State of Wash. v. C. I. R.

• Decision Date: 19 October 1982
• Docket Number: No. 82-1108,82-1108
• Citation: 692 F.2d 128
• Parties: , 82-2 USTC P 9631 STATE OF WASHINGTON v. COMMISSIONER OF INTERNAL REVENUE, Appellant.
• Court: U.S. Court of Appeals — District of Columbia Circuit

Page 128

692 F.2d 128

223 U.S.App.D.C. 404, 82-2 USTC P 9631

STATE OF WASHINGTON v. COMMISSIONER OF INTERNAL REVENUE, Appellant.

No. 82-1108.

United States Court of Appeals, District of Columbia Circuit.

Argued Sept. 10, 1982.

Decided Oct. 19, 1982.

Appeal from a Decision of the United States Tax Court (Tax Court No. 16153-79B).

Gilbert S. Rothenberg, Atty., Dept. of Justice, Washington, D.C., 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 the brief, for appellant.

Walter D. Haynes, Washington, D.C., with whom C. Willis Ritter and David L. Miller, Washington, D.C., were on the brief, for appellee.

Before ROBINSON, Chief Judge, and WRIGHT and WALD, Circuit Judges.

Opinion for the court filed by Circuit Judge J. SKELLY WRIGHT.

J. SKELLY WRIGHT, Circuit Judge:

The Commissioner of the Internal Revenue Service (IRS), appellant, seeks review of a Tax Court decision which held that the discount and issuance expenses incurred by the State of Washington, appellee, on a proposed sale of bonds can be considered in computing bond yield under Section 103(c)(2)(A) of the Internal Revenue Code (IRC). ¹ Because we find the Tax Court decision to be the correct interpretation of the statute, we affirm.

I. BACKGROUND

In April 1971, the State of Washington issued limited revenue bonds to finance the construction of public schools. ² These bonds bear semiannual interest rates ranging from six percent to eight percent, are redeemable beginning in 1986, and mature annually on May 1 of each year through 2001. Following issuance of these bonds, the State amended its constitution in November 1972 to authorize the State to pledge its full faith, credit, and taxing power to the payment of debt service on new bonds which otherwise would be payable only from the limited revenues pledged to outstanding bonds. Because bonds backed by the full faith and credit of the State are assigned higher credit ratings and can bear lower interest rates, the State decided to refund the outstanding limited revenue bonds with general obligation bonds. It could thereby reduce the cost of its debt service.

On December 5, 1978, the State authorized the issuance of approximately $15 million of general obligation bonds. Under the proposed issuance plan, the bonds would be sold by sealed bid at a public auction. They would be awarded to the bidder whose offer, taking into account the coupon rate and the price to be received, achieves the lowest net cost for the State. The proposed bonds would bear coupon rates ranging from four and three-quarters percent to five and five-eighths percent. The State anticipates that the refunding bonds would issue at 98.5 percent of par, and that the purchaser would resell the bonds to the public at 100 percent of par. However, the purchaser would acquire complete ownership of the bonds and would be under no obligation to the State to resell them. The State expects to incur approximately $40,000 in issuance expenses, including attorney fees, printing and delivery costs, and preparation and distribution costs. Since the outstanding bonds cannot be immediately redeemed and retired, the State also plans to invest the proceeds of the issuance in direct obligations of the United States. ³

As is the customary practice, the State requested the IRS to rule ⁴ that the bonds would not be "arbitrage bonds" within the meaning of the IRC and therefore that the interest paid to holders of its bonds would be exempt from taxation. ⁵ Under Section 103(c), the interest on state or municipal bonds will not be tax exempt if the issuer invests the receipts in taxable securities which produce a greater "yield," and thereby earns profits solely at the expense of the Federal Treasury. ⁶ Section 103(c)(2) provides, in pertinent part, that

the term "arbitrage bond" means 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 to produce a yield over the term of the issue which is materially higher (taking into account any discount or premium) than the yield on obligations of such issue[.]

In its request, the State asked the Commissioner to rule that the proposed issuance and reinvestment plan fell within the safe harbors of this section, and thus did not constitute taxable arbitrage bonds.

The State calculated Section 103(c)'s "yield" rate by taking into account both the discount and issuance expenses it would incur in selling the bonds. Treasury regulations provide that "the term 'yield' means that yield which when used in computing the present worth of all payments of principal and interest to be paid on the obligation produces an amount equal to the purchase price." Treas.Reg. Sec. 1.103-13(c)(1)(ii) (1978). ⁷ But applicable regulations also prohibit the inclusion of administrative costs and discount in the purchase price component of the yield calculation. See Treas.Reg. Sec. 1.103-12(d)(1) and (d)(2) (1978). Because of these latter regulations, the IRS determined that the issuance constituted arbitrage bonds. Therefore, the Commissioner denied the State's request for approval of its plan as a tax-exempt issuance.

The State responded by filing an action in the Tax Court for a declaratory judgment that its proposed issuance would not constitute "arbitrage bonds." ⁸ The Tax Court agreed with the State. It held that discount and issuance expenses were part of the cost of borrowing money, and that Congress had intended that all such costs be taken into account in determining whether "arbitrage profits" would be earned on investments of tax-free bond receipts. State of Washington v. Comm'r of Internal Revenue 7 T.C. 656 (1981). ⁹ The Commissioner appeals this judgment.

II. CONSISTENCY OF STATUTE AND REGULATIONS

Section 103(c)(6) specifically provides that "[t]he Secretary shall prescribe such regulations as may be necessary to carry out the purposes of this subsection." ¹⁰ The Tax Court, however, found that the regulations excluding administrative costs and discounts from the yield calculation (vis-a-vis the purchase price) were inconsistent with the statute and therefore exceeded the bounds of permissible administrative flexibility. ¹¹ The Commissioner advances three arguments in appealing this judgment: (1) that the Tax Court improperly gave the term "yield" two different meanings; (2) that the Tax Court failed to give effect to Congress' intent in enacting the arbitrage provisions; and (3) that the Commissioner's experience in administering the arbitrage provisions illustrates the reasonableness and necessity of his regulations. We examine each argument separately.

A. Interpretation of Term "Yield"

As previously noted, Section 103(c)(2) deems bonds to be "arbitrage bonds" if the proceeds will produce

a yield over the term of the issue which is materially higher (taking into account discount or premium) than the yield on * * * [the] obligation [itself] * * *.

The Tax Court held that while the language of Section 103(c)(2) is far from clear, it seemingly requires a comparison between the rate of return the State as bond issuer earns on its investment in U.S. Treasury certificates and the rate of return the first purchaser earns on the State's bonds. 77 T.C. at 669. The Tax Court's position essentially is that the term "yield" refers to the issuer's--the state government's--cost of money: the cost of refunding one issue and of purchasing another. Since discount and issuance expense are part of the cost of money, the Tax Court concluded that the State should be able to include them in the yield calculation.

The Commissioner contends, however, that the Tax Court applied two different interpretations of the term "yield"--the first referring to the rate of return to the State as holder of federal obligations, and the second referring to the cost to the State as issuer of its own bonds. Giving two meanings to the same term in the same section violates a cardinal rule of statutory construction, and the Commissioner therefore urges that the Tax Court be reversed. The Commissioner would instead require states and municipalities to calculate yield in terms of the rate of return to the respective holders: the purchasing public and the issuer. This calculation, he contends, would give consistent meaning to the term "yield" in Section 103(c)(2).

1. Discount.

The State and the Tax Court present the better construction of the statutory term. "Yield" has a common and accepted meaning: it is the economic return on a debt instrument. THE AMERICAN COLLEGE DICTIONARY 1415 (1962); 1 S. LEVINE, FINANCIAL ANALYST'S HANDBOOK 339 (1975); G. MUNN & F. GARCIA, ENCYCLOPEDIA OF BANKING AND FINANCE 948 (7th ed. 1972). The Treasury regulation that defines the term "yield" accepts this common meaning by defining it to be the rate "which, when used in computing the present worth of all payments of principal and interest to be paid on the obligation, produces an amount equal to the purchase price." Treas.Reg. Sec. 1.103-13(c)(1) (1978). "Yield" therefore changes whenever a different purchase price is paid. But whenever a bond is sold--from state to underwriter or from underwriter to public--a different purchase price is paid, and a different yield must result. Yield can be consistently determined only by using the purchase prices in the transactions to which the State was a party--the purchase price paid to the State for its bonds and the purchase price paid by the State for the U.S. Treasury certificates. It is the State that borrows money, and it is the State that buys Treasury certificates; only the State can earn arbitrage profits, and only the State can eliminate those profits by restricting the yield of its investment. By interpreting the relevant...