In August last year, the IRS proposed modifications to the arbitrage regulations concerning prepayments of goods or services. The proposed modifications were severely criticized at hearings held in January.

The focus of both the present rule and the proposed rule is on whether a prepayment produces an impermissible arbitrage profit. Arbitrage, in its simplest form, is the borrowing of money at tax-exempt rates and then reinvesting the money at a higher taxable rate. The IRS appears to be concerned that a prepayment could result in arbitrage in the following types of situation: Assume each year an issuer is purchasing goods for $100. The provider offers to enter into a contract to provide those goods for ten years for a prepayment of $565, which is the present value of ten annual $100 payments, discounted at 12%. The issuer issues $565 of tax-exempt bonds at 7%. The present value of 10 annual payments, discounted at 7%, is $702. The question is whether the difference of $137 represents an impermissible arbitrage profit.

Most of the attention has focused on prepayments of natural gas supplies. At the same time that the proposed regulations are being considered, the IRS has begun a number of audits of these types of natural gas prepayment transactions. In many cases, issuers (typically, a joint action agency which purchases natural gas for smaller cities) prepays a supply of natural gas, and then enters into a swap agreement, essentially trading a fixed price natural gas supply contract for one which delivers natural gas at the market rate at the time of delivery.

The technical issue is whether the prepayment gives rise to "investment-type property." Before the 1986 Tax Act, arbitrage only resulted from the investment of tax-exempt bond proceeds in taxable securities and similar obligations. The 1986 Act added to impermissible investments "investment type property." The current and proposed regulations generally provide that investment type property is property held principally as a passive investment vehicle. Prepayments are treated as investment type property if a principal purpose of prepaying is to receive an investment return from the time when the prepayment is made until the time the payment otherwise would be made. The current regulations contain two important exceptions, which would be retained under the Proposed Regulation. A prepayment would not be treated as investment type property if (i) it is made for a substantial business purpose and (ii) the issuer has no commercially reasonable alternative to the prepayment.

The IRS has stated that the reason for the Proposed Regulation is to make sure that a prepayment made after property is acquired is still treated as a prepayment. That specific concern arose from statements made in City of Columbus v. Commissioner, where the Court of Appeals held that the issuance of bonds by the City of Columbus to prepay a pension obligation to Ohio did not give rise to arbitrage bonds. But the preamble to the Proposed Regulation suggests that the IRS' real concern reaches much further. The preamble requested comments on a number of related issues concerning prepayments. And, the tenor of the request for comments was such that most bond lawyers perceive the IRS as inclined to review any prepayment extremely carefully.

Virtually everyone who spoke at the IRS's January hearings was critical of the regulations, as have been the numerous comments sent to the IRS, including comments by the National Association of Bond Lawyers. Issuers, and their counsel who spoke stated that the prepayments were chiefly entered into to assure a future source of supply. The hearings also gave some insight into IRS concerns. One concern raised by IRS officials is why forward supply contracts (i.e., a contract to assure future supplies at either a fixed price or spot prices, in either case payable only on delivery) could not solve the issue of insuring future supplies. It was also clear that the IRS remains very concerned about swap arrangements which convert the prepayment to a spot price payment at the time of delivery.

Although the IRS has started out by focusing on natural gas supply contracts, the proposed rule could affect all types of prepayments, whether for goods or services. Something as simple as a debt incurred to pay for a prepaid telephone plan could lead to questions about the program being taxable.

The breadth of the IRS position should give any issuer pause before moving forward on any prepayment. Any prepayment contract which is paid for, or could be deemed to be paid for, with tax-exempt obligations must be carefully reviewed. If you would like any more information on this topic, or any other tax-exempt question, please call any of the lawyers in our Public Finance Group.

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.