Harbor Bancorp & Subsidiaries v. Commissioner of Internal Revenue, 105 T. C. 260 (1995)

Tax-exempt bond proceeds must be used for their intended governmental purpose; misuse for arbitrage purposes results in the loss of tax-exempt status.

Summary

The U. S. Tax Court ruled that interest from bonds issued by the Riverside County Housing Authority to finance low-income housing was taxable because the proceeds were misused for arbitrage. The bonds were sold to fund two housing projects, but the proceeds were diverted to purchase higher-yielding investments, violating IRS arbitrage regulations. The court held that the bonds were issued on February 20, 1986, not December 31, 1985, as claimed by petitioners, and thus subject to post-1985 arbitrage rules. The Housing Authority failed to rebate the arbitrage profits to the U. S. government, leading to the bonds being treated as taxable arbitrage bonds.

Facts

The Housing Authority of Riverside County issued bonds to finance low-income housing projects, Whitewater and Ironwood. The bonds were purchased by Harbor Bancorp and the Keiths, who received interest they believed was tax-exempt. However, the bond proceeds were diverted by intermediaries to purchase Guaranteed Investment Contracts (GICs) that yielded higher returns than the bonds. These GICs were used to secure the bonds’ repayment rather than funding the housing projects, resulting in arbitrage profits.

Procedural History

The Commissioner determined that the interest on the bonds was taxable due to the arbitrage issue and notified the Housing Authority. The Housing Authority refused to pay the required arbitrage rebate, leading to a dispute. The case was heard by the U. S. Tax Court, which found for the Commissioner, ruling that the bonds were taxable arbitrage bonds.

Issue(s)

1. Whether the bonds were issued on December 31, 1985, or February 20, 1986, affecting the applicability of post-1985 arbitrage rules.
2. Whether the misuse of bond proceeds to purchase higher-yielding investments constituted arbitrage under IRS regulations.
3. Whether the failure to rebate arbitrage profits to the U. S. government resulted in the loss of the bonds’ tax-exempt status.

Holding

1. No, because the bonds were not issued until February 20, 1986, when actual funds were transferred, making them subject to post-1985 arbitrage rules.
2. Yes, because the bond proceeds were used to purchase GICs, which were nonpurpose investments yielding higher returns than the bonds, thus constituting arbitrage.
3. Yes, because the Housing Authority failed to rebate the arbitrage profits to the U. S. government as required, resulting in the bonds being treated as taxable arbitrage bonds.

Court’s Reasoning

The court determined that the bonds were issued on February 20, 1986, when actual funds were transferred, not on December 31, 1985, as claimed by the petitioners. This ruling subjected the bonds to the post-1985 arbitrage rules under Section 148(f) of the Internal Revenue Code. The court found that the bond proceeds were used to purchase GICs, which were nonpurpose investments that produced higher yields than the bonds, creating arbitrage profits. The Housing Authority’s failure to rebate these profits to the U. S. government resulted in the bonds being treated as taxable arbitrage bonds. The court emphasized that the misuse of bond proceeds by intermediaries was irrelevant to the legal analysis, as the focus was on the actual use of the proceeds and the issuer’s failure to comply with arbitrage regulations.

Practical Implications

This decision underscores the importance of ensuring that tax-exempt bond proceeds are used for their intended governmental purpose. Bond issuers must closely monitor the use of proceeds to prevent arbitrage, as failure to do so can result in the loss of tax-exempt status. The ruling also highlights the need for bondholders to be aware of the potential risks associated with tax-exempt bonds, as they may be held liable for taxes if the issuer fails to comply with IRS regulations. Subsequent cases have reinforced the principles established in this case, emphasizing the strict application of arbitrage rules to tax-exempt bonds.