United States: How To Live With A 501(c)(3) Bond Issue

The bond documents have been bound in a neat, thick transcript. The chief financial officer has worked for months with the board of directors, management, bond counsel and the remainder of the bond working group to structure and close a successful 501(c)(3) bond issue. The 501(c)(3) nonprofit commences its building program with the bond proceeds and looks forward to enjoying the low, tax-exempt interest rate on the bonds for their full term. What more does the nonprofit need to do?

Although continuing compliance with a tax-exempt 501(c)(3) bond issue need not be burdensome, it is rife with specialized and non-intuitive requirements. Because a nonprofit may be using bonds for the first time or may use them infrequently, and because during the term of a bond issue there will be personnel changes and many other demands for the attention of these persons, compliance requirements can present traps for the unwary. A failure to comply with applicable rules and regulations, in the worst case scenario, can result in the bonds becoming taxable retroactively to their date of issuance. Accordingly, we recommend that the nonprofit's appropriate personnel take time to understand the compliance requirements and to prepare and memorialize a compliance program. Only when the compliance program is in place should the bond document transcript be put on the shelf and everyone's full attention return to the nonprofit's mission.

This article provides a brief overview of 501(c)(3) bond financing and identifies continuing compliance issues. Practical suggestions are made for how the nonprofit can live comfortably with its bond issue.

Brief Overview of 501(c)(3) Financing.

Nonprofit organizations having 501(c)(3) status increasingly are taking advantage of low interest rate, tax-exempt financing to finance capital projects or to refinance existing debt. The Federal Tax Code permits this lower cost borrowing in recognition of the important societal functions performed by nonprofits. Although nonprofits may be debt-averse in general, bond financing can make sound financial sense.

Bond financing usually takes the form of a loan from a state or local governmental body, often a development authority. State laws vary concerning bond financing for nonprofits, but is available in most jurisdictions. Such bonds are revenue bonds, repayable solely from the amounts to be paid by the nonprofit and any credit enhancement (such as a letter of credit or bond insurance) that it procures, or from assets or other security that it may pledge for this purpose. The interest rate is low because 501(c)(3) bonds issued by the governmental body can be qualified under the Federal Tax Code to pay tax-exempt interest to the investors, and the low interest rate is passed on to the nonprofit. The moneys raised from the bonds will be used to acquire or construct the capital facilities that the nonprofit chooses.

Bond financing can be used for land acquisition, bricks and mortar, furniture, furnishings and equipment and many other costs associated with a nonprofit's charitable, educational, recreational or other exempt purposes, including in proper circumstances refinancing of capital debt and providing working capital. Bond financing may permit a nonprofit to build its facilities sooner or expand the scope of its projects. With facilities financed by low-interest, long-term bonds, fundraising moneys can go to build endowment or to fund other programs.

The principal qualification requirements for a tax-exempt 501(c)(3) bond issue can be stated relatively simply. All property financed with the proceeds of the bonds must be owned by a 501(c)(3) organization. No more than 5% of the proceeds of the bonds may be put to "private business use," or be secured by or be derived from payments respecting property put to such private business use. Private business use means use by a 501(c)(3) organization that produces "unrelated business taxable income" or use by others in any non-governmental trade or business. The property financed must be the subject of an appropriate public hearing and governmental approval. Finally, "arbitrage," the practice of using bonds to acquire higher yielding investments, or to replace funds used directly or indirectly to acquire higher yielding investments, is limited by law and regulation.

Despite the simple statement of these requirements, the concepts and rules are complex and their application to particular circumstances can be difficult. The nonprofit will have had the benefit of the analysis and advice of nationally recognized and expert bond counsel in putting together and closing the bond transaction. Following closing, the nonprofit may be largely on its own, except to the extent it determines to further consult qualified experts from time to time.

The remainder of this article discusses the common tax compliance requirements falling to a nonprofit as a result of a bond issue. Concrete examples of the application of these requirements are given. The principal issues around which such compliance revolve are:

  • Is 501(c)(3) status maintained?
  • How are the bond proceeds used?
  • How are the financed facilities used?
  • What if financed property is disposed of?
  • How is prohibited arbitrage avoided?

Is 501(c)(3) Status Maintained?

Nonprofits should be familiar with requirements for maintaining their 501(c)(3) status, and keeping a bond issue tax-exempt is not the principal consideration in that regard. Nevertheless, because a bond issue will only remain tax-exempt if the nonprofit maintains its 501(c)(3) status, it is pertinent here to briefly review the requirements for maintaining the nonprofit's 501(c)(3) status.

Having received a 501(c)(3) determination letter from the I.R.S., a nonprofit will generally maintain that status as long as it does not materially change its methods of operation, purposes or character. The determination letter usually states that the nonprofit should communicate to the I.R.S. as soon as possible a change in its methods of operation, purposes or character, as the determination letter is based upon the information originally contained in the nonprofit's application for the determination letter. A material change could be the basis for the I.R.S. to modify or revoke a nonprofit's 501(c)(3) status, but in most instances the change does not go to qualifying criteria and will be merely noted. Communication of a change to the I.R.S. might take the form of reflecting the information on the annual reporting Form 990 or transmitting a separate explanation. An explanation letter might simply note the change, or request the I.R.S. to reconfirm the determination letter.

Changes that surely should be communicated to the I.R.S. include any change in the legal form of the nonprofit (for example re-incorporation from one state to another), any change in its purposes or principal activities (for example adding housing assistance to a job training program), a change in its organizational structure (such as the way in which the board of trustees is selected), or a change in its methods of operation (such as a material change in the sources of its support).

Other ways in which a nonprofit could endanger its 501(c)(3) status are to actually operate outside of its governing documents or its determination letter, to fail to make required informational filings with the I.R.S. or to violate the several specific I.R.S. rules governing such organizations, for example the rules against private inurement of the benefits of the nonprofit to insiders or other private interests, or rules prohibiting nonprofits from engaging in certain political activities.

The nonprofit's determination letter normally provides whether or not the nonprofit is required to file annually a Form 990 information return. Unless an exemption applies, for example the exemption for church-affiliated schools below the college level, each nonprofit is required to disclose financial and other information on Form 990. Nonprofit organizations are required to make available their determination letter and the related application and certain other information to persons requesting that information.

In addition, certain types of nonprofits must comply with specialized I.R.S. rules. Private schools with 501(c)(3) status, for example, are required to publish annually a nondiscrimination notice in a prescribed form.

How are the Bond Proceeds Used?

Allocation of Proceeds.

The bond documents prepared for closing will contain a description of the "project" planned to be financed. In a bond transaction, funds to pay for the costs of the project may come from a variety of sources including bond proceeds, donations and the nonprofit's accumulated funds. The process of allocation establishes which dollars are treated as spent for which costs. For these and most purposes, "proceeds" of the bonds include the "sale proceeds" generated by the sale of the bonds, and the "investment proceeds" earned by the investment of the proceeds prior to their application to project costs. Very likely the bond closing documents include tax certifications including the amount of proceeds of the bonds expected to be applied for various purposes, such as closing costs, capitalized interest, credit enhancement costs and costs of the acquisition of the various components of the project. This initial certification represents the nonprofit's expectations and estimates only, and for tax purposes the actual allocation of bond proceeds will be determinative.

The principal purpose of any allocation is to assure compliance with the bond qualification rules that no more than 2% of the sale proceeds of the bonds be applied to "costs of issuance" of the bonds and that at least 95% of the total proceeds of the bonds (including investment proceeds) are used to acquire property within the scope of the project owned by the nonprofit and not put to private business use.

Unless another method is selected by the nonprofit, bond proceeds are considered allocated based on a tracing of actual uses to which the dollars withdrawn from the "project fund" containing the bond proceeds are put. Significantly, a different allocation can be made by the nonprofit during a limited period after the actual expenditures are made, and this may be beneficial.

Bad Money.

The difference between the 95% of total proceeds required to be spent on property owned by the nonprofit and not put to private business use and 100% of total bond proceeds is sometimes referred to as the "bad money basket" or "bad money." The 2% of bond sale proceeds that can be applied to costs of issuance falls into and reduces the bad money basket to approximately 3%. Although it may not be appropriate or prudent to do so, under the tax rules the bad money could be used for a variety of purposes, including private-use property or working capital. However, any application of bad money for non-qualifying uses reduces the percentage of private business use of the financed property that will be permitted over the term of the bond issue. For example, if 1% of the bond sale proceeds is used to purchase property to be used to produce unrelated business taxable income, this amount reduces the 5% private use that will be permitted of qualifying property financed with the bonds over the life of the bond issue to approximately 4%.

Cost of Issuance Limitation.

That no more than 2% of the sale proceeds of the bonds may be used to pay costs of issuance is a bright-line rule, the violation of which can render the bonds taxable from the date of their issuance. Costs of issuance is a broad concept, and includes: underwriters' spread, whether realized as a fee or derived through purchase of the bonds at a discount below the price at which they are expected to be sold to the public; counsel fees, including bond counsel, underwriter's counsel, issuer's counsel, nonprofit's counsel, as well as any other specialized counsel fees incurred in connection with the borrowing; financial advisor fees incurred in connection with the borrowing; rating agency fees; trustee fees incurred in connection with the borrowing; paying agent and authenticating agent fees related to issuance of the bonds; accounting fees related to issuance of the bonds; printing costs; costs incurred in connection with the required public approval process; costs of engineering and feasibility studies if necessary to the issuance of the bonds; and similar costs. Care should be exercised that amounts that might be treated as costs of issuance are not separately paid from the project fund as project or development costs, as this can result in greater than 2% of sale proceeds being applied to costs of issuance. This rule might also be violated if the sale proceeds of the bonds are later considered to be reduced. For example, if the maximum 2% of bond sale proceeds is used at closing to pay costs of issuance, and if all of the bond proceeds are not later used and the excess proceeds are applied to reduce the principal of the bonds, the result may be that more than 2% of bond proceeds are applied to costs of issuance. This suggests either caution in the early application of bond proceeds to costs of issuance, or a later reallocation of bond proceeds to cure the violation, as discussed below.

Reallocation.

A nonprofit may reallocate bond proceeds to different expenditures within a limited timeframe. Any reallocation must be made no later than 18 months after the later of the date of the expenditure or the date the financed project is placed into service, but in no event later than 60 days after the fifth anniversary of the bond closing.

To illustrate how a reallocation, or for that matter an initial allocation, might be used to the best advantage of a nonprofit, consider a private school with a project requiring a $10,000,000 total investment. The investment consists of a $3,620,000 library, a $3,500,000 stadium and a $2,380,000 gymnasium, $150,000 of costs of issuance, $250,000 of interest to be paid on the bonds during the construction of the project, and $100,000 of credit enhancement fees during the construction of the project. For the purpose of funding this project the school raised $4,000,000 through fundraising and borrowed $6,000,000 through tax-exempt bonds. The school initially paid from the bond proceeds $120,000 of the costs of issuance, the $3,500,000 cost of the stadium and the $2,380,000 cost of the gym. The school used the $4,000,000 of fundraising receipts for the library, which it named after the principal donor, and for the remaining costs.

There are several potential disadvantages to this allocation. First, the school may wish to allow the stadium or the gym to be leased for a portion of the time over the 20-year term of the financing for periodic use by a for-profit sports team, which could constitute private business use of a bond-financed facility. Further, the use of the bond proceeds for costs of issuance reduces the permitted private business use of the bond-financed facilities from 5% to approximately 3%. For example, if use of the gym for private summer sports camps operated by the basketball coach or an outside company, which could constitute private business use of a bond-financed facility, might be desirable in the future, this reduction might prove detrimental.

It may be more desirable to reallocate all of the bond proceeds to costs of the library and the gymnasium. The fundraising monies would be allocated to all of the remaining costs, including all costs of issuance. Under this reallocation, there are no bond-funded costs of issuance to reduce the 5% of private business use permitted over the life of the bond issue of the gymnasium and library financed, and the stadium is not a bond-financed facility subject to limitations on private business use at all. Even though the library is a bond-financed facility, it can still be named for the principal donor.

When a reallocation is considered or if there are unused bond proceeds after the contemplated project is completed, bond counsel should be consulted. Allocation of bond proceeds must be within the scope of a "TEFRA" public hearing and approval, and the Treasury Regulations prescribe particular methods for the use of excess bond proceeds.

How Are the Financed Facilities Used?

The facilities that a nonprofit finances with bonds during the term of the bonds may see varied uses not wholly consistent with the nonprofit's 501(c)(3) mission. Auditoriums, meeting rooms and recreation facilities might be leased to private groups. Healthcare organizations make space available to a variety of professionals conducting a part or even all of their for-profit business on their premises. A school may allow independent summer camps to be conducted at its facilities. And why should space in a nonprofit's parking lot remain unused when it is not needed? There are even more subtle ways in which private use of bond-financed facilities might be generated. Any sort of manager or operator hired to oversee a portion of a nonprofit's facilities or operations can create private business use of bond-financed facilities. For example, a nonprofit may consider it a burden to hire its own personnel to operate its cafeteria, and instead allow a private operation to provide the service at no cost to the nonprofit. Bond-financed property might include generally unusable land on which a cellular provider might wish to erect a tower. The nonprofit itself may conduct operations that are unrelated to its exempt purpose, for example a school's sale of branded merchandise. These normal activities and uses are not prohibited, but are limited by the "private activity" tests to assure that the advantaged bond financing principally furthers 501(c)(3) purposes.

Private Activity Tests.

The private activity tests have the purpose of limiting the amount of tax-exempt bonds that finance non-501(c)(3), non-governmental activities, without regard to whether the bonds actually transfer benefits of the financings. There are two tests, and when both are triggered, the bonds can fail to achieve tax-exempt status. One test, the "private business use test," prohibits the use of more than 5% of the bond proceeds (including property financed with bond proceeds) in the trade or business of any person other than the nonprofit entity. The second test, or the "private security or payment test," provides that no more than 5% of the payment of principal or interest on the bonds may be secured, directly or indirectly, by property used in the trade or business, or derived from payments related to property used in the trade or business. Typically, where the private business use test is triggered, the private security or payment test will also be triggered. Accordingly, this article focuses on the private business use test. So long as the nonprofit stays within the limits of the private business use test, the tax-exempt status of the bonds will not be jeopardized by the private activity tests.

Private Business Use Test. Property financed with tax-exempt 501(c)(3) bonds must not only be owned by the nonprofit, but all except an insubstantial portion must be used to further its charitable, educational, recreational or other exempt purpose. Bonds may be denied tax-exempt status if property financed by more than 5% of the proceeds is used in a non-501(c)(3) trade or business of a non-governmental person. "Bad" use can arise either from use by a nonprofit of the property to generate unrelated business taxable income, or use of the property by a for-profit entity in a private business use. This article will focus on private business use, as most nonprofits are familiar with the rules concerning unrelated business taxable income.

Determining what constitutes private business use can be difficult, and measuring the amount of private business use over the life of the bonds adds to the complexity. For these purposes, private business use is use of bond-financed property in a non-501(c)(3) trade or business. A trade or business is broadly defined to include any activity carried on by an artificial entity; use by a natural person not engaged in a trade or business is acceptable. Often private business use arises where a nonprofit enters into arrangements with entities, other than the general public, for the temporary or long-term use of all or a portion of a bond-financed facility. Leases and many other operating arrangements can give rise to private business use.

General Public Use. Use by the general public is not private business use. If a facility is available for use on the same basis by natural persons not engaged in a trade or business, it may be made available to business entities. For example, if a nonprofit's parking deck is reasonably expected, due to its location, to be utilized more than 5% by entities engaged in nearby trades or businesses, this may not place the deck in private business use, if it is in fact available to the general public on a monthly, first come–first served, basis at rates determined each month. Different rates may apply to different classes of users, such as volume purchasers, if the differences in rates are customary and reasonable. However, an arrangement will not be treated as general public use if it is for a binding term of greater than 180 days.

Incidental and Short-Term Uses. Certain use arrangements are exempted from treatment as private business use. Contracts for services that are solely incidental to the primary functions of a financed facility, for example the contract with the cleaning service, a billing agency, or the office equipment supplier, do not produce private business use. Merely incidental uses of portions of bond-financed facilities representing less than 2.5% of the bond proceeds are disregarded when used for vending machines, pay telephones and kiosks, or when the private use does not involve transfer of possession and control of physically separate space. Some short-term arrangements also are disregarded. Exceptions are available for use arrangements having a term not greater than thirty days if entered into at arm's length at fair market compensation, and for use arrangements not longer than ninety days if available to all persons engaged in a trade or business at generally applicable and uniformly applied rates. So, casual short-term leases should not give rise to private business use concerns.

Leases and Similar Agreements. A lease of bond-financed property to a non-501(c)(3) non-governmental entity normally creates private business use of that property. Other contracts, not denominated as leases, may be characterized as leases, based on all the facts and circumstances, including the degree of control over the property that is exercised by the contracting party and whether the contracting party bears a risk of loss of the financed property. A lease by one 501(c)(3) organization to another does not create private business use so long as the lessee does not use the bond-financed property to generate unrelated business taxable income.

Management, Operation and Service Contracts. For some nonprofits it is not at all unusual to enter into management, operation and service contracts, for example a contract for the operation of a hospital food service or for the outside management of an assisted living facility. Such contracts (generally referred to as "management contracts") can give rise to private business use if the compensation earned by the service provider is based in whole or in part on a share of net profits from the operation of the property. For example, the gift shop operator that is not paid a cent by the nonprofit but keeps (or shares with the nonprofit) the net revenues of the gift shop operation is engaged in a private business use of the facility.

Safe Harbor Management Contracts. The I.R.S. gives guidance on certain management contract arrangements that constitute "safe harbors" from treatment as private business use contracts. The safe harbors focus on two primary characteristics of the contract: the type of compensation to the service provider and the length of the contract. In order for any of the safe harbors to apply, no part of the compensation may be based on the net profits of the facilities and there must be no relationship with the service provider which substantially limits the nonprofit's ability to exercise its rights.

The safe harbors deal with three types of compensation arrangements: periodic fixed-fee arrangements, per-unit arrangements, and capitation arrangements. A periodic fixed fee is a stated dollar amount for services rendered for a specified period of time. A per-unit fee is a fee based on a unit of service provided specified in the contract or otherwise determined by an independent third party, for example, a stated dollar amount for each specified medical procedure performed, car parked or passenger mile. A capitation fee is a dollar amount per person served.

The safe harbors permit longer contracts when a greater portion of the compensation to the manager is fixed. For example, no private business use will result where at least 95% of the compensation for each annual period during the term of a management contract is based on a periodic fixed fee; however, the term of the contract, including all renewal options, cannot exceed the lesser of 80% of the reasonably expected useful life of the financed property or 15 years. A second safe harbor exists where at least 80% of the compensation for each annual period is based on a periodic fixed fee; however, the term of the contract, including all renewal options, cannot exceed the lesser of 80% of the reasonably expected useful life of the financed property or 10 years. These 15- and 10-year safe harbors also allow for a one-time incentive award during the term of the contract, equal to a single-stated dollar amount, by which compensation automatically increases when a gross revenue or expense target (but not both) is reached. Under a third safe harbor, a contract may have a term of up to five years if it is terminable by the nonprofit on reasonable notice, without penalty or cost, at the end of the third year and compensation consists at least 50% of a periodic fixed fee, entirely of a capitation fee, or entirely of a mixture of capitation and periodic fixed fees. Finally, a safe harbor is available for a three-year contract (terminable by the nonprofit without cause at the end of the second year) if all of the compensation is based on per-unit fees, or a combination of per-unit fees and a periodic fixed fee.

Research Agreements. Agreements for the conduct at bond-financed facilities of research that will be made available to private entities may result in private business use. Arrangements may be permitted if the research conducted is original research for the advancement of scientific knowledge not having a specific commercial objective. Product testing supporting the trade or business of a private entity will generally not be permitted. However, corporate-sponsored research should not produce private business use if the sponsor of the research must pay a competitive price for any license or other use of the technology resulting from the research.

Determining Amounts of Private Business Use.

Assuming that an arrangement gives rise to private business use, how does a nonprofit determine whether the amount of use would exceed the applicable limitation? If the bonds have a twenty-five year term and the nonprofit does not need all of its space initially, but expects to grow into the space over the years, it might wish to lease substantially more than 5% of the space in the initial years. This can be permissible.

Private business use is measured by calculating the percentage of private business use for each year, and then determining the average private use over the entire measurement period. The measurement period generally begins on the later of the date the bonds are issued 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 the bonds.

The method for determining the average private business use in any given year varies depending on whether the financed property is used at different times by the nonprofit and by private businesses, or is used by both at the same time. For use at different times, the average amount of private business use generally is based on the amount of time that the facility is used for private business use over the total time of all actual use (disregarding time during which the facility is unused).

When the facility is used for the nonprofit's and the private business's use simultaneously, the average amount of private business use may be determined on any reasonable basis that properly reflects the proportion of benefit to be derived by the various users. For example, the fair market value of the space in use or square footage might be used, if reasonable under the circumstances and if the method is consistently applied. The average amount of private business use of a parking garage with unassigned spaces is generally based on the number of spaces used for private business as a percentage of the total number of spaces. Use of common areas like lobbies and elevators must be allocated by a consistent, reasonable method that reflects the benefits to be derived by the various users. However, if when the bonds are issued private business use is reasonably expected to have a significantly greater fair market value than the nonprofit use, the amount of private business use must be determined by using the relative fair market values.

If heavy private business use occurs early in the bond transaction, the nonprofit must exercise care that the bonds remain outstanding and that the private business use is averaged-down over the remaining term. Where the private business use occurs later in the term of the bonds, there can be greater certainty that average private business use will not exceed the applicable limitation.

What If Financed Property Is Disposed Of?

Much can happen in twenty to thirty years, a typical bond issue term. It may be necessary or prudent for the nonprofit to dispose of some of the bond-financed property prior to the end of its expected useful life, due to changes in operational strategies, restructuring, needs for cash, or underperformance of particular assets. A significant sale to a private business would generally result in an intentional triggering of the private activity tests, and the bonds could be taxed retroactively to the date of their issuance.

Sales and dispositions are permitted, but appropriate action must be taken to remedy the situation. Five pre-conditions exist for the use of these remedies. The nonprofit must have reasonably expected when the bonds were issued that it would meet the private activity limitations for the bonds' entire term. The term of the bonds must not have been longer than was reasonably necessary for the purposes for which the bonds were issued. The sale or other disposition of the bond-financed property must be an arm's length transaction at fair market value. Prior to the disposition, the project fund must have been fully expended for the project. Finally, the proceeds of the disposition thereafter must be treated as "proceeds" of the bond issue for the purposes of the arbitrage yield restriction and rebate rules discussed below.

Any amounts derived from the sale, exchange or other disposition of bond-financed property, including the value of property or agreements for services received in exchange for such property, are the "disposition proceeds" and must be handled appropriately. The nonprofit needs also to determine the amount of "non-qualified bonds" created by the disposition. Non-qualified bonds are that percentage of outstanding bonds equal to the highest percentage of private business use in any one-year period that will occur following the disposition. For a simple example, if the bonds originally financed four clinics of equal cost, value and size, and one is sold after a period of time, 25% of the bonds outstanding at the time of the sale become non-qualified bonds. But if each of the clinics has a consistent 5% private business use, that 5% gets added so that 30% of the bonds are non-qualified bonds. Obviously, the amount of disposition proceeds will not always equal the amount of non-qualified bonds.

There are four methods for remedying the disqualified use arising from a disposition of bond-financed property. First, the nonprofit may redeem (pay off) the amount of non-qualified bonds within ninety days of the disposition. If that amount of bonds is not then redeemable, the nonprofit can establish an escrow to defease (provide for the payment of) an appropriate amount of bonds that will be paid or redeemed within 10˝ years of the bond issuance date.

Second, if the disposition was all for cash, bonds may be redeemed or defeased in an amount equal to the disposition proceeds. This is helpful if the nonprofit experienced a loss on the sale of the property.

If the disposition is all for cash, a third alternative is to spend the disposition proceeds on other property for the nonprofit that does not give rise to private business use. The nonprofit must reasonably expect to spend the disposition proceeds entirely within two years of receipt, and if not spent at the end of that period the remaining amount must be used to redeem or defease bonds. This may be the most attractive alternative, as it keeps low-interest bonds outstanding. Care must be exercised that the arbitrage and rebate rules discussed in the next section are complied with during the period in which the disposition proceeds are held for reuse.

A final alternative is available only if the purchaser of the bond-financed facility is a governmental unit or another 501(c)(3) organization not putting the property to private business use and if the purchaser does not use tax-exempt bonds for the purchase. In such a case the disposition proceeds can be placed in a yield-restricted escrow to pay the next debt service on the bonds as it becomes due.

If none of these options are practical, a closing agreement must be reached with the I.R.S. In any of these instances, bond counsel should be consulted to assure that improper treatment will not result in the taxability of the bonds.

How Does One Avoid Arbitrage?

Entire books have been written on bond arbitrage and rebate. In fact, the I.R.S. regulations virtually constitute a book, comprising eleven articles and over one hundred pages, some of which is written as mathematical formulas. Obviously, this most difficult subject can only be treated in a cursory manner here. The nonprofit should consult with appropriate professionals if the issues discussed arise.

Once again, the basic rule is simply stated. Bonds will be treated as taxable "arbitrage bonds" if any of the "gross proceeds" connected with the bond issue are reasonably expected to be used directly or indirectly to acquire higher yielding investments or to replace funds which were used directly or indirectly to acquire higher yielding investments. An allied rule requires, unless an exception applies, that excess arbitrage profits must be "rebated" (paid) to the U.S. Treasury.

Expectations and Intentional Acts.

Bond counsel will have investigated arbitrage concerns in connection with the structuring and closing of the bond issue. The bond documents should have been drawn so that, at the time of closing, the bonds will not be taxable arbitrage bonds so long as unexpected events do not occur and ongoing requirements (that should be mentioned in the bond documents) are complied with. Typically, a non-arbitrage or tax certification included among the bond documents summarizes the expectations and frequently describes ongoing compliance requirements with more or less detail.

The unexpected happens, however, and a number of events may occur which give rise to arbitrage concerns. The bond proceeds are not spent as soon as anticipated, or are not expended entirely. Bond-financed property is sold or disposed of. The bonds are paid early. Funds are deemed established during the course of the bond issue that were not contemplated by the bond documents. A credit enhancer or a representative of the bondholder requests and is given liquid collateral or a negative pledge of liquid assets. A nonprofit using bonds needs to be sensitive to possible arbitrage issues because these or other occurrences can give rise to "gross proceeds" somehow connected to the bonds, that can be invested. Intentional actions taken by a nonprofit may give rise to arbitrage and rebate responsibilities even though arbitrage is generally judged based on expectations at the time of a bond closing. For example, the sale of bond-financed property may give rise to disposition proceeds that are treated as gross proceeds of the bonds for arbitrage and rebate purposes, as discussed above.

Proceeds, Replacement Proceeds and Gross Proceeds.

Concepts of "proceeds" are essential to understanding the arbitrage and rebate rules. As discussed above, "proceeds" of the bonds include proceeds of the sale of the bonds and proceeds from the investment of proceeds. Arbitrage and rebate rules use a broader concept of "gross proceeds" which includes these types of proceeds and also "replacement proceeds."

Replacement proceeds can arise throughout the life of a bond issue, if there are other monies or funds of a nonprofit that have a sufficiently close connection or "nexus" to the bonds or the bond-financed property to conclude that the amounts would have been used to acquire the property if the bonds were not used for that purpose. The mere availability of non-bond monies to pay for a project or the preliminary earmarking of funds for that purpose will not alone make those monies replacement proceeds, but other quite indirect connections can throw them into that category.

Replacement proceeds concerns may arise when a nonprofit has other non-bond resources to pay for its project when it issues the bonds. The bond rules do not require the nonprofit to be "broke" to borrow, but if a nonprofit reasonably expects to use those resources to pay the debt service on the bonds, or then or subsequently enters into a pledge or negative pledge of liquid collateral to secure the bonds, replacement proceeds may be created that are subject to the arbitrage yield and rebate requirements, discussed below. Replacement proceeds include among other things, sinking funds, pledged funds and funds subject to a negative pledge.

A "sinking fund" is a fund or source, called by any name, that is reasonably expected to be used directly or indirectly to pay principal or interest on the bonds. For example, if a nonprofit has other investments prior to closing its bond issue, and it reasonably expects at the time of closing that it will use some of these investments to pay the debt service on the bond issue over its life, those investments, to the extent expected to be so used, can constitute replacement proceeds subject to the arbitrage and rebate rules. A sinking fund should not be confused with the debt service fund (frequently called the "bond fund") established under the bond documents for temporary deposit of amounts to be used to pay scheduled debt service, which debt service fund usually enjoys limited exemptions from arbitrage and rebate rules.

A "pledged fund" is any amount that is directly or indirectly pledged to pay debt service on bonds. A pledge may be cast in any form, if the substance of the arrangement provides reasonable assurance that the funds will be available to pay debt service even if the nonprofit encounters financial difficulties. For example, a repair and replacement fund might constitute replacement proceeds if the bondholders have rights to reach those funds and the nonprofit could only withdraw them for repairs and replacements after it achieved some stabilization level of revenues that is not reasonably expected to be reached. An example of an indirect pledged fund occurs when a bank that provides a letter of credit to enhance the credit of the bonds requires a pledge of the nonprofit's investments as collateral.

Replacement proceeds are created by a "negative pledge" when the nonprofit agrees to maintain on hand some of its funds at a specific level, providing indirect security for the bond issue. However, an amount is not treated as negatively placed if the nonprofit may grant rights in the amount that are superior to the rights of the bondholder (or credit enhancer), for example if it can pledge it to others. A nonprofit also can agree to maintain an amount that does not exceed the reasonable needs for which it is maintained if compliance with the agreement is tested no more frequently than semi-annually and the amount reserved may be spent without substantial restriction other than a requirement to replenish the amount by the next testing date. For example, a capital reserve fund equal to the estimated cost of roof replacement can be required if the covenant is tested only as described above.

Yield Restriction Requirements.

Gross proceeds subject to the arbitrage rules are subjected to two inter-related requirements, the yield restriction requirement and the rebate requirement. Yield restriction requires that the yield on investment of gross proceeds of bonds not exceed the yield on the bonds, unless the monies are being invested during an allowed temporary investment period. Generally the bond issue's project fund generally enjoys a three-year temporary investment period, its debt service fund enjoys a thirteen-month temporary investment period, and a reasonably required reserve or replacement fund enjoys a temporary investment period so long as it does not exceed a size limitation stated in the bond documents and the regulations. Other amounts, particularly replacement proceeds, have short temporary investment periods not exceeding thirty days, and as a result must be "yield restricted." In short, that means such amount must be invested by a permitted method that does not produce an arbitrage profit, and bond counsel will have to be consulted.

Rebate Requirements.

The related concept of rebate means that arbitrage profits from the investment of gross proceeds of bonds must be "rebated" (paid) to the Federal Treasury. Rebate applies to investment of all gross proceeds, even during a temporary period in which higher yielding investments are permitted, although one of several exceptions may apply. An exception applies to a debt service fund that does not yield more than $100,000 per year. An exception applies to the project fund if all of the proceeds are spent within six months, or if at least 15% of the proceeds are spent within six months, at least 60% within twelve months, and all of the proceeds within eighteen months (with an exception for reasonable retainage up to 5% spent within thirty months). A more generous and more complicated two-year spending exception is available when a project is primarily a construction project. Details concerning qualification for these exemptions are usually included in the bond documents, or can be found in the regulations.

No exception from rebate is available for amounts in a reserve fund, for earnings on a debt service fund in excess of $100,000 per year, or for replacement proceeds. If these exist, rebate will always be required.

The bond documents should be checked for their specific requirements concerning record keeping for rebate purposes, and the periodic filing of rebate reports or payment of rebate payments. These provisions usually mirror the regulations, which require rebate payments to be made at every fifth anniversary of the bond closing and within sixty (60) days of the payment of the bonds in full.

Unless exemptions are clearly applicable to all proceeds, nonprofits typically hire consultants or qualified accountants or lawyers to track and compute rebate. Rebate is a compliance requirement in every bond issue, even if to determine that exemptions are still applicable, and nonprofits using bonds should not rely on others to call to their attention the periodic requirements for rebate computations, payments and filings. Someone at the nonprofit should be charged with assuring compliance.

Conclusion

That thick bond document transcript cannot be placed on the shelf and forgotten. Nonprofits are well advised to prepare or have prepared a compliance checklist addressing the matters discussed in this article as they apply in the particular circumstances and under the bond documents. The checklist and a binder of pertinent reference materials should be reviewed periodically, perhaps annually, to assure that the necessary questions are asked and that reports and other compliance matters are attended to. With proper preparation, this need not be an onerous task. Any difficult issues can be referred to legal or financial experts when required, but only if the nonprofit is alert as to when to seek this assistance.

The checklist should address a number of items discussed in greater detail above. Has the nonprofit taken the necessary steps to assure that its 501(c)(3) status is maintained? Has the nonprofit assured that the bond proceeds were applied or allocated appropriately and in a manner creating the greatest flexibility? Are the bond-financed facilities continuing to be used in an appropriate manner, and are leases, management or service arrangements being entered into that give rise to private business use in excess of permitted limits? Has or will bond-financed property been disposed of, and have or will the disposition proceeds be applied as permitted? Is impermissible arbitrage being avoided? Are required rebate reports and payments necessary? A sample annual compliance checklist is included with this article. It will not fit every circumstance or be complete, but it will provide a useful starting point.

Properly managed, these compliance burdens should prove insignificant compared to the dramatic advantage of the tax-exempt interest rates offered by the bonds. The use of bonds should produce the intended consequence of providing a significant financial advantage to nonprofits to aid them in pursuing their critical missions.

SAMPLE ANNUAL COMPLIANCE CHECKLIST

  1. Have any leases, management contracts, use arrangements or service contracts been entered into in the past year which have not been reviewed for compliance with Revenue Procedure 97-13? Are any new leases, management contracts, use arrangements or service contracts, or amendments to existing arrangements, contemplated for the coming year?
  2. Have any significant assets, including real or personal property of any kind, been leased, sold, removed or otherwise disposed of by nonprofit in the past year? Are any such dispositions planned for the upcoming year?
  3. Has nonprofit avoided using endowment funds or other investments to make debt service payments on the Bonds in the past year? Will such debt service payments anticipated for the upcoming year be provided for from operating funds? Has any "earmarking" or other action been taken that might otherwise lead to endowment funds or other investments being considered "replacement proceeds"?
  4. Has nonprofit materially changed the method of conducting its business or engaged in any new business unrelated to its current operations? Has nonprofit materially altered its articles of incorporation or bylaws?
  5. Have any liens been placed on assets of the nonprofit or has the nonprofit pledged any portion of its assets?
  6. Has nonprofit calculated and paid any rebate payments owing to the Internal Revenue Service or determined that an exemption applies?
  7. Has form 990, if required, been filed with the Internal Revenue Service?
  8. Has nonprofit complied with other specific requirements in the bond documents? These might include compliance with coverage ratios, information reporting requirements, payment of fees to trustees and credit providers, provision of no-default certificates, maintenance of casualty insurance, etc.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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