THE SHORT ANSWER
Under the federal arbitrage rules, replacement proceeds are amounts with a sufficiently direct nexus to a bond issue that they would have been used for its governmental purpose if bond proceeds had not been used for it. Treasury Regulation §1.148-1(c) names sinking funds and pledged funds as replacement proceeds, which brings them into gross proceeds and, outside temporary periods and the reserve fund and minor portion exceptions, subjects them to yield restriction.
Sinking funds and pledged funds count as bond proceeds when they meet the definition of replacement proceeds in Treasury Regulation §1.148-1(c)(1): amounts that have a sufficiently direct nexus to a bond issue or its governmental purpose that they would have been used for that purpose if bond proceeds had not been available.
Replacement proceeds are part of an issue's gross proceeds, so they sit inside the arbitrage rules alongside the proceeds of every other fund that holds bond proceeds.
Whether the amounts in a particular fund meet the definition is fact-specific, and bond counsel makes that determination for a given issue.
What are replacement proceeds?
Replacement proceeds are amounts that have a sufficiently direct nexus to an issue or its governmental purpose that they would have been used for that purpose if bond proceeds had not been, under Treasury Regulation §1.148-1(c)(1).
The definition matters because of what it feeds: Treasury Regulation §1.148-1(b) defines gross proceeds as any proceeds and replacement proceeds of an issue, and proceeds covers sale proceeds, investment proceeds and transferred proceeds.
The regulation then names categories of replacement proceeds: sinking funds, pledged funds and other replacement proceeds, and a negative pledge is one form of pledged fund.
| Amount the regulation names | What the definition says | Where |
|---|---|---|
| Sinking fund | A debt service, redemption, reserve, replacement or similar fund, to the extent reasonably expected to be used to pay principal or interest on the issue | §1.148-1(c)(2) |
| Pledged fund | Any amount directly or indirectly pledged to pay principal or interest on the issue | §1.148-1(c)(3)(i) |
| Pledged fund: indirect pledge | A pledge to a guarantor of the issue | §1.148-1(c)(3)(i) |
| Pledged fund: negative pledge | An agreement to keep an amount at a set level for bondholders can itself be a pledge, unless an exception applies | §1.148-1(c)(3)(ii) |
Mere availability or preliminary earmarking of amounts for a governmental purpose does not in itself establish a sufficient nexus to cause those amounts to be replacement proceeds.
A second and different definition applies on the advisory side: SEC Rule 15Ba1-1(m)(1) treats proceeds of municipal securities as including sale proceeds, investment income, and pledged funds such as reserves and sinking funds held under the bond documents, and those amounts stop being proceeds when they are spent on the authorized purposes.
The SEC definition serves the municipal advisor rules and differs from the tax definitions in Treas. Reg. §1.148-1, so the two are not interchangeable.
Which funds are sinking funds?
Treasury Regulation §1.148-1(c)(2) defines a sinking fund as a debt service fund, redemption fund, reserve fund, replacement fund, or any similar fund, to the extent reasonably expected to be used directly or indirectly to pay principal or interest on the issue.
The definition turns on the extent of reasonably expected use rather than on a fund's name: it applies to the extent the amounts are reasonably expected to be used directly or indirectly to pay principal or interest on the issue.
The closing phrase, or any similar fund, extends the list beyond the four fund types named first.
Because reserve funds are on the list, a fund held to cure shortfalls in debt service sits within the definition to the extent it is reasonably expected to be used to pay principal or interest on the issue.
How a bona fide debt service fund is defined is the subject of the debt service fund page, and investing a reserve fund is covered on the debt service reserve fund page.
What are pledged funds and negative pledges?
A pledged fund is any amount that is directly or indirectly pledged to pay principal or interest on the issue, a pledge to a guarantor of the issue is an indirect pledge, and an agreement to keep an amount at a set level for bondholders can itself be a pledge, under Treasury Regulation §1.148-1(c)(3).
An agreement to keep an amount at a set level for bondholders can itself be a pledge, which the regulation calls a negative pledge (§1.148-1(c)(3)(ii)).
The regulation provides two exceptions for negative pledges, under §1.148-1(c)(3).
A negative pledge does not count if the issuer can grant superior rights in the amount.
It also does not count if the amount does not exceed reasonable needs, is tested no more often than every 6 months, and can be spent freely subject only to replenishment by the next test date, with all three conditions met.
Whether a covenant in a given set of bond documents is a negative pledge within the definition, and whether an exception applies, is a determination for bond counsel.
The bond indenture page covers the funds an indenture establishes and the permitted investments clause that states the instruments in which proceeds may be invested under the bond contract.
What do replacement proceeds mean for investing a fund?
Once amounts are replacement proceeds, they are part of gross proceeds, so the yield restriction rules apply to the fund's investments outside temporary periods and the reserve fund and minor portion exceptions.
For investments in a refunding escrow or for investments allocable to replacement proceeds, Treasury Regulation §1.148-2(d)(2)(ii) provides that materially higher means one-thousandth of 1 percentage point.
For most investments, a yield more than one-eighth of 1 percentage point above the bond yield is materially higher, under §1.148-2(d)(2)(i).
Program investments carry a 1.5 percentage point standard, qualified student loans that are program investments carry 2 percentage points, and tax-exempt bonds that are not investment property carry no yield limit (§1.148-2(d)(2)(iii)-(v)).
The temporary periods for these amounts differ by fund: Treasury Regulation §1.148-2(e)(5)(i) gives amounts in a bona fide debt service fund a 13-month temporary period, and §1.148-2(e)(5)(ii) gives other replacement proceeds generally 30 days from the date they first become replacement proceeds.
If only part of a fund is a bona fide debt service fund, only that part gets the 13 months.
The complete set of temporary periods is on the temporary periods page.
| Consequence for replacement proceeds | Rule | Where |
|---|---|---|
| Yield standard outside the exceptions | Materially higher means one-thousandth of 1 percentage point above the bond yield | §1.148-2(d)(2)(ii) |
| Temporary period, bona fide debt service fund | 13 months | §1.148-2(e)(5)(i) |
| Temporary period, other replacement proceeds | Generally 30 days from when they first become replacement proceeds | §1.148-2(e)(5)(ii) |
The rebate spending exceptions use modified definitions of gross proceeds, which the spending exceptions page covers.
The reason for the limits is statutory: under 26 U.S.C. 148(a), a bond is an arbitrage bond if any portion of the issue's proceeds is reasonably expected, at the time of issuance, to be used directly or indirectly to acquire higher yielding investments or to replace funds used to acquire them, and intentional use of proceeds that way has the same result.
Section 103(a) of the Internal Revenue Code excludes interest on state or local bonds from gross income, and section 103(b)(2) provides that the exclusion does not apply to any arbitrage bond within the meaning of section 148.
Earning a higher yield is not by itself the test, because the rules permit arbitrage in several circumstances, including temporary periods, reserve funds and the minor portion exception.
Whether interest on a particular issue remains excluded from gross income depends on all of sections 103 and 141 through 150, and bond counsel and tax counsel make that determination.
These rules are old enough to have shaped the market's infrastructure: Treasury established the SLGS program in 1972 as the result of 1969 federal legislation that restricted state and local governments from earning arbitrage profits on bond proceeds.
mGIC offers a free reinvestment review of existing bond-proceeds investments, covering a fund's objectives, permitted investments, draw schedule and market conditions.
To start a conversation about a specific fund, contact mGIC through the contact page.
Final determinations about whether amounts are replacement proceeds, and about how an issue's funds may be invested, belong to bond counsel and tax counsel.
Frequently asked questions
Is a debt service reserve fund a sinking fund?
Treasury Regulation §1.148-1(c)(2) includes reserve funds in the sinking fund definition, to the extent the fund is reasonably expected to be used to pay principal or interest on the issue. The extent language matters, because the definition reaches only the amounts expected to service the bonds.
Do the SEC and tax definitions of proceeds match?
No. SEC Rule 15Ba1-1(m)(1) defines proceeds of municipal securities to include sale proceeds, investment income and pledged funds such as reserves and sinking funds, and the amounts stop being proceeds when spent on the authorized purposes. That definition serves the municipal advisor rules and differs from the tax definitions in Treas. Reg. §1.148-1.
When does the 30-day temporary period for replacement proceeds begin?
Under Treasury Regulation §1.148-2(e)(5)(ii), other replacement proceeds get 30 days from the date they first become replacement proceeds. Amounts in a bona fide debt service fund get a 13-month temporary period instead, under §1.148-2(e)(5)(i).
Does the name of a fund control whether it holds replacement proceeds?
The tax definitions turn on expected use and on pledges, not on the account's label. Whether amounts in a particular fund are replacement proceeds is fact-specific, and bond counsel makes that determination.
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.
