5 million. Bank invests these monies together with 
its other funds. In substance, the transaction is a loan by City to 
Bank, under which Bank enters into a series of transactions that, in 
effect, result in Bank retaining $9.5 million in amounts treated as 
proceeds of the 1994 issue. Those amounts are invested in materially 
higher yielding investments that provide funds sufficient to equal or 
exceed the Bank's liability under the letter of credit. Alternatively, 
the letter of credit is investment property in a sinking fund for the 
1994 issue provided by Developer, a substantial beneficiary of the 
financing. Because, in substance, Developer acquires the $10 million 
principal amount letter of credit for a fair market value purchase price 
of $9.5 million, the letter of credit is a materially higher yielding 
investment. Neither result would change if Developer's obligation under 
the Bank note is contingent on Bank performing its obligation under the 
letter of credit. Each characterization causes the bonds to be arbitrage 
bonds.
    Example 2. Bonds outstanding longer than necessary for yield-
blending device. (i) Longer bond maturity to create sinking fund. In 
1994, Authority issues an advance refunding issue (the refunding issue) 
to refund a 1982 prior issue (the prior issue). Under current market 
conditions, Authority will have to invest the refunding escrow at a 
yield significantly below the yield on the refunding issue. Authority 
issues its refunding issue with a longer weighted average maturity than 
otherwise necessary primarily for the purpose of creating a sinking fund 
for the refunding issue that will be invested in a guaranteed investment 
contract. The weighted average maturity of the refunding issue is less 
than 120 percent of the remaining average economic life of the 
facilities financed with the proceeds of the prior issue. The guaranteed 
investment contract has a yield that is higher than the yield on the 
refunding issue. The yield on the refunding escrow blended with the 
yield on the guaranteed investment contract does not exceed the yield on 
the issue. The refunding issue uses an abusive arbitrage device and the 
bonds of the issue are arbitrage bonds under section 148(a).
    (ii) Refunding of noncallable bonds. The facts are the same as in 
paragraph (i) of this Example 2 except that instead of structuring the 
refunding issue to enable it to take advantage of sinking fund 
investments, Authority will also refund other long-term, non-callable 
bonds in the same refunding issue. There are no savings attributable to 
the refunding of the non-callable bonds (e.g.,

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a low-to-high refunding). The Authority invests the portion of the 
proceeds of the refunding issue allocable to the refunding of the non-
callable bonds in the refunding escrow at a yield that is higher than 
the yield on the refunding issue, based on the relatively long escrow 
period for this portion of the refunding. The Authority invests the 
other portion of the proceeds of the refunding issue in the refunding 
escrow at a yield lower than the yield on the refunding issue. The 
blended yield on all the investments in the refunding escrow for the 
prior issues does not exceed the yield on the refunding issue. The 
portion of the refunding issue used to refund the noncallable bonds, 
however, was not otherwise necessary and was issued primarily to exploit 
the difference between taxable and tax-exempt rates for that long 
portion of the refunding escrow to minimize the effect of lower yielding 
investments in the other portion of the escrow. The refunding issue uses 
an abusive arbitrage device and the bonds of the issue are arbitrage 
bonds.
    (iii) Governmental purpose. In paragraphs (i) and (ii) of this 
Example 2, the existence of a governmental purpose for the described 
financing structures would not change the conclusions unless Authority 
clearly established that the primary purpose for the use of the 
particular structure was a bona fide governmental purpose. The fact that 
each financing structure had the effect of eliminating significant 
amounts of negative arbitrage is strong evidence of a primary purpose 
that is not a bona fide governmental purpose. Moreover, in paragraph (i) 
of this Example 2, the structure of the refunding issue coupled with the 
acquisition of the guaranteed investment contract to lock in the 
investment yield associated with the structure is strong evidence of a 
primary purpose that is not a bona fide governmental purpose.
    Example 3. Window refunding. (i) Authority issues its 1994 refunding 
issue to refund a portion of the principal and interest on its 
outstanding 1985 issue. The 1994 refunding issue is structured using 
zero-coupon bonds that pay no interest or principal for the 5-year 
period following the issue date. The proceeds of the 1994 refunding 
issue are deposited in a refunding escrow to be used to pay only the 
interest requirements of the refunded portion of the 1985 issue. 
Authority enters into a guaranteed investment contract with a financial 
institution, G, under which G agrees to provide a guaranteed yield on 
revenues invested by Authority during the 5-year period following the 
issue date. The guaranteed investment contract has a yield that is no 
higher than the yield on the refunding issue. The revenues to be 
invested under this guaranteed investment contract consist of the 
amounts that Authority otherwise would have used to pay principal and 
interest on the 1994 refunding issue. The guaranteed investment contract 
is structured to generate receipts at times and in amounts sufficient to 
pay the principal and redemption requirements of the refunded portion of 
the 1985 issue. A principal purpose of these transactions is to avoid 
transferred proceeds. Authority will continue to invest the unspent 
proceeds of the 1985 issue that are on deposit in a refunding escrow for 
its 1982 issue at a yield equal to the yield on the 1985 issue and will 
not otherwise treat those unspent proceeds as transferred proceeds of 
the 1994 refunding issue. The 1994 refunding issue is an issue of 
arbitrage bonds since those bonds involve a transaction or series of 
transactions that overburdens the market by leaving bonds outstanding 
longer than is necessary to obtain a material financial advantage based 
on arbitrage. Specifically, Authority has structured the 1994 refunding 
issue to make available for the refunding of the 1985 issue replacement 
proceeds rather than proceeds so that the unspent proceeds of the 1985 
issue will not become transferred proceeds of the 1994 refunding issue.
    (ii) The result would be the same in each of the following 
circumstances:
    (A) The facts are the same as in paragraph (i) of this Example 3 
except that Authority does not enter into the guaranteed investment 
contract but instead, as of the issue date of the 1994 refunding issue, 
reasonably expects that the released revenues will be available for 
investment until used to pay principal and interest on the 1985 issue.
    (B) The facts are the same as in paragraph (i) of this Example 3 
except that there are no unspent proceeds of the 1985 issue and 
Authority invests the released revenues at a yield materially higher 
than the yield on the 1994 issue.
    (C) The facts are the same as in paragraph (i) of this Example 3 
except that Authority uses the proceeds of the 1994 issue for capital 
projects instead of to refund a portion of the 1985 issue.
    Example 4. Sale of conduit loan. On January 1, 1994, Authority 
issues a conduit financing issue (the 1994 conduit financing issue) and 
uses the proceeds to purchase from City, an unrelated party, a tax-
exempt bond of City (the City note). The proceeds of the 1994 conduit 
financing issue are to be used to advance refund a prior conduit 
financing issue that was issued in 1988 and used to make a loan to City. 
The 1994 conduit financing issue and the City note each have a yield of 
8 percent on January 1, 1994. On June 30, 1996, interest rates have 
decreased and Authority sells the City note to D, a person unrelated to 
either City or Authority. Based on the sale price of the City note and 
treating June 30, 1996 as the issue date of the City note, the City note 
has a 6 percent yield. Authority deposits the proceeds of the sale of 
the City note into an escrow to redeem the bonds of the 1994 conduit 
financing issue on January 1, 2001. The escrow is invested in nonpurpose

[[Page 145]]

investments having a yield of 8 percent. For purposes of section 149(d), 
City and Authority are related parties and, therefore, the issue date of 
the City note is treated as being June 30, 1996. Thus, the City note is 
an advance refunding of Authority's 1994 conduit financing issue. 
Interest on the City note is not exempt from Federal income tax from the 
date it is sold to D under section 149(d), because, by investing the 
escrow investments at a yield of 8 percent instead of a yield not 
materially higher than 6 percent, the sale of the City note employs a 
device to obtain a material financial advantage, based on arbitrage, 
apart from the savings attributable to lower interest rates. In 
addition, the City note is not a tax-exempt bond because the note is the 
second advance refunding of the original bond under section 149(d)(3). 
The City note also employs an abusive arbitrage device and is an 
arbitrage bond under section 148.
    Example 5. Re-refunding. (i) On January 1, 1984, City issues a tax-
exempt issue (the 1984 issue) to finance the cost of constructing a 
prison. The 1984 issue has a 7 percent yield and a 30-year maturity. The 
1984 issue is callable at any time on or after January 1, 1994. On 
January 1, 1990, City issues a refunding issue (the 1990 issue) to 
advance refund the 1984 issue. The 1990 issue has an 8 percent yield and 
a 30-year maturity. The 1990 issue is callable at any time on or after 
January 1, 2000. The proceeds of the 1990 issue are invested at an 8 
percent yield in a refunding escrow for the 1984 issue (the original 
1984 escrow) in a manner sufficient to pay debt service on the 1984 
issue until maturity (i.e., an escrow to maturity). On January 1, 1994, 
City issues a refunding issue (the 1994 issue). The 1994 issue has a 6 
percent yield and a 30-year maturity. City does not invest the proceeds 
of the 1994 issue in a refunding escrow for the 1990 issue in a manner 
sufficient to pay a portion of the debt service until, and redeem a 
portion of that issue on, January 1, 2000. Instead, City invests those 
proceeds at a 6 percent yield in a new refunding escrow for a portion of 
the 1984 issue (the new 1984 escrow) in a manner sufficient to pay debt 
service on a portion of the 1984 issue until maturity. City also 
liquidates the investments allocable to the proceeds of the 1990 issue 
held in the original 1984 escrow and reinvests those proceeds in an 
escrow to pay a portion of the debt service on the 1990 issue itself 
until, and redeem a portion of that issue on, January 1, 2000 (the 1990 
escrow). The 1994 bonds are arbitrage bonds and employ an abusive device 
under section 149(d)(4). Although, in form, the proceeds of the 1994 
issue are used to pay principal on the 1984 issue, this accounting for 
the use of the proceeds of the 1994 issue is an unreasonable, 
inconsistent accounting method under Sec. 1.148-6(a). Moreover, since 
the proceeds of the 1990 issue were set aside in an escrow to be used to 
retire the 1984 issue, the use of proceeds of the 1994 issue for that 
same purpose involves a replacement of funds invested in higher yielding 
investments under section 148(a)(2). Thus, using a reasonable, 
consistent accounting method and giving effect to the substance of the 
transaction, the proceeds of the 1994 issue are treated as used to 
refund the 1990 issue and are allocable to the 1990 escrow. The proceeds 
of the 1990 issue are treated as used to refund the 1984 issue and are 
allocable to the investments in the new 1984 escrow. The proceeds of the 
1990 issue allocable to the nonpurpose investments in the new 1984 
escrow become transferred proceeds of the 1994 issue as principal is 
paid on the 1990 issue from amounts on deposit in the 1990 escrow. As a 
result, the yield on nonpurpose investments allocable to the 1994 issue 
is materially higher than the yield on the 1994 issue, causing the bonds 
of the 1994 issue to be arbitrage bonds. In addition, the transaction 
employs a device under section 149(d)(4) to obtain a material financial 
advantage based on arbitrage, other than savings attributable to lower 
interest rates.
    (ii) The following changes in the facts do not affect the conclusion 
that the 1994 issue consists of arbitrage bonds--
    (1) The 1990 issue is a taxable issue;
    (2) The original 1984 escrow is used to pay the 1994 issue (rather 
than the 1990 issue); or
    (3) The 1994 issue is used to retire the 1984 issue within 90 days 
of January 1, 1994.

    (e) Authority of the Commissioner to prevent transactions that are 
inconsistent with the purpose of the arbitrage investment restrictions. 
If an issuer enters into a transaction for a principal purpose of 
obtaining a material financial advantage based on the difference between 
tax-exempt and taxable interest rates in a manner that is inconsistent 
with the purposes of section 148, the Commissioner may exercise the 
Commissioner's discretion to depart from the rules of Sec. 1.148-1 
through Sec. 1.148-11 as necessary to reflect the economics of the 
transaction to prevent such financial advantage. For this purpose, the 
Commissioner may recompute yield on an issue or on investments, 
reallocate payments and receipts on investments, recompute the rebate 
amount on an issue, treat a hedge as either a qualified hedge or not a 
qualified hedge, or otherwise adjust any item whatsoever bearing upon 
the investments and expenditures of gross proceeds of an issue. For 
example, if the amount paid for a hedge is specifically based on the 
amount of arbitrage earned or expected to be earned on the hedged bonds, 
a

[[Page 146]]

principal purpose of entering into the contract is to obtain a material 
financial advantage based on the difference between tax-exempt and 
taxable interest rates in a manner that is inconsistent with the 
purposes of section 148.
    (f) Authority of the Commissioner to require an earlier date for 
payment of rebate. If the Commissioner determines that an issue is 
likely to fail to meet the requirements of Sec. 1.148-3 and that a 
failure to serve a notice of demand for payment on the issuer will 
jeopardize the assessment or collection of tax on interest paid or to be 
paid on the issue, the date that the Commissioner serves notice on the 
issuer is treated as a required computation date for payment of rebate 
for that issue.
    (g) Authority of the Commissioner to waive regulatory limitations. 
Notwithstanding any specific provision in Secs. 1.148-1 through 1.148-
11, the Commissioner may prescribe extensions of temporary periods, 
larger reasonably required reserve or replacement funds, or consequences 
of failures or remedial action under section 148 in lieu of or in 
addition to other consequences of those failures, or take other action, 
if the Commissioner finds that good faith or other similar circumstances 
so warrant, consistent with the purposes of section 148.

[T.D. 8476, 58 FR 33544, June 18, 1993; 58 FR 44453, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24046, May 10, 1994; T.D. 8476, 59 FR 24351, 
May 11, 1994; T.D. 8718, 62 FR 25512, May 9, 1997; T.D. 9777, 81 FR 
46597, July 18, 2016]



Sec. 1.148-11  Effective/applicability dates.

    (a) In general. Except as otherwise provided in this section, 
Secs. 1.148-1 through 1.148-11 apply to bonds sold on or after July 8, 
1997.
    (b) Elective retroactive application in whole--(1) In general. 
Except as otherwise provided in this section, and subject to the 
applicable effective dates for the corresponding statutory provisions, 
an issuer may apply the provisions of Secs. 1.148-1 through 1.148-11 in 
whole, but not in part, to any issue that is outstanding on July 8, 
1997, and is subject to section 148(f) or to sections 103(c)(6) or 
103A(i) of the Internal Revenue Code of 1954, in lieu of otherwise 
applicable regulations under those sections.
    (2) No elective retroactive application for 18-month spending 
exception. The provisions of Sec. 1.148-7(d) (relating to the 18-month 
spending exception) may not be applied to any issue issued on or before 
June 30, 1993.
    (3) No elective retroactive application for hedges of fixed rate 
issues. The provisions of Sec. 1.148-4(h)(2)(i)(B) (relating to hedges 
of fixed rate issues) may not be applied to any bond sold on or before 
July 8, 1997.
    (4) No elective retroactive application for safe harbor for 
establishing fair market value for guaranteed investment contracts and 
investments purchased for a yield restricted defeasance escrow. The 
provisions of Secs. 1.148-5(d)(6)(iii) (relating to the safe harbor for 
establishing fair market value of guaranteed investment contracts and 
yield restricted defeasance escrow investments) and 1.148-5(e)(2)(iv) 
(relating to a special rule for yield restricted defeasance escrow 
investments) may not be applied to any bond sold before December 30, 
1998.
    (c) Elective retroactive application of certain provisions and 
special rules--(1) Retroactive application of overpayment recovery 
provisions. An issuer may apply the provisions of Sec. 1.148-3(i) to any 
issue that is subject to section 148(f) or to sections 103(c)(6) or 
103A(i) of the Internal Revenue Code of 1954.
    (2) Certain allocations of multipurpose issues. An allocation of 
bonds to a refunding purpose under Sec. 1.148-9(h) may be adjusted as 
necessary to reflect allocations made between May 18, 1992, and August 
15, 1993, if the allocations satisfied the corresponding prior provision 
of Sec. 1.148-11(j)(4) under applicable prior regulations.
    (3) Special limitation. The provisions of Sec. 1.148-9 apply to 
issues issued before August 15, 1993, only if the issuer in good faith 
estimates the present value savings, if any, associated with the effect 
of the application of that section on refunding escrows, using any 
reasonable accounting method, and applies those savings, if any, to 
redeem outstanding tax-exempt bonds of the applicable issue at the 
earliest possible

[[Page 147]]

date on which those bonds may be redeemed or otherwise retired. These 
savings are not reduced to take into account any administrative costs 
associated with applying these provisions retroactively.
    (d) Transition rule excepting certain state guarantee funds from the 
definition of replacement proceeds--(1) Certain perpetual trust funds. 
(i) A guarantee by a fund created and controlled by a State and 
established pursuant to its constitution does not cause the amounts in 
the fund to be pledged funds treated as replacement proceeds if--
    (A) Substantially all of the corpus of the fund consists of 
nonfinancial assets, revenues derived from these assets, gifts, and 
bequests;
    (B) The corpus of the guarantee fund may be invaded only to support 
specifically designated essential governmental functions (designated 
functions) carried on by political subdivisions with general taxing 
powers or public elementary and public secondary schools;
    (C) Substantially all of the available income of the fund is 
required to be applied annually to support designated functions;
    (D) The issue guaranteed consists of obligations that are not 
private activity bonds (other than qualified 501(c)(3) bonds) 
substantially all of the proceeds of which are to be used for designated 
functions;
    (E) The fund satisfied each of the requirements of paragraphs 
(d)(1)(i) through (d)(1)(iii) of this section on August 16, 1986; and
    (F) As of the sale date of the bonds to be guaranteed, the amount of 
the bonds to be guaranteed by the fund plus the then-outstanding amount 
of bonds previously guaranteed by the fund does not exceed a total 
amount equal to 500 percent of the total costs of the assets held by the 
fund as of December 16, 2009.
    (ii) The Commissioner may, by published guidance, set forth 
additional circumstances under which guarantees by certain perpetual 
trust funds will not cause amounts in the fund to be treated as 
replacement proceeds.
    (2) Permanent University Fund. Replacement proceeds do not include 
amounts allocable to investments of the fund described in section 648 of 
Public Law 98-369.
    (e) Transition rule regarding special allowance payments. Section 
1.148-5(b)(5) applies to any bond issued after January 5, 1990, except a 
bond issued exclusively to refund a bond issued before January 6, 1990, 
if the amount of the refunding bond does not exceed 101 percent of the 
amount of the refunded bond, and the maturity date of the refunding bond 
is not later than the date that is 17 years after the date on which the 
refunded bond was issued (or, in the case of a series of refundings, the 
date on which the original bond was issued), but only if Sec. 1.148-
2(d)(2)(iv) is applied by substituting 1 and one-half percentage points 
for 2 percentage points.
    (f) Transition rule regarding applicability of yield reduction rule. 
Section 1.148-5(c) applies to nonpurpose investments allocable to 
replacement proceeds of an issue that are held in a reserve or 
replacement fund to the extent that--
    (1) Amounts must be paid into the fund under a constitutional 
provision, statute, or ordinance adopted before May 3, 1978;
    (2) Under that provision, amounts paid into the fund (and investment 
earnings thereon) can be used only to pay debt service on the issues; 
and
    (3) The size of the payments made into the fund is independent of 
the size of the outstanding issues or the debt service thereon.
    (g) Provisions applicable to certain bonds sold before effective 
date. Except for bonds to which paragraph (b)(1) of this section 
applies--
    (1) Section 1.148-11A provides rules applicable to bonds sold after 
June 6, 1994, and before July 8, 1997; and
    (2) Sections 1.148-1 through 1.148-11 as in effect on July 1, 1993 
(see 26 CFR part 1 as revised April 1, 1994), and Sec. 1.148-11A(i) 
(relating to elective retroactive application of certain provisions) 
provide rules applicable to certain issues issued before June 7, 1994.
    (h) Safe harbor for establishing fair market value for guaranteed 
investment contracts and investments purchased for a yield restricted 
defeasance escrow. The provisions of Sec. 1.148-5(d)(6)(iii) are 
applicable to bonds sold on or after March 1, 1999. Issuers may apply 
these

[[Page 148]]

provisions to bonds sold on or after December 30, 1998, and before March 
1, 1999.
    (i) Special rule for certain broker's commissions and similar fees. 
Section 1.148-5(e)(2)(iii) applies to bonds sold on or after February 9, 
2004. In the case of bonds sold before February 9, 2004, that are 
subject to Sec. 1.148-5 (pre-effective date bonds), issuers may apply 
Sec. 1.148-5(e)(2)(iii), in whole but not in part, with respect to 
transactions entered into on or after December 11, 2003. If an issuer 
applies Sec. 1.148-5(e)(2)(iii) to pre-effective date bonds, the per-
issue safe harbor in Sec. 1.148-5(e)(2)(iii)(B)(1)(ii) is applied by 
taking into account all brokers' commissions or similar fees with 
respect to guaranteed investment contracts and investments for yield 
restricted defeasance escrows that the issuer treats as qualified 
administrative costs for the issue, including all such commissions or 
fees paid before February 9, 2004. For purposes of Secs. 1.148-
5(e)(2)(iii)(B)(3) and 1.148-5(e)(2)(iii)(B)(6) (relating to cost-of-
living adjustments), transactions entered into before 2003 are treated 
as entered into in 2003.
    (j) Certain prepayments. Section 1.148-1(e)(1) and (2) apply to 
bonds sold on or after October 3, 2003. Issuers may apply Sec. 1.148-
1(e)(1) and (2), in whole but not in part, to bonds sold before October 
3, 2003, that are subject to Sec. 1.148-1.
    (k) Certain arbitrage guidance updates--(1) In general. Sections 
1.148-1(c)(4)(i)(B)(1); 1.148-1(c)(4)(i)(B)(4); 1.148-1(c)(4)(ii); 
1.148-2(e)(3)(i); 1.148-3(d)(1)(iv); 1.148-3(d)(4); 1.148-4(a); 1.148-
4(b)(3)(i); 1.148-4(h)(2)(ii)(A); 1.148-4(h)(2)(v); 1.148-4(h)(2)(vi); 
1.148(h)(4)(i)(C); 1.148-5(c)(3); 1.148-5(d)(2); 1.148-5(d)(3); 1.148-
5(d)(6)(i); 1.148-5(d)(6)(iii)(A); 1.148-5(e)(2)(ii)(B); 1.148-6(d)(4); 
1.148-7(c)(3)(v); 1.148-7(i)(6)(ii); 1.148-10(a)(4); 1.148-10(e); 1.148-
11(d)(1)(i)(B); 1.148-11(d)(1)(i)(D); 1.148-11(d)(1)(i)(F); and 1.148-
11(d)(1)(ii) apply to bonds sold on or after October 17, 2016.
    (2) Valuation of investments in refunding transactions. Section 
1.148-5(d)(3) also applies to bonds refunded by bonds sold on or after 
October 17, 2016.
    (3) Rebate overpayment recovery. (i) Section 1.148-3(i)(3)(i) 
applies to claims arising from an issue of bonds to which Sec. 1.148-
3(i) applies and for which the final computation date is after June 24, 
2008. For purposes of this paragraph (k)(3)(i), issues for which the 
actual final computation date is on or before June 24, 2008, are deemed 
to have a final computation date of July 1, 2008, for purposes of 
applying Sec. 1.148-3(i)(3)(i).
    (ii) Section 1.148-3(i)(3)(ii) and (iii) apply to claims arising 
from an issue of bonds to which Sec. 1.148-3(i) applies and for which 
the final computation date is after September 16, 2013.
    (iii) Section 1.148-3(j) applies to bonds subject to Sec. 1.148-
3(i).
    (4) Hedge identification. Section 1.148-4(h)(2)(viii) applies to 
hedges that are entered into on or after October 17, 2016.
    (5) Hedge modifications and termination. Section 1.148-
4(h)(3)(iv)(A) through (H) and (h)(4)(iv) apply to--
    (i) Hedges that are entered into on or after October 17, 2016;
    (ii) Qualified hedges that are modified on or after October 17, 2016 
with respect to modifications on or after such date; and
    (iii) Qualified hedges on bonds that are refunded on or after 
October 17, 2016 with respect to the refunding on or after such date.
    (6) Small issuer exception to rebate requirement for conduit 
borrowers of pooled financings. Section 1.148-8(d) applies to bonds 
issued after May 17, 2006.
    (l) Permissive application of certain arbitrage updates--(1) In 
general. Except as otherwise provided in this paragraph (l), issuers may 
apply the provisions described in paragraph (k)(1), (2), and (5) in 
whole, but not in part, to bonds sold before October 17, 2016.
    (2) Computation credit. Issuers may apply Sec. 1.148-3(d)(1)(iv) and 
(d)(4) for bond years ending on or after July 18, 2016.
    (3) Yield reduction payments. Issuers may apply Sec. 1.148-5(c)(3) 
for investments purchased on or after July 18, 2016.
    (4) External commingled funds. Issuers may apply Sec. 1.148-
5(e)(2)(ii)(B) with respect to costs incurred on or after July 18, 2016.
    (m) Definition of issue price. The definition of issue price in 
Sec. 1.148-1(b) and

[[Page 149]]

(f) applies to bonds that are sold on or after June 7, 2017.

[T.D. 8476, 58 FR 33547, June 18, 1993; 58 FR 44453, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24046, May 10, 1994; T.D. 8718, 62 FR 25512, 
May 9, 1997; T.D. 8476, 64 FR 37037, July 9, 1999; T.D. 9085, 68 FR 
45777, Aug. 4, 2003; T.D. 9097, 68 FR 69023, Dec. 11, 2003; T.D. 9701, 
79 FR 67351, Nov. 13, 2014; T.D. 9777, 81 FR 46597, July 18, 2016; 81 FR 
57459, Aug. 23, 2016; T.D. 9801, 81 FR 89004, Dec. 9, 2016]



Sec. 1.149(b)-1  Federally guaranteed bonds.

    (a) General rule. Under section 149(b) and this section, nothing in 
section 103(a) or in any other provision of law shall be construed to 
provide an exemption from Federal income tax for interest on any bond 
issued as part of an issue that is federally guaranteed.
    (b) Exceptions. Pursuant to section 149(b)(3)(B), section 149(b)(1) 
and paragraph (a) of this section do not apply to--
    (1) Investments in obligations issued pursuant to Sec. 21B(d)(3) of 
the Federal Home Loan Bank Act, as amended by Sec. 511 of the Financial 
Institutions Reform, Recovery, and Enforcement Act of 1989, or any 
successor provision; or
    (2) Any investments that are held in a refunding escrow (as defined 
in Sec. 1.148-1).
    (c) Effective date. This section applies to investments made after 
June 30, 1993.

[T.D. 8476, 58 FR 33548, June 18, 1993]



Sec. 1.149(d)-1  Limitations on advance refundings.

    (a) General rule. Under section 149(d) and this section, nothing in 
section 103(a) or in any other provision of law shall be construed to 
provide an exemption from Federal income tax for interest on any bond 
issued as part of an issue described in paragraphs (2), (3), or (4) of 
section 149(d).
    (b) Advance refunding issues that employ abusive devices--(1) In 
general. An advance refunding issue employs an abusive device and is 
described in section 149(d)(4) if the issue violates any of the anti-
abuse rules under Sec. 1.148-10.
    (2) Failure to pay required rebate. An advance refunding issue is 
described in section 149(d)(4) if the issue fails to meet the 
requirements of Sec. 1.148-3. This paragraph (b)(2) applies to any 
advance refunding issue issued after August 31, 1986.
    (3) Mixed escrows invested in tax-exempt bonds. An advance refunding 
issue is described in section 149(d)(4) if--
    (i) Any of the proceeds of the issue are invested in a refunding 
escrow in which a portion of the proceeds are invested in tax-exempt 
bonds and a portion of the proceeds are invested in nonpurpose 
investments;
    (ii) The yield on the tax-exempt bonds in the refunding escrow 
exceeds the yield on the issue;
    (iii) The yield on all the investments (including investment 
property and tax-exempt bonds) in the refunding escrow exceeds the yield 
on the issue; and
    (iv) The weighted average maturity of the tax-exempt bonds in the 
refunding escrow is more than 25 percent greater or less than the 
weighted average maturity of the nonpurpose investments in the refunding 
escrow, and the weighted average maturity of nonpurpose investments in 
the refunding escrow is greater than 60 days.
    (4) Tax-exempt conduit loans. For purposes of applying section 
149(d) to a conduit financing issue that finances any conduit loan that 
is a tax-exempt bond, the actual issuer of a conduit financing issue and 
the conduit borrower of that conduit financing issue are treated as 
related parties. Thus, the issue date of the conduit loan does not occur 
prior to the date on which the actual issuer of the conduit financing 
issue sells, exchanges, or otherwise disposes of that conduit loan, and 
the use of the proceeds of the disposition to pay debt service on the 
conduit financing issue causes the conduit loan to be a refunding issue. 
See Sec. 1.148-10(d), Example 4.
    (c) Unrefunded debt service remains eligible for future advance 
refunding. For purposes of section 149(d)(3)(A)(i), any principal or 
interest on a prior issue that has not been paid or provided for by any 
advance refunding issue is treated as not having been advance refunded.
    (d) Application of arbitrage regulations--(1) Application of 
multipurpose issue rules. For purposes of sections 149(d)(2) and 
(3)(A)(i), (ii), and (iii), the

[[Page 150]]

provisions of the multipurpose issue rule in Sec. 1.148-9(h) apply, 
except that the limitation in Sec. 1.148-9(h)(5) is disregarded.
    (2) General mixed escrow rules. For purposes of section 149(d), the 
provisions of Sec. 1.148-9(c) (relating to mixed escrows) apply, except 
that those provisions do not apply for purposes of section 149(d)(2) and 
(d)(3)(A) (i) and (ii) to amounts that were not gross proceeds of the 
prior issue before the issue date of the refunding issue.
    (3) Temporary periods and minor portions. Section 1.148-9(d) and (f) 
contains rules applicable to temporary periods and minor portions for 
advance refunding issues.
    (4) Definitions. Section 1.148-1 applies for purposes of section 
149(d).
    (e) Taxable refundings--(1) In general. Except as provided in 
paragraph (e)(2) of this section, for purposes of section 
149(d)(3)(A)(i), an advance refunding issue the interest on which is not 
excludable from gross income under section 103(a) (i.e., a taxable 
advance refunding issue) is not taken into account. In addition, for 
this purpose, an advance refunding of a taxable issue is not taken into 
account unless the taxable issue is a conduit loan of a tax-exempt 
conduit financing issue.
    (2) Use to avoid section 149(d)(3)(A)(i). A taxable issue is taken 
into account under section 149(d)(3)(A)(i) if it is issued to avoid the 
limitations of that section. For example, in the case of a refunding of 
a tax-exempt issue with a taxable advance refunding issue that is, in 
turn, currently refunded with a tax-exempt issue, the taxable advance 
refunding issue is taken into account under section 149(d)(3)(A)(i) if 
the two tax-exempt issues are outstanding concurrently for more than 90 
days.
    (f) Redemption at first call date--(1) General rule. Under sections 
149(d)(3)(A) (ii) and (iii) (the first call requirement), bonds refunded 
by an advance refunding must be redeemed on their first call date if the 
savings test under section 149(d)(3)(B)(i) (the savings test) is 
satisfied. The savings test is satisfied if the issuer may realize 
present value debt service savings (determined without regard to 
administrative expenses) in connection with the issue of which the 
refunding bond is a part.
    (2) First call date. First call date means the earliest date on 
which a bond may be redeemed (or, if issued before 1986, on the earliest 
date on which that bond may be redeemed at a redemption price not in 
excess of 103 percent of par). If, however, the savings test is not met 
with respect to the date described in the preceding sentence (i.e., 
there are no present value savings if the refunded bonds are retired on 
that date), the first call date is the first date thereafter on which 
the bonds can be redeemed and on which the savings test is met.
    (3) Application of savings test to multipurpose issues. Except as 
otherwise provided in this paragraph (f)(3), the multipurpose issue 
rules in Sec. 1.148-9(h) apply for purposes of the savings test. If any 
separate issue in a multipurpose issue increases the aggregate present 
value debt service savings on the entire multipurpose issue or reduces 
the present value debt service losses on that entire multipurpose issue, 
that separate issue satisfies the savings test.
    (g) Limitation on advance refundings of private activity bonds. 
Under section 149(d)(2) and this section, interest on a bond is not 
excluded from gross income if any portion of the issue of which the bond 
is a part is issued to advance refund a private activity bond (other 
than a qualified 501(c)(3) bond). For this purpose, the term private 
activity bond--
    (1) Includes a qualified bond described in section 141(e) (other 
than a qualified 501(c)(3) bond), regardless of whether the refunding 
issue consists of private activity bonds under Sec. 1.141-13; and
    (2) Does not include a taxable bond.
    (h) Effective dates--(1) In general. Except as provided in this 
paragraph (h), this section applies to bonds issued after June 30, 1993, 
to which Secs. 1.148-1 through 1.148-11 apply, including conduit loans 
that are treated as issued after June 30, 1993, under paragraph (b)(4) 
of this section. In addition, this section applies to any issue to which 
the election described in Sec. 1.148-11(b)(1) is made.
    (2) Special effective date for paragraph (b)(3). Paragraph (b)(3) of 
this section

[[Page 151]]

applies to any advance refunding issue issued after May 28, 1991.
    (3) Special effective date for paragraph (f)(3). Paragraph (f)(3) of 
this section applies to bonds sold on or after July 8, 1997 and to any 
issue to which the election described in Sec. 1.148-11(b)(1) is made. 
See Sec. 1.148-11A(i) for rules relating to certain bonds sold before 
July 8, 1997.
    (4) Special effective date for paragraph (g). See Sec. 1.141-15 for 
the applicability date of paragraph (g) of this section.

[T.D. 8476, 58 FR 33548, June 18, 1993; 58 FR 44453, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24046, May 10, 1994; T.D. 8718, 62 FR 25513, 
May 9, 1997; T.D. 9234, 70 FR 75035, Dec. 19, 2005]



Sec. 1.149(e)-1  Information reporting requirements for tax-exempt
bonds.

    (a) General rule. Interest on a bond is included in gross income 
unless certain information with respect to the issue of which the bond 
is a part is reported to the Internal Revenue Service in accordance with 
the requirements of this section. This section applies to any bond if 
the issue of which the bond is a part is issued after December 31, 1986 
(including any bond issued to refund a bond issued on or before December 
31, 1986).
    (b) Requirements for private activity bonds--(1) In general. If the 
issue of which the bond is a part is an issue of private activity bonds, 
the issuer must comply with the following requirements--
    (i) Not later than the 15th day of the second calendar month after 
the close of the calendar quarter in which the issue is issued, the 
issuer must file with the Internal Revenue Service a completed 
information reporting form prescribed for this purpose;
    (ii) If any bond that is part of the issue is taken into account 
under section 146 (relating to volume cap on private activity bonds), 
the state certification requirement of paragraph (b)(2) of this section 
must be satisfied; and
    (iii) If any bond that is part of the issue is a qualified mortgage 
bond or qualified veterans' mortgage bond (within the meaning of section 
143 (a) or (b) or section 103A(c) (1) or (3) as in effect on the day 
before enactment of the Tax Reform Act of 1986), the issuer must submit 
the annual report containing information on the borrowers of the 
original proceeds of the issue as required under Sec. 1.103A-2 
(k)(2)(ii) and (k)(3) through (k)(6).
    (2) State certification with respect to volume cap--(i) In general. 
If an issue is subject to the volume cap under section 146, a state 
official designated by state law (if there is no such official, then the 
governor or the governor's delegate) must certify that the issue meets 
the requirements of section 146, and a copy of this certification must 
be attached to the information reporting form filed with respect to the 
issue. In the case of any constitutional home rule city (as defined in 
section 146(d)(3)(C)), the preceding sentence is applied by substituting 
``city'' for ``state'' and ``chief executive officer'' for ``governor.''
    (ii) Certification. The certifying official need not perform an 
independent investigation in order to certify that the issue meets the 
requirements of section 146. For example, if the certifying official 
receives an affidavit that was executed by an officer of the issuer who 
is responsible for issuing the bonds and that sets forth, in brief and 
summary terms, the facts necessary to determine that the issue meets the 
requirements of section 146 and if the certifying official has compared 
the information in that affidavit to other readily available information 
with respect to that issuer (e.g., previous affidavits and 
certifications for other private activity bonds issued by that issuer), 
the certifying official may rely on the affidavit.
    (c) Requirements for governmental bonds--(1) Issue price of $100,000 
or more. If the issue of which the bond is a part has an issue price of 
$100,000 or more and is not an issue of private activity bonds, then, 
not later than the 15th day of the second calendar month after the close 
of the calendar quarter in which the issue is issued, the issuer must 
file with the Internal Revenue Service a completed information reporting 
form prescribed for this purpose.
    (2) Issue price of less than $100,000--(i) In general. If the issue 
of which the bond is a part has an issue price of less than $100,000 and 
is not an issue of private activity bonds, the issuer must file with the 
Internal Revenue Service

[[Page 152]]

one of the following information reporting forms within the prescribed 
period--
    (A) Separate return. Not later than the 15th day of the second 
calendar month after the close of the calendar quarter in which the 
issue is issued, a completed information reporting form prescribed for 
this purpose with respect to that issue; or
    (B) Consolidated return. Not later than February 15 of the calendar 
year following the calendar year in which the issue is issued, a 
completed information form prescribed for this purpose with respect to 
all issues to which this paragraph (c)(2) applies that were issued by 
the issuer during the calendar year and for which information was not 
reported on a separate information return pursuant to paragraph 
(c)(2)(i)(A) of this section.
    (ii) Bond issues issued before January 1, 1992. Paragraph 
(c)(2)(i)(A) of this section does not apply if the issue of which the 
bond is a part is issued before January 1, 1992.
    (iii) Extended filing date for first and second calendar quarters of 
1992. If the issue of which the bond is a part is issued during the 
first or second calendar quarter of 1992, the prescribed period for 
filing an information reporting form with respect to that issue pursuant 
to paragraph (c)(2)(i)(A) of this section is extended until November 16, 
1992.
    (d) Filing of forms and special rules--(1) Completed form. For 
purposes of this section--
    (i) Good faith effort. An information reporting form is treated as 
completed if the issuer (or a person acting on behalf of the issuer) has 
made a good faith effort to complete the form (taking into account the 
instructions to the form).
    (ii) Information. In general, information reporting forms filed 
pursuant to this section must be completed on the basis of available 
information and reasonable expectations as of the date the issue is 
issued. Forms that are filed on a consolidated basis pursuant to 
paragraph (c)(2)(i)(B) of this section, however, may be completed on the 
basis of information readily available to the issuer at the close of the 
calendar year to which the form relates, supplemented by estimates made 
in good faith.
    (iii) Certain information not required. An issuer need not report to 
the Internal Revenue Service any information specified in the first 
sentence of section 149(e)(2) that is not required to be reported to the 
Internal Revenue Service pursuant to the information reporting forms 
prescribed under that section and the instructions to those forms.
    (2) Manner of filing--(i) Place for filing. The information 
reporting form must be filed with the Internal Revenue Service at the 
address specified on the form or in the instructions to the form.
    (ii) Extension of time. The Commissioner may grant an extension of 
time to file any form or attachment required under this section if the 
Commissioner determines that the failure to file in a timely manner was 
not due to willful neglect. The Commissioner may make this determination 
with respect to an issue or to a class of issues.
    (e) Definitions. For purposes of this section only--(1) Private 
activity bond. The term ``private activity bond'' has the meaning given 
that term in section 141(a) of the Internal Revenue Code, except that 
the term does not include any bond described in section 1312(c) of the 
Tax Reform Act of 1986 to which section 1312 or 1313 of the Tax Reform 
Act of 1986 applies.
    (2) Issue--(i) In general. Except as otherwise provided in this 
paragraph (e)(2), bonds are treated as part of the same issue only if 
the bonds are issued--
    (A) By the same issuer;
    (B) On the same date; and
    (C) Pursuant to a single transaction or to a series of related 
transactions.
    (ii) Draw-down loans, commercial paper, etc. (A) Bonds issued during 
the same calendar year may be treated as part of the same tissue if the 
bonds are issued--
    (1) Pursuant to a loan agreement under which amounts are to be 
advanced periodically (``draw-down loan''); or
    (2) With a term not exceeding 270 days.
    (B) In addition, the bonds must be equally and ratably secured under 
a single indenture or loan agreement and issued pursuant to a common 
financing arrangement (e.g., pursuant to the

[[Page 153]]

same official statement that is periodically updated to reflect changing 
factual circumstances). In the case of bonds issued pursuant to a draw-
down loan that meets the requirements of the preceding sentence, bonds 
issued during different calendar years may be treated as part of the 
same issue if all the amounts to be advanced pursuant to the draw-down 
loan are reasonably expected to be advanced within three years of the 
date of issue of the first bond.
    (iii) Leases and installment sales. Bonds other than private 
activity bonds may be treated as part of the same issue if--
    (A) The bonds are issued pursuant to a single agreement that is in 
the form of a lease or installment sales agreement; and
    (B) All of the property covered by that agreement is reasonably 
expected to be delivered within three years of the date of issue of the 
first bond.
    (iv) Qualified 501(c)(3) bonds. If an issuer elects under section 
141(b)(9) to treat a portion of an issue as a qualified 501(c)(3) bond, 
that portion is treated as a separate issue.
    (3) Date of issue--(i) Bond. The date of issue of a bond is 
determined under Sec. 1.150-1.
    (ii) Issue. The date of issue of an issue of bonds is the date of 
issue of the first bond that is part of the issue. See paragraphs (e)(2) 
(ii) and (iii) of this section for rules relating to draw-down loans, 
commercial paper, etc., and leases and installment sales.
    (iii) Bonds to which prior law applied. Notwithstanding the 
provisions of this paragraph (e)(3), an issue for which an information 
report was required to be filed under section 103(l) or section 
103A(j)(3) is treated as issued prior to January 1, 1987.
    (4) Issue price. The term ``issue price'' has the same meaning given 
the term under Sec. 1.148-1(b).

[T.D. 8425, 57 FR 36002, Aug. 12, 1992, as amended at 59 FR 24351, May 
11, 1994]



Sec. 1.149(g)-1  Hedge bonds.

    (a) Certain definitions. Except as otherwise provided, the 
definitions set forth in Sec. 1.148-1 apply for purposes of section 
149(g) and this section. In addition, the following terms have the 
following meanings:
    Reasonable expectations means reasonable expectations (as defined in 
Sec. 1.148-1), as modified to take into account the provisions of 
section 149(f)(2)(B).
    Spendable proceeds means net sale proceeds (as defined in 
Sec. 1.148-1).
    (b) Applicability of arbitrage allocation and accounting rules. 
Section 1.148-6 applies for purposes of section 149(g), except that an 
expenditure that results in the creation of replacement proceeds (other 
than amounts in a bona fide debt service fund or a reasonably required 
reserve or replacement fund) is not an expenditure for purposes of 
section 149(g).
    (c) Refundings--(1) Investment in tax-exempt bonds. A bond issued to 
refund a bond that is a tax-exempt bond by virtue of the rule in section 
149(g)(3)(B) is not a tax-exempt bond unless the gross proceeds of that 
refunding bond (other than proceeds in a refunding escrow for the 
refunded bond) satisfy the requirements of section 149(g)(3)(B).
    (2) Anti-abuse rule. A refunding bond is treated as a hedge bond 
unless there is a significant governmental purpose for the issuance of 
that bond (e.g., an advance refunding bond issued to realize debt 
service savings or to relieve the issuer of significantly burdensome 
document provisions, but not to otherwise hedge against future increases 
in interest rates).
    (d) Effective date. This section applies to bonds issued after June 
30, 1993 to which Secs. 1.148-1 through 1.148-11 apply. In addition, 
this section applies to any issue to which the election described in 
Sec. 1.148-11(b)(1) is made.

[T.D. 8476, 58 FR 33549, June 18, 1993]



Sec. 1.150-1  Definitions.

    (a) Scope and effective date--(1) In general. Except as otherwise 
provided, the definitions in this section apply for all purposes of 
sections 103 and 141 through 150.
    (2) Effective/applicability date--(i) In general. Except as 
otherwise provided in this paragraph (a)(2), this section applies to 
issues issued after June 30, 1993 to which Secs. 1.148-1 through 1.148-
11 apply. In addition, this section (other than paragraph (c)(3) of this 
section)

[[Page 154]]

applies to any issue to which the election described in Sec. 1.148-
11(b)(1) is made.
    (ii) Special effective date for paragraphs (c)(1), (c)(4)(iii), and 
(c)(6). Paragraphs (c)(1), (c)(4)(iii), and (c)(6) of this section apply 
to bonds sold on or after July 8, 1997 and to any issue to which the 
election described in Sec. 1.148-11(b)(1) is made. See Sec. 1.148-11A(i) 
for rules relating to certain bonds sold before July 8, 1997.
    (iii) Special effective date for definitions of tax-advantaged bond, 
issue, and grant. The definition of tax-advantaged bond in paragraph (b) 
of this section, the revisions to the definition of issue in paragraph 
(c)(2) of this section, and the definition and rules regarding the 
treatment of grants in paragraph (f) of this section apply to bonds that 
are sold on or after October 17, 2016.
    (3) Exceptions to general effective date. See Sec. 1.141-15 for the 
applicability date of the definition of bond documents contained in 
paragraph (b) of this section and the effective date of paragraph 
(c)(3)(ii) of this section.
    (4) Additional exception to the general applicability date. Section 
1.150-1(b), Issuance costs, applies on and after July 6, 2011.
    (b) Certain general definitions. The following definitions apply:
    Bond means any obligation of a State or political subdivision 
thereof under section 103(c)(1).
    Bond documents means the bond indenture or resolution, transcript of 
proceedings, and any related documents.
    Capital expenditure means any cost of a type that is properly 
chargeable to capital account (or would be so chargeable with a proper 
election or with the application of the definition of placed in service 
under Sec. 1.150-2(c)) under general Federal income tax principles. For 
example, costs incurred to acquire, construct, or improve land, 
buildings, and equipment generally are capital expenditures. Whether an 
expenditure is a capital expenditure is determined at the time the 
expenditure is paid with respect to the property. Future changes in law 
do not affect whether an expenditure is a capital expenditure.
    Conduit borrower means the obligor on a purpose investment (as 
defined in Sec. 1.148-1). For example, if an issuer invests proceeds in 
a purpose investment in the form of a loan, lease, installment sale 
obligation, or similar obligation to another entity and the obligor uses 
the proceeds to carry out the governmental purpose of the issue, the 
obligor is a conduit borrower.
    Conduit financing issue means an issue the proceeds of which are 
used or are reasonably expected to be used to finance at least one 
purpose investment representing at least one conduit loan to one conduit 
borrower.
    Conduit loan means a purpose investment (as defined in Sec. 1.148-
1).
    Governmental bond means any bond of an issue of tax-exempt bonds in 
which none of the bonds are private activity bonds.
    Issuance costs means costs to the extent incurred in connection 
with, and allocable to, the issuance of an issue within the meaning of 
section 147(g). For example, issuance costs include the following costs 
but only to the extent incurred in connection with, and allocable to, 
the borrowing: underwriters' spread; counsel fees; financial advisory 
fees; fees paid to an organization to evaluate the credit quality of an 
issue; trustee fees; paying agent fees; bond registrar, certification, 
and authentication fees; accounting fees; printing costs for bonds and 
offering documents; public approval process costs; engineering and 
feasibility study costs; guarantee fees, other than for qualified 
guarantees (as defined in Sec. 1.148-4(f)); and similar costs.
    Issue date means, in reference to an issue, the first date on which 
the issuer receives the purchase price in exchange for delivery of the 
evidence of indebtedness representing any bond included in the issue. 
Issue date means, in reference to a bond, the date on which the issuer 
receives the purchase price in exchange for that bond. In no event is 
the issue date earlier than the first day on which interest begins to 
accrue on the bond or bonds for Federal income tax purposes.
    Obligation means any valid evidence of indebtedness under general 
Federal income tax principles.
    Pooled financing issue means an issue the proceeds of which are to 
be used to finance purpose investments representing conduit loans to two 
or more

[[Page 155]]

conduit borrowers, unless those conduit loans are to be used to finance 
a single capital project.
    Private activity bond means a private activity bond (as defined in 
section 141).
    Qualified mortgage loan means a mortgage loan with respect to an 
owner-occupied residence acquired with the proceeds of an obligation 
described in section 143(a)(1) or 143(b) (or applicable prior law).
    Qualified student loan means a student loan acquired with the 
proceeds of an obligation described in section 144(b)(1).
    Related party means, in reference to a governmental unit or a 
501(c)(3) organization, any member of the same controlled group, and, in 
reference to any person that is not a governmental unit or 501(c)(3) 
organization, a related person (as defined in section 144(a)(3)).
    Taxable bond means any obligation the interest on which is not 
excludable from gross income under section 103.
    Tax-advantaged bond means a tax-exempt bond, a taxable bond that 
provides a federal tax credit to the investor with respect to the 
issuer's borrowing costs, a taxable bond that provides a refundable 
federal tax credit payable directly to the issuer of the bond for its 
borrowing costs under section 6431, or any future similar bond that 
provides a federal tax benefit that reduces an issuer's borrowing costs. 
Examples of tax-advantaged bonds include qualified tax credit bonds 
under section 54A(d)(1) and build America bonds under section 54AA.
    Tax-exempt bond means any bond the interest on which is excludable 
from gross income under section 103(a). For purposes of section 148, 
tax-exempt bond includes:
    (1) An interest in a regulated investment company to the extent that 
at least 95 percent of the income to the holder of the interest is 
interest that is excludable from gross income under section 103; and
    (2) A certificate of indebtedness issued by the United States 
Treasury pursuant to the Demand Deposit State and Local Government 
Series program described in 31 CFR part 344.
    Working capital expenditure means any cost that is not a capital 
expenditure. Generally, current operating expenses are working capital 
expenditures.
    (c) Definition of issue--(1) In general. Except as otherwise 
provided in this paragraph (c), the term issue means two or more bonds 
that meet all of the following requirements:
    (i) Sold at substantially the same time. The bonds are sold at 
substantially the same time. Bonds are treated as sold at substantially 
the same time if they are sold less than 15 days apart.
    (ii) Sold pursuant to the same plan of financing. The bonds are sold 
pursuant to the same plan of financing. Factors material to the plan of 
financing include the purposes for the bonds and the structure of the 
financing. For example, generally--
    (A) Bonds to finance a single facility or related facilities are 
part of the same plan of financing;
    (B) Short-term bonds to finance working capital expenditures and 
long-term bonds to finance capital projects are not part of the same 
plan of financing; and
    (C) Certificates of participation in a lease and general obligation 
bonds secured by tax revenues are not part of the same plan of 
financing.
    (iii) Payable from same source of funds. The bonds are reasonably 
expected to be paid from substantially the same source of funds, 
determined without regard to guarantees from parties unrelated to the 
obligor.
    (2) Exceptions for different types of tax-advantaged bonds and 
taxable bonds. Each type of tax-advantaged bond that has a different 
structure for delivery of the tax benefit that reduces the issuer's 
borrowing costs or different program eligibility requirements is treated 
as part of a different issue under this paragraph (c). Further, tax-
advantaged bonds and bonds that are not tax-advantaged bonds are treated 
as part of different issues under this paragraph (c). The issuance of 
tax-advantaged bonds in a transaction with other bonds that are not tax-
advantaged bonds must be tested under the arbitrage anti-abuse rules 
under Sec. 1.148-10(a) and other applicable anti-abuse rules (for 
example, limitations against window maturity structures or unreasonable 
allocations of bonds).

[[Page 156]]

    (3) Exception for certain bonds financing separate purposes--(i) In 
general. Bonds may be treated as part of separate issues if the 
requirements of this paragraph (c)(3) are satisfied. Each of these 
separate issues must finance a separate purpose (e.g., refunding a 
separate prior issue, financing a separate purpose investment, financing 
integrated or functionally related capital projects, and financing any 
clearly discrete governmental purpose). Each of these separate issues 
independently must be a tax-exempt bond (e.g., a governmental bond or a 
qualified mortgage bond). The aggregate proceeds, investments, and bonds 
in such a transaction must be allocated between each of the separate 
issues using a reasonable, consistently applied allocation method. If 
any separate issue consists of refunding bonds, the allocation rules in 
Sec. 1.148-9(h) must be satisfied. An allocation is not reasonable if it 
achieves more favorable results under sections 103 and 141 to 150 than 
could be achieved with actual separate issues. All allocations under 
this paragraph (c)(3) must be made in writing on or before the issue 
date.
    (ii) Exceptions. This paragraph (c)(3) does not apply for purposes 
of sections 141, 144(a), 148, 149(d) and 149(g).
    (4) Special rules for certain financings--(i) Draw-down loans. Bonds 
issued pursuant to a draw-down loan are treated as part of a single 
issue. The issue date of that issue is the first date on which the 
aggregate draws under the loan exceed the lesser of $50,000 or 5 percent 
of the issue price.
    (ii) Commercial paper--(A) In general. Short-term bonds having a 
maturity of 270 days or less (commercial paper) issued pursuant to the 
same commercial paper program may be treated as part of a single issue, 
the issue date of which is the first date the aggregate amount of 
commercial paper issued under the program exceeds the lesser of $50,000 
or 5 percent of the aggregate issue price of the commercial paper in the 
program. A commercial paper program is a program to issue commercial 
paper to finance or refinance the same governmental purpose pursuant to 
a single master legal document. Commercial paper is not part of the same 
commercial paper program unless issued during an 18-month period, 
beginning on the deemed issue date. In addition, commercial paper issued 
after the end of this 18-month period may be treated as part of the 
program to the extent issued to refund commercial paper that is part of 
the program, but only to the extent that--
    (1) There is no increase in the principal amount outstanding; and
    (2) The program does not have a term in excess of--
    (i) 30 years; or
    (ii) The period reasonably necessary for the governmental purposes 
of the program.
    (B) Safe harbor. The requirement of paragraph (c)(4)(ii)(A)(2) of 
this section is treated as satisfied if the weighted average maturity of 
the issue does not exceed 120 percent of the weighted average expected 
economic life of the property financed by the issue.
    (iii) Certain general obligation bonds. Except as otherwise provided 
in paragraph (c)(2) of this section, bonds that are secured by a pledge 
of the issuer's full faith and credit (or a substantially similar 
pledge) and sold and issued on the same dates pursuant to a single 
offering document may be treated as part of the same issue if the issuer 
so elects on or before the issue date.
    (5) Anti-abuse rule. In order to prevent the avoidance of sections 
103 and 141 through 150 and the general purposes thereof, the 
Commissioner may treat bonds as part of the same issue or as part of 
separate issues to clearly reflect the economic substance of a 
transaction.
    (6) Sale date. The sale date of a bond is the first day on which 
there is a binding contract in writing for the sale or exchange of the 
bond.
    (d) Definition of refunding issue and related definitions--(1) 
General definition of refunding issue. Refunding issue means an issue of 
obligations the proceeds of which are used to pay principal, interest, 
or redemption price on another issue (a prior issue, as more 
particularly defined in paragraph (d)(5) of this section), including the 
issuance costs, accrued interest, capitalized interest on the refunding 
issue, a reserve or replacement fund, or similar costs, if any, properly 
allocable to that refunding issue.

[[Page 157]]

    (2) Exceptions and special rules. For purposes of paragraph (d)(1) 
of this section, the following exceptions and special rules apply--
    (i) Payment of certain interest. An issue is not a refunding issue 
if the only principal and interest that is paid with proceeds of the 
issue (determined without regard to the multipurpose issue rules of 
Sec. 1.148-9(h)) is interest on another issue that--
    (A) Accrues on the other issue during a one-year period including 
the issue date of the issue that finances the interest;
    (B) Is a capital expenditure; or
    (C) Is a working capital expenditure to which the de minimis rule of 
Sec. 1.148-6(d)(3)(ii)(A) applies.
    (ii) Certain issues with different obligors--(A) In general. An 
issue is not a refunding issue to the extent that the obligor (as 
defined in paragraph (d)(2)(ii)(B) of this section) of one issue is 
neither the obligor of the other issue nor a related party with respect 
to the obligor of the other issue.
    (B) Definition of obligor. The obligor of an issue means the actual 
issuer of the issue, except that the obligor of the portion of an issue 
properly allocable to an investment in a purpose investment means the 
conduit borrower under that purpose investment. The obligor of an issue 
used to finance qualified mortgage loans, qualified student loans, or 
similar program investments (as defined in Sec. 1.148-1) does not 
include the ultimate recipient of the loan (e.g., the homeowner, the 
student).
    (iii) Certain special rules for purpose investments. For purposes of 
this paragraph (d), the following special rules apply:
    (A) Refunding of a conduit financing issue by a conduit loan 
refunding issue. Except as provided in paragraph (d)(2)(iii)(B) of this 
section, the use of the proceeds of an issue that is used to refund an 
obligation that is a purpose investment (a conduit refunding issue) by 
the actual issuer of the conduit financing issue determines whether the 
conduit refunding issue is a refunding of the conduit financing issue 
(in addition to a refunding of the obligation that is the purpose 
investment).
    (B) Recycling of certain payments under purpose investments. A 
conduit refunding issue is not a refunding of a conduit financing issue 
to the extent that the actual issuer of the conduit financing issue 
reasonably expects as of the date of receipt of the proceeds of the 
conduit refunding issue to use those amounts within 6 months (or, if 
greater, during the applicable temporary period for those amounts under 
section 148(c) or under applicable prior law) to acquire a new purpose 
investment. Any new purpose investment is treated as made from the 
proceeds of the conduit financing issue.
    (C) Application to tax-exempt loans. For purposes of this paragraph 
(d), obligations that would be purpose investments (absent section 
148(b)(3)(A)) are treated as purpose investments.
    (iv) Substance of transaction controls. In the absence of other 
applicable controlling rules under this paragraph (d), the determination 
of whether an issue is a refunding issue is based on the substance of 
the transaction in light of all the facts and circumstances.
    (v) Certain integrated transactions in connection with asset 
acquisition not treated as refunding issues. If, within six months 
before or after a person assumes (including taking subject to) 
obligations of an unrelated party in connection with an asset 
acquisition (other than a transaction to which section 381(a) applies if 
the person assuming the obligation is the acquiring corporation within 
the meaning of section 381(a)), the assumed issue is refinanced, the 
refinancing issue is not treated as a refunding issue.
    (3) Current refunding issue. Current refunding issue means:
    (i) Except as provided in paragraph (d)(3)(ii) of this section, a 
refunding issue that is issued not more than 90 days before the last 
expenditure of any proceeds of the refunding issue for the payment of 
principal or interest on the prior issue; and
    (ii) In the case of a refunding issue issued before 1986--
    (A) A refunding issue that is issued not more than 180 days before 
the last expenditure of any proceeds of the refunding issue for the 
payment of principal or interest on the prior issue; or
    (B) A refunding issue if the prior issue had a term of less than 3 
years

[[Page 158]]

and was sold in anticipation of permanent financing, but only if the 
aggregate term of all prior issues sold in anticipation of permanent 
financing was less than 3 years.
    (4) Advance refunding issue. Advance refunding issue means a 
refunding issue that is not a current refunding issue.
    (5) Prior issue. Prior issue means an issue of obligations all or a 
portion of the principal, interest, or call premium on which is paid or 
provided for with proceeds of a refunding issue. A prior issue may be 
issued before, at the same time as, or after a refunding issue. If the 
refunded and unrefunded portions of a prior issue are treated as 
separate issues under Sec. 1.148-9(i), for the purposes for which that 
section applies, except to the extent that the context clearly requires 
otherwise, references to a prior issue refer only to the refunded 
portion of that prior issue.
    (e) Controlled group means a group of entities controlled directly 
or indirectly by the same entity or group of entities within the meaning 
of this paragraph (e).
    (1) Direct control. The determination of direct control is made on 
the basis of all the relevant facts and circumstances. One entity or 
group of entities (the controlling entity) generally controls another 
entity or group of entities (the controlled entity) for purposes of this 
paragraph if the controlling entity possesses either of the following 
rights or powers and the rights or powers are discretionary and non-
ministerial--
    (i) The right or power both to approve and to remove without cause a 
controlling portion of the governing body of the controlled entity; or
    (ii) The right or power to require the use of funds or assets of the 
controlled entity for any purpose of the controlling entity.
    (2) Indirect control. If a controlling entity controls a controlled 
entity under the test in paragraph (e)(1) of this section, then the 
controlling entity also controls all entities controlled, directly or 
indirectly, by the controlled entity or entities.
    (3) Exception for general purpose governmental entities. An entity 
is not a controlled entity under this paragraph (e) if the entity 
possesses substantial taxing, eminent domain, and police powers. For 
example, a city possessing substantial amounts of each of these 
sovereign powers is not a controlled entity of the state.
    (f) Definition and treatment of grants--(1) Definition. Grant means 
a transfer for a governmental purpose of money or property to a 
transferee that is not a related party to or an agent of the transferor. 
The transfer must not impose any obligation or condition to directly or 
indirectly repay any amount to the transferor or a related party. 
Obligations or conditions intended solely to assure expenditure of the 
transferred moneys in accordance with the governmental purpose of the 
transfer do not prevent a transfer from being a grant.
    (2) Treatment. Except as otherwise provided (for example, 
Sec. 1.148-6(d)(4), which treats proceeds used for grants as spent for 
arbitrage purposes when the grant is made), the character and nature of 
a grantee's use of proceeds are taken into account in determining which 
rules are applicable to the bond issue and whether the applicable 
requirements for the bond issue are met. For example, a grantee's use of 
proceeds generally determines whether the proceeds are used for capital 
projects or working capital expenditures under section 148 and whether 
the qualified purposes for the specific type of bond issue are met.

[T.D. 8476, 58 FR 33549, June 18, 1993; 58 FR 44453, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24046, May 10, 1994; T.D. 8712, 62 FR 2304, 
Jan. 16, 1997; T.D. 8718, 62 FR 25513, May 9, 1997; T.D. 9234, 70 FR 
75036, Dec. 19, 2005; T.D. 9533, 76 FR 39280, July 6, 2011; T.D. 9637, 
78 FR 54759, Sept. 6, 2013; T.D. 9777, 81 FR 46598, July 18, 2016]



Sec. 1.150-2  Proceeds of bonds used for reimbursement.

    (a) Table of contents. This table of contents contains a listing of 
the headings contained in Sec. 1.150-2.

    (a) Table of contents.
    (b) Scope.
    (c) Definitions.
    (d) General operating rules for reimbursement expenditures.
    (1) Official intent.
    (2) Reimbursement period.
    (3) Nature of expenditure.
    (e) Official intent rules.

[[Page 159]]

    (1) Form of official intent.
    (2) Project description in official intent.
    (3) Reasonableness of official intent.
    (f) Exceptions to general operating rules.
    (1) De minimis exception.
    (2) Preliminary expenditures exception.
    (g) Special rules on refundings.
    (1) In general--once financed, not reimbursed.
    (2) Certain proceeds of prior issue used for reimbursement treated 
as unspent.
    (h) Anti-abuse rules.
    (1) General rule.
    (2) One-year step transaction rule.
    (i) Authority of the Commissioner to prescribe rules.
    (j) Effective date.
    (1) In general.
    (2) Transitional rules.
    (3) Nature of expenditure.

    (b) Scope. This section applies to reimbursement bonds (as defined 
in paragraph (c) of this section) for all purposes of sections 103 and 
141 to 150.
    (c) Definitions. The following definitions apply:
    Issuer means--
    (1) For any private activity bond (excluding a qualified 501(c)(3) 
bond, qualified student loan bond, qualified mortgage bond, or qualified 
veterans' mortgage bond), the entity that actually issues the 
reimbursement bond; and
    (2) For any bond not described in paragraph (1) of this definition, 
either the entity that actually issues the reimbursement bond or, to the 
extent that the reimbursement bond proceeds are to be loaned to a 
conduit borrower, that conduit borrower.
    Official intent means an issuer's declaration of intent to reimburse 
an original expenditure with proceeds of an obligation.
    Original expenditure means an expenditure for a governmental purpose 
that is originally paid from a source other than a reimbursement bond.
    Placed in service means, with respect to a facility, the date on 
which, based on all the facts and circumstances--
    (1) The facility has reached a degree of completion which would 
permit its operation at substantially its design level; and
    (2) The facility is, in fact, in operation at such level.
    Reimbursement allocation means an allocation in writing that 
evidences an issuer's use of proceeds of a reimbursement bond to 
reimburse an original expenditure. An allocation made within 30 days 
after the issue date of a reimbursement bond may be treated as made on 
the issue date.
    Reimbursement bond means the portion of an issue allocated to 
reimburse an original expenditure that was paid before the issue date.
    (d) General operating rules for reimbursement expenditures. Except 
as otherwise provided, a reimbursement allocation is treated as an 
expenditure of proceeds of a reimbursement bond for the governmental 
purpose of the original expenditure on the date of the reimbursement 
allocation only if:
    (1) Official intent. Not later than 60 days after payment of the 
original expenditure, the issuer adopts an official intent for the 
original expenditure that satisfies paragraph (e) of this section.
    (2) Reimbursement period--(i) In general. The reimbursement 
allocation is made not later than 18 months after the later of--
    (A) The date the original expenditure is paid; or
    (B) The date the project is placed in service or abandoned, but in 
no event more than 3 years after the original expenditure is paid.
    (ii) Special rule for small issuers. In applying paragraph (d)(2)(i) 
of this section to an issue that satisfies section 148(f)(4)(D)(i) (I) 
through (IV), the ``18 month'' limitation is changed to ``3 years'' and 
the ``3-year'' maximum reimbursement period is disregarded.
    (iii) Special rule for long-term construction projects. In applying 
paragraph (d)(2)(i) to a construction project for which both the issuer 
and a licensed architect or engineer certify that at least 5 years is 
necessary to complete construction of the project, the maximum 
reimbursement period is changed from ``3 years'' to ``5 years.''
    (3) Nature of expenditure. The original expenditure is a capital 
expenditure, a cost of issuance for a bond, an expenditure described in 
Sec. 1.148-6(d)(3)(ii)(B) (relating to certain extraordinary working 
capital items), a grant (as defined in Sec. 1.150-1(f)), a qualified 
student loan, a qualified mortgage loan, or a qualified veterans' 
mortgage loan.
    (e) Official intent rules. An official intent satisfies this 
paragraph (e) if:

[[Page 160]]

    (1) Form of official intent. The official intent is made in any 
reasonable form, including issuer resolution, action by an appropriate 
representative of the issuer (e.g., a person authorized or designated to 
declare official intent on behalf of the issuer), or specific 
legislative authorization for the issuance of obligations for a 
particular project.
    (2) Project description in official intent--(i) In general. The 
official intent generally describes the project for which the original 
expenditure is paid and states the maximum principal amount of 
obligations expected to be issued for the project. A project includes 
any property, project, or program (e.g., highway capital improvement 
program, hospital equipment acquisition, or school building renovation).
    (ii) Fund accounting. A project description is sufficient if it 
identifies, by name and functional purpose, the fund or account from 
which the original expenditure is paid (e.g., parks and recreation 
fund--recreational facility capital improvement program).
    (iii) Reasonable deviations in project description. Deviations 
between a project described in an official intent and the actual project 
financed with reimbursement bonds do not invalidate the official intent 
to the extent that the actual project is reasonably related in function 
to the described project. For example, hospital equipment is a 
reasonable deviation from hospital building improvements. In contrast, a 
city office building rehabilitation is not a reasonable deviation from 
highway improvements.
    (3) Reasonableness of official intent. On the date of the 
declaration, the issuer must have a reasonable expectation (as defined 
in Sec. 1.148-1(b)) that it will reimburse the original expenditure with 
proceeds of an obligation. Official intents declared as a matter of 
course or in amounts substantially in excess of the amounts expected to 
be necessary for the project (e.g., blanket declarations) are not 
reasonable. Similarly, a pattern of failure to reimburse actual original 
expenditures covered by official intents (other than in extraordinary 
circumstances) is evidence of unreasonableness. An official intent 
declared pursuant to a specific legislative authorization is rebuttably 
presumed to satisfy this paragraph (e)(3).
    (f) Exceptions to general operating rules--(1) De minimis exception. 
Paragraphs (d)(1) and (d)(2) of this section do not apply to costs of 
issuance of any bond or to an amount not in excess of the lesser of 
$100,000 or 5 percent of the proceeds of the issue.
    (2) Preliminary expenditures exception. Paragraphs (d)(1) and (d)(2) 
of this section do not apply to any preliminary expenditures, up to an 
amount not in excess of 20 percent of the aggregate issue price of the 
issue or issues that finance or are reasonably expected by the issuer to 
finance the project for which the preliminary expenditures were 
incurred. Preliminary expenditures include architectural, engineering, 
surveying, soil testing, reimbursement bond issuance, and similar costs 
that are incurred prior to commencement of acquisition, construction, or 
rehabilitation of a project, other than land acquisition, site 
preparation, and similar costs incident to commencement of construction.
    (g) Special rules on refundings--(1) In general--once financed, not 
reimbursed. Except as provided in paragraph (g)(2) of this section, 
paragraph (d) of this section does not apply to an allocation to pay 
principal or interest on an obligation or to reimburse an original 
expenditure paid by another obligation. Instead, such an allocation is 
analyzed under rules on refunding issues. See Sec. 1.148-9.
    (2) Certain proceeds of prior issue used for reimbursement treated 
as unspent. In the case of a refunding issue (or series of refunding 
issues), proceeds of a prior issue purportedly used to reimburse 
original expenditures are treated as unspent proceeds of the prior issue 
unless the purported reimbursement was a valid expenditure under 
applicable law on reimbursement expenditures on the issue date of the 
prior issue.
    (h) Anti-abuse rules--(1) General rule. A reimbursement allocation 
is not an expenditure of proceeds of an issue under this section if the 
allocation employs an abusive arbitrage device under Sec. 1.148-10 to 
avoid the arbitrage restrictions or to avoid the restrictions under 
sections 142 through 147.

[[Page 161]]

    (2) One-year step transaction rule--(i) Creation of replacement 
proceeds. A purported reimbursement allocation is invalid and thus is 
not an expenditure of proceeds of an issue if, within 1 year after the 
allocation, funds corresponding to the proceeds of a reimbursement bond 
for which a reimbursement allocation was made are used in a manner that 
results in the creation of replacement proceeds (as defined in 
Sec. 1.148-1) of that issue or another issue. The preceding sentence 
does not apply to amounts deposited in a bona fide debt service fund (as 
defined in Sec. 1.148-1).
    (ii) Example. The provisions of paragraph (h)(2)(i) of this section 
are illustrated by the following example.

    Example. On January 1, 1994, County A issues an issue of 7 percent 
tax-exempt bonds (the 1994 issue) and makes a purported reimbursement 
allocation to reimburse an original expenditure for specified capital 
improvements. A immediately deposits funds corresponding to the proceeds 
subject to the reimbursement allocation in an escrow fund to provide for 
payment of principal and interest on its outstanding 1991 issue of 9 
percent tax-exempt bonds (the prior issue). The use of amounts 
corresponding to the proceeds of the reimbursement bonds to create a 
sinking fund for another issue within 1 year after the purported 
reimbursement allocation invalidates the reimbursement allocation. The 
proceeds retain their character as unspent proceeds of the 7 percent 
issue upon deposit in the escrow fund. Accordingly, the proceeds are 
subject to the 7 percent yield restriction of the 1994 issue instead of 
the 9 percent yield restriction of the prior issue.

    (i) Authority of the Commissioner to prescribe rules. The 
Commissioner may by revenue ruling or revenue procedure (see 
Sec. 601.601(d)(2)(ii)(b) of this chapter) prescribe rules for the 
expenditure of proceeds of reimbursement bonds in circumstances that do 
not otherwise satisfy this section.
    (j) Effective date--(1) In general. Except as otherwise provided, 
the provisions of this section apply to all allocations of proceeds of 
reimbursement bonds issued after June 30, 1993.
    (2) Transitional rules--(i) Official intent. An official intent is 
treated as satisfying the official intent requirement of paragraph 
(d)(1) of this section if it--
    (A) Satisfied the applicable provisions of Sec. 1.103-8(a)(5) as in 
effect prior to July 1, 1993, (as contained in 26 CFR part 1 revised as 
of April 1, 1993) and was made prior to that date, or
    (B) Satisfied the applicable provisions of Sec. 1.103-18 as in 
effect between January 27, 1992, and June 30, 1993, (as contained in 26 
CFR part 1 revised as of April 1, 1993) and was made during that period.
    (ii) Certain expenditures of private activity bonds. For any 
expenditure that was originally paid prior to August 15, 1993, and that 
would have qualified for expenditure by reimbursement from the proceeds 
of a private activity bond under T.D. 7199, section 1.103-8(a)(5), 1972-
2 C.B. 45 (see Sec. 601.601(d)(2)(ii)(b)) of this chapter, the 
requirements of that section may be applied in lieu of this section.
    (3) Nature of expenditure. Paragraph (d)(3) of this section applies 
to bonds that are sold on or after October 17, 2016.

[T.D. 8476, 58 FR 33551, June 18, 1993; 58 FR 44453, Aug. 23, 1993; T.D. 
9777, 81 FR 46598, July 18, 2016]



Sec. 1.150-4  Change in use of facilities financed with tax-exempt
private activity bonds.

    (a) Scope. This section applies for purposes of the rules for change 
of use of facilities financed with private activity bonds under sections 
150(b)(3) (relating to qualified 501(c)(3) bonds), 150(b)(4) (relating 
to certain exempt facility bonds and small issue bonds), 150(b)(5) 
(relating to facilities required to be owned by governmental units or 
501(c)(3) organizations), and 150(c).
    (b) Effect of remedial actions--(1) In general. Except as provided 
in this section, the change of use provisions of sections 150(b) (3) 
through (5), and 150(c) apply even if the issuer takes a remedial action 
described in Secs. 1.142-2, 1.144-2, or 1.145-2.
    (2) Exceptions--(i) Redemption. If nonqualified bonds are redeemed 
within 90 days of a deliberate action under Sec. 1.145-2(a) or within 90 
days of the date on which a failure to properly use proceeds occurs 
under Sec. 1.142-2 or Sec. 1.144-2, sections 150(b) (3) through (5) do 
not apply during the period between that date and the date on which the 
nonqualified bonds are redeemed.

[[Page 162]]

    (ii) Alternative qualifying use of facility. If a bond-financed 
facility is used for an alternative qualifying use under Secs. 1.145-2 
and 1.141-12(f), sections 150(b) (3) and (5) do not apply because of the 
alternative use.
    (iii) Alternative use of disposition proceeds. If disposition 
proceeds are used for a qualifying purpose under Secs. 1.145-2 and 
1.141-12(e), 1.142-2(c)(4), or 1.144-2, sections 150(b) (3) through (5) 
do not apply because of the deliberate action that gave rise to the 
disposition proceeds after the date on which all of the disposition 
proceeds have been expended on the qualifying purpose. If all of the 
disposition proceeds are so expended within 90 days of the date of the 
deliberate action, however, sections 150(b) (3) through (5) do not apply 
because of the deliberate action.
    (c) Allocation rules--(1) In general. If a change in use of a 
portion of the property financed with an issue of qualified private 
activity bonds causes section 150 (b)(3), (b)(4), or (b)(5) to apply to 
an issue, the bonds of the issue allocable to that portion under section 
150(c)(3) are the same as the nonqualified bonds determined for purposes 
of Secs. 1.142-1, 1.144-1, and 1.145-1, except that bonds allocable to 
all common areas are also allocated to that portion.
    (2) Special rule when remedial action is taken. If an issuer takes a 
remedial action with respect to an issue of private activity bonds under 
Secs. 1.142-2, 1.144-2, or 1.145-2, the bonds of the issue allocable to 
a portion of property are the same as the nonqualified bonds determined 
for purposes of those sections.
    (d) Effective dates. For effective dates of this section, see 
Sec. 1.141-16.

[T.D. 8712, 62 FR 2304, Jan. 16, 1997]



Sec. 1.150-5  Filing notices and elections.

    (a) In general. Notices and elections under the following sections 
must be filed with the Internal Revenue Service, 1111 Constitution 
Avenue, NW, Attention: T:GE:TEB:O, Washington, DC 20224 or such other 
place designated by publication of a notice in the Internal Revenue 
Bulletin--
    (1) Section 1.141-12(d)(4);
    (2) Section 1.142(f)(4)-1; and
    (3) Section 1.142-2(c)(2).
    (b) Effective dates. This section applies to notices and elections 
filed on or after January 19, 2001.

[T.D. 8941, 66 FR 4671, Jan. 18, 2001, as amended by T.D. 9741, 80 FR 
65646, Oct. 27, 2015]

   Regulations Applicable to Certain Bonds Sold Prior to July 8, 1997

    Editorial Note: IRS redesignated the following sections to appear 
below the undesignated center heading ``Regulations Applicable to 
Certain Bonds Sold Prior to July 8, 1997'' and preceding the 
undesignated center heading ``Deductions for Personal Exemptions.'' See 
62 FR 25507 and 25513, May 9, 1997 for the specific sections involved in 
the redesignation.



Sec. 1.148-1A  Definitions and elections.

    (a) [Reserved]. For guidance see Sec. 1.148-1.
    (b) Certain definitions.
    Investment-type property. See Sec. 1.148-1(b). Investment-type 
property also includes a contract that would be a hedge (within the 
meaning of Sec. 1.148-4(h)) except that it contains a significant 
investment element.
    (c) through (c)(4)(i) [Reserved]. For guidance see Sec. 1.148-1.
    (c)(4)(ii) Bonds financing a working capital reserve--(A) In 
general. Except as otherwise provided in Sec. 1.148-1(c)(4)(ii)(B), 
replacement proceeds arise to the extent a working capital reserve is, 
directly or indirectly, financed with the proceeds of the issue 
(regardless of the expenditure of proceeds of the issue). Thus, for 
example, if an issuer that does not maintain a working capital reserve 
borrows to fund such a reserve, the issuer will have replacement 
proceeds. To determine the amount of a working capital reserve 
maintained, an issuer may use the average amount maintained as a working 
capital reserve during annual periods of at least one year, the last of 
which ends within a year before the issue date. For example, the amount 
of a working capital reserve may be computed using the average of the 
beginning or ending monthly balances of the amount maintained as a 
reserve (net of unexpended gross proceeds) during the one year period 
preceding the issue date.

[T.D. 8538, 59 FR 24041, May 10, 1994. Redesignated by T.D. 8718, 62 FR 
25507, May 9, 1997]

[[Page 163]]



Sec. 1.148-2A  General arbitrage yield restriction rules.

    (a) through (b)(2)(i) [Reserved]. For guidance see Sec. 1.148-2.
    (b)(2)(ii) Exceptions to certification requirement. An issuer is not 
required to make a certification for an issue under Sec. 1.148-
2(b)(2)(i) if--
    (A) The issuer reasonably expects as of the issue date that there 
will be no unspent gross proceeds after the issue date, other than gross 
proceeds in a bona fide debt service fund (e.g., equipment lease 
financings in which the issuer purchases equipment in exchange for an 
installment payment note); or
    (B) The issue price of the issue does not exceed $1,000,000.

[T.D. 8538, 59 FR 24042, May 10, 1994. Redesignated by T.D. 8718, 62 FR 
25507, May 9, 1997]



Sec. 1.148-3A  General arbitrage rebate rules.

    (a) through (h)(2) [Reserved]. For guidance see Sec. 1.148-3.
    (h)(3) Waivers of the penalty. For purposes of Sec. 1.148-3(h)(3), 
willful neglect does not include a failure that is attributable solely 
to the permissible retroactive selection of a short first bond year if 
the rebate amount that the issuer failed to pay is paid within 60 days 
of the selection of that bond year.

[T.D. 8538, 59 FR 24042, May 10, 1994. Redesignated by T.D. 8718, 62 FR 
25507, May 9, 1997]



Sec. 1.148-4A  Yield on an issue of bonds.

    (a) through (b)(4) [Reserved]. For guidance see Sec. 1.148-4.
    (b)(5) Special aggregation rule treating certain bonds as a single 
fixed yield bond. Two variable yield bonds of an issue are treated in 
the aggregate as a single fixed yield bond if--
    (i) Aggregate treatment would result in the single bond being a 
fixed yield bond; and
    (ii) The terms of the bonds do not contain any features that could 
distort the aggregate fixed yield from what the yield would be if a 
single fixed yield bond were issued. For example, if an issue contains a 
bond bearing interest at a floating rate and a related bond bearing 
interest at a rate equal to a fixed rate minus that floating rate, those 
two bonds are treated as a single fixed yield bond only if neither bond 
may be redeemed unless the other bond is also redeemed at the same time.
    (c) through (f) [Reserved]. For guidance see Sec. 1.148-4.
    (g) Yield on certain mortgage revenue and student loan bonds. For 
purposes of section 148 and Sec. 1.148-4, section 143(g)(2)(C)(ii) 
applies to the computation of yield on an issue of qualified mortgage 
bonds or qualified veterans' mortgage bonds. For purposes of applying 
sections 148 and 143(g) to a variable yield issue of qualified mortgage 
bonds, qualified veterans' mortgage bonds, or qualified student loan 
bonds, the yield on that issue is computed over the term of the issue, 
and Sec. 1.148-4(d) does not apply to the issue. As of any date before 
the final maturity date, the yield over the term of the issue is based 
on the actual amounts paid or received to that date and the amounts that 
are reasonably expected (as of that date) to be paid or received over 
the remaining term of the issue.
    (h) Qualified hedging transactions--(1) In general. Payments made or 
received by an issuer under a qualified hedge (as defined in Sec. 1.148-
4(h)(2)) relating to bonds of an issue are taken into account (as 
provided in paragraph (h)(3) of this section) to determine the yield on 
the issue. Except as provided in paragraphs (h)(4) and (h)(5)(ii)(C) of 
this section, the bonds to which a qualified hedge relates are treated 
as variable yield bonds. These hedging rules apply solely for purposes 
of sections 143(g), 148, and 149(d).
    (2) (i) through (vi) [Reserved]. For guidance see Sec. 1.148-
4(h)(2).
    (2)(vii) Timing and duration. For a contract to be a qualified hedge 
under Sec. 1.148-4(h)(2), payments must not begin to accrue under the 
contract on a date earlier than the issue date of the hedged bonds and 
must not accrue longer than the hedged interest payments on the hedged 
bonds.
    (viii) [Reserved]. For guidance see Sec. 1.148-4(h).
    (ix) Identification. For a contract to be a qualified hedge under 
Sec. 1.148-4(h)(2), the contract must be identified by the actual issuer 
on its books and records maintained for the hedged bonds not later than 
three days after

[[Page 164]]

the date on which the parties enter into the contract. The 
identification must specify the hedge provider, the terms of the 
contract, and the hedged bonds. The identification must contain 
sufficient detail to establish that the requirements of Sec. 1.148-
4(h)(2), and if applicable, paragraph (h)(4) of this section are 
satisfied. The existence of the hedge must be noted on all forms filed 
with the Internal Revenue Service for the issue on or after the date on 
which the hedge is entered into.
    (3) Accounting for qualified hedges--(i) In general. Except as 
otherwise provided in paragraph (h)(4) of this section, payments made or 
received by the issuer under a qualified hedge are treated as payments 
made or received, as appropriate, on the hedged bonds that are taken 
into account in determining the yield on those bonds. These payments are 
reasonably allocated to the hedged bonds in the period to which the 
payments relate, as determined under paragraph (h)(3)(iii) of this 
section. Payments made or received by the issuer include payments deemed 
made or received when a contract is terminated or deemed terminated 
under this paragraph (h)(3). Payments reasonably allocable to the 
reduction of risk of interest rate changes and to the hedge provider's 
overhead under this paragraph (h) are included as payments made or 
received under a qualified hedge.
    (ii) Exclusions from hedge. Payments for services or other items 
under the contract that are not expressly treated as payments under the 
qualified hedge under paragraph (h)(3)(i) of this section are not 
payments with respect to a qualified hedge.
    (iii) Timing and allocation of payments. The period to which a 
payment made by the issuer relates is determined under general Federal 
income tax principles, including, without limitation, Sec. 1.446-3, and 
adjusted as necessary to reflect the end of a computation period and the 
start of a new computation period. Except as provided in paragraphs 
(h)(3)(iv) and (h)(5)(ii) of this section, a payment received by the 
issuer is taken into account in the period that the interest payment 
that the payment hedges is required to be made.
    (iv) Termination payments--(A) Termination defined. A termination of 
a qualified hedge includes any sale or other disposition of the hedge by 
the issuer, or the acquisition by the issuer of an offsetting hedge. A 
deemed termination occurs when the hedged bonds are redeemed and when a 
hedge ceases to be a qualified hedge of the hedged bonds. In the case of 
an assignment by a hedge provider of its remaining rights and 
obligations on the hedge to a third party or a modification of the 
hedging contract, the assignment or modification is treated as a 
termination with respect to the issuer only if it results in a deemed 
exchange of the hedge and a realization event under section 1001.
    (B) General rule. A payment made or received by an issuer to 
terminate a qualified hedge, including loss or gain realized or deemed 
realized, is treated as a payment made or received on the hedged bonds, 
as appropriate. The payment is reasonably allocated to the remaining 
periods originally covered by the terminated hedge in a manner that 
reflects the economic substance of the hedge.
    (C) Special rule for terminations when bonds are redeemed. Except as 
otherwise provided in this paragraph (h)(3)(iv)(C) and in paragraph 
(h)(3)(iv)(D) of this section, when a qualified hedge is deemed 
terminated because the hedged bonds are redeemed, the fair market value 
of the contract on the redemption date is treated as a termination 
payment made or received on that date. When hedged bonds are redeemed, 
any payment received by the issuer on termination of a hedge, including 
a termination payment or a deemed termination payment, reduces, but not 
below zero, the interest payments made by the issuer on the hedged bonds 
in the computation period ending on the termination date. The remainder 
of the payment, if any, is reasonably allocated over the bond years in 
the immediately preceding computation period or periods to the extent 
necessary to eliminate the excess.
    (D) Special rules for refundings. To the extent that the hedged 
bonds are redeemed using the proceeds of a refunding issue, the 
termination payment is accounted for under paragraph

[[Page 165]]

(h)(3)(iv)(B) of this section by treating it as a payment on the 
refunding issue, rather than the hedged bonds. In addition, to the 
extent that the refunding issue, rather than the hedged bonds, has been 
redeemed, paragraph (h)(3)(iv)(C) of this section applies to the 
termination payment by treating it as a payment on the redeemed 
refunding issue.
    (E) Safe harbor for certain non-level payments. A non-level payment 
to terminate a hedge does not result in that hedge failing to satisfy 
the applicable provisions of paragraph (h)(3)(iv)(B) of this section if 
the payment is allocated to each bond year for which the hedge would 
have been in effect in accordance with this paragraph (h)(3)(iv)(E). For 
a variable yield issue, an equal amount (or for any short bond year, a 
proportionate amount of the equal amount) must be allocated to each bond 
year such that the sum of the present values of the annual amounts 
equals the present value of the non-level payment. Present value is 
computed as of the day the hedge is terminated, using the yield on the 
hedged bonds, determined without regard to the non-level payment. The 
yield used for this purpose is computed for the period beginning on the 
first date the hedge is in effect and ending on the date the hedge is 
terminated. On the other hand, for a fixed yield issue, the non-level 
payment is taken into account as a single payment on the date it is 
paid.
    (4) Certain variable yield bonds treated as fixed yield bonds--(i) 
In general. Except as otherwise provided in this paragraph (h)(4), if 
the issuer of variable yield bonds enters into a qualified hedge, the 
hedged bonds are treated as fixed yield bonds paying a fixed interest 
rate if:
    (A) Start date. The date on which payments begin to accrue on the 
hedge is not later than 15 days after the issue date of the hedged 
bonds.
    (B) Maturity. The term of the hedge is equal to the entire period 
during which the hedged bonds bear interest at variable interest rates.
    (C) Payments closely correspond. Payments to be received under the 
hedge correspond closely in time to the hedged portion of the payments 
on the hedged bonds. Hedge payments received within 15 days of the 
related payments on the hedged bonds generally so correspond.
    (D) Aggregate payments fixed. Taking into account all payments made 
and received under the hedge and all payments on the hedged bonds (i.e., 
after netting all payments), the issuer's aggregate payments are fixed 
and determinable as of a date not later than 15 days after the issue 
date of the hedged bonds. Payments on bonds are treated as fixed for 
purposes of this paragraph (h)(4)(i)(D) if payments on the bonds are 
based, in whole or in part, on one interest rate, payments on the hedge 
are based, in whole or in part, on a second interest rate that is 
substantially the same as, but not identical to, the first interest rate 
and payments on the bonds would be fixed if the two rates were 
identical. Rates are treated as substantially the same if they are 
reasonably expected to be substantially the same throughout the term of 
the hedge. For example, an objective 30-day tax-exempt variable rate 
index or other objective index (e.g., J.J. Kenny Index, PSA Municipal 
swap index, a percentage of LIBOR) may be substantially the same as an 
issuer's individual 30-day interest rate.
    (ii) Accounting. Except as otherwise provided in this paragraph 
(h)(4)(ii), in determining yield on the hedged bonds, all the issuer's 
actual interest payments on the hedged bonds and all payments made and 
received on a hedge described in paragraph (h)(4)(i) of this section are 
taken into account. If payments on the bonds and payments on the hedge 
are based, in whole or in part, on variable interest rates that are 
substantially the same within the meaning of paragraph (h)(4)(i)(D) of 
this section (but not identical), yield on the issue is determined by 
treating the variable interest rates as identical. For example, if 
variable rate bonds bearing interest at a weekly rate equal to the rate 
necessary to remarket the bonds at par are hedged with an interest rate 
swap under which the issuer receives payments based on a short-term 
floating rate index that is substantially the same as, but not identical 
to, the weekly rate on the bonds, the interest payments on the bonds are

[[Page 166]]

treated as equal to the payments received by the issuer under the swap 
for purposes of computing the yield on the bonds.
    (iii) Effect of termination--(A) In general. Except as otherwise 
provided in this paragraph (h)(4)(iii) and paragraph (h)(5) of this 
section, the issue of which the hedged bonds are a part is treated as if 
it were reissued as of the termination date of the qualified hedge 
covered by paragraph (h)(4)(i) of this section in determining yield on 
the hedged bonds for purposes of Sec. 1.148-3. The redemption price of 
the retired issue and the issue price of the new issue equal the 
aggregate values of all the bonds of the issue on the termination date. 
In computing the yield on the new issue for this purpose, any 
termination payment is accounted for under paragraph (h)(3)(iv) of this 
section, applied by treating the termination payment as made or received 
on the new issue under this paragraph (h)(4)(iii).
    (B) Effect of early termination. Except as otherwise provided in 
this paragraph (h)(4)(iii), the general rules of paragraph (h)(4)(i) of 
this section do not apply in determining the yield on the hedged bonds 
for purposes of Sec. 1.148-3 if the hedge is terminated or deemed 
terminated within 5 years after the issue date of the issue of which the 
hedged bonds are a part. Thus, the hedged bonds are treated as variable 
yield bonds for purposes of Sec. 1.148-3 from the issue date.
    (C) Certain terminations disregarded. This paragraph (h)(4)(iii) 
does not apply to a termination if, based on the facts and circumstances 
(e.g., taking into account both the termination and any qualified hedge 
that immediately replaces the terminated hedge), there is no change in 
the yield. In addition, this paragraph (h)(4)(iii) does not apply to a 
termination caused by the bankruptcy or insolvency of the hedge provider 
if the Commissioner determines that the termination occurred without any 
action by the issuer (other than to protect its rights under the hedge).
    (5) Special rules for certain hedges--(i) Certain acquisition 
payments. A payment to the issuer by the hedge provider (e.g., an up-
front payment for an off-market swap) in connection with the acquisition 
of a hedge that, but for that payment, would be a qualified hedge, does 
not cause the hedge to fail to be a qualified hedge provided the payment 
to the issuer and the issuer's payments under the hedge in excess of 
those that it would make if the hedge bore rates equal to the on-market 
rates for the hedge are separately identified in a certification of the 
hedge provider and not taken into account in determining the yield on 
the issue of which the hedged bonds are a part. The on-market rates are 
determined as of the date the parties enter into the contract.
    (ii) Anticipatory hedges--(A) In general. A contract does not fail 
to be a hedge under Sec. 1.148-4(h)(2)(i)(A) solely because it is 
entered into with respect to an anticipated issuance of tax-exempt 
bonds. The identification required under Sec. 1.148-4T(h)(2)(ix) must 
specify the reasonably expected governmental purpose, principal amount, 
and issue date of the hedged bonds, and the manner in which interest is 
reasonably expected to be computed.
    (B) Special rules. Payments made in connection with the issuance of 
a bond to terminate or otherwise close (terminate) an anticipatory hedge 
of that bond do not prevent the hedge from satisfying the requirements 
of Sec. 1.148-4(h)(2)(vi) and paragraph (h)(2)(vii) of this section. 
Amounts received or deemed to be received by the issuer in connection 
with the issuance of the hedged bonds to terminate an anticipatory hedge 
are treated as proceeds of the hedged bonds.
    (C) Fixed yield treatment. A bond that is hedged with an 
anticipatory hedge is a fixed yield bond if, taking into account 
payments on the hedge that are made or fixed on or before the issue date 
of the bond and the payments to be made on the bond, the bond satisfies 
the definition of fixed yield bond. See also paragraph (h)(4) of this 
section.
    (6) Authority of the Commissioner--(i) In general. A contract is not 
a qualified hedge if the Commissioner determines, based on all the facts 
and circumstances, that treating the contract as a qualified hedge would 
provide a material potential for arbitrage, or a principal purpose for 
entering into the contract is that arbitrage potential. For example, a 
contract that requires a

[[Page 167]]

substantial nonperiodic payment may constitute, in whole or part, an 
embedded loan, investment-type property, or other investment.
    (ii) Other qualified hedges. The Commissioner, by publication of a 
revenue ruling or revenue procedure, may specify contracts that do not 
otherwise meet the requirements of Sec. 1.148-4(h)(2) as qualified 
hedges and contracts that do not otherwise meet the requirements of 
paragraph (h)(4) of this section as causing the hedged bonds to be 
treated as fixed yield bonds.
    (iii) Recomputation of yield. If an issuer enters into a hedge that 
is not properly identified, fails to properly associate an anticipatory 
hedge with the hedged bonds, or otherwise fails to meet the requirements 
of this section, the Commissioner may recompute the yield on the issue 
taking the hedge into account if the failure to take the hedge into 
account distorts that yield or otherwise fails to clearly reflect the 
economic substance of the transaction.

[T.D. 8538, 59 FR 24042, May 10, 1994. Redesignated by T.D. 8718, 62 FR 
25507, May 9, 1997]



Sec. 1.148-5A  Yield and valuation of investments.

    (a) through (b)(2)(ii) [Reserved]. For guidance see Sec. 1.148-5.
    (b)(2)(iii) Permissive application of single investment rules to 
certain yield restricted investments for all purposes of section 148. 
For all purposes of section 148, an issuer may treat all of the yield 
restricted nonpurpose investments in a refunding escrow and a sinking 
fund that is reasonably expected as of the issue date to be maintained 
to reduce the yield on the investments in the refunding escrow as a 
single investment having a single yield, determined under 
Sec. 1.148(b)(2).
    (b) (2)(iv) through (c)(1) [Reserved]. For guidance see Sec. 1.148-
5.
    (c)(2) Manner of payment--(i) In general. Except as otherwise 
provided in Sec. 1.148-5(c)(2)(ii), an amount is paid under Sec. 1.148-
5(c) if it is paid to the United States at the same time and in the same 
manner as rebate amounts are required to be paid or at such other time 
or in such manner as the Commissioner may prescribe. For example, yield 
reduction payments must be made on or before the date of required rebate 
installment payments as described in Sec. 1.148-3(f). The date a payment 
is required to be paid is determined without regard to Sec. 1.148-3(h). 
An amount that is paid untimely is not taken into account under this 
paragraph (c) unless the Commissioner determines that the failure to pay 
timely is not due to willful neglect. The provisions of Sec. 1.148-3(i) 
apply to payments made under Sec. 1.148-5(c).
    (c)(2)(ii) through (c)(3)(i) [Reserved]. For guidance see 
Sec. 1.148-5.
    (c)(3)(ii) Exception to yield reduction payments rule for advance 
refunding issues. Section 1.148-5(c)(1) does not apply to investments 
allocable to gross proceeds of an advance refunding issue, other than--
    (A) Transferred proceeds to which Sec. 1.148-5(c)(3)(i)(C) applies;
    (B) Replacement proceeds to which Sec. 1.148-5(c)(3)(i)(F) applies; 
and
    (C) Transferred proceeds to which Sec. 1.148-5(c)(3)(i)(E) applies, 
but only to the extent necessary to satisfy yield restriction under 
section 148(a) on those proceeds treating all investments allocable to 
those proceeds as a separate class.
    (d)(1) through (d)(3)(i) [Reserved]. For guidance see Sec. 1.148-5.
    (d)(3)(ii) Exception to fair market value requirement for 
transferred proceeds allocations, universal cap allocations, and 
commingled funds. Section 1.148-5(d)(3)(i) does not apply if the 
investment is allocated from one issue to another issue as a result of 
the transferred proceeds allocation rule under Sec. 1.148-9(b) or the 
universal cap rule under Sec. 1.148-6(b)(2), provided that both issues 
consist exclusively of tax-exempt bonds. In addition, Sec. 1.148-
5(d)(3)(i) does not apply to investments in a commingled fund (other 
than a bona fide debt service fund) unless it is an investment being 
initially deposited in or withdrawn from a commingled fund described in 
Sec. 1.148-6(e)(5)(iii).
    (e)(1) through (e)(2)(ii)(A) [Reserved]. For guidance see 
Sec. 1.148-5.
    (e)(2)(ii)(B) External commingled funds. For any semiannual period, 
a commingled fund satisfies the 10 percent requirement of Sec. 1.148-
5(e)(2)(ii)(B) if--
    (1) Based on average amounts on deposit, this requirement was 
satisfied for the prior semiannual period; and

[[Page 168]]

    (2) The fund does not accept deposits that would cause it to fail to 
meet this requirement.
    (iii) Special rule for guaranteed investment contracts. For a 
guaranteed investment contract, a broker's commission or similar fee 
paid on behalf of either an issuer or the provider is treated as an 
administrative cost and, except in the case of an issue that satisfies 
section 148(f)(4)(D)(i), is not a qualified administrative cost to the 
extent that the present value of the commission, as of the date the 
contract is allocated to the issue, exceeds the present value of annual 
payments equal to .05 percent of the weighted average amount reasonably 
expected to be invested each year of the term of the contract. For this 
purpose, present value is computed using the taxable discount rate used 
by the parties to compute the commission or, if not readily 
ascertainable, a reasonable taxable discount rate.

[T.D. 8538, 59 FR 24045, May 10, 1994. Redesignated by T.D. 8718, 62 FR 
25507, May 9, 1997]



Sec. 1.148-6A  General allocation and accounting rules.

    (a) through (d)(3)(iii)(B) [Reserved]. For guidance see Sec. 1.148-
6.
    (d)(3)(iii)(C) Qualified endowment funds treated as unavailable. For 
a 501(c)(3) organization, a qualified endowment fund is treated as 
unavailable. A fund is a qualified endowment fund if--
    (1) The fund is derived from gifts or bequests, or the income 
thereon, that were neither made nor reasonably expected to be used to 
pay working capital expenditures;
    (2) Pursuant to reasonable, established practices of the 
organization, the governing body of the 501(c)(3) organization 
designates and consistently operates the fund as a permanent endowment 
fund or quasi-endowment fund restricted as to use; and
    (3) There is an independent verification (e.g., from an independent 
certified public accountant) that the fund is reasonably necessary as 
part of the organization's permanent capital.

[T.D. 8538, 59 FR 24045, May 10, 1994. Redesignated by T.D. 8718, 62 FR 
25507, May 9, 1997]



Sec. 1.148-9A  Arbitrage rules for refunding issues.

    (a) through (c)(2)(ii)(A) [Reserved]. For guidance see Sec. 1.148-9.
    (c)(2)(ii)(B) Permissive allocation of non-proceeds to earliest 
expenditures. Excluding amounts covered by Sec. 1.148-9(c)(2)(ii)(A) and 
subject to any required earlier expenditure of those amounts, any 
amounts in a mixed escrow that are not proceeds of a refunding issue may 
be allocated to the earliest maturing investments in the mixed escrow, 
provided that those investments mature and the proceeds thereof are 
expended before the date of any expenditure from the mixed escrow to pay 
any principal of the prior issue.
    (d) through (h)(4)(v) [Reserved]. For guidance see Sec. 1.148-9.
    (h)(4)(vi) Exception for refundings of interim notes. Section 1.148-
9(h)(4)(v) need not be applied to refunding bonds issued to provide 
permanent financing for one or more projects if the prior issue had a 
term of less than 3 years and was sold in anticipation of permanent 
financing, but only if the aggregate term of all prior issues sold in 
anticipation of permanent financing was less than 3 years.

[T.D. 8538, 59 FR 24045, May 10, 1994. Redesignated by T.D. 8718, 62 FR 
25507, May 9, 1997]



Sec. 1.148-10A  Anti-abuse rules and authority of Commissioner.

    (a) through (b)(1) [Reserved]. For guidance see Sec. 1.148-10.
    (b)(2) Application. The provisions of Sec. 1.148-10(b) only apply to 
the portion of an issue that, as a result of actions taken (or actions 
not taken) after the issue date, overburdens the market for tax-exempt 
bonds, except that for an issue that is reasonably expected as of the 
issue date to overburden the market, those provisions apply to all of 
the gross proceeds of the issue.
    (c) through (c)(2)(viii) [Reserved]. For guidance see Sec. 1.148-10.
    (c)(2)(ix) For purposes of Sec. 1.148-10(c)(2), excess gross 
proceeds do not include gross proceeds allocable to fees for a qualified 
hedge for the refunding issue.

[T.D. 8538, 59 FR 24046, May 10, 1994. Redesignated by T.D. 8718, 62 FR 
25507, May 9, 1997]

[[Page 169]]



Sec. 1.148-11A  Effective dates.

    (a) through (c)(3) [Reserved]. For guidance see Sec. 1.148-11.
    (c)(4) Retroactive application of overpayment recovery provisions. 
An issuer may apply the provisions of Sec. 1.148-3(i) to any issue that 
is subject to section 148(f) or to sections 103(c)(6) or 103A(i) of the 
Internal Revenue Code of 1954.
    (d) through (h) [Reserved]. For guidance see Sec. 1.148-11.
    (i) Transition rules for certain amendments--(1) In general. Section 
1.103-8(a)(5), Secs. 1.148-1, 1.148-2, 1.148-3, 1.148-4, .148-5, 1.148-
6, 1.148-7, 1.148-8, 1.148-9, 1.148-10, 1.148-11, 1.149(d)-1, and 1.150-
1 as in effect on June 7, 1994 (see 26 CFR part 1 as revised April 1, 
1997), and Secs. 1.148-1A through 1.148-11A, 1.149(d)-1A, and 1.150-1A 
apply, in whole, but not in part--
    (i) To bonds sold after June 6, 1994, and before July 8, 1997;
    (ii) To bonds issued before July 1, 1993, that are outstanding on 
June 7, 1994, if the first time the issuer applies Secs. 1.148-1 through 
1.148-11 as in effect on June 7, 1994 (see 26 CFR part 1 as revised 
April 1, 1997), to the bonds under Sec. 1.148-11 (b) or (c) is after 
June 6, 1994, and before July 8, 1997;
    (iii) At the option of the issuer, to bonds to which Secs. 1.148-1 
through 1.148-11, as in effect on July 1, 1993 (see 26 CFR part 1 as 
revised April 1, 1994), apply, if the bonds are outstanding on June 7, 
1994, and the issuer applies Sec. 1.103-8(a)(5), Secs. 1.148-1, 1.148-2, 
1.148-3, 1.148-4, 1.148-5, 1.148-6, 1.148-7, 1.148-8, 1.148-9, 1.148-10, 
1.148-11, 1.149(d)-1, and 1.150-1 as in effect on June 7, 1994 (see 26 
CFR part 1 as revised April 1, 1997), and Secs. 1.148-1A through 1.148-
11A, 1.149(d)-1A, and 1.150-1A to the bonds before July 8, 1997.
    (2) Special rule. For purposes of paragraph (i)(1) of this section, 
any reference to a particular paragraph of Secs. 1.148-1T, 1.148-2T, 
1.148-3T, 1.148-4T, 1.148-5T, 1.148-6T, 1.148-9T, 1.148-10T, 1.148-11T, 
1.149(d)-1T, or 1.150-1T shall be applied as a reference to the 
corresponding paragraph of Secs. 1.148-1A, 1.148-2A, 1.148-3A, 1.148-4A, 
1.148-5A, 1.148-6A, 1.148-9A, 1.148-10A, 1.148-11A, 1.149(d)-1A, or 
1.150-1A, respectively.
    (3) Identification of certain hedges. For any hedge entered into 
after June 18, 1993, and on or before June 6, 1994, that would be a 
qualified hedge within the meaning of Sec. 1.148-4(h)(2), as in effect 
on June 7, 1994 (see 26 CFR part 1 as revised April 1, 1997), except 
that the hedge does not meet the requirements of Sec. 1.148-4A(h)(2)(ix) 
because the issuer failed to identify the hedge not later than 3 days 
after which the issuer and the provider entered into the contract, the 
requirements of Sec. 1.148-4A(h)(2)(ix) are treated as met if the 
contract is identified by the actual issuer on its books and records 
maintained for the hedged bonds not later than July 8, 1997.

[T.D. 8538, 59 FR 24046, May 10, 1994. Redesignated and amended by T.D. 
8718, 62 FR 25507, 25513, May 9, 1997]



Sec. 1.149(d)-1A  Limitations on advance refundings.

    (a) through (f)(2) [Reserved]. For guidance see Sec. 1.149(d)-1.
    (f)(3) Application of savings test to multipurpose issues. Except as 
otherwise provided in this paragraph (f)(3), the multipurpose issue 
rules in Sec. 1.148-9(h) apply for purposes of the savings test. If any 
separate issue in a multipurpose issue increases the aggregate present 
value debt service savings on the entire multipurpose issue or reduces 
the present value debt service losses on that entire multipurpose issue, 
that separate issue satisfies the savings test.

[T.D. 8538, 59 FR 24046, May 10, 1994. Redesignated by T.D. 8718, 62 FR 
25513, May 9, 1997]



Sec. 1.150-1A  Definitions.

    (a) through (b) [Reserved]. For guidance see Sec. 1.150-1.
    (c) Definition of issue--(1) In general. Except as otherwise 
provided, the provisions of this paragraph (c) apply for all purposes of 
sections 103 and 141 through 150. Except as otherwise provided in this 
paragraph (c), two or more bonds are treated as part of the same issue 
if all of the following factors are present:
    (i) Sold at substantially the same time. The bonds are sold at 
substantially the same time. Bonds are treated as sold at substantially 
the same time if they are sold less than 15 days apart. For this purpose 
only, a variable yield bond is treated as sold on its issue date.

[[Page 170]]

    (ii) Sold pursuant to the same plan of financing. The bonds are sold 
pursuant to the same plan of financing. Factors material to the plan of 
financing include the purposes for the bonds and the structure of the 
financing. For example, generally--
    (A) Bonds to finance a single facility or related facilities are 
part of the same plan of financing;
    (B) Short-term bonds to finance working capital expenditures and 
long-term bonds to finance capital projects are not part of the same 
plan of financing; and
    (C) Certificates of participation in a lease and general obligation 
bonds secured by tax revenues are not part of the same plan of 
financing.
    (iii) Payable from same source of funds. The bonds are reasonably 
expected to be paid from substantially the same source of funds, 
determined without regard to guarantees from parties unrelated to the 
obligor.
    (2) through (4)(ii) [Reserved]. For guidance see Sec. 1.150-1 (c)(3) 
through (c)(4)(ii).
    (c)(4)(iii) Certain general obligation bonds. Bonds are part of the 
same issue if secured by a pledge of the issuer's full faith and credit 
(or a substantially similar pledge) and sold and issued on the same 
dates pursuant to a single offering document.
    (5) [Reserved]. For guidance see Sec. 1.150-1(c)(5).
    (6) Sale date. The sale date of a bond is the first day on which 
there is a binding contract in writing for the sale or exchange of the 
bond.

[T.D. 8538, 59 FR 24046, May 10, 1994. Redesignated by T.D. 8718, 62 FR 
25513, May 9, 1997]

                   Deductions for Personal Exemptions



Sec. 1.151-1  Deductions for personal exemptions.

    (a) In general. (1) In computing taxable income, an individual is 
allowed a deduction for the exemptions specified in section 151. Such 
exemptions are: (i) The exemptions for an individual taxpayer and spouse 
(the so-called personal exemptions); (ii) the additional exemptions for 
a taxpayer attaining the age of 65 years and spouse attaining the age of 
65 years (the so-called old-age exemptions); (iii) the additional 
exemptions for a blind taxpayer and a blind spouse; and (iv) the 
exemptions for dependents of the taxpayer.
    (2) A nonresident alien individual who is a bona fide resident of 
Puerto Rico during the entire taxable year and subject to tax under 
section 1 or 1201(b) is allowed as deductions the exemptions specified 
in section 151, even though as to the United States such individual is a 
nonresident alien. See section 876 and the regulations thereunder, 
relating to alien residents of Puerto Rico.
    (b) Exemptions for individual taxpayer and spouse (so-called 
personal exemptions). Section 151(b) allows an exemption for the 
taxpayer and an additional exemption for the spouse of the taxpayer if a 
joint return is not made by the taxpayer and his spouse, and if the 
spouse, for the calendar year in which the taxable year of the taxpayer 
begins, has no gross income and is not the dependent of another 
taxpayer. Thus, a husband is not entitled to an exemption for his wife 
on his separate return for the taxable year beginning in a calendar year 
during which she has any gross income (though insufficient to require 
her to file a return). Since, in the case of a joint return, there are 
two taxpayers (although under section 6013 there is only one income for 
the two taxpayers on such return, i.e., their aggregate income), two 
exemptions are allowed on such return, one for each taxpayer spouse. If 
in any case a joint return is made by the taxpayer and his spouse, no 
other person is allowed an exemption for such spouse even though such 
other person would have been entitled to claim an exemption for such 
spouse as a dependent if such joint return had not been made.
    (c) Exemptions for taxpayer attaining the age of 65 and spouse 
attaining the age of 65 (so-called old-age exemptions). (1) Section 
151(c) provides an additional exemption for the taxpayer if he has 
attained the age of 65 before the close of his taxable year. An 
additional exemption is also allowed to the taxpayer for his spouse if a 
joint return is not made by the taxpayer and his spouse and if the 
spouse has attained the age of 65 before the close of the taxable year 
of the taxpayer and, for the calendar year in which the taxable year of

[[Page 171]]

the taxpayer begins, the spouse has no gross income and is not the 
dependent of another taxpayer. If a husband and wife make a joint 
return, an old-age exemption will be allowed as to each taxpayer spouse 
who has attained the age of 65 before the close of the taxable year for 
which the joint return is made. The exemptions under section 151(c) are 
in addition to the exemptions for the taxpayer and spouse under section 
151(b).
    (2) In determining the age of an individual for the purposes of the 
exemption for old age, the last day of the taxable year of the taxpayer 
is the controlling date. Thus, in the event of a separate return by a 
husband, no additional exemption for old age may be claimed for his 
spouse unless such spouse has attained the age of 65 on or before the 
close of the taxable year of the husband. In no event shall the 
additional exemption for old age be allowed with respect to a spouse who 
dies before attaining the age of 65 even though such spouse would have 
attained the age of 65 before the close of the taxable year of the 
taxpayer. For the purposes of the old-age exemption, an individual 
attains the age of 65 on the first moment of the day preceding his 
sixty-fifth birthday. Accordingly, an individual whose sixty-fifth 
birthday falls on January 1 in a given year attains the age of 65 on the 
last day of the calendar year immediately preceding.
    (d) Exemptions for the blind. (1) Section 151(d) provides an 
additional exemption for the taxpayer if he is blind at the close of his 
taxable year. An additional exemption is also allowed to the taxpayer 
for his spouse if the spouse is blind and, for the calendar year in 
which the taxable year of the taxpayer begins, has no gross income and 
is not the dependent of another taxpayer. The determination of whether 
the spouse is blind shall be made as of the close of the taxable year of 
the taxpayer, unless the spouse dies during such taxable year, in which 
case such determination shall be made as of the time of such death.
    (2) The exemptions for the blind are in addition to the exemptions 
for the taxpayer and spouse under section 151(b) and are also in 
addition to the exemptions under section 151(c) for taxpayers and 
spouses attaining the age of 65 years. Thus, a single individual who has 
attained the age of 65 before the close of his taxable year and who is 
blind at the close of his taxable year is entitled, in addition to the 
so-called personal exemption, to two further exemptions, one by reason 
of his age and the other by reason of his blindness. If a husband and 
wife make a joint return, an exemption for the blind will be allowed as 
to each taxpayer spouse who is blind at the close of the taxable year 
for which the joint return is made.
    (3) A taxpayer claiming an exemption allowed by section 151(d) for a 
blind taxpayer and a blind spouse shall, if the individual for whom the 
exemption is claimed is not totally blind as of the last day of the 
taxable year of the taxpayer (or, in the case of a spouse who dies 
during such taxable year, as of the time of such death), attach to his 
return a certificate from a physician skilled in the diseases of the eye 
or a registered optometrist stating that as of the applicable status 
determination date in the opinion of such physician or optometrist (i) 
the central visual acuity of the individual for whom the exemption is 
claimed did not exceed 20/200 in the better eye with correcting lenses 
or (ii) such individual's visual acuity was accompanied by a limitation 
in the fields of vision such that the widest diameter of the visual 
field subtends an angle no greater than 20 degrees. If such individual 
is totally blind as of the status determination date there shall be 
attached to the return a statement by the person or persons making the 
return setting forth such fact.
    (4) Notwithstanding subparagraph (3) of this paragraph, this 
subparagraph may be applied where the individual for whom an exemption 
under section 151(d) is claimed is not totally blind, and in the 
certified opinion of an examining physician skilled in the diseases of 
the eye there is no reasonable probability that the individual's visual 
acuity will ever improve beyond the minimum standards described in 
subparagraph (3) of this paragraph. In this event, if the examination 
occurs during a taxable year for which the exemption

[[Page 172]]

is claimed, and the examining physician certifies that, in his opinion, 
the condition is irreversible, and a copy of this certification is filed 
with the return for that taxable year, then a statement described in 
subparagraph (3) of this paragraph need not be attached to such 
individual's return for subsequent taxable years so long as the 
condition remains irreversible. The taxpayer shall retain a copy of the 
certified opinion in his records, and a statement referring to such 
opinion shall be attached to future returns claiming the section 151(d) 
exemption.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7114, 36 FR 
9018, May 18, 1971; T.D. 7230, 37 FR 28288, Dec. 22, 1972]



Sec. 1.151-2  Additional exemptions for dependents.

    (a) Section 151(e) allows to a taxpayer an exemption for each 
dependent (as defined in section 152) whose gross income (as defined in 
section 61) for the calendar year in which the taxable year of the 
taxpayer begins is less than the amount provided in section 151(e)(1)(A) 
applicable to the taxable year of the taxpayer, or who is a child of the 
taxpayer and who--
    (1) The taxable year of the taxpayer begins, or
    (2) Is a student, as defined in paragraph (b) of Sec. 1.151-3.

No exemption shall be allowed under section 151(e) for any dependent who 
has made a joint return with his spouse under section 6013 for the 
taxable year beginning in the calendar year in which the taxable year of 
the taxpayer begins. The amount provided in section 151(e)(1)(A) is $750 
in the case of a taxable year beginning after December 31, 1972; $700 in 
the case of a taxable year beginning after December 31, 1971, and before 
January 1, 1973; $650 in the case of a taxable year beginning after 
December 31, 1970, and before January 1, 1972; $625 in the case of a 
taxable year beginning after December 31, 1969, and before January 1, 
1971; and $600 in the case of a taxable year beginning before January 1, 
1970. For special rules in the case of a taxpayer whose taxable year is 
a fiscal year ending after December 31, 1969, and beginning before 
January 1, 1973, see section 21(d) and the regulations thereunder.
    (b) The only exemption allowed for a dependent of the taxpayer is 
that provided by section 151(e). The exemptions provided by section 
151(c) (old-age exemptions) and section 151(d) (exemptions for the 
blind) are allowed only for the taxpayer or his spouse. For example, 
where a taxpayer provides the entire support for his father who meets 
all the requirements of a dependent, he is entitled to only one 
exemption for his father (section 151(e)), even though his father is 
over the age of 65.

[T.D. 7114, 36 FR 9019, May 18, 1971]



Sec. 1.151-3  Definitions.

    (a) Child. For purposes of sections 151(e), 152, and the regulations 
thereunder, the term ``child'' means a son, stepson, daughter, 
stepdaughter, adopted son, adopted daughter, or for taxable years 
beginning after December 31, 1958, a child who is a member of an 
individual's household if the child was placed with the individual by an 
authorized placement agency for legal adoption pursuant to a formal 
application filed by the individual with the agency (see paragraph 
(c)(2) of Sec. 1.152-2), or, for taxable years beginning after December 
31, 1969, a foster child (if such foster child satisfies the 
requirements set forth in paragraph (b) of Sec. 1.152-1 with respect to 
the taxpayer) of the taxpayer.
    (b) Student. For purposes of section 151(e) and section 152(d), and 
the regulations thereunder, the term ``student'' means an individual who 
during each of 5 calendar months during the calendar year in which the 
taxable year of the taxpayer begins is a full-time student at an 
educational institution or is pursuing a full-time course of 
institutional on-farm training under the supervision of an accredited 
agent of an educational institution or of a State or political 
subdivision of a State. An example of ``institutional on-farm training'' 
is that authorized by 38 U.S.C. 1652 (formerly section 252 of the 
Veterans' Readjustment Assistance Act of 1952), as described in section 
252 of such act. A full-time student is one who is enrolled for some 
part of 5 calendar months for the number of hours or courses which is 
considered to be full-time attendance. The 5 calendar months need not be 
consecutive.

[[Page 173]]

School attendance exclusively at night does not constitute full-time 
attendance. However, full-time attendance at an educational institution 
may include some attendance at night in connection with a full-time 
course of study.
    (c) Educational institution. For purposes of sections 151(e) and 
152, and the regulations thereunder, the term ``educational 
institution'' means a school maintaining a regular faculty and 
established curriculum, and having an organized body of students in 
attendance. It includes primary and secondary schools, colleges, 
universities, normal schools, technical schools, mechanical schools, and 
similar institutions, but does not include noneducational institutions, 
on-the-job training, correspondence schools, night schools, and so 
forth.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7051, 35 FR 
11020, July 9, 1970]



Sec. 1.151-4  Amount of deduction for each exemption under section 151.

    The amount allowed as a deduction for each exemption under section 
151 is (a) $750 in the case of a taxable year beginning after December 
31, 1972; (b) $700 in the case of a taxable year beginning after 
December 31, 1971, and before January 1, 1973; (c) $650 in the case of a 
taxable year beginning after December 31, 1970, and before January 1, 
1972; (d) $625 in the case of a taxable year beginning after December 
31, 1969, and before January 1, 1971; and (e) $600 in the case of a 
taxable year beginning before January 1, 1970. For special rules in the 
case of a fiscal year ending after December 31, 1969, and beginning 
before January 1, 1973, see section 21(d) and the regulations 
thereunder.

[T.D. 7114, 36 FR 9019, May 18, 1971]



Sec. 1.152-1  General definition of a dependent.

    (a)(1) For purposes of the income taxes imposed on individuals by 
chapter 1 of the Code, the term ``dependent'' means any individual 
described in paragraphs (1) through (10) of section 152(a) over half of 
whose support, for the calendar year in which the taxable year of the 
taxpayer begins, was received from the taxpayer.
    (2)(i) For purposes of determining whether or not an individual 
received, for a given calendar year, over half of his support from the 
taxpayer, there shall be taken into account the amount of support 
received from the taxpayer as compared to the entire amount of support 
which the individual received from all sources, including support which 
the individual himself supplied. The term ``support'' includes food, 
shelter, clothing, medical and dental care, education, and the like. 
Generally, the amount of an item of support will be the amount of 
expense incurred by the one furnishing such item. If the item of support 
furnished an individual is in the form of property or lodging, it will 
be necessary to measure the amount of such item of support in terms of 
its fair market value.
    (ii) In computing the amount which is contributed for the support of 
an individual, there must be included any amount which is contributed by 
such individual for his own support, including income which is 
ordinarily excludable from gross income, such as benefits received under 
the Social Security Act (42 U.S.C. ch. 7). For example, a father 
receives $800 social security benefits, $400 interest, and $1,000 from 
his son during 1955, all of which sums represent his sole support during 
that year. The fact that the social security benefits of $800 are not 
includible in the father's gross income does not prevent such amount 
from entering into the computation of the total amount contributed for 
the father's support. Consequently, since the son's contribution of 
$1,000 was less than one-half of the father's support ($2,200) he may 
not claim his father as a dependent.
    (iii)(a) For purposes of determining the amount of support furnished 
for a child (or children) by a taxpayer for a given calendar year, an 
arrearage payment made in a year subsequent to a calendar year for which 
there is an unpaid liability shall not be treated as paid either during 
that calendar year or in the year of payment, but no amount shall be 
treated as an arrearage payment to the extent that there is an unpaid 
liability (determined without regard to such payment) with respect to 
the support of a child for the taxable year of payment; and

[[Page 174]]

    (b) Similarly, payments made prior to any calendar year (whether or 
not made in the form of a lump sum payment in settlement of the parent's 
liability for support) shall not be treated as made during such calendar 
year, but payments made during any calendar year from amounts set aside 
in trust by a parent in a prior year, shall be treated as made during 
the calendar year in which paid.
    (b) Section 152(a)(9) applies to any individual (other than an 
individual who at any time during the taxable year was the spouse, 
determined without regard to section 153, of the taxpayer) who lives 
with the taxpayer and is a member of the taxpayer's household during the 
entire taxable year of the taxpayer. An individual is not a member of 
the taxpayer's household if at any time during the taxable year of the 
taxpayer the relationship between such individual and the taxpayer is in 
violation of local law. It is not necessary under section 152(a)(9) that 
the dependent be related to the taxpayer. For example, foster children 
may qualify as dependents. It is necessary, however, that the taxpayer 
both maintain and occupy the household. The taxpayer and dependent will 
be considered as occupying the household for such entire taxable year 
notwithstanding temporary absences from the household due to special 
circumstances. A nonpermanent failure to occupy the common abode by 
reason of illness, education, business, vacation, military service, or a 
custody agreement under which the dependent is absent for less than six 
months in the taxable year of the taxpayer, shall be considered 
temporary absence due to special circumstances. The fact that the 
dependent dies during the year shall not deprive the taxpayer of the 
deduction if the dependent lived in the household for the entire part of 
the year preceding his death. Likewise, the period during the taxable 
year preceding the birth of an individual shall not prevent such 
individual from qualifying as a dependent under section 152(a)(9). 
Moreover, a child who actually becomes a member of the taxpayer's 
household during the taxable year shall not be prevented from being 
considered a member of such household for the entire taxable year, if 
the child is required to remain in a hospital for a period following its 
birth, and if such child would otherwise have been a member of the 
taxpayer's household during such period.
    (c) In the case of a child of the taxpayer who is under 19 or who is 
a student, the taxpayer may claim the dependency exemption for such 
child provided he has furnished more than one-half of the support of 
such child for the calendar year in which the taxable year of the 
taxpayer begins, even though the income of the child for such calendar 
year may be equal to or in excess of the amount determined pursuant to 
Sec. 1.151-2 applicable to such calendar year. In such a case, there may 
be two exemptions claimed for the child: One on the parent's (or 
stepparent's) return, and one on the child's return. In determining 
whether the taxpayer does in fact furnish more than one-half of the 
support of an individual who is a child, as defined in paragraph (a) of 
Sec. 1.151-3, of the taxpayer and who is a student, as defined in 
paragraph (b) of Sec. 1.151-3, a special rule regarding scholarships 
applies. Amounts received as scholarships, as defined in paragraph (a) 
of Sec. 1.117-3, for study at an educational institution shall not be 
considered in determining whether the taxpayer furnishes more than one-
half the support of such individual. For example, A has a child who 
receives a $1,000 scholarship to the X college for 1 year. A contributes 
$500, which constitutes the balance of the child's support for that 
year. A may claim the child as a dependent, as the $1,000 scholarship is 
not counted in determining the support of the child. For purposes of 
this paragraph, amounts received for tuition payments and allowances by 
a veteran under the provisions of the Servicemen's Readjustment Act of 
1944 (58 Stat. 284) or the Veterans' Readjustment Assistance Act of 1952 
(38 U.S.C. ch. 38) are not amounts received as scholarships. See also 
Sec. 1.117-4. For definition of the

[[Page 175]]

terms ``child'', ``student'', and ``educational institution'', as used 
in this paragraph, see Sec. 1.151-3.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6603, 28 FR 
7094, July 11, 1963; T.D. 7099, 36 FR 5337, Mar. 20, 1971; T.D. 7114, 36 
FR 9019, May 18, 1971]



Sec. 1.152-2  Rules relating to general definition of dependent.

    (a)(1) Except as provided in subparagraph (2) of this paragraph, to 
qualify as a dependent an individual must be a citizen or resident of 
the United States or be a resident of the Canal Zone, the Republic of 
Panama, Canada, or Mexico, or, for taxable years beginning after 
December 31, 1971, a national of the United States, at some time during 
the calendar year in which the taxable year of the taxpayer begins. A 
resident of the Republic of the Philippines who was born to or legally 
adopted by the taxpayer in the Philippine Islands before January 1, 
1956, at a time when the taxpayer was a member of the Armed Forces of 
the United States, may also be claimed as a dependent if such resident 
otherwise qualifies as a dependent. For definition of ``Armed Forces of 
the United States,'' see section 7701(a)(15).
    (2)(i) For any taxable year beginning after December 31, 1957, a 
taxpayer who is a citizen, or, for any taxable year beginning after 
December 31, 1971, a national, of the United States is permitted under 
section 152(b)(3)(B) to treat as a dependent his legally adopted child 
who lives with him, as a member of his household, for the entire taxable 
year and who, but for the citizenship, nationality, or residence 
requirements of section 152(b)(3) and subparagraph (1) of this 
paragraph, would qualify as a dependent of the taxpayer for such taxable 
year.
    (ii) Under section 152(b)(3)(B) and this subparagraph, it is 
necessary that the taxpayer both maintain and occupy the household. The 
taxpayer and his legally adopted child will be considered as occupying 
the household for the entire taxable year of the taxpayer 
notwithstanding temporary absences from the household due to special 
circumstances. A nonpermanent failure to occupy the common abode by 
reason of illness, education, business, vacation, military service, or a 
custody agreement under which the legally adopted child is absent for 
less than six months in the taxable year of the taxpayer shall be 
considered temporary absence due to special circumstances. The fact that 
a legally adopted child dies during the year shall not deprive the 
taxpayer of the deduction if the child lived in the household for the 
entire part of the year preceding his death. The period during the 
taxable year preceding the birth of a child shall not prevent such child 
from qualifying as a dependent under this subparagraph. Moreover, a 
legally adopted child who actually becomes a member of the taxpayer's 
household during the taxable year shall not be prevented from being 
considered a member of such household for the entire taxable year, if 
the child is required to remain in a hospital for a period following its 
birth and if such child would otherwise have been a member of the 
taxpayer's household during such period.
    (iii) For purposes of section 152(b)(3)(B) and this subparagraph, 
any child whose legal adoption by the taxpayer (a citizen or national of 
the United States) becomes final at any time before the end of the 
taxable year of the taxpayer shall not be disqualified as a dependent of 
such taxpayer by reason of his citizenship, nationality, or residence, 
provided the child lived with the taxpayer and was a member of the 
taxpayer's household for the entire taxable year in which the legal 
adoption became final. For example, A, a citizen of the United States 
who makes his income tax returns on the basis of the calendar year, is 
employed in Brazil by an agency of the United States Government. In 
October 1958 he takes into his household C, a resident of Brazil who is 
not a citizen of the United States, for the purpose of initiating 
adoption proceedings. C lives with A and is a member of his household 
for the remainder of 1958 and for the entire calendar year 1959. On July 
1, 1959, the adoption proceedings were completed and C became the 
legally adopted child of A. If C otherwise qualifies as a dependent, he 
may be claimed as a dependent by A for 1959.

[[Page 176]]

    (b) A payment to a wife which is includible in her gross income 
under section 71 or section 682 shall not be considered a payment by her 
husband for the support of any dependent.
    (c)(1) For purposes of determining the existence of any of the 
relationships specified in section 152 (a) or (b)(1), a legally adopted 
child of an individual shall be treated as a child of such individual by 
blood.
    (2) For any taxable year beginning after December 31, 1958, a child 
who is a member of an individual's household also shall be treated as a 
child of such individual by blood if the child was placed with the 
individual by an authorized placement agency for legal adoption pursuant 
to a formal application filed by the individual with the agency. For 
purposes of this subparagraph an authorized placement agency is any 
agency which is authorized by a State, the District of Columbia, a 
possession of the United States, a foreign country, or a political 
subdivision of any of the foregoing to place children for adoption. A 
taxpayer who claims as a dependent a child placed with him for adoption 
shall attach to his income tax return a statement setting forth the name 
of the child for whom the dependency deduction is claimed, the name and 
address of the authorized placement agency, and the date the formal 
application was filed with the agency.
    (3) The application of this paragraph may be illustrated by the 
following example:

    Example. On March 1, 1959, D, a resident of the United States, made 
formal application to an authorized child placement agency for the 
placement of E, a resident of the United States, with him for legal 
adoption. On June 1, 1959, E was placed with D for legal adoption. 
During the year 1959 E received over one-half of his support from D. D 
may claim E as a dependent for 1959. Since E was a resident of the 
United States, his qualification as a dependent is in no way based on 
the provisions of section 152(b)(3)(B). Therefore, it is immaterial that 
E was not a member of D's household during the entire taxable year.

    (4) For purposes of determining the existence of any of the 
relationships specified in section 152 (a) or (b)(1), a foster child of 
an individual (if such foster child satisfies the requirements set forth 
in paragraph (b) of Sec. 1.152-1 with respect to such individual) shall, 
for taxable years beginning after December 31, 1969, be treated as a 
child of such individual by blood. For purposes of this subparagraph, a 
foster child is a child who is in the care of a person or persons (other 
than the parents or adopted parents of the child) who care for the child 
as their own child. Status as a foster child is not dependent upon or 
affected by the circumstances under which the child became a member of 
the household.
    (d) In the case of a joint return it is not necessary that the 
prescribed relationship exist between the person claimed as a dependent 
and the spouse who furnishes the support; it is sufficient if the 
prescribed relationship exists with respect to either spouse. Thus, a 
husband and wife making a joint return may claim as a dependent a 
daughter of the wife's brother (wife's niece) even though the husband is 
the one who furnishes the chief support. The relationship of affinity 
once existing will not terminate by divorce or the death of a spouse. 
For example, a widower may continue to claim his deceased wife's father 
(his father-in-law) as a dependent provided he meets the other 
requirements of section 151.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6603, 28 FR 
7094, July 11, 1963; T.D. 7051, 35 FR 11020, July 9, 1970; T.D. 7291, 38 
FR 33396, Dec. 4, 1973]



Sec. 1.152-3  Multiple support agreements.

    (a) Section 152(c) provides that a taxpayer shall be treated as 
having contributed over half of the support of an individual for the 
calendar year (in cases where two or more taxpayers contributed to the 
support of such individual) if--
    (1) No one person contributed over half of the individual's support,
    (2) Each member of the group which collectively contributed more 
than half of the support of the individual would have been entitled to 
claim the individual as a dependent but for the fact that he did not 
contribute more than one-half of such support.
    (3) The member of the group claiming the individual as a dependent 
contributed more than 10 percent of the individual's support, and
    (4) Each other person in the group who contributed more than 10 
percent

[[Page 177]]

of such support furnishes to the taxpayer claiming the dependent a 
written declaration that such other person will not claim the individual 
as a dependent for any taxable year beginning in such calendar year.
    (b) Examples. Application of the rule contained in paragraph (a) of 
this section may be illustrated by the following examples:

    Example 1. During the taxable year, brothers A, B, C, and D 
contributed the entire support of their mother in the following 
percentages: A, 30 percent; B, 20 percent; C, 29 percent; and D, 21 
percent. Any one of the brothers, except for the fact that he did not 
contribute more than half of her support, would have been entitled to 
claim his mother as a dependent. Consequently, any one of the brothers 
could claim a deduction for the exemption of the mother if he obtained a 
written declaration (as provided in paragraph (a)(4) of this section) 
from each of the other brothers. Even though A and D together 
contributed more than one-half the support of the mother, A, if he 
wished to claim his mother as a dependent, would be required to obtain 
written declarations from B, C, and D, since each of those three 
contributed more than 10 percent of the support and, but for the failure 
to contribute more than half of the mother's support, would have been 
entitled to claim his mother as a dependent.
    Example 2. During the taxable year, E, an individual who resides 
with his son, S, received his entire support for that year as follows:

------------------------------------------------------------------------
                                                              Percentage
                           Source                              of total
------------------------------------------------------------------------
Social Security............................................           25
N, an unrelated neighbor...................................           11
B, a brother...............................................           14
D, a daughter..............................................           10
S, a son...................................................           40
    Total received by E....................................          100
------------------------------------------------------------------------

    B, D, and S are persons each of whom, but for the fact that none 
contributed more than half of E's support, could claim E as a dependent 
for the taxable year. The three together contributed 64 percent of E's 
support, and, thus, each is a member of the group to be considered for 
the purpose of section 152(c). B and S are the only members of such 
group who can meet all the requirements of section 152(c), and either 
one could claim E as a dependent for his taxable year if he obtained a 
written declaration (as provided in paragraph (a)(4) of this section) 
signed by the other, and furnished the other information required by the 
return with respect to all the contributions to E. Inasmuch as D did not 
contribute more than 10 percent of E's support, she is not entitled to 
claim E as a dependent for the taxable year nor is she required to 
furnish a written declaration with respect to her contributions to E. N 
contributed over 10 percent of the support of E, but, since he is an 
unrelated neighbor, he does not qualify as a member of the group for the 
purpose of the multiple support agreement under section 152(c).

    (c)(1) The member of a group of contributors who claims an 
individual as a dependent for a taxable year beginning before January 1, 
2002, under the multiple support agreement provisions of section 152(c) 
must attach to the member's income tax return for the year of the 
deduction a written declaration from each of the other persons who 
contributed more than 10 percent of the support of such individual and 
who, but for the failure to contribute more than half of the support of 
the individual, would have been entitled to claim the individual as a 
dependent.
    (2) The taxpayer claiming an individual as a dependent for a taxable 
year beginning after December 31, 2001, under the multiple support 
agreement provisions of section 152(c) must provide with the income tax 
return for the year of the deduction--
    (i) A statement identifying each of the other persons who 
contributed more than 10 percent of the support of the individual and 
who, but for the failure to contribute more than half of the support of 
the individual, would have been entitled to claim the individual as a 
dependent; and
    (ii) A statement indicating that the taxpayer obtained a written 
declaration from each of the persons described in section 152(c)(2) 
waiving the right to claim the individual as a dependent.
    (3) The taxpayer claiming the individual as a dependent for a 
taxable year beginning after December 31, 2001, must retain the waiver 
declarations and should be prepared to furnish the waiver declarations 
and any other information necessary to substantiate the claim, which may 
include a statement showing the names of all contributors (whether or 
not members of the group described in section 152(c)(2)) and

[[Page 178]]

the amount contributed by each to the support of the claimed dependent.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6603, 28 FR 
7094, July 11, 1963; T.D. 8989, 67 FR 20031, Apr. 24, 2002; T.D. 9040, 
68 FR 4920, Jan. 31, 2003]



Sec. 1.152-4  Special rule for a child of divorced or separated
parents or parents who live apart.

    (a) In general. A taxpayer may claim a dependency deduction for a 
child (as defined in section 152(f)(1)) only if the child is the 
qualifying child of the taxpayer under section 152(c) or the qualifying 
relative of the taxpayer under section 152(d). Section 152(c)(4)(B) 
provides that a child who is claimed as a qualifying child by parents 
who do not file a joint return together is treated as the qualifying 
child of the parent with whom the child resides for a longer period of 
time during the taxable year or, if the child resides with both parents 
for an equal period of time, of the parent with the higher adjusted 
gross income. However, a child is treated as the qualifying child or 
qualifying relative of the noncustodial parent if the custodial parent 
releases a claim to the exemption under section 152(e) and this section.
    (b) Release of claim by custodial parent--(1) In general. Under 
section 152(e)(1), notwithstanding section 152(c)(1)(B), (c)(4), or 
(d)(1)(C), a child is treated as the qualifying child or qualifying 
relative of the noncustodial parent (as defined in paragraph (d) of this 
section) if the requirements of paragraphs (b)(2) and (b)(3) of this 
section are met.
    (2) Support, custody, and parental status--(i) In general. The 
requirements of this paragraph (b)(2) are met if the parents of the 
child provide over one-half of the child's support for the calendar 
year, the child is in the custody of one or both parents for more than 
one-half of the calendar year, and the parents--
    (A) Are divorced or legally separated under a decree of divorce or 
separate maintenance;
    (B) Are separated under a written separation agreement; or
    (C) Live apart at all times during the last 6 months of the calendar 
year whether or not they are or were married.
    (ii) Multiple support agreement. The requirements of this paragraph 
(b)(2) are not met if over one-half of the support of the child is 
treated as having been received from a taxpayer under section 152(d)(3).
    (3) Release of claim to child. The requirements of this paragraph 
(b)(3) are met for a calendar year if--
    (i) The custodial parent signs a written declaration that the 
custodial parent will not claim the child as a dependent for any taxable 
year beginning in that calendar year and the noncustodial parent 
attaches the declaration to the noncustodial parent's return for the 
taxable year; or
    (ii) A qualified pre-1985 instrument, as defined in section 
152(e)(3)(B), applicable to the taxable year beginning in that calendar 
year, provides that the noncustodial parent is entitled to the 
dependency exemption for the child and the noncustodial parent provides 
at least $600 for the support of the child during the calendar year.
    (c) Custody. A child is in the custody of one or both parents for 
more than one-half of the calendar year if one or both parents have the 
right under state law to physical custody of the child for more than 
one-half of the calendar year.
    (d) Custodial parent--(1) In general. The custodial parent is the 
parent with whom the child resides for the greater number of nights 
during the calendar year, and the noncustodial parent is the parent who 
is not the custodial parent. A child is treated as residing with neither 
parent if the child is emancipated under state law. For purposes of this 
section, a child resides with a parent for a night if the child sleeps--
    (i) At the residence of that parent (whether or not the parent is 
present); or
    (ii) In the company of the parent, when the child does not sleep at 
a parent's residence (for example, the parent and child are on vacation 
together).
    (2) Night straddling taxable years. A night that extends over two 
taxable years is allocated to the taxable year in which the night 
begins.
    (3) Absences. (i) Except as provided in paragraph (d)(3)(ii) of this 
section, for purposes of this paragraph (d), a child

[[Page 179]]

who does not reside (within the meaning of paragraph (d)(1) of this 
section) with a parent for a night is treated as residing with the 
parent with whom the child would have resided for the night but for the 
absence.
    (ii) A child who does not reside (within the meaning of paragraph 
(d)(1) of this section) with a parent for a night is treated as not 
residing with either parent for that night if it cannot be determined 
with which parent the child would have resided or if the child would not 
have resided with either parent for the night.
    (4) Special rule for equal number of nights. If a child is in the 
custody of one or both parents for more than one-half of the calendar 
year and the child resides with each parent for an equal number of 
nights during the calendar year, the parent with the higher adjusted 
gross income for the calendar year is treated as the custodial parent.
    (5) Exception for a parent who works at night. If, in a calendar 
year, due to a parent's nighttime work schedule, a child resides for a 
greater number of days but not nights with the parent who works at 
night, that parent is treated as the custodial parent. On a school day, 
the child is treated as residing at the primary residence registered 
with the school.
    (e) Written declaration--(1) Form of declaration--(i) In general. 
The written declaration under paragraph (b)(3)(i) of this section must 
be an unconditional release of the custodial parent's claim to the child 
as a dependent for the year or years for which the declaration is 
effective. A declaration is not unconditional if the custodial parent's 
release of the right to claim the child as a dependent requires the 
satisfaction of any condition, including the noncustodial parent's 
meeting of an obligation such as the payment of support. A written 
declaration must name the noncustodial parent to whom the exemption is 
released. A written declaration must specify the year or years for which 
it is effective. A written declaration that specifies all future years 
is treated as specifying the first taxable year after the taxable year 
of execution and all subsequent taxable years.
    (ii) Form designated by IRS. A written declaration may be made on 
Form 8332, Release/Revocation of Release of Claim to Exemption for Child 
by Custodial Parent, or successor form designated by the IRS. A written 
declaration not on the form designated by the IRS must conform to the 
substance of that form and must be a document executed for the sole 
purpose of serving as a written declaration under this section. A court 
order or decree or a separation agreement may not serve as a written 
declaration.
    (2) Attachment to return. A noncustodial parent must attach a copy 
of the written declaration to the parent's return for each taxable year 
in which the child is claimed as a dependent.
    (3) Revocation of written declaration--(i) In general. A parent may 
revoke a written declaration described in paragraph (e)(1) of this 
section by providing written notice of the revocation to the other 
parent. The parent revoking the written declaration must make reasonable 
efforts to provide actual notice to the other parent. The revocation may 
be effective no earlier than the taxable year that begins in the first 
calendar year after the calendar year in which the parent revoking the 
written declaration provides, or makes reasonable efforts to provide, 
the written notice.
    (ii) Form of revocation. The revocation may be made on Form 8332, 
Release/Revocation of Release of Claim to Exemption for Child by 
Custodial Parent, or successor form designated by the IRS whether or not 
the written declaration was made on a form designated by the IRS. A 
revocation not on that form must conform to the substance of the form 
and must be a document executed for the sole purpose of serving as a 
revocation under this section. The revocation must specify the year or 
years for which the revocation is effective. A revocation that specifies 
all future years is treated as specifying the first taxable year after 
the taxable year the revocation is executed and all subsequent taxable 
years.
    (iii) Attachment to return. The parent revoking the written 
declaration must attach a copy of the revocation to the parent's return 
for each taxable year for which the parent claims a child as a dependent 
as a result of the revocation. The parent revoking the written 
declaration must keep a copy of the

[[Page 180]]

revocation and evidence of delivery of the notice to the other parent, 
or of the reasonable efforts to provide actual notice.
    (4) Ineffective declaration or revocation. A written declaration or 
revocation that fails to satisfy the requirements of this paragraph (e) 
has no effect.
    (5) Written declaration executed in a taxable year beginning on or 
before July 2, 2008. A written declaration executed in a taxable year 
beginning on or before July 2, 2008, that satisfies the requirements for 
the form of a written declaration in effect at the time the written 
declaration is executed, will be treated as meeting the requirements of 
paragraph (e)(1) of this section. Paragraph (e)(3) of this section 
applies without regard to whether a custodial parent executed the 
written declaration in a taxable year beginning on or before July 2, 
2008.
    (f) Coordination with other sections. If section 152(e) and this 
section apply, a child is treated as the dependent of both parents for 
purposes of sections 105(b), 132(h)(2)(B), and 213(d)(5).
    (g) Examples. The provisions of this section are illustrated by the 
following examples that assume, unless otherwise provided, that each 
taxpayer's taxable year is the calendar year, one or both of the child's 
parents provide over one-half of the child's support for the calendar 
year, one or both parents have the right under state law to physical 
custody of the child for more than one-half of the calendar year, and 
the child otherwise meets the requirements of a qualifying child under 
section 152(c) or a qualifying relative under section 152(d). In 
addition, in each of the examples, no qualified pre-1985 instrument or 
multiple support agreement is in effect. The examples are as follows:

    Example 1. (i) B and C are the divorced parents of Child. In 2009, 
Child resides with B for 210 nights and with C for 155 nights. B 
executes a Form 8332 for 2009 releasing B's right to claim Child as a 
dependent for that year, which C attaches to C's 2009 return.
    (ii) Under paragraph (d) of this section, B is the custodial parent 
of Child in 2009 because B is the parent with whom Child resides for the 
greater number of nights in 2009. Because the requirements of paragraphs 
(b)(2) and (3) of this section are met, C may claim Child as a 
dependent.
    Example 2. The facts are the same as in Example 1 except that B does 
not execute a Form 8332 or similar declaration for 2009. Therefore, 
section 152(e) and this section do not apply. Whether Child is the 
qualifying child or qualifying relative of B or C is determined under 
section 152(c) or (d).
    Example 3. (i) D and E are the divorced parents of Child. Under a 
custody decree, Grandmother has the right under state law to physical 
custody of Child from January 1 to July 31, 2009.
    (ii) Because D and E do not have the right under state law to 
physical custody of Child for over one-half of the 2009 calendar year, 
under paragraph (c) of this section, Child is not in the custody of one 
or both parents for over one-half of the calendar year. Therefore, 
section 152(e) and this section do not apply, and whether Child is the 
qualifying child or qualifying relative of D, E, or Grandmother is 
determined under section 152(c) or (d).
    Example 4. (i) The facts are the same as in Example 3, except that 
Grandmother has the right to physical custody of Child from January 1 to 
March 31, 2009, and, as a result, Child resides with Grandmother during 
this period. D and E jointly have the right to physical custody of Child 
from April 1 to December 31, 2009. During this period, Child resides 
with D for 180 nights and with E for 95 nights. D executes a Form 8332 
for 2009 releasing D's right to claim Child as a dependent for that 
year, which E attaches to E's 2009 return.
    (ii) Under paragraph (c) of this section, Child is in the custody of 
D and E for over one-half of the calendar year, because D and E have the 
right under state law to physical custody of Child for over one-half of 
the calendar year.
    (iii) Under paragraph (d)(3)(ii) of this section, the nights that 
Child resides with Grandmother are not allocated to either parent. Child 
resides with D for a greater number of nights than with E during the 
calendar year and, under paragraph (d)(1) of this section, D is the 
custodial parent.
    (iv) Because the requirements of paragraphs (b)(2) and (3) of this 
section are met, section 152(e) and this section apply, and E may claim 
Child as a dependent.
    Example 5. (i) The facts are the same as in Example 4, except that D 
is away on military service from April 10 to June 15, 2009, and 
September 6 to October 20, 2009. During these periods Child resides with 
Grandmother in Grandmother's residence. Child would have resided with D 
if D had not been away on military service. Grandmother claims Child as 
a dependent on Grandmother's 2009 return.
    (ii) Under paragraph (d)(3)(i) of this section, Child is treated as 
residing with D for the nights that D is away on military service. 
Because the requirements of paragraphs (b)(2) and (3) of this section 
are met, section 152(e) and this section apply, and E, not

[[Page 181]]

Grandmother, may claim Child as a dependent.
    Example 6. F and G are the divorced parents of Child. In May of 
2009, Child turns age 18 and is emancipated under the law of the state 
where Child resides. Therefore, in 2009 and later years, F and G do not 
have the right under state law to physical custody of Child for over 
one-half of the calendar year, and Child is not in the custody of F and 
G for over one-half of the calendar year. Section 152(e) and this 
section do not apply, and whether Child is the qualifying child or 
qualifying relative of F or G is determined under section 152(c) or (d).
    Example 7. (i) The facts are the same as in Example 6, except that 
Child turns age 18 and is emancipated under state law on August 1, 2009, 
resides with F from January 1, 2009, through May 31, 2009, and resides 
with G from June 1, 2009, through December 31, 2009. F executes a Form 
8332 releasing F's right to claim Child as a dependent for 2009, which G 
attaches to G's 2009 return.
    (ii) Under paragraph (c) of this section, Child is in the custody of 
F and G for over one-half of the calendar year.
    (iii) Under paragraph (d)(1) of this section, Child is treated as 
not residing with either parent after Child's emancipation. Therefore, 
Child resides with F for 151 nights and with G for 61 nights. Because 
the requirements of paragraphs (b)(2) and (3) of this section are met, 
section 152(e) and this section apply, and G may claim Child as a 
dependent.
    Example 8. H and J are the divorced parents of Child. Child 
generally resides with H during the week and with J every other weekend. 
Child resides with J in H's residence for 10 consecutive nights while H 
is hospitalized. Under paragraph (d)(1)(i) of this section, Child 
resides with H for the 10 nights.
    Example 9. K and L, who are separated under a written separation 
agreement, are the parents of Child. In August 2009, K and Child spend 
10 nights together in a hotel while on vacation. Under paragraph 
(d)(1)(ii) of this section, Child resides with K for the 10 nights that 
K and Child are on vacation.
    Example 10. M and N are the divorced parents of Child. On December 
31, 2009, Child attends a party at M's residence. After midnight on 
January 1, 2010, Child travels to N's residence, where Child sleeps. 
Under paragraph (d)(1) of this section, Child resides with N for the 
night of December 31, 2009, to January 1, 2010, because Child sleeps at 
N's residence that night. However, under paragraph (d)(2) of this 
section, the night of December 31, 2009, to January 1, 2010, is 
allocated to taxable year 2009 for purposes of determining whether Child 
resides with M or N for a greater number of nights in 2009.
    Example 11. O and P, who never married, are the parents of Child. In 
2009, Child spends alternate weeks residing with O and P. During a week 
that Child is residing with O, O gives Child permission to spend a night 
at the home of a friend. Under paragraph (d)(3)(i) of this section, the 
night Child spends at the friend's home is treated as a night that Child 
resides with O.
    Example 12. The facts are the same as in Example 11, except that 
Child also resides at summer camp for 6 weeks. Because Child resides 
with each parent for alternate weeks, Child would have resided with O 
for 3 weeks and with P for 3 weeks of the period that Child is at camp. 
Under paragraph (d)(3)(i) of this section, Child is treated as residing 
with O for 3 weeks and with P for 3 weeks.
    Example 13. The facts are the same as in Example 12, except that 
Child does not spend alternate weeks residing with O and P, and it 
cannot be determined whether Child would have resided with O or P for 
the period that Child is at camp. Under paragraph (d)(3)(ii) of this 
section, Child is treated as residing with neither parent for the 6 
weeks.
    Example 14. (i) Q and R are the divorced parents of Child. Q works 
from 11 PM to 7 AM Sunday through Thursday nights. Because of Q's 
nighttime work schedule, Child resides with R Sunday through Thursday 
nights and with Q Friday and Saturday nights. Therefore, in 2009, Child 
resides with R for 261 nights and with Q for 104 nights. Child spends 
all daytime hours when Child is not in school with Q and Q's address is 
registered with Child's school as Child's primary residence. Q executes 
a Form 8332 for 2009 releasing Q's right to claim Child as a dependent 
for that year, which R attaches to R's 2009 return.
    (ii) Under paragraph (d) of this section, Q is the custodial parent 
of Child in 2009. Child resides with R for a greater number of nights 
than with Q due to Q's nighttime work schedule, and Child spends a 
greater number of days with Q. Therefore, paragraph (d)(5) of this 
section applies rather than paragraph (d)(1) of this section. Because 
the requirements of paragraphs (b)(2) and (3) of this section are met, R 
may claim Child as a dependent.
    Example 15. (i) In 2009, S and T, the parents of Child, execute a 
written separation agreement. The agreement provides that Child will 
live with S and that T will make monthly child support payments to S. In 
2009, Child resides with S for 335 nights and with T for 30 nights. S 
executes a letter declaring that S will not claim Child as a dependent 
in 2009 and in subsequent alternate years. The letter contains all the 
information requested on Form 8332, does not require the satisfaction of 
any condition such as T's payment of support, and has no purpose other 
than to serve as a written declaration under section 152(e) and this 
section. T attaches the letter to T's return for 2009 and 2011.
    (ii) In 2010, T fails to provide support for Child, and S executes a 
Form 8332 revoking

[[Page 182]]

the release of S's right to claim Child as a dependent for 2011. S 
delivers a copy of the Form 8332 to T, attaches a copy of the Form 8332 
to S's tax return for 2011, and keeps a copy of the Form 8332 and 
evidence of delivery of the written notice to T.
    (iii) T may claim Child as a dependent for 2009 because S releases 
the right to claim Child as a dependent under paragraph (b)(3) of this 
section by executing the letter, which conforms to the requirements of 
paragraph (e)(1) of this section, and T attaches the letter to T's 
return in accordance with paragraph (e)(2) of this section. In 2010, S 
revokes the release of the claim in accordance with paragraph (e)(3) of 
this section, and the revocation takes effect in 2011, the taxable year 
that begins in the first calendar year after S provides written notice 
of the revocation to T. Therefore, in 2011, section 152(e) and this 
section do not apply, and whether Child is the qualifying child or 
qualifying relative of S or T is determined under section 152(c) or (d).
    Example 16. The facts are the same as Example 15, except that the 
letter expressly states that S releases the right to claim Child as a 
dependent only if T is current in the payment of support for Child at 
the end of the calendar year. The letter does not qualify as a written 
declaration under paragraph (b)(3) of this section because S's agreement 
not to claim Child as a dependent is conditioned on T's payment of 
support and, under paragraph (e)(1)(i) of this section, a written 
declaration must be unconditional. Therefore, section 152(e) and this 
section do not apply, and whether Child is the qualifying child or 
qualifying relative of S or T for 2009 as well as 2011 is determined 
under section 152(c) or (d).
    Example 17. (i) U and V are the divorced parents of Child. Child 
resides with U for more nights than with V in 2009 through 2011. In 
2009, U provides a written statement to V declaring that U will not 
claim Child as a dependent, but the statement does not specify the year 
or years it is effective. V attaches the statement to V's returns for 
2009 through 2011.
    (ii) Because the written statement does not specify a year or years, 
under paragraph (e)(1) of this section, it is not a written declaration 
that conforms to the substance of Form 8332. Under paragraph (e)(4) of 
this section, the statement has no effect. Section 152(e) and this 
section do not apply, and whether Child is the qualifying child or 
qualifying relative of U or V is determined under section 152(c) or (d).
    Example 18. (i) W and X are the divorced parents of Child. In 2009, 
Child resides solely with W. The divorce decree requires X to pay child 
support to W and requires W to execute a Form 8332 releasing W's right 
to claim Child as a dependent. W fails to sign a Form 8332 for 2009, and 
X attaches an unsigned Form 8332 to X's return for 2009.
    (ii) The order in the divorce decree requiring W to execute a Form 
8332 is ineffective to allocate the right to claim Child as a dependent 
to X. Furthermore, under paragraph (e)(1) of this section, the unsigned 
Form 8332 does not conform to the substance of Form 8332, and under 
paragraph (e)(4) of this section, the Form 8332 has no effect. 
Therefore, section 152(e) and this section do not apply, and whether 
Child is the qualifying child or qualifying relative of W or X is 
determined under section 152(c) or (d).
    (iii) If, however, W executes a Form 8332 for 2009, and X attaches 
the Form 8332 to X's return, then X may claim Child as a dependent in 
2009.
    Example 19. (i) Y and Z are the divorced parents of Child. In 2003, 
Y and Z enter into a separation agreement, which is incorporated into a 
divorce decree, under which Y, the custodial parent, releases Y's right 
to claim Child as a dependent for all future years. The separation 
agreement satisfies the requirements for the form of a written 
declaration in effect at the time it is executed. Z attaches a copy of 
the separation agreement to Z's returns for 2003 through 2009.
    (ii) Under paragraph (e)(1)(ii) of this section, a separation 
agreement may not serve as a written declaration. However, under 
paragraph (e)(5) of this section, a written declaration executed in a 
taxable year beginning on or before July 2, 2008, that satisfies the 
requirements for the form of a written declaration in effect at the time 
the written declaration is executed, will be treated as meeting the 
requirements of paragraph (e)(1) of this section. Therefore, the 
separation agreement may serve as the written declaration required by 
paragraph (b)(3)(i) of this section for 2009, and Z may claim Child as a 
dependent in 2009 and later years.
    Example 20. (i) The facts are the same as in Example 19, except that 
in 2009 Y executes a Form 8332 revoking the release of Y's right to 
claim Child as a dependent for 2010. Y complies with all the 
requirements of paragraph (e)(3) of this section.
    (ii) Although Y executes the separation agreement releasing Y's 
right to claim Child as a dependent in a taxable year beginning on or 
before July 2, 2008, under paragraph (e)(5) of this section, Y's 
execution of the Form 8332 in 2009 is effective to revoke the release. 
Therefore, section 152(e) and this section do not apply in 2010, and 
whether Child is the qualifying child or qualifying relative of Y or Z 
is determined under section 152(c) or (d).


[[Page 183]]


    (h) Effective/applicability date. This section applies to taxable 
years beginning after July 2, 2008.

[T.D. 9408, 73 FR 37801, July 2, 2008]



Sec. 1.153-1  Determination of marital status.

    For the purpose of determining the right of an individual to claim 
an exemption for his spouse under section 151(b), the determination of 
whether such individual is married shall be made as of the close of his 
taxable year, unless his spouse dies during such year, in which case the 
determination shall be made as of the time of such death. An individual 
legally separated from his spouse under a decree of divorce or separate 
maintenance shall not be considered as married. The provisions of this 
section may be illustrated by the following examples:

    Example 1. A, who files his returns on the basis of a calendar year, 
married B on December 31, 1956. B, who had never previously married, had 
no gross income for the calendar year 1956 nor was she the dependent of 
another taxpayer for such year. A may claim an exemption for B for 1956.
    Example 2. C and his wife, D, were married in 1940. They remained 
married until July 1956 at which time D was granted a decree of divorce. 
C, who files his income tax returns on a calendar year basis, cannot 
claim an exemption for D on his 1956 return as C and D were not married 
on the last day of C's taxable year. Had D died instead of being 
divorced, C could have claimed an exemption for D for 1956 as their 
marital status would have been determined as of the date of D's death.



Sec. 1.154  Statutory provisions; cross references.

    Sec. 154. Cross references. (1) For definitions of ``husband'' and 
``wife'', as used in section 152(b)(4), see section 7701(a)(17).
    (2) For deductions of estates and trusts, in lieu of the exemptions 
under section 151, see section 642(b).
    (3) For exemptions of nonresident aliens, see section 873(b)(3).
    (4) For exemptions of citizens deriving income mainly from sources 
within possessions of the United States, see section 931(e).

(Sec. 154 as amended by sec. 103(c)(2), Foreign Investors Tax Act 1966 
(80 Stat. 1551))

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960, as 
amended by T.D. 7332, 39 FR 44216, Dec. 23, 1974]

          Itemized Deductions for Individuals and Corporations



Sec. 1.161-1  Allowance of deductions.

    Section 161 provides for the allowance as deductions, in computing 
taxable income under section 63(a), of the items specified in Part VI 
(section 161 and following), Subchapter B, Chapter 1 of the Code, 
subject to the exceptions provided in Part IX (section 261 and 
following), of such Subchapter B, relating to items not deductible. 
Double deductions are not permitted. Amounts deducted under one 
provision of the Internal Revenue Code of 1954 cannot again be deducted 
under any other provision thereof. See also section 7852(c), relating to 
the taking into account, both in computing a tax under Subtitle A of the 
Internal Revenue Code of 1954 and a tax under Chapter 1 or 2 of the 
Internal Revenue Code of 1939, of the same item of deduction.



Sec. 1.162-1  Business expenses.

    (a) In general. Business expenses deductible from gross income 
include the ordinary and necessary expenditures directly connected with 
or pertaining to the taxpayer's trade or business, except items which 
are used as the basis for a deduction or a credit under provisions of 
law other than section 162. The cost of goods purchased for resale, with 
proper adjustment for opening and closing inventories, is deducted from 
gross sales in computing gross income. See paragraph (a) of Sec. 1.161-
3. Among the items included in business expenses are management 
expenses, commissions (but see section 263 and the regulations 
thereunder), labor, supplies, incidental repairs, operating expenses of 
automobiles used in the trade or business, traveling expenses while away 
from home solely in the pursuit of a trade or business (see Sec. 1.162-
2), advertising and other selling expenses, together with insurance 
premiums against fire, storm, theft, accident, or other similar losses 
in the case of a business, and rental for the use of business property. 
No such item shall be included in business expenses, however, to the 
extent that it is used by the taxpayer in computing the cost of property 
included in its inventory or used in determining the gain or loss basis 
of

[[Page 184]]

its plant, equipment, or other property. See section 1054 and the 
regulations thereunder. A deduction for an expense paid or incurred 
after December 30, 1969, which would otherwise be allowable under 
section 162 shall not be denied on the grounds that allowance of such 
deduction would frustrate a sharply defined public policy. See section 
162(c), (f), and (g) and the regulations thereunder. The full amount of 
the allowable deduction for ordinary and necessary expenses in carrying 
on a business is deductible, even though such expenses exceed the gross 
income derived during the taxable year from such business. In the case 
of any sports program to which section 114 (relating to sports programs 
conducted for the American National Red Cross) applies, expenses 
described in section 114(a)(2) shall be allowable as deductions under 
section 162(a) only to the extent that such expenses exceed the amount 
excluded from gross income under section 114(a).
    (b) Cross references. (1) For charitable contributions by 
individuals and corporations not deductible under section 162, see 
Sec. 1.162-15.
    (2) For items not deductible, see sections 261-276, inclusive, and 
the regulations thereunder.
    (3) For research and experimental expenditures, see section 174 and 
regulations thereunder.
    (4) For soil and water conservation expenditures, see section 175 
and regulations thereunder.
    (5) For expenditures attributable to grant or loan by United States 
for encouragement of exploration for, or development or mining of, 
critical and strategic minerals or metals, see section 621 and 
regulations thereunder.
    (6) For treatment of certain rental payments with respect to public 
utility property, see section 167(1) and Sec. 1.167(1)-3.
    (7) For limitations on the deductibility of miscellaneous itemized 
deductions, see section 67 and Secs. 1.67-1T through 1.67-4T.
    (8) For the timing of deductions with respect to notional principal 
contracts. see Sec. 1.446-3.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6690, 28 FR 
12253, Nov. 19, 1963; T.D. 6996, 34 FR 835, Jan. 18, 1969; T.D. 7315, 39 
FR 20203, June 7, 1974; T.D. 7345, 40 FR 7437, Feb. 20, 1975; T.D. 8189, 
53 FR 9881, Mar. 28, 1988; T.D. 8491, 58 FR 53128, Oct. 14, 1993]



Sec. 1.162-2  Traveling expenses.

    (a) Traveling expenses include travel fares, meals and lodging, and 
expenses incident to travel such as expenses for sample rooms, telephone 
and telegraph, public stenographers, etc. Only such traveling expenses 
as are reasonable and necessary in the conduct of the taxpayer's 
business and directly attributable to it may be deducted. If the trip is 
undertaken for other than business purposes, the travel fares and 
expenses incident to travel are personal expenses and the meals and 
lodging are living expenses. If the trip is solely on business, the 
reasonable and necessary traveling expenses, including travel fares, 
meals and lodging, and expenses incident to travel, are business 
expenses. For the allowance of traveling expenses as deductions in 
determining adjusted gross income, see section 62(2)(B) and the 
regulations thereunder.
    (b)(1) If a taxpayer travels to a destination and while at such 
destination engages in both business and personal activities, traveling 
expenses to and from such destination are deductible only if the trip is 
related primarily to the taxpayer's trade or business. If the trip is 
primarily personal in nature, the traveling expenses to and from the 
destination are not deductible even though the taxpayer engages in 
business activities while at such destination. However, expenses while 
at the destination which are properly allocable to the taxpayer's trade 
or business are deductible even though the traveling expenses to and 
from the destination are not deductible.
    (2) Whether a trip is related primarily to the taxpayer's trade or 
business or is primarily personal in nature depends on the facts and 
circumstances in each case. The amount of time during the period of the 
trip which is spent on personal activity compared to the

[[Page 185]]

amount of time spent on activities directly relating to the taxpayer's 
trade or business is an important factor in determining whether the trip 
is primarily personal. If, for example, a taxpayer spends one week while 
at a destination on activities which are directly related to his trade 
or business and subsequently spends an additional five weeks for 
vacation or other personal activities, the trip will be considered 
primarily personal in nature in the absence of a clear showing to the 
contrary.
    (c) Where a taxpayer's wife accompanies him on a business trip, 
expenses attributable to her travel are not deductible unless it can be 
adequately shown that the wife's presence on the trip has a bona fide 
business purpose. The wife's performance of some incidental service does 
not cause her expenses to qualify as deductible business expenses. The 
same rules apply to any other members of the taxpayer's family who 
accompany him on such a trip.
    (d) Expenses paid or incurred by a taxpayer in attending a 
convention or other meeting may constitute an ordinary and necessary 
business expense under section 162 depending upon the facts and 
circumstances of each case. No distinction will be made between self-
employed persons and employees. The fact that an employee uses vacation 
or leave time or that his attendance at the convention is voluntary will 
not necessarily prohibit the allowance of the deduction. The allowance 
of deductions for such expenses will depend upon whether there is a 
sufficient relationship between the taxpayer's trade of business and his 
attendance at the convention or other meeting so that he is benefiting 
or advancing the interests of his trade or business by such attendance. 
If the convention is for political, social or other purposes unrelated 
to the taxpayer's trade or business, the expenses are not deductible.
    (e) Commuters' fares are not considered as business expenses and are 
not deductible.
    (f) For rules with respect to the reporting and substantiation of 
traveling and other business expenses of employees for taxable years 
beginning after December 31, 1957, see Sec. 1.162-17.



Sec. 1.162-3  Materials and supplies.

    (a) In general--(1) Non-incidental materials and supplies. Except as 
provided in paragraphs (d), (e), and (f) of this section, amounts paid 
to acquire or produce materials and supplies (as defined in paragraph 
(c) of this section) are deductible in the taxable year in which the 
materials and supplies are first used in the taxpayer's operations or 
are consumed in the taxpayer's operations.
    (2) Incidental materials and supplies. Amounts paid to acquire or 
produce incidental materials and supplies (as defined in paragraph (c) 
of this section) that are carried on hand and for which no record of 
consumption is kept or of which physical inventories at the beginning 
and end of the taxable year are not taken, are deductible in the taxable 
year in which these amounts are paid, provided taxable income is clearly 
reflected.
    (3) Use or consumption of rotable and temporary spare parts. Except 
as provided in paragraphs (d), (e), and (f) of this section, for 
purposes of paragraph (a)(1) of this section, rotable and temporary 
spare parts (defined under paragraph (c)(2) of this section) are first 
used in the taxpayer's operations or are consumed in the taxpayer's 
operations in the taxable year in which the taxpayer disposes of the 
parts.
    (b) Coordination with other provisions of the Internal Revenue Code. 
Nothing in this section changes the treatment of any amount that is 
specifically provided for under any provision of the Internal Revenue 
Code (Code) or regulations other than section 162(a) or section 212 and 
the regulations under those sections. For example, see Sec. 1.263(a)-3, 
which requires taxpayers to capitalize amounts paid to improve tangible 
property and section 263A and the regulations under section 263A, which 
require taxpayers to capitalize the direct and allocable indirect costs, 
including the cost of materials and supplies, of property produced by 
the taxpayer and property acquired for resale. See also Sec. 1.471-1, 
which requires taxpayers to include in inventory certain materials and 
supplies.

[[Page 186]]

    (c) Definitions--(1) Materials and supplies. For purposes of this 
section, materials and supplies means tangible property that is used or 
consumed in the taxpayer's operations that is not inventory and that--
    (i) Is a component acquired to maintain, repair, or improve a unit 
of tangible property (as determined under Sec. 1.263(a)-3(e)) owned, 
leased, or serviced by the taxpayer and that is not acquired as part of 
any single unit of tangible property;
    (ii) Consists of fuel, lubricants, water, and similar items, 
reasonably expected to be consumed in 12 months or less, beginning when 
used in the taxpayer's operations;
    (iii) Is a unit of property as determined under Sec. 1.263(a)-3(e) 
that has an economic useful life of 12 months or less, beginning when 
the property is used or consumed in the taxpayer's operations;
    (iv) Is a unit of property as determined under Sec. 1.263(a)-3(e) 
that has an acquisition cost or production cost (as determined under 
section 263A) of $200 or less (or other amount as identified in 
published guidance in the Federal Register or in the Internal Revenue 
Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this chapter); or
    (v) Is identified in published guidance in the Federal Register or 
in the Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this 
chapter) as materials and supplies for which treatment is permitted 
under this section.
    (2) Rotable and temporary spare parts. For purposes of this section, 
rotable spare parts are materials and supplies under paragraph (c)(1)(i) 
of this section that are acquired for installation on a unit of 
property, removable from that unit of property, generally repaired or 
improved, and either reinstalled on the same or other property or stored 
for later installation. Temporary spare parts are materials and supplies 
under paragraph (c)(1)(i) of this section that are used temporarily 
until a new or repaired part can be installed and then are removed and 
stored for later installation.
    (3) Standby emergency spare parts. Standby emergency spare parts are 
materials and supplies under paragraph (c)(1)(i) of this section that 
are--
    (i) Acquired when particular machinery or equipment is acquired (or 
later acquired and set aside for use in particular machinery or 
equipment);
    (ii) Set aside for use as replacements to avoid substantial 
operational time loss caused by emergencies due to particular machinery 
or equipment failure;
    (iii) Located at or near the site of the installed related machinery 
or equipment so as to be readily available when needed;
    (iv) Directly related to the particular machinery or piece of 
equipment they serve;
    (v) Normally expensive;
    (vi) Only available on special order and not readily available from 
a vendor or manufacturer;
    (vii) Not subject to normal periodic replacement;
    (viii) Not interchangeable in other machines or equipment;
    (ix) [Reserved]
    (x) Not acquired in quantity (generally only one is on hand for each 
piece of machinery or equipment); and
    (xi) Not repaired and reused.
    (4) Economic useful life--(i) General rule. The economic useful life 
of a unit of property is not necessarily the useful life inherent in the 
property but is the period over which the property may reasonably be 
expected to be useful to the taxpayer or, if the taxpayer is engaged in 
a trade or business or an activity for the production of income, the 
period over which the property may reasonably be expected to be useful 
to the taxpayer in its trade or business or for the production of 
income, as applicable. The factors that must be considered in 
determining this period are provided under Sec. 1.167(a)-1(b).
    (ii) Taxpayers with an applicable financial statement. For taxpayers 
with an applicable financial statement (as defined in paragraph 
(c)(4)(iii) of this section), the economic useful life of a unit of 
property, solely for the purposes of applying the provisions of this 
paragraph (c), is the useful life initially used by the taxpayer for 
purposes of determining depreciation in its applicable financial 
statement, regardless of any salvage value of the property. If a 
taxpayer does not have an applicable financial statement for the taxable

[[Page 187]]

year in which a unit of property was originally acquired or produced, 
the economic useful life of the unit of property must be determined 
under paragraph (c)(4)(i) of this section. Further, if a taxpayer treats 
amounts paid for a unit of property as an expense in its applicable 
financial statement on a basis other than the useful life of the 
property or if a taxpayer does not depreciate the unit of property on 
its applicable financial statement, the economic useful life of the unit 
of property must be determined under paragraph (c)(4)(i) of this 
section. For example, if a taxpayer has a policy of treating as an 
expense on its applicable financial statement amounts paid for a unit of 
property costing less than a certain dollar amount, notwithstanding that 
the unit of property has a useful life of more than one year, the 
economic useful life of the unit of property must be determined under 
paragraph (c)(4)(i) of this section.
    (iii) Definition of applicable financial statement. The taxpayer's 
applicable financial statement is the taxpayer's financial statement 
listed in paragraphs (c)(4)(iii)(A) through (C) of this section that has 
the highest priority (including within paragraph (c)(4)(iii)(B) of this 
section). The financial statements are, in descending priority--
    (A) A financial statement required to be filed with the Securities 
and Exchange Commission (SEC) (the 10-K or the Annual Statement to 
Shareholders);
    (B) A certified audited financial statement that is accompanied by 
the report of an independent certified public accountant (or in the case 
of a foreign entity, by the report of a similarly qualified independent 
professional), that is used for--
    (1) Credit purposes;
    (2) Reporting to shareholders, partners, or similar persons; or
    (3) Any other substantial non-tax purpose; or
    (C) A financial statement (other than a tax return) required to be 
provided to the federal or a state government or any federal or state 
agency (other than the SEC or the Internal Revenue Service).
    (5) Amount paid. For purposes of this section, in the case of a 
taxpayer using an accrual method of accounting, the terms amount paid 
and payment mean a liability incurred (within the meaning of Sec. 1.446-
1(c)(1)(ii)). A liability may not be taken into account under this 
section prior to the taxable year during which the liability is 
incurred.
    (6) Produce. For purposes of this section, produce means construct, 
build, install, manufacture, develop, create, raise, or grow. This 
definition is intended to have the same meaning as the definition used 
for purposes of section 263A(g)(1) and Sec. 1.263A-2(a)(1)(i), except 
that improvements are excluded from the definition in this paragraph 
(c)(6) and are separately defined and addressed in Sec. 1.263(a)-3. 
Amounts paid to produce materials and supplies are subject to section 
263A.
    (d) Election to capitalize and depreciate certain materials and 
supplies--(1) In general. A taxpayer may elect to treat as a capital 
expenditure and to treat as an asset subject to the allowance for 
depreciation the cost of any rotable spare part, temporary spare part, 
or standby emergency spare part as defined in paragraph (c)(2) or (c)(3) 
of this section. Except as specified in paragraph (d)(2) of this 
section, an election made under this paragraph (d) applies to amounts 
paid during the taxable year to acquire or produce any rotable, 
temporary, or standby emergency spare part to which paragraph (a) of 
this section would apply (but for the election under this paragraph 
(d)). Any property for which this election is made shall not be treated 
as a material or a supply.
    (2) Exceptions. A taxpayer may not elect to capitalize and 
depreciate under this paragraph (d) any amount paid to acquire or 
produce a rotable, temporary, or standby emergency spare part defined in 
paragraph (c)(2) or (c)(3) of this section if--
    (i) The rotable, temporary, or standby emergency spare part is 
intended to be used as a component of a unit of property under paragraph 
(c)(1)(iii), (iv), or (v) of this section;
    (ii) The rotable, temporary, or standby emergency spare part is 
intended to be used as a component of a property described in paragraph 
(c)(1)(i) and the taxpayer cannot or has not elected to

[[Page 188]]

capitalize and depreciate that property under this paragraph (d); or
    (iii) The amount is paid to acquire or produce a rotable or 
temporary spare part and the taxpayer uses the optional method of 
accounting for rotable and temporary spare parts under paragraph (e) to 
of this section.
    (3) Manner of electing. A taxpayer makes the election under this 
paragraph (d) by capitalizing the amounts paid to acquire or produce a 
rotable, temporary, or standby emergency spare part in the taxable year 
the amounts are paid and by beginning to depreciate the costs when the 
asset is placed in service by the taxpayer for purposes of determining 
depreciation under the applicable provisions of the Internal Revenue 
Code and the Treasury Regulations. Section 1.263(a)-2 provides for the 
treatment of amounts paid to acquire or produce real or personal 
tangible property. A taxpayer must make the election under this 
paragraph (d) in its timely filed original Federal tax return (including 
extensions) for the taxable year the asset is placed in service by the 
taxpayer for purposes of determining depreciation. Sections 301.9100-1 
through 301.9100-3 of this chapter provide the rules governing 
extensions of the time to make regulatory elections. In the case of an S 
corporation or a partnership, the election is made by the S corporation 
or partnership, and not by the shareholders or partners. A taxpayer may 
make an election for each rotable, temporary, or standby emergency spare 
part that qualifies for the election under this paragraph (d). This 
election does not apply to an asset or a portion thereof placed in 
service and disposed of in the same taxable year. A taxpayer may revoke 
an election made under this paragraph (d) or made under Sec. 1.162-
3T(d), as contained in 26 CFR part 1, revised as of April 1, 2013, only 
by filing a request for a private letter ruling and obtaining the 
Commissioner's consent to revoke the election. The Commissioner may 
grant a request to revoke this election if the taxpayer acted reasonably 
and in good faith and the revocation will not prejudice the interests of 
the Government. See generally Sec. 301.9100-3 of this chapter. The 
manner of electing and revoking the election to capitalize under this 
paragraph (d) or under Sec. 1.162-3T(d), as contained in 26 CFR part 1, 
revised as of April 1, 2013, may be modified through guidance of general 
applicability (see Secs. 601.601(d)(2) and 601.602 of this chapter). An 
election may not be made or revoked through the filing of an application 
for change in accounting method or, before obtaining the Commissioner's 
consent to make the late election or to revoke the election, by filing 
an amended Federal tax return.
    (e) Optional method of accounting for rotable and temporary spare 
parts--(1) In general. This paragraph (e) provides an optional method of 
accounting for rotable and temporary spare parts (the optional method 
for rotable parts). A taxpayer may use the optional method for rotable 
parts, instead of the general rule under paragraph (a)(3) of this 
section, to account for its rotable and temporary spare parts as defined 
in paragraph (c)(2) of this section. A taxpayer that uses the optional 
method for rotable parts must use this method for all of its pools of 
rotable and temporary spare parts used in the same trade or business and 
for which it uses this method for its books and records. If a taxpayer 
uses the optional method for rotable parts for pools of rotable and 
temporary spare parts for which the taxpayer does not use the optional 
method for its books and records, then the taxpayer must use the 
optional method for all its pools in the same trade or business, whether 
rotable or temporary. The optional method for rotable parts is a method 
of accounting under section 446(a). Under the optional method for 
rotable parts, the taxpayer must apply the rules in this paragraph (e) 
to each rotable or temporary spare part (part) upon the taxpayer's 
initial installation, removal, repair, maintenance or improvement, 
reinstallation, and disposal of each part.
    (2) Description of optional method for rotable parts--(i) Initial 
installation. The taxpayer must deduct the amount paid to acquire or 
produce the part in the taxable year that the part is first installed on 
a unit of property for use in the taxpayer's operations.
    (ii) Removal from unit of property. In each taxable year in which 
the part is

[[Page 189]]

removed from a unit of property to which it was initially or 
subsequently installed, the taxpayer must--
    (A) Include in gross income the fair market value of the part; and
    (B) Include in the basis of the part the fair market value of the 
part included in income under paragraph (e)(2)(ii)(A) of this section 
and the amount paid to remove the part from the unit of property.
    (iii) Repair, maintenance, or improvement of part. The taxpayer may 
not currently deduct and must include in the basis of the part any 
amounts paid to maintain, repair, or improve the part in the taxable 
year these amounts are paid.
    (iv) Reinstallation of part. The taxpayer must deduct the amounts 
paid to reinstall the part and those amounts included in the basis of 
the part under paragraphs (e)(2)(ii)(B) and (e)(2)(iii) of this section, 
to the extent that those amounts have not been previously deducted under 
this paragraph (e)(2)(iv), in the taxable year that the part is 
reinstalled on a unit of property.
    (v) Disposal of the part. The taxpayer must deduct the amounts 
included in the basis of the part under paragraphs (e)(2)(ii)(B) and 
(e)(2)(iii) of this section, to the extent that those amounts have not 
been previously deducted under paragraph (e)(2)(iv) of this section, in 
the taxable year in which the part is disposed of by the taxpayer.
    (f) Application of de minimis safe harbor. If a taxpayer elects to 
apply the de minimis safe harbor under Sec. 1.263(a)-1(f) to amounts 
paid for the production or acquisition of tangible property, then the 
taxpayer must apply the de minimis safe harbor to amounts paid for all 
materials and supplies that meet the requirements of Sec. 1.263(a)-1(f), 
except for those materials and supplies that the taxpayer elects to 
capitalize and depreciate under paragraph (d) of this section or for 
which the taxpayer properly uses the optional method of accounting for 
rotable and temporary spare parts under paragraph (e) of this section. 
If the taxpayer properly applies the de minimis safe harbor under 
Sec. 1.263(a)-1(f) to amounts paid for materials and supplies, then 
these amounts are not treated as amounts paid for materials and supplies 
under this section. See Sec. 1.263(a)-1(f)(5) for the time and manner of 
electing the de minimis safe harbor and Sec. 1.263(a)-1(f)(3)(iv) for 
the treatment of safe harbor amounts.
    (g) Sale or disposition of materials and supplies. Upon sale or 
other disposition, materials and supplies as defined in this section are 
not treated as a capital asset under section 1221 or as property used in 
the trade or business under section 1231. Any asset for which the 
taxpayer makes the election to capitalize and depreciate under paragraph 
(d) of this section shall not be treated as a material or supply, and 
the recognition and character of the gain or loss for such depreciable 
asset are determined under other applicable provisions of the Code.
    (h) Examples. The rules of this section are illustrated by the 
following examples, in which it is assumed, unless otherwise stated, 
that the property is not an incidental material or supply, that the 
taxpayer computes its income on a calendar year basis, that the taxpayer 
does not make the election to apply paragraph (d) of this section, or 
use the method of accounting described in paragraph (e) of this section, 
and that the taxpayer has not elected to apply the de minimis safe 
harbor under Sec. 1.263(a)-1(f). The following examples illustrate only 
the application of this section and, unless otherwise stated, do not 
address the treatment under other provisions of the Code (for example, 
section 263A).

    Example 1 Non-rotable components. A owns a fleet of aircraft that it 
operates in its business. In Year 1, A purchases a stock of spare parts, 
which it uses to maintain and repair its aircraft. A keeps a record of 
consumption of these spare parts. In Year 2, A uses the spare parts for 
the repair and maintenance of one of its aircraft. Assume each aircraft 
is a unit of property under Sec. 1.263(a)-3(e) and that spare parts are 
not rotable or temporary spare parts under paragraph (c)(2) of this 
section. Assume these repair and maintenance activities do not improve 
the aircraft under Sec. 1.263(a)-3. These parts are materials and 
supplies under paragraph (c)(1)(i) of this section because they are 
components acquired and used to maintain and repair A's aircraft. Under 
paragraph (a)(1) of this section, the amounts that A paid for the spare 
parts in Year 1 are deductible in Year 2, the taxable year in which the 
spare parts are first used to repair and maintain the aircraft.

[[Page 190]]

    Example 2 Rotable spare parts; disposal method. B operates a fleet 
of specialized vehicles that it uses in its service business. Assume 
that each vehicle is a unit of property under Sec. 1.263(a)-3(e). At the 
time that it acquires a new type of vehicle, B also acquires a 
substantial number of rotable spare parts that it will keep on hand to 
quickly replace similar parts in B's vehicles as those parts break down 
or wear out. These rotable parts are removable from the vehicles and are 
repaired so that they can be reinstalled on the same or similar 
vehicles. In Year 1, B acquires several vehicles and a number of rotable 
spare parts to be used as replacement parts in these vehicles. In Year 
2, B repairs several vehicles by using these rotable spare parts to 
replace worn or damaged parts. In Year 3, B removes these rotable spare 
parts from its vehicles, repairs the parts, and reinstalls them on other 
similar vehicles. In Year 5, B can no longer use the rotable parts it 
acquired in Year 1 and disposes of them as scrap. Assume that B does not 
improve any of the rotable spare parts under Sec. 1.263(a)-3. Under 
paragraph (c)(1)(i) of this section, the rotable spare parts acquired in 
Year 1 are materials and supplies. Under paragraph (a)(3) of this 
section, rotable spare parts are generally used or consumed in the 
taxable year in which the taxpayer disposes of the parts. Therefore, 
under paragraph (a)(1) of this section, the amounts that B paid for the 
rotable spare parts in Year 1 are deductible in Year 5, the taxable year 
in which B disposes of the parts.
    Example 3 Rotable spare parts; application of optional method of 
accounting. C operates a fleet of specialized vehicles that it uses in 
its service business. Assume that each vehicle is a unit of property 
under Sec. 1.263(a)-3(e). At the time that it acquires a new type of 
vehicle, C also acquires a substantial number of rotable spare parts 
that it will keep on hand to replace similar parts in C's vehicles as 
those parts break down or wear out. These rotable parts are removable 
from the vehicles and are repaired so that they can be reinstalled on 
the same or similar vehicles. C uses the optional method of accounting 
for all its rotable and temporary spare parts under paragraph (e) of 
this section. In Year 1, C acquires several vehicles and a number of 
rotable spare parts (the ``Year 1 rotable parts'') to be used as 
replacement parts in these vehicles. In Year 2, C repairs several 
vehicles and uses the Year 1 rotable parts to replace worn or damaged 
parts. In Year 3, C pays amounts to remove these Year 1 rotable parts 
from its vehicles. In Year 4, C pays amounts to maintain, repair, or 
improve the Year 1 rotable parts. In Year 5, C pays amounts to reinstall 
the Year 1 rotable parts on other similar vehicles. In Year 8, C removes 
the Year 1 rotable parts from these vehicles and stores these parts for 
possible later use. In Year 9, C disposes of the Year 1 rotable parts. 
Under paragraph (e) of this section, C must deduct the amounts paid to 
acquire and install the Year 1 rotable parts in Year 2, the taxable year 
in which the rotable parts are first installed by C in C's vehicles. In 
Year 3, when C removes the Year 1 rotable parts from its vehicles, C 
must include in its gross income the fair market value of each part. 
Also, in Year 3, C must include in the basis of each Year 1 rotable part 
the fair market value of the rotable part and the amount paid to remove 
the rotable part from the vehicle. In Year 4, C must include in the 
basis of each Year 1 rotable part the amounts paid to maintain, repair, 
or improve each rotable part. In Year 5, the year that C reinstalls the 
Year 1 rotable parts (as repaired or improved) in other vehicles, C must 
deduct the reinstallation costs and the amounts previously included in 
the basis of each part. In Year 8, the year that C removes the Year 1 
rotable parts from the vehicles, C must include in income the fair 
market value of each rotable part removed. In addition, in Year 8, C 
must include in the basis of each part the fair market value of that 
part and the amount paid to remove each rotable part from the vehicle. 
In Year 9, the year that C disposes of the Year 1 rotable parts, C may 
deduct the amounts remaining in the basis of each rotable part.
    Example 4 Rotable part acquired as part of a single unit of 
property; not material or supply. D operates a fleet of aircraft. In 
Year 1, D acquires a new aircraft, which includes two new aircraft 
engines. The aircraft costs $500,000 and has an economic useful life of 
more than 12 months, beginning when it is placed in service. In Year 5, 
after the aircraft is operated for several years in D's business, D 
removes the engines from the aircraft, repairs or improves the engines, 
and either reinstalls the engines on a similar aircraft or stores the 
engines for later reinstallation. Assume the aircraft purchased in Year 
1, including its two engines, is a unit of property under Sec. 1.263(a)-
3(e). Because the engines were acquired as part of the aircraft, a 
single unit of property, the engines are not materials or supplies under 
paragraph (c)(1)(i) of this section nor rotable or temporary spare parts 
under paragraph (c)(2) of this section. Accordingly, D may not apply the 
rules of this section to the aircraft engines upon the original 
acquisition of the aircraft nor after the removal of the engines from 
the aircraft for use in the same or similar aircraft. Rather, D must 
apply the rules under Secs. 1.263(a)-2 and 1.263(a)-3 to the aircraft, 
including its engines, to determine the treatment of amounts paid to 
acquire, produce, or improve the unit of property.
    Example 5 Consumable property. E operates a fleet of aircraft that 
carries freight for its customers. E has several storage tanks on its 
premises, which hold jet fuel for its aircraft.

[[Page 191]]

Assume that once the jet fuel is placed in E's aircraft, the jet fuel is 
reasonably expected to be consumed within 12 months or less. On December 
31, Year 1, E purchases a two-year supply of jet fuel. In Year 2, E uses 
a portion of the jet fuel purchased on December 31, Year 1, to fuel the 
aircraft used in its business. The jet fuel that E purchased in Year 1 
is a material or supply under paragraph (c)(1)(ii) of this section 
because it is reasonably expected to be consumed within 12 months or 
less from the time it is placed in E's aircraft. Under paragraph (a)(1) 
of this section, E may deduct in Year 2 the amounts paid for the portion 
of jet fuel used in the operation of E's aircraft in Year 2.
    Example 6 Unit of property that costs $200 or less. F operates a 
business that rents out a variety of small individual items to customers 
(rental items). F maintains a supply of rental items on hand. In Year 1, 
F purchases a large quantity of rental items to use in its rental 
business. Assume that each rental item is a unit of property under 
Sec. 1.263(a)-3(e) and costs $200 or less. In Year 2, F begins using all 
the rental items purchased in Year 1 by providing them to customers of 
its rental business. F does not sell or exchange these items on 
established retail markets at any time after the items are used in the 
rental business. The rental items are materials and supplies under 
paragraph (c)(1)(iv) of this section. Under paragraph (a)(1) of this 
section, the amounts that F paid for the rental items in Year 1 are 
deductible in Year 2, the taxable year in which the rental items are 
first used in F's business.
    Example 7 Unit of property that costs $200 or less. G provides 
billing services to its customers. In Year 1, G pays amounts to purchase 
50 scanners to be used by its employees. Assume each scanner is a unit 
of property under Sec. 1.263(a)-3(e) and costs less than $200. In Year 
1, G's employees begin using 35 of the scanners, and F stores the 
remaining 15 scanners for use in a later taxable year. The scanners are 
materials and supplies under paragraph (c)(1)(iv) of this section. Under 
paragraph (a)(1) of this section, the amounts G paid for 35 of the 
scanners are deductible in Year 1, the taxable year in which G first 
uses each of those scanners. The amounts that G paid for each of the 
remaining 15 scanners are deductible in the taxable year in which each 
machine is first used in G's business.
    Example 8 Materials and supplies that cost less than $200; de 
minimis safe harbor. Assume the same facts as in Example 7 except that 
G's scanners qualify for the de minimis safe harbor under Sec. 1.263(a)-
1(f), and G properly elects to apply the de minimis safe harbor under 
Sec. 1.263(a)-1(f) to amounts paid in Year 1. G must apply the de 
minimis safe harbor under Sec. 1.263(a)-1(f) to amounts paid for the 
scanners, rather than treat these amounts as costs of materials and 
supplies under this section. In accordance with Sec. 1.263(a)-
1(f)(3)(iv), G may deduct the amounts paid for all 50 scanners under 
Sec. 1.162-1 in the taxable year the amounts are paid.
    Example 9 Unit of property that costs $200 or less; bulk purchase. H 
provides consulting services to its customers. In Year 1, H pays $500 to 
purchase one box of 10 toner cartridges to use as needed for H's 
printers. Assume each toner cartridge is a unit of property under 
Sec. 1.263(a)-3(e). In Year 1, H's employees place 8 of the toner 
cartridges in printers in H's office, and store the remaining 2 
cartridges for use in a later taxable year. The toner cartridges are 
materials and supplies under paragraph (c)(1)(iv) of this section 
because even though purchased in one box costing more than $200, the 
allocable cost of each unit of property equals $50. Therefore, under 
paragraph (a)(1) of this section, the $400 paid by H for 8 of the 
cartridges is deductible in Year 1, the taxable year in which H first 
uses each of those cartridges. The amounts paid by H for each of the 
remaining 2 cartridges ($50 each) are deductible in the taxable year in 
which each cartridge is first used in H's business.
    Example 10 Materials and supplies used in improvements; coordination 
with Sec. 1.263(a)-3. J owns various machines that are used in its 
business. Assume that each machine is a unit of property under 
Sec. 1.263(a)-3(e). In Year 1, J purchases a supply of spare parts for 
its machines. J acquired the parts to use in the repair or maintenance 
of the machines under Sec. 1.162-4 or in the improvement of the machines 
under Sec. 1.263(a)-3. The spare parts are not rotable or temporary 
spare parts under paragraph (c)(2) of this section. In Year 2, J uses 
all of these spare parts in an activity that improves a machine under 
Sec. 1.263(a)-3. Under paragraph (c)(1)(i) of this section, the spare 
parts purchased by J in Year 1 are materials and supplies. Under 
paragraph (a)(1) of this section, the amounts paid for the spare parts 
are otherwise deductible as materials and supplies in Year 2, the 
taxable year in which J uses those parts. However, because these 
materials and supplies are used to improve J's machine, J is required to 
capitalize the amounts paid for those spare parts under Sec. 1.263(a)-3.
    Example 11 Cost of producing materials and supplies; coordination 
with section 263A. K is a manufacturer that produces liquid waste as 
part of its operations. K determines that its current liquid waste 
disposal process is inadequate. To remedy the problem, in Year 1, K 
constructs a leaching pit to provide a draining area for the liquid 
waste. Assume the leaching pit is a unit of property under 
Sec. 1.263(a)-3(e) and has an economic useful life of 12 months or less, 
starting on the date that K begins to use the leaching pit as a draining 
area. At the end of this period, K's factory will be connected to the 
local sewer

[[Page 192]]

system. In Year 2, K starts using the leaching pit in its operations. 
The amounts paid to construct the leaching pit (including the direct and 
allocable indirect costs of property produced under section 263A) are 
amounts paid for a material or supply under paragraph (c)(1)(iii) of 
this section. However, the amounts paid to construct the leaching pit 
may be subject to capitalization under section 263A if these amounts 
comprise the direct or allocable indirect costs of property produced by 
K.
    Example 12 Costs of acquiring materials and supplies for production 
of property; coordination with section 263A. In Year 1, L purchases 
jigs, dies, molds, and patterns for use in the manufacture of L's 
products. Assume each jig, die, mold, and pattern is a unit of property 
under Sec. 1.263(a)-3(e). The economic useful life of each jig, die, 
mold, and pattern is 12 months or less, beginning when each item is used 
in the manufacturing process. The jigs, dies, molds, and patterns are 
not components acquired to maintain, repair, or improve any of L's 
equipment under paragraph (c)(1)(i) of this section. L begins using the 
jigs, dies, molds and patterns in Year 2 to manufacture its products. 
These items are materials and supplies under paragraph (c)(1)(iii) of 
this section. Under paragraph (a)(1) of this section, the amounts paid 
for the items are otherwise deductible in Year 2, the taxable year in 
which L first uses those items. However, the amounts paid for these 
materials and supplies may be subject to capitalization under section 
263A if these amounts comprise the direct or allocable indirect costs of 
property produced by L.
    Example 13 Election to capitalize and depreciate. M is in the mining 
business. M acquires certain temporary spare parts, which it keeps on 
hand to avoid operational time loss in the event it must make temporary 
repairs to a unit of property that is subject to depreciation. These 
parts are not used to improve property under Sec. 1.263(a)-3(d). These 
temporary spare parts are used until a new or repaired part can be 
installed and then are removed and stored for later temporary 
installation. M does not use the optional method of accounting for 
rotable and temporary spare parts in paragraph (e) of this section for 
any of its rotable or temporary spare parts. The temporary spare parts 
are materials and supplies under paragraph (c)(1)(i) of this section. 
Under paragraphs (a)(1) and (a)(3) of this section, the amounts paid for 
the temporary spare parts are deductible in the taxable year in which 
they are disposed of by M. However, because it is unlikely that the 
temporary spare parts will be disposed of in the near future, M would 
prefer to treat the amounts paid for the spare parts as capital 
expenditures subject to depreciation. M may elect under paragraph (d) of 
this section to treat the cost of each temporary spare part as a capital 
expenditure and as an asset subject to an allowance for depreciation. M 
makes this election by capitalizing the amounts paid for each spare part 
in the taxable year that M acquires the spare parts and by beginning to 
recover the costs of each part on its timely filed Federal tax return 
for the taxable year in which the part is placed in service for purposes 
of determining depreciation under the applicable provisions of the 
Internal Revenue Code and the Treasury Regulations. See Sec. 1.263(a)-
2(g) for the treatment of capital expenditures.
    Example 14 Election to apply de minimis safe harbor. (i) N provides 
consulting services to its customers. In Year 1, N pays amounts to 
purchase 50 laptop computers. Each laptop computer is a unit of property 
under Sec. 1.263(a)-3(e), costs $400, and has an economic useful life of 
more than 12 months. Also in Year 1, N purchases 50 office chairs to be 
used by its employees. Each office chair is a unit of property that 
costs $100. N has an applicable financial statement (as defined in 
Sec. 1.263(a)-1(f)(4)) and N has a written accounting policy at the 
beginning Year 1 to expense amounts paid for units of property costing 
$500 or less. N treats amounts paid for property costing $500 or less as 
an expense on its applicable financial statement in Year 1.
    (ii) The laptop computers are not materials or supplies under 
paragraph (c) of this section. Therefore, the amounts N pays for the 
computers must generally be capitalized under Sec. 1.263(a)-2(d) as 
amounts paid for the acquisition of tangible property. The office chairs 
are materials and supplies under paragraph (c)(1)(iv) of this section. 
Thus, under paragraph (a)(1) of this section, the amounts paid for the 
office chairs are deductible in the taxable year in which they are first 
used in N's business. However, under paragraph (f) of this section, if N 
properly elects to apply the de minimis safe harbor under Sec. 1.263(a)-
1(f) to amounts paid in Year 1, then N must apply the de minimis safe 
harbor under Sec. 1.263(a)-1(f) to amounts paid for the computers and 
the office chairs, rather than treat the office chairs as the costs of 
materials and supplies under Sec. 1.162-3. Under the de minimis safe 
harbor, N may not capitalize the amounts paid for the computers under 
Sec. 1.263(a)-2 nor treat the office chairs as materials and supplies 
under Sec. 1.162-3. Instead, in accordance with Sec. 1.263(a)-
1(f)(3)(iv), under Sec. 1.162-1, N may deduct the amounts paid for the 
computers and the office chairs in the taxable year paid.

    (i) Accounting method changes. Except as otherwise provided in this 
section, a change to comply with this section is a change in method of 
accounting to which the provisions of sections 446 and 481 and the 
accompanying regulations apply. A taxpayer seeking to change to a method 
of accounting permitted in

[[Page 193]]

this section must secure the consent of the Commissioner in accordance 
with Sec. 1.446-1(e) and follow the administrative procedures issued 
under Sec. 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to 
change its accounting method.
    (j) Effective/applicability date--(1) In general. This section 
generally applies to amounts paid or incurred in taxable years beginning 
on or after January 1, 2014. However, a taxpayer may apply paragraph (e) 
of this section (the optional method of accounting for rotable and 
temporary spare parts) to taxable years beginning on or after January 1, 
2014. Except as provided in paragraphs (j)(2) and (j)(3) of this 
section, Sec. 1.162-3 as contained in 26 CFR part 1 edition revised as 
of April 1, 2011, applies to taxable years beginning before January 1, 
2014.
    (2) Early application of this section--(i) In general. Except for 
paragraph (e) of this section, a taxpayer may choose to apply this 
section to amounts paid or incurred in taxable years beginning on or 
after January 1, 2012. A taxpayer may choose to apply paragraph (e) of 
this section (the optional method of accounting for rotable and 
temporary spare parts) to taxable years beginning on or after January 1, 
2012.
    (ii) Transition rule for election to capitalize materials and 
supplies on 2012 and 2013 returns. If under paragraph (j)(2)(i) of this 
section, a taxpayer chooses to make the election to capitalize and 
depreciate certain materials and supplies under paragraph (d) of this 
section for its taxable year beginning on or after January 1, 2012, and 
ending on or before September 19, 2013 (applicable taxable year), and 
the taxpayer did not make the election specified in paragraph (d)(3) of 
this section on its timely filed original Federal tax return for the 
applicable taxable year, the taxpayer must make the election specified 
in paragraph (d)(3) of this section for the applicable taxable year by 
filing an amended Federal tax return for the applicable taxable year on 
or before 180 days from the due date including extensions of the 
taxpayer's Federal tax return for the applicable taxable year, 
notwithstanding that the taxpayer may not have extended the due date.
    (3) Optional application of TD 9564. Except for Sec. 1.162-3T(e), a 
taxpayer may choose to apply Sec. 1.162-3T as contained in TD 9564 (76 
FR 81060) December 27, 2011, to amounts paid or incurred (to acquire or 
produce property) in taxable years beginning on or after January 1, 
2012, and before January 1, 2014. In applying Sec. 1.162-3T(d)(3), as 
contained in 26 CFR part 1, revised as of April 1, 2013, a taxpayer 
makes the election under Sec. 1.162-3T(d) by capitalizing the amounts 
paid to acquire or produce a material or supply in the taxable year the 
amounts are paid and by beginning to depreciate the costs when the asset 
is placed in service by the taxpayer for purposes of determining 
depreciation under the applicable provisions of the Internal Revenue 
Code and the Treasury Regulations. The election under Sec. 1.162-3T(d), 
as contained in 26 CFR part 1, revised as of April 1, 2013, does not 
apply to an asset or a portion thereof placed in service and disposed of 
in the same taxable year. A taxpayer may choose to apply Sec. 1.162-
3T(e) (the optional method of accounting for rotable and temporary spare 
parts) as contained in TD 9564 (76 FR 81060) December 27, 2011, to 
taxable years beginning on or after January 1, 2012, and before January 
1, 2014.

[T.D. 9636, 78 FR 57701, Sept. 19, 2013, as amended at 79 FR 42190, July 
21, 2014]



Sec. 1.162-4  Repairs.

    (a) In general. A taxpayer may deduct amounts paid for repairs and 
maintenance to tangible property if the amounts paid are not otherwise 
required to be capitalized. Optionally, Sec. 1.263(a)-3(n) provides an 
election to capitalize amounts paid for repair and maintenance 
consistent with the taxpayer's books and records.
    (b) Accounting method changes. A change to comply with this section 
is a change in method of accounting to which the provisions of sections 
446 and 481 and the accompanying regulations apply. A taxpayer seeking 
to change to a method of accounting permitted in this section must 
secure the consent of the Commissioner in accordance with Sec. 1.446-
1(e) and follow the administrative procedures issued under Sec. 1.446-

[[Page 194]]

1(e)(3)(ii) for obtaining the Commissioner's consent to change its 
accounting method.
    (c) Effective/applicability date--(1) In general. This section 
applies to taxable years beginning on or after January 1, 2014. Except 
as provided in paragraphs (c)(2) and (c)(3) of this section, Sec. 1.162-
4 as contained in 26 CFR part 1 edition revised as of April 1, 2011, 
applies to taxable years beginning before January 1, 2014.
    (2) Early application of this section. A taxpayer may choose to 
apply this section to taxable years beginning on or after January 1, 
2012.
    (3) Optional application of TD 9564. A taxpayer may choose to apply 
Sec. 1.162-4T as contained in TD 9564 (76 FR 81060), December 27, 2011, 
to taxable years beginning on or after January 1, 2012, and before 
January 1, 2014.

[T.D. 9636, 78 FR 57705, Sept. 19, 2013, as amended at 79 FR 42191, July 
21, 2014]



Sec. 1.162-5  Expenses for education.

    (a) General rule. Expenditures made by an individual for education 
(including research undertaken as part of his educational program) which 
are not expenditures of a type described in paragraph (b) (2) or (3) of 
this section are deductible as ordinary and necessary business expenses 
(even though the education may lead to a degree) if the education--
    (1) Maintains or improves skills required by the individual in his 
employment or other trade or business, or
    (2) Meets the express requirements of the individual's employer, or 
the requirements of applicable law or regulations, imposed as a 
condition to the retention by the individual of an established 
employment relationship, status, or rate of compensation.
    (b) Nondeductible educational expenditures--(1) In general. 
Educational expenditures described in subparagraphs (2) and (3) of this 
paragraph are personal expenditures or constitute an inseparable 
aggregate of personal and capital expenditures and, therefore, are not 
deductible as ordinary and necessary business expenses even though the 
education may maintain or improve skills required by the individual in 
his employment or other trade or business or may meet the express 
requirements of the individual's employer or of applicable law or 
regulations.
    (2) Minimum educational requirements. (i) The first category of 
nondeductible educational expenses within the scope of subparagraph (1) 
of this paragraph are expenditures made by an individual for education 
which is required of him in order to meet the minimum educational 
requirements for qualification in his employment or other trade or 
business. The minimum education necessary to qualify for a position or 
other trade or business must be determined from a consideration of such 
factors as the requirements of the employer, the applicable law and 
regulations, and the standards of the profession, trade, or business 
involved. The fact that an individual is already performing service in 
an employment status does not establish that he has met the minimum 
educational requirements for qualification in that employment. Once an 
individual has met the minimum educational requirements for 
qualification in his employment or other trade or business (as in effect 
when he enters the employment or trade or business), he shall be treated 
as continuing to meet those requirements even though they are changed.
    (ii) The minimum educational requirements for qualification of a 
particular individual in a position in an educational institution is the 
minimum level of education (in terms of aggregate college hours or 
degree) which under the applicable laws or regulations, in effect at the 
time this individual is first employed in such position, is normally 
required of an individual initially being employed in such a position. 
If there are no normal requirements as to the minimum level of education 
required for a position in an educational institution, then an 
individual in such a position shall be considered to have met the 
minimum educational requirements for qualification in that position when 
he becomes a member of the faculty of the educational institution. The 
determination of whether an individual is a member of the faculty of an 
educational institution must be made on the basis of

[[Page 195]]

the particular practices of the institution. However, an individual will 
ordinarily be considered to be a member of the faculty of an institution 
if (a) he has tenure or his years of service are being counted toward 
obtaining tenure; (b) the institution is making contributions to a 
retirement plan (other than Social Security or a similar program) in 
respect of his employment; or (c) he has a vote in faculty affairs.
    (iii) The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. General facts:State X requires a bachelor's degree for 
beginning secondary school teachers which must include 30 credit hours 
of professional educational courses. In addition, in order to retain his 
position, a secondary school teacher must complete a fifth year of 
preparation within 10 years after beginning his employment. If an 
employing school official certifies to the State Department of Education 
that applicants having a bachelor's degree and the required courses in 
professional education cannot be found, he may hire individuals as 
secondary school teachers if they have completed a minimum of 90 
semester hours of college work. However, to be retained in his position, 
such an individual must obtain his bachelor's degree and complete the 
required professional educational courses within 3 years after his 
employment commences. Under these facts, a bachelor's degree, without 
regard to whether it includes 30 credit hours of professional 
educational courses, is considered to be the minimum educational 
requirement for qualification as a secondary school teacher in State X. 
This is the case notwithstanding the number of teachers who are actually 
hired without such a degree. The following are examples of the 
application of these facts in particular situations:
    Situation 1. A, at the time he is employed as a secondary school 
teacher in State X, has a bachelor's degree including 30 credit hours of 
professional educational courses. After his employment, A completes a 
fifth college year of education and, as a result, is issued a standard 
certificate. The fifth college year of education undertaken by A is not 
education required to meet the minimum educational requirements for 
qualification as a secondary school teacher. Accordingly, the 
expenditures for such education are deductible unless the expenditures 
are for education which is part of a program of study being pursued by A 
which will lead to qualifying him in a new trade or business.
    Situation 2. Because of a shortage of applicants meeting the stated 
requirements, B, who has a bachelor's degree, is employed as a secondary 
school teacher in State X even though he has only 20 credit hours of 
professional educational courses. After his employment, B takes an 
additional 10 credit hours of professional educational courses. Since 
these courses do not constitute education required to meet the minimum 
educational requirements for qualification as a secondary school teacher 
which is a bachelor's degree and will not lead to qualifying B in a new 
trade or business, the expenditures for such courses are deductible.
    Situation 3. Because of a shortage of applicants meeting the stated 
requirements, C is employed as a secondary school teacher in State X 
although he has only 90 semester hours of college work toward his 
bachelor's degree. After his employment, C undertakes courses leading to 
a bachelor's degree. These courses (including any courses in 
professional education) constitute education required to meet the 
minimum educational requirements for qualification as a secondary school 
teacher. Accordingly, the expenditures for such education are not 
deductible.
    Situation 4. Subsequent to the employment of A, B, and C, but before 
they have completed a fifth college year of education, State X changes 
its requirements affecting secondary school teachers to provide that 
beginning teachers must have completed 5 college years of preparation. 
In the cases of A, B, and C, a fifth college year of education is not 
considered to be education undertaken to meet the minimum educational 
requirements for qualifications as a secondary school teacher. 
Accordingly, expenditures for a fifth year of college will be deductible 
unless the expenditures are for education which is part of a program 
being pursued by A, B, or C which will lead to qualifying him in a new 
trade or business.
    Example 2. D, who holds a bachelor's degree, obtains temporary 
employment as an instructor at University Y and undertakes graduate 
courses as a candidate for a graduate degree. D may become a faculty 
member only if he obtains a graduate degree and may continue to hold a 
position as instructor only so long as he shows satisfactory progress 
towards obtaining this graduate degree. The graduate courses taken by D 
constitute education required to meet the minimum educational 
requirements for qualification in D's trade or business and, thus, the 
expenditures for such courses are not deductible.
    Example 3. E, who has completed 2 years of a normal 3-year law 
school course leading to a bachelor of laws degree (LL.B.), is hired by 
a law firm to do legal research and perform other functions on a full-
time basis. As a condition to continued employment, E is required to 
obtain an LL.B. and pass the State bar examination. E completes his law 
school education by attending night law school, and he takes a bar 
review course in order to prepare for the State bar examination. The law

[[Page 196]]

courses and bar review course constitute education required to meet the 
minimum educational requirements for qualification in E's trade or 
business and, thus, the expenditures for such courses are not 
deductible.

    (3) Qualification for new trade or business. (i) The second category 
of nondeductible educational expenses within the scope of subparagraph 
(1) of this paragraph are expenditures made by an individual for 
education which is part of a program of study being pursued by him which 
will lead to qualifying him in a new trade or business. In the case of 
an employee, a change of duties does not constitute a new trade or 
business if the new duties involve the same general type of work as is 
involved in the individual's present employment. For this purpose, all 
teaching and related duties shall be considered to involve the same 
general type of work. The following are examples of changes in duties 
which do not constitute new trades or businesses:
    (a) Elementary to secondary school classroom teacher.
    (b) Classroom teacher in one subject (such as mathematics) to 
classroom teacher in another subject (such as science).
    (c) Classroom teacher to guidance counselor.
    (d) Classroom teacher to principal.
    (ii) The application of this subparagraph to individuals other than 
teachers may be illustrated by the following examples:

    Example 1. A, a self-employed individual practicing a profession 
other than law, for example, engineering, accounting, etc., attends law 
school at night and after completing his law school studies receives a 
bachelor of laws degree. The expenditures made by A in attending law 
school are nondeductible because this course of study qualifies him for 
a new trade or business.
    Example 2. Assume the same facts as in example (1) except that A has 
the status of an employee rather than a self-employed individual, and 
that his employer requires him to obtain a bachelor of laws degree. A 
intends to continue practicing his nonlegal profession as an employee of 
such employer. Nevertheless, the expenditures made by A in attending law 
school are not deductible since this course of study qualifies him for a 
new trade or business.
    Example 3. B, a general practitioner of medicine, takes a 2-week 
course reviewing new developments in several specialized fields of 
medicine. B's expenses for the course are deductible because the course 
maintains or improves skills required by him in his trade or business 
and does not qualify him for a new trade or business.
    Example 4. C, while engaged in the private practice of psychiatry, 
undertakes a program of study and training at an accredited 
psychoanalytic institute which will lead to qualifying him to practice 
psychoanalysis. C's expenditures for such study and training are 
deductible because the study and training maintains or improves skills 
required by him in his trade or business and does not qualify him for a 
new trade or business.

    (c) Deductible educational expenditures--(1) Maintaining or 
improving skills. The deduction under the category of expenditures for 
education which maintains or improves skills required by the individual 
in his employment or other trade or business includes refresher courses 
or courses dealing with current developments as well as academic or 
vocational courses provided the expenditures for the courses are not 
within either category of nondeductible expenditures described in 
paragraph (b) (2) or (3) of this section.
    (2) Meeting requirements of employer. An individual is considered to 
have undertaken education in order to meet the express requirements of 
his employer, or the requirements of applicable law or regulations, 
imposed as a condition to the retention by the taxpayer of his 
established employment relationship, status, or rate of compensation 
only if such requirements are imposed for a bona fide business purpose 
of the individual's employer. Only the minimum education necessary to 
the retention by the individual of his established employment 
relationship, status, or rate of compensation may be considered as 
undertaken to meet the express requirements of the taxpayer's employer. 
However, education in excess of such minimum education may qualify as 
education undertaken in order to maintain or improve the skills required 
by the taxpayer in his employment or other trade or business (see 
subparagraph (1) of this paragraph). In no event, however, is a 
deduction allowable for expenditures for education which, even though 
for education required by the employer or applicable law or regulations, 
are within one of

[[Page 197]]

the categories of nondeductible expenditures described in paragraph (b) 
(2) and (3) of this section.
    (d) Travel as a form of education. Subject to the provisions of 
paragraph (b) and (e) of this section, expenditures for travel 
(including travel while on sabbatical leave) as a form of education are 
deductible only to the extent such expenditures are attributable to a 
period of travel that is directly related to the duties of the 
individual in his employment or other trade or business. For this 
purpose, a period of travel shall be considered directly related to the 
duties of an individual in his employment or other trade or business 
only if the major portion of the activities during such period is of a 
nature which directly maintains or improves skills required by the 
individual in such employment or other trade or business. The approval 
of a travel program by an employer or the fact that travel is accepted 
by an employer in the fulfillment of its requirements for retention of 
rate of compensation, status or employment, is not determinative that 
the required relationship exists between the travel involved and the 
duties of the individual in his particular position.
    (e) Travel away from home. (1) If an individual travels away from 
home primarily to obtain education the expenses of which are deductible 
under this section, his expenditures for travel, meals, and lodging 
while away from home are deductible. However, if as an incident of such 
trip the individual engages in some personal activity such as 
sightseeing, social visiting, or entertaining, or other recreation, the 
portion of the expenses attributable to such personal activity 
constitutes nondeductible personal or living expenses and is not 
allowable as a deduction. If the individual's travel away from home is 
primarily personal, the individual's expenditures for travel, meals and 
lodging (other than meals and lodging during the time spent in 
participating in deductible education pursuits) are not deductible. 
Whether a particular trip is primarily person or primarily to obtain 
education the expenses of which are deductible under this section 
depends upon all the facts and circumstances of each case. An important 
factor to be taken into consideration in making the determination is the 
relative amount of time devoted to personal activity as compared with 
the time devoted to educational pursuits. The rules set forth in this 
paragraph are subject to the provisions of section 162(a)(2), relating 
to deductibility of certain traveling expenses, and section 274 (c) and 
(d), relating to allocation of certain foreign travel expenses and 
substantiation required, respectively, and the regulations thereunder.
    (2) Examples. The application of this subsection may be illustrated 
by the following examples:

    Example 1. A, a self-employed tax practitioner, decides to take a 1-
week course in new developments in taxation, which is offered in City X, 
500 miles away from his home. His primary purpose in going to X is to 
take the course, but he also takes a side trip to City Y (50 miles from 
X) for 1 day, takes a sightseeing trip while in X, and entertains some 
personal friends. A's transportation expenses to City X and return to 
his home are deductible but his transportation expenses to City Y are 
not deductible. A's expenses for meals and lodging while away from home 
will be allocated between his educational pursuits and his personal 
activities. Those expenses which are entirely personal, such as 
sightseeing and entertaining friends, are not deductible to any extent.
    Example 2. The facts are the same as in example (1) except that A's 
primary purpose in going to City X is to take a vacation. This purpose 
is indicated by several factors, one of which is the fact that he spends 
only 1 week attending the tax course and devotes 5 weeks entirely to 
personal activities. None of A's transportation expenses are deductible 
and his expenses for meals and lodging while away from home are not 
deductible to the extent attributable to personal activities. His 
expenses for meals and lodging allocable to the week attending the tax 
course are, however, deductible.
    Example 3. B, a high school mathematics teacher in New York City, in 
the summertime travels to a university in California in order to take a 
mathematics course the expense of which is deductible under this 
section. B pursues only one-fourth of a full course of study and the 
remainder of her time is devoted to personal activities the expense of 
which is not deductible. Absent a showing by B of a substantial 
nonpersonal reason for taking the course in the university in 
California, the trip is considered taken primarily for personal reasons 
and the cost of traveling from New York City to California and return 
would not be deductible. However, one-fourth of the cost of B's

[[Page 198]]

meals and lodging while attending the university in California may be 
considered properly allocable to deductible educational pursuits and, 
therefore, is deductible.

[T.D. 6918, 32 FR 6679, May 2, 1967]



Sec. 1.162-7  Compensation for personal services.

    (a) There may be included among the ordinary and necessary expenses 
paid or incurred in carrying on any trade or business a reasonable 
allowance for salaries or other compensation for personal services 
actually rendered. The test of deductibility in the case of compensation 
payments is whether they are reasonable and are in fact payments purely 
for services.
    (b) The test set forth in paragraph (a) of this section and its 
practical application may be further stated and illustrated as follows:
    (1) Any amount paid in the form of compensation, but not in fact as 
the purchase price of services, is not deductible. An ostensible salary 
paid by a corporation may be a distribution of a dividend on stock. This 
is likely to occur in the case of a corporation having few shareholders, 
practically all of whom draw salaries. If in such a case the salaries 
are in excess of those ordinarily paid for similar services and the 
excessive payments correspond or bear a close relationship to the 
stockholdings of the officers or employees, it would seem likely that 
the salaries are not paid wholly for services rendered, but that the 
excessive payments are a distribution of earnings upon the stock. An 
ostensible salary may be in part payment for property. This may occur, 
for example, where a partnership sells out to a corporation, the former 
partners agreeing to continue in the service of the corporation. In such 
a case it may be found that the salaries of the former partners are not 
merely for services, but in part constitute payment for the transfer of 
their business.
    (2) The form or method of fixing compensation is not decisive as to 
deductibility. While any form of contingent compensation invites 
scrutiny as a possible distribution of earnings of the enterprise, it 
does not follow that payments on a contingent basis are to be treated 
fundamentally on any basis different from that applying to compensation 
at a flat rate. Generally speaking, if contingent compensation is paid 
pursuant to a free bargain between the employer and the individual made 
before the services are rendered, not influenced by any consideration on 
the part of the employer other than that of securing on fair and 
advantageous terms the services of the individual, it should be allowed 
as a deduction even though in the actual working out of the contract it 
may prove to be greater than the amount which would ordinarily be paid.
    (3) In any event the allowance for the compensation paid may not 
exceed what is reasonable under all the circumstances. It is, in 
general, just to assume that reasonable and true compensation is only 
such amount as would ordinarily be paid for like services by like 
enterprises under like circumstances. The circumstances to be taken into 
consideration are those existing at the date when the contract for 
services was made, not those existing at the date when the contract is 
questioned.
    (4) For disallowance of deduction in the case of certain transfers 
of stock pursuant to employees stock options, see section 421 and the 
regulations thereunder.



Sec. 1.162-8  Treatment of excessive compensation.

    The income tax liability of the recipient in respect of an amount 
ostensibly paid to him as compensation, but not allowed to be deducted 
as such by the payor, will depend upon the circumstances of each case. 
Thus, in the case of excessive payments by corporations, if such 
payments correspond or bear a close relationship to stockholdings, and 
are found to be a distribution of earnings or profits, the excessive 
payments will be treated as a dividend. If such payments constitute 
payment for property, they should be treated by the payor as a capital 
expenditure and by the recipient as part of the purchase price. In the 
absence of evidence to justify other treatment, excessive payments for 
salaries or other compensation for personal services will be included in 
gross income of the recipient.

[[Page 199]]



Sec. 1.162-9  Bonuses to employees.

    Bonuses to employees will constitute allowable deductions from gross 
income when such payments are made in good faith and as additional 
compensation for the services actually rendered by the employees, 
provided such payments, when added to the stipulated salaries, do not 
exceed a reasonable compensation for the services rendered. It is 
immaterial whether such bonuses are paid in cash or in kind or partly in 
cash and partly in kind. Donations made to employees and others, which 
do not have in them the element of compensation or which are in excess 
of reasonable compensation for services, are not deductible from gross 
income.



Sec. 1.162-10  Certain employee benefits.

    (a) In general. Amounts paid or accrued by a taxpayer on account of 
injuries received by employees and lump sum amounts paid or accrued as 
compensation for injuries, are proper deductions as ordinary and 
necessary expenses. Such deductions are limited to the amount not 
compensated for by insurance or otherwise. Amounts paid or accrued 
within the taxable year for dismissal wages, unemployment benefits, 
guaranteed annual wages, vacations, or a sickness, accident, 
hospitalization, medical expense, recreational, welfare, or similar 
benefit plan, are deductible under section 162(a) if they are ordinary 
and necessary expenses of the trade or business. However, except as 
provided in paragraph (b) of this section, such amounts shall not be 
deductible under section 162(a) if, under any circumstances, they may be 
used to provide benefits under a stock bonus, pension, annuity, profit-
sharing, or other deferred compensation plan of the type referred to in 
section 404(a). In such an event, the extent to which these amounts are 
deductible from gross income shall be governed by the provisions of 
section 404 and the regulations issued thereunder.
    (b) Certain negotiated plans. (1) Subject to the limitations set 
forth in subparagraphs (2) and (3) of this paragraph, contributions paid 
by an employer under a plan under which such contributions are held in a 
welfare trust for the purpose of paying (either from principal or income 
or both) for the benefit of employees, their families, and dependents, 
at least medical or hospital care, and pensions on retirement or death 
of employees, are deductible when paid as business expenses under 
section 162(a).
    (2) For the purpose of subparagraph (1) of this paragraph, the word 
``plan'' means any plan established prior to January 1, 1954, as a 
result of an agreement between employee representatives and the 
Government of the United States, during a period of Government 
operation, under seizure powers, of a major part of the productive 
facilities of the industry in which the employer claiming the deduction 
is engaged. The phrase ``plan established prior to January 1, 1954, as a 
result of an agreement'' is intended primarily to cover a trust 
established under the terms of such an agreement. It also includes a 
trust established under a plan of an employer, or group of employers, 
who, by reason of producing the same commodity, are in competition with 
the employers whose facilities were seized and who would therefore be 
expected to establish such a trust as a reasonable measure to maintain a 
sound position in the labor market producing the commodity. For example, 
if a trust was established under such an agreement in the bituminous 
coal industry, a similar trust established in the anthracite coal 
industry within a reasonable time, but before January 1, 1954, would 
qualify under subparagraph (1) of this paragraph.
    (3) If any trust described in subparagraph (2) of this paragraph 
becomes qualified for exemption from tax under the provisions of section 
501(a), the deductibility of contributions by an employer to such trust 
on or after any date of such qualification shall no longer be governed 
by the provisions of section 162, even though the trust may later lose 
its exemption from tax under section 501(a).
    (c) Other plans providing deferred compensation. For rules relating 
to the deduction of amounts paid to or under a stock bonus, pension, 
annuity, or profit-sharing plan or amounts paid or accrued under any 
other plan deferring

[[Page 200]]

the receipt of compensation, see section 404 and the regulations 
thereunder.



Sec. 1.162-10T  Questions and answers relating to the deduction of
employee benefits under the Tax Reform Act of 1984; certain limits 
on amounts deductible 
          (temporary).

    Q-1: How does the amendment of section 404(b) by the Tax Reform Act 
of 1984 affect the deduction of employee benefits under section 162 of 
the Internal Revenue Code?
    A-1: As amended by the Tax Reform Act of 1984, section 404(b) 
clarifies that section 404(a) and (d) (in the case of employees and 
nonemployees, respectively) shall govern the deduction of contributions 
paid or compensation paid or incurred under a plan, or method or 
arrangement, deferring the receipt of compensation or providing for 
deferred benefits. Section 404(a) and (d) requires that such a 
contribution or compensation be paid or incurred for purposes of section 
162 or 212 and satisfy the requirements for deductibility under either 
of these sections. However, notwithstanding the above, section 404 does 
not apply to contributions paid or accrued with respect to a ``welfare 
benefit fund'' (as defined in section 419(e)) after July 18, 1984, in 
taxable years of employers (and payors) ending after that date.
    Also, section 463 shall govern the deduction of vacation pay by a 
taxpayer that has elected the application of such section. Section 
404(b), as amended, generally applies to contributions paid and 
compensation paid or incurred after July 18, 1984, in taxable years of 
employers (and payors) ending after that date. See Q&A-3 of 
Sec. 1.404(b)-1T. For rules relating to the deduction of contributions 
attributable to the provision of deferred benefits, see section 404 (a), 
(b) and (d) and Sec. 1.404(a)-1T, Sec. 1.404(b)-1T and Sec. 1.404(d)-1T. 
For rules relating to the deduction of contributions paid or accrued 
with respect to a welfare benefit fund, see section 419, Sec. 1.419-1T 
and Sec. 1.419A-2T. For rules relating to the deduction of vacation pay 
for which an election is made under section 463, see Sec. 301.9100-16T 
of this chapter and Sec. 1.463-1T.
    Q-2: How does the enactment of section 419 by the Tax Reform Act of 
1984 affect the deduction of employee benefits under section 162?
    A-2: As enacted by the Tax Reform Act of 1984, section 419 shall 
govern the deduction of contributions paid or accrued by an employer (or 
a person receiving services under section 419(g)) with respect to a 
``welfare benefit fund'' (within the meaning of section 419(e)) after 
December 31, 1985, in taxable years of the employer (or person receiving 
the services) ending after that date. Section 419(a) requires that such 
a contribution be paid or accrued for purposes of section 162 or 212 and 
satisfy the requirements for deductibility under either of those 
sections. Generally, subject to a binding contract exception (as 
described in section 511(e)(5) of the Tax Reform Act of 1984), section 
419 shall also govern the deduction of the contribution of a facility 
(or other contribution used to acquire or improve a facility) to a 
welfare benefit fund after June 22, 1984. See Q&A-11 of Sec. 1.419-1T. 
In the case of a welfare benefit fund maintained pursuant to a 
collective bargaining agreement, section 419 applies to the extent 
provided under the special effective date rule described in Q&A-2 of 
Sec. 1.419-1T and the special rules of Sec. 1.419A-2T. For rules 
relating to the deduction of contributions paid or accrued with respect 
to a welfare benefit fund, see section 419 and Sec. 1.419-1T.

[T.D. 8073, 51 FR 4319, Feb. 4, 1986, as amended by T.D. 8435, 57 FR 
43896, Sept. 23, 1992]



Sec. 1.162-11  Rentals.

    (a) Acquisition of a leasehold. If a leasehold is acquired for 
business purposes for a specified sum, the purchaser may take as a 
deduction in his return an aliquot part of such sum each year, based on 
the number of years the lease has to run. Taxes paid by a tenant to or 
for a landlord for business property are additional rent and constitute 
a deductible item to the tenant and taxable income to the landlord, the 
amount of the tax being deductible by the latter. For disallowance of 
deduction for income taxes paid by a lessee corporation pursuant to a 
lease arrangement with the lessor corporation, see section 110 and the 
regulations thereunder. See section 178 and the regulations thereunder 
for rules governing the effect to

[[Page 201]]

be given renewal options in amortizing the costs incurred after July 28, 
1958 of acquiring a lease. See Sec. 1.197-2 for rules governing the 
amortization of costs to acquire limited interests in section 197 
intangibles.
    (b) Improvements by lessee on lessor's property--(1) In general. The 
cost to a taxpayer of erecting buildings or making permanent 
improvements on property of which the taxpayer is a lessee is a capital 
expenditure. For the rules regarding improvements to leased property 
when the improvements are tangible property, see Sec. 1.263(a)-3(f). For 
the rules regarding depreciation or amortization deductions for 
leasehold improvements, see Sec. 1.167(a)-4.
    (2) Effective/applicability date--(i) In general. This paragraph (b) 
applies to taxable years beginning on or after January 1, 2014. Except 
as provided in paragraphs (b)(2)(ii) and (b)(2)(iii) of this section, 
Sec. 1.162-11(b) as contained in 26 CFR part 1 edition revised as of 
April 1, 2011, applies to taxable years beginning before January 1, 
2014.
    (ii) Early application of this paragraph. A taxpayer may choose to 
apply this paragraph (b) to taxable years beginning on or after January 
1, 2012.
    (iii) Optional application of TD 9564. A taxpayer may choose to 
apply Sec. 1.162-11T(b) as contained in TD 9564 (76 FR 81060) December 
27, 2011, to taxable years beginning on or after January 1, 2012, and 
before January 1, 2014.

[T.D. 6520, 25 FR 13692, Dec. 24, 1960, as amended by T.D. 8865, 65 FR 
3825, Jan. 25, 2000; T.D. 9564, 76 FR 81084, Dec. 27, 2011; T.D. 9636, 
78 FR 57706, Sept. 19, 2013 ]



Sec. 1.162-12  Expenses of farmers.

    (a) Farms engaged in for profit. A farmer who operates a farm for 
profit is entitled to deduct from gross income as necessary expenses all 
amounts actually expended in the carrying on of the business of farming. 
The cost of ordinary tools of short life or small cost, such as hand 
tools, including shovels, rakes, etc., may be deducted. The purchase of 
feed and other costs connected with raising livestock may be treated as 
expense deductions insofar as such costs represent actual outlay, but 
not including the value of farm produce grown upon the farm or the labor 
of the taxpayer. For rules regarding the capitalization of expenses of 
producing property in the trade or business of farming, see section 263A 
and the regulations thereunder. For taxable years beginning after July 
12, 1972, where a farmer is engaged in producing crops and the process 
of gathering and disposal of such crops is not completed within the 
taxable year in which such crops were planted, expenses deducted may, 
with the consent of the Commissioner (see section 446 and the 
regulations thereunder), be determined upon the crop method, and such 
deductions must be taken in the taxable year in which the gross income 
from the crop has been realized. For taxable years beginning on or 
before July 12, 1972, where a farmer is engaged in producing crops which 
take more than a year from the time of planting to the process of 
gathering and disposal, expenses deducted may, with the consent of the 
Commissioner (see section 446 and the regulations thereunder), be 
determined upon the crop method, and such deductions must be taken in 
the taxable year in which the gross income from the crop has been 
realized. If a farmer does not compute income upon the crop method, the 
cost of seeds and young plants which are purchased for further 
development and cultivation prior to sale in later years may be deducted 
as an expense for the year of purchase, provided the farmer follows a 
consistent practice of deducting such costs as an expense from year to 
year. The preceding sentence does not apply to the cost of seeds and 
young plants connected with the planting of timber (see section 611 and 
the regulations thereunder). For rules regarding the capitalization of 
expenses of producing property in the trade or business of farming, see 
section 263A of the Internal Revenue Code and Sec. 1.263A-4. The cost of 
farm machinery, equipment, and farm buildings represents a capital 
investment and is not an allowable deduction as an item of expense. 
Amounts expended in the development of farms, orchards, and ranches 
prior to the time when the productive state is reached may, at the 
election of the taxpayer, be regarded as investments of capital. For the 
treatment of soil and

[[Page 202]]

water conservation expenditures as expenses which are not chargeable to 
capital account, see section 175 and the regulations thereunder. For 
taxable years beginning after December 31, 1959, in the case of 
expenditures paid or incurred by farmers for fertilizer, lime, etc., see 
section 180 and the regulations thereunder. Amounts expended in 
purchasing work, breeding, dairy, or sporting animals are regarded as 
investments of capital, and shall be depreciated unless such animals are 
included in an inventory in accordance with Sec. 1.61-4. The purchase 
price of an automobile, even when wholly used in carrying on farming 
operations, is not deductible, but is regarded as an investment of 
capital. The cost of gasoline, repairs, and upkeep of an automobile if 
used wholly in the business of farming is deductible as an expense; if 
used partly for business purposes and partly for the pleasure or 
convenience of the taxpayer or his family, such cost may be apportioned 
according to the extent of the use for purposes of business and pleasure 
or convenience, and only the proportion of such cost justly attributable 
to business purposes is deductible as a necessary expense.
    (b) Farms not engaged in for profit; taxable years beginning before 
January 1, 1970--(1) In general. If a farm is operated for recreation or 
pleasure and not on a commercial basis, and if the expenses incurred in 
connection with the farm are in excess of the receipts therefrom, the 
entire receipts from the sale of farm products may be ignored in 
rendering a return of income, and the expenses incurred, being regarded 
as personal expenses, will not constitute allowable deductions.
    (2) Effective date. The provisions of this paragraph shall apply 
with respect to taxable years beginning before January 1, 1970.
    (3) Cross reference. For provisions relating to activities not 
engaged in for profit, applicable to taxable years beginning after 
December 31, 1969, see section 183 and the regulations thereunder.

[T.D. 7198, 37 FR 13679, July 13, 1972, as amended by T.D. 8729, 62 FR 
44546, Aug. 22, 1997; T.D. 8897, 65 FR 50643, Aug. 21, 2000]



Sec. 1.162-13  Depositors' guaranty fund.

    Banking corporations which pursuant to the laws of the State in 
which they are doing business are required to set apart, keep, and 
maintain in their banks the amount levied and assessed against them by 
the State authorities as a ``Depositors' guaranty fund,'' may deduct 
from their gross income the amount so set apart each year to this fund 
provided that such fund, when set aside and carried to the credit of the 
State banking board or duly authorized State officer, ceases to be an 
asset of the bank and may be withdrawn in whole or in part upon demand 
by such board or State officer to meet the needs of these officers in 
reimbursing depositors in insolvent banks, and provided further that no 
portion of the amount thus set aside and credited is returnable under 
the laws of the State to the assets of the banking corporation. If, 
however, such amount is simply set up on the books of the bank as a 
reserve to meet a contingent liability and remains an asset of the bank, 
it will not be deductible except as it is actually paid out as required 
by law and upon demand of the proper State officers.



Sec. 1.162-14  Expenditures for advertising or promotion of good will.

    A corporation which has, for the purpose of computing its excess 
profits tax credit under Subchapter E, Chapter 2, or Subchapter D, 
Chapter 1 of the Internal Revenue Code of 1939, elected under section 
733 or section 451 (applicable to the excess profits tax imposed by 
Subchapter E of Chapter 2, and Subchapter D of Chapter 1, respectively) 
to charge to capital account for taxable years in its base period 
expenditures for advertising or the promotion of good will which may be 
regarded as capital investments, may not deduct similar expenditures for 
the taxable year. See section 263(b). Such a taxpayer has the burden of 
proving that expenditures for advertising or the promotion of good will 
which it seeks to deduct in the taxable year may not be regarded as 
capital investments under the provisions of the regulations prescribed 
under section 733 or section 451 of the Internal Revenue Code of 1939.

[[Page 203]]

See 26 CFR, 1938 ed., 35.733-2 (Regulations 112) and 26 CFR (1939) 
40.451-2 (Regulations 130). For the disallowance of deductions for the 
cost of advertising in programs of certain conventions of political 
parties, or in publications part of the proceeds of which directly or 
indirectly inures (or is intended to inure) to or for the use of a 
political party or political candidate, see Sec. 1.276-1.

[T.D. 6996, 34 FR 835, Jan. 18, 1969]



Sec. 1.162-15  Contributions, dues, etc.

    (a) Contributions to organizations described in section 170--(1) In 
general. No deduction is allowable under section 162(a) for a 
contribution or gift by an individual or a corporation if any part 
thereof is deductible under section 170. For example, if a taxpayer 
makes a contribution of $5,000 and only $4,000 of this amount is 
deductible under section 170(a) (whether because of the percentage 
limitation under either section 170(b) (1) or (2), the requirement as to 
time of payment, or both) no deduction is allowable under section 162(a) 
for the remaining $1,000.
    (2) Scope of limitations. The limitations provided in section 162(b) 
and this paragraph apply only to payments which are in fact 
contributions or gifts to organizations described in section 170. For 
example, payments by a transit company to a local hospital (which is a 
charitable organization within the meaning of section 170) in 
consideration of a binding obligation on the part of the hospital to 
provide hospital services and facilities for the company's employees are 
not contributions or gifts within the meaning of section 170 and may be 
deductible under section 162(a) if the requirements of section 162(a) 
are otherwise satisfied.
    (b) Other contributions. Donations to organizations other than those 
described in section 170 which bear a direct relationship to the 
taxpayer's business and are made with a reasonable expectation of a 
financial return commensurate with the amount of the donation may 
constitute allowable deductions as business expenses, provided the 
donation is not made for a purpose for which a deduction is not 
allowable by reason of the provisions of paragraph (b)(1)(i) or (c) of 
Sec. 1.162-20. For example, a transit company may donate a sum of money 
to an organization (of a class not referred to in section 170) intending 
to hold a convention in the city in which it operates, with a reasonable 
expectation that the holding of such convention will augment its income 
through a greater number of people using its transportation facilities.
    (c) Dues. Dues and other payments to an organization, such as a 
labor union or a trade association, which otherwise meet the 
requirements of the regulations under section 162, are deductible in 
full. For limitations on the deductibility of dues and other payments, 
see paragraph (b) and (c) of Sec. 1.162-20.
    (d) Cross reference. For provisions dealing with expenditures for 
institutional or ``good will'' advertising, see Sec. 1.162-20.

[T.D. 6819, 30 FR 5580, Apr. 20, 1965]



Sec. 1.162-16  Cross reference.

    For special rules relating to expenses in connection with 
subdividing real property for sale, see section 1237 and the regulations 
thereunder.



Sec. 1.162-17  Reporting and substantiation of certain business
expenses of employees.

    (a) Introductory. The purpose of the regulations in this section is 
to provide rules for the reporting of information on income tax returns 
by taxpayers who pay or incur ordinary and necessary business expenses 
in connection with the performance of services as an employee and to 
furnish guidance as to the type of records which will be useful in 
compiling such information and in its substantiation, if required. The 
rules prescribed in this section do not apply to expenses paid or 
incurred for incidentals, such as office supplies for the employer or 
local transportation in connection with an errand. Employees incurring 
such incidental expenses are not required to provide substantiation for 
such amounts. The term ``ordinary and necessary business expenses'' 
means only those expenses which are ordinary and necessary in the 
conduct of the taxpayer's business and are directly attributable to such 
business. The term does not include nondeductible personal, living or 
family expenses.

[[Page 204]]

    (b) Expenses for which the employee is required to account to his 
employer--(1) Reimbursements equal to expenses. The employee need not 
report on his tax return (either itemized or in total amount) expenses 
for travel, transportation, entertainment, and similar purposes paid or 
incurred by him solely for the benefit of his employer for which he is 
required to account and does account to his employer and which are 
charged directly or indirectly to the employer (for example, through 
credit cards) or for which the employee is paid through advances, 
reimbursements, or otherwise, provided the total amount of such 
advances, reimbursements, and charges is equal to such expenses. In such 
a case the taxpayer need only state in his return that the total of 
amounts charged directly or indirectly to his employer through credit 
cards or otherwise and received from the employer as advances or 
reimbursements did not exceed the ordinary and necessary business 
expenses paid or incurred by the employee.
    (2) Reimbursements in excess of expenses. In case the total of 
amounts charged directly or indirectly to the employer and received from 
the employer as advances, reimbursements, or otherwise, exceeds the 
ordinary and necessary business expenses paid or incurred by the 
employee and the employee is required to and does account to his 
employer for such expenses, the taxpayer must include such excess in 
income and state on his return that he has done so.
    (3) Expenses in excess of reimbursements. If the employee's ordinary 
and necessary business expenses exceed the total of the amounts charged 
directly or indirectly to the employer and received from the employer as 
advances, reimbursements, or otherwise, and the employee is required to 
and does account to his employer for such expenses, the taxpayer may 
make the statement in his return required by subparagraph (1) of this 
paragraph unless he wishes to claim a deduction for such excess. If, 
however, he wishes to secure a deduction for such excess, he must submit 
a statement showing the following information as part of his tax return:
    (i) The total of any charges paid or borne by the employer and of 
any other amounts received from the employer for payment of expenses 
whether by means of advances, reimbursements or otherwise; and
    (ii) The nature of his occupation, the number of days away from home 
on business, and the total amount of ordinary and necessary business 
expenses paid or incurred by him (including those charged directly or 
indirectly to the employer through credit cards or otherwise) broken 
down into such broad categories as transportation, meals and lodging 
while away from home overnight, entertainment expenses, and other 
business expenses.
    (4) To ``account'' to his employer as used in this section means to 
submit an expense account or other required written statement to the 
employer showing the business nature and the amount of all the 
employee's expenses (including those charged directly or indirectly to 
the employer through credit cards or otherwise) broken down into such 
broad categories as transportation, meals and lodging while away from 
home overnight, entertainment expenses, and other business expenses. For 
this purpose, the Commissioner in his discretion may approve reasonable 
business practices under which mileage, per diem in lieu of subsistence, 
and similar allowances providing for ordinary and necessary business 
expenses in accordance with a fixed scale may be regarded as equivalent 
to an accounting to the employer.
    (c) Expenses for which the employee is not required to account to 
his employer. If the employee is not required to account to his employer 
for his ordinary and necessary business expenses, e.g., travel, 
transportation, entertainment, and similar items, or, though required, 
fails to account for such expenses, he must submit, as a part of his tax 
return, a statement showing the following information:
    (1) The total of all amounts received as advances or reimbursements 
from his employer in connection with the ordinary and necessary business 
expenses of the employee, including amounts charged directly or 
indirectly to the employer through credit cards or otherwise; and

[[Page 205]]

    (2) The nature of his occupation, the number of days away from home 
on business, and the total amount of ordinary and necessary business 
expenses paid or incurred by him (including those charged directly or 
indirectly to the employer through credit cards or otherwise) broken 
down into such broad categories as transportation, meals and lodging 
while away from home overnight, entertainment expenses, and other 
business expenses.
    (d) Substantiation of items of expense. (1) Although the 
Commissioner may require any taxpayer to substantiate such information 
concerning expense accounts as may appear to be pertinent in determining 
tax liability, taxpayers ordinarily will not be called upon to 
substantiate expense account information except those in the following 
categories:
    (i) A taxpayer who is not required to account to his employer, or 
who does not account;
    (ii) A taxpayer whose expenses exceed the total of amounts charged 
to his employer and amounts received through advances, reimbursements or 
otherwise and who claims a deduction on his return for such excess;
    (iii) A taxpayer who is related to his employer within the meaning 
of section 267(b); and
    (iv) Other taxpayers in cases where it is determined that the 
accounting procedures used by the employer for the reporting and 
substantiation of expenses by employees are not adequate.
    (2) The Code contemplates that taxpayers keep such records as will 
be sufficient to enable the Commissioner to correctly determine income 
tax liability. Accordingly, it is to the advantage of taxpayers who may 
be called upon to substantiate expense account information to maintain 
as adequate and detailed records of travel, transportation, 
entertainment, and similar business expenses as practical since the 
burden of proof is upon the taxpayer to show that such expenses were not 
only paid or incurred but also that they constitute ordinary and 
necessary business expenses. One method for substantiating expenses 
incurred by an employee in connection with his employment is through the 
preparation of a daily diary or record of expenditures, maintained in 
sufficient detail to enable him to readily identify the amount and 
nature of any expenditure, and the preservation of supporting documents, 
especially in connection with large or exceptional expenditures. 
Nevertheless, it is recognized that by reason of the nature of certain 
expenses or the circumstances under which they are incurred, it is often 
difficult for an employee to maintain detailed records or to preserve 
supporting documents for all his expenses. Detailed records of small 
expenditures incurred in traveling or for transportation, as for 
example, tips, will not be required.
    (3) Where records are incomplete or documentary proof is 
unavailable, it may be possible to establish the amount of the 
expenditures by approximations based upon reliable secondary sources of 
information and collateral evidence. For example, in connection with an 
item of traveling expense a taxpayer might establish that he was in a 
travel status a certain number of days but that it was impracticable for 
him to establish the details of all his various items of travel expense. 
In such a case rail fares or plane fares can usually be ascertained with 
exactness and automobile costs approximated on the basis of mileage 
covered. A reasonable approximation of meals and lodging might be based 
upon receipted hotel bills or upon average daily rates for such 
accommodations and meals prevailing in the particular community for 
comparable accommodations. Since detailed records of incidental items 
are not required, deductions for these items may be based upon a 
reasonable approximation. In cases where a taxpayer is called upon to 
substantiate expense account information, the burden is on the taxpayer 
to establish that the amounts claimed as a deduction are reasonably 
accurate and constitute ordinary and necessary business expenses paid or 
incurred by him in connection with his trade or business. In connection 
with the determination of factual matters of this type, due 
consideration will be given to the reasonableness of the stated 
expenditures for the claimed purposes in relation to the taxpayer's 
circumstances (such as his income and the nature of his occupation), to 
the reliability and accuracy of records in

[[Page 206]]

connection with other items more readily lending themselves to detailed 
recordkeeping, and to all of the facts and circumstances in the 
particular case.
    (e) Applicability. (1) Except as provided in subparagraph (2) of 
this paragraph, the provisions of the regulations in this section are 
supplemental to existing regulations relating to information required to 
be submitted with income tax returns, and shall be applicable with 
respect to taxable years beginning after December 31, 1957, 
notwithstanding any existing regulation to the contrary.
    (2) With respect to taxable years ending after December 31, 1962, 
but only in respect of periods after such date, the provisions of the 
regulations in this section are superseded by the regulations under 
section 274(d) to the extent inconsistent therewith. See Sec. 1.274-5.
    (3) For taxable years beginning on or after January 1, 1989, the 
provisions of this section are superseded by the regulations under 
section 62(c) to the extent this section is inconsistent with those 
regulations. See Sec. 1.62-2.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6630, 27 FR 
12935, Dec. 29, 1962; T.D. 8276, 54 FR 51026, Dec. 12, 1989; T.D. 8324, 
55 FR 51695, Dec. 17, 1990]



Sec. 1.162-18  Illegal bribes and kickbacks.

    (a) Illegal payments to government officials or employees--(1) In 
general. No deduction shall be allowed under section 162(a) for any 
amount paid or incurred, directly or indirectly, to an official or 
employee of any government, or of any agency or other instrumentality of 
any government, if--
    (i) In the case of a payment made to an official or employee of a 
government other than a foreign government described in subparagraph (3) 
(ii) or (iii) of this paragraph, the payment constitutes an illegal 
bribe or kickback, or
    (ii) In the case of a payment made to an official or employee of a 
foreign government described in subparagraph (3) (ii) or (iii) of this 
paragraph, the making of the payment would be unlawful under the laws of 
the United States (if such laws were applicable to the payment and to 
the official or employee at the time the expenses were paid or 
incurred).

No deduction shall be allowed for an accrued expense if the eventual 
payment thereof would fall within the prohibition of this section. The 
place where the expenses are paid or incurred is immaterial. For 
purposes of subdivision (ii) of this subparagraph, lawfulness, or 
unlawfulness of the payment under the laws of the foreign country is 
immaterial.
    (2) Indirect payment. For purposes of this paragraph, an indirect 
payment to an individual shall include any payment which inures to his 
benefit or promotes his interests, regardless of the medium in which the 
payment is made and regardless of the identity of the immediate 
recipient or payor. Thus, for example, payment made to an agent, 
relative, or independent contractor of an official or employee, or even 
directly into the general treasury of a foreign country of which the 
beneficiary is an official or employee, may be treated as an indirect 
payment to the official or employee, if in fact such payment inures or 
will inure to his benefit or promotes or will promote his financial or 
other interests. A payment made by an agent or independent contractor of 
the taxpayer which benefits the taxpayer shall be treated as an indirect 
payment by the taxpayer to the official or employee.
    (3) Official or employee of a government. Any individual officially 
connected with--
    (i) The Government of the United States, a State, a territory or 
possession of the United States, the District of Columbia, or the 
Commonwealth of Puerto Rico,
    (ii) The government of a foreign country, or
    (iii) A political subdivision of, or a corporation or other entity 
serving as an agency or instrumentality of, any of the above,

in whatever capacity, whether on a permanent or temporary basis, and 
whether or not serving for compensation, shall be included within the 
term ``official or employee of a government'', regardless of the place 
of residence or post of duty of such individual. An independent 
contractor would not ordinarily be considered to

[[Page 207]]

be an official or employee. For purposes of section 162(c) and this 
paragraph, the term ``foreign country'' shall include any foreign 
nation, whether or not such nation has been accorded diplomatic 
recognition by the United States. Individuals who purport to act on 
behalf of or as the government of a foreign nation, or an agency or 
instrumentality thereof, shall be treated under this section as 
officials or employees of a foreign government, whether or not such 
individuals in fact control such foreign nation, agency, or 
instrumentality, and whether or not such individuals are accorded 
diplomatic recognition. Accordingly, a group in rebellion against an 
established government shall be treated as officials or employees of a 
foreign government, as shall officials or employees of the government 
against which the group is in rebellion.
    (4) Laws of the United States. The term ``laws of the United 
States'', to which reference is made in paragraph (a)(1)(ii) of this 
section, shall be deemed to include only Federal statutes, including 
State laws which are assimilated into Federal law by Federal statute, 
and legislative and interpretative regulations thereunder. The term 
shall also be limited to statutes which prohibit some act or acts, for 
the violation of which there is a civil or criminal penalty.
    (5) Burden of proof. In any proceeding involving the issue of 
whether, for purposes of section 162(c)(1), a payment made to a 
government official or employee constitutes an illegal bribe or kickback 
(or would be unlawful under the laws of the United States) the burden of 
proof in respect of such issue shall be upon the Commissioner to the 
same extent as he bears the burden of proof in civil fraud cases under 
section 7454 (i.e., he must prove the illegality of the payment by clear 
and convincing evidence).
    (6) Example. The application of this paragraph may be illustrated by 
the following example:

    Example. X Corp. is in the business of selling hospital equipment in 
State Y. During 1970, X Corp. employed A who at the time was employed 
full time by State Y as Superintendent of Hospitals. The purpose of A's 
employment by X Corp. was to procure for it an improper advantage over 
other concerns in the making of sales to hospitals in respect of which 
A, as Superintendent, had authority. X Corp. paid A $5,000 during 1970. 
The making of this payment was illegal under the laws of State Y. Under 
section 162(c)(1), X Corp. is precluded from deducting as a trade or 
business expense the $5,000 paid to A.

    (b) Other illegal payments--(1) In general. No deduction shall be 
allowed under section 162(a) for any payment (other than a payment 
described in paragraph (a) of this section) made, directly or 
indirectly, to any person, if the payment constitutes an illegal bribe, 
illegal kickback, or other illegal payment under the laws of the United 
States (as defined in paragraph (a)(4) of this section), or under any 
State law (but only if such State law is generally enforced), which 
subjects the payor to a criminal penalty or the loss (including a 
suspension) of license or privilege to engage in a trade or business 
(whether or not such penalty or loss is actually imposed upon the 
taxpayer). For purposes of this paragraph, a kickback includes a payment 
in consideration of the referral of a client, patient, or customer. This 
paragraph applies only to payments made after December 30, 1969.
    (2) State law. For purposes of this paragraph, State law means a 
statute of a State or the District of Columbia.
    (3) Generally enforced. For purposes of this paragraph, a State law 
shall be considered to be generally enforced unless it is never enforced 
or the only persons normally charged with violations thereof in the 
State (or the District of Columbia) enacting the law are infamous or 
those whose violations are extraordinarily flagrant. For example, a 
criminal statute of a State shall be considered to be generally enforced 
unless violations of the statute which are brought to the attention of 
appropriate enforcement authorities do not result in any enforcement 
action in the absence of unusual circumstances.
    (4) Burden of proof. In any proceeding involving the issue of 
whether, for purposes of section 162(c)(2), a payment constitutes an 
illegal bribe, illegal kickback, or other illegal payment the burden of 
proof in respect of such issue shall be upon the Commissioner to the 
same extent as he bears the burden of

[[Page 208]]

proof in civil fraud cases under section 7454 (i.e., he must prove the 
illegality of the payment by clear and convincing evidence).
    (5) Example. The application of this paragraph may be illustrated by 
the following example:

    Example. X Corp., a calendar-year taxpayer, is engaged in the ship 
repair business in State Y. During 1970, repairs on foreign ships 
accounted for a substantial part of its total business. It was X Corp.'s 
practice to kick back approximately 10 percent of the repair bill to the 
captain and chief engineer of all foreign-owned vessels, which kickbacks 
are illegal under a law of State Y (which is generally enforced) and 
potentially subject X Corp. to fines. During 1970, X Corp. paid $50,000 
in such kickbacks. On X Corp.'s return for 1970, a deduction under 
section 162 was taken for the $50,000. The deduction of the $50,000 of 
illegal kickbacks during 1970 is disallowed under section 162(c)(2), 
whether or not X Corp. is prosecuted with respect to the kickbacks.

    (c) Kickbacks, rebates, and bribes under medicare and medicaid. No 
deduction shall be allowed under section 162(a) for any kickback, 
rebate, or bribe (whether or not illegal) made on or after December 10, 
1971, by any provider of services, supplier, physician, or other person 
who furnishes items or services for which payment is or may be made 
under the Social Security Act, as amended, or in whole or in part out of 
Federal funds under a State plan approved under such Act, if such 
kickback, rebate, or bribe is made in connection with the furnishing of 
such items or services or the making or receipt of such payments. For 
purposes of this paragraph, a kickback includes a payment in 
consideration of the referral of a client, patient, or customer.

[T.D. 7345, 40 FR 7437, Feb. 20, 1975; 40 FR 8948, Mar. 4, 1975]



Sec. 1.162-19  Capital contributions to Federal National Mortgage
Association.

    (a) In general. The initial holder of stock of the Federal National 
Mortgage Association (FNMA) which is issued pursuant to section 303(c) 
of the Federal National Mortgage Association Charter Act (12 U.S.C., 
section 1718) in a taxable year beginning after December 31, 1959, shall 
treat the excess, if any, of the issuance price (the amount of capital 
contributions evidenced by a share of stock) over the fair market value 
of the stock as of the issue date of such stock as an ordinary and 
necessary business expense paid or incurred during the year in which 
occurs the date of issuance of the stock. To the extent that a sale to 
FNMA of mortgage paper gives rise to the issuance of a share of FNMA 
stock during a taxable year beginning after December 31, 1959, such sale 
is to be treated in a manner consistent with the purpose for, and the 
legislative intent underlying the enactment of, the provisions of 
section 8, Act of September 14, 1960 (Pub. L. 86-779, 74 Stat. 1003). 
Thus, for the purpose of determining an initial holder's gain or loss 
from the sale to FNMA of mortgage paper, with respect to which a share 
of FNMA stock is issued in a taxable year beginning after December 31, 
1959 (irrespective of when the sale is made), the amount realized by the 
initial holder from the sale of the mortgage paper is the amount of the 
``FNMA purchase price''. The ``FNMA purchase price'' is the gross amount 
of the consideration agreed upon between FNMA and the initial holder for 
the purchase of the mortgage paper, without regard to any deduction 
therefrom as, for example, a deduction representing a capital 
contribution or a purchase or marketing fee. The date of issuance of the 
stock is the date which appears on the stock certificates of the initial 
holder as the date of issue. The initial holder is the original 
purchaser who is issued stock of the Federal National Mortgage 
Association pursuant to section 303(c) of the Act, and who appears on 
the books of FNMA as the initial holder. In determining the period for 
which the initial holder has held such stock, such period shall begin 
with the date of issuance.
    (b) Examples. The provisions of paragraph (a) of this section may be 
illustrated by the following examples:

    Example 1. A, a banking institution which reports its income on a 
calendar year basis, sold mortgage paper with an outstanding principal 
balance of $12,500 to FNMA on October 17, 1960. The FNMA purchase price 
was $11,500. A's basis for the mortgage paper was $10,500. In accordance 
with the terms of the contract, FNMA deducted $375 ($250 representing 
capital contribution and $125 representing purchase and marketing fee) 
from

[[Page 209]]

the amount of the purchase price. FNMA credited A's account with the 
amount of the capital contribution. A stock certificate evidencing two 
shares of FNMA common stock of $100 par value was mailed to A and FNMA 
deducted $200 from A's account, leaving a net balance of $50 in such 
account. The stock certificate, bearing an issue date of November 1, 
1960, was received by A on November 7, 1960. The fair market value of a 
share of FNMA stock on October 17, 1960, was $65, on November 1, 1960, 
was $67, and on November 7, 1960, was $68. A may deduct $66 the 
difference between the issuance price ($200) and the fair market value 
($134) of the two shares of stock on the date of issuance (November 1, 
1960), as a business expense for the taxable year 1960. The basis of 
each share of stock issued as of November 1, 1960 will be $67. See 
section 1054 and Sec. 1.1054-1. A's gain from the sale of the mortgage 
paper is $875 computed as follows:

Amount realized in FNMA purchase price........................   $11,500
A's basis in mortgage paper.........................   $10,500
Purchase and marketing fee..........................       125
                                                     ----------
                                                                  10,625
                                                               ---------
Gain on sale..................................................       875
 

    Example 2. Assume the same facts as in Example (1), and, in 
addition, that A sold to FNMA on December 15, 1960, additional mortgage 
paper having an outstanding principal balance of $12,500. FNMA deducted 
from the FNMA purchase price $250 representing capital contribution and 
credited A's account with this amount. A then had a total credit of $300 
to his account consisting of the $50 balance from the transaction 
described in Example (1) and $250 from the December 15th transaction. A 
stock certificate evidencing three shares of FNMA common stock of $100 
par value was mailed to A and FNMA deducted $300 from A's account. The 
stock certificate, bearing an issue date of January 1, 1961, was 
received by A on January 9, 1961. The fair market value of a share of 
FNMA stock on January 1, 1961, was $69. A may deduct $93, the difference 
between the issuance price ($300) and the fair market value ($207) of 
the three shares of stock on the date of issuance (January 1, 1961), as 
a business expense for the taxable year 1961. The gain or loss on the 
sale of mortgage paper on December 15, 1960, is reportable for the 
taxable year 1960.

[T.D. 6690, 28 FR 12253, Nov. 19, 1963]



Sec. 1.162-20  Expenditures attributable to lobbying, political
campaigns, attempts to influence legislation, etc., and certain 
advertising.

    (a) In general--(1) Scope of section. This section contains rules 
governing the deductibility or nondeductibility of expenditures for 
lobbying purposes, for the promotion or defeat of legislation, for 
political campaign purposes (including the support of or opposition to 
any candidate for public office) or for carrying on propaganda 
(including advertising) related to any of the foregoing purposes. For 
rules applicable to such expenditures in respect of taxable years 
beginning before January 1, 1963, and for taxable years beginning after 
December 31, 1962, see paragraphs (b) and (c), respectively, of this 
section. This section also deals with expenditures for institutional or 
``good will'' advertising.
    (2) Institutional or ``good will'' advertising. Expenditures for 
institutional or ``good will'' advertising which keeps the taxpayer's 
name before the public are generally deductible as ordinary and 
necessary business expenses provided the expenditures are related to the 
patronage the taxpayer might reasonably expect in the future. For 
example, a deduction will ordinarily be allowed for the cost of 
advertising which keeps the taxpayer's name before the public in 
connection with encouraging contributions to such organizations as the 
Red Cross, the purchase of United States Savings Bonds, or participation 
in similar causes. In like fashion, expenditures for advertising which 
presents views on economic, financial, social, or other subjects of a 
general nature, but which does not involve any of the activities 
specified in paragraph (b) or (c) of this section for which a deduction 
is not allowable, are deductible if they otherwise meet the requirements 
of the regulations under section 162.
    (b) Taxable years beginning before January 1, 1963--(1) In general. 
(i) For taxable years beginning before January 1, 1963, expenditures for 
lobbying purposes, for the promotion or defeat of legislation, for 
political campaign purposes (including the support of or opposition to 
any candidate for public office), or for carrying on propaganda 
(including advertising) related to any of the foregoing purposes are not 
deductible from gross income. For example, the cost of advertising to 
promote or defeat legislation or to influence the public with respect to 
the desirability

[[Page 210]]

or undesirability of proposed legislation is not deductible as a 
business expense, even though the legislation may directly affect the 
taxpayer's business.
    (ii) If a substantial part of the activities of an organization, 
such as a labor union or a trade association, consists of one or more of 
the activities specified in the first sentence of this subparagraph, 
deduction will be allowed only for such portion of the dues or other 
payments to the organization as the taxpayer can clearly establish is 
attributable to activities other than those so specified. The 
determination of whether such specified activities constitute a 
substantial part of an organization's activities shall be based on all 
the facts and circumstances. In no event shall special assessments or 
similar payments (including an increase in dues) made to any 
organization for any of such specified purposes be deductible. For other 
provisions relating to the deductibility of dues and other payments to 
an organization, such as a labor union or a trade association, see 
paragraph (c) of Sec. 1.162-15.
    (2) Expenditures for promotion or defeat of legislation. For 
purposes of this paragraph, expenditures for the promotion or the defeat 
of legislation include, but shall not be limited to, expenditures for 
the purpose of attempting to--
    (i) Influence members of a legislative body directly, or indirectly 
by urging or encouraging the public to contact such members for the 
purpose of proposing, supporting, or opposing legislation, or
    (ii) Influence the public to approve or reject a measure in a 
referendum, initiative, vote on a constitutional amendment, or similar 
procedure.
    (c) Taxable years beginning after December 31, 1962--(1) In general. 
For taxable years beginning after December 31, 1962, certain types of 
expenses incurred with respect to legislative matters are deductible 
under section 162(a) if they otherwise meet the requirements of the 
regulations under section 162. These deductible expenses are described 
in subparagraph (2) of this paragraph. All other expenditures for 
lobbying purposes, for the promotion or defeat of legislation (see 
paragraph (b)(2) of this section), for political campaign purposes 
(including the support of or opposition to any candidate for public 
office), or for carrying on propaganda (including advertising) relating 
to any of the foregoing purposes are not deductible from gross income 
for such taxable years. For the disallowance of deductions for bad debts 
and worthless securities of a political party, see Sec. 1.271-1. For the 
disallowance of deductions for certain indirect political contributions, 
such as the cost of certain advertising and the cost of admission to 
certain dinners, programs, and inaugural events, see Sec. 1.276-1.
    (2) Appearances, etc., with respect to legislation--(i) General 
rule. Pursuant to the provisions of section 162(e), expenses incurred 
with respect to legislative matters which may be deductible are those 
ordinary and necessary expenses (including, but not limited to, 
traveling expenses described in section 162(a)(2) and the cost of 
preparing testimony) paid or incurred by the taxpayer during a taxable 
year beginning after December 31, 1962, in carrying on any trade or 
business which are in direct connection with--
    (a) Appearances before, submission of statements to, or sending 
communications to, the committees, or individual members of Congress or 
of any legislative body of a State, a possession of the United States, 
or a political subdivision of any of the foregoing with respect to 
legislation or proposed legislation of direct interest to the taxpayer, 
or
    (b) Communication of information between the taxpayer and an 
organization of which he is a member with respect to legislation or 
proposed legislation of direct interest to the taxpayer and to such 
organization.

For provisions relating to dues paid or incurred with respect to an 
organization of which the taxpayer is a member, see subparagraph (3) of 
this paragraph.
    (ii) Legislation or proposed legislation of direct interest to the 
taxpayer--(a) Legislation or proposed legislation. The term 
``legislation or proposed legislation'' includes bills and resolutions 
introduced by a member of Congress or other legislative body referred to 
in subdivision (i)(a) of this subparagraph for consideration by such 
body as well

[[Page 211]]

as oral or written proposals for legislative action submitted to the 
legislative body or to a committee or member of such body.
    (b) Direct interest--(1) In general. (i) Legislation or proposed 
legislation is of direct interest to a taxpayer if the legislation or 
proposed legislation is of such a nature that it will, or may reasonably 
be expected to, affect the trade or business of the taxpayer. It is 
immaterial whether the effect, or expected effect, on the trade or 
business will be beneficial or detrimental to the trade or business or 
whether it will be immediate. If legislation or proposed legislation has 
such a relationship to a trade or business that the expenses of any 
appearance or communication in connection with the legislation meets the 
ordinary and necessary test of section 162(a), then such legislation 
ordinarily meets the direct interest test of section 162(e). However, if 
the nature of the legislation or proposed legislation is such that the 
likelihood of its having an effect on the trade or business of the 
taxpayer is remote or speculative, the legislation or proposed 
legislation is not of direct interest to the taxpayer. Legislation or 
proposed legislation which will not affect the trade or business of the 
taxpayer is not of direct interest to the taxpayer even though such 
legislation will affect the personal, living, or family activities or 
expenses of the taxpayer. Legislation or proposed legislation is not of 
direct interest to a taxpayer merely because it may affect business in 
general; however, if the legislation or proposed legislation will, or 
may reasonably be expected to, affect the taxpayer's trade or business 
it will be of direct interest to the taxpayer even though it also will 
affect the trade or business of other taxpayers or business in general. 
To meet the direct interest test, it is not necessary that all 
provisions of the legislation or proposed legislation have an effect, or 
expected effect, on the taxpayer's trade or business. The test will be 
met if one of the provisions of the legislation has the specified 
effect. Legislation or proposed legislation will be considered to be of 
direct interest to a membership organization if it is of direct interest 
to the organization, as such, or if it is of direct interest to one or 
more of its members.
    (ii) Legislation which would increase or decrease the taxes 
applicable to the trade or business, increase or decrease the operating 
costs or earnings of the trade or business, or increase or decrease the 
administrative burdens connected with the trade or business meets the 
direct interest test. Legislation which would increase the social 
security benefits or liberalize the right to such benefits meets the 
direct interest test because such changes in the social security 
benefits may reasonably be expected to affect the retirement benefits 
which the employer will be asked to provide his employees or to increase 
his taxes. Legislation which would impose a retailer's sales tax is of 
direct interest to a retailer because, although the tax may be passed on 
to his customers, collection of the tax will impose additional burdens 
on the retailer, and because the increased cost of his products to the 
consumer may reduce the demand for them. Legislation which would provide 
an income tax credit or exclusion for shareholders is of direct interest 
to a corporation, because those tax benefits may increase the sources of 
capital available to the corporation. Legislation which would favorably 
or adversely affect the business of a competitor so as to affect the 
taxpayer's competitive position is of direct interest to the taxpayer. 
Legislation which would improve the school system of a community is of 
direct interest to a membership organization comprised of employers in 
the community because the improved school system is likely to make the 
community more attractive to prospective employees of such employers. On 
the other hand, proposed legislation relating to Presidential succession 
in the event of the death of the President has only a remote and 
speculative effect on any trade or business and therefore does not meet 
the direct interest test. Similarly, if a corporation is represented 
before a congressional committee to oppose an appropriation bill merely 
because of a desire to bring increased Government economy with the hope 
that such economy will eventually cause a reduction in the Federal 
income tax, the legislation does not

[[Page 212]]

meet the direct interest test because any effect it may have upon the 
corporation's trade or business is highly speculative.
    (2) Appearances, etc., by expert witnesses. (i) An appearance or 
communication (of a type described in paragraph (c)(2)(i)(a) of this 
section) by an individual in connection with legislation or proposed 
legislation shall be considered to be with respect to legislation of 
direct interest to such individual if the legislation is in a field in 
which he specializes as an employee, if the appearance or communication 
is not on behalf of his employer, and if it is customary for individuals 
in his type of employment to publicly express their views in respect of 
matters in their field of competence. Expenses incurred by such an 
individual in connection with such an appearance of communication, 
including traveling expenses properly allocable thereto, represent 
ordinary and necessary business expenses and are, therefore, deductible 
under section 162. For example, if a university professor who teaches in 
the field of money and banking appears, on his own behalf, before a 
legislative committee to testify on proposed legislation regarding the 
banking system, his expenses incurred in connection with such appearance 
are deductible under section 162 since university professors customarily 
take an active part in the development of the law in their field of 
competence and publicly communicate the results of their work.
    (ii) An appearance or communication (of a type described in 
paragraph (c)(2)(i)(a) of this section) by an employee or self-employed 
individual in connection with legislation or proposed legislation shall 
be considered to be with respect to legislation of direct interest to 
such person if the legislation is in the field in which he specializes 
in his business (or as an employee) and if the appearance or 
communication is made pursuant to an invitation extended to him 
individually for the purpose of receiving his expert testimony. Expenses 
incurred by an employee or self-employed individual in connection with 
such an appearance or communication, including traveling expenses 
properly allocable thereto, represent ordinary and necessary business 
expenses and are, therefore, deductible under section 162. For example, 
if a self-employed individual is personally invited by a congressional 
committee to testify on proposed legislation in the field in which he 
specializes in his business, his expenses incurred in connection with 
such appearance are deductible under section 162. If a self-employed 
individual makes an appearance, on his own behalf, before a legislative 
committee without having been extended an invitation his expenses will 
be deductible to the extent otherwise provided in this paragraph.
    (3) Nominations, etc. A taxpayer does not have a direct interest in 
matters such as nominations, appointments, or the operation of the 
legislative body.
    (iii) Allowable expenses. To be deductible under section 162(a), 
expenditures which meet the tests of deductibility under the provisions 
of this paragraph must also qualify as ordinary and necessary business 
expenses under section 162(a) and, in addition, be in direct connection 
with the carrying on of the activities specified in subdivision (i)(a) 
or (i)(b) of this subparagraph. For example, a taxpayer appearing before 
a committee of the Congress to present testimony concerning legislation 
or proposed legislation in which he has a direct interest may deduct the 
ordinary and necessary expenses directly connected with his appearance, 
such as traveling expenses described in section 162(a)(2), and the cost 
of preparing testimony.
    (3) Deductibility of dues and other payments to an organization. If 
a substantial part of the activities of an organization, such as a labor 
union or a trade association, consists of one or more of the activities 
to which this paragraph relates (legislative matters, political 
campaigns, etc.), exclusive of any activity constituting an appearance 
or communication with respect to legislation or proposed legislation of 
direct interest to the organization (see subparagraph (c)(2)(ii)(b)(1)), 
a deduction will be allowed only for such portion of the dues or other 
payments to the organization as the taxpayer can clearly establish is 
attributable to activities to which this paragraph does not relate

[[Page 213]]

and to any activity constituting an appearance or communication with 
respect to legislation or proposed legislation of direct interest to the 
organization. The determination of whether a substantial part of an 
organization's activities consists of one or more of the activities to 
which this paragraph relates (exclusive of appearances or communications 
with respect to legislation or proposed legislation of direct interest 
to the organization) shall be based on all the facts and circumstances. 
In no event shall a deduction be allowed for that portion of a special 
assessment or similar payment (including an increase in dues) made to 
any organization for any activity to which this paragraph relates if the 
activity does not constitute an appearance or communication with respect 
to legislation or proposed legislation of direct interest to the 
organization. If an organization pays or incurs expenses allocable to 
legislative activities which meet the tests of subdivisions (i) and (ii) 
of subparagraph (2) of this paragraph (appearances or communications 
with respect to legislation or proposed legislation of direct interest 
to the organization), on behalf of its members, the dues paid by a 
taxpayer are deductible to the extent used for such activities. Dues 
paid by a taxpayer will be considered to be used for such an activity, 
and thus deductible, although the legislation or proposed legislation 
involved is not of direct interest to the taxpayer, if, pursuant to the 
provisions of subparagraph (2)(ii)(b)(1) of this paragraph, the 
legislation or proposed legislation is of direct interest to the 
organization, as such, or is of direct interest to one or more members 
of the organization. For other provisions relating to the deductibility 
of dues and other payments to an organization, such as a labor union or 
a trade association, see paragraph (c) of Sec. 1.162-15.
    (4) Limitations. No deduction shall be allowed under section 162(a) 
for any amount paid or incurred (whether by way of contribution, gift, 
or otherwise) in connection with any attempt to influence the general 
public, or segments thereof, with respect to legislative matters, 
elections, or referendums. For example, no deduction shall be allowed 
for any expenses incurred in connection with ``grassroot'' campaigns or 
any other attempts to urge or encourage the public to contact members of 
a legislative body for the purpose of proposing, supporting, or opposing 
legislation.
    (5) Expenses paid or incurred after December 31, 1993, in connection 
with influencing legislation other than certain local legislation. The 
provisions of paragraphs (c)(1) through (3) of this section are 
superseded for expenses paid or incurred after December 31, 1993, in 
connection with influencing legislation (other than certain local 
legislation) to the extent inconsistent with section 162(e)(1)(A) (as 
limited by section 162(e)(2)) and Secs. 1.162-20(d) and 1.162-29.
    (d) Dues allocable to expenditures after 1993. No deduction is 
allowed under section 162(a) for the portion of dues or other similar 
amounts paid by the taxpayer to an organization exempt from tax (other 
than an organization described in section 501(c)(3)) which the 
organization notifies the taxpayer under section 6033(e)(1)(A)(ii) is 
allocable to expenditures to which section 162(e)(1) applies. The first 
sentence of this paragraph (d) applies to dues or other similar amounts 
whether or not paid on or before December 31, 1993. Section 1.162-
20(c)(3) is superseded to the extent inconsistent with this paragraph 
(d).

[T.D. 6819, 30 FR 5581, Apr. 20, 1965, as amended by T.D. 6996, 34 FR 
835, Jan. 18, 1969; T.D. 8602, 60 FR 37573, July 21, 1995]



Sec. 1.162-21  Fines and penalties.

    (a) In general. No deduction shall be allowed under section 162(a) 
for any fine or similar penalty paid to--
    (1) The government of the United States, a State, a territory or 
possession of the United States, the District of Columbia, or the 
Commonwealth of Puerto Rico;
    (2) The government of a foreign country; or
    (3) A political subdivision of, or corporation or other entity 
serving as an agency or instrumentality of, any of the above.
    (b) Definition. (1) For purposes of this section a fine or similar 
penalty includes an amount--
    (i) Paid pursuant to conviction or a plea of guilty or nolo 
contendere for a

[[Page 214]]

crime (felony or misdemeanor) in a criminal proceeding;
    (ii) Paid as a civil penalty imposed by Federal, State, or local 
law, including additions to tax and additional amounts and assessable 
penalties imposed by chapter 68 of the Internal Revenue Code of 1954;
    (iii) Paid in settlement of the taxpayer's actual or potential 
liability for a fine or penalty (civil or criminal); or
    (iv) Forfeited as collateral posted in connection with a proceeding 
which could result in imposition of such a fine or penalty.
    (2) The amount of a fine or penalty does not include legal fees and 
related expenses paid or incurred in the defense of a prosecution or 
civil action arising from a violation of the law imposing the fine or 
civil penalty, nor court costs assessed against the taxpayer, or 
stenographic and printing charges. Compensatory damages (including 
damages under section 4A of the Clayton Act (15 U.S.C. 15a), as amended) 
paid to a government do not constitute a fine or penalty.
    (c) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. M Corp. was indicted under section 1 of the Sherman Anti-
Trust Act (15 U.S.C. 1) for fixing and maintaining prices of certain 
electrical products. M Corp. was convicted and was fined $50,000. The 
United States sued M Corp. under section 4A of the Clayton Act (15 
U.S.C. 15a) for $100,000, the amount of the actual damages resulting 
from the price fixing of which M Corp. was convicted. Pursuant to a 
final judgment entered in the civil action. M Corp. paid the United 
States $100,000 in damages. Section 162(f) precludes M Corp. from 
deducting the fine of $50,000 as a trade or business expense. Section 
162(f) does not preclude it from deducting the $100,000 paid to the 
United States as actual damages.
    Example 2. N Corp. was found to have violated 33 U.S.C. 1321(b)(3) 
when a vessel it operated discharged oil in harmful quantities into the 
navigable waters of the United States. A civil penalty under 33 U.S.C. 
1321(b)(6) of $5,000 was assessed against N Corp. with respect to the 
discharge. N Corp. paid $5,000 to the Coast Guard in payment of the 
civil penalty. Section 162(f) precludes N Corp. from deducting the 
$5,000 penalty.
    Example 3. O Corp., a manufacturer of motor vehicles, was found to 
have violated 42 U.S.C. 1857f-2(a)(1) by selling a new motor vehicle 
which was not covered by the required certificate of conformity. 
Pursuant to 42 U.S.C. 1857f-4, O Corp. was required to pay, and did pay, 
a civil penalty of $10,000. In addition, pursuant to 42 U.S.C. 1857f-
5a(c)(1), O Corp. was required to expend, and did expend, $500 in order 
to remedy the nonconformity of that motor vehicle. Section 162(f) 
precludes O Corp. from deducting the $10,000 penalty as a trade or 
business expense, but does not preclude it from deducting the $500 which 
it expended to remedy the nonconformity.
    Example 4. P Corp. was the operator of a coal mine in which occurred 
a violation of a mandatory safety standard prescribed by the Federal 
Coal Mine Health and Safety Act of 1969 (30 U.S.C. 801 et seq.). 
Pursuant to 30 U.S.C. 819(a), a civil penalty of $10,000 was assessed 
against P Corp., and P Corp. paid the penalty. Section 162(f) precludes 
P Corp. from deducting the $10,000 penalty.
    Example 5. Q Corp., a common carrier engaged in interstate commerce 
by railroad, hauled a railroad car which was not equipped with efficient 
hand brakes, in violation of 45 U.S.C. 11. Q Corp. was found to be 
liable for a penalty of $250 pursuant to 45 U.S.C. 13. Q Corp. paid that 
penalty. Section 162(f) precludes Q Corp. from deducting the $250 
penalty.
    Example 6. R Corp. owned and operated on the highways of State X a 
truck weighing in excess of the amount permitted under the law of State 
X. R Corp. was found to have violated the law and was assessed a fine of 
$85 which it paid to State X. Section 162(f) precludes R Corp. from 
deducting the amount so paid.
    Example 7. S Corp. was found to have violated a law of State Y which 
prohibited the emission into the air of particulate matter in excess of 
a limit set forth in a regulation promulgated under that law. The 
Environmental Quality Hearing Board of State Y assessed a fine of $500 
against S Corp. The fine was payable to State Y, and S Corp. paid it. 
Section 162(f) precludes S Corp. from deducting the $500 fine.
    Example 8. T Corp. was found by a magistrate of City Z to be 
operating in such city an apartment building which did not conform to a 
provision of the city housing code requiring operable fire escapes on 
apartment buildings of that type. Upon the basis of the magistrate's 
finding, T Corp. was required to pay, and did pay, a fine of $200 to 
City Z. Section 162(f) precludes T Corp. from deducting the $200 fine.

[T.D. 7345, 40 FR 7437, Feb. 20, 1975; 40 FR 8948, Mar. 4, 1975, as 
amended by T.D. 7366, 40 FR 29290, July 11, 1975]

[[Page 215]]



Sec. 1.162-22  Treble damage payments under the antitrust laws.

    (a) In general. In the case of a taxpayer who after December 31, 
1969, either is convicted in a criminal action of a violation of the 
Federal antitrust laws or enters a plea of guilty or nolo contendere to 
an indictment or information charging such a violation, and whose 
conviction or plea does not occur in a new trial following an appeal of 
a conviction on or before such date, no deduction shall be allowed under 
section 162(a) for two-thirds of any amount paid or incurred after 
December 31, 1969, with respect to--
    (1) Any judgment for damages entered against the taxpayer under 
section 4 of the Clayton Act (15 U.S.C. 15), as amended, on account of 
such violation or any related violation of the Federal antitrust laws, 
provided such related violation occurred prior to the date of the final 
judgment of such conviction, or
    (2) Settlement of any action brought under such section 4 on account 
of such violation or related violation.

For the purposes of this section, where a civil judgment has been 
entered or a settlement made with respect to a violation of the 
antitrust laws and a criminal proceeding is based upon the same 
violation, the criminal proceeding need not have been brought prior to 
the civil judgment or settlement. If, in his return for any taxable 
year, a taxpayer claims a deduction for an amount paid or incurred with 
respect to a judgment or settlement described in the first sentence of 
this paragraph and is subsequently convicted of a violation of the 
antitrust laws which makes a portion of such amount unallowable, then 
the taxpayer shall file an amended return for such taxable year on which 
the amount of the deduction is appropriately reduced. Attorney's fees, 
court costs, and other amounts paid or incurred in connection with a 
controversy under such section 4 which meet the requirements of section 
162 are deductible under that section. For purposes of subparagraph (2) 
of this paragraph, the amount paid or incurred in settlement shall not 
include amounts attributable to the plaintiff's costs of suit and 
attorney's fees, to the extent that such costs or fees have actually 
been paid.
    (b) Conviction. For purposes of paragraph (a) of this section, a 
taxpayer is convicted of a violation of the antitrust laws if a judgment 
of conviction (whether or not a final judgment) with respect to such 
violation has been entered against him, provided a subsequent final 
judgment of acquittal has not been entered or criminal prosecution with 
respect to such violation terminated without a final judgment of 
conviction. During the pendency of an appeal or other action directly 
contesting a judgment of conviction, the taxpayer should file a 
protective claim for credit or refund to avoid being barred by the 
period of limitations on credit or refund under section 6511.
    (c) Related violation. For purposes of this section, a violation of 
the Federal antitrust laws is related to a subsequent violation if (1) 
with respect to the subsequent violation the United States obtains both 
a judgment in a criminal proceeding and an injunction against the 
taxpayer, and (2) the taxpayer's actions which constituted the prior 
violation would have contravened such injunction if such injunction were 
applicable at the time of the prior violation.
    (d) Settlement following a dismissal of an action or amendment of 
the complaint. For purposes of paragraph (a)(2) of this section, an 
amount may be considered as paid in settlement of an action even though 
the action is dismissed or otherwise disposed of prior to such 
settlement or the complaint is amended to eliminate the claim with 
respect to the violation or related violation.
    (e) Antitrust laws. The term ``antitrust laws'' as used in section 
162(g) and this section shall include the Federal acts enumerated in 
paragraph (1) of section 1 of the Clayton Act (15 U.S.C. 12), as 
amended.
    (f) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. In 1970, the United States instituted a criminal 
prosecution against X Co., Y Co., A, the president of X Co., and B, the 
president of Y Co., under section 1 of the Sherman Anti-Trust Act, 15 
U.S.C. 1. In the indictment, the defendants were charged with conspiring 
to fix and maintain prices of electrical transformers from 1965 to 1970. 
All

[[Page 216]]

defendants entered pleas of nolo contendere to these charges. These 
pleas were accepted and judgments of conviction entered. In a companion 
civil suit, the United States obtained an injunction prohibiting the 
defendants from conspiring to fix and maintain prices in the electrical 
transformer market. Thereafter, Z Co. sued X Co. and Y Co. for $300,000 
in treble damages under section 4 of the Clayton Act. Z Co.'s complaint 
alleged that the criminal conspiracy between X Co. and Y Co. forced Z 
Co. to pay excessive prices for electrical transformers. X Co. and Y Co. 
each paid Z Co. $85,000 in full settlement of Z Co.'s action. Of each 
$85,000 paid, $10,000 was attributable to court costs and attorney's 
fees actually paid by Z Co. Under section 162(g), X Co. and Y Co. are 
each precluded from deducting as a trade or business expense more than 
$35,000 of the $85,000 paid to Z Co. in settlement--

$10,000 + [($85,000-$10,000)  3]

    Example 2. Assume the same facts as in example (1) except that Z 
Co.'s claim for treble damages was based on a conspiracy to fix and 
maintain prices in the sale of electrical transformers during 1963. 
Although the criminal prosecution of the defendants did not involve 1963 
(a year barred by the applicable criminal statute of limitations when 
the prosecution was instituted), Z Co.'s pleadings alleged that the 
civil statute of limitations had been tolled by the defendants' 
fraudulent concealment of their conspiracy. Since the United States has 
obtained both a judgment in a criminal proceeding and an injunction 
against the defendants in connection with their activities from 1965 to 
1970, and the alleged actions of the defendants in 1963 would have 
contravened such injunction if it were applicable in 1963, the alleged 
violation in 1963 is related to the violation from 1965 to 1970. 
Accordingly, the tax consequences to X Co. and Y Co. of the payments of 
$85,000 in settlement of Z Co.'s claim against X Co. and Y Co. are the 
same as in example (1).
    Example 3. Assume the same facts as in example (1) except that Z 
Co.'s claim for treble damages was based on a conspiracy to fix and 
maintain prices with respect to electrical insulators for high-tension 
power poles. Since the civil action was not based on the same violation 
of the Federal antitrust laws as the criminal action, or on a related 
violation (a violation which would have contravened the injunction if it 
were applicable), X Co. and Y Co. are not precluded by section 162(g) 
from deducting as a trade or business expense the entire $85,000 paid by 
each in settlement of the civil action.

[T.D. 7217, 37 FR 23916, Nov. 10, 1972]



Sec. 1.162-24  Travel expenses of state legislators.

    (a) In general. For purposes of section 162(a), in the case of any 
taxpayer who is a state legislator at any time during the taxable year 
and who makes an election under section 162(h) for the taxable year--
    (1) The taxpayer's place of residence within the legislative 
district represented by the taxpayer is the taxpayer's home for that 
taxable year;
    (2) The taxpayer is deemed to have expended for living expenses (in 
connection with the taxpayer's trade or business as a legislator) an 
amount determined by multiplying the number of legislative days of the 
taxpayer during the taxable year by the greater of--
    (i) The amount generally allowable with respect to those days to 
employees of the state of which the taxpayer is a legislator for per 
diem while away from home, to the extent the amount does not exceed 110 
percent of the amount described in paragraph (a)(2)(ii) of this section; 
or
    (ii) The Federal per diem with respect to those days for the 
taxpayer's state capital; and
    (3) The taxpayer is deemed to be away from home in the pursuit of a 
trade or business on each legislative day.
    (b) Legislative day. For purposes of section 162(h)(1) and this 
section, for any taxpayer who makes an election under section 162(h), a 
legislative day is any day on which the taxpayer is a state legislator 
and--
    (1) The legislature is in session;
    (2) The legislature is not in session for a period that is not 
longer than 4 consecutive days, without extension for Saturdays, 
Sundays, or holidays;
    (3) The taxpayer's attendance at a meeting of a committee of the 
legislature is formally recorded; or
    (4) The taxpayer's attendance at any session of the legislature that 
only a limited number of members are expected to attend (such as a pro 
forma session), on any day not described in paragraph (b)(1) or (b)(2) 
of this section, is formally recorded.
    (c) Fifty mile rule. Section 162(h) and this section do not apply to 
any taxpayer who is a state legislator and whose place of residence 
within the

[[Page 217]]

legislative district represented by the taxpayer is 50 or fewer miles 
from the capitol building of the state. For purposes of this paragraph 
(c), the distance between the taxpayer's place of residence within the 
legislative district represented by the taxpayer and the capitol 
building of the state is the shortest of the more commonly traveled 
routes between the two points.
    (d) Definitions and special rules. The following definitions apply 
for purposes of section 162(h) and this section.
    (1) State legislator. A taxpayer becomes a state legislator on the 
day the taxpayer is sworn into office and ceases to be a state 
legislator on the day following the day on which the taxpayer's term in 
office ends.
    (2) Living expenses. Living expenses include lodging, meals, and 
incidental expenses. Incidental expenses has the same meaning as in 41 
CFR 300-3.1.
    (3) In session--(i) In general. For purposes of this section, the 
legislature of which a taxpayer is a member is in session on any day if, 
at any time during that day, the members of the legislature are expected 
to attend and participate as an assembled body of the legislature.
    (ii) Examples. The following examples illustrate the rules of this 
paragraph (d)(3):

    Example 1. B is a member of the legislature of State X. On Day 1, 
the State X legislature is convened and the members of the legislature 
are expected to attend and participate. On Day 1, the State X 
legislature is in session within the meaning of paragraph (d)(3)(i) of 
this section. B does not attend the session of the State X legislature 
on Day 1. However, Day 1 is a legislative day for B for purposes of 
section 162(h)(2)(A) and paragraph (b)(1) of this section.
    Example 2. C, D, and E are members of the legislature of State X. On 
Day 2, the State X legislature is convened for a limited session in 
which not all members of the legislature are expected to attend and 
participate. Thus, on Day 2 the legislature is not in session within the 
meaning of paragraph (d)(3)(i) of this section, and Day 2 is not a 
legislative day under paragraph (b)(1) of this section. In addition, Day 
2 is not a day described in paragraph (b)(2) of this section. C and D 
are the only members who are called to, and do, attend the limited 
session on Day 2, and their attendance at the session is formally 
recorded. E is not called and does not attend. Therefore, Day 2 is a 
legislative day as to C and D under section 162(h)(2)(B) and paragraph 
(b)(4) of this section. Day 2 is not a legislative day as to E.

    (4) Committee of the legislature. A committee of the legislature is 
any group that includes one or more legislators and that is charged with 
conducting business of the legislature. Committees of the legislature 
include, but are not limited to, committees to which the legislature 
refers bills for consideration, committees that the legislature has 
authorized to conduct inquiries into matters of public concern, and 
committees charged with the internal administration of the legislature. 
For purposes of this section, groups that are not considered committees 
of the legislature include, but are not limited to, groups that promote 
particular issues, raise campaign funds, or are caucuses of members of a 
political party.
    (5) Federal per diem. The Federal per diem for any city and day is 
the maximum amount allowable to employees of the executive branch of the 
Federal government for living expenses while away from home in pursuit 
of a trade or business in that city on that day. See 5 U.S.C. 5702 and 
the regulations under that section.
    (e) Election--(1) Time for making election. A taxpayer's election 
under section 162(h) must be made for each taxable year for which the 
election is to be in effect and must be made no later than the due date 
(including extensions) of the taxpayer's Federal income tax return for 
the taxable year.
    (2) Manner of making election. A taxpayer makes an election under 
section 162(h) by attaching a statement to the taxpayer's income tax 
return for the taxable year for which the election is made. The 
statement must include--
    (i) The taxpayer's name, address, and taxpayer identification 
number;
    (ii) A statement that the taxpayer is making an election under 
section 162(h); and
    (iii) Information establishing that the taxpayer is a state 
legislator entitled to make the election, for example, a statement 
identifying the taxpayer's state and legislative district and 
representing that the taxpayer's place of residence in the legislative 
district is not 50 or fewer miles from the state capitol building.

[[Page 218]]

    (3) Revocation of election. An election under section 162(h) may be 
revoked only with the consent of the Commissioner. An application for 
consent to revoke an election must be signed by the taxpayer and filed 
with the submission processing center with which the election was filed, 
and must include--
    (i) The taxpayer's name, address, and taxpayer identification 
number;
    (ii) A statement that the taxpayer is revoking an election under 
section 162(h) for a specified year; and
    (iii) A statement explaining why the taxpayer seeks to revoke the 
election.
    (f) Effect of election on otherwise deductible expenses for travel 
away from home--(1) Legislative days--(i) Living expenses. For any 
legislative day for which an election under section 162(h) and this 
section is in effect, the amount of an electing taxpayer's living 
expenses while away from home is the greater of the amount of the living 
expenses--
    (A) Specified in paragraph (a)(2) of this section in connection with 
the trade or business of being a legislator; or
    (B) Otherwise allowable under section 162(a)(2) in the pursuit of 
any trade or business of the taxpayer.
    (ii) Other expenses. For any legislative day for which an election 
under section 162(h) and this section is in effect, the amount of an 
electing taxpayer's expenses (other than living expenses) for travel 
away from home is the sum of the substantiated expenses, such as 
expenses for travel fares, telephone calls, and local transportation, 
that are otherwise deductible under section 162(a)(2) in the pursuit of 
any trade or business of the taxpayer.
    (2) Non-legislative days. For any day that is not a legislative day, 
the amount of an electing taxpayer's expenses (including amounts for 
living expenses) for travel away from home is the sum of the 
substantiated expenses that are otherwise deductible under section 
162(a)(2) in the pursuit of any trade or business of the taxpayer.
    (g) Cross references. See Sec. 1.62-1T(e)(4) for rules regarding 
allocation of unreimbursed expenses of state legislators and section 
274(n) for limitations on the amount allowable as a deduction for 
expenses for or allocable to meals.
    (h) Effective/applicability date. This section applies to expenses 
paid or incurred, or deemed expended under section 162(h), in taxable 
years beginning after April 8, 2010.

[T.D. 9481, 75 FR 17856, Apr. 8, 2010]



Sec. 1.162-25  Deductions with respect to noncash fringe benefits.

    (a) [Reserved]
    (b) Employee. If an employer provides the use of a vehicle (as 
defined in Sec. 1.61-21(e)(2)) to an employee as a noncash fringe 
benefit and includes the entire value of the benefit in the employee's 
gross income without taking into account any exclusion for a working 
condition fringe allowable under section 132 and the regulations 
thereunder, the employee may deduct that value multiplied by the 
percentage of the total use of the vehicle that is in connection with 
the employer's trade or business (business value). For taxable years 
beginning before January 1, 1990, the employee may deduct the business 
value from gross income in determining adjusted gross income. For 
taxable years beginning on or after January 1, 1990, the employee may 
deduct the business value only as a miscellaneous itemized deduction in 
determining taxable income, subject to the 2-percent floor provided in 
section 67. If the employer determines the value of the noncash fringe 
benefit under a special accounting rule that allows the employer to 
treat the value of benefits provided during the last two months of the 
calendar year or any shorter period as paid during the subsequent 
calendar year, then the employee must determine the deduction allowable 
under this paragraph (b) without regard to any use of the benefit during 
those last two months or any shorter period. The employee may not use a 
cents-per-mile valuation method to determine the deduction allowable 
under this paragraph (b).

[T.D. 8451, 57 FR 57669, Dec. 7, 1992; 57 FR 60568, Dec. 21, 1992]



Sec. 1.162-25T  Deductions with respect to noncash fringe benefits 
(temporary).

    (a) Employer. If an employer includes the value of a noncash fringe 
benefit in

[[Page 219]]

an employee's gross income, the employer may not deduct this amount as 
compensation for services, but rather may deduct only the costs incurred 
by the employer in providing the benefit to the employee. The employer 
may be allowed a cost recovery deduction under section 168 or a 
deduction under section 179 for an expense not chargeable to capital 
account, or, if the noncash fringe benefit is property leased by the 
employer, a deduction for the ordinary and necessary business expense of 
leasing the property.
    (b) [Reserved]
    (c) Examples. The following examples illustrate the provisions of 
this section.

    Example 1. On January 1, 1986, X Company owns and provides the use 
of an automobile with a fair market value of $20,000 to E, an employee, 
for the entire calendar year. Both X and E compute taxable income on the 
basis of the calendar year. Seventy percent of the use of the automobile 
by E is in connection with X's trade or business. If X uses the special 
rule provided in Sec. 1.61-2T for valuing the availability of the 
automobile and takes into account the amount excludable as a working 
condition fringe, X would include $1,680 ($5,600, the Annual Lease 
Value, less 70 percent of $5,600) in E's gross income for 1986. X may 
not deduct the amount included in E's income as compensation for 
services. X may, however, determine a cost recovery deduction under 
section 168, subject to the limitations under section 280F, for taxable 
year 1986.
    Example 2. The facts are the same as in example (1), except that X 
includes $5,600 in E's gross income, the value of the noncash fringe 
benefit without taking into account the amount excludable as a working 
condition fringe. X may not deduct that amount as compensation for 
services, but may determine a cost recovery deduction under section 168, 
subject to the limitations under section 280F. For purposes of 
determining adjusted gross income, E may deduct $3,920 ($5,600 
multiplied by the percent of business use).

[T.D. 8061, 50 FR 46013, Nov. 6, 1985, as amended by T.D. 8063, 50 FR 
52312, Dec. 23, 1985; T.D. 8276, 54 FR 51026, Dec. 12, 1989; T.D. 8451, 
57 FR 57669, Dec. 7, 1992]



Sec. 1.162-27  Certain employee remuneration in excess of $1,000,000.

    (a) Scope. This section provides rules for the application of the $1 
million deduction limit under section 162(m) of the Internal Revenue 
Code. Paragraph (b) of this section provides the general rule limiting 
deductions under section 162(m). Paragraph (c) of this section provides 
definitions of generally applicable terms. Paragraph (d) of this section 
provides an exception from the deduction limit for compensation payable 
on a commission basis. Paragraph (e) of this section provides an 
exception for qualified performance-based compensation. Paragraphs (f) 
and (g) of this section provide special rules for corporations that 
become publicly held corporations and payments that are subject to 
section 280G, respectively. Paragraph (h) of this section provides 
transition rules, including the rules for contracts that are 
grandfathered and not subject to section 162(m). Paragraph (j) of this 
section contains the effective date provisions. For rules concerning the 
deductibility of compensation for services that are not covered by 
section 162(m) and this section, see section 162(a)(1) and Sec. 1.162-7. 
This section is not determinative as to whether compensation meets the 
requirements of section 162(a)(1).
    (b) Limitation on deduction. Section 162(m) precludes a deduction 
under chapter 1 of the Internal Revenue Code by any publicly held 
corporation for compensation paid to any covered employee to the extent 
that the compensation for the taxable year exceeds $1,000,000.
    (c) Definitions--(1) Publicly held corporation--(i) General rule. A 
publicly held corporation means any corporation issuing any class of 
common equity securities required to be registered under section 12 of 
the Exchange Act. A corporation is not considered publicly held if the 
registration of its equity securities is voluntary. For purposes of this 
section, whether a corporation is publicly held is determined based 
solely on whether, as of the last day of its taxable year, the 
corporation is subject to the reporting obligations of section 12 of the 
Exchange Act.
    (ii) Affiliated groups. A publicly held corporation includes an 
affiliated group of corporations, as defined in section 1504 (determined 
without regard to section 1504(b)). For purposes of this section, 
however, an affiliated group of corporations does not include any 
subsidiary that is itself a publicly held corporation. Such a publicly 
held

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subsidiary, and its subsidiaries (if any), are separately subject to 
this section. If a covered employee is paid compensation in a taxable 
year by more than one member of an affiliated group, compensation paid 
by each member of the affiliated group is aggregated with compensation 
paid to the covered employee by all other members of the group. Any 
amount disallowed as a deduction by this section must be prorated among 
the payor corporations in proportion to the amount of compensation paid 
to the covered employee by each such corporation in the taxable year.
    (2) Covered employee--(i) General rule. A covered employee means any 
individual who, on the last day of the taxable year, is--
    (A) The chief executive officer of the corporation or is acting in 
such capacity; or
    (B) Among the four highest compensated officers (other than the 
chief executive officer).
    (ii) Application of rules of the Securities and Exchange Commission. 
Whether an individual is the chief executive officer described in 
paragraph (c)(2)(i)(A) of this section or an officer described in 
paragraph (c)(2)(i)(B) of this section is determined pursuant to the 
executive compensation disclosure rules under the Exchange Act.
    (3) Compensation--(i) In general. For purposes of the deduction 
limitation described in paragraph (b) of this section, compensation 
means the aggregate amount allowable as a deduction under chapter 1 of 
the Internal Revenue Code for the taxable year (determined without 
regard to section 162(m)) for remuneration for services performed by a 
covered employee, whether or not the services were performed during the 
taxable year.
    (ii) Exceptions. Compensation does not include--
    (A) Remuneration covered in section 3121(a)(5)(A) through section 
3121(a)(5)(D) (concerning remuneration that is not treated as wages for 
purposes of the Federal Insurance Contributions Act); and
    (B) Remuneration consisting of any benefit provided to or on behalf 
of an employee if, at the time the benefit is provided, it is reasonable 
to believe that the employee will be able to exclude it from gross 
income. In addition, compensation does not include salary reduction 
contributions described in section 3121(v)(1).
    (4) Compensation Committee. The compensation committee means the 
committee of directors (including any subcommittee of directors) of the 
publicly held corporation that has the authority to establish and 
administer performance goals described in paragraph (e)(2) of this 
section, and to certify that performance goals are attained, as 
described in paragraph (e)(5) of this section. A committee of directors 
is not treated as failing to have the authority to establish performance 
goals merely because the goals are ratified by the board of directors of 
the publicly held corporation or, if applicable, any other committee of 
the board of directors. See paragraph (e)(3) of this section for rules 
concerning the composition of the compensation committee.
    (5) Exchange Act. The Exchange Act means the Securities Exchange Act 
of 1934.
    (6) Examples. This paragraph (c) may be illustrated by the following 
examples:

    Example 1. Corporation X is a publicly held corporation with a July 
1 to June 30 fiscal year. For Corporation X's taxable year ending on 
June 30, 1995, Corporation X pays compensation of $2,000,000 to A, an 
employee. However, A's compensation is not required to be reported to 
shareholders under the executive compensation disclosure rules of the 
Exchange Act because A is neither the chief executive officer nor one of 
the four highest compensated officers employed on the last day of the 
taxable year. A's compensation is not subject to the deduction 
limitation of paragraph (b) of this section.
    Example 2. C, a covered employee, performs services and receives 
compensation from Corporations X, Y, and Z, members of an affiliated 
group of corporations. Corporation X, the parent corporation, is a 
publicly held corporation. The total compensation paid to C from all 
affiliated group members is $3,000,000 for the taxable year, of which 
Corporation X pays $1,500,000; Corporation Y pays $900,000; and 
Corporation Z pays $600,000. Because the compensation paid by all 
affiliated group members is aggregated for purposes of section 162(m), 
$2,000,000 of the aggregate compensation paid is nondeductible. 
Corporations X, Y, and Z each are treated as paying a ratable portion of 
the nondeductible compensation. Thus, two

[[Page 221]]

thirds of each corporation's payment will be nondeductible. Corporation 
X has a nondeductible compensation expense of $1,000,000 ($1,500,000  x  
$2,000,000/$3,000,000). Corporation Y has a nondeductible compensation 
expense of $600,000 ($900,000  x  $2,000,000/$3,000,000). Corporation Z 
has a nondeductible compensation expense of $400,000 ($600,000  x  
$2,000,000/$3,000,000).
    Example 3. Corporation W, a calendar year taxpayer, has total assets 
equal to or exceeding $5 million and a class of equity security held of 
record by 500 or more persons on December 31, 1994. However, under the 
Exchange Act, Corporation W is not required to file a registration 
statement with respect to that security until April 30, 1995. Thus, 
Corporation W is not a publicly held corporation on December 31, 1994, 
but is a publicly held corporation on December 31, 1995.
    Example 4. The facts are the same as in Example 3, except that on 
December 15, 1996, Corporation W files with the Securities and Exchange 
Commission to disclose that Corporation W is no longer required to be 
registered under section 12 of the Exchange Act and to terminate its 
registration of securities under that provision. Because Corporation W 
is no longer subject to Exchange Act reporting obligations as of 
December 31, 1996, Corporation W is not a publicly held corporation for 
taxable year 1996, even though the registration of Corporation W's 
securities does not terminate until 90 days after Corporation W files 
with the Securities and Exchange Commission.

    (d) Exception for compensation paid on a commission basis. The 
deduction limit in paragraph (b) of this section shall not apply to any 
compensation paid on a commission basis. For this purpose, compensation 
is paid on a commission basis if the facts and circumstances show that 
it is paid solely on account of income generated directly by the 
individual performance of the individual to whom the compensation is 
paid. Compensation does not fail to be attributable directly to the 
individual merely because support services, such as secretarial or 
research services, are utilized in generating the income. However, if 
compensation is paid on account of broader performance standards, such 
as income produced by a business unit of the corporation, the 
compensation does not qualify for the exception provided under this 
paragraph (d).
    (e) Exception for qualified performance-based compensation--
    (1) In general. The deduction limit in paragraph (b) of this section 
does not apply to qualified performance-based compensation. Qualified 
performance-based compensation is compensation that meets all of the 
requirements of paragraphs (e)(2) through (e)(5) of this section.
    (2) Performance goal requirement--(i) Preestablished goal. Qualified 
performance-based compensation must be paid solely on account of the 
attainment of one or more preestablished, objective performance goals. A 
performance goal is considered preestablished if it is established in 
writing by the compensation committee not later than 90 days after the 
commencement of the period of service to which the performance goal 
relates, provided that the outcome is substantially uncertain at the 
time the compensation committee actually establishes the goal. However, 
in no event will a performance goal be considered to be preestablished 
if it is established after 25 percent of the period of service (as 
scheduled in good faith at the time the goal is established) has 
elapsed. A performance goal is objective if a third party having 
knowledge of the relevant facts could determine whether the goal is met. 
Performance goals can be based on one or more business criteria that 
apply to the individual, a business unit, or the corporation as a whole. 
Such business criteria could include, for example, stock price, market 
share, sales, earnings per share, return on equity, or costs. A 
performance goal need not, however, be based upon an increase or 
positive result under a business criterion and could include, for 
example, maintaining the status quo or limiting economic losses 
(measured, in each case, by reference to a specific business criterion). 
A performance goal does not include the mere continued employment of the 
covered employee. Thus, a vesting provision based solely on continued 
employment would not constitute a performance goal. See paragraph 
(e)(2)(vi) of this section for rules on compensation that is based on an 
increase in the price of stock.
    (ii) Objective compensation formula. A preestablished performance 
goal must state, in terms of an objective formula or standard, the 
method for computing the amount of compensation payable to the employee 
if the goal is attained. A

[[Page 222]]

formula or standard is objective if a third party having knowledge of 
the relevant performance results could calculate the amount to be paid 
to the employee. In addition, a formula or standard must specify the 
individual employees or class of employees to which it applies.
    (iii) Discretion. (A) The terms of an objective formula or standard 
must preclude discretion to increase the amount of compensation payable 
that would otherwise be due upon attainment of the goal. A performance 
goal is not discretionary for purposes of this paragraph (e)(2)(iii) 
merely because the compensation committee reduces or eliminates the 
compensation or other economic benefit that was due upon attainment of 
the goal. However, the exercise of negative discretion with respect to 
one employee is not permitted to result in an increase in the amount 
payable to another employee. Thus, for example, in the case of a bonus 
pool, if the amount payable to each employee is stated in terms of a 
percentage of the pool, the sum of these individual percentages of the 
pool is not permitted to exceed 100 percent. If the terms of an 
objective formula or standard fail to preclude discretion to increase 
the amount of compensation merely because the amount of compensation to 
be paid upon attainment of the performance goal is based, in whole or in 
part, on a percentage of salary or base pay and the dollar amount of the 
salary or base pay is not fixed at the time the performance goal is 
established, then the objective formula or standard will not be 
considered discretionary for purposes of this paragraph (e)(2)(iii) if 
the maximum dollar amount to be paid is fixed at that time.
    (B) If compensation is payable upon or after the attainment of a 
performance goal, and a change is made to accelerate the payment of 
compensation to an earlier date after the attainment of the goal, the 
change will be treated as an increase in the amount of compensation, 
unless the amount of compensation paid is discounted to reasonably 
reflect the time value of money. If compensation is payable upon or 
after the attainment of a performance goal, and a change is made to 
defer the payment of compensation to a later date, any amount paid in 
excess of the amount that was originally owed to the employee will not 
be treated as an increase in the amount of compensation if the 
additional amount is based either on a reasonable rate of interest or on 
one or more predetermined actual investments (whether or not assets 
associated with the amount originally owed are actually invested 
therein) such that the amount payable by the employer at the later date 
will be based on the actual rate of return of a specific investment 
(including any decrease as well as any increase in the value of an 
investment). If compensation is payable in the form of property, a 
change in the timing of the transfer of that property after the 
attainment of the goal will not be treated as an increase in the amount 
of compensation for purposes of this paragraph (e)(2)(iii). Thus, for 
example, if the terms of a stock grant provide for stock to be 
transferred after the attainment of a performance goal and the transfer 
of the stock also is subject to a vesting schedule, a change in the 
vesting schedule that either accelerates or defers the transfer of stock 
will not be treated as an increase in the amount of compensation payable 
under the performance goal.
    (C) Compensation attributable to a stock option, stock appreciation 
right, or other stock-based compensation does not fail to satisfy the 
requirements of this paragraph (e)(2) to the extent that a change in the 
grant or award is made to reflect a change in corporate capitalization, 
such as a stock split or dividend, or a corporate transaction, such as 
any merger of a corporation into another corporation, any consolidation 
of two or more corporations into another corporation, any separation of 
a corporation (including a spinoff or other distribution of stock or 
property by a corporation), any reorganization of a corporation (whether 
or not such reorganization comes within the definition of such term in 
section 368), or any partial or complete liquidation by a corporation.
    (iv) Grant-by-grant determination. The determination of whether 
compensation satisfies the requirements of this paragraph (e)(2) 
generally shall be made on a grant-by-grant basis. Thus,

[[Page 223]]

for example, whether compensation attributable to a stock option grant 
satisfies the requirements of this paragraph (e)(2) generally is 
determined on the basis of the particular grant made and without regard 
to the terms of any other option grant, or other grant of compensation, 
to the same or another employee. As a further example, except as 
provided in paragraph (e)(2)(vi), whether a grant of restricted stock or 
other stock-based compensation satisfies the requirements of this 
paragraph (e)(2) is determined without regard to whether dividends, 
dividend equivalents, or other similar distributions with respect to 
stock, on such stock-based compensation are payable prior to the 
attainment of the performance goal. Dividends, dividend equivalents, or 
other similar distributions with respect to stock that are treated as 
separate grants under this paragraph (e)(2)(iv) are not performance-
based compensation unless they separately satisfy the requirements of 
this paragraph (e)(2).
    (v) Compensation contingent upon attainment of performance goal. 
Compensation does not satisfy the requirements of this paragraph (e)(2) 
if the facts and circumstances indicate that the employee would receive 
all or part of the compensation regardless of whether the performance 
goal is attained. Thus, if the payment of compensation under a grant or 
award is only nominally or partially contingent on attaining a 
performance goal, none of the compensation payable under the grant or 
award will be considered performance-based. For example, if an employee 
is entitled to a bonus under either of two arrangements, where payment 
under a nonperformance-based arrangement is contingent upon the failure 
to attain the performance goals under an otherwise performance-based 
arrangement, then neither arrangement provides for compensation that 
satisfies the requirements of this paragraph (e)(2). Compensation does 
not fail to be qualified performance-based compensation merely because 
the plan allows the compensation to be payable upon death, disability, 
or change of ownership or control, although compensation actually paid 
on account of those events prior to the attainment of the performance 
goal would not satisfy the requirements of this paragraph (e)(2). As an 
exception to the general rule set forth in the first sentence of 
paragraph (e)(2)(iv) of this section, the facts-and-circumstances 
determination referred to in the first sentence of this paragraph 
(e)(2)(v) is made taking into account all plans, arrangements, and 
agreements that provide for compensation to the employee.
    (vi) Application of requirements to stock options and stock 
appreciation rights--(A) In general. Compensation attributable to a 
stock option or a stock appreciation right is deemed to satisfy the 
requirements of this paragraph (e)(2) if the grant or award is made by 
the compensation committee; the plan under which the option or right is 
granted states the maximum number of shares with respect to which 
options or rights may be granted during a specified period to any 
individual employee; and, under the terms of the option or right, the 
amount of compensation the employee may receive is based solely on an 
increase in the value of the stock after the date of the grant or award. 
A plan may satisfy the requirement to provide a maximum number of shares 
with respect to which stock options and stock appreciation rights may be 
granted to any individual employee during a specified period if the plan 
specifies an aggregate maximum number of shares with respect to which 
stock options, stock appreciation rights, restricted stock, restricted 
stock units and other equity-based awards that may be granted to any 
individual employee during a specified period under a plan approved by 
shareholders in accordance with Sec. 1.162-27(e)(4). If the amount of 
compensation the employee may receive under the grant or award is not 
based solely on an increase in the value of the stock after the date of 
grant or award (for example, in the case of restricted stock, or an 
option that is granted with an exercise price that is less than the fair 
market value of the stock as of the date of grant), none of the 
compensation attributable to the grant or award is qualified 
performance-based compensation under this paragraph (e)(2)(vi)(A). 
Whether a stock option grant is based solely on an increase in

[[Page 224]]

the value of the stock after the date of grant is determined without 
regard to any dividend equivalent that may be payable, provided that 
payment of the dividend equivalent is not made contingent on the 
exercise of the option. The rule that the compensation attributable to a 
stock option or stock appreciation right must be based solely on an 
increase in the value of the stock after the date of grant or award does 
not apply if the grant or award is made on account of, or if the vesting 
or exercisability of the grant or award is contingent on, the attainment 
of a performance goal that satisfies the requirements of this paragraph 
(e)(2).
    (B) Cancellation and repricing. Compensation attributable to a stock 
option or stock appreciation right does not satisfy the requirements of 
this paragraph (e)(2) to the extent that the number of options granted 
exceeds the maximum number of shares for which options may be granted to 
the employee as specified in the plan. If an option is canceled, the 
canceled option continues to be counted against the maximum number of 
shares for which options may be granted to the employee under the plan. 
If, after grant, the exercise price of an option is reduced, the 
transaction is treated as a cancellation of the option and a grant of a 
new option. In such case, both the option that is deemed to be canceled 
and the option that is deemed to be granted reduce the maximum number of 
shares for which options may be granted to the employee under the plan. 
This paragraph (e)(2)(vi)(B) also applies in the case of a stock 
appreciation right where, after the award is made, the base amount on 
which stock appreciation is calculated is reduced to reflect a reduction 
in the fair market value of stock.
    (vii) Examples. This paragraph (e)(2) may be illustrated by the 
following examples:

    Example 1. No later than 90 days after the start of a fiscal year, 
but while the outcome is substantially uncertain, Corporation S 
establishes a bonus plan under which A, the chief executive officer, 
will receive a cash bonus of $500,000, if year-end corporate sales are 
increased by at least 5 percent. The compensation committee retains the 
right, if the performance goal is met, to reduce the bonus payment to A 
if, in its judgment, other subjective factors warrant a reduction. The 
bonus will meet the requirements of this paragraph (e)(2).
    Example 2. The facts are the same as in Example 1, except that the 
bonus is based on a percentage of Corporation S's total sales for the 
fiscal year. Because Corporation S is virtually certain to have some 
sales for the fiscal year, the outcome of the performance goal is not 
substantially uncertain, and therefore the bonus does not meet the 
requirements of this paragraph (e)(2).
    Example 3. The facts are the same as in Example 1, except that the 
bonus is based on a percentage of Corporation S's total profits for the 
fiscal year. Although some sales are virtually certain for virtually all 
public companies, it is substantially uncertain whether a company will 
have profits for a specified future period even if the company has a 
history of profitability. Therefore, the bonus will meet the 
requirements of this paragraph (e)(2).
    Example 4. B is the general counsel of Corporation R, which is 
engaged in patent litigation with Corporation S. Representatives of 
Corporation S have informally indicated to Corporation R a willingness 
to settle the litigation for $50,000,000. Subsequently, the compensation 
committee of Corporation R agrees to pay B a bonus if B obtains a formal 
settlement for at least $50,000,000. The bonus to B does not meet the 
requirement of this paragraph (e)(2) because the performance goal was 
not established at a time when the outcome was substantially uncertain.
    Example 5. Corporation S, a public utility, adopts a bonus plan for 
selected salaried employees that will pay a bonus at the end of a 3-year 
period of $750,000 each if, at the end of the 3 years, the price of S 
stock has increased by 10 percent. The plan also provides that the 10-
percent goal will automatically adjust upward or downward by the 
percentage change in a published utilities index. Thus, for example, if 
the published utilities index shows a net increase of 5 percent over a 
3-year period, then the salaried employees would receive a bonus only if 
Corporation S stock has increased by 15 percent. Conversely, if the 
published utilities index shows a net decrease of 5 percent over a 3-
year period, then the salaried employees would receive a bonus if 
Corporation S stock has increased by 5 percent. Because these automatic 
adjustments in the performance goal are preestablished, the bonus meets 
the requirement of this paragraph (e)(2), notwithstanding the potential 
changes in the performance goal.
    Example 6. The facts are the same as in Example 5, except that the 
bonus plan provides that, at the end of the 3-year period, a bonus of 
$750,000 will be paid to each salaried employee if either the price of 
Corporation S stock has increased by 10 percent or the earnings per 
share on Corporation S stock

[[Page 225]]

have increased by 5 percent. If both the earnings-per-share goal and the 
stock-price goal are preestablished, the compensation committee's 
discretion to choose to pay a bonus under either of the two goals does 
not cause any bonus paid under the plan to fail to meet the requirement 
of this paragraph (e)(2) because each goal independently meets the 
requirements of this paragraph (e)(2). The choice to pay under either of 
the two goals is tantamount to the discretion to choose not to pay under 
one of the goals, as provided in paragraph (e)(2)(iii) of this section.
    Example 7. Corporation U establishes a bonus plan under which a 
specified class of employees will participate in a bonus pool if certain 
preestablished performance goals are attained. The amount of the bonus 
pool is determined under an objective formula. Under the terms of the 
bonus plan, the compensation committee retains the discretion to 
determine the fraction of the bonus pool that each employee may receive. 
The bonus plan does not satisfy the requirements of this paragraph 
(e)(2). Although the aggregate amount of the bonus plan is determined 
under an objective formula, a third party could not determine the amount 
that any individual could receive under the plan.
    Example 8. The facts are the same as in Example 7, except that the 
bonus plan provides that a specified share of the bonus pool is payable 
to each employee, and the total of these shares does not exceed 100% of 
the pool. The bonus plan satisfies the requirements of this paragraph 
(e)(2). In addition, the bonus plan will satisfy the requirements of 
this paragraph (e)(2) even if the compensation committee retains the 
discretion to reduce the compensation payable to any individual 
employee, provided that a reduction in the amount of one employee's 
bonus does not result in an increase in the amount of any other 
employee's bonus.
    Example 9. Corporation V establishes a stock option plan for 
salaried employees. The terms of the stock option plan specify that no 
individual salaried employee shall receive options for more than 100,000 
shares over any 3-year period. The compensation committee grants options 
for 50,000 shares to each of several salaried employees. The exercise 
price of each option is equal to or greater than the fair market value 
of a share of V stock at the time of each grant. Compensation 
attributable to the exercise of the options satisfies the requirements 
of paragraph (e)(2)(vi) of this section. If, however, the terms of the 
options provide that the exercise price is less than fair market value 
of a share of V stock at the date of grant, no compensation attributable 
to the exercise of those options satisfies the requirements of this 
paragraph (e)(2) unless issuance or exercise of the options was 
contingent upon the attainment of a preestablished performance goal that 
satisfies this paragraph (e)(2). If, however, the terms of the plan also 
provide that Corporation V could grant options to purchase no more than 
900,000 shares over any 3-year period, but did not provide a limitation 
on the number of shares that any individual employee could purchase, 
then no compensation attributable to the exercise of those options 
satisfies the requirements of paragraph (e)(2)(vi) of this section.
    Example 10. The facts are the same as in Example 9, except that, 
within the same 3-year grant period, the fair market value of 
Corporation V stock is significantly less than the exercise price of the 
options. The compensation committee reprices those options to that lower 
current fair market value of Corporation V stock. The repricing of the 
options for 50,000 shares held by each salaried employee is treated as 
the grant of new options for an additional 50,000 shares to each 
employee. Thus, each of the salaried employees is treated as having 
received grants for 100,000 shares. Consequently,