Refunded-bond mortgage loans remain allocated to transferred proceeds

Plain-English summary

An issuer used transferred proceeds of refunding mortgage bonds both to make new mortgage loans and to fund a reserve. When investments exceeded the bonds' universal cap, the issuer treated the mortgage loans as allocated to replacement proceeds and deallocated them before touching the reserve investments. Chief Counsel concluded that the loans remained investments allocable to transferred proceeds because their classification follows the source used to finance them. The mortgage loans and reserve investments therefore occupied the same priority under the universal-cap ordering rule, with portions allocated under the permitted ratable or representative method.

Ruling snapshot

• Question: Are mortgage loans financed with transferred proceeds treated as allocated to transferred proceeds or replacement proceeds when applying the universal cap?
• Outcome: Advice given. They remain allocated to transferred proceeds.
• Key authorities: IRC §§ 143, 148; Treas. Reg. §§ 1.148-1, 1.148-6(b), 1.148-6(d)

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 201723017
       Release Date: 6/9/2017
       CC:FIP:B05                                       Third Party Communication: None
       POSTU-132430-16                                  Date of Communication: Not Applicable

UILC: 143.00-00, 148.00-00

date: March 07, 2017

 to:   Area Counsel, PCLA
       (TEGE Division Counsel)

from: Senior Technician Reviewer, Branch 5
(Financial Institutions & Products)

subject: Deallocation of investments under the universal cap rules

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.


       LEGEND

       Bonds         --------------------------------------------------------------------------------------------------
                    -----------------
                    ----------------------------------------------------------------------------
                    -----------------------------------------------------------------------
                    ----------------------------------------------------------------------------------------------
                    ---------------------------------------------------------------------

       Issuer       ---------------------------------------------------------------------------------------------------
                    ----------------------

       Issue Date   ---------------------

       Date 2       ------------------

       a            ---------------

       b            ---------------

                                       2

POSTU-132430-16

c -------------

d -------------

e ---

f ---------------

ISSUE

Whether, for purposes of deallocating investments under the general ordering rule in
§ 1.148-6(b)(2)(iv) of the Income Tax Regulations, the qualified mortgage loans that
were financed with transferred proceeds of the Bonds are investments allocable to
replacement proceeds or are investments allocable to transferred proceeds.

CONCLUSION

The qualified mortgage loans financed with transferred proceeds of the Bonds are
investments allocable to transferred proceeds for purposes of the universal cap ordering
rule.

FACTS

The facts below have been provided by the examining agent.

On Issue Date, Issuer issued the Bonds as qualified mortgage bonds and used the
proceeds of the Bonds to currently refund certain prior bonds (the “Prior Bonds”). Upon
the refunding, proceeds of the Prior Bonds, including unspent sales proceeds and
repayments of mortgages made with proceeds of the Prior Bonds, became transferred
proceeds of the Bonds. The Issuer used transferred proceeds of the Bonds to fund a
reserve fund for the Bonds (the “Reserve Fund”) and to finance new mortgage loans.

As of Date 2, the value of the outstanding Bonds was $a, an amount less than the
investments allocable to the Bonds. The values of investments allocable to the Bonds
were as follows:

        Mortgage loans financed with transferred proceeds            $b

        Mortgage loans financed with proceeds of other bonds         $c

        Investment acquired with transferred proceeds                $d
         in the Reserve Fund

                                        3

POSTU-132430-16

        Investment acquired with investment proceeds                   $e
         In the Reserve Fund

        Total Investments allocable to the Bonds                       $f

As of Date 2, Issuer deallocated all of the mortgage loans financed with proceeds of
other issues and a portion of the mortgage loans that were financed with transferred
proceeds. Issuer did not deallocate any portion of the investment in the Reserve Fund.

The Issuer has filed Form 8038-R to request a refund of an overpayment of rebate.

LAW AND ANALYSIS

Section 143(a)(1) provides that the term “qualified mortgage bond” means a bond which
is issued as part of a qualified mortgage issue. Section 143(a)(2) provides that the term
“qualified mortgage issue” means an issue by a State or political subdivision thereof of 1
or more bonds, but only if, among other requirements, such issue meets the
requirements of § 143(g). Section 143(g)(1) provides, in pertinent part, that an issue
meets the requirements of § 143(g) only if such issue meets the requirements of
§ 143(g)(2) (that the effective rate of mortgage interest not exceed the bond yield by
more than 1.125 percentage points) in addition to the requirements of § 148.

Section 148(a) provides that, for purposes of § 103, the term “arbitrage bond” means
any bond issued as part of an issue any portion of the proceeds of which are reasonably
expected (at the time of issuance of the bond) to be used or are intentionally used
directly or indirectly (1) to acquire higher yielding investments, or (2) to replace funds
which were used directly or indirectly to acquire higher yielding investments. Section
148(f) provides that a bond is an arbitrage bond if an amount equal to certain
investment earnings on nonpurpose investments in excess of the bond yield is not paid
timely.

Section 1.148-6(b)(1) provides, in part, that amounts cease to be allocated to an issue
as proceeds only when those amounts are allocated to an expenditure for a
governmental purpose, are allocated to transferred proceeds of another issue, or cease
to be allocated to that issue at retirement of the issue or under the universal cap of
§ 1.148-6(b)(2). Under § 1.148-6(b)(1), amounts that cease to be allocated to an issue
as gross proceeds are eligible for allocation to another issue.

Section 1.148-6(b)(2)(ii) provides that, except as otherwise provided, amounts that
would otherwise be gross proceeds allocable to an issue are allocated (and remain
allocated) to the issue only to the extent that the value of the nonpurpose investments
allocable to those gross proceeds does not exceed the value of all outstanding bonds of
the issue. For this purpose, gross proceeds allocable to qualified mortgage loans,

                                        4

POSTU-132430-16

among other things, are treated as nonpurpose investments. The value of all
outstanding bonds of the issue is referred to as the universal cap.

Section 1.148-6(b)(2)(iv)(A) provides that if the value of all nonpurpose investments
allocated to the gross proceeds of an issue exceeds the universal cap for that issue on
a date as of which the cap is determined under § 1.148-6(b)(2)(iii), nonpurpose
investments allocable to gross proceeds necessary to eliminate that excess cease to be
allocated to the issue, in the following order of priority--

(1) First, nonpurpose investments allocable to replacement proceeds;
(2) Second, nonpurpose investments allocable to transferred proceeds; and
(3) Third, nonpurpose investments allocable to sale proceeds and investment
proceeds.

Section 1.148-6(b)(2)(iv)(C) provides that portions of investments to which the universal
cap applies are allocated under either the ratable method or the representative method
in the same manner as allocations of portions of investments to transferred proceeds
under § 1.148-9(c).

Section 1.148-1(b) provides the following definitions:

“Gross proceeds” means any proceeds and replacement proceeds of an issue.

“Proceeds” means any sale proceeds, investment proceeds, and transferred proceeds
of an issue. Proceeds do not include, however, amounts actually or constructively
received with respect to a purpose investment that are properly allocable to the
immaterially higher yield under § 1.148-2(d) or § 143(g), or to qualified administrative
costs recoverable under § 1.148-5(e).

Section 1.148-1(c) provides, in part, that amounts are replacement proceeds of an issue
if the amounts have a sufficiently direct nexus to the issue or to the governmental
purpose of the issue to conclude that the amounts would have been used for that
governmental purpose if the proceeds of the issue were not used or to be used for that
governmental purpose. For this purpose, governmental purposes include the expected
use of amounts for the payment of debt service on a particular date.

Section 1.148-6(d)(2)(ii) provides that if gross proceeds of an issue are allocated to a
purpose investment that is a qualified mortgage loan or a qualified student loan, those
gross proceeds are allocated to an expenditure for the governmental purpose of the
issue on the date on which the issuer allocates gross proceeds to that purpose
investment. Section 1.148-6(d)(2)(iii) provides that regardless of whether gross
proceeds of a conduit financing issue invested in a purpose investment have been
allocated to an expenditure under § 1.148-6(d)(2)(i) or (ii), with respect to the actual
issuer those gross proceeds continue to be allocated to the purpose investment until the
sale, discharge, or other disposition of the purpose investment.

                                         5

POSTU-132430-16

As of Date 2, the value of the investments allocable to the Bonds exceeded the value of
the outstanding Bonds, or universal cap. In deallocating investments, the Issuer
deallocated all of the mortgage loans financed with proceeds of issues other than the
Bonds, the amount of which was less than the value of the investments in excess of the
universal cap. The Issuer deallocated the remaining amount of the excess (the
“Remainder”) solely from the mortgage loans financed with transferred proceeds of the
Bonds and none from the investment in the Reserve Fund.

The Agent argues that the Remainder should have been deallocated using ratable
portions of the investment of $d in the Reserve Fund and the mortgage loans financed
with proceeds of the Bonds, because these investments were financed with, and
therefore allocable to, transferred proceeds of the Bonds.

The Issuer argues that it properly deallocated the entire Remainder from the mortgage
loans acquired with transferred proceeds of the Bonds because these mortgage loans
should be treated as allocable to replacement proceeds. Specifically, the Issuer argues
that once the transferred proceeds were spent on the mortgage loans, these mortgage
loans should be treated as allocable to replacement proceeds because the repayments
of these mortgage loans are pledged to the repayment of the Bonds, and these
mortgage loans deallocated prior to the deallocation of any investments in the Reserve
Fund.

For the following reasons, we agree with the Agent. In determining to which type of
gross proceeds the investments are allocable, we look to the source of the financing for
those investments. Both the mortgage loans financed with the Bonds and the $d of
investments in the Reserve Fund were acquired with transferred proceeds, not
replacement proceeds, of the Bonds. Under § 1.148-1(c)(1), amounts are replacement
proceeds of an issue if such amounts would have been used for the governmental
purpose of the issue if the proceeds of the issue were not so used. Here, the Issuer
used proceeds, specifically transferred proceeds, of the Bonds to acquire these
mortgage loans. Under § 1.148-6(d)(2)(iii), those proceeds of the Bonds continue to be
allocated to the mortgage loans financed with the transferred proceeds and, under the
facts of this case, those proceeds continue to be transferred proceeds. Thus, the loans
are allocable to transferred proceeds. These mortgage loans are distinguishable from
the mortgage loans financed with proceeds of other issues that have been allocated to
the Bonds after being deallocated from those other issues.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 317-6980 if you have any further questions.