City of Tucson, Ariz. v. C.I.R., No. 82-2187

CourtUnited States Courts of Appeals. United States Court of Appeals (District of Columbia)
Writing for the CourtBefore ROBINSON, Circuit Judge, and WRIGHT and MacKINNON; SPOTTSWOOD W. ROBINSON, III; J. SKELLY WRIGHT
Citation820 F.2d 1283
Parties, 60 A.F.T.R.2d 87-5018, 56 USLW 2024, 87-1 USTC P 9360 CITY OF TUCSON, ARIZONA, Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
Docket NumberNo. 82-2187
Decision Date24 September 1987

Page 1283

820 F.2d 1283
261 U.S.App.D.C. 104, 60 A.F.T.R.2d
87-5018, 56 USLW 2024,
87-1 USTC P 9360
CITY OF TUCSON, ARIZONA, Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE, Appellee.
No. 82-2187.
United States Court of Appeals,
District of Columbia Circuit.
Argued March 28, 1983.
Decided June 12, 1987.
As Amended on Denial of Rehearing Sept. 24, 1987.

Page 1284

Appeal from an Order of the United States Tax Court (Tax Court No. 3889-80B).

Charles E. James, Jr., Phoenix, Ariz., for appellant.

Jay Miller, Atty., Dept. of Justice, of the Bar of the Supreme Court of the State of Michigan, pro hac vice, by special leave of Court, with whom Glenn L. Archer, Jr., Asst. Atty. Gen., and Michael L. Paup and Richard Farber, Attys., Dept. of Justice, Washington, D.C., were on brief, for appellee. L. Michael Wachtel, Counsel, Internal Revenue Service, Washington, D.C., also entered an appearance for appellee.

David H. Nelson, was on brief, for City of Phoenix, Arizona, amicus curiae, urging reversal.

Sidney G. Leech and Herman B. Rosenthal, Baltimore, Md., were on brief, for Nat. Ass'n of Bond Lawyers, amicus curiae, urging reversal.

Before ROBINSON, Circuit Judge, and WRIGHT and MacKINNON, Senior Circuit Judges.

Opinion for the Court filed by Circuit Judge ROBINSON.

Dissenting opinion filed by Senior Circuit Judge WRIGHT.

SPOTTSWOOD W. ROBINSON, III, Circuit Judge:

The City of Tucson, Arizona, challenges a regulation of the Department of the Treasury on the ground of incompatibility with the statutory proscription it purports to implement. The regulation 1 provides that sinking funds established by state and local governments for payment of principal or interest on their bonds are subject to the yield restriction imposed by Section 103(c) of the Internal Revenue Code. 2 Each security in an issue covered by that section is classified as an "arbitrage bond," the interest on which does not enjoy any tax-exempt status as a municipal obligation. The United States Tax Court upheld the regulation. 3

We find that neither the statutory text nor the legislative scheme sustains the Department's interpretation of Section 103(c).

Page 1285

We therefore reverse the Tax Court's decision and set aside the questioned regulation.
I

Section 103(a)(1) of the Internal Revenue Code confers a general exclusion of interest on municipal bonds from gross income for purposes of federal taxation. 4 This concession has created a separate financial market in which state and local governments can borrow at interest rates significantly below those featured by taxable obligations. 5 While the interest differential undoubtedly is integral to a congressional effort to enhance governmental capacity to finance public works, 6 it has also afforded to issuers of municipal bonds an opportunity to pursue purely monetary goals at the expense of the animating legislative policy. The exclusion has enabled state and local governments to market their bonds at low rates of interest and use the proceeds to purchase taxable securities providing comparatively higher yields. Instead of providing funds for public improvements, municipal bond issues thus could be used simply to garner profits from the disparity in interest rates. Serving in this fashion as entrepreneurial vehicles for governmental issuers, municipal securities functioned as arbitrage bonds, in derogation of the legislative intent. 7

Responsively to the prevalence of this practice, Congress enacted, as part of the Tax Reform Act of 1969, a provision denying tax exclusion of interest on municipal bond issues the proceeds of which expectably would produce arbitrage profits. 8 Codified as Section 103(c)(2) of the Internal Revenue Code, that provision expressly defines a non-exempt "arbitrage bond" as

any obligation which is issued as part of an issue all or a major portion of the proceeds of which are reasonably expected to be used directly or indirectly--

(A) to acquire securities ... or obligations ... which may be reasonably expected at the time of issuance of such issue, to produce a yield over the term of the issue which is materially higher ... than the yield on obligations of such issue, or

(B) to replace funds which were used directly or indirectly to acquire securities or obligations described in subparagraph (A). 9

While not designed to cover all transactions in which municipal issues could serve to some extent as investment conduits, 10 Section 103(c)(2) does curtail the most pervasive and serious abuses by effecting a "mechanical test" 11 for identification of municipal securities actually functioning as arbitrage bonds. 12

Page 1286

The focal point of the case at bar is a regulation by the Department of the Treasury 13 purportedly pursuant to its authority to "prescribe such regulations as may be necessary to carry out the purposes of [Section 103(c) ]." 14 That regulation undertakes to implement the statutory provision classifying as arbitrage bonds state or local issues producing proceeds "all or a major portion of" which "are reasonably expected to be used directly or indirectly ... to replace funds which were used directly or indirectly to acquire" instruments offering a materially higher yield. 15 The regulation specifies that amounts held in sinking funds to be used to pay principal or interest on municipal bonds are to be deemed "proceeds of the issue." 16 Accordingly, investment of such funds in higher-yielding securities pending the occasion to discharge principal and interest on the bonds issued would transform them into nonexempt arbitrage bonds.

The validity of this regulation is the sole question on appeal. The City of Tucson issued four series of general obligation bonds, and proposed to issue a fifth, to finance various public works in obedience to the mandate of a special bond referendum. 17 The proceeds of each issue have been and would be expended solely for public improvements, 18 and principal and

Page 1287

interest on the first, third, and fifth series would be paid from a common sinking fund. 19 As required by state law, the City levies annually an ad valorem property tax, from which payments are made annually into the sinking fund. 20 The City candidly acknowledges, however, an intent to invest the tax revenues placed in the sinking fund in higher-yielding securities until needed for debt service on its own issues, 21 and therein lies the problem. The regulation implicated here, while in terms inapplicable to the already-issued first and third series, would subject to Section 103(c)'s yield restriction all proceeds from future issues utilizing the sinking fund. 22 For this reason, the City petitioned the Tax Court for a judgment declaring the regulation invalid as an impermissible extension of the arbitrage-bond provision of Section 103(c), 23 and from the Tax Court's decision upholding the sinking fund regulation the City took this appeal. 24
II

The standard governing our review of the regulation under attack is well established. A treasury regulation commands significant judicial deference as a construction of a statute by the authority entrusted with its administration, 25 especially when, as here, the statute so construed itself contains an express grant of rulemaking power. 26 The regulation must

Page 1288

be sustained if it "implement[s] the congressional mandate in some reasonable manner;" 27 it may be nullified only if "unreasonable and plainly inconsistent" with that mandate. 28

We emphasize, however, that these principles, while providing impetus for judicial validation of disputed regulations, do not give the Treasury Department carte blanche in interpreting the tax laws. As the Supreme Court has put it, the Department sets "the framework for judicial analysis; it does not displace it," 29 and when we "can measure the Commissioner's interpretation against a specific provision of the Code, we owe the interpretation less deference" than it would otherwise command. 30 Courts routinely have subjected administrative regulations to close scrutiny on review, annulling those that are incompatible with the underlying statute or otherwise unreasonable, including those attempting to "enlarge the scope of the statute." 31 Mindful of these prescriptions, we turn to the issue presented.

III A.

The Department's sinking fund regulation incorporates an expansive reading of the statutory replacement theory it supposedly implements. Under Section 103(c)(2)(B), a municipal bond issue forfeits its tax exclusion if the issuer uses all or a major portion of the proceeds therefrom to "replace" funds used earlier to acquire higher-yielding securities. 32 Prototypically, a replacement occurs when the issuer places in an investment fund monies that otherwise would be dedicated to a discrete public use, and then channels the proceeds of its bond issue into the void created by the diversion. Section 103(c)(2)(B) endeavors to eliminate this thinly veiled method of circumventing the prohibition on arbitrage. The regulation here assailed, however, reshapes the statutory command and extends it far beyond these contours. It theorizes that proceeds of a municipal bond issue, in whatever manner actually used, "replace" monies, from whatever source derived, deposited in a sinking fund that will be used to pay principal or interest on the bonds. 33 The question whether this formulation is faithful to the replacement concept embodied in Section 103(c)(2)(B) is the crux of this case.

Courts attribute to nontechnical statutory words their "known and ordinary signification." 34 This longstanding guide to

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statutory construction assumes special stature with respect to revenue laws in general 35 and Section 103(c) in particular, 36 and we find it dispositive here. 37 As ordinarily used and comprehended, "replace" is equated with such expressions "to take the place of," "to serve as a substitute for or successor of," and "to supplant." 38 The sinking fund...

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3 practice notes
  • Estate of Wood v. C.I.R., No. 89-2366
    • United States
    • United States Courts of Appeals. United States Court of Appeals (8th Circuit)
    • October 10, 1990
    ...See Yellow Freight Sys., Inc. v. United States, 538 F.2d 790, 795-96 (8th Cir.1976); see also City of Tucson, Ariz. v. Commissioner, 820 F.2d 1283, 1287-88 (D.C.Cir.1987) (giving substantial deference to regulation). There is no question that the estate's return was not delivered to the IRS......
  • Nalle v. C.I.R., No. 94-40661
    • United States
    • United States Courts of Appeals. United States Court of Appeals (5th Circuit)
    • June 20, 1995
    ...at 367 (holding that regulation amended statute because it altered the scope of the statute). 12 See also City of Tucson v. Commissioner, 820 F.2d 1283, 1290 (D.C.Cir.1987) (rejecting regulation that "forged, not a reasonable implementation of the legislative mandate, but rather an imp......
  • American Dental Ass'n v. Shalala, No. 92-5038
    • United States
    • United States Courts of Appeals. United States Court of Appeals (District of Columbia)
    • August 27, 1993
    ...have distinguished persons from entities in their "known and ordinary signification[s]." City of Tucson v. Commissioner, 820 F.2d 1283, 1288 (D.C.Cir.1987) (quoting Old Colony R.R. v. Commissioner, 284 U.S. 552, 560, 52 S.Ct. 211, 213, 76 L.Ed. 484 (1932)); see also Wolverine Powe......
3 cases
  • Estate of Wood v. C.I.R., No. 89-2366
    • United States
    • United States Courts of Appeals. United States Court of Appeals (8th Circuit)
    • October 10, 1990
    ...See Yellow Freight Sys., Inc. v. United States, 538 F.2d 790, 795-96 (8th Cir.1976); see also City of Tucson, Ariz. v. Commissioner, 820 F.2d 1283, 1287-88 (D.C.Cir.1987) (giving substantial deference to regulation). There is no question that the estate's return was not delivered to the IRS......
  • Nalle v. C.I.R., No. 94-40661
    • United States
    • United States Courts of Appeals. United States Court of Appeals (5th Circuit)
    • June 20, 1995
    ...at 367 (holding that regulation amended statute because it altered the scope of the statute). 12 See also City of Tucson v. Commissioner, 820 F.2d 1283, 1290 (D.C.Cir.1987) (rejecting regulation that "forged, not a reasonable implementation of the legislative mandate, but rather an imp......
  • American Dental Ass'n v. Shalala, No. 92-5038
    • United States
    • United States Courts of Appeals. United States Court of Appeals (District of Columbia)
    • August 27, 1993
    ...have distinguished persons from entities in their "known and ordinary signification[s]." City of Tucson v. Commissioner, 820 F.2d 1283, 1288 (D.C.Cir.1987) (quoting Old Colony R.R. v. Commissioner, 284 U.S. 552, 560, 52 S.Ct. 211, 213, 76 L.Ed. 484 (1932)); see also Wolverine Powe......

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