Many of you have been involved in the issuance of tax-exempt bonds. At some point in the issuance process, you probably took part in conversations with bond counsel and the underwriter involving tax issues related to the bonds.

Words like private activity bonds, advance refunding, rebate, small issuer exemption and arbitrage were probably used. The field of bond tax law is replete with jargon. If you only issue bonds every few years, how can you be expected to invest the time necessary to learn this strange language?

The best approach, when you are confronted with a difficult subject matter outside your field of expertise, is to try to understand the fundamental concepts in straightforward language. Once you have mastered the fundamentals, you can then ask appropriate questions of the professionals you retain and have them answer you in plain English.

The purpose of this article is to present the basic federal tax concepts related to municipal bonds so that you can better approach the issues which arise in your bond issues. This article is not intended either to be a detailed explanation of the regulations or to provide tax advise for any specific situations. You should consult with your bond professionals as to your particular circumstances.

The first step is to realize the importance of what is being regulated. The interest paid by the local government to the holder of the bond is excluded from gross income for purposes of federal income tax. Two parties benefit from this treatment: the holder receives tax-exempt interest and the local government gets to borrow at lower tax-exempt rates. One party loses: the federal government does not collect tax revenues on the holders interest income.

The second step is to realize who is making the rules in the area of federal tax law: Congress, the Treasury Department and the Internal Revenue Service (who are referred to in this article collectively as the Feds). The Feds, as the only loser in this arrangement, take the attitude that the tax exemption is a subsidy or gift by the federal government to state and local governments. The federal government therefore believes that it can change the rules as it pleases or even eliminate the exemption entirely.

The third step is to realize what policies are guiding the Feds actions in this area. The Feds do not appear to be interested in totally eliminating the exemption (for obvious political reasons); however the Feds do want to provide the exemption only to bonds which are promoting a valid public purpose. All of the laws and regulations in this area are promulgated by the Feds to keep local governments from abusing the tax exemption.

The Feds pursue their policies through three basic types of restrictions: (1) limiting the ability of private parties to benefit from tax-exempt financed facilities; (2) limiting the ability of local governments to earn a profit on bond proceeds, and (3) containing the drain on the U.S. Treasury by limiting the amount of bonds which may be issued.

A. Limiting Private Use

Prior to 1983, almost any governmental, nonprofit, industrial or commercial facility could be financed through tax-exempt bonds. From the early to mid-80s the tax-exempt bond market grew so fast that the Feds became alarmed. As a result, the Feds in the last ten years have cut back on the types of facilities which can be so financed to governmental, some nonprofit, very few industrial and no commercial.

In structuring a governmental bond issue you need to be careful to avoid private use of the facility as much as possible. The regulations contain specific limitations. Such private use could include leasing the unused portion of a municipal building to a private company. It could also include a special rate and capacity arrangement with a major industrial user of a water system.

Changing the use of a public facility after the bonds are issued can also be a problem. Check with your bond counsel before entering into any contracts allowing a private entitys use of a public facility. If you violate the private use restrictions, the interest on your bonds could be declared taxable.

B. Limiting Arbitrage Profits

Tax-exempt bonds bear interest at a lower rate than comparable taxable securities. This enables a local government unit (in normal market conditions) to issue tax-exempt bonds, take the bond proceeds, and invest them in higher yielding taxable securities. Of course, local governments do not pay income taxes, so the spread between the interest payments on the bonds and the interest earnings on the investments is profit to the local government. This profit is called arbitrage.

As you can imagine, the Feds are not thrilled with local governments taking advantage of the tax exemption to earn arbitrage. The Feds want to see the bond proceeds spent as soon as possible on the project being financed.

The Feds use two primary mechanisms to limit arbitrage: temporary periods and rebate. A local government is permitted to earn arbitrage only during a temporary period; once the temporary period ends, bond proceeds may not be invested at a rate in excess of the bond yield. The most common temporary period rule states that a local government must spend at least 85% of its bond proceeds within three years (subject to certain exceptions, of course).

Notwithstanding the ability to earn arbitrage during temporary periods, the local government must rebate the arbitrage to the Feds unless it falls under certain specific exceptions to rebate. Of course rebate is a fancy word for a federal tax on investment income of local governments. And you thought you were a tax-exempt entity?

You should consult with your bond counsel on the exceptions to the rebate requirement: the small issuer exception for local governments issuing under $5,000,000 of bonds and notes in a calendar year (the limit is $10,000,000 for school districts in certain situations); the six month exception if all bond proceeds are spent in six months; the two year construction exception if the bond proceeds are spent on construction projects within a specified two year schedule; and the eighteen month exception if the bond proceeds are spent for the governmental purposes within a specified eighteen month schedule.

C. Limiting Amount Of Bonds Issued

The Feds have placed a number of restrictions on the volume of tax-exempt bonds which may be issued to finance industrial facilities and the amount of bonds which may be issued to benefit each nonprofit organization. The Feds generally have not limited the amount of bonds which a local government may issue, except when it comes to advance refundings.

As with a home mortgage, it is often advantageous for a local government to refinance its debt to take advantage of lower interest rates. The local government issues refunding bonds, the proceeds of which pay off the prior refunded bonds.

In a current refunding the proceeds of the refunding bonds are promptly applied to pay off the refunded bonds. In an advance refunding, the proceeds of the refunding bonds are invested in an escrow fund and are used to pay off the refunded bonds over time. In certain advance refundings, both the refunding bonds and the refunded bonds can remain in the market for years.

If a local government does an original bond issue plus two advance refundings for a $5,000,000 project, it could end up having $15,000,000 of tax-exempt bonds in the market related to that project. Of course, the thought of tax-exempt interest being earned by holders of $15,000,000 of bonds for a $5,000,000 project greatly concerns the Feds. As a result, the Feds have put strong limits on advance refundings.

D. Conclusion

Almost all of the tax issues which arise in your bond issues can be understood in the context of the policies and general limitations described above. The twists and turns under the regulations seem endless, but you can usually get a handle on the issues if you put them in the context of these fundamental concepts.

These materials are intended to furnish general information and should not be relied upon as advice in specific situations.

Saul Ewing LLP

Centre Square West

1500 Market Street, 38th Floor

Philadelphia, PA 19102

web: www.saul.com