§ 148 — Arbitrage

(a) For purposes of section 103, the term “arbitrage bond” means any bond issued as part of an issue any portion of the proceeds of which are reasonably expected (at the time of issuance of the bond) to be used directly or indirectly— (1) to acquire higher yielding investments, or (2) to replace funds which were used directly or indirectly to acquire higher yielding investments. (b) For purposes of this section— (1) The term “higher yielding investments” means any investment property which produces a yield over the term of the issue which is materially higher than the yield on the issue. (2) The term “investment property” means— (A) any security (within the meaning of section 165(g)(2)(A) or (B)), (B) any obligation, (C) any annuity contract, (D) any investment-type property, or (E) in the case of a bond other than a private activity bond, any residential rental property for family units which is not located within the jurisdiction of the issuer and which is not acquired to implement a court ordered or approved housing desegregation plan. (A) Except as provided in subparagraph (B), the term “investment property” does not include any tax-exempt bond. (B) With respect to an issue other than an issue a part of which is a specified private activity bond (as defined in section 57(a)(5)(C)), the term “investment property” includes a specified private activity bond (as so defined). (A) The term “investment-type property” does not include a prepayment under a qualified natural gas supply contract. (B) For purposes of this paragraph, the term “qualified natural gas supply contract” means any contract to acquire natural gas for resale by a utility owned by a governmental unit if the amount of gas permitted to be acquired under the contract by the utility during any year does not exceed the sum of— (i) the annual average amount during the testing period of natural gas purchased (other than for resale) by customers of such utility who are located within the service area of such utility, and (ii) the amount of natural gas to be used to transport the prepaid natural gas to the utility during such year. (C) Natural gas used to generate electricity shall be taken into account in determining the average under subparagraph (B)(i)— (i) only if the electricity is generated by a utility owned by a governmental unit, and (ii) only to the extent that the electricity is sold (other than for resale) to customers of such utility who are located within the service area of such utility. (i) If— (I) after the close of the testing period and before the date of issuance of the issue, the utility owned by a governmental unit enters into a contract to supply natural gas (other than for resale) for a business use at a property within the service area of such utility, and (II) the utility did not supply natural gas to such property during the testing period or the ratable amount of natural gas to be supplied under the contract is significantly greater than the ratable amount of gas supplied to such property during the testing period, (ii) The average under subparagraph (B)(i) shall not exceed the annual amount of natural gas reasonably expected to be purchased (other than for resale) by persons who are located within the service area of such utility and who, as of the date of issuance of the issue, are customers of such utility. (E) The Secretary may increase the average under subparagraph (B)(i) for any period if the utility owned by the governmental unit establishes to the satisfaction of the Secretary that, based on objective evidence of growth in natural gas consumption or population, such average would otherwise be insufficient for such period. (i) The amount otherwise permitted to be acquired under the contract for any period shall be reduced by— (I) the applicable share of natural gas held by the utility on the date of issuance of the issue, and (II) the natural gas (not taken into account under subclause (I)) which the utility has a right to acquire during such period (determined as of the date of issuance of the issue). (ii) For purposes of the clause (i), the term “applicable share” means, with respect to any period, the natural gas allocable to such period if the gas were allocated ratably over the period to which the prepayment relates. (G) Subparagraph (A) shall cease to apply to any issue if the utility owned by the governmental unit engages in any intentional act to render the volume of natural gas acquired by such prepayment to be in excess of the sum of— (i) the amount of natural gas needed (other than for resale) by customers of such utility who are located within the service area of such utility, and (ii) the amount of natural gas used to transport such natural gas to the utility. (H) For purposes of this paragraph, the term “testing period” means, with respect to an issue, the most recent 5 calendar years ending before the date of issuance of the issue. (I) For purposes of this paragraph, the service area of a utility owned by a governmental unit shall be comprised of— (i) any area throughout which such utility provided at all times during the testing period— (I) in the case of a natural gas utility, natural gas transmission or distribution services, and (II) in the case of an electric utility, electricity distribution services, (ii) any area within a county contiguous to the area described in clause (i) in which retail customers of such utility are located if such area is not also served by another utility providing natural gas or electricity services, as the case may be, and (iii) any area recognized as the service area of such utility under State or Federal law. (1) For purposes of subsection (a), a bond shall not be treated as an arbitrage bond solely by reason of the fact that the proceeds of the issue of which such bond is a part may be invested in higher yielding investments for a reasonable temporary period until such proceeds are needed for the purpose for which such issue was issued. (A) The temporary period referred to in paragraph (1) shall not exceed 6 months with respect to the proceeds of an issue which are to be used to make or finance loans (other than nonpurpose investments) to 2 or more persons. (B) Subparagraph (A) shall be applied by substituting “3 months” for “6 months” with respect to the proceeds from the sale or repayment of any loan which are to be used to make or finance any loan. For purposes of the preceding sentence, a nonpurpose investment shall not be treated as a loan. (C) In the case of an issue described in subparagraph (A) any portion of which is used to make or finance loans for construction expenditures (within the meaning of subsection (f)(4)(C)(iv))— (i) rules similar to the rules of subsection (f)(4)(C)(v) shall apply, and (ii) subparagraph (A) shall be applied with respect to such portion by substituting “2 years” for “6 months”. (D) This paragraph shall not apply to any qualified mortgage bond or qualified veterans’ mortgage bond. (1) For purposes of subsection (a), a bond shall not be treated as an arbitrage bond solely by reason of the fact that an amount of the proceeds of the issue of which such bond is a part may be invested in higher yielding investments which are part of a reasonably required reserve or replacement fund. The amount referred to in the preceding sentence shall not exceed 10 percent of the proceeds of such issue unless the issuer establishes to the satisfaction of the Secretary that a higher amount is necessary. (2) A bond issued as part of an issue shall be treated as an arbitrage bond if the amount of the proceeds from the sale of such issue which is part of any reserve or replacement fund exceeds 10 percent of the proceeds of the issue (or such higher amount which the issuer establishes is necessary to the satisfaction of the Secretary). (e) Notwithstanding subsections (a), (c), and (d), a bond issued as part of an issue shall not be treated as an arbitrage bond solely by reason of the fact that an amount of the proceeds of such issue (in addition to the amounts under subsections (c) and (d)) is invested in higher yielding investments if such amount does not exceed the lesser of— (1) 5 percent of the proceeds of the issue, or (2) $100,000. (1) A bond which is part of an issue shall be treated as an arbitrage bond if the requirements of paragraphs (2) and (3) are not met with respect to such issue. The preceding sentence shall not apply to any qualified veterans’ mortgage bond. (2) An issue shall be treated as meeting the requirements of this paragraph only if an amount equal to the sum of— (A) the excess of— (i) the amount earned on all nonpurpose investments (other than investments attributable to an excess described in this subparagraph), over (ii) the amount which would have been earned if such nonpurpose investments were invested at a rate equal to the yield on the issue, plus (B) any income attributable to the excess described in subparagraph (A), (3) Except to the extent provided by the Secretary, the amount which is required to be paid to the United States by the issuer shall be paid in installments which are made at least once every 5 years. Each installment shall be in an amount which ensures that 90 percent of the amount described in paragraph (2) with respect to the issue at the time payment of such installment is required will have been paid to the United States. The last installment shall be made no later than 60 days after the day on which the last bond of the issue is redeemed and shall be in an amount sufficient to pay the remaining balance of the amount described in paragraph (2) with respect to such issue. A series of issues which are redeemed during a 6-month period (or such longer period as the Secretary may prescribe) shall be treated (at the election of the issuer) as 1 issue for purposes of the preceding sentence if no bond which is part of any issue in such series has a maturity of more than 270 days or is a private activity bond. In the case of a tax and revenue anticipation bond, the last installment shall not be required to be made before the date 8 months after the date of issuance of the issue of which the bond is a part. (A) In determining the aggregate amount earned on nonpurpose investments for purposes of paragraph (2)— (i) any gain or loss on the disposition of a nonpurpose investment shall be taken into account, and (ii) any amount earned on a bona fide debt service fund shall not be taken into account if the gross earnings on such fund for the bond year is less than $100,000. (B) Under regulations prescribed by the Secretary— (i) An issue shall, for purposes of this subsection, be treated as meeting the requirements of paragraph (2) if— (I) the gross proceeds of such issue are expended for the governmental purposes for which the issue was issued no later than the day which is 6 months after the date of issuance of the issue, and (II) the requirements of paragraph (2) are met with respect to amounts not required to be spent as provided in subclause (I) (other than earnings on amounts in any bona fide debt service fund). (I) In the case of an issue described in subclause (II), clause (i) shall be applied by substituting “1 year” for “6 months” each place it appears with respect to the portion of the proceeds of the issue which are not expended in accordance with clause (i) if such portion does not exceed 5 percent of the proceeds of the issue. (II) An issue is described in this subclause if no bond which is part of such issue is a private activity bond (other than a qualified 501(c)(3) bond) or a tax or revenue anticipation bond. (I) For purposes of clause (i), in the case of an issue of tax or revenue anticipation bonds, the net proceeds of such issue (including earnings thereon) shall be treated as expended for the governmental purpose of the issue on the 1st day after the date of issuance that the cumulative cash flow deficit to be financed by such issue exceeds 90 percent of the proceeds of such issue. (II) For purposes of subclause (I), the term “cumulative cash flow deficit” means, as of the date of computation, the excess of the expenses paid during the period described in subclause (III) which would ordinarily be paid out of or financed by anticipated tax or other revenues over the aggregate amount available (other than from the proceeds of the issue) during such period for the payment of such expenses. (III) For purposes of subclause (II), the period described in this subclause is the period beginning on the date of issuance of the issue and ending on the earlier of the date 6 months after such date of issuance or the date of the computation of cumulative cash flow deficit. (iv) For purposes of this subparagraph, payments of principal on the bonds which are part of an issue shall not be treated as expended for the governmental purposes of the issue. (i) In the case of a construction issue, paragraph (2) shall not apply to the available construction proceeds of such issue if the spending requirements of clause (ii) are met. (ii) The spending requirements of this clause are met if at least— (I) 10 percent of the available construction proceeds of the construction issue are spent for the governmental purposes of the issue within the 6-month period beginning on the date the bonds are issued, (II) 45 percent of such proceeds are spent for such purposes within the 1-year period beginning on such date, (III) 75 percent of such proceeds are spent for such purposes within the 18-month period beginning on such date, and (IV) 100 percent of such proceeds are spent for such purposes within the 2-year period beginning on such date. (iii) The spending requirement of clause (ii)(IV) shall be treated as met if— (I) such requirement would be met at the close of such 2-year period but for a reasonable retainage (not exceeding 5 percent of the available construction proceeds of the construction issue), and (II) 100 percent of the available construction proceeds of the construction issue are spent for the governmental purposes of the issue within the 3-year period beginning on the date the bonds are issued. (iv) For purposes of this subparagraph, the term “construction issue” means any issue if— (I) at least 75 percent of the available construction proceeds of such issue are to be used for construction expenditures with respect to property which is to be owned by a governmental unit or a 501(c)(3) organization, and (II) all of the bonds which are part of such issue are qualified 501(c)(3) bonds, bonds which are not private activity bonds, or private activity bonds issued to finance property to be owned by a governmental unit or a 501(c)(3) organization. (v) If— (I) all of the construction expenditures to be financed by an issue are to be financed from a portion thereof, and (II) the issuer elects to treat such portion as a construction issue for purposes of this subparagraph, (vi) For purposes of this subparagraph— (I) The term “available construction proceeds” means the amount equal to the issue price (within the meaning of sections 1273 and 1274) of the construction issue, increased by earnings on the issue price, earnings on amounts in any reasonably required reserve or replacement fund not funded from the issue, and earnings on all of the foregoing earnings, and reduced by the amount of the issue price in any reasonably required reserve or replacement fund and the issuance costs financed by the issue. (II) The term “available construction proceeds” shall not include amounts earned on any reasonably required reserve or replacement fund after the earlier of the close of the 2-year period described in clause (ii) or the date the construction is substantially completed. (III) The term “available construction proceeds” shall not include payments on any obligation acquired to carry out the governmental purposes of the issue and shall not include earnings on such payments. (IV) At the election of the issuer, the term “available construction proceeds” shall not include earnings on any reasonably required reserve or replacement fund. (I) At the election of the issuer, paragraph (2) shall not apply to available construction proceeds which do not meet the spending requirements of clause (ii) if the issuer pays a penalty, with respect to each 6-month period after the date the bonds were issued, equal to 1½ percent of the amount of the available construction proceeds of the issue which, as of the close of such 6-month period, is not spent as required by clause (ii). (II) The penalty imposed by this clause shall cease to apply only as provided in clause (viii) or after the latest maturity date of any bond in the issue (including any refunding bond with respect thereto). (viii) At the election of the issuer (made not later than 90 days after the earlier of the end of the initial temporary period or the date the construction is substantially completed), the penalty under clause (vii) shall not apply to any 6-month period after the initial temporary period under subsection (c) if the requirements of subclauses (I), (II), and (III) are met. (I) The requirement of this subclause is met if the issuer pays a penalty equal to 3 percent of the amount of available construction proceeds of the issue which is not spent for the governmental purposes of the issue as of the close of such initial temporary period multiplied by the number of years (including fractions thereof) in the initial temporary period. (II) The requirement of this subclause is met if the amount of the available construction proceeds of the issue which is not spent for the governmental purposes of the issue as of the close of such initial temporary period is invested at a yield not exceeding the yield on the issue or which is invested in any tax-exempt bond which is not investment property. (III) The requirement of this subclause is met if the amount of the available construction proceeds of the issue which is not spent for the governmental purposes of the issue as of the earliest date on which bonds may be redeemed is used to redeem bonds on such date. (ix) If— (I) the construction to be financed by a construction issue is substantially completed before the end of the initial temporary period, (II) the issuer identifies an amount of available construction proceeds which will not be spent for the governmental purposes of the issue, (III) the issuer has made the election under clause (viii), and (IV) the issuer makes an election under this clause before the close of the initial temporary period and not later than 90 days after the date the construction is substantially completed, (x) In the case of a failure (which is not due to willful neglect) to pay any penalty required to be paid under clause (vii) or (viii) in the amount or at the time prescribed therefor, the Secretary may treat such failure as not occurring if, in addition to paying such penalty, the issuer pays a penalty equal to the sum of— (I) 50 percent of the amount which was not paid in accordance with clauses (vii) and (viii), plus (II) interest (at the underpayment rate established under section 6621) on the portion of the amount which was not paid on the date required for the period beginning on such date. (xi) At the election of the issuer of an issue the proceeds of which are to be used to make or finance loans (other than nonpurpose investments) to 2 or more persons, the periods described in clauses (ii) and (iii) shall begin on— (I) the date the loan is made, in the case of loans made within the 1-year period after the date the bonds are issued, and (II) the date following such 1-year period, in the case of loans made after such 1-year period. (xii) For purposes of this subparagraph, payments of principal on the bonds which are part of the construction issue shall not be treated as an expenditure of the available construction proceeds of the issue. (I) Except as provided in this clause, clause (vii)(II), and the last sentence of clause (x), this subparagraph shall not apply to any refunding bond and no proceeds of a refunded bond shall be treated for purposes of this subparagraph as proceeds of a refunding bond. (II) For purposes of clause (v), any portion of an issue which is used to refund any issue (or portion thereof) shall be treated as a separate issue. (III) The requirements of paragraph (2) shall be treated as met with respect to earnings for any period if a penalty is paid under clause (vii) or (viii) with respect to such earnings for such period. (xiv) Any election under this subparagraph (other than clauses (viii) and (ix)) shall be made on or before the date the bonds are issued; and, once made, shall be irrevocable. (xv) Any penalty under this subparagraph shall be paid to the United States not later than 90 days after the period to which the penalty relates. (xvi) If the spending requirements of clause (ii) are met with respect to the available construction proceeds of a construction issue, then paragraph (2) shall not apply to earnings on a bona fide debt service fund for such issue. (i) An issue shall, for purposes of this subsection, be treated as meeting the requirements of paragraphs (2) and (3) if— (I) the issue is issued by a governmental unit with general taxing powers, (II) no bond which is part of such issue is a private activity bond, (III) 95 percent or more of the net proceeds of such issue are to be used for local governmental activities of the issuer (or of a governmental unit the jurisdiction of which is entirely within the jurisdiction of the issuer), and (IV) the aggregate face amount of all tax-exempt bonds (other than private activity bonds) issued by such unit during the calendar year in which such issue is issued is not reasonably expected to exceed $5,000,000. (ii) For purposes of subclause (IV) of clause (i)— (I) an issuer and all entities which issue bonds on behalf of such issuer shall be treated as 1 issuer, (II) all bonds issued by a subordinate entity shall, for purposes of applying such subclause to each other entity to which such entity is subordinate, be treated as issued by such other entity, and (III) an entity formed (or, to the extent provided by the Secretary, availed of) to avoid the purposes of such subclause (IV) and all other entities benefiting thereby shall be treated as 1 issuer. (iii) There shall not be taken into account under subclause (IV) of clause (i) any bond issued to refund (other than to advance refund) any bond to the extent the amount of the refunding bond does not exceed the outstanding amount of the refunded bond. (iv) An issue issued by a subordinate entity of a governmental unit with general taxing powers shall be treated as described in clause (i)(I) if the aggregate face amount of such issue does not exceed the lesser of— (I) $5,000,000, or (II) the amount which, when added to the aggregate face amount of other issues issued by such entity, does not exceed the portion of the $5,000,000 limitation under clause (i)(IV) which such governmental unit allocates to such entity. (v) If any portion of an issue is issued to refund other bonds, such portion shall be treated as a separate issue which does not meet the requirements of paragraphs (2) and (3) by reason of this subparagraph unless— (I) the aggregate face amount of such issue does not exceed $5,000,000, (II) each refunded bond was issued as part of an issue which was treated as meeting the requirements of paragraphs (2) and (3) by reason of this subparagraph, (III) the average maturity date of the refunding bonds issued as part of such issue is not later than the average maturity date of the bonds to be refunded by such issue, and (IV) no refunding bond has a maturity date which is later than the date which is 30 years after the date the original bond was issued. (vi) If section 141(a) did not apply to any refunded bond, the issue of which such refunded bond was a part shall be treated as meeting the requirements of subclause (II) of clause (v) if— (I) such issue was issued by a governmental unit with general taxing powers, (II) no bond issued as part of such issue was an industrial development bond (as defined in section 103(b)(2), but without regard to subparagraph (B) of section 103(b)(3)) or a private loan bond (as defined in section 103(o)(2)(A), but without regard to any exception from such definition other than section 103(o)(2)(C)), and (III) the aggregate face amount of all tax-exempt bonds (other than bonds described in subclause (II)) issued by such unit during the calendar year in which such issue was issued did not exceed $5,000,000. (vii) Each of the $5,000,000 amounts in the preceding provisions of this subparagraph shall be increased by the lesser of $10,000,000 or so much of the aggregate face amount of the bonds as are attributable to financing the construction (within the meaning of subparagraph (C)(iv)) of public school facilities. (5) Gross income shall not include the sum described in paragraph (2). Notwithstanding any other provision of this title, no deduction shall be allowed for any amount paid to the United States under paragraph (2). (6) For purposes of this subsection and subsections (c) and (d)— (A) The term “nonpurpose investment” means any investment property which— (i) is acquired with the gross proceeds of an issue, and (ii) is not acquired in order to carry out the governmental purpose of the issue. (B) Except as otherwise provided by the Secretary, the gross proceeds of an issue include— (i) amounts received (including repayments of principal) as a result of investing the original proceeds of the issue, and (ii) amounts to be used to pay debt service on the issue. (7) In the case of an issue which would (but for this paragraph) fail to meet the requirements of paragraph (2) or (3), the Secretary may treat such issue as not failing to meet such requirements if— (A) no bond which is part of such issue is a private activity bond (other than a qualified 501(c)(3) bond), (B) the failure to meet such requirements is not due to willful neglect, and (C) the issuer pays to the United States a penalty in an amount equal to the sum of— (i) 50 percent of the amount which was not paid in accordance with paragraphs (2) and (3), plus (ii) interest (at the underpayment rate established under section 6621) on the portion of the amount which was not paid on the date required under paragraph (3) for the period beginning on such date. (g) Except to the extent otherwise provided in regulations, payments made by the Secretary of Education pursuant to section 438 of the Higher Education Act of 1965 are not to be taken into account, for purposes of subsection (a)(1), in determining yields on student loan notes. (h) For purposes of this section, the yield on an issue shall be determined on the basis of the issue price (within the meaning of sections 1273 and 1274). (i) The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section.