Advance refunding bond limitations under Internal Revenue Code Section 149(d)

This Issue Snapshot will help agents identify if an advance refunding has complied with the limitations imposed on advance refundings by IRC Section 149(d). Note this Issue Snapshot addresses certain matters related to advance refunding bonds issued on or before December 31, 2017.¹

IRC Section and Treasury Regulation

• IRC Section 149(d)
• Treasury Regulation Section 1.149(d)-1

Resources (court cases, Chief Counsel Advice, Revenue Rulings, internal resources)

• Chief Counsel Advice 201843009 PDF (2018 Chief Counsel Advice regarding the use of tax-exempt bonds to advance refund taxable bonds)
• Field Service Advice Memoranda CC:TL-N-2234-93 (1993 Field Service Advice discussing prohibition against advance refundings for industrial development bonds)
• Field Service Advice Memoranda CC:TL-N-2669-95 (1995 Field Service Advice discussing refundings involving the transition rule for transferred proceeds)
• Field Service Advice Memoranda 200037006 (2000 Field Service Advice discussing refundings when there is a change in ownership of financed facility)
• Field Service Advice Memoranda 200229020 (2002 Field Service Advice discussing whether a device was employed to obtain a material financial advantage (based on arbitrage) apart from savings attributable to lower interest rates as described in IRC Section 149(d)(4))
• Notice 2002-73 | 2002-2 C.B. 844 | 2002-46 I.R.B. 844 (2002 Notice discussing Liberty Zone advance refunding bonds)
• Notice 2006-41 | 2006-1 C.B. 857 | 2006-18 I.R.B. 857 (2006 Notice discussing Gulf Opportunity Zone Advance Refunding Bonds)

Analysis

The general rules that define and limit advance refundings are in IRC Section 149(d) and the accompanying regulations under Treasury Regulation Section 1.149(d)-1. IRC Section 149(d) places limits on advance refunding bonds, which it defines as a bond issued to advance refund another bond more than 90 days before the redemption of the refunded bond.

Definition of refunding bonds

"Refunding issue" is defined in Treasury Regulation Section 1.150-1(d). Under this definition, with certain exceptions and special rules, a refunding issue is an issue of obligations the proceeds of which are used to pay principal, interest, or redemption price on another issue of bonds (the "refunded issue"). The refunded (or "prior") issue may be an issue that was issued prior to, at the same time as, or after, the issuance of the refunding issue.

Definition of advance refunding

IRC Section 149(d)(5) defines an advance refunding as a bond issued to refund another bond on a date more than 90 days before the redemption of the refunded bond.

Certain prohibitions

IRC Section 149(d)(1) precludes bonds described in IRC Section 149(d)(2), that is, bonds issued to advance refund private activity bonds (other than qualified 501(c)(3) bonds), from being tax-exempt. This applies even if the advance refunding issue would be a governmental bond or a qualified 501(c)(3) bond after application of the rules in Treasury Regulation 1.141-13.

Only governmental bonds and qualified 501(c)(3) bonds may be advance refunded by a tax-exempt bond.

Limitation on advance refunding

IRC Section 149(d)(3)(A)(i) provides limitations on the number of times a bond can be advance refunded.

If the original bond was issued after 1985, only one advance refunding is permitted with respect to that bond, including any bond that refunds that bond.

If the original bond was issued before 1986, two advance refundings are permitted taking into account the following modifications under IRC Section 149(d)(6):

• A refunding occurring before 1986 is treated as an advance refunding only if the refunding bond was issued more than 180 days before the redemption of the refunded bond, AND
• if the original bond was issued before 1986 it is treated as if advance refunded only once before March 15, 1986, regardless of the number of times it was advance refunded before such date.

Frequently, an issue of bonds consists of several different bonds, generally with varying maturities, each of which may be advance refunded only once if issued after 1985. These various bonds are generally referred to as either serial bonds or term bonds that, collectively, become the bond issue. See Treas. Reg. Section 1.150-1(c) for the definition of "issue." In some cases, the different serial or term bonds of an issue may be advance refunded by different advance refunding bond issues. This is acceptable if no particular serial or term bond (or its associated advance refunding bond) is advance refunded more than once. See Example below.

Taxable refunding

If an issuer cannot issue a tax-exempt advance refunding bond, but still wishes to advance refund, another option may be to use an issue of taxable advance refunding bonds.

Treasury Regulation Section 1.149(d)-(1)(e)(1) provides that, generally, for purposes of the limitation on the number of advance refundings:

• taxable advance refunding issues are not counted, AND
• an advance refunding of a taxable issue is not counted (except when the taxable issue is a conduit loan of a tax-exempt conduit financing issue).

IRC Section 149(d) does not apply to refunding bonds that are taxable. However, Treasury Regulation Section 1.149(d)-(1)(e)(2) provides that if a taxable bond is issued to avoid the advance refunding limitations of IRC Section 149(d)(3)(A)(i), the taxable bond will be counted as a tax-exempt issue. For example, if a taxable advance refunding issue is used to refund a tax-exempt issue, and the taxable issue is then currently refunded with another 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.

Redemption requirements

One of the most common reasons for issuing advance refunding bonds is to save money as a result of lower interest rates. In such cases, if the issuer may realize present value debt service savings (determined without regard to administrative expenses) in connection with issuance of the refunding issue, then IRC Section 149(d)(3)(B)(i) directs that the following redemption rules apply:

• IRC Section 149(d)(3)(A)(ii) provides that if the refunded bonds were issued before 1986, the refunded bond must be redeemed not later than the earliest date on which such bond may be redeemed at par or at a premium of three percent or less.
• IRC Section 149(d)(3)(A)(iii) provides that if the refunded bonds were issued after 1985, the refunded bond must be redeemed not later than the earliest date on which such bond may be redeemed.

IRC Section 149(d)(3)(B)(ii) provides that for purposes of applying the above rules, the earliest date for redemption shall not be earlier than the 90th day after the issuance date of the refunding bond.

In effect, for bonds issued after 1985, redemption requirements (also referred to as "first call requirement") result in an issuer having to call the refunded bonds on the first date there is any amount of present value savings, regardless of redemption premium. For bonds that were issued prior to 1986, the issuer may delay redeeming the bonds until the redemption premium no longer exceeds three percent.

Savings test

Treasury Regulation Section 1.149(d)-1(f)(3) provides that the multipurpose issue rules in Treasury Regulation Section 1.148-9(h) apply for purposes of the savings test of IRC Section 149(d)(3)(B)(i).

If any separate issue in a multipurpose issue increases the aggregate present value of debt service savings or reduces the present value debt service losses on the entire multipurpose issue, that separate issue satisfies the savings test. Satisfying the savings test then requires the issuer to follow the redemption requirements detailed above.

Abusive arbitrage devices

IRC Section 149(d) provides that the interest on a refunding bond described in IRC Section 149(d)(4), that is, an advance refunding bond that employs an abusive device, will NOT be tax-exempt. An abusive device is employed if a material financial advantage (based on arbitrage) is obtained.

Savings attributable to lower interest rates is not an abusive arbitrage device.

Treasury Regulation Section 1.149(d)-1(b) provides that 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 Treasury Regulation Section 1.148-10,
• the issue fails to meet the general rebate requirements of Treasury Regulation Section 1.148-3,
• any of the proceeds of the issue are invested in certain refunding escrows, as described in Treasury Regulation Section 1.149(d)-1(b)(3) (see Mixed Escrows Invested in Certain Tax-Exempt Bonds, below), OR
• investment of funds resulting from the sale of a tax-exempt conduit loan that is used to pay debt service on the conduit financing issue, is made at a yield in excess of the yield at which such conduit loan was sold. (Treasury Regulation Section 1.149(d)-1(b)(4) and Section 1.148-10(d), Example 4)

Mixed escrows invested in certain tax-exempt bonds

Treasury Regulation Section 1.149(d)-1(d)(2) provides that, for purposes of certain limitations on advance refundings, the mixed escrow rules in Treasury Regulation Section 1.148-9(c) do not apply to amounts that were NOT gross proceeds of the prior issue before the issue date of the refunding issue.

Treasury Regulation Section 1.149(d)-1(b)(3) provides that an advance refunding issue is abusive if:

• 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,
• the yield on the tax-exempt bonds in the refunding escrow exceeds the yield on the issue,
• the yield on all the investments (including investment property and tax-exempt bonds) in the refunding escrow exceeds the yield on the issue, AND
• 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.

Treasury Regulation Section 1.149(d)-1(b)(3) prevents issuers from inappropriately taking advantage of the spread between long-term tax-exempt obligations and short-term taxable obligations. Generally, investments in tax-exempt obligations are not considered to be investment property under IRC Section 148. Consequently, but for this rule, funding an escrow with long-term higher yielding tax-exempt obligations and short-term taxable obligations would allow an issuer to earn a yield (based on actual cash flows) in excess of the advance refunding bond yield. Note, however, that this rule does not apply if the escrow is funded solely with tax-exempt bonds. See Preamble, T.D. 8345, Section I, 56 FR 19023, 19027 (April 25, 1991).

Temporary periods

Additionally, IRC Section 149(d)(3)(A)(iv) provides that, with respect to advance refundings:

• proceeds of a refunding issue are permitted an initial temporary period of 30 days after issuance, AND
• the initial temporary period of any remaining proceeds of the refunded bond ends on the issue date of the refunding bonds.

Treasury Regulation Section 1.149(d)-(1)(d)(3) provides that the rules in Treasury Regulation Section 1.148-9(d) apply to advance refunding issues.

For example, if a construction bond has a 3-year temporary period that has not yet expired, but is advance refunded, the temporary period will terminate as of the date of issue of the refunding issue, under IRC Section 149(d)(3).

Issue indicators or audit tips

Indicators:

If the proceeds of an issue of refunding bonds are deposited in some sort of fund (typically referred to as an "escrow fund") for more than 90 days, before being expended to refund any portion of the refunded bonds, then the bonds are advance refunding bonds.

Audit tips:

If the bonds are advance refunding bonds, some key considerations are:

• Verify the advance refunding bonds were issued on or before December 31, 2017. Otherwise, rules other than those described in this Issue Snapshot may apply.
• Verify the refunded bonds were new money bonds or current refunding bonds. If not, verify it is a permitted advance refunding given the limitations on the number of advance refundings.
• If there are multiple issues of advance refundings associated with one refunded bond issue, check whether any bond maturities were advance refunded more than once.
• If a refunded bond consisted, in part, of advance refunding bonds, check whether any of those advance refunding bonds were advance refunded again.
• If the refunded bonds consisted of private activity bonds, other than 501(c)(3) bonds, it is not a permitted advance refunding.

Of course, there are numerous other requirements and limitations on advance refunding bonds that may also be considered during the course of an examination, some of which have been described above.

Example:

When reviewing multiple issues of advance refundings associated with one refunded bond issue, a key consideration is whether any bond maturities were advance refunded more than once. The following is an example of a review of such situation using a single serial bond of a multi-series bond issue.

Refunded multipurpose bond:

Refunding bond allocations:

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¹Section 13532 of Public Law No. 115-97, 131 Stat. 2054, 2154 (2017) (the "2017 Act") repealed the authority to issue tax-exempt advance refunding bonds after December 31, 2017. References to IRC Section 149(d) in this Issue Snapshot are to that subsection as in effect prior to amendment by the 2017 Act. See Chief Counsel Advice 201843009 for a discussion of advance refunding bonds issued after December 31, 2017.