Questions often arise regarding the tax law restrictions on the issuance of tax-exempt bonds to finance working capital expenditures. The IRS arbitrage regulations place restrictions on working capital financings, particularly in the case of long-term financings. For tax purposes, a “working capital expenditure” is defined as any expenditure other than a capital expenditure. Thus, most importantly, expenditures for operating expenses are considered working capital expenditures for tax purposes. As further described, restrictions that apply to bonds issued for working capital purposes can also apply to bonds for financing capital expenditures if the bond maturities significantly exceed the useful life of the financed assets.
The primary tax law issues raised by the use of tax-exempt bond proceeds for working capital expenditures are:
- When are the proceeds treated as “spent” for tax purposes?
- Is the term of the bonds issued for working capital expenditures sufficiently long enough for the bonds to be subject to special maturity limitations and other revenues of the issuer to be potentially subject to tax law restrictions as replacement proceeds?
When are the proceeds treated as spent?
An important threshold question that arises in any working capital financing is when the proceeds of that borrowing are treated as spent so they are no longer subject to tax law restrictions. Proceeds to be spent on capital expenditures are treated as spent when the expenditure is paid. In contrast, proceeds to be used for working capital expenditures are subject to a more-restrictive regime.
Specifically, unless a special exception applies, proceeds to be spent for working capital expenditures are only treated as spent after all other “available amounts” have been expended. In other words, proceeds for working capital expenditures are spent last, and only after any other available amounts held by the issuer are spent (a “proceeds-spent-last” rule). This summary focuses on working capital costs that do not qualify for an exception to the proceeds-spent-last rule (“Restricted Working Capital”), but also considers the impact of financing other expenditures in certain situations.
The rules to determine the timing of the expenditure of proceeds for Restricted Working Capital start with a determination of the issuer’s “available amounts,” because those amounts must be spent first. Available amounts include funds of the issuer of the bonds and any related party that may be used for working capital expenditures of the type being financed by the issue, but only if those amounts can be used without legislative or judicial action and without a legislative, judicial, or contractual obligation to repay those amounts. Available amounts do not include proceeds of the bond issue. Importantly, available amounts do not include a “reasonable working capital reserve,” defined as an amount up to 5 percent of the issuer’s prior year expenditures (capital and working capital) paid from that prior year’s current revenues. Therefore, proceeds to be spent for Restricted Working Capital are spent on any date only as the issuer demonstrates that it has no available amounts (but excluding amounts that constitute a reasonable working capital reserve). Stated differently, the proceeds are only spent as and to the extent that the issuer’s available amounts drop below the sum of the 5 percent permitted working capital reserve and the relevant bond proceeds.
For example, for an issuer that made $100 million of expenditures out of current revenues during the prior year and issues $20 million in working capital bonds, the bond proceeds are not spent until the issuer’s balance of available amounts and unspent bond proceeds is at or below $25 million ($20 million of proceeds plus the $5 million — 5% — reserve). Bond proceeds that are not treated as spent under this methodology continue to be treated as unspent bond proceeds for tax purposes, even if they can be traced directly to working capital expenditures. The ability to exclude the full 5 percent working capital reserve amount, regardless of whether the issuer has traditionally retained that level of a cash balance, was a positive change that the IRS made when it amended the regulations in 2015.
There are important exceptions to the proceeds-spent-last rule that apply to certain types of working capital expenditures. Specifically, for example, the proceeds-spent-last rule does not apply to proceeds that are to be used to make grants to unrelated persons (regardless of their use of the funds), extraordinary working capital expenditures, and proceeds used for capitalized interest. The exception for capitalized interest applies to interest that accrues during the three-year period after the date of issue or the period that ends one year after the related project is completed. If one of the exceptions applies, those proceeds are treated as spent when the expenditure is made.
Maturity limits and replacement proceeds
Even after bond proceeds are spent for tax purposes, another type of arbitrage issue related to “replacement proceeds” can arise in connection with long-term financings of working capital expenditures. For tax-exempt bonds that finance working capital expenditures, replacement proceeds are funds of an issuer that, under certain circumstances, are treated as proceeds for tax purposes and, as such, are subject to various tax law limitations. The arbitrage regulations are designed to ensure that the average amortization of an issue of tax-exempt bonds is consistent with the expected life of the assets financed by the issue. In furtherance of this approach, the use of proceeds of long-terms bonds for working capital expenditures raises potential replacement proceeds consequences, which can affect permitted bond maturities, redemption requirements, and the use of the issuer’s funds on hand.
The use of bond proceeds for working capital expenditures, such as operating expenses, may result in the subsequent creation of replacement proceeds if the term of the related bonds is longer than reasonably necessary for the governmental purpose of the bonds. Specifically, the regulations provide that so-called “other replacement proceeds” will arise if the term of a bond issue is longer than reasonably necessary for the governmental purpose of the issue, but only if the issuer expects to have available amounts on hand (with available amounts defined as above) during the period that the bond issue is outstanding for longer than necessary. For bonds to finance Restricted Working Capital, the regulations contain a safe harbor that provides that other replacement proceeds will not arise if the term of the bonds does not exceed 13 months or two years for tax anticipation notes. If the term of an issue to finance working capital expenditures exceeds the applicable limit, the issuer must be prepared to deal with the consequences of other replacement proceeds potentially arising, as described below.
In 2015, the IRS issued regulations containing a new safe harbor regarding the financing of working capital expenditures. These regulations provided guidance that replaced the non-precedential guidance that had been contained in a single private letter ruling that is now more than 25 years old. The safe harbor in the regulations contains two basic requirements and may be applied to any bond that finances working capital expenditures: first, that beginning in the first testing year, the issuer annually test whether it has available amounts; and second, that it use any such available amounts to redeem tax-exempt bonds or to invest in other tax-exempt bonds. These rules are described in more detail below.
The basic concept behind these regulations is that an issuer that has both long-term working capital bonds and available amounts in excess of the permitted working capital reserve has indirectly issued tax-exempt bonds that are financing those available amounts and, therefore, creates a potential for abuse of the arbitrage rules by overburdening the market. The safe harbor is designed to eliminate this potential abuse while still permitting the issuance of long-term bonds for working capital expenditures.
Long-term working capital financing
An issuer that issues long-term bonds to finance working capital expenditures will satisfy the safe harbor if it complies with the following rules.
Annual testing requirement. Beginning as of the first day of the fiscal year that is no later than the date the issuer reasonably expects to have available amounts (the “First Testing Year”), and in no event a date that is later than the five years after the issue date, the issuer must begin testing for excess available amounts and then must continue that annual testing (the “Annual Testing”) until all of its long-term working capital bonds are retired.
Required use of available amounts. Within 90 days of the start of the fiscal year in which there are available amounts, those available amounts must be used either to (i) redeem the long-term working capital bonds or other Eligible Tax-Exempt Bonds (as defined below) of the issuer or a related party; or (ii) invest in Eligible Tax-Exempt Bonds (together, (i) and (ii) are referred to as “Remediation”). The maximum amount that an issuer is required to use for Remediation is the outstanding amount of the tax-exempt bonds that are treated as financing working capital expenditures.
Generally, “Eligible Tax-Exempt Bonds” for this purpose include a bond the interest on which is excludable from gross income under Section 103 of the Internal Revenue Code and that is not a specified private activity bond that is subject to the alternative minimum tax, or a certificate of indebtedness issued by the United States Treasury pursuant to the Demand Deposit State and Local Government Series program. With limited exceptions, any amounts required to be invested in Eligible Tax-Exempt Bonds must be invested continuously in such bonds. Importantly, an issuer has 30 days to spend amounts previously invested in Eligible Tax-Exempt Bonds for a governmental purpose on any date on which the issuer has no other available amounts for such purpose, or to redeem Eligible Tax-Exempt Bonds.
To the extent that an issuer’s transaction is structured in a manner that it must annually test for the existence of other replacement proceeds, there may be an impact on the issuer’s general fund monies and the amount of tax or revenue anticipation notes that may be issued in future years. Specifically, general fund revenues may be treated as other replacement proceeds and, therefore, required to be used to redeem certain tax-exempt bonds or invested in other Eligible Tax-Exempt Bonds. These consequences would apply only if the issuer’s available amounts exceed the permitted working capital reserve.
Replacement proceeds in certain long-term financings
The “other replacement proceeds” issue described above in connection with long-term financings of working capital can also arise in connection with bonds that have long average maturities relative to the average economic life of the assets financed or refinanced. Specifically, other replacement proceeds may arise if the weighted average maturity of a bond issue is more than 120 percent of the weighted average economic life of the facilities financed or refinanced by the bond issue (the “maturity limit”). In a financing that does not satisfy this maturity limit requirement, the long-term working capital safe harbor described above can be applied to the bond issue beginning at the point in time that the maturity limit for the bonds is exceeded.
For example, assume an issuer does a “scoop and toss” refunding in which it issues relatively long-term bonds to refund principal due in the current year. If the average maturity of the refunding bonds causes the maturity limit to be exceeded beginning in the tenth year, the issuer can address any other replacement proceeds concerns by testing its available amounts in that tenth year and continuing to do so until the final maturity of the bond issue. If the issuer has available amounts in any of those years, it will have to use the funds to redeem its own tax-exempt bonds or invest in other Eligible Tax-Exempt Bonds as described above.
- This safe harbor does not apply to bonds issued for working capital expenditures that are not Restricted Working Capital. To the extent the only working capital financed is capitalized interest on the bonds that meets the exception described herein, and the bonds also financed capital expenditures, the working capital will be treated as part of the capital project and would be subject to the 120% test described below.
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- In addition to creating other replacement proceeds, these consequences could include treatment of the bond issue as involving an “overburdening” of the market for tax exempt bonds. The consequences of an overburdening include the need to restrict every investment of bond proceeds separately, the required application of the proceeds-spent-last method of accounting for all types of expenditures of bond proceeds (capital or working capital), and the inapplicability of the rules permitting the issuer to exclude a reasonable working capital reserve for certain purposes from available amounts.
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