NATIONAL ASSOCIATION OF BOND LAWYERS COMMENTS ON IRS PROPOSED REGULATIONS REGARDING QUALIFIED ZONE ACADEMY BONDS

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1 NATIONAL ASSOCIATION OF BOND LAWYERS COMMENTS ON IRS PROPOSED REGULATIONS REGARDING QUALIFIED ZONE ACADEMY BONDS I. INTRODUCTION The following are comments prepared by a subcommittee 1 of the General Tax Matters Committee (the Committee ) of the National Association of Bond Lawyers ( NABL ) addressing the notice of proposed rulemaking (REG ), Qualified Zone Academy Bonds; Obligations of States and Political Subdivisions, RIN 1545-BC61, published in the Federal Register on March 26, 2004 (the Proposed Regulations ). These comments were prepared by the Committee in accordance with NABL s purposes. While not all members of the Committee necessarily concur in each of these comments, the comments represent the consensus of the participants. Reference herein to the term we or the Committee is to the participants identified on the cover page. In addition, certain members of the Board of Directors of NABL have reviewed the comments. We would welcome the opportunity to discuss these comments with representatives of the Department of the Treasury and the Internal Revenue Service ( IRS ) and to answer any questions that the comments may raise. NABL was incorporated as an Illinois nonprofit corporation on February 5, 1979, for the purposes of educating its members and others in the law relating to state and municipal bonds and other obligations, providing a forum for the exchange of ideas as to law and practice, improving the state of the art in the field, providing advice and comment at the Federal, state and local levels with respect to legislation, regulations, rulings and other actions, or proposals therefor, affecting state and municipal obligations, and providing advice and comment with regard to state and municipal obligations in proceedings before courts and administrative bodies through briefs and memoranda as a friend of the court or agency. NABL currently has approximately 3,000 members. As an initial matter we want to commend the IRS for reviewing and proposing amendments to the final Treasury Regulations on QZABs to provide guidance on the maximum term, permissible use of proceeds, and remedial actions for QZABs. In particular, we commend the provisions of the Proposed Regulations on the maximum term for QZABs, the treatment of unspent proceeds, the measurement of the private business contribution requirement and the conclusive effect of expenditures on development of course materials and training of teachers and other school personnel. By setting forth predictable, common-sense rules, these provisions will help issuers of 1 These comments were prepared through the efforts of G. Mark Mamantov, E. Alston Ray, Nancy M. Hagquist, Arthur E. Anderson II, Mark H. Vacha, Linda B. Schakel, Carol L. Lew and Larry Salva. 1

2 QZABs and local education agencies better serve students and, we believe, improve Federal tax compliance. Our comments below are intended to highlight certain areas where additional clarification would be helpful and where further improvements would be welcomed to allow greater flexibility for issuers and education agencies. These comments do not purport to be comprehensive, but we hope that you will find them to be constructive. II. BACKGROUND Section 1397E of the Internal Revenue Code (the Code ) provides that state and local governments may issue taxable obligations known as QZABs ( QZABs ) to finance certain eligible public school qualified purposes with respect to a qualified zone academy. Banks, insurance companies and certain other eligible taxpayers that hold QZABs on a credit allowance date will be allowed a credit against Federal income tax for the taxable year that includes the credit allowance date in an amount equal to the product of the applicable credit rate and the face amount of the QZAB held by the eligible taxpayer on the credit allowance date. A. Summary of Final Treasury Regulations and related Code Sections Related to the Proposed Regulations and these Comments Temporary regulations interpreting Section 1397E were published on January 7, 1998 (63 FR 671), and amended on July 1, 1999 (64 FR 35573). Final regulations under Section 1397(E) (65 FR 57732) were published on September 26, 2000 (the Final Regulations ). The Final Regulations or related Code provisions are herein described with respect to the three areas in which the Proposed Regulations are designed to provide guidance: (i) the maximum term of QZABs, (ii) the permissible use of QZAB proceeds, and (iii) remedial actions for QZABs. Section E-1(d) of the Final Regulations provides that the maximum term for a QZAB is determined under Section 1397E(d)(3) by using a discount rate equal to 110 percent of the long-term adjusted applicable Federal rate. This is designed to produce a term that results in the present value of the obligation to repay the principal on the QZAB being equal to 50 percent of the face amount of the QZAB. As a consequence of changes in interest rates, such 50 percent target requires the maximum term for a QZAB to be reset. Section E-1(d) of the Final Regulations provides that the maximum term of a QZAB is determined based on the month in which the QZAB is issued. Section 1397E(d)(1)(A) requires at least 95 percent of the proceeds of a QZAB issue to be used for a qualified purpose with respect to a qualified zone academy established by an eligible local education agency. A qualified purpose is defined by Section 1397E(d)(5) to embrace four categories, (i) rehabilitating or repairing the public school facility in which the qualified zone academy is established, (ii) providing 2

3 equipment at the qualified zone academy, (iii) developing course materials for education to be provided at such academy, and (iv) training teachers and other school personnel in such academy. A qualified zone academy is defined by Section 1397E(d)(4)(A) to encompass either a public school or an academic program within a public school. In either case, a qualified zone academy is to provide education or training below the postsecondary level and is subject to additional requirements. First, the qualified zone academy must be established by and operated under the supervision of an eligible local education agency. Second, the qualified zone academy must be designed in cooperation with business for preparing students in accordance with certain requirements of Section 1397E relating to the preparation of students. Third, there must be a comprehensive education plan of the qualified zone academy approved by the eligible local education agency. Fourth, students in the qualified zone academy must be subject to the same standards as other students educated by the local education agency. Fifth, the public school in which the qualified zone academy is housed must be located in an empowerment zone or enterprise community or there must be a reasonable expectation (as of the date of issuance of the QZAB) that at least 35 percent of the students attending the school or participating in the program constituting the qualified zone academy will be eligible for free or reduced-cost lunches under the Federal school lunch program. Neither Section 1397E nor the Final Regulations expressly specify or provide for remedial actions that can be taken by issuers of QZABs to cure a violation of the requirement that at least 95 percent of the proceeds of a QZAB issue be used for a qualified purpose with respect to a qualified zone academy. B. Summary of Proposed Treasury Regulations relating to Qualified Zone Academy Bonds Explanation of Provisions I. Maximum Term Section 1397E(d)(3) provides that the Secretary of the Treasury Department shall determine, during each calendar month, the maximum term for QZABs issued during the following calendar month. Section 1397E(d)(3) states that the maximum term shall be the term that the Secretary estimates will result in the present value of the obligation to repay the principal on the bond being equal to 50 percent of the face amount of the bond. Section E-1(d) of the final regulations provides that the maximum term for a QZAB is determined under Section 1397E(d)(3) by using a discount rate equal to 110 percent of the long-term adjusted applicable Federal rate (AFR), compounded semiannually, for the month in which the bond is issued. The IRS publishes the long-term adjusted AFR each month in a revenue ruling. The preamble to the Proposed Regulations states that the credit rate and maximum term should be determined on the same day because the credit rate for a bond depends on its maximum term. Accordingly, the Proposed Regulations amend E-1(d) to 3

4 provide that the maximum term for a QZAB is determined based on the first day on which there is a binding contract in writing for the sale or exchange of the bond. II. Use of Proceeds and Remedial Actions A. In general Section 1397E(d)(1)(A) provides that a bond issued as part of an issue is a QZAB only if, among other requirements, at least 95 percent of the proceeds of the issue are to be used for a qualified purpose with respect to a qualified zone academy established by an eligible local education agency (as defined in section 1397E(d)(4)(B)). Section 1397E(d)(5) defines qualified purpose, with respect to any qualified zone academy, as (i) rehabilitating or repairing the public school facility in which such academy is established, (ii) providing equipment for use at such academy, (iii) developing course materials for education to be provided at such academy, and (iv) training teachers and other school personnel in such academy. Section 1397E(d)(4)(A) defines qualified zone academy as any public school (or academic program within a public school) that is established by and operated under the supervision of an eligible local education agency to provide education or training below the postsecondary level if: (1) the public school or program is designed in cooperation with business in accordance with section 1397E(d)(4)(A)(i); (2) students in the public school or program will be subject to the same academic standards and assessments as other students educated by the eligible local education agency; (3) the comprehensive education plan of the public school or program is approved by the eligible local education agency; and (4) the public school is located in an empowerment zone or enterprise community (as defined in section 1393), or there is a reasonable expectation (as of the date of issuance of the bonds) that at least 35 percent of the students attending the school or participating in the program will be eligible for free or reduced-cost lunches under the school lunch program established under the Richard B. Russell National School Lunch Act. The Proposed Regulations provide that, in general, an issue must satisfy three requirements to comply with section 1397E(d)(1)(A). First, the issuer must reasonably expect, as of the date of issuance of the issue, that at least 95 percent of the proceeds of the issue will be expended with due diligence. Second, the issuer must reasonably expect, as of the date of issuance of the issue, that at least 95 percent of the proceeds of the issue will be used for a qualified purpose with respect to a qualified zone academy for the entire term of the issue (without regard to any redemption provision). Third, except as otherwise provided in the remedial action provisions of the proposed regulations, discussed below, at least 95 percent of the proceeds of the issue must actually be used for a qualified purpose with respect to a qualified zone academy for the entire term of the issue (without regard to any redemption provision). For these purposes, any unspent proceeds are treated as used for a qualified purpose with respect to a qualified zone academy during any period that the issuer reasonably expects that those proceeds will be expended with due diligence for a qualified purpose with respect to a qualified zone academy. 4

5 2. Proceeds Expended for Rehabilitation, Repair or Equipment Section 1397E(d)(5)(A) and (B) provides that the term qualified purpose with respect to any qualified zone academy includes rehabilitating or repairing the public school facility in which such academy is established, and providing equipment for use at such academy. The Proposed Regulations specify that, if proceeds of an issue are expended for a purpose described in section 1397E(d)(5)(A) or (B) with respect to a qualified zone academy, then those proceeds are treated as used for a qualified purpose with respect to the academy during any period after such expenditure that (1) the property financed with those proceeds is used for the purposes of the academy and (2) the academy maintains its status as a qualified zone academy. For this purpose, the retirement from service of financed property due to normal wear or obsolescence does not cause the property not to be used for a qualified purpose with respect to a qualified zone academy. 3. Proceeds Expended to Develop Course Materials or Train Teachers Section 1397E(d)(5)(C) and (D) provides that the term qualified purpose with respect to any qualified zone academy includes developing course materials for education to be provided at such academy, and training teachers and other school personnel in such academy. The Proposed Regulations provide that, if proceeds of an issue are expended for a purpose described in section 1397E(d)(5)(C) or (D) with respect to a qualified zone academy, then those proceeds are treated as used for a qualified purpose with respect to the academy during any period after such expenditure. 4. Special Rule for Determining Status as Qualified Zone Academy Section 1397E(d)(4)(A)(iv) provides that a public school (or academic program within a public school) is a qualified zone academy only if, among other requirements, the public school is located in an empowerment zone or enterprise community, or there is a reasonable expectation (as of the date of issuance of the bonds) that at least 35 percent of the students attending the school or participating in the program (as the case may be) will be eligible for free or reduced-cost lunches under the school lunch program established under the Richard B. Russell National School Lunch Act. For purposes of determining whether an issue complies with section 1397E(d)(4)(A)(iv), the Proposed Regulations provide that a public school is treated as located in an empowerment zone or enterprise community for the entire term of the issue if the public school is located in an empowerment zone or enterprise community on the date of issuance of the issue. B. Remedial actions 1. In General The Proposed Regulations specify two remedial actions that may be taken in certain circumstances if less than 95 percent of the proceeds of an issue is actually used for a qualified purpose with respect to a qualified zone academy. These remedial actions are available only if the issuer reasonably expected on the date of issuance of the issue that: (1) at least 95 percent of the proceeds of the issue would be expended with due 5

6 diligence; and (2) at least 95 percent of the proceeds of the issue would be used for a qualified purpose with respect to a qualified zone academy for the entire term of the issue (without regard to any redemption provision). The two remedial actions specified in the proposed regulations are (1) redemption or defeasance of the nonqualified bonds and (2) alternative use of the disposition proceeds. If the applicable requirements are met, the redemption or defeasance remedial action is available to cure any failure to satisfy the 95-percent test that was not reasonably expected as of the date of issuance. The alternative use of disposition proceeds remedial action applies only to certain dispositions of financed property for cash. 2. Redemption or Defeasance of Nonqualified Bonds The Proposed Regulations provide that a redemption or defeasance remedial action is taken if: (1) all of the nonqualified bonds of the issue (determined by applying the principles of (e)) are redeemed within 90 days after the date on which the failure to properly use proceeds occurs; (2) if any nonqualified bonds of the issue are not redeemed within 90 days after the date on which the failure to properly use proceeds occurs (the unredeemed nonqualified bonds), a defeasance escrow is established for the unredeemed nonqualified bonds within 90 days after the date on which the failure to properly use proceeds occurs; or (3) if the failure to properly use proceeds is a disposition of financed property described in section 1397E(d)(5)(A) or (B) and the consideration for the disposition is exclusively cash, all of the disposition proceeds (as defined in (c)(1)) are used within 90 days after the date of the disposition to redeem, or establish a defeasance escrow for, a pro rata portion of the nonqualified bonds of the issue. For proceeds that are not spent, a failure to properly use proceeds occurs on the earlier of: (1) the first date on which the public school (or academic program within the public school) does not constitute a qualified zone academy; and (2) the first date on which the issuer reasonably expects that less than 95 percent of the proceeds of the issue will be expended with due diligence for a qualified purpose with respect to a qualified zone academy. For proceeds that have been spent for rehabilitation, repair or equipment described in section 1397E(d)(5)(A) or (B) with respect to a qualified zone academy, a failure to properly use proceeds occurs on the earlier of: (1) the first date on which the public school (or academic program within the public school) does not constitute a qualified zone academy; and (2) the first date on which an action is taken that causes less than 95 percent of the proceeds of the issue to be used for a qualified purpose with respect to a qualified zone academy. If proceeds have been spent for course materials or training described in section 1397E(d)(5)(C) or (D) with respect to a qualified zone academy, no event subsequent to such expenditure shall constitute a failure to properly use such proceeds. A defeasance escrow is defined as an irrevocable escrow established to retire bonds on the earliest call date after the date on which the failure to properly use proceeds occurs in an amount that is sufficient to retire the bonds on that call date. At least 90 percent of the weighted average amount in a defeasance escrow must be invested in investments (as defined in (b)), except that no amount in a defeasance escrow 6

7 may be invested in any investment the obligor (or any person that is a related party with respect to the obligor within the meaning of (b)) of which is a user of proceeds of the bonds. All purchases or sales of an investment in a defeasance escrow must be made at the fair market value of the investment within the meaning of (d)(6). In addition, the Proposed Regulations provide that the issuer must pay to the United States, at the same time and in the same manner as rebate amounts are required to be paid under (or at such other time or in such other manner as the Commissioner may prescribe), 100 percent of the investment earnings on amounts in the defeasance escrow. For this purpose, the first computation period begins on the date on which the failure to properly use proceeds occurs. Proceeds of QZABs (other than unspent proceeds of the issue for which the failure to properly use proceeds occurs) are not permitted to be used to redeem or defease the nonqualified bonds. The issuer must provide written notice to the Commissioner of the establishment of the defeasance escrow within 90 days of the date the defeasance escrow is established. 3. Alternative Use of the Disposition Proceeds The alternative use of disposition proceeds remedial action has four requirements. First, the failure to properly use proceeds must be a disposition of financed property described in section 1397E(d)(5)(A) or (B) and the consideration for the disposition must be exclusively cash. Second, the issuer must reasonably expect as of the date of the disposition that: (1) all of the disposition proceeds, plus any amounts received from investing the disposition proceeds, will be expended within two years after the date of the disposition for a qualified purpose with respect to a qualified zone academy; or (2) to the extent not expected to be so expended, used within 90 days after the date of the disposition to take a redemption or defeasance remedial action. Third, the disposition proceeds, plus any amounts received from investing the disposition proceeds, must be treated as proceeds for purposes of section 1397E. Fourth, if all of the disposition proceeds, plus any amounts received from investing the disposition proceeds, are not actually expended for a qualified purpose within the two-year period beginning on the date of the disposition (or used within 90 days after the date of the disposition to take a redemption or defeasance remedial action), the remainder of such amounts must be used within 90 days after the end of that two-year period for a redemption or defeasance remedial action. C. Definition of proceeds In general, (b) defines sale proceeds as any amounts actually or constructively received from the sale of an issue, including amounts used to pay underwriters' discount or compensation. The proposed regulations provide that, for purposes of the QZAB provisions (other than the private business contribution requirement, discussed below), proceeds means sale proceeds as defined in (b), plus any amounts received from investing sale proceeds. Thus, under the proposed regulations, the requirement in section 1397E(d)(1)(A) that at least 95 percent of the 7

8 proceeds of an issue be used for a qualified purpose with respect to a qualified zone academy is applied by taking into account not only the sale proceeds of the issue, but also any amounts received from investing those sale proceeds. Section 1397E(d)(1)(C)(ii) provides that a bond is a QZAB only if, among other requirements, the issuer certifies that it has written assurances that the private business contribution requirement of section 1397E(d)(2) will be met with respect to the qualified zone academy. Section 1397E(d)(2)(A) provides that the private business contribution requirement is met if the eligible local education agency that established the qualified zone academy has written commitments from private entities to make qualified contributions (as defined in section 1397E(d)(2)(B)) having a present value (as of the date of issuance of the issue) of not less than ten percent of the proceeds of the issue. The proposed regulations provide that, for purposes of the private business contribution requirement of section 1397E(d)(2), proceeds means sale proceeds as defined in (b). Thus, the private business contribution requirement is applied by taking into account only the sale proceeds of the issue without regard to any amounts received or expected to be received from investing those sale proceeds. D. Payment of principal, interest or redemption price The proposed regulations provide that the use of sale proceeds of a QZAB, and investment earnings thereon, to pay principal, interest or redemption price of the bond or another bond is not a qualified purpose within the meaning of section 1397E(d)(5). Thus, the use of sale proceeds of a bond, and investment earnings thereon, to refund another bond is not a qualified purpose. In addition, the use of sale proceeds of a bond, and investment earnings thereon, to fund a sinking fund to repay the bond is not a qualified purpose. Proposed Effective Dates The proposed regulations are proposed to apply to bonds sold on or after the date that is 60 days after publication of final regulations in the Federal Register (the effective date). Issuers may apply the proposed regulations in whole, but not in part, to bonds sold before the effective date, except that: (1) issuers may apply the proposed regulations without regard to E-1(h)(8) (relating to the definition of proceeds) to bonds sold before the effective date; and (2) E-1(d) (relating to the maximum term of a QZAB) and E-1(h)(2) (relating to reimbursement of expenditures with proceeds of a QZAB) may not be applied to bonds issued before July 1, III. COMMENTS AND RECOMMENDATIONS A. Proposed Regulations E-1(d) Maximum Term The proposed change to set the maximum term based on the sale date of the bond rather than the issue date is particularly helpful to issuers. We would request that the IRS clarify whether the credit rate and maximum term will continue to be available on the internet site of the Bureau of Public Debt or whether Notice will be revised. 8

9 B. Proposed Regulations E-1(2)(ii) - Requirement of Actual Use of QZAB Proceeds For Qualified Purpose with respect to a Qualified Zone Academy We request that this provision be altered to conform with the reasonable expectations/deliberate actions provisions of Regulations (d), specifically including the definition of deliberate action and the safe harbor exception for actions not treated as deliberate actions set forth in Regulation (d)(3). The statutory language of Sections 141 and 1397E both use the phrase "are to be used" and this type of cross-reference would assist issuers in interpreting the Proposed Regulations. C. Proposed Regulations E-1(h)(4)(i)(B) The Academy Maintains Its Status as a Qualified Zone Academy We believe that in many instances it may be difficult for a school district to meet the requirement that the school or program maintain its status as a "qualified zone academy". In some cases, the proceeds were used in very specifically designed programs that may, due to changing technology or other larger economic, business and social forces, warrant disbanding the program. In general, it may be unreasonable to think that specially designed programs would remain in place for the twelve to thirteen year term of a QZAB. In other cases, the program may heavily depend on the role of private parties beyond the control of the issuer. Private businesses are subject to insolvency, restructurings and relocations. This concern is particularly acute in situations in which the qualified zone academy is a specialized academic program within a public school that is not only designed in cooperation with business, but may also rely on business for aid or private contributions to continue in operation. A QZAB issuer or eligible local education agency may be forced to discontinue a program because it cannot force a business to continue its participation in such a charitable endeavor. In such cases where a program is abandoned or discontinued, an issuer should be required to take a remedial action only if the issuer receives cash (that is, sells the property) that could be used to defease the bonds or to fund an alternate use. If the issuer is able to use the renovated space or equipment purchased with the proceeds of the QZAB for other educational programs of the issuer, we believe the issuer should be able to continue to receive the benefits of the tax credit bond program. This could be accomplished by deeming the abandonment of the qualified zone academy programs in the same manner as a retirement from service of obsolete equipment under Proposed Regulations E-1(h)(4)(ii). In the alternative, the Proposed Regulations could be revised to provide a third remedial action option to permit a QZAB issuer, within a defined period of time, to institute an alternative qualifying academic program if the issuer designated an academic program within a public school as the qualified zone academy under Code Section 1397E(d)(4)(A). D. Proposed Regulation E-1(h)(6) - Permissible Use of QZAB Proceeds (35% School Lunch Program test) 9

10 We request that E-1(h)(6) be amended to provide that compliance with the 35 percent free or reduced-cost school lunch program test for determining status as a qualified zone academy shall be conclusively established based on the reasonable expectations of the QZAB issuer on the date of issuance of the QZAB in the same manner as location in an empowerment zone or enterprise community is established on the date of issuance. We believe that such a provision is supported by Section 1397E-1(d)(4)(A)(iv)(II) which states that there is a reasonable expectation (as of the date of issuance of the bonds) that at least 35 percent of the students attending the school or participating in the program (as the case may be) will be eligible for free or reduced-cost lunches under the school lunch program established under the Richard B. Russell National School Lunch Act (emphasis added). A QZAB issuer should not lose the benefit of 0% (or below market rate) financing because the economic circumstances of the students attending a qualified zone academy have improved. Indeed, we believe that it is the sincere and profound hope and expectation of the Senators and Congressmen supporting the QZAB program that these circumstances will improve. Moreover, the specter of short-term pain of remedial action should not be allowed to discourage QZAB issuers from considering school or school district mergers or annexations that may offer huge (but financially hard-to-quantify) long-term benefits for less-fortunate school children. Such a merger or annexation, unforeseen on the date of issuance of the QZAB, may push the school lunch program participation percentage below 35%, yet be greatly beneficial for the school and the students. E. Proposed Regulations E-1(h)(7)(ii)(B) - Remedial Actions (Call Provisions) We request that this portion of the Proposed Regulations be supplemented in two respects. First, it would be helpful if a provision were added to the effect that, in general, a legal defeasance of a QZAB pursuant to its terms and, at least within the context of a remedial action, the addition of a legal defeasance provision to a QZAB would not (i) constitute a "significant modification" under Regulations or (ii) reduce the face amount of the bond held by the taxpayer for purposes of Code Section 1397E(b). Given the provisions of the Proposed Regulations that the use of sale proceeds of a bond, and investment earnings thereon, to pay debt service on a bond is a not a qualified purpose within the meaning of Section 1397E(d)(5), it would additionally be helpful if a provision were added that a significant modification in the context of the taking of remedial actions would not be treated as a reissuance. This provision is needed because many outstanding QZABs have no defeasance provisions and were not issued with call provisions. Consequently, we feel that the effectiveness of the Proposed Regulations, and their cost-effective usefulness to QZAB issuers, would be enhanced by indicating that the addition of a call provision to a QZAB subsequent to its date of issuance would not constitute a significant modification of the QZAB debt instrument or in any way trigger a reissuance of the QZAB. This is 10

11 particularly critical if the QZAB is issued with original issue discount and/or bears interest in order to supplement the total return thereon. A QZAB issuer may strongly prefer to redeem such a QZAB rather than defease it because the rebate requirement will be particularly costly to it. F. Proposed Regulations E-1(h)(7)(ii)(C) Remedial Actions (Rebate Requirement) We make two initial observations as context for our comments on this portion of the Proposed Regulations. First, unlike a typical tax-exempt bond defeasance escrow, these provisions do not permit for the net funding of a defeasance escrow. Second, QZABs may be issued with original issue discount and/or a supplemental interest rate. Consequently, some QZABs have a yield above 0%. These factors suggest that the 100% rebate requirement contained in this portion of the Proposed Regulations may be burdensome on all QZAB issuers, who will need to gross fund any defeasance escrow, and particularly burdensome on some, who will need to gross fund a defeasance escrow in an amount in excess of the principal amount of the QZAB to be defeased. We recommend consideration of one of two alternative proposals. First, the rebate requirement could apply only to investment earnings in excess of the yield on the QZAB. This would be helpful for those issuers who are defeasing QZABs which have a yield in excess of 0%. Second, the rebate requirement could be calculated to equal investment earnings that, taking account of maturing principal on defeasance investments, are in excess of the total debt service requirements to be paid out of the defeasance escrow. The purpose of the second alternative is to provide for the net funding of the entire payment requirements out of a defeasance escrow. Net funding would preserve resources for QZAB issuers which, almost by definition, lack the resources available to wealthier school districts. As an alternative to these approaches, the proposal in Section E of these comments, allowing the addition of redemption provisions to a QZAB without triggering a reissuance of the QZAB, would mitigate the burden on QZAB issuers establishing a defeasance escrow since such redemption provisions could be structured to provide for a very short or no escrow period until the redemption date for the QZAB. The Proposed Regulations provide the issuer with a 90 day period between the date of failure and the creation of an escrow, but require that the computation period for rebate purposes begin on the date of failure. This creates a possible 90 day period during which an issuer would be required to compute yield on an escrow that is yet to be established. Therefore, we also suggest that the first computation period for determining the payment of rebate begin on the date the defeasance escrow is established. G. Proposed Regulations E-1(h)(7)(iii)(B)(1) - Alternative Use of Disposition Proceeds (Amount of Disposition Proceeds) We request clarification of the provisions in Proposed Regulations E- 1(h)(7)(iii)(B)(1) relating to the determination of the amount of disposition proceeds required to be expended for a qualified purpose within two years of the date of the disposition of the QZAB financed property. We believe the text All of the disposition proceeds (as defined in (c)(1)), plus any amounts received from investing the 11

12 disposition proceeds could be read to require more proceeds to be expended on qualified purposes than the original amount of proceeds of the QZAB. We would propose, analogizing to the concept of the universal cap that applies for tax-exempt bonds, that the amounts relating to a disposition that are required to be expended for a qualified purpose be capped at the principal amount of the QZAB outstanding at the time of the disposition. H. Proposed Regulations E-1(h)(7)(ii)(B)(3) - Definition of Defeasance Escrow (Certain Existing Security Structures) We understand that many QZAB financings have been structured in a variety of ways that are secured by, and wholly or partially payable from, a sinking or escrow fund held by a party independent of the QZAB issuer. Many of these types of funds are invested in guaranteed investment contracts or other arrangements, premised on the QZAB remaining outstanding for its entire stated term, pursuant to which investment earnings are crucial for the security of the QZAB bondholder. It may be difficult for a number of QZAB issuers to elect to apply the remedial action provisions of the Proposed Regulations to these already existing structures. We would appreciate guidance as to how appropriate remedial action can be taken in these situations or clarification that no remedial action is needed. I. Proposed Regulations E-1(h)(8)(i) - Definition of Defeasance Escrow (Certain Existing Security Structures) We request that the definition of proceeds for purposes of applying the 95% expenditure test in Section 1397E should limit proceeds to sale proceeds and not include investment proceeds. This approach would be consistent with the approach already taken in applying the 95% test in Sections 142 and 144 of the Code relating to the expenditure of proceeds of exempt facility bonds and qualified small issue bonds, which are the most analogous provisions in the Code. This approach is also consistent with sound policy. When sizing a bond issue to assure compliance with the 95% expenditure test, it could be very difficult for a QZAB issuer to include investment proceeds because of the volatility of interest rates and the inherent uncertainty that exists relating to the timing of the expenditure of proceeds. For these reasons, the Service has consistently permitted the exclusion of interest earnings in determining whether the 95% test has been met under Sections 142 and 144 of the Code, and the same approach should be taken with respect to the expenditure of QZAB proceeds under Section 1397E. 12