THE SHORT ANSWER
A temporary period is the window in which tax-exempt bond proceeds may be invested above the bond yield without making the bonds arbitrage bonds. Capital project proceeds generally get 3 years if three tests are met, working capital and bona fide debt service funds get 13 months, and refunding proceeds get 30 days, or 90 days for a current refunding.
A temporary period is the length of time federal arbitrage rules let an issuer invest bond proceeds above the bond yield while it waits to spend them.
Section 148(c)(1) of the Internal Revenue Code says a bond is not an arbitrage bond solely because its proceeds are invested in higher yielding investments for a reasonable temporary period until they are needed.
How long that period lasts depends on what the proceeds are for, and it shapes how an issuer can invest a construction fund in its first years.
What is a temporary period?
A temporary period is an exception to yield restriction, the rule that otherwise caps the yield on invested proceeds at the bond yield.
Outside a temporary period, Treasury Regulation §1.148-2(d)(2)(i) treats an investment yield as "materially higher" than the bond yield if it exceeds it by more than one-eighth of 1 percentage point.
For refunding escrows and replacement proceeds, §1.148-2(d)(2)(ii) sets a much tighter line: one-thousandth of 1 percentage point.
Temporary periods are measured against the issuer's reasonable expectations on the issue date, which Treasury Regulation §1.148-2(b) requires an issuer officer to certify in good faith in most issues.
| Proceeds | Temporary period | Where the rule is |
|---|---|---|
| Capital projects (three tests met) | 3 years from the issue date | §1.148-2(e)(2)(i) |
| Capital projects with substantial construction, certified | 5 years | §1.148-2(e)(2)(ii) |
| Working capital expected to be spent within 13 months | 13 months | §1.148-2(e)(3)(i) |
| Bona fide debt service fund | 13 months | §1.148-2(e)(5)(i) |
| Investment proceeds | 1 year from receipt | §1.148-2(e)(6) |
| Pooled financing, before the loans are made | 6 months | §1.148-2(e)(4)(i) |
| Refunding proceeds, general rule | 30 days | §1.148-9(d)(2)(i) |
| Current refunding proceeds | 90 days | §1.148-9(d)(2)(ii) |
| Other gross proceeds not otherwise eligible | 30 days | §1.148-2(e)(7) |
How does the 3-year capital projects period work?
Net sale proceeds and investment proceeds reasonably expected to be spent on capital projects get a 3-year temporary period from the issue date if the issuer reasonably expects to meet three tests, under Treasury Regulation §1.148-2(e)(2)(i).
The expenditure test requires that at least 85% of net sale proceeds be allocated to capital project expenditures by the end of the 3-year period.
The time test requires that within 6 months of the issue date the issuer incur a substantial binding obligation to a third party to spend at least 5% of net sale proceeds on the project.
An obligation subject to contingencies within the issuer's or a related party's control does not count as binding for the time test.
The due diligence test requires that completing the project and allocating the proceeds go forward with due diligence.
For projects with substantial construction expenditures, §1.148-2(e)(2)(ii) substitutes a 5-year period when both the issuer and a licensed architect or engineer certify that the longer period is necessary.
The capital projects period does not apply to refunding issues, which have their own rules in §1.148-9.
Because the 3-year clock starts on the issue date, the investment term for a construction fund can be built around the project's draw schedule and the end of the period.
What are the 13-month periods for working capital and debt service?
Proceeds reasonably expected to be spent on working capital expenditures within 13 months get a 13-month temporary period from the issue date, under Treasury Regulation §1.148-2(e)(3)(i).
Amounts in a bona fide debt service fund also qualify for a 13-month temporary period under §1.148-2(e)(5)(i).
If only part of a fund qualifies as a bona fide debt service fund, only that part gets the 13 months.
Other replacement proceeds generally get 30 days from the date they first become replacement proceeds, under §1.148-2(e)(5)(ii).
Investment proceeds, meaning the earnings on invested proceeds, generally get a 1-year temporary period from receipt under §1.148-2(e)(6).
How do the refunding temporary periods work?
Proceeds of a refunding issue, other than transferred proceeds, generally get a 30-day temporary period under Treasury Regulation §1.148-9(d)(2)(i).
Proceeds of a current refunding issue get 90 days instead, or at most 30 days if the refunding issue's original term is 270 days or less, under §1.148-9(d)(2)(ii).
Transferred proceeds follow separate temporary period rules in §1.148-9(d)(2)(iii).
Because these windows are short, the one-thousandth of a percentage point standard for escrows comes into play early in a refunding escrow.
What happens when a temporary period ends?
When a temporary period ends, any proceeds still unspent become subject to yield restriction and generally may not be invested at a yield materially higher than the bond yield.
Treasury Regulation §1.148-5(b)(3) allows investments held past a temporary period to be treated as purchased at fair market value at the end of the period for yield-restriction purposes.
An issuer has two broad ways to meet yield restriction after the period ends: invest at or below the permitted yield, or, for eligible investments, make yield reduction payments.
Under §1.148-5(c)(1), a yield reduction payment is an amount paid to the United States that is treated as reducing the investment's yield.
Yield reduction payments are available only for the categories listed in §1.148-5(c)(3), which include nonpurpose investments of proceeds that qualified for the capital project, working capital, pooled financing or investment-proceeds temporary periods.
A temporary period also does not settle the rebate question.
IRS Publication 5271 notes that even when the yield restriction rules allow an issuer to invest above the bond yield, the rebate rules may require it to pay those arbitrage earnings to the U.S. Treasury unless a rebate exception applies.
Why temporary periods shape the investment decision
The temporary period sets the window in which an issuer may earn above the bond yield, so it drives the term and withdrawal terms of a construction fund investment.
An investment that runs past the end of the period, or a project that spends more slowly than expected, can leave proceeds that must then be yield restricted.
Before choosing between a guaranteed investment contract, a full-flex repurchase agreement or a structured Treasury portfolio, it helps to map the expected draws against the temporary period and the spending exceptions the issue may use.
If you want an independent look at how your current investments line up with your temporary periods, mGIC can check your proceeds against the rules as part of a no-obligation reinvestment review.
Final determinations about which temporary periods apply to an issue belong to bond counsel and tax counsel.
Frequently asked questions
Does a temporary period also exempt the earnings from rebate?
No. A temporary period is an exception to yield restriction only. IRS Publication 5271 notes that even when the yield restriction rules allow an issuer to invest above the bond yield, the rebate rules may still require those earnings to be paid to the U.S. Treasury unless a rebate exception applies.
Can an issuer give up its temporary period?
Yes. Treasury Regulation §1.148-2(h) lets an issuer elect, on or before the issue date, to waive the right to invest at higher yields during a temporary period. Whether a waiver makes sense for a given issue is a question for bond counsel.
When does a project need the 5-year temporary period instead of 3 years?
Under §1.148-2(e)(2)(ii), the 5-year period is available for capital projects with substantial construction expenditures when both the issuer and a licensed architect or engineer certify that the longer period is necessary.
Are temporary periods judged on what actually happens or on expectations?
On expectations. Treasury Regulation §1.148-2(b) judges arbitrage status on the issuer's reasonable expectations as of the issue date, which an issuer officer certifies in good faith in most issues.
Sources
This page is general educational information about municipal finance and federal and state rules as of the date shown. It is not legal, tax or investment advice, and it is not a recommendation about any particular investment. Product availability, legality and suitability depend on the issuer, jurisdiction, governing documents and transaction-specific facts. Final legal and tax determinations remain with the issuer's bond counsel, tax counsel and other advisors.
