This Issue Snapshot will help agents understand what "universal cap" is and explain in detail how to identify the circumstances in which the universal cap has been exceeded and how to determine which gross proceeds must be deallocated through application of the ordering rules. IRC Section and Treas. Regulation Internal Revenue Code Section 148 (the "Code") Treasury Regulation Section 1.148-6 (the "Regulations") Resources (court cases, Chief Counsel Advice, Revenue Rulings, internal resources) TAM 200424003 (2004 Technical Advice Memorandum discussing universal cap in an abusive transaction) CCA 201723017 (2017 Chief Counsel Advice discussing deallocation of investments under the universal cap rule) Analysis The universal cap rule limits the amount of gross proceeds allocable to a bond issue and subject to the arbitrage restrictions. The universal cap rule generally provides that the amount of gross proceeds and allocable investments of a bond issue subject to the arbitrage restrictions is limited to the value of the outstanding bonds of the issue on a testing date. The value of all outstanding bonds of the issue is referred to as the universal cap. The amount of gross proceeds and allocable investments of a bond issue is measured by determining the value of nonpurpose investments (see enhanced definition in Special Considerations below) allocated to gross proceeds of an issue of bonds on a testing date. The amount of the bonds outstanding is established based on the value of the bonds on a testing date. Special considerations For purposes of testing nonpurpose investments against the universal cap: Nonpurpose investments include (see Section 1.148-6(b)(2)(ii) of the Regulations): Cash, Tax-exempt bonds that would be nonpurpose investments (absent Section 148(b)(3)(A) of the Code), Qualified student loans, and Qualified mortgage loans. For purposes of testing under the universal cap rule, 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. The values of bonds and investments are determined under Sections 1.148-4(e) and 1.148-5(d) of the Regulations, 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 on a testing date. All values are determined as of the close of business on each testing date, after giving effect to all payments on bonds and payments for and receipts on investments on that date. Frequency of universal cap testing Generally, the first required testing date is the first day of the first bond year that commences after the second anniversary of the issue date. Consequently, the first required testing date is generally the beginning of the third bond year if there is no short first bond year, or the beginning of the fourth bond year if there is a short first bond year. Thereafter, the universal cap must be tested as of the first day of each bond year. For refunding and refunded issues, the foregoing rule generally applies, except that if (within a given bond year) proceeds of the refunded issue would become transferred proceeds of the refunding issue, then the cap and values must be determined as of that transfer date in lieu of the beginning of that particular bond year. There is an exception to testing the universal cap if the requirements detailed in Section 1.148-6(b)(2)(i) of the Regulations are met. Deallocation order of gross proceeds and allocable investments If the value of all nonpurpose investments of an issue exceeds the universal cap for that issue on a testing date, then nonpurpose investments equal to the amount of the excess cease to be allocated to the issue. Nonpurpose investments must be deallocated in the following order of priority— First, nonpurpose investments allocable to replacement proceeds (defined in Section 1.148-1(c) of the Regulations); Second, nonpurpose investments allocable to transferred proceeds (defined in Section 1.148-9 of the Regulations); and Third, nonpurpose investments allocable to sale proceeds and investment proceeds (defined in Section 1.148-1(b) of the Regulations). Permitted methods of deallocating investments Portions of investments to be deallocated as a result of application of the universal cap are allocated under either the ratable method or the representative method in the same manner as allocations of portions of investments to transferred proceeds under Section 1.148-9(c) of the Regulations. The ratable method requires a ratable portion of each nonpurpose investment allocated to gross proceeds of the issue to be deallocated under the universal cap rule. The representative method requires representative portions of the portfolio of nonpurpose investments allocated to gross proceeds of the issue to be deallocated under the universal cap rule. 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 deallocated 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 of funds it deems appropriate, such as a reserve fund or a construction fund. Treatment of deallocated amounts Except as provided in Section 1.148-9(b)(3) of the Regulations, discussed in the next paragraph, 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. Transferred proceeds and corresponding investments must be allocated to a refunding issue on any date required by Sections 1.148-9(b)(1) and (c) of the Regulations before application of the universal cap rule 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. Issue indicators or audit tips If there is a significant amount of unspent gross proceeds allocable to a bond issue as of the first bond year that commences after the second anniversary of the issue date (see Frequency of Universal Cap Testing above), then there is a higher probability of the universal cap rule causing a portion of the gross proceeds to be deallocated from the bonds. As individual bonds of the bond issue mature, the value of the bond issue declines. If the gross proceeds and investments allocable to the bonds do not also decline over time, or decline more slowly, then the amount of gross proceeds associated with the bond issue may exceed the value of the bond issue on a given date resulting in the portion of the gross proceeds that exceeds the value of the bond issue becoming deallocated and no longer treated as gross proceeds of the bonds. For example, if a bond was issued to finance a construction project and has the following characteristics as of the beginning of the third bond year: little of the sales proceeds have been spent, a portion of the principal of the bonds has matured, and/or the issuer has accumulated significant debt service funds in excess of an amount that qualifies as a bona fide debt service fund (replacement proceeds), then the issue might have unspent gross proceeds that exceed the universal cap. Indicators: Significant amounts of unspent sales proceeds (in construction, escrow and/or reserve fund). Significant amounts accumulated in a debt service fund (in excess of a bona fide debt service fund) and/or reserve fund. Significant amounts in a sinking fund or other fund pledged to pay debt service on the bonds. Excessive amounts of purpose investments allocated to the bonds (e.g., qualified student loans or qualified mortgage bonds) together with nonpurpose investments. Short bond maturities or a fast amortization schedule that results in a decline in the value of the bonds (e.g., sizable principal maturities early in the life of bond issue). Advance refunding escrow that pays out minimal amounts during first few years. Example: For example, if the value of an issue is $1,224,500 as of the beginning of its fourth bond year, but the value of nonpurpose investments allocable to gross proceeds totals $1,300,000, the universal cap has been exceeded. The excess gross proceeds (totaling $75,500) are no longer considered gross proceeds of the bonds and must be deallocated from the bonds using the ratable method or the representative method. These excess gross proceeds may be reallocated as required to another bond issue, generally as replacement proceeds (transferred proceeds may require special treatment). If the issue had the following nonpurpose investment values: Construction Fund (sales and investment proceeds): $ 750,000 Refunding Escrow (sales and investment proceeds): 481,500 Transferred Proceeds: 12,300 Replacement Proceeds: 56,200 ---------- Total: $1,300,000 ========== Then the issuer would be required to deallocate: first, replacement proceeds ($56,200), next, transferred proceeds ($12,300), and lastly, sales and investment proceeds ($7,000) before enough excess proceeds are deallocated to meet the universal cap limitation. As a result, nonpurpose investments with the following values would have to be deallocated on a ratable basis given a Refunding Escrow funded exclusively with sales proceeds: Construction Fund: $ 4,300 Refunding Escrow: 2,700 Transferred Proceeds: 12,300 Replacement Proceeds: 56,200 -------- Total: $ 75,500 ========
