105 T.C. No. 19
UNITED STATES TAX COURT
HARBOR BANCORP & SUBSIDIARIES, Petitioner
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
EDWARD J. KEITH AND ELENA KEITH, Petitioners
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 24112-92, 5857-93. Filed October 16, 1995.
The Housing Authority of Riverside County,
California, issued revenue bonds to finance the
construction of multifamily housing for families of low
and moderate incomes. Ps purchased some of these bonds
and, believing that the bonds were tax exempt, did not
include the interest received thereon in income. Sec.
103(a), I.R.C., generally provides a tax exemption for
interest earned on bonds issued by State and local
governments. This exemption does not apply to
"arbitrage bonds". Sec. 103(c), I.R.C. Under sec.
148(f), I.R.C., a bond is treated as an "arbitrage
bond" if (1) the bond proceeds are used to purchase
investments that are not acquired to carry out the
governmental purpose of the bond issue; (2) the
investment of the bond proceeds produces an excess
amount of earnings described in sec. 148(f)(2), I.R.C.;
and (3) the bond issuer fails to pay such excess amount
to the United States. The Commissioner determined that
the bonds should be treated as arbitrage bonds pursuant
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to sec. 148(f), I.R.C., and that, as a result, the
interest on the bonds was not excludable from Ps'
income.
Held: The Commissioner's determination is upheld.
The bonds are to be treated as arbitrage bonds pursuant
to sec. 148(f), I.R.C. The interest on the bonds is
not excludable from Ps' taxable income under sec.
103(a), I.R.C.
Anita C. Esslinger, Mary Gassmann Reichert, Brenda J.
Talent, Juan D. Keller, Michael F. Coles, and Linda M.
Martinez (specially recognized), for petitioner in docket No.
24112-92.
Mary Gassmann Reichert, Juan D. Keller, Michael F. Coles,
and Linda M. Martinez (specially recognized), for petitioners in
docket No. 5857-93.
Clifton B. Cates III, Lillian D. Brigman, Debra Lynn Reale,
and Jon Kent, for respondent.
RUWE, Judge:* Respondent determined the following
deficiencies in petitioners' Federal income taxes:
Harbor Bancorp & Subsidiaries
docket No. 24112-92
Year Deficiency
1988 $6,587
1989 6,588
1990 6,588
*
This case was reassigned to Judge Robert P. Ruwe by order
of the Chief Judge.
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Edward J. and Elena Keith
docket No. 5857-93
Year Deficiency
1989 $14,709
1990 18,521
1991 14,840
These consolidated cases are test cases that involve the
Commissioner's attempt to tax interest received on two
multifamily housing revenue bonds (the Bonds) issued by the
Housing Authority of the County of Riverside, California (the
Housing Authority). The ultimate issue for decision is whether
interest on the Bonds is excludable from gross income under
section 103(a). This, in turn, will depend on the applicability
of section 148(f). References to section 103 are to that section
of the Internal Revenue Code of 1954,1 as amended, and references
to section 148 are to that section of the Internal Revenue Code
of 1986.2
Some of the facts have been stipulated and are found
accordingly. The stipulations of fact and attached exhibits are
1
We apply sec. 103 of the 1954 Code as in effect for Feb.
20, 1986, instead of the 1986 Code, because (1) sec. 1301 of the
Tax Reform Act of 1986 (TRA), Pub. L. 99-514, 100 Stat. 2085,
2602, which amended sec. 103, became effective for bonds issued
after Aug. 15, 1986, TRA sec. 1311(a), 100 Stat. 2659, and (2)
the bonds we deal with were issued before that date.
2
We apply sec. 148(f) of the 1986 Code, because (1) TRA sec.
1314(d)(1), 100 Stat. 2664, provides that sec. 103 of the 1954
Code shall be treated as including the requirements of sec.
148(f) of the 1986 Code for bonds issued after Dec. 31, 1985, and
(2) we conclude, infra, that the bonds we deal with were issued
after that date.
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incorporated herein by this reference. The trial judge made the
following findings of fact, which we adopt.
FINDINGS OF FACT
At the time its petition was filed, the principal office of
petitioner Harbor Bancorp & Subsidiaries was Long Beach,
California. Petitioners Edward J. and Elena Keith resided in
Pebble Beach, California, when they filed their joint petition.
Riverside County is a political subdivision of the State of
California, governed by an elected board of supervisors. Within
the Riverside County government exists the Housing Authority.
The Housing Authority is empowered to issue revenue bonds, the
proceeds of which are lent to private developers to construct
housing projects. The Riverside County Housing Authority
Advisory Commission (Advisory Commission) was created to review
proposed multifamily housing bond issuances.
By the mid-1980's, there was a large demand for low- and
moderate-income housing in Riverside County. In the fall of
1985, an established commercial and residential development
company named SBE Development, Inc. (SBE), approached officials
of Riverside County seeking "conduit financing"3 to fund
3
Conduit financing is distinguishable from "governmental
financing" in which the bond proceeds would be used directly by
the governmental unit in order to construct public facilities,
such as roads, bridges, and schools. Here, the Bond proceeds
were not going to be used directly by the issuing governmental
unit (the Housing Authority), but rather by a private developer,
(continued...)
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construction of two multifamily housing projects in Riverside
County. SBE was a California corporation founded in the early
1970's by Craig K. Etchegoyen, who was its chief executive
officer and president. One of these projects was the Whitewater
Garden Apartments (Whitewater), a proposed 460-unit multifamily
rental project to be located in Cathedral City, California. Its
anticipated cost was slightly more than $17 million. The other
was the Ironwood Apartments (Ironwood), a proposed 312-unit
project located in Moreno Valley, California. Its anticipated
cost was slightly more than $12 million. Twenty percent of the
apartment units to be constructed in each of these projects were
to be set aside to provide housing for low-to-moderate-income
families.
SBE submitted detailed information concerning the
feasibility of the projects to Riverside County officials. Upon
receipt of the development information, the Housing Authority and
related county agencies conducted an extensive review of the
proposals to determine the need, feasibility, cost effectiveness,
accessibility, and desirability of these projects. The Housing
Authority approved the projects and thereafter engaged the law
firm of Camfield & Christopher to act as bond counsel.
James W. Newman, Jr., was a partner in the Houston office of
the law firm of Stubbeman, McRae, Sealy, Laughlin & Browder
(...continued)
a partnership in which SBE was the general partner.
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(Stubbeman). Mr. Newman (and thereafter Stubbeman) acted as
special tax counsel and underwriter's counsel on the Whitewater
and Ironwood bond issues. Mr. Newman prepared the Bond documents
used in the Whitewater and Ironwood deals. It is customary for
bond counsel to draft, disseminate, and revise all documents
needed to bring about the issuance of a tax-exempt bond. In this
case, however, Stubbeman assumed that responsibility inasmuch as
it was preparing several sets of similar documents for a number
of other bond transactions to be issued at the same time as the
Whitewater and Ironwood bonds.
The plan that was developed contemplated that two firms--
Donaldson, Lufkin & Jenrette Securities (DLJ) and Drexel,
Burnham, Lambert, Inc. (Drexel)--would be the underwriters on the
Whitewater and Ironwood bond issues. Ira McCown, an investment
banker at DLJ, was deeply involved in bringing the Whitewater and
Ironwood bonds to market. The Interfirst Bank of Houston would
be trustee for the bondholders. The financing plan further
contemplated that the Housing Authority would issue the Bonds and
then lend the Bond proceeds to a developer, in exchange for a
developer note. The Housing Authority would then assign the
developer note to the Trustee bank. The developer would make
payments on its note to the Trustee bank. The developer would
use the Bond proceeds, which were to be in a "developer loan
fund", to construct the projects.
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With respect to each project, SBE operated as a general
partner of a partnership formed to act as the developer. The
developer of the Whitewater Project was the Whitewater Limited
Partnership (Whitewater, Ltd.), and the developer of the Ironwood
Project was Ironwood Apartments, Ltd. (Ironwood, Ltd.).
Credit Enhancement
As security for the loan, each developer was to obtain an
irrevocable letter of credit, in exchange for a second
developer's note, called a "reimbursement note", secured by a
mortgage on the property to be developed. The provider of the
letter of credit would then discount the developer's note to
another entity--the "mortgage purchaser"--in exchange for cash
that the letter of credit provider would use to acquire, from a
solid financial institution, a "guaranteed investment contract"
(GIC). The GIC would be pledged to secure payment of interest
and principal, under the letter of credit, to the bondholders.
In effect, each developer would issue a second note in order to
obtain a guaranteed means of repayment on its first note.
For the Ironwood project, the letter of credit provider was
to be Mercantile Capital Finance Corp. No. 30 (MCFC No. 30) and
for the Whitewater project, Mercantile Capital Finance Corp. No.
47 (MCFC No. 47). The sole shareholder of each of these
corporations was James J. Keefe. The mortgage purchaser for both
projects was Unified Capital Corp. (Unified). This entity was
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owned by Mr. Keefe, Steven Tetrick, and Steve Jarchow. Mr.
Tetrick was Unified's chief executive officer.
Notice of Hearing
In November and December of 1985, the Housing Authority
published notices of a hearing on the Ironwood bond issue in the
Press Enterprise, a newspaper of general circulation in Riverside
County. Subsequently, on December 17, 1985, the Housing
Authority authorized the issuance of the Ironwood bonds in the
amount of $13 million.
Apparently because of staff oversight, there was no
newspaper publication concerning hearings held on December 3,
1985, on the Whitewater bonds by both the Advisory Commission and
the Housing Authority. However, both the Housing Authority and
the Advisory Commission followed notification procedures for such
hearings under a California statute known as the Brown Act. As
required by the Brown Act, the Advisory Commission posted notices
containing the agenda of its December 3, 1985, meeting regarding
the proposed issuance of the Whitewater bonds at least 72 hours
prior to the date thereof. The notice containing the agenda was
posted at Riverside County's eight public housing projects and at
the Indio and Riverside County Housing Authority offices. Listed
in the notice as "New Business" was "Recommend approval of
Resolution Number 85-052 - Bond Financing - Whitewater Garden
Apartments Multi-Family Housing Revenue Bond ($17,200,000)."
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Also as required under the Brown Act, the Housing Authority
gave notice by distributing several hundred copies of its agenda
throughout Riverside County at least 72 hours in advance of its
hearings. The copies were distributed to all personnel in the
office of the clerk of the board of supervisors, members of the
board of supervisors, local news media (including the Press
Enterprise), the county courthouse (for public posting in the
clerk's office), all county offices, and a list of developers and
attorneys. The notices stated that at the December 3, 1985,
meeting of the board of supervisors and Housing Authority,
consideration would be given to "Resolution 85-709 approving the
issuance of bonds by the Housing Authority of the County of
Riverside for the SBE Development Corp. Project ($17,200,000)."
A notice for a special meeting of the Housing Authority on
December 10, 1985, announced that the Housing Authority would
give consideration to "Resolution 85-052 approving the Whitewater
Garden Apartments Multi-family issuance of tax-exempt revenue
bonds and approving documentation for issuance of revenue bonds."
Early in December 1985, the board of supervisors of
Riverside County authorized the issuance of the Whitewater bonds
in the amount of $17,200,000 and, a week later, transferred its
rights and duties with respect to such issuance to the Housing
Authority.
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Preclosing Activities
Prior to closing on the Whitewater and Ironwood bond issues,
officials of the Housing Authority, Riverside County's counsel,
the trustee's officers and its counsel, and bond counsel all
engaged in reviewing drafts of the Bond documents.
On December 17, 1985, William A. Rosenberger, executive
director of the Housing Authority, executed a "Non-Arbitrage
Certificate" for the Whitewater and Ironwood bonds. Therein, he
represented that the Housing Authority, as issuer of the Bonds,
reasonably expected that the Bond proceeds would be used for the
construction of multifamily housing. He further represented
that, except for a permissible temporary period, the Bonds would
not be invested in higher yielding taxable securities in an
attempt to gain arbitrage profits. Bond counsel checked with the
county government and were informed that notices of hearings on
the Bonds had been published.
The parties to the Bond issuances then attended a preclosing
at the Stubbeman office in Houston in mid-December 1985. Mr.
Christopher, as the Housing Authority's bond counsel, represented
Riverside County. Also present at the preclosing were Mr. Newman
and two other lawyers from the Stubbeman firm, Mr. McCown from
DLJ, and representatives from Unified. The purpose of the
preclosing was to obtain signatures and otherwise put the
documents into form for the final closing. The Stubbeman firm
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held the documents so executed in escrow pending the final
closing.
Changes in the Program
Because of a pending change in the tax law setting forth
restrictive new arbitrage rebate rules on bonds issued after
December 31, 1985, there was considerable pressure for local
governments to issue multifamily housing bonds on or before
December 31, 1985. As the anticipated December 31, 1985, closing
date approached, principals of DLJ informed Mr. McCown that the
firm was financially unable to underwrite the large number of
tax-exempt bonds that were scheduled for closing on December 31,
1985. Mr. McCown scrambled to find another underwriter. (Drexel
had lessened its involvement in underwriting these types of
securities by this time and was not a viable alternative.)
Mr. McCown was on good terms with Arthur Abba Goldberg, vice
president of the investment firm of Matthews & Wright, Inc., a
Wall Street underwriter. Mr. Goldberg told Mr. McCown that his
firm would underwrite the Bond transactions. Mr. McCown then
informed Mr. Newman that the Matthews & Wright firm would do the
underwriting. Mr. Newman had dealt with Matthews & Wright in the
past and agreed to the substitution of underwriters.
Prior to being sold to the public, the Bonds needed to be
rated by a recognized rating agency, such as Standard & Poor's
Corp. Because the rating agencies needed a period of time to
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rate the Bonds, the Bonds were to be "temporarily warehoused"--
that is, the Bonds were to be sold and held prior to their
ultimate sale to the investing public. Two days before closing,
a representative from Matthews & Wright informed Mr. Newman that
an entity known as the Commercial Bank of the Americas, Ltd.,
located on the island of Saipan in the Northern Marianas, would
purchase the Bonds from Matthews & Wright and hold them for
temporary "warehousing". Mr. Newman subsequently discovered that
the Commercial Bank of the Americas no longer had a banking
charter and was operating simply as a corporation.
On December 30, 1985, Mr. Newman instructed Richard B.
Hemingway, an associate in the Stubbeman firm, to take the
Whitewater, Ironwood, and 16 other bond certificates to New York.
Karen J. Cole, a representative of Interfirst Bank, was also in
New York on other business on December 31, 1985. Although she
had little prior involvement in the Bonds' issuance, she was
asked to go to the offices of Matthews & Wright to attend the
closing.
Mr. Goldberg headed a federal credit union named New
American Federal Credit Union, located in Jersey City, New Jersey
(the credit union). On December 31, 1985, Mr. Goldberg
instructed Joel S. Schwartz, the general manager of the credit
union, to come to Matthews & Wright and to bring "starter kit"
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books of the credit union's share drafts4 with him. Mr. Goldberg
informed Mr. Schwartz that he (Mr. Schwartz) would be signing
documents as a representative of the Commercial Bank of the
Americas.
On December 31, 1985, using credit union starter kits,
personnel at the offices of Matthews & Wright prepared the
endorsements and typed out the faces of 24 share drafts. These
included a share draft payable to Interfirst as trustee in the
amount of $17,613,020.83 for Whitewater, and another in the
amount of $13,083,958.33 for Ironwood. On that day, share drafts
totaling approximately $750 million were drawn by Matthews &
Wright on a nonexistent account at the credit union.
At the closing, Mr. Hemingway showed the documents relating
to the issuance of the Bonds to Ms. Cole and then delivered them
to Mr. Goldberg. Following directions from her home office, Ms.
Cole received the Whitewater and Ironwood share drafts. She
endorsed these share drafts "without recourse" to the Commercial
Bank of the Americas to purchase two investment agreements from
that institution. As of December 31, 1985, the Commercial Bank
of the Americas had no apparent assets in excess of $5,011 in an
account with the Bank of Guam.
Mr. Schwartz, on behalf of the Commercial Bank of the
Americas, then endorsed these share drafts back to Matthews &
4
These "share drafts" were the functional equivalent of a
check drawn on the credit union.
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Wright. He did so as an accommodation to Mr. Goldberg, who told
him that it was a legitimate transaction. An employee of
Matthews & Wright then restrictively endorsed these share drafts
for deposit to the account of Matthews & Wright. These share
drafts did not enter any banking channels; instead, Mr. Schwartz
took them home over New Year's Eve and later kept them in a file
at the credit union.
Also, on December 31, 1985, in Houston, Interfirst's
officer, H. Bradbury Foster, exchanged cross-receipts with Mr.
McCown, who was now representing Matthews & Wright's interests.
Interfirst recorded evidence of the share drafts and of their
exchange for the investment agreements on its corporate trust
books for December 31, 1985.
Officers of Interfirst were familiar with Matthews & Wright
as being a Wall Street underwriter of tax-exempt municipal bonds.
Just before the closing, they were informed that the Bonds would
be held and warehoused by the Commercial Bank of the Americas in
exchange for its investment agreements. Mr. Foster found the
Commercial Bank of the Americas listed in an international
banking directory. The information in the directory matched the
information concerning the bank he had received from Mr. Newman.
Mr. Foster also contacted Interfirst's international department,
which verified his information. Interfirst's head office then
referred him to the bank's New York international office. That
office also verified the information he had received. When
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Interfirst received the share drafts, it had no reason to believe
that they could be dishonored.
Because the Stubbeman firm was responsible for a number of
closings in New York, and because it was issuing the tax opinion
in those issues, it was decided that the Stubbeman firm, rather
than Mr. Christopher's firm (the actual bond counsel) would be
present. Mr. Christopher had no reason to mistrust the Stubbeman
firm.
On or about December 31, 1985, Mr. Newman telephoned Mr.
Christopher to tell him that the Bonds had been sold. Mr. Newman
did not, however, immediately inform bond counsel or county
authorities of the change in underwriters. Mr. Newman did not
convey to bond counsel the fact that a substitution of
underwriters had occurred until after the beginning of 1986.
Thus, Mr. Christopher first learned on February 10, 1986, from a
Drexel employee that Matthews & Wright--and not DLJ--was
warehousing the Bonds. Mr. Christopher was upset with the news.
He telephoned Mercantile Capital Corp., leaving a message as to
his displeasure at not being informed of the change in
underwriters. Two days later he further learned that Drexel was
out of the deal. On the same day, he was advised by Mr. Newman
that because the Bond documents were still in escrow, they could
be amended without following formal amendment procedures.
Had Mr. Christopher been aware of the developments
surrounding the issuance of the Bonds, he would not have
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authorized the use of his opinion. He would have recommended
that the Housing Authority not proceed with the issuance.
Neither Mr. Rosenberger nor anyone else in the Housing
Authority knew of the switch in underwriters until February 1986,
when Mr. Rosenberger was advised of the change by bond counsel.
Mr. Rosenberger believed that the closing on the issuance of the
Bonds occurred on December 31, 1985. As chief of the Riverside
County Housing Authority, Mr. Rosenberger relied upon county
counsel and bond counsel to advise him with respect to the
documents and to discuss any terms that might cause a potential
problem.
County counsel had not been made aware of these problems.
Mr. Anthony Wetherbee served as deputy county counsel and was
primarily responsible for reviewing bond issuances of Riverside
County during 1984 and 1985. He typically consulted with bond
counsel concerning documentation for a given bond issue. Mr.
Wetherbee participated in about 30 or 40 bond closings for
Riverside County. With respect to the Ironwood and Whitewater
issuances, he observed that they differed from other financing in
several ways. For example, most of the documents were being
prepared by the underwriter's counsel, the Stubbeman firm, and
not by bond counsel. The closing was to take place out of State,
but that was not unusual because the primary attorneys (the
Stubbeman firm) were in Texas. Another distinguishing factor was
that the Bonds were to be "warehoused"--kept by the underwriters
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until they were rated by a rating agency and made available to
the investing public. Mr. Wetherbee was aware of a sense of
urgency in issuing the Bonds before the end of 1985 because of a
pending change in the tax laws. These differences, however, did
not operate as a "flag" to indicate that anything was improper
with the issuance. Had Mr. Wetherbee been informed of the
details concerning the alleged closing and the subsequent
remarketing of the Bonds, he would not have recommended that the
Housing Authority proceed, and, in his opinion, the Housing
Authority would not in fact have proceeded with the financing.
After December 31, 1985, as a result of the change in the
underwriter, bond counsel urged the Housing Authority to pass a
resolution ratifying assignment of the underwriting agreement to
Matthews & Wright. The Housing Authority did so.
Events of February 20, 1986
A number of carefully orchestrated events occurred on
February 20, 1986, most of them taking place by wire transfers.
First, Matthews & Wright borrowed $58,475,287.37 from Security
Pacific National Bank (Security Pacific) pursuant to an existing
credit arrangement. The money was then wire transferred to Chase
Manhattan Bank for the account of the New American Federal Credit
Union, and for further credit to the Commercial Bank of the
Americas in order to purchase, inter alia, the Bonds. Matthews &
Wright pledged the Bonds, among other things, as collateral for
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the loan. (Matthews & Wright repaid this loan later in 1986
using funds received from the sale of the Bonds to the investing
public.) The money from Security Pacific, less an amount paid to
redeem a relatively small amount of the Ironwood bonds,
ultimately went to the Heritage National Bank of Austin, Texas
(Heritage). Heritage deposited $17,778,146.53 of these funds
into the "developer loan fund" account of Whitewater, Ltd. Of
this amount, $1,425,000 was used to purchase land for the
Whitewater project.
Whitewater, Ltd., had agreed to provide credit enhancement
for the Whitewater bonds by obtaining a letter of credit. To
arrange for this letter of credit, Whitewater, Ltd., entered into
an agreement with MCFC No. 47 and gave MCFC No. 47 a
reimbursement note, secured by a First Deed of Trust on the
Whitewater project. On the same day, pursuant to a "deposit
agreement", Whitewater, Ltd., transferred the $17,778,146.53 from
its developer loan fund at Heritage to Unified's account at
Heritage. This transaction was made pursuant to an understanding
that Unified would disburse the Bond proceeds, as needed, for
construction. This deposit agreement was not revealed to the
Housing Authority or its counsel. Using the bond proceeds from
Whitewater's developer loan fund, Unified then purchased
Whitewater, Ltd.'s reimbursement note, secured by the First Deed
of Trust, from MCFC No. 47 for $16,110,817.98. MCFC No. 47 used
this $16,110,817.98 to purchase a "Settlement Annuity Contract"
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from Crown Life Insurance Co. (This was the Whitewater
Guaranteed Investment Contract, or Whitewater GIC.) Thus, the
source of the funds from which the Whitewater bonds would be paid
was now Crown Life Insurance Co.
Similar transactions also took place on February 20, 1986,
with the $12,190,843.34 proceeds of the Ironwood bonds. These
proceeds were deposited in an Ironwood, Ltd., account at
Heritage. Ironwood, Ltd., gave a reimbursement note, secured by
a similar mortgage on the Ironwood property, to MCFC No. 30 in
exchange for a letter of credit securing payment of the Ironwood
bonds. But again, without the knowledge of the Housing
Authority, Ironwood, Ltd., deposited the $12,190,843.34 proceeds
with Unified. Using these proceeds, Unified purchased the
Ironwood reimbursement note from MCFC No. 30 for $11,047.408.05.
MCFC No. 30 used this latter amount to purchase a "Settlement
Annuity Contract" from Crown Life Insurance Co. (This was the
Ironwood Guaranteed Investment Contract, or Ironwood GIC.)
Although most of the Bond proceeds went into the GIC's,
substantial sums were used to pay fees, including fees to
Stubbeman, Unified, and MCFC Nos. 30 and 47. The Housing
Authority, however, only received reimbursement of administrative
fees of $16,250 in connection with the issuance of the Ironwood
bonds, and $21,375 with respect to the Whitewater bonds.
Once the money went into the GIC's, it was there
irrevocably. Although the proceeds available to buy the GIC's
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were diminished by numerous fee payments, because the GIC's paid
interest at higher rates than the Bonds, the remaining proceeds
were sufficient to guarantee payment of both principal and
interest to the holders of the Bonds. In fact, the payments
yielded by the Whitewater and Ironwood GIC's exactly equaled the
debt service requirements needed to pay the bondholders.
Pursuant to "Collateral Security Agreements", MCFC Nos. 47
and 30 pledged the Whitewater and Ironwood GIC's as security and
as sources of payment to the trustee, so that the trustee might
make scheduled payments to the Whitewater and Ironwood
bondholders.
Events After February 20, 1986
Standard & Poor's rating service noted that payment of
principal and interest for the Bonds was secured by guaranteed
investment contracts issued by a solid insurance company. This
security was sufficient for Standard & Poor's to issue a Triple-A
rating for the Bonds. Nevertheless, the effect of the diversion
of Bond proceeds from the developer loan fund to the purchase of
the GIC's was that no moneys were available to be expended on
construction of the projects. Mr. Etchegoyen of SBE, the general
partner of the Whitewater and Ironwood developers, sought funds
from the deposit agreements with Unified so that he might
undertake construction of the projects, but Unified refused.
When he sought to determine why he could not get the funds, Mr.
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Tetrick, the president of Unified, provided him with excuses,
saying that Mr. Tetrick would have to check with Mr. Keefe, who
headed the MCFC entities.
In the absence of funds, the Whitewater project was not
constructed. In an assignment dated August 4, 1987, Unified
assigned its rights under the Ironwood reimbursement note to Far
West Savings and Loan Association, which replaced Unified as the
construction lender. SBE issued a new note to Far West Savings,
secured by a deed and an assignment of rents. The deed
identified the Ironwood bonds at issue and stated, in pertinent
part:
the proceeds of the Bonds * * * are to be loaned to
Trustor for the purpose of providing construction and
permanent financing for the acquisition of that certain
real property situate[d] in the County of Riverside
* * *
The Ironwood project, currently operating under the name
Cross Creek Village, was completed in March 1989 with funds
borrowed from Far West Savings and Loan Association. The
resulting capital construction costs allocated to the Ironwood
project were more than 90 percent of the face amount of the
Ironwood bonds. When they were occupied, 20 percent of the
apartments were occupied by persons of low or moderate income.
SBE suffered severe financial reverses as a result of defaulting
on these projects, and Mr. Etchegoyen eventually lost his company
to his creditors.
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In 1988, Mr. Newman pleaded guilty to criminal charges in
connection with the issuance of other purported tax-exempt bonds
that supposedly closed on December 31, 1985. Mr. McCown resigned
from DLJ and, in 1990, pleaded guilty to aiding and abetting the
filing of false tax returns in connection with the Matthews &
Wright tax-exempt bond transactions. Mr. Goldberg was indicted,
with others, in connection with certain bond transactions in the
Territory of Guam and negotiated a plea arrangement.
Petitioners' Bond Purchases
On July 25, 1986, Harbor Bancorp acquired Whitewater bonds
with a face amount of $250,000. In the same month, the Keiths
acquired Ironwood bonds with a $400,000 face amount and
Whitewater bonds with a face amount of $300,000. Harbor Bancorp
received $19,375 of interest on the Whitewater bonds in each of
the years 1988, 1989, and 1990. The Keiths received $54,250 of
interest on the Whitewater and Ironwood bonds in each of the
years 1989, 1990, and 1991. Neither Harbor Bancorp nor the
Keiths included the interest received on the Bonds in the gross
income that they reported on their Federal income tax returns for
the years in issue.
On February 20, 1991, the Commissioner notified the Housing
Authority that the interest paid on the Bonds would be treated as
taxable income to the bondholders unless the Housing Authority
paid, to the United States, the amount required by section
- 23 -
148(f), which the Commissioner determined to be $2,250,475 with
respect to the Whitewater bonds, and $1,543,199 with respect to
the Ironwood bonds.5 The Housing Authority refused to make such
payments.
OPINION
Section 103(a) generally excludes interest earned on State
and local government bonds from taxable income. This exclusion,
however, does not apply to "arbitrage bonds". Sec. 103(c)(1).6
Section 103(c)(2) defines an arbitrage bond generally as a bond
the proceeds of which are "reasonably expected" to be used to
acquire higher yielding investments. Section 148(f)(1) provides
that if the requirements of section 148(f)(2) are not met, State
and local government bonds will be "treated as" arbitrage bonds.
Respondent's primary argument is based on section 148(f).
Accordingly, we will first consider whether the Bonds should be
treated as arbitrage bonds under section 148(f).
5
On June 20, 1991, the Housing Authority filed an action in
the U.S. District Court in Los Angeles, California, seeking a
preliminary injunction enjoining the Internal Revenue Service
from declaring the interest on the Bonds taxable. On June 20,
1991, Judge Marshall of the District Court granted a preliminary
injunction. On July 23, 1992, she dissolved the injunction,
ruling that the court lacked jurisdiction. No decision on the
merits was entered.
6
Sec. 103(c)(1) provides that "any arbitrage bond shall be
treated as an obligation not described in subsection (a)(1) or
(2)."
- 24 -
Section 148(f) was enacted by the Tax Reform Act of 1986,
and it is applicable to bonds issued after December 31, 1985.
Tax Reform Act of 1986, Pub. L. 99-514, sec. 1314(d), 100 Stat.
2664.7 Thus, our initial determination must be whether the Bonds
were issued on December 31, 1985, as petitioners contend, or on
February 20, 1986, as respondent contends. This is a mixed
question of fact and law, and we adopt the following analysis and
findings of the trial judge regarding the date on which the Bonds
were issued.
"Date of issue" is defined in section 1.103-13(b)(6), Income
Tax Regs., as
the date on which there is a physical delivery of the
evidences of indebtedness in exchange for the amount of
the issue price. For example, obligations are issued
when the issuer physically exchanges the obligations
for the underwriter's (or other purchaser's) check.[8]
7
TRA sec. 1314(d), 100 Stat. 2664, provides:
Except as otherwise provided in this subsection, in the
case of a bond issued after December 31, 1985, section
103 of the 1954 Code shall be treated as including the
requirements of section 148(f) of the 1986 Code in
order for section 103(a) of the 1954 Code to apply.
8
Respondent insists that the proper definition of "issue
date" for the Bonds involved here is that contained in sec.
1.150-1(c)(2), 57 Fed. Reg. 21032 (May 10, 1994), which provides:
(2) Date of Issue. The date of issue of a bond
is the first day on which there is physical delivery of
the written evidence of the bond in exchange for the
purchase price. Such day shall not be earlier than the
first day on which interest begins to accrue on the
(continued...)
- 25 -
Courts have never regarded "the simple expedient of drawing
up papers" as controlling for tax purposes when the objective
realities are to the contrary. Commissioner v. Tower, 327 U.S.
280, 291 (1946). Here, the hastily drawn up papers used at the
putative closings on December 31, 1985, utterly fail to reflect
objective reality. The alleged payment for the Bonds took the
form of share drafts from starter kits, drawn on nonexistent
accounts at a Jersey City credit union. The agent of the trustee
promptly endorsed these items, without recourse to the trustee,
to the order of an undercapitalized institution located in Saipan
that had recently lost its banking license. In exchange, the
trustee took the Saipan institution's investment agreements. If,
on December 31, 1985,--the alleged "date of issue"--the trustee
had sought either to cash the share drafts or to collect upon its
investment agreements, it would have been unsuccessful. Neither
the share drafts nor the investment agreements had any substance
behind them. These items fell embarrassingly short of
representing actual payment for the Bonds within the meaning of
the Commissioner's regulations. Accordingly, the date of issue
of the Bonds was not December 31, 1985, but rather February 20,
1986, when actual funds were transferred from Security Pacific
(...continued)
bond for federal income tax purposes.
Suffice it to say our determination as to the date of issue would
be the same under either version.
- 26 -
Bank to Chase Manhattan Bank and subsequently to Heritage, to the
credit of the developer partnerships and then to Unified.
Because the Bonds were issued after December 31, 1985, section
148(f) applies.
Section 148(f)(1) provides that a bond shall be treated as
an arbitrage bond unless the amount described in section
148(f)(2) is paid to the United States. Such amount is 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),
Sec. 148(f)(2). Payments required by section 148(f)(2) are
generally required to be made at 5-year intervals. Each required
installment must be in an amount that ensures that 90 percent of
the amount described in section 148(f)(2) has been paid, and full
payment must be made with the last installment. Sec. 148(f)(3).9
9
Sec. 148(f)(3) provides in part:
Except to the extent provided by the Secretary, the
amount which is required to be paid to the United
(continued...)
- 27 -
Failure to pay the required amount results in the bond's being
treated as an arbitrage bond, which results in the loss of tax-
exempt status.
The parties have stipulated that no payments required by
section 148(f) were made to the United States. Therefore, if (1)
the Whitewater and Ironwood GIC's constitute nonpurpose
investments of the proceeds of the Bonds, and (2) these
investments earned a higher rate of return than the yield rate on
the Bonds, then the Bonds must be treated as arbitrage bonds
pursuant to section 148(f).
A "nonpurpose investment" is defined as any investment
property that is acquired with the gross proceeds of a bond issue
and is not acquired to carry out the governmental purpose of the
issue. Sec. 148(f)(6)(A). "Gross proceeds" include any amounts
actually or constructively received from the sale of the bonds as
well as any amounts received from investing the original proceeds
(...continued)
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.
There is no dispute that the Housing Authority of Riverside
County has not made such a payment within the time prescribed by
sec. 148(f)(3).
- 28 -
of the bond issue. Sec. 148(f)(6)(B); sec. 1.148-8(d)(1)-(5),
Income Tax Regs.
The Whitewater and Ironwood GIC's were acquired with the
gross proceeds of the Whitewater and Ironwood bond issues,
respectively. These proceeds were first placed in developer loan
fund accounts and then transferred to Unified. Unified then
transferred most of these proceeds to the MCFC entities, which,
in turn, used them to purchase the GIC's. Following the flow of
funds on February 20, 1986, it is clear that $16,110,817.98 of
Whitewater bond proceeds and $11,047,408.05 of Ironwood bond
proceeds were expended to acquire the GIC's. The governmental
purpose for the issuance of the Whitewater and Ironwood bonds was
the construction of low- and moderate-income multifamily housing
projects. The GIC's were not acquired to carry out this
governmental purpose. Accordingly, the GIC's constituted
nonpurpose investments within the meaning of section
148(f)(6)(A).
Petitioners argue that the GIC's do not constitute
nonpurpose investments, because neither the Housing Authority nor
the developer made an "investment decision". Petitioners ask
this Court to construe the meaning of "nonpurpose investment" to
exclude any unauthorized investment.10 However, the statute does
10
Petitioners also argue that the Treasury's regulation
defining "nonpurpose investment" is invalid, because the
definition therein is broader than the definition in the statute.
We fail to see a significant difference in the definitions. Sec.
(continued...)
- 29 -
not provide such an exclusion. Section 148(f)(6)(A) defines a
nonpurpose investment broadly to include any investment property
that is acquired with the gross proceeds of an issue, and is not
acquired to carry out the governmental purpose of the issue.11
While the Housing Authority did not directly purchase the GIC's
(...continued)
148(f)(6)(A) defines "nonpurpose investment" as any investment
property that is acquired with the gross proceeds of an issue and
is not acquired to carry out the governmental purpose of the
issue. Sec. 1.148-8(e)(9), Income Tax Regs., defines "nonpurpose
investment" as any investment that is not a purpose investment.
"Purpose investment" is defined as any investment that is
allocated to the gross proceeds of an issue and that is acquired
to carry out the governmental purpose of the issue. Sec. 1.148-
8(e)(10), Income Tax Regs. In any event, we have relied upon the
statutory definition for purposes of our holding.
11
Sec. 148(f)(6) provides:
(6) Definitions.--For purposes of this subsection and
subsections (c) and (d)--
(A) Nonpurpose Investment.--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) Gross proceeds.--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.
- 30 -
and, presumably, did not intend that the Bond proceeds be used to
purchase the GIC's, the GIC's were in fact purchased with the
proceeds of the Bonds and committed to provide funds for the
repayment of principal and interest on the Bonds rather than for
the governmental purpose of constructing multifamily housing.
Thus, the GIC's fall within the statutory definition of
nonpurpose investments.
Next, we must determine whether there was an amount earned
on the nonpurpose investments that exceeded the amount that would
have been earned if the nonpurpose investments had been invested
at a rate equal to the yield on the Bond issues (hereinafter
sometimes referred to as the excess amount). Sec. 148(f)(2).12
An amount earned within the meaning of section 148(f)(2) is an
amount actually or constructively received by the bond issuer
from the nonpurpose investment. See secs. 1.148-2(b)(2)(i),
1.148-8(d)(5), Income Tax Regs.13 Here, the amounts earned on
12
Sec. 148(f)(4) contains special rules for applying par.
(2). Petitioners make no claim that these special rules require
any modification to the computation of the excess amount defined
in sec. 148(f)(2), and we find nothing in par. (4) that would
modify the literal application of par. (2) to the facts in this
case.
13
Sec. 1.148-2(b)(2)(i), Income Tax Regs., provides:
The term "receipt" means, with respect to an investment
allocated to an issue, any amount actually or
constructively received with respect to the investment.
Except as provided in § 1.148-4(c)(3), receipts are not
reduced by selling commissions, administrative
expenses, or similar expenses. * * *
(continued...)
- 31 -
the GIC's were constructively received by the Housing Authority
because the proceeds of the GIC's were used to pay the debt
service on the Bonds that the Housing Authority had issued.14
Logic indicates that the amount earned on the nonpurpose
investments (the GIC's) was substantially in excess of the amount
which would have been earned if the amounts invested in the GIC's
had been invested at a rate equal to the yield on the Bond
issues. The amount available to buy the GIC's--the Bond
proceeds--had been diminished by substantial fee payments and by
the purchase of land. Nevertheless, the payments yielded by the
Whitewater and Ironwood GIC's exactly equaled the debt service
payments specified in the Bond documents. Because an amount that
was substantially less than the Bond proceeds was invested in the
GIC's, and because the GIC's nevertheless generated enough
revenue to pay the Bonds' debt service requirements, it follows
that the GIC's paid interest at higher rates than the yield on
the Bonds. It further follows that amounts earned on the
(...continued)
Sec. 1.148-8(d)(5), Income Tax Regs., provides:
The term "investment proceeds" means, with respect to
an issue, any amounts actually or constructively
received from investing original proceeds of the issue.
14
Satisfaction of a debtor's obligation by means of a third
party's payment to the creditor is the equivalent of receipt by
the debtor. Old Colony Trust Co. v. Commissioner, 279 U.S. 716,
729 (1929); Amos v. Commissioner, 47 T.C. 65, 70 (1966); see
Bintliff v. United States, 462 F.2d 403, 408 (5th Cir. 1972).
- 32 -
investment of a given sum at the rate of the higher yielding
GIC's would substantially exceed amounts earned upon investment
of that same sum at the yield rate of the Bonds.
The regulations calculate the excess amount to be paid to
the United States as the future value of all nonpurpose receipts
over the future value of all nonpurpose payments. Sec. 1.148-
2(a)(1) and (2), Income Tax Regs. "Receipts" are defined to
include any amount actually or constructively received with
respect to the investment (but not reduced by administrative or
similar expenses). Sec. 1.148-2(b)(2)(i), Income Tax Regs.15
"Payments" are defined to include the amount of gross proceeds of
the bond issue to which the investment is allocated (not
including administrative or similar expenses), whether or not the
investment was directly purchased with such gross proceeds. Sec.
1.148-2(b)(3)(i) and (ii), Income Tax Regs.
The parties have stipulated the schedule of payments for and
receipts pursuant to the Whitewater GIC as follows:
Date Payment Receipt
2/20/86 $16,110,817.98
5/27/86 $678,125
11/26/86 678,125
5/27/87 678,125
11/25/87 678,125
5/27/88 678,125
11/25/88 678,125
15
For an investment held at the end of a computation period,
the term "receipt" includes the fair market value of the
investment at the end of that period. Sec. 1.148-2(b)(2)(iii),
Income Tax Regs.
- 33 -
5/26/89 678,125
11/24/89 678,125
5/25/90 678,125
11/26/90 678,125
5/24/91 678,125
11/26/91 678,125
5/27/92 678,125
11/25/92 678,125
5/27/93 678,125
11/26/93 18,178,125
Similarly, the schedule of payments for and receipts pursuant to
the Ironwood GIC has been stipulated by the parties as follows:
Date Payment Receipt
2/20/86 $11,047,408.05
5/27/86 $465,000
11/26/86 465,000
5/27/87 465,000
11/25/87 465,000
5/27/88 465,000
11/25/88 465,000
5/26/89 465,000
11/24/89 465,000
5/25/90 465,000
11/26/90 465,000
5/24/91 465,000
11/26/91 465,000
5/27/92 465,000
11/25/92 465,000
5/27/93 465,000
11/26/93 12,465,000
Utilizing the procedures outlined in sections 1.148-2 and
1.148-8, Income Tax Regs.,16 respondent has undertaken to show
how much the amount earned on the GIC's exceeded the amount which
would have been earned if the GIC's had been invested at a rate
16
Sec. 148(i) provides that "The Secretary shall prescribe
such regulations as may be necessary or appropriate to carry out
the purposes of this section."
- 34 -
equal to the yield on the Bond issues. These calculations
indicate that the yield of the Whitewater GIC was 9.5520 percent,
and the yield of the Whitewater bonds was 7.3750 percent. As of
February 20, 1991, the first computation date, respondent's
calculations indicate that the future value of the earnings on
the Whitewater GIC exceeded the amounts that would have been
earned if the GIC were invested at the yield rate of the
Whitewater bonds by $2,079,204.05.17 Equivalent calculations for
the Ironwood bonds show that the yield on the Ironwood GIC was
again 9.5520 percent while the yield on the Ironwood bonds was
7.6652 percent, generating an excess of $1,242,876.71 as of the
17
Respondent computed this excess as follows:
Days
Payment Receipt Future Value To Comp.
2/20/86 (16,110,817.98) (23,140,973.48) 1800
5/27/86 678,125.00 955,210.32 1703
11/26/86 678,125.00 921,424.96 1524
5/27/87 678,125.00 888,477.02 1343
11/25/87 678,125.00 857,224.42 1165
5/27/88 678,125.00 826.405.87 983
11/25/88 678,125.00 797,336.65 805
5/26/89 678,125.00 768,825.81 624
11/24/89 678,125.00 741,782.00 446
5/25/90 678,125.00 715,257.66 265
11/26/90 678,125.00 689,681.77 84
2/20/91 17,061,551.08 17,061,551.08 0
2/20/91 (3,000.00) 0.00 (3,000.00) 0
5/27/92 0.00 0.00 -457
1/25/92 0.00 0.00 -635
5/27/93 0.00 0.00 -817
11/26/93 0.00 0.00 -996
(16,113,817.98) 23,842,801.08 2,079,204.05
Respondent used the same procedure in calculating the excess amount for the
Ironwood bonds.
- 35 -
first computation date according to respondent. In their briefs,
petitioners did not attempt to refute respondent's calculations.
We are convinced that the amounts earned on the GIC's
substantially exceeded the amounts which would have been earned
if the GIC's had paid a rate equal to the yield of the Bonds.
Petitioners do not seriously contend otherwise. We need not, and
do not, decide the exact amount of that excess. In order to hold
that the Bonds should be treated as arbitrage bonds within the
meaning of section 148(f), it is sufficient to find, as we do,
that the amount earned on the nonpurpose investments (the GIC's)
substantially exceeded the amount that would have been earned if
the nonpurpose investment had been invested at a rate equal to
the yield on the Bond issues, and that the Bond issuer failed to
pay the amount of that excess to the United States at the
required time.
Petitioners argue that a literal reading of section 148(f)
should not apply to the Bonds at issue, because the statute was
intended only to recapture the economic benefit received by the
issuer. Petitioners cite Washington v. Commissioner, 692 F.2d
128 (D.C. Cir. 1982), affg. 77 T.C. 656 (1981), for the
proposition that a bond issuer must realize an economic benefit
in order to trigger the arbitrage provisions. In State of
Washington, this Court concluded that the general arbitrage
provisions of section 103(c) were intended to apply only where
the issuer of the bond realized an economic benefit. As a
- 36 -
result, we held that the costs of issuing the bonds, including
underwriting costs, should be taken into account in determining
the existence of arbitrage. The Court of Appeals for the
District of Columbia Circuit affirmed.
In 1986, when Congress enacted section 148, it specifically
reversed Washington v. Commissioner, supra.
The bill provides that, under all arbitrage
restrictions applicable to tax-exempt bonds, the yield
on an issue is determined based on the issue price,
taking into account the Code rules on original issue
discount and discounts on debt instruments issued for
property (secs. 1273 and 1274). This amendment
reverses the holding in the case State of Washington v.
Commissioner, supra. [S. Rept. 99-313, at 845 (1986),
1986-3 C.B. (Vol. 3) 1, 845.]
The Committee explained the reason for this change as follows:
The committee believes it is important for issuers
of tax-exempt bonds to pay the costs associated with
their borrowing. The bill provides that the costs of
issuance, including attorneys' fees and underwriters'
commissions, must be paid by the issuers or
beneficiaries of the bonds, rather than recovered
through arbitrage profits at the Federal Government's
expense. The committee believes that this restriction
will result in a more efficient use of tax-exempt
financing, as borrowers will more closely monitor the
costs of their borrowing. However, the committee
intends to monitor the effect of these provisions to
determine whether further restrictions on costs such as
attorneys' fees and underwriters' commissions are
needed. [S. Rept. 99-313, supra at 828, 1986-3 C.B.
(Vol. 3) at 828.]
From this, it is clear that when Congress enacted section 148, it
did not want to permit the investment of tax-exempt bond proceeds
in higher yielding investments, the income from which would be
- 37 -
used to recover costs associated with the bond issue. In the
instant case, that is exactly what happened. When all the smoke
had cleared, the underwriters, bankers, and attorneys had
received substantial amounts from the Bonds' proceeds, and the
repayment of those Bonds had been secured by the purchase of the
GIC's. The relatively small amount left was insufficient to
accomplish the governmental purpose of the bonds.
Petitioners next argue that section 148(f) should not apply
when the governmental issuer of the bonds did not intend that the
bond proceeds be invested in higher yielding, nonpurpose
obligations. However, the literal provisions of section
148(f)(1) and (2) make no reference to the issuer's intent.
Rather, the language of section 148(f)(2) is computational in
nature and unambiguous.18
18
There is no need to resort to legislative history, unless
the statutory language is ambiguous. In Hubbard v. United
States, 514 U.S. , , , 115 S. Ct. 1754, 1759, 1761
(1995), the Supreme Court recently stated:
In the ordinary case, absent any "indication that doing
so would frustrate Congress's clear intention or yield
patent absurdity, our obligation is to apply the
statute as Congress wrote it." BFP v. Resolution Trust
Corp., 511 U.S. (1994) (SOUTER, J., dissenting).
* * * * * * *
Courts should not rely on inconclusive statutory
history as a basis for refusing to give effect to the
plain language of an Act of Congress, particularly when
the Legislature has specifically defined the
controverted term. * * *
- 38 -
The statutory context of section 148(f) also supports a
literal application of its terms. The general definition of an
"arbitrage bond" is contained in section 103(c)(2). An
"arbitrage bond", within the meaning of that section, is one that
the issuer "reasonably expected" to produce arbitrage. If an
issuer "reasonably expected" to earn arbitrage with bond
proceeds, the bonds are not tax exempt. Section 148(f) is an
additional arbitrage restriction. It was intended to restrict
arbitrage even further than the historic reasonable expectation
test. In its explanation of the new section 148(f) provisions,
the Senate Finance Committee report states:
The bill generally extends to all tax-exempt bonds
(including refunding issues) additional arbitrage
restrictions similar to those presently applicable to
most IDBs and to qualified mortgage bonds. These
restrictions, requiring the rebate of certain arbitrage
profits and limiting investment of bond proceeds in
nonpurpose obligations, are in addition to the general
arbitrage restrictions for all tax-exempt bonds. [S.
Rept. 99-313, supra at 845, 1986-3 C.B. (Vol. 3) at
845; emphasis added.]
See also H. Rept. 99-426 (1985), 1986-3 C.B. (Vol. 2) 1, 555.
There is no indication in the statute or legislative history that
Congress wanted to limit section 148(f) to situations where the
issuer intended, or reasonably expected, to earn arbitrage.
Were we to superimpose an intent requirement onto section
148(f), that section would become redundant. Section 103(c)
already defined arbitrage bonds as those whose proceeds the
issuer reasonably expected, at the time of issue, would be used
- 39 -
to produce arbitrage. For bonds issued after August 15, 1986,
the general definition of an arbitrage bond appears in section
148(a). Section 148(a) expanded the definition to include not
only bonds that the issuer reasonably expected, at the time of
issuance, would produce arbitrage, but also bonds whose proceeds
were at any time "intentionally" used by the issuer to acquire
higher yielding investments. Arbitrage bonds within the
definition of section 103(c) and section 148(a) are not tax
exempt, and there are no statutory provisions allowing the issuer
to attain or regain tax exempt status by paying the amount of
arbitrage earnings to the Federal Government. In contrast, a
bond's treatment as an arbitrage bond under section 148(f)
depends first upon whether a payment to the United States is
required by section 148(f). This cannot be ascertained until
after the date the State or local government bonds are issued and
after the nonpurpose investment is made. The first computation
date for making this determination is normally 5 years after the
original bond issue. Furthermore, section 148(f)(1) and (2) does
not treat a bond as an arbitrage bond merely because of the
existence of excess earnings within the meaning of section
148(f)(2). Rather, it is the existence of such excess (based on
a mathematical calculation) plus the failure of the issuer to pay
the excess amount to the Federal Government that triggers
arbitrage bond treatment and the resulting loss of tax-exempt
status.
- 40 -
The regulations under section 148(f) are consistent with the
statute and legislative history in that they are mechanical in
nature and require no reference to the issuer's intent or
expectations. The section 148(f)(2) amount is defined as the
excess of the future value of all nonpurpose receipts over the
future value of all nonpurpose payments. Sec. 1.148-2(a), Income
Tax Regs. "Receipts" are defined broadly to include any amount
actually or constructively received with respect to the
investment as well as the fair market value of the investment at
the end of a computation period. Sec. 1.148-2(b)(2)(i), (iii),
Income Tax Regs. "Payments" are also defined broadly and include
the amount of gross proceeds of the issue to which the investment
is allocated, whether or not the investment was directly
purchased with such gross proceeds. Sec. 1.148-2(b)(3)(i) and
(ii), Income Tax Regs. If the receipts exceed the payments,
there is an amount that must be paid to the United States in
order to avoid treatment as an arbitrage bond.
It is clear that the investments in the GIC's earned a
higher rate of return than the yield on the Bonds. This produced
an excess amount within the meaning of section 148(f)(2). It is
also clear that some of the excess was used for purposes that
Congress did not want to subsidize through Federal tax
exemptions. Congress provided that the exempt status of such
bonds could be maintained only if the issuer paid the excess
amount as defined in section 148(f)(2) to the United States.
- 41 -
Here, the issuer has thus far refused to pay that amount.
Accordingly, we hold that the Whitewater and the Ironwood bonds
are to be treated as arbitrage bonds pursuant to section 148(f)
and that the interest earned thereon is includable in
petitioners' income.19
Because we have determined that the Bonds are to be treated
as arbitrage bonds under section 148(f), we must address some of
the other arguments advanced by petitioners. Petitioners contend
that respondent lacks the authority to tax the bondholders, and
that her sole remedy is to disqualify the issuer from certifying
the nonarbitrage status of its tax-exempt bonds in the future
under section 1.103-13(a)(2)(iv), Income Tax Regs. The
regulation cited by petitioners neither states nor implies such a
proposition. Petitioners have cited no authority to show why the
decertification remedy is inconsistent with the Commissioner's
concurrent duty to collect income taxes on interest from bonds
that are not exempt from tax under section 103. See secs. 6212,
7601. It is not uncommon for the Commissioner to have a variety
of ways to carry out her duties. See, e.g., Pesch v.
Commissioner, 78 T.C. 100, 117-118 (1982).
19
The parties addressed the following additional issues on
brief: (1) Whether the Bonds are arbitrage bonds within the
meaning of sec. 103(c)(2); (2) whether the Bonds are taxable
industrial development bonds within the meaning of sec. 103(b);
and (3) with respect to one of the involved bond issues, whether
the public approval requirement set forth in sec. 103(k) was
satisfied. However, because we hold that the Bonds are to be
treated as arbitrage bonds under sec. 148(f), we need not decide
these issues.
- 42 -
Petitioners also argue that respondent has impermissibly
discriminated against them by taxing them on the Bond proceeds
while, in other cases, respondent has settled with the issuers.20
This argument is wide of the mark. It is the responsibility of
this Court to apply the law to the facts before it and to
determine the tax liability of petitioners before it. The
Commissioner's treatment of other taxpayers has generally been
considered irrelevant in making that determination. Jaggard v.
Commissioner, 76 T.C. 222, 226 (1981) (citing Teichgraeber v.
Commissioner, 64 T.C. 453, 456 (1975)). To establish illegal
discrimination by the Commissioner, petitioners must show more
than the fact that they have been treated less favorably than
other similarly situated taxpayers. Petitioners must also show
that such allegedly discriminatory treatment is based upon
impermissible considerations such as race, religion, or the
desire to prevent the exercise of constitutional rights. Penn-
Field Indus., Inc. v. Commissioner, 74 T.C. 720, 723 (1980).
Petitioners have not shown, in the first instance, that
other similarly situated taxpayers received better treatment. In
addition, petitioners have not demonstrated that respondent has
used impermissible criteria in determining the deficiencies in
20
Any "settlements" with bond issuers may well have included
the issuers' payment of an amount pursuant to sec. 148(f)(2).
The Housing Authority of Riverside County has made no such
payment.
- 43 -
issue. Petitioners may be, as they allege, the first bondholders
to be taxed upon interest received from purportedly tax-exempt
bonds that fail to meet the requirements for tax exemption.
However, that does not mean that they have been targets of
impermissible discrimination.21
Finally, we realize that under our holding, it is the
bondholders, rather than the bond issuer, that bear the immediate
brunt of the issuer's failure to pay the amount required by
section 148(f)(2). However, the statutory exemption from Federal
tax for interest on State and local government bonds is
conditioned on the requirement that the bond issuer pay the
amount required by section 148(f)(2), and exclusions from taxable
income are to be narrowly construed. Commissioner v. Schleier,
21
Petitioners rely on International Business Machines Corp.
v. United States, 170 Ct. Cl. 357, 343 F.2d 914 (1965), to
support their claim of discrimination. In that case, one of
IBM's competitors had obtained a ruling from the Commissioner
that certain equipment was exempt from an excise tax. IBM sought
a similar ruling for similar equipment, which the Commissioner
finally denied 2 years later. At the time of the denial, the
Commissioner prospectively revoked the favorable ruling that
IBM's competitor had received, but the competitor had already
enjoyed several years of favorable tax treatment. The Court of
Claims found that this course of conduct constituted "manifest
and unjustifiable discrimination", and its effect "was to favor
the other competitor so sharply that fairness called upon the
Commissioner, if he could under Section 7805(b), to establish a
greater measure of equality." 343 F.2d at 923.
We find that the present case is distinguishable from IBM.
The present case does not involve a determination by the
Commissioner, which has the effect of penalizing petitioners and
favoring similarly situated taxpayers so as to give them a
significant competitive or financial advantage.
- 44 -
515 U.S. ___, ___, 115 S. Ct. 2159, 2163 (1995). The simple fact
is that the statutory requirements for exempting the interest
earned on the Bonds have not been met. As with other debtor-
creditor relationships, the risk that the issuer of bonds will
not live up to the responsibilities undertaken when it
represented the quality of its obligations must be born by the
bond purchasers.
One might also sympathize with the situation of the Housing
Authority of Riverside County. However, it seems clear that, as
between it and the Federal Government, the Housing Authority
should bear responsibility for what happened. The Housing
Authority issued the Bonds and selected those who were
responsible for implementing their issuance and applying the
proceeds. Congress clearly wanted bond issuers to be responsible
for meeting the requirements for tax exemption. The Housing
Authority certified that the Bonds would qualify for tax
exemption. Like any other local government bond issuer, the
Housing Authority was responsible for paying any amount required
by section 148(f)(2), regardless of whether it intended to
generate the excess described in section 148(f)(2). It has thus
far chosen not to do so. Unfortunately for its bondholders, the
- 45 -
statutorily required result of this choice is that the interest
on the Bonds is not exempt from Federal taxation.
Decisions will be entered
for respondent.
Reviewed by the Court.
HAMBLEN, CHABOT, GERBER, WRIGHT, PARR, WELLS, WHALEN,
COLVIN, BEGHE, CHIECHI, LARO, FOLEY, and VASQUEZ, JJ., agree with
this majority opinion.
SWIFT, J., concurs in the result only.
- 46 -
HALPERN, J., concurring: I agree with the majority's
opinion except in one respect, the majority's reliance on tracing
the bond proceeds into the GIC's. I am not convinced that the
statute (sec. 148(f)) contemplates tracing, and I would rely on a
different rationale, viz, that the issuer (the Housing Authority)
itself invested in the GIC's.
The key to the majority's analysis concerning section 148(f)
is in the following paragraph:
The Whitewater and Ironwood GIC's were acquired
with the gross proceeds of the Whitewater and Ironwood
bond issues, respectively. These proceeds were first
placed in developer loan fund accounts and then
transferred to Unified. Unified then transferred most
of these proceeds to the MCFC entities, which, in turn,
used them to purchase the GIC's. Following the flow of
funds on February 20, 1986, it is clear that
$16,110,817.98 of Whitewater bond proceeds and
$11,047,408.05 of Ironwood bond proceeds were expended
to acquire the GIC's. The governmental purpose for the
issuance of the Whitewater and Ironwood bonds was the
construction of low- and moderate-income multifamily
housing projects. The GIC's were not acquired to carry
out this governmental purpose. Accordingly, the GIC's
constituted nonpurpose investments within the meaning
of section 148(f)(6)(A). [Majority op. p. 28.]
Petitioners attempt to rebut the majority's conclusion about
the GIC's by (1) conceding that, yes, the bond proceeds are
traceable into the GIC's, but (2) arguing that the GIC's were an
unauthorized investment. In effect, petitioners' argument is
that, whatever in fact happened to the bond proceeds, the Housing
Authority did not do it: Some other guys (thieves!) did it. Id.
p. 28. The majority makes plain that, to the majority, it does
- 47 -
not matter who invested the bond proceeds in the GIC's, so long
as someone (anyone) invested the bond proceeds in the GIC's:
While the Housing Authority did not directly purchase
the GIC's and, presumably, did not intend that the Bond
proceeds be used to purchase the GIC's, the GIC's were
in fact purchased with the proceeds of the Bonds and
committed to provide funds for the repayment of
principal and interest on the Bonds rather than for the
governmental purpose of constructing multifamily
housing. Thus, the GIC's fall within the statutory
definition of nonpurpose investments. [Id. at 29-30.]
Section 148(f)(6)(A) defines the term "nonpurpose
investment". The operative provision, however, is section
148(f)(2)(A), which provides that the rebatable excess of an
arbitrage bond is determined by starting with "the amount earned
on all nonpurpose investments". An important question, of
course, is: investment by whom? The majority's analysis
implicitly leads to the conclusion that, if A lends bond proceeds
to B, who lends them to C, who makes an investment of the bond
proceeds that, in A's hands, would be a nonpurpose investment,
the bonds issued by A can be arbitrage bonds under section
148(f). A's balance sheet, however, shows only B's obligation,
and the only investment made by A is in a loan to B. The
majority's analysis, in effect, attributes C's use of the bond
proceeds to A. Generally, unless there is some special
arrangement between the parties to a loan, we would not attribute
the actions of the borrower to the lender. If A lends money to
B, who, without any instruction from A, buys drugs with the
money, we do not attribute the drugs to A. A pertinent
- 48 -
regulation is section 1.103-13(f)(1), Income Tax Regs.,22 which
provides:
In general. A State or local governmental unit shall
allocate the cost of its acquired obligations to the
unspent proceeds of each issue of governmental
obligations issued by such unit. * * * [Emphasis
added.]
The majority fails to state who it thinks is making the
nonpurpose investments in the GIC's. If it is any person other
than the Housing Authority, then the majority fails adequately to
emphasize and justify its tracing rationale.
I would not attempt to justify a tracing rationale. I think
that, on the facts of this case, we can find that the Housing
Authority made nonpurpose investments. I would do so as follows.
The financing plan was that the Housing Authority would lend
the bond proceeds to the developers and, in consideration
thereof, receive the developer notes and the benefit of the
letters of credit. The letters of credit were to be secured by
the GIC's. Indeed, the expectation was that the letters of
credit would be the exclusive source of repayment to the Housing
Authority (and on the Bonds). The first paragraph of the first
page of the Secondary Offering Statement of the Ironwood Bond
issue states in part:
22
The parties agree that sec. 1.103-13(f), Income Tax
Regs. (1979), is the appropriate regulation governing the
allocation of investments to bond proceeds in the case of the
bonds in issue.
- 49 -
The Bonds are secured by, and are paid solely from, a
direct pay Letter of Credit issued by Mercantile
Capital Finance Corporation No. 30 (the "Credit
Institution") to secure and provide the source of
repayment of the principal of, and interest on, a loan
to be made to the Developer to finance the Development
(as hereinafter defined) with respect to which the
Bonds are issued. The sole source of payment of the
Letter of Credit is a guaranteed investment contract
. . . described herein, the payments on which are to be
made to the First National Bank of Commerce, New
Orleans, Louisiana, as collateral agent (the Collateral
Agent").
The Secondary Offering Statement for the Whitewater bonds is
identical except that Mercantile Capital Finance Corporation
(MCFC) No. 47 is substituted for MCFC No. 30. The letters of
credit (secured by the guaranteed investment contracts) were,
thus, in substance, if not in form, investment property held by
the Housing Authority. I say that for the following reasons:
The letters of credit were to be the source of funds to discharge
the Housing Authority's nominal obligation to repay the bonds.
The developer notes were of no economic consequence to the
Housing Authority (or to the bondholders). Neither the Housing
Authority nor the bondholders necessarily cared whether the
developer notes were paid. Indeed, it is difficult to see how,
if the deal had gone as planned, the developers could have paid
off both the developer notes and the reimbursement notes (issued
to pay for the letters of credit). Based on that rationale, I
would say that the letters of credit were acquired by the Housing
Authority and were not acquired in order to carry out the
governmental purpose of the issue. Accordingly, the letters of
- 50 -
credit constitute nonpurpose investments within the meaning of
section 148(f)(6)(A).
My analysis does not turn on the diversion of the bond
proceeds from the contemplated purposes of the bond issues.
Thus, it should answer the criticism of Judge Jacobs as to the
reasonable expectations of the Housing Authority officials on
February 20, 1986, the date on which the majority finds (and
Judge Jacobs agrees) the bonds were issued. As of that date,
apparently, the "black [boxes]" referred to by Judge Jacobs
(Jacobs, J., dissenting op. note 4) had been designed, as
integral parts of the bond financings, and were known to (or
should have been known to) the Housing Authority.
- 51 -
BEGHE, J., concurring: I agree with and have joined the
majority opinion that the bonds in question were taxable
arbitrage bonds within the meaning of section 148(f): the bond
proceeds were used to purchase investments that were not acquired
to carry out the governmental purpose; those investments produced
excess earnings under section 148(f)(2); and the issuer has
failed to rebate the amount of the excess earnings to the United
States. In enacting section 148(f) of the 1986 Code, Congress
repudiated the holding of Washington v. Commissioner, 77 T.C. 656
(1981), affd. 692 F.2d 128 (D.C. Cir. 1982), and thereby made
clear that "amounts earned" on nonpurpose investments are not
limited to amounts that directly inure to the issuer: they also
include excess earnings that enable more than a de minimis part
of the bond proceeds to be diverted to pay underwriters, bond and
tax counsel, and other service providers. See S. Rept. 99-313,
at 828, 845 (1985), 1986-3 C.B. (Vol. 3) 1, 828, 845. As a
result, the interest on the bonds ostensibly issued by the
Riverside Housing Authority was not excludable from the income of
the bondholders under section 103.
I write separately to focus on three additional grounds, the
first two of which were also advanced by respondent, for holding
taxable the bonds in this case (and the bonds in other pending
cases).
- 52 -
I.
I believe that the bonds in question were arbitrage bonds on
the date of issuance under section 103(d), as enacted by the Tax
Reform Act of 1969, Pub. L. 91-172, sec. 601(a), 83 Stat. 487,
656. Contrary to Judge Jacobs, dissenting op. p. 65, I believe
that the Riverside Housing Authority failed to show, as of the
date of issuance in February 1986, that it did not reasonably
expect that the proceeds would be invested in higher yield
obligations.
On the subject of reasonable expectations, petitioners are
off base in arguing that, if our decision goes against them, the
standard of care required of state and local issuers will have
been retroactively made higher than it was or should have been at
the time the deals were done. I agree with respondent that the
issuer's standard of care set forth in section 1.148-1(b), Income
Tax Regs. (the 1993 reg.), is basically no different from what
was required under the regulation in effect in 1985-86, section
1.103-13(a)(2), Income Tax Regs. (the 1979 reg.). Even if there
may now be a higher level of consciousness among state and local
bond issuers and their counsel about the levels of due diligence
required, reasonableness is an objective and normative standard.
By any such standard, the Riverside Housing Authority and its
counsel were egregiously and inexcusably lax in failing to
- 53 -
monitor the Whitewater and Ironwood transactions and in allowing
the messes to happen.1
II.
In addition to being arbitrage bonds, the bonds were also
taxable industrial development bonds under section 103(b)(1) of
the 1954 Code.
Petitioners have conceded that the Whitewater and Ironwood
bonds were industrial development bonds within the meaning of
1
What I have in mind here was said by Judge Learned Hand
in the landmark tort case in which he made it clear that a
normative standard of care and reasonableness--that courts are
authorized to determine and impose--trumps the customary
practices of a particular industry:
Is it then a final answer that the business had
not yet generally adopted receiving sets? There are,
no doubt, cases where courts seem to make the general practice of
the calling the standard of proper diligence; we have indeed
given some currency to the notion ourselves. Indeed in most
cases reasonable prudence is in fact common prudence; but
strictly it is never its measure; a whole calling may have unduly
lagged in the adoption of new and available devices. It never
may set its own tests, however persuasive be its usages. Courts
must in the end say what is required; there are precautions so
imperative that even their universal disregard will not excuse
their omission. But here there was no custom at all as to
receiving sets; some had them, some did not; the most that can be
argued is that they had not yet become general. Certainly in
such a case we need not pause; when some have thought a device
necessary, at least we may say that they were right, and the
others too slack. The statute does not bear on this situation at
all. It prescribes not a receiving, but a transmitting set, and
for a very different purpose; to call for help, not to get news.
We hold the tugs therefore because had they been properly
equipped, they would have got the Arlington reports. The injury
was a direct consequence of this unseaworthiness. [The T.J.
Hooper v. Northern Barge Corp., 60 F.2d 737, 739 (2d Cir. 1932);
citations omitted.]
- 54 -
section 103(b)(2) of the 1954 Code, on the ground that the
proceeds of both issues were "to be used directly . . . in any
trade or business carried on by any person who is not an exempt
person." The only dispute on this issue is whether the bonds
qualified under section 103(b)(4)(A), which provides that an
industrial development bond will not be taxable under section
103(b)(1) if it is part of an issue "substantially all of the
proceeds of which are to be used to provide" (emphasis added)
various exempt facilities. The question is the meaning of the
phrase "are to be used".
Both the Whitewater and the Ironwood issues were industrial
development bonds under section 103(b)(2) because the proceeds
were to be lent to private, for-profit developers for the purpose
of constructing apartment projects to be used in a private trade
or business, and repayment of the bonds was to be secured,
directly or indirectly, by the apartment projects and the income
they produced. Although the documents provided that the
Whitewater bonds and the Ironwood bonds were to fund the
construction of residential rental properties that would meet the
20 percent low-income set-aside requirements of section
103(b)(4)(A)(ii),2 what is in dispute is whether substantially
2
Respondent concedes that the Ironwood project met the low-
income set-aside requirements of sec. 103(b)(4)(A)(ii).
- 55 -
all the proceeds of the Whitewater and Ironwood bonds were to be
used for residential rental property.
While the phrase in section 103(b)(4) is "are to be used,"
the statutory sentence does not stop there but sets forth low-
income residence requirements that must be met "at all times
during the qualified project period". Thus, compliance requires
examination of actual events occurring after the issue date. It
would be illogical to suggest that expectations controlled until
the units were occupied, and that thereafter actual events would
control. Such a reading would put a party that never tried to
build the residential rental project in a better position than a
party who built the project but inadvertently failed to satisfy
the low-income requirements. Under section 1.103-8(b)(6)(ii) and
(iii), Income Tax Regs. (the 1979 reg.), issuers are permitted a
reasonable period of time to correct noncompliance.
Section 1.103-8(b)(6)(i) and (9), Income Tax Regs. (the 1979
reg.), makes clear that satisfaction of the residential rental
property exception of section 103(b)(4)(A) requires more than
just a good faith hope or assumption that the proceeds of a bond
issue will be properly applied. Section 1.103-8(b)(6)(i), Income
Tax Regs. (the 1979 reg.), provides that a post-issuance
nonconforming change will vitiate the exemption--retroactive to
the original issue date--unless corrected within a reasonable
time. Examples (4) and (5) of section 1.103-8(b)(9), Income Tax
Regs. (the 1979 reg.), illustrate this rule.
- 56 -
In example (5), 5 years after constructing a qualified
residential rental project, Corporation P, the developer and
owner, converted 80 percent of the units into nonqualifying
condominium units and repaid the loan to State X, the bond
issuer, which in turn redeemed the bonds. The example concludes
that the bonds were not used to provide residential rental
housing within the meaning of section 103(b)(4)(A).
In example (4), there is a similar disqualifying event, the
failure of the issuer, County Z, to enforce the 20 percent
requirement. As a result, the bonds are classified as nonexempt
industrial development bonds, retroactive to the date of
issuance.3
Petitioners would construe examples (4) and (5) as
inapplicable because the disqualifying actions by the issuers or
developers are "volitional". I believe that the examples do
apply to the case at hand because in each of them--as in the case
at hand--the governmental issuer fails to enforce the statutory
3
See also sec. 1.103-8(a)(1), Income Tax Regs. (the 1979
reg.). ("Substantially all of the proceeds of an issue of
governmental obligations are used to provide an exempt facility
if 90% or more of such proceeds are so used."); H. Conf. Rept.
99-841, at II-697 (1986), 1986-3 C.B. (Vol. 4) 1, 697 ("The
conference agreement further provides that at least 95 percent of
the net proceeds of each issue must be used for the exempt
facility for which the bonds are issued"); Woods v. Homes &
Structures, Inc., 489 F. Supp. 1270, 1292 (D. Kan. 1980)
("Although section 103, speaks in prospective terms * * * we tend
to agree with plaintiffs that the actual distribution of the
proceeds will control.").
- 57 -
requirements that are violated by the developer-owner of the
project.
The Whitewater project was never built; no units were ever
built for rental to low- and moderate-income tenants or to anyone
else. Indeed, the Whitewater project could never have been built
with bond proceeds because, on February 20, 1986, $16,110,817.98
(91 percent) of the $17,778,146.53 of the Whitewater bond
proceeds was invested in a GIC that had the same maturity as the
bonds.
The appropriate test is whether the issuer reasonably
expects, at the time the bonds are issued, that substantially all
of the bond proceeds will be devoted to the exempt facility and
the issuer thereafter takes steps to ensure that the bond
proceeds are used in a manner consistent with those expectations.
In addition, in conduit financing transactions such as Whitewater
and Ironwood, the expectations and subsequent conduct of the
conduit borrowers, the Whitewater and Ironwood partnerships, must
also be considered. Industrial development bond financing by
definition contemplates significant involvement by
nongovernmental parties. Interest on industrial development
bonds is exempt from taxation only if the exempt facility rules
are met. Because the exempt facility rules require proceeds to
be spent in a specified manner and because a conduit borrower is
a necessary party to an exempt facility financing, testing
compliance with the exempt facility rules in the use at hand
- 58 -
requires consideration of the actions of the conduit borrowers,
the Whitewater and Ironwood partnerships.
Construing section 103(b)(4) to require subsequent conduct
in furtherance of the original reasonable expectations is
consistent with the statutory language and furthers the statutory
purpose. Section 103(b)(4) contains set-aside requirements that
must be met throughout the "qualified project period" (a period
that begins on the first day in which 10 percent of the project
units are occupied). If those set-aside requirements are not
met, the interest on the bonds is taxable from the date of
issuance, irrespective of the reasonableness of the issuer's
expectations at the inception of the deal. Sec. 103(b)(4)(A),
(12)(B). Thus, the phrase "are to be used" looks to how the bond
proceeds are actually used, not just to how the proceeds were
expected to be used at the time the bonds were issued.
This conclusion is supported by the contrasting language of
subsections (c) and (b) of section 103. Section 103(c) defines
an "arbitrage bond" as a bond "the proceeds of which are
reasonably expected to be used" (emphasis added) for higher
yielding investments. Compare the clear command of section
103(c) to look only at expectations with the language of section
103(b), which provides how substantially all of the "proceeds of
* * * [the bond issue] are to be used." (Emphasis added.) This
difference in focus strongly suggests that Congress intended two
- 59 -
different tests to apply and that the test in section 103(b) was
intended to be more than a pure expectations test.
This suggested reading of this statutory provision also
prevents bizarre and inappropriate results. If only expectations
on the date of issue are relevant, then an issuer who initially
planned to have residential rental property built, but never took
steps to assure that the housing project was constructed, would
be better off under the statute than an issuer who actually
caused the housing to be constructed but then inadvertently
failed to satisfy the set-aside requirements. Such an anomalous
result would be the product of petitioners' interpretation of the
statute. Thus, substantially all of the Whitewater bond proceeds
were not "to be used" for residential rental property within the
meaning of section 103(b)(4).
While respondent concedes that the Ironwood project was
built and provided housing for low- and moderate-income tenants,
the Ironwood bonds are nevertheless not entitled to tax-exempt
status under section 103(b)(4). Just like the Whitewater bonds,
substantially all of the bond proceeds ($11,047,408.05 of the
$12,190,843.34 or 91 percent of the proceeds) went directly into
a higher yielding GIC that had the same maturity as the bonds.
Because the bond proceeds were tied up in the GIC, another source
of funds had to be found to pay for the project. That source
turned out to be Far West Savings and Loan, which made a
conventional secured construction loan of $10,300,000 to Ironwood
- 60 -
Apartments Ltd. evidenced by a disbursement agreement, promissory
note, deed of trust, and other related loan documents.
Except for the relatively modest amount spent to purchase
the Ironwood land, the Ironwood project was financed by a
conventional mortgage loan from a conventional savings and loan,
not with bond proceeds. Given the structure of the deal, it
could not have been otherwise. The lion's share of the Ironwood
bond proceeds had already been invested in the Ironwood GIC.
From February 20, 1986, until December 1, 1993, when the GIC paid
off and the bonds were redeemed, that is where they stayed.
The Riverside Housing Authority could not have reasonably
expected that substantially all of the proceeds of the Whitewater
and Ironwood bonds would be used to construct the projects. This
is because the bond financing documents deprived it, the Trustee,
and the conduit borrowers (the developers) of control over the
bond proceeds and allowed the bond proceeds to be diverted.
Without any agreement, the Riverside Housing Authority, the
Trustee, and the conduit borrowers had no assurance that the bond
proceeds would be used, as required by the bond indentures, to
finance the multifamily housing projects.
Petitioners have argued that the Riverside Housing Authority
was duped, indeed that the bond proceeds were stolen, and Judge
Jacobs seems to agree. It was not, however, reasonable for the
Riverside Housing Authority to sponsor a financing structure that
permitted it, the Trustee, and the developer to lose control of
- 61 -
the bond proceeds. Like section 103(c), section 103(b) should
not be read to encourage issuers both to be ignorant of the facts
prospectively and to remain ignorant and do nothing after the
fact.
Because the Whitewater and Ironwood bonds were not exempt
industrial development bonds under section 103(b)(4), by virtue
of section 103(b)(1), they were not tax-exempt bonds under
section 103(a).
Petitioners and Judge Jacobs, dissenting op. note 2, argue
that the diversion of the bond proceeds amounted to "involuntary
noncompliance" under section 1.103-8(b)(6)(iii), Income Tax Regs.
(the 1979 reg.). Their argument seems to be based on the
assumption or assertion that nothing could be done after the fact
by the Riverside Housing Authority because the bond proceeds had
flowed irrevocably to Crown Life Insurance Co., which had issued
the GIC's. Judge Jacobs states that "the Bond proceeds were
improperly locked into GIC's", dissenting op. note 2. However, I
don't understand why the Riverside Housing Authority could not
have brought a successful action to revoke the GIC's and recover
the proceeds for use as originally intended. If the funds had
been unlawfully diverted, didn't Crown Life Insurance Co. have
notice, actual or constructive, of this fact? The answer to
these questions may be that the Riverside Housing Authority
decided, once things started to go badly for the developer, that
it would be better to leave the bond holders with the continuing
- 62 -
better assurance that they would receive interest and principal
payments, as originally scheduled, through the security of the
GIC's. Even if such had been the case, the security so created
must be at the price of the loss of the tax exemption for the
interest on the bonds.
III.
Although I accept the stipulations of the parties and the
findings of the trier of fact, as adopted by the majority in the
case at hand, I'm impelled to raise a question that may be
germane to other pending cases. If the failures in other cases
of the purported government issuers to supervise the receipt and
disposition of bond proceeds were as egregious as they were in
the case at hand, the question that may arise in such other cases
is whether the bonds were ever issued or validly issued by the
local governments or authorities.
In the case at hand, it might well have been concluded that
the Riverside Housing Authority was so out of the loop that,
under step transaction principles, the bond holders were the
recipients of nothing more than the obligations of Crown Life
Insurance Co. or of undivided interests in the GIC's--taxable
obligations of a private issuer--that were purchased with the
bond proceeds for their benefit. The Housing Authority was so
lax in failing to see to it that the proceeds were used for the
intended purpose as to raise the question whether the Housing
Authority actually had any such purpose, thereby calling into
- 63 -
question the validity of its purported issuance of bonds. As the
Court of Appeals for the District of Columbia Circuit said in
Washington v. Commissioner, 692 F.2d at 137:
Still, states and municipalities should be
chary in their issuance of tax-free bonds and their
subsequent reinvestment of the proceeds. It is a
fundamental principle of state and municipal bond law
that the issuing body must have a legitimate,
independent purpose to sell debt instruments in order
to raise moneys. L. Jones, THE LAW OF BONDS AND BOND
SECURITIES §12 (1950). If no such purpose exists, the
issuance would be violative of local law, and should
not qualify for the tax exemption that Section 103
provides for validly issued municipal and state bonds.
* * *
The steps in the analysis would be along the following
lines:
1. The bonds were sold to the public as the Housing
Authority's revenue bonds, based on representations that the
proceeds would be used to finance construction of the housing
projects.
2. Because the obligations on the bonds were nonrecourse to
the Housing Authority, the primary sources of payment of the bond
obligations were to be the housing projects and the income
streams that the projects were expected to generate.
3. Contrary to the conception underlying a properly
structured "black box" scheme,4 the proceeds of the bond
offerings were irrevocably diverted from the projects on the day
4
I have my doubts about the efficaciousness of the "black
box" scheme, but, under the facts of the purported bond issues of
the Riverside Housing Authority, that question need not detain us
in other cases in which the bond proceeds were diverted in
similar fashion.
- 64 -
of issuance and what was substituted for the projects as security
for the obligations to the investors were shell corporations'
letters of credit secured by the GIC's.
4. What this means is that the so-called originator of the
conduit financings, the Housing Authority, was eliminated from
(or never even got into) the loop. The Housing Authority as such
did not issue its own bonds. All that the so-called bonds
purportedly issued by the Housing Authority evidenced were the
interests of the bond holders in the GIC's, which were
obligations of a taxable entity, the Crown Life Insurance Co. As
a result, the bonds were taxable obligations from their
inception.
All the woofing about reasonable expectations, monitoring
actual usage, the arbitrage rebate rules, and the status of the
bonds as industrial development bonds may well be subsequent
questions that one need never get to under a proper tax analysis.
CHABOT, J., agrees with this concurring opinion.
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JACOBS, J., dissenting: The majority opinion is premised on
the notion that section 148(f) is unambiguous, thus preventing us
from looking beyond the words of the statute. In my opinion, the
majority's mechanical interpretation of section 148(f), when
applied to the unusual facts of this case,1 leads to a result that
does not comport with the rationale behind the promulgation of the
arbitrage provisions. See Birdwell v. Skeen, 983 F.2d 1332, 1337
(5th Cir. 1993); Wilshire Westwood Associates v. Atlantic
Richfield Corp., 881 F.2d 801, 804 (9th Cir. 1989). Accordingly,
I believe that we should resort to the legislative history for aid
in applying section 148(f) to the facts of this case. By doing so,
I conclude, as petitioners do, that Congress did not intend to make
the issuers of tax-exempt bonds (here, the Housing Authority of
Riverside County, California) the insurers for wrongful actions of
those who misuse the bond proceeds to earn arbitrage profits for
themselves. Accordingly, I would hold that the Bonds issued by the
Housing Authority are not arbitrage bonds. I would further hold
that the Bonds are nontaxable industrial development bonds.2
1
Statutory text should not be read in an atmosphere of
sterility, but rather in the context of the specific facts and
circumstances of each case. See 2A Singer, Sutherland Statutory
Construction, sec. 45.12, at 61 (5th ed. 1992). "The use of
literalism suggests that a judge puts on blinders, so to speak,
obscuring from view everything but the text of the statute whose
effect on the matter at issue is in question." Id. sec. 46.02,
at 92.
2
Admittedly, the Bonds were industrial development bonds
under sec. 103(b)(2). However, the Bonds come within the
exception provided by sec. 103(b)(4)(A). That section provides
that the interest on the obligations is not taxable as long as
(continued...)
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Ultimately, I would hold that the interest on the Bonds is
excludable from gross income under section 103(a).
Section 103(a) provides that a taxpayer's gross income does
not include interest earned on the obligations of a State or a
political subdivision of a State. This exemption has been a
feature of the Internal Revenue Code ever since the Federal income
tax was adopted in 1913. S. Rept. 91-552, at 219 (1969), 1969-3
C.B. 423, 562. The purpose of this exemption is to assist State
and local governments by allowing them to issue marketable bonds at
interest rates below those of corporate and Federal securities.
See, e.g., State of Washington v. Commissioner, 77 T.C. 656
(1981), affd. 692 F.2d 128 (D.C. Cir. 1982); 113 Cong. Rec. 31,611
(daily ed. Nov. 8, 1967) (statement of Senator Ribicoff).
2
(...continued)
substantially all of the proceeds are to be used to construct
residential rental property where 20 percent or more of the units
in each project are to be occupied by individuals of low or
moderate income. Such obligations are referred to in the body of
this dissent as nontaxable industrial development bonds.
Pursuant to sec. 1.103-8(b)(6)(iii), Income Tax Regs.,
the "substantially all" requirements of sec. 103(b)(4) do not
apply to a project in the event of "involuntary noncompliance",
provided the obligation used to provide financing for the project
is retired within a reasonable period. In my opinion, the Bonds
satisfied the "substantially all" requirements of sec. 1.103-
8(b)(6)(iii), Income Tax Regs., because the Whitewater and
Ironwood projects were not constructed due to "involuntary
noncompliance" on the part of the Housing Authority of Riverside
County. Further, because the Bond proceeds were improperly
locked into GIC's, the term of the GIC's determined when the
Bonds could be retired.
Morever, with respect to the Whitewater bonds, I would
hold that their issuance satisfied the reasonable public notice
requirements of sec. 103(k)(2)(B)(i).
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Having been the trial judge,3 I had the opportunity to observe
William Rosenberger (executive director of the Housing Authority
and the person charged with responsibility for the issuance of the
Bonds) testify. I am convinced that he, as well as the other
Housing Authority officials, reasonably expected that the Bond
proceeds would be used for the construction of housing for low-to-
moderate-income families and that the GIC's would be held by the
MCFC companies as unrelated guarantors of the bond payments. I am
further convinced that at no relevant time did he or other Housing
Authority officials have any reason to suspect that Unified and the
MCFC companies would divert the Bond proceeds from the construction
of housing to the purchase of GIC's, which in turn would be used to
pay the debt service on the Bonds.4
3
The majority opinion has adopted my findings of fact.
See majority op. p. 4.
4
In basic bond financing, bond proceeds are disbursed
directly to the developer in exchange for the developer's note,
which is secured by a lien on the underlying project (including
the anticipated revenue stream). In many instances, a credit
enhancement instrument, such as a letter of credit, is obtained.
The bond issue in this case involved a form of "black box"
structure. Theoretically, in such a structure, the bond proceeds
are disbursed to the developer pursuant to an unsecured loan
agreement with the issuer. The developer then invests the bond
proceeds with a financial institution. Simultaneously, the
developer procures a letter of credit to secure repayment of the
bonds from another institution (the L/C provider) in exchange for
a mortgage on the project. The L/C provider simultaneously sells
the project mortgage to the financial institution where the bond
proceeds are invested. Finally, and also simultaneously with the
other transactions, the L/C provider purchases a GIC from an
insurance carrier and hypothecates it to secure the interest and
principal payments on the bonds. Thus, in theory, the black box
structure makes bond proceeds available to a developer for
construction on a credit enhanced and rated basis.
(continued...)
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The Housing Authority did not benefit from the misuse of the
Bond proceeds. The majority, however, would attribute the
shenanigans of the wrongdoers to the Housing Authority; I would
not.
The development of the arbitrage provisions shows that
Congress sought to prevent States and their subdivisions from
misusing their tax-exempt privileges by issuing low-yielding bonds
and thereafter investing the bond proceeds into higher-yielding
instruments. There is no indication that Congress would require
States or local governments to rebate amounts that they never
authorized or received.
In 1969, when Congress enacted the section 103 provisions
removing arbitrage bonds from tax-exempt status, the Senate Finance
Committee explained that it did so to ensure that the Federal
Government does not become "an unintended source of revenue for
State and local governments". S. Rept. 91-522, supra at 219, 1969-
3 C.B. at 562. Concerns later developed, however, that unwary
purchasers of tax-exempt bonds might be taxed upon the interest
4
(...continued)
In this case, the black box structure was corrupted by
the use of Unified, a shell entity, instead of a bona fide
financial institution that was supposed to be both the depository
of the bond proceeds and the buyer (from separate funds) of the
project mortgage from the L/C provider. Because Unified had no
substantial capital of its own, it used the Bond proceeds to buy
the project mortgage; and via this route, the Bond proceeds were
invested in the GIC's. Unified improperly used the Bond proceeds
to purchase the GIC's, causing the Commissioner to assert that
the Bonds are to be treated as arbitrage bonds pursuant to the
provisions of sec. 148(f). Hence, the central failure in this
case was the improper use of the Bond proceeds by Unified to
purchase the GIC's.
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received if the issuer subsequently used the proceeds for arbitrage
revenue. At a congressional hearing in 1978, Assistant Secretary
Lubick was asked whether the Commissioner could change his mind
about the nonarbitrage status of a bond after it was issued. Mr.
Lubick replied: "That is a determination which is made as of the
issuance date. The fact that the [issuer] goes on and does
something different from what it proposed originally does not
change the status of the bond. This determination is made ab
initio." Revenue Act of 1978: Hearings on H.R. 13511 before the
Senate Comm. on Finance, 95th Cong., 2d Sess. 958-959 (1978).
In 1984, Congress reviewed the various remaining provisions
that permitted States to collect arbitrage and noted: "Present
rules permit issuers to retain any arbitrage earned under these
rules". H. Conf. Rept. 98-861, at 1205 (1984), 1984-3 C.B. (Vol.
2) 1, 459 (emphasis supplied). Congress therefore made the rebate
provisions applicable to certain industrial development bonds and
to certain student loan bonds. Sec. 103(c)(6), as added by Deficit
Reduction Act of 1984, Pub. L. 98-369, sec. 624(a), 98 Stat. 922.
In the Tax Reform Act of 1986, Congress decided to extend the
rebate requirements to additional classes of tax-exempt bonds,
including those issued to provide multifamily residential housing.5
See Tax Reform Act of 1986 (TRA), Pub. L. 99-514, sec. 1314(d), 100
Stat. 2664. With this change came new rules relating to the
5
I agree with the majority's conclusion that the date of
issuance of the Bonds was not Dec. 31, 1985, but rather Feb. 20,
1986.
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computation of the rebate. The amount to be rebated is determined
by first finding the amount earned on "nonpurpose investments".
These earnings then are compared to the amount that would be
yielded at the bond issue's rate of interest. For such purposes,
the Commissioner's regulations, in general, require an allocation
of the higher-earning nonpurpose "acquired obligations" to bond
proceeds under an accounting pooling convention. These
regulations, however, continue to reflect that the "acquired
obligations" to be scrutinized are those acquired by the State or
local government that issues the bonds. Thus, section 1.103-
13(f)(1), Income Tax Regs., provides:
In general. A State or local government unit shall
allocate the cost of its acquired obligations to the
unspent proceeds of each issue of governmental
obligations issued by such unit. * * * [Emphasis added.]
Congress added another important provision in the Tax Reform
Act of 1986 when it provided that a bond will be considered an
arbitrage bond if, after the bond is issued, the issuer
intentionally uses the proceeds to earn arbitrage. Sec. 148(a), as
added by TRA sec. 1301(b), 100 Stat. 2641; see H. Conf. Rept. 98-
841, at II-746 (1986), 1986-3 C.B. (Vol. 4), 1, 746. By its terms,
section 148(a) will remove the tax-exempt status of a bond
retroactively, but only when the issuer intentionally contravenes
the provisions against arbitrage. This new provision thus provides
an exception to the assurances earlier provided by Assistant
Secretary Lubick that the tax-exempt status of a bond would be
determined as of the date of issue.
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The legislative history of the arbitrage and rebate provisions
shows a consistent congressional intent that State and local
governments (the issuers) not profit from arbitrage. It is plain
that, in requiring rebates of excess earnings on "nonpurpose
investments", Congress contemplated investments made by the
issuers, not unauthorized investments of bond proceeds diverted to
improper uses by others. As petitioners state in their brief:
"Nothing * * * suggests that money once stolen is subject to the
yield restriction rules".
When Congress enacted section 148(f), it did not intend to
require the rebate of arbitrage created by the unauthorized acts of
persons other than the issuer and not received by the issuer. Such
amounts are not amounts earned on nonpurpose investments within the
meaning of that provision. My conclusion is reinforced by
Congress' contemporaneous inclusion of section 148(a) in the Tax
Reform Act of 1986. As a result of the enactment of section
148(a), Congress expanded the definition of arbitrage bonds to
include those that involved the issuer's intentional acquisition of
post-issuance arbitrage earnings. Congress thus put the tax
exemption for interest earned on bonds at risk where a State or its
subdivision intentionally used the bond proceeds to earn arbitrage
profits. In such a circumstance, a violation of section 148(a)
cannot be cured. However, by enacting section 148(f), Congress
permitted the use of the rebate provisions to preserve the bonds'
exempt status in situations where the issuer unintentionally made
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a post-issuance, nonpurpose investment that yielded earnings in
excess of the bond earnings.
Section 148(f) by its terms applies only to amounts earned on
nonpurpose investments. Nothing in section 148(f) indicates that
it should apply to an issuer that did not make any nonpurpose
investment.