Policy 1803: Tax Exempt Bond Compliance
Subject Area: Tax Exempt Bond Compliance
Responsible Office: The Office of Treasury Management
Approval: Vice President for Operations and Chief Financial Officer
Originally Issued: August 2014
Revised: February 2017
Refer Questions To: Sanja E. Noble (773) 702-5130
The purpose of this policy is to provide a framework for complying with federal laws relating to the issuance and post issuance monitoring of tax-exempt bonds, and to describe the University’s processes for fulfilling these requirements during both pre- and post-issuance periods. This policy also provides guidance to University units involved in tax-exempt financings so that they understand and are able to carry out their roles in these processes.
The University relies on the tax-exempt bond market to finance portions of certain University capital projects, including new buildings, renovation and repairs of all or portions of existing buildings, landscaping, and campus utility and infrastructure projects. The consequences of violating federal laws in these areas can be severe and can include the retroactive loss of tax-exempt status for bonds, significant financial liability to the IRS and/or bondholders, reputational damage, and the inability to access the tax-exempt bond market in the future. Accordingly, this policy provides guidance in the following areas:
- Identification of applicable Internal Revenue Code provisions and Treasury rules and regulations relating to tax-exempt debt compliance (collectively, the “Tax Rules”);
- Definition of the University’s policy for complying with the Tax Rules to safeguard against violations that may result in penalty or the loss of the tax-exempt status of its bonds;
- Assignment of responsibility for tax-exempt bond compliance to specific departments to maintain continuity and ensure that sufficient information is routinely identified, maintained and shared as required or appropriate; and,
- Identification of the University’s continuing disclosure requirements and establishment of procedures for providing annual disclosure, “event disclosure” and voluntary disclosure through the Electronic Municipal Market Access (EMMA) system (or successor systems).
The principal purposes of the policy are to ensure that (1) the proceeds of tax exempt bonds are spent as required by both the bond documents and the Tax Rules and (2) the projects financed by tax-exempt bonds do not have impermissible amounts of “bad use,” also known as “private use.” In simplest terms, “good use” is use exclusively by the University in connection with its charitable activities, while “bad use” is use by or for the benefit of private, for-profit entities or the Federal Government. There are special rules relating to sponsored research. Management and development contracts with private parties also can create bad use. There are also requirements requiring the timely expenditure of bond proceeds (usually within three years) and on the payment of investment “arbitrage” arising from the investment of bond proceeds prior to their expenditure.
The University recognizes compliance with the Tax Rules is fluid and complex. Accordingly, this Policy requires ongoing monitoring and will be reviewed periodically and modified as necessary.
The Office of Treasury Management is responsible for administering and overseeing the day-to-day aspects of this policy.
The Office of Treasury Management within the Office of Finance and Administration officially interprets this policy. The Office of Treasury Management is responsible for obtaining approval for any revisions as required by the policy. The Office of the Vice President for Operations and Chief Financial Officer, and delegated parties, is responsible for responding to inquiries by investors, rating agencies and other outside parties relating to the status of projects, the financial condition of the University and any other events that may affect investors. All such inquiries should be referred to the Office of the Vice President for Operations and Chief Financial Officer.
Tax-exempt debt compliance begins with the proper planning for debt issuances. While capital projects can be proposed and approved at any time during the year, it is expected that the majority will be identified during the annual capital budget review process, managed by the Budget Office under the Office of the Provost, and approved by the Board of Trustees. During the capital budget process, projects intended to be financed with tax-exempt debt should be reviewed for potential private use and sectarian use concerns.
Approved capital projects which are identified to be funded in whole or part through debt financing are assembled on a “project list” that details those planned projects for which tax-exempt bond proceeds are expected to be used and the expected amount to be reimbursed from those proceeds on each project. The project list is ultimately provided to the Illinois Finance Authority (IFA) as required. Following the creation of an approved project list, the following key authorizations are generally required to be in place prior to any tax-exempt debt issuance:
Authorization of Debt — All tax-exempt bond indebtedness incurred by the University must be authorized by the Board of Trustees.
Declaration of Intent To Borrow and Reimbursement Resolution — While the Tax Rules limit the ability of the University to use tax-exempt bond proceeds to reimburse itself for costs incurred prior to the issuance of the bonds, the University can in many circumstances preserve the right to reimburse itself for current expenditures with the proceeds of future bonds by passing a qualifying “reimbursement resolution” or adopting a qualifying expression of intent to reimburse. The Board of Trustees can take such action.
Legal Opinions – Legal opinions are required on debt authorizations and the effect on the tax-exempt status of the debt being issued. For new bond issues, external bond counsel opines on the validity and tax exempt status of the bonds, while University counsel opines on the authorization of the bonds and compliance with existing bond documents and similar restrictions.
Tax Certificate –is required to properly document the validity (and tax-exempt status) of the financing and to evidence compliance with applicable laws and regulatory requirements at the time of issuance. The Tax Certificate sets forth the University’s expectations as to the use of bond proceeds and must be reviewed by the Office of Legal Counsel and the Office of Treasury Management.
The Office of Treasury Management will manage the pre-issuance process including the drafting, review, and development of any needed resolutions, write-ups, project lists, or other materials, in consultation with the Office of Legal Counsel.
For bonds to continue to qualify for tax-exempt status, the applicable detailed provisions in the Tax Rules must be satisfied. Post-issuance debt compliance generally falls into the following categories:
- Expenditure and allocation of bond proceeds
- Investment of bond proceeds
- Replacement proceeds
- Review of bond financed project(s) for potential private business use
- Change in use
- Disclosure and other filing requirements
- Record retention
If the potential to fail to comply with post-issuance compliance activities is identified, the Office of Treasury Management will notify the Associate Vice President for Finance, Executive Director for Compliance Internal Audit, Vice President for Operations, Chief Financial Officer, and the Office of Legal Counsel, which may seek the advice of bond counsel in order to assess the need to take remedial actions.
Expenditure and Allocation of Bond Proceeds
Bond proceeds can only be used for eligible project costs in accordance with the Tax Rules and the restrictions of the bond documents. The spending of bond proceeds and related investment earnings toward eligible project costs must be tracked to ensure they are used for qualified purposes. Bond proceeds shall only be disbursed for the following expenditures:
- Project Costs
- Capitalized Interest
- Bond Issuance Costs
The Office of Financial Services is responsible for verifying that bond proceeds are spent on qualified purposes and for maintaining related payment records. At the conclusion of a project, a final allocation should be compiled, documenting the use of all bond proceeds and related investment earnings. This documentation will be part of the permanent records for the particular bond transaction. The Tax Rules permit a reallocation of use of bond proceeds if action is taken not later than 18 months after the later of the date of the expenditure or the date the project is placed in service. The Office of Legal Counsel should be consulted regarding any planned reallocations, but in all events the reallocation has to be made within 60 days after the fifth anniversary of the bond issuance or payment of the bonds in full.
The Office of Financial Services, in coordination with the Office of Treasury Management, supervises the reimbursement process and should regularly review the reimbursement resolutions as reimbursements progress to see if they need to be updated to cover project changes. In general bond proceeds can be used for reimbursement for prior costs within 18 months after the project is “placed in service” but in no event later than three years after the date of the expenditures. There are exceptions for certain preliminary costs, such as architects’ and engineering fees.
Spending Requirements and Arbitrage Rebate
There are restrictions on the timing of the expenditure of bond proceeds. Generally proceeds must be spent within three years of bond issuance. If it appears that all proceeds will not be spent within the three year period, the Office of Legal Counsel should be consulted.
The Tax Rules generally require borrowers to calculate and pay or “rebate” to the U.S. Government any “arbitrage profit” earned on the investment of bond proceeds prior to their expenditure. Arbitrage profit is the investment gain made by investing the proceeds of tax exempt bonds at a yield that is higher than the yield on the bonds issued. Arbitrage compliance is governed by complex provisions of the Tax Rules. There are several “rebate exceptions” if bond proceeds are spent promptly.
As a general rule, the University will seek to spend proceeds within two years of the issue date to meet the two year spending rebate exception. The two year spending exception for construction issues requires that proceeds be spent as follows:
- 10% within 6 months of issue date
- 45% within 12 months of issue date
- 75% within 18 months of issue date
- 100% (less “reasonable retainage”) within 24 months of issue date
Expenditures should be reviewed 30 days prior to the end of each six month period to minimize the chance of forfeiting the rebate exception. The two year exception applies only to transactions primarily for construction. In addition, there is an 18 month exception available for bonds with the following spending thresholds:
- 15% within 6 months of issue
- 60% within 12 months of issue
- 100% within 18 months of issue
Actual spending, as defined by the actual monthly cash reimbursements received, will be tracked on the monthly reimbursement schedule maintained by Financial Services in consultation with the Office of Treasury Management.
Once the bond proceeds from a transaction have been received, the Office of Treasury Management shall recommend an appropriate investment vehicle in which to invest any tax exempt proceeds over the project period. The determination of whether an investment is appropriate shall be governed by the Tax Certificate prepared for the University’s tax-exempt debt that contains the applicable yield restriction investment limitations and the related trust indenture that typically includes a definition of permitted qualified investments. The Office of Treasury Management, with assistance from Financial Services, shall maintain records of all earnings generated by the investment of bond proceeds and adjust the investment allocations or alert the Office of Legal Counsel as needed.
At predetermined dates outlined in the bond documents, a calculation is required to verify that any earnings have conformed to the restrictions set forth in each tax certificate. This calculation is typically performed by a third party arbitrage rebate firm. The Office of Treasury Management will track the due dates of each required calculation and alert the Office of Legal Counsel to any approaching deadline. The Office of Treasury Management will then select and engage an appropriate third party to perform each required calculation.
Replacement proceeds are amounts that have a sufficiently direct “nexus” to a tax-exempt bond issue or to the purpose of the bond issue to conclude that the amounts would have been used for that purpose if the proceeds of the bond issue were not used or expected to be used for such purpose. Replacement proceeds include, but are not limited to, pledged funds and sinking funds. A pledged fund is any amount for which there are reasonable assurances that such amounts will be available to pay debt service on a tax exempt issue if the University encounters financial difficulties. A sinking fund includes any debt service, redemption, reserve, replacement or similar fund to the extent reasonably expected to be used to pay principal or interest on a bond issue. Sinking funds include funds that are formally designated as such, as well as any fund that is expected to be used (even indirectly) to pay debt service on a bond issue. If amounts are deemed to be replacement proceeds of a bond issue, the University is required to comply with the yield restriction rules or an exemption therefrom in respect of such amounts in order to prevent the bonds from being considered arbitrage bonds.
Sinking Funds as “Replacement Proceeds”
1. The University seeks to avoid having its endowment, or any portions thereof, constitute a sinking fund. Accordingly:
1. The University will not make principal or interest payments directly out of its endowment; all interest and principal payments on tax exempt bonds will be provided for as part of the University’s operating budget; and
2. The University will avoid any internal or external communications that suggest that its endowment is a dedicated source of funds for the satisfaction of interest and principal payment obligations on tax exempt bonds.
2. More generally, the University will seek to avoid actions or statements that might support the characterization of any portion of its endowment or other financial assets of the University as a sinking fund.
Gifts as “Replacement Proceeds”
1. For any facility whose construction costs will be financed at least in part with tax exempt bonds, the University will endeavor to structure and size the issue to take into account any gifts toward construction costs that are expected to be received.
2. The University does not anticipate financing the construction of 100% of the costs of any facility with tax-exempt bond proceeds. However with respect to any facility the construction of which was 100% financed by tax exempt bonds, the University will seek to avoid having gift amounts treated as replacement proceeds by ensuring that:
1. Fundraising materials do not solicit donations specifically for the “bricks and mortar” of the tax exempt financed facility or for the payment of debt service on such facility;
2. The facility is not the principal focus of fundraising materials, even if the materials do not restrict any donated funds to the costs of that project;
3. Unless donor considerations dictate otherwise, gift instruments are clear that donated funds can be allocated to items that are not directly related to the cost of constructing the facility; and
4. If a donor cannot be persuaded to include language in the gift instrument disclaiming any obligation on the University’s part to use the gift for construction of the building being named for the donor, the gift instrument is at least clear that the gift can be used to fund maintenance expenses, a depreciation reserve or programs conducted in the facility, rather than being restricted to “construct,” “build,” or “establish” the tax-exempt financed facility.
5. With respect to any facility the construction of which was less than 100% financed by tax exempt bonds, it is permissible to deviate from the guidelines set forth in paragraph 2 above with respect to solicitations for gifts in amounts equal to or less than the portion of the construction cost that was not financed with tax exempt debt; any amounts raised in excess of such non-tax exempt bond cost shortfall through the use of fundraising materials or gift instruments that deviate from the guidelines set forth in paragraph 2 above, however, will most likely be deemed to be replacement proceeds of the bond issue and in all likelihood will need to be used to pay down bonds. Prior to any pay down of bonds the Office of Treasury Management should consult with the Office of Legal Counsel to develop a plan to comply with the yield restriction requirements or an applicable exemption therefrom or, to the extent permitted, to ensure that the University makes appropriate yield reduction payments with respect to such excess amounts.
6. If a pledged gift or an anticipated bequest has a connection to a particular project, the Office of Treasury Management will consult with the Office of Legal Counsel to determine whether the connection constitutes a sufficiently strong “nexus” to the project such that non-tax exempt bond funds, such as taxable debt or department reserves, should be used to pay for the project pending receipt of the pledged gift or anticipated bequest.
7. The appropriate Development Office personnel will be apprised of the guidelines set forth in this section. The Office of Treasury Management will monitor to ensure that training is repeated periodically and that new staff is trained as necessary.
Review of bond financed project(s) for potential private business use
The Tax Rules generally limit the amount of Private Business Use of facilities financed with tax-exempt bond proceeds. The Tax Rules also prohibit the use of facilities financed with tax-exempt bond proceeds for sectarian purposes in a manner that is prohibited by the Establishment of Religion Clause of the First Amendment to the Constitution of the United States of America or by any comparable provisions of the Constitution of the State of Illinois.
Private Business Use is use (directly or indirectly) in a trade or business of a Non-Governmental person. Use by a for-profit entity or any other non-501(c)(3) entity or the federal government is considered use by a Non-Governmental Person and can therefore constitute private business use. Use by a 501(c)(3) entity in an unrelated trade or business is also private use. Pursuant to the Private Business Use test, the tax-exempt status of a bond issuance is jeopardized if more than 5% of the proceeds are used in a Private Business Use. Improper use of the bond financed facility is considered bad use of the proceeds of the bonds that financed the facility. Generally, most Private Business Use in a tax-exempt financed facility arises from the following types of arrangements:
Ownership: A sale or transfer of ownership to a Non-Governmental Person of tax-exempt financed property. For 501(c)(3) bonds, no portion of the bond financed property can be owned by a private, for-profit entity.
Leases: Any arrangement where the University leases a tax-exempt financed property to a Non-Governmental Person. Transactions that are not called lease transactions may be treated as a lease based on the level of control given to the Non-Governmental Person and whether the Non-Governmental Person bears the risk of loss.
Management Contracts: A management contract is any arrangement whereby a Non-Governmental Person actively manages the operations of a facility. Management contracts include, for example, contracts for dining services (including food courts and cafes), retail services (including book stores and gift shops), facility management, or vivarium services (management of an animal facility). The basic rules for permitted management contracts are set forth in IRS Revenue Procedure 97- 13 and Rev. Proc. 2017-13. As a general principle, the contract should not give the private party any kind of profit sharing or “investment” in the undertaking, and the term of the contract must be limited based on the type of compensation to the Non-Governmental Entity. All management contracts for bond-financed space should be reviewed by the Office of Legal Counsel prior to being entered into.
Sponsored Research Agreements: Any research that is sponsored by a Non-Governmental Person (including the federal government and its agencies). The basic rules for determining when sponsored research is not considered “Private use” are set forth in IRS Revenue Procedure 2007-47. Generally, qualifying research agreements must be for “basic research” and the rights of the sponsor to the results of the research must comply with the stated rules.
Other Actual or Beneficial Use: Any other arrangement that conveys special legal entitlements to a Non-Governmental Person for beneficial use of tax-exempt financed property, such as an arrangement that conveys priority rights to use a tax-exempt financed facility, will result in Private Business Use. Examples of such “special legal entitlements” include summer camps having the exclusive right to use an athletic facility, specially designed courses open only to one company, or use of a parking garage for a private event.
Use of Qualified Improvements by a Private User does not constitute “Private Use.” A “Qualified Improvement” is an improvement to a building (including its structural components and land functionally related and subordinate to the building) where the following requirements are satisfied:
1. The building was placed in service more than 1 year before the construction of acquisition of the improvement is begun;
2. The improvement is not an enlargement of the building or an improvement of interior space occupied exclusively for any private business use;
3. No portion of the improved building or any payments in respect of the improved building are taken into account under Section 141(b)(2)(A) of the Internal Revenue Code (the private security test); and
4. No more than 15 percent of the improved building is used for private business use.
The Office of Treasury Management will be responsible for supervising the monitoring of private use and, with assistance from the Office of Financial Services, will maintain and distribute a Private Use Questionnaire to responsible Department(s) and Facility Managers on at least an annual basis. The Office of Treasury Management and Office of Financial Services and will analyze questionnaire responses to:
(i) determine whether taxable financing is appropriate for a particular capital project;
(ii) identify impermissible Private Business Use in existing facilities so that corrective action can be taken; and
(iii) collect information necessary for reporting purposes to calculate Private Use per project and per bond issue. If potentially impermissible Private Business Use is identified, the Office of Treasury Management will notify the Executive Vice President for Administration and Chief Financial Officer and seek the advice of the Office of Legal Counsel.
The Office of Treasury Management will also be responsible for monitoring for impermissible sectarian uses of facilities financed with tax-exempt debt.
Change in Use
Each department using facilities financed with tax-exempt debt is responsible for notifying the Office of Treasury Management before there is a change in use of the facility financed with tax-exempt debt. In the event such a change in use may result in excessive Private Use for a bond issue, the University may avail itself of rules under Treasury Regulation section 1.141-12 which provide for “remedial action” by redemption or defeasance of nonqualified bonds. Failure to meet remedial action may result in significant penalties which may be borne by the school, department or division.
In limited circumstance, remedial action may be taken by applying disposition proceeds to other qualifying capital expenditures.
The University will seek the advice of bond counsel in the event remedial action may be required. To the extent a potential violation of Private Use rules arises that cannot be corrected through remedial action, or in the event of a potential arbitrage violation, the University will seek the advice of bond counsel concerning its alternatives.
Disclosure and other filing requirements
The University is required to provide the following filings:
- Tax Forms – Tax-exempt debt obligation issuers are required to file the 8038 series of IRS forms (8038, 8038-G, 8038-T, and 8038-R) in accordance with applicable federal law.
- Arbitrage Certificates – Within five years of the anniversary of the debt issue to close out the issue, the University, must calculate any arbitrage on the debt in a final accounting, and make any required rebate payment.
The Office of Treasury Management is responsible for ensuring that such filings are made.
In connection with the issuance of tax-exempt bonds the University enters into continuing disclosure agreements (“CDAs”). These are required, not by the Tax Rules, but by a rule of the United States Securities and Exchange Commission that requires the University’s bond underwriters to require the execution of a CDA in connection with sale of bonds to the public. The CDAs require the University to file certain annual financial and operating information with the Electronic Municipal Market Access System (“EMMA.”) maintained by the Municipal Securities Rulemaking Board. EMMA permits bond investors to access the information to assess the University’s financial position. The CDAs also require the University to disclose through EMMA certain specified events (“event disclosure”) such as bond defaults.
The Office of Treasury Management is responsible for making all filings required by CDAs, and any events affecting such filings should be reported to the Office of Treasury Management.
It is the University’s policy to retain all records relating to tax-exempt bond financings for the entire term of the bond issue (typically, up to 40 years) plus any refunding bonds, plus three years. This policy supersedes any other documented retention policies at the University to the extent of any inconsistency. Generally, records refer to all documents, agreements, reports, accounts and certifications relating to the:
- Issuance of tax-exempt bonds
- Investment of bond proceeds
- Expenditure and allocation of bond proceeds
- Use of debt-financed property
- Disclosure and other filing requirements
Specific departments are responsible for the following:
The Office of Treasury Management – is responsible for maintaining records relating to the issuance of the University’s tax-exempt bonds, the investment of bond proceeds, the responses to the annual private use questionnaire with a conclusion as to compliance with the Private Use limitations, and the University’s annual continuing disclosures.
Financial Services – is responsible for maintaining records on the expenditure and allocation of bond proceeds including construction contracts, vendor invoices, payments and requisitions. Financial Services will also retain the audited financial statements and reports of any prior IRS examinations of University or bond financings.
The unit responsible for service contracts, leases, and other pertinent contracts are responsible for maintaining records relating to Private Use. Units responsible include but are not limited to the following:
University Research Administration (URA) – is responsible for maintaining records relating to all research contracts.
Facilities Services – is responsible for space management, leases, and management contracts.
Commercial Real Estate Operations (CREO) – is responsible for leases and management or service contracts.
Payroll, Procurement and Payment Services (PPPS) (a unit within Financial Services) – is responsible for leases and management and service contracts.
Campus and Student Life (CSL) – is responsible for leases, management or service contracts, and short-term or periodic rentals.
Any unit that leases or rents its space is responsible for that lease.
The Office of Treasury Management in consultation with the Offices of Legal Counsel and Financial Services will develop training materials and facilitate training seminars for employees in departments that are impacted by this policy. These offices will also be available to answer relevant questions as needed.