Changing tax-exempt government securities to special 90-day certificates of debt doesn't violate the rule for keeping enough money invested for long-term expenses, if certain conditions are met, according to a recent released Office of Chief Council (OCC) memorandum (202326019), issued by the Internal Revenue Service (IRS).
Conversions of these government securities - issued pursuant to the Demand Deposit State and Local Government Series program (i.e. demand deposit SLGS) - to special 90-day certificates of indebtedness (i.e. special 90-day C of I) are governed under Treasury Regulation (Treas. Reg.) section 1.148-1(c)(4)(ii)(C).
Additionally, the OCC memorandum clarified that after such a conversion, an issuer's investment in demand deposit SLGS does not lose its status as a tax exempt bond under Treas. Reg. section 1.150-1(b) if the special 90-day C of I are reinvested in demand deposit SLGS when the issuance of demand deposit SLGS resumes.
Internal Revenue Code (IRC) section 103(a) says that interest earned from state or local bonds is generally not taxable. However, this exemption does not apply to interest earned from arbitrage bonds (as defined under IRC section 148), which are bonds issued with the intention of using the money to invest in higher-yielding investments. A safe harbor rule (under Treas. Reg. 1.148-1(c)(4)(ii)(C)) requires any money invested in eligible tax-exempt bonds (such as demand deposit SLGS) to be continuously invested.
If the money is held for up to 30 days before being reinvested in eligible tax-exempt bonds, it's still considered invested. However, if the money is held for longer than 30 days, the IRS Commissioner can allow an extension under certain circumstances (under Treas. Reg. section 1.148-10(g)).
Conversion of demand deposit SLGS to special 90-day certificates of indebtedness (C of I)
When demand deposit SGLS - meeting the requirements of the Treas. Reg. 1.148-1(c)(4)(ii)(C) safe harbor - were converted, the money that was available for investment was no longer invested in tax-exempt bonds. However, according to the OCC memorandum, the Commissioner could decide to treat the special 90-day C of I as demand deposit SLGS during the period when the issuance of demand deposit SLGS was suspended.
Conversion of demand deposit SLGS to special 90-day C of I replacement funds
Similarly, if replacement funds were invested in demand deposit SLGS to avoid investing in higher-yielding investments, and then converted to special 90-day C of I, the Commissioner could also treat the C of I as demand deposit SLGS during the period when the issuance of demand deposit SLGS was suspended.
Note: The IRS will occasionally release internal memoranda to request information between associate counsel and the IRS Office of Chief Counsel. These memoranda are similar to Private Letter Rulings (PLRs) in that they are provided to the public to help guide and advise tax practitioners on applicable rules and procedures through the eyes of the IRS. Like PLRs, internal memoranda should not be used or cited as precedent.