City of Columbus, Ohio v. C.I.R.

• Decision Date: 13 May 1997
• Docket Number: No. 96-1282,96-1282
• Citation: 112 F.3d 1201
• Parties: , 79 A.F.T.R.2d 97-2582, 97-1 USTC P 50,424 CITY OF COLUMBUS, OHIO, Appellant v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Appellee.
• Court: U.S. Court of Appeals — District of Columbia Circuit

Page 1201

112 F.3d 1201

324 U.S.App.D.C. 235, 79 A.F.T.R.2d 97-2582,

97-1 USTC P 50,424

CITY OF COLUMBUS, OHIO, Appellant v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Appellee.

No. 96-1282.

United States Court of Appeals District of Columbia Circuit.

Argued Feb. 24, 1997.

Decided May 13, 1997.

Appeal from the United States Tax Court (3301-95B).

David L. Miller, Washington, DC, argued the cause for appellant. With him on the briefs was David A. Rogers, Washington, DC.

Kenneth W. Rosenberg, Attorney, U.S. Department of Justice, Washington, DC, argued the cause for appellee. With him on the brief was Loretta C. Argrett, Assistant Attorney General, Washington, DC, and Richard Farber, Attorney, Cleveland, OH. Gary R. Allen, Attorney, Washington, DC, entered an appearance.

Before EDWARDS, Chief Judge, SENTELLE and RANDOLPH, Circuit Judges.

Opinion of the Court filed by Circuit Judge RANDOLPH.

RANDOLPH, Circuit Judge:

The City of Columbus, Ohio, issued short-term Bond Anticipation Notes to satisfy a financial obligation to the State of Ohio. Columbus intends to issue long-term bonds to refinance the currently outstanding Notes. The ultimate question in this appeal from the Tax Court is whether the city's proposed bonds would be "arbitrage bonds" within the meaning of § 148 of the Internal Revenue Code of 1986, as amended, a question of significance to the parties because interest on municipal bonds is exempt from taxation under § 103(a) of the 1986 Code, while interest on arbitrage bonds is not.

I

Columbus had been administering two unfunded pension funds for its police officers and firefighters. Then, in the mid-1960's, the State of Ohio created the Police and Firemen's Disability and Pension Fund, a statewide pension fund replacing the unfunded plans of municipalities with a fully-funded pension plan for police officers and firefighters. This State Fund assumed the pre-1967 pension liabilities of Ohio municipalities. State law required each municipality to transfer its liabilities and assets to the State Fund and then pay the State Fund the present value of the municipality's accrued unfunded pension liability. Columbus's bill came to $42,687,799. Municipalities had the option of satisfying their obligations to the State Fund immediately or over a period of time, with interest. Columbus chose the latter course and began making annual payments to the State Fund. After several changes in state law, the city wound up with a payment schedule imposing annual interest charges of 4.25% until the year 2035.

In 1993, Ohio offered municipalities the opportunity to prepay at a discount their obligation to the State Fund in a single, lump-sum payment. See OHIO REV.CODE ANN. § 742.30(C) (Anderson Supp.1995). The State Fund adopted a discount of 35%, allowing municipalities to satisfy their obligations by paying 65% of their outstanding principal balance. Thirty-six Ohio municipalities, including Columbus, accepted the offer. This reduced Columbus's obligation from $41,435,720 to $26,933,218. On January 31, 1994, Columbus paid the State Fund $27,304,720, an amount representing the city's discounted outstanding principal balance plus $371,502 in interest.

Columbus had contemplated financing this 1994 payment by issuing tax-exempt bonds, and asked the IRS for a ruling that the interest on its bonds would qualify for tax exemption under § 103 of the 1986 Code. In the meantime, Columbus had issued $27,300,000 in one-year Bond Anticipation Notes in January 1994. The Notes' proceeds were transferred to the State Fund to satisfy the lump-sum agreement. When (for reasons described next) the Assistant Chief Counsel of the Treasury issued a private letter ruling against the city, Columbus once again issued one-year Notes in 1995 to pay off the 1994 Notes. These Notes were set to mature on January 30, 1996. All the proceeds of the 1995 Notes were used to pay off the 1994 Notes. Columbus intends to continue in this manner, refinancing outstanding Notes with subsequent short-term issues, until there is a final judicial determination regarding the tax status of its proposed bonds. ¹ At that time, Columbus's plan is to issue long-term bonds either on a tax-exempt or taxable basis, and immediately use the bonds' proceeds to pay off outstanding Notes and associated expenses.

Columbus submitted its ruling request to the Internal Revenue Service seeking a determination that the assumed 6% interest, compounded semiannually, on its proposed long-term bonds would be excludable from the bondholders' gross income under § 103 of the 1986 Code. The private letter ruling against Columbus--that the proposed bonds would be arbitrage bonds and hence the interest on them would be included in the bondholders' gross income--rested mainly on a theory not raised in this appeal. The Assistant Chief Counsel noticed that the State Fund was earning 8.25% compounded annually on the money in the pension fund. Priv. Ltr. Rul. 95-09-035 (Mar. 3, 1995). On the other hand, the city's proposed bonds would yield 6%. The ruling stated that "the State Fund expected to be able to invest the amount of the prepayment of the City Liability at a yield that is materially higher than the yield on the issue of Proposed Bonds." Id. This constituted "arbitrage." No matter that two separate entities were involved, with one (the city) issuing the bonds and paying the "yield" on them, with the other (the State Fund) investing the proceeds and receiving the "yield" on those investments. There was, according to the ruling, no requirement "that investments must be owned or directly controlled by an issuer to be treated as proceeds of an issue." Id.

Columbus filed a petition in the Tax Court seeking a declaratory judgment that the interest on the proposed bonds would be tax-exempt. The Tax Court held that the proposed bonds would be "arbitrage" bonds within the meaning of § 148(a) of the 1986 Code. Without mentioning the theory of the private letter ruling, the court reasoned that Columbus's prepayment of its obligation to the State Fund at a discount produced the equivalent of a 7.57484% "yield" on its "investment," a materially higher "yield" than the 6% it would be paying on the proposed bonds. The 7.57484% figure represented the per annum rate at which the city would have had to invest the amount of its lump-sum payment to have received a stream of income equal to the installment payments it would otherwise have made to the State Fund. We will have more to say about the Tax Court's rationale in a moment.

II

Why the special rules about "arbitrage" bonds? The Internal Revenue Code had, for many years, excluded from gross income the interest taxpayers receive on state or local bonds. This enabled states and municipalities to issue tax-exempt bonds at interest rates favorable to them. These governmental entities also could, through so-called "arbitrage," reap returns at the expense of the federal treasury. A municipality could, for instance, issue tax-exempt bonds at 6% and then invest the proceeds in taxable securities yielding, say, 10%.1 B. BITTKER & L. LOKKEN, FEDERAL TAXATION OF INCOME, ESTATES, AND GIFTS p 15.5.1 (2d ed.1989). The arbitrage bond provisions of the 1986 Internal Revenue Code, like their counterparts in the Tax Reform Act of 1969, Pub.L. No.91-172, 83 Stat. 656, were designed to put a stop to this practice. See State of Washington v. Commissioner, 692 F.2d 128, 134 (D.C.Cir.1982).

While interest on state or local bonds remains generally exempt from federal taxation, § 103(b) of the 1986 Code renders the exemption inapplicable to any "arbitrage bond" within the meaning of § 148. An "arbitrage bond," as § 148(a) defines it, is

any bond issued as part of an issue any portion of the proceeds of which are reasonably expected (at the time of issuance of the bond) to be used indirectly or directly-- (1) to acquire higher yielding investments, or

(2) to replace funds which were used directly or indirectly to acquire higher yielding investments.

A "higher yielding investment" is, according to § 148(b)(1), "any investment property which produces a yield over the term of the issue which is materially higher than the yield on the issue." "Investment property" is defined in § 148(b)(2)(D) to include "any investment-type property."

Through a critical, but unchallenged Treasury regulation, "investment-type property" includes "a prepayment for property or services ... if a principal purpose for prepaying is to receive an investment return from the time the prepayment is made until the time payment otherwise would be made." Treas. Reg. § 1.148-1(b). The rulemaking notice proposing the prepayment regulation tells us almost nothing of its origins or of the problems it was meant to solve. 57 Fed.Reg. 53,046, 53,047 (1992). The private letter ruling in this case offered this brief explanation: "Prepayments contain a time value of money component, giving them a built-in investment return." Priv. Ltr. Rul. 95-09-035 (Mar. 3, 1995). As applied to the city and its prepayment, the explanation makes no sense. A prepayment can contain a time value of money component for the payee, but here the payee was the State Fund. As to payees or recipients of prepayments, the value to them lies in the adage: "A bird in the hand is worth two in the bush." In financial terms, cash today is worth more than cash in the future and investors would rather have the cash now so that they can increase its value over time. (Of course, other factors such as inflation and risk can decrease the value of money in the future.) See Motion Picture Ass'n of America, Inc. v. Oman, 969 F.2d 1154, 1157 (D.C.Cir.1992); Daniel I. Halperin, Interest in Disguise: Taxing the "Time Value of Money," 95 YALE L.J. 506 (1986). Thus, the private letter ruling's observations about the time value of money and the purpose of the prepayment regulation are pertinent to the State Fund, but not to Columbus. The financial...