Qualified Zone Academy Bonds; Obligations of States and Political Subdivisions, 38767-38778 [E7-13665]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 72, Number 135 (Monday, July 16, 2007)]
[Rules and Regulations]
[Pages 38767-38778]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E7-13665]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9339]
RIN 1545-BG44


Qualified Zone Academy Bonds; Obligations of States and Political 
Subdivisions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary regulations that 
provide guidance to state and local governments that issue qualified 
zone academy bonds and to banks, insurance companies, and other 
taxpayers that hold those bonds on the program requirements for 
qualified zone academy bonds. The temporary regulations implement the 
amendments to section 1397E of the Internal Revenue Code (Code) 
(discussed in this preamble) and provide guidance on the maximum term, 
permissible use of proceeds, and remedial actions for qualified zone 
academy bonds. The text of these temporary regulations also serves as 
the text of the proposed regulations set forth in the notice of 
proposed rulemaking on this subject in the Proposed Rules section in 
this issue of the Federal Register. The portions of this rule that are 
final regulations provide necessary cross-references to the temporary 
regulations.

DATES: Effective Date: These regulations are effective on September 14, 
2007.
    Applicability Date: For dates of applicability, see Sec.  1.1397E-
1(m) of these regulations.

FOR FURTHER INFORMATION CONTACT: Timothy L. Jones or Zoran Stojanovic, 
(202) 622-3980 (not a toll-free number).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    These temporary regulations are being issued without prior notice 
and public procedure pursuant to the Administrative Procedure Act (5 
U.S.C. 553). For this reason, the collection of information contained 
in these regulations has been reviewed, and pending receipt and 
evaluation of public comments, approved by the Office of Management and 
Budget under control number 1545-1908. Responses to this collection of 
information are required to obtain or retain a benefit.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    For further information concerning this collection of information, 
and where to submit comments on the collection of information and the 
accuracy of the estimated burden, and suggestions for reducing this 
burden, please refer to the preamble to the cross-referencing notice of 
proposed rulemaking published in the Proposed Rules section of this 
issue of the Federal Register.
    Books and records relating to a collection of information must be

[[Page 38768]]

retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    Section 1397E(a) of the Code provides that an eligible taxpayer 
(within the meaning of section 1397E(d)(6)) that holds a qualified zone 
academy bond (``QZAB'' or ``QZABs'') on a credit allowance date is 
allowed a credit against Federal income tax for the taxable year that 
includes the credit allowance date. In general, a QZAB is a bond issued 
by a state or local government to finance certain eligible public 
school purposes under section 1397E(d). Section 1397E(b) provides that 
the amount of the QZAB credit equals the product of the credit rate and 
the face amount of the bond held by the taxpayer on the credit 
allowance date. Under section 1397E(b)(2), the credit rate is 
determined by the Treasury Department and equals the percentage that 
the Department estimates generally will permit the issuance of QZABs 
without discount and without interest cost to the issuer. Section 
1397E(i)(1) defines ``credit allowance date'' as the last day of the 
one-year period beginning on the issue date of the issue and the last 
day of each successive one-year period thereafter. Under section 
1397E(d)(3), the maximum term of a QZAB is determined by the Treasury 
Department and equals the term that the Treasury Department estimates 
will result in the present value of the obligation to repay the 
principal on the bond being equal to 50 percent of the face amount of 
the bond.
    Section 1397E(j) provides that the amount of the QZAB credit 
allowed to the taxpayer is included in the taxpayer's gross income.
    Section 1397E(e) imposes a national limitation on the amount of 
QZABs that may be issued for each calendar year. The limitation is 
allocated by the Treasury Department among the States on the basis of 
their respective populations of individuals below the poverty line.
    Section 1397E was amended by section 107 of the Tax Relief and 
Health Care Act of 2006, Public Law 109-432, 120 Stat. 2922 (2006) (the 
``2006 Act''), by adding certain requirements for a bond to be a QZAB. 
In general, the 2006 Act added a new five-year spending period 
requirement, arbitrage investment restrictions, and information 
reporting requirements. Specifically, the 2006 Act added new section 
1397E(f), which generally imposes spending period restrictions under 
which an issuer of QZABs must reasonably expect, as of the issue date, 
that: (1) At least 95 percent of the proceeds from the sale of the 
issue are to be spent for one or more qualified purposes with respect 
to qualified zone academies within the 5-year period beginning on the 
issue date of the QZAB; (2) a binding commitment with a third party to 
spend at least 10 percent of the proceeds from the sale of the issue 
will be incurred within the six-month period beginning on the issue 
date of the QZAB; and (3) such purposes will be completed with due 
diligence and the proceeds from the sale of the issue will be spent 
with due diligence. New Section 1397E(f)(2) added by the 2006 Act 
provides authority to the Secretary of the Treasury to extend the five-
year spending period. To the extent that less than 95 percent of the 
proceeds of the issue are spent within the five-year spending period 
(plus any extension granted by the Secretary of the Treasury), the 2006 
Act requires the issuer to redeem the nonqualified bonds within 90 days 
after the end of such period.
    In addition, the 2006 Act added new section 1397E(g), which 
generally requires that an issue of QZABs must satisfy the arbitrage 
investment restrictions of section 148 with respect to the proceeds of 
the issue.
    Finally, the 2006 Act added new section 1397E(h), which generally 
requires that issuers of QZABs submit information reporting returns to 
the IRS similar to the information reporting returns required to be 
submitted to the IRS under section 149(e) for tax-exempt state or local 
bonds.
    Temporary regulations (TD 8755) interpreting section 1397E were 
published on January 7, 1998 (63 FR 671), and amended on July 1, 1999 
(TD 8826; 64 FR 35573). Final regulations under section 1397E (TD 8903) 
were published on September 26, 2000 (65 FR 57732) (the ``Final 
Regulations''). On March 26, 2004, a notice of proposed rulemaking 
(REG-121475-03) was published in the Federal Register (69 FR 15747) 
(the ``2004 Proposed Regulations''). The 2004 Proposed Regulations 
proposed to amend the existing Final Regulations by providing guidance 
on the maximum term, permissible use of proceeds, and remedial actions 
for QZABs. A public hearing was scheduled for July 21, 2004. The public 
hearing was cancelled because no requests to speak were received. 
Written comments on the 2004 Proposed Regulations were received. After 
consideration of the written comments, and in light of the statutory 
changes made by the 2006 Act, the need for regulatory guidance on those 
statutory changes, and the close connection between that needed 
guidance and the guidance in the 2004 Proposed Regulations, the IRS and 
the Treasury Department have determined to issue coordinated guidance 
in these temporary regulations (the ``Temporary Regulations''), with an 
opportunity for public comment in the corresponding proposed 
regulations (the ``Proposed Regulations''). Set forth in this preamble 
is an explanation of certain provisions of the Temporary Regulations.

Explanation of Provisions

I. Certain Definitions

A. In General
    The Temporary Regulations employ certain definitions used in the 
tax-exempt bond area. Thus, the Temporary Regulations employ certain 
definitions used for general tax-exempt bond purposes in Sec.  1.150-1 
and certain definitions used for purposes of the arbitrage investment 
restrictions on tax-exempt bonds in Sec.  1.148-1(b).
B. Definitions of Various Types of Proceeds in General
    In general, Sec.  1.148-1(b) defines ``sale proceeds'' as any 
amounts actually or constructively received from the sale of an issue, 
including amounts used to pay underwriters' discount or compensation. 
In addition, Sec.  1.148-1(b) defines ``investment proceeds'' to mean 
any amounts actually or constructively received from investing proceeds 
of an issue. Further, Sec.  1.148-1(c) defines ``replacement proceeds'' 
to include certain amounts with a reasonable nexus to a bond issue, 
such as sinking funds reasonably expected to be used to pay debt 
service on a bond issue and pledged funds pledged to pay debt service 
on a bond issue with a reasonable assurance that the funds will be 
available to pay such debt service.
C. Proceeds for Purposes of the Use and Spending Requirements
    In general, the Temporary Regulations provide that, for purposes of 
the provisions of QZAB provisions regarding the use and expenditure of 
proceeds for qualified purposes within prescribed periods, ``proceeds'' 
means sale proceeds, as defined in Sec.  1.148-1(b), plus investment 
proceeds, as defined in Sec.  1.148-1(b). Thus, under the Temporary 
Regulations, the requirement in section 1397E(d)(1)(A) to use at least 
95 percent of the proceeds of an issue for a qualified purpose with 
respect to a qualified zone academy applies by taking into account both 
the sale

[[Page 38769]]

proceeds of the issue and any investment proceeds received from 
investing those sale proceeds. Similarly, under the Temporary 
Regulations, the requirement in section 1397E(f) to spend at least 95 
percent of the proceeds from the sale of an issue on qualified purposes 
within a five-year period and the associated requirements in section 
1397E(f) apply to both sale proceeds of an issue and investment 
proceeds derived from investing sale proceeds.
    Some commentators suggested that, for purposes of the 95-percent 
test, the definition of ``proceeds'' should be limited to sale proceeds 
and should exclude amounts received from investing sale proceeds. These 
commentators suggested that, when sizing a bond issue to comply with 
the 95-percent test, it could be difficult for an issuer to include 
investment earnings because interest rates may be volatile and the 
timing of expenditures may be uncertain. The IRS and the Treasury 
Department have considered this comment and have concluded that the 
definition of proceeds in the 2004 Proposed Regulations that applies 
for purposes of the 95-percent test is appropriate to ensure the use 
and expenditures of proceeds of QZABs for one or more qualified 
purposes under section 1397E(d)(5) and (f). Thus, the Temporary 
Regulations retain this provision. This approach is consistent with the 
view that, for purposes of certain similar provisions on qualified 
private activity bonds under section 141, which are based on use of 95% 
of the net proceeds, as defined in section 150(a)(3), for qualified 
purposes, net proceeds properly include both sale proceeds and 
investment proceeds pending expenditures for ultimate qualified 
governmental purposes, with certain reductions inapplicable to QZABs.
D. Proceeds for Purposes of Private Business Contribution
    Section 1397E(d)(1)(C)(ii) provides that a bond is a QZAB only if, 
among other requirements, the issuer certifies that it has written 
assurances that the private business contribution requirement of 
section 1397E(d)(2) will be met with respect to the qualified zone 
academy. Section 1397E(d)(2)(A) provides that the private business 
contribution requirement is met if the eligible local education agency 
that established the qualified zone academy has written commitments 
from private entities to make qualified contributions (as defined in 
section 1397E(d)(2)(B)) having a present value (as of the issue date of 
the issue) of not less than ten percent of the proceeds of the issue. 
The 2004 Proposed Regulations provide that, for purposes of the private 
business contribution requirement of section 1397E(d)(2), proceeds 
means sale proceeds, as defined in Sec.  1.148-1(b), without regard to 
any investment proceeds received or expected to be received from 
investing those sale proceeds. Commentators supported this narrower 
definition of ``proceeds'' in the 2004 Proposed Regulations for 
purposes of the private business contribution requirement. The 
Temporary Regulations retain this provision.

II. Maximum Term

    Section 1397E(d)(3) provides that the Secretary of the Treasury 
Department shall determine, during each calendar month, the maximum 
term for QZABs issued during the following calendar month. Section 
1397E(d)(3) states that the maximum term shall be the term that the 
Secretary estimates will result in the present value of the obligation 
to repay the principal on the bond being equal to 50 percent of the 
face amount of the bond. Section 1.1397E-1(d) of the existing Final 
Regulations provides that the maximum term for a QZAB is determined 
under section 1397E(d)(3) by using a discount rate equal to 110 percent 
of the long-term adjusted applicable Federal rate (AFR), compounded 
semi-annually, for the month in which the bond is issued. The IRS 
publishes the long-term adjusted AFR each month in a revenue ruling. 
See Sec.  601.601(d)(2)(ii)(b).
    Section 1397E(b)(2) provides that the Secretary shall determine, 
during each calendar month, a credit rate for QZABs issued during the 
following calendar month. Section 1.1397E-1(b) provides that the 
Secretary shall determine monthly (or more often as deemed necessary by 
the Secretary) the credit rate the Secretary estimates generally will 
permit the issuance of a QZAB without discount and without interest 
cost to the issuer. Notice 99-35 (1999-2 CB 26), see Sec.  
601.601(d)(2)(ii)(b) (``Notice 99-35''), indicates that, until further 
notice, the credit rate for a QZAB will be published daily by the 
Bureau of Public Debt on its Internet site for State and Local 
Government Series securities (https://www.treasurydirect.gov). Notice 
99-35 also provides that the credit rate shall be applied to a QZAB on 
the first day on which there is a binding contract in writing for the 
sale or exchange of the bond. Notice 99-35 states that the credit rate 
will be determined by the Treasury Department based on its estimate of 
the yield on outstanding AA rated corporate bonds of a similar maturity 
for the business day immediately prior to the date on which there is a 
binding contract in writing for the sale or exchange of the bond.
    Prior to the issuance of the 2004 Proposed Regulations, questions 
were raised regarding the maximum term of a QZAB that is sold in one 
month and issued in another month. Section 1.1397E-1(d) of the existing 
Final Regulations provides that the maximum term is determined based on 
the month in which the bond is issued. However, under Notice 99-35, the 
credit rate for a QZAB is determined based on the first day on which 
there is a binding contract in writing for the sale or exchange of the 
bond. The credit rate and maximum term should be determined on the same 
day because the credit rate for a bond depends on its maximum term. 
Accordingly, the 2004 Proposed Regulations would amend Sec.  1.1397E-
1(d) to provide that the maximum term for a QZAB is determined based on 
the first day on which there is a binding contract in writing for the 
sale or exchange of the bond.
    Commentators supported the maximum term provisions in the 2004 
Proposed Regulations. The Temporary Regulations retain these 
provisions.
    At the present time, the Treasury Department is continuing its 
current practice of publishing the credit rate and maximum term for 
QZABs on the Bureau of Public Debt's Internet site for State and Local 
Government Series securities (https://www.publicdebt.treas.gov).

III. Use of Proceeds and Remedial Actions

A. In General
    Section 1397E(d)(1) provides that a bond issued as part of an issue 
is a QZAB only if, among other requirements, at least 95 percent of the 
proceeds of the issue are to be used for a qualified purpose with 
respect to a qualified zone academy established by an eligible local 
education agency (as defined in section 1397E(d)(4)(B)) and the issue 
meets the requirements of section 1397E(f) (relating to spending 
periods), section 1397E(g) (relating to arbitrage), and section 
1397E(h) (relating to information reporting requirements). Section 
1397E(d)(5) defines ``qualified purposes'' for any qualified zone 
academy to include: (i) Rehabilitating or repairing the public school 
facility in which such academy is established, (ii) providing equipment 
for use at such academy, (iii) developing course materials for 
education to be provided at such academy, and (iv) training teachers 
and other school personnel in such academy. Section 1397E(d)(4)(A)

[[Page 38770]]

defines ``qualified zone academy'' as any public school (or academic 
program within a public school) that is established by and operated 
under the supervision of an eligible local education agency to provide 
education or training below the postsecondary level if: (1) The public 
school or program is designed in cooperation with business in 
accordance with section 1397E(d)(4)(A)(i); (2) students in the public 
school or program will be subject to the same academic standards and 
assessments as other students educated by the eligible local education 
agency; (3) the comprehensive education plan of the public school or 
program is approved by the eligible local education agency; and (4) the 
public school is located in an empowerment zone or enterprise community 
(as defined in section 1393), or there is a reasonable expectation (as 
of the issue date of the bonds) that at least 35 percent of the 
students attending the school or participating in the program will be 
eligible for free or reduced-cost lunches under the school lunch 
program established under the Richard B. Russell National School Lunch 
Act.

B. Compliance With 95-Percent Test

1. In General
    The 2004 Proposed Regulations provide guidance on compliance with 
the 95-percent test in section 1397E(d)(1)(A). Specifically, the 2004 
Proposed Regulations provide that, in general, an issue must satisfy 
two requirements to comply with section 1397E(d)(1)(A). First, the 
issuer must reasonably expect, as of the issue date of the issue, to 
use at least 95 percent of the proceeds of the issue for a qualified 
purpose with respect to a qualified zone academy for the entire term of 
the issue (without regard to any redemption provision). Second, except 
as otherwise provided in the remedial action provisions of the 2004 
Proposed Regulations, at least 95 percent of the proceeds of the issue 
must actually be used for a qualified purpose with respect to a 
qualified zone academy for the entire term of the issue (without regard 
to any redemption provision). For these purposes, under the 2004 
Proposed Regulations, any unspent proceeds are treated as used for a 
qualified purpose with respect to a qualified zone academy during any 
period that the issuer reasonably expects that those proceeds will be 
spent with due diligence for a qualified purpose with respect to a 
qualified zone academy.
    Some commentators suggested a modification of the requirement in 
the 2004 Proposed Regulations that at least 95 percent of the proceeds 
of an issue both be reasonably expected to be used and actually be used 
for a qualified purpose for the entire term of the issue. Specifically, 
these commentators requested that the requirement be altered to conform 
to the tax-exempt bond provisions of Sec.  1.141-2(d), which look to a 
similar standard based on reasonable expectations and deliberate 
actions within an issuer's control, with certain exceptions for 
involuntary conversions and actions in response to directives from the 
Federal government. These commentators noted that use of the standards 
under section 141 would be appropriate because the statutory language 
of sections 141 and 1397E both use the phrase ``are to be used.'' In 
substance, the standards for interpreting this phrase under the 2004 
Proposed Regulations and under section 141 both incorporate reasonable 
expectations and actual use, with certain special exceptions to actual 
use in the case of the standard under section 141. The IRS and the 
Treasury Department believe, however, that compliance standards for the 
actual use of proceeds appropriately may take into account the 
particular governmental program involved.
    The Temporary Regulations do not adopt the suggestion to conform 
the 95-percent test for QZABs to the deliberate action provisions of 
Sec.  1.141-2(d). The Temporary Regulations retain the proposed 
standard based on reasonable expectations and actual use. The actual 
use test is set forth under section 1397E(f)(3), as introduced by the 
2006 Act, and is appropriate for the circumstances involved with QZABs. 
In addition, the control-based exceptions to actual use under the 
deliberate action standard under section 141 raise certain 
administrability concerns in the context of QZABs. For example, it may 
be particularly difficult to determine if a loss of qualified zone 
academy status is within an issuer's control.
    The Temporary Regulations provide guidance on the spending period 
requirements introduced by the 2006 Act in section 1397E(f). 
Specifically, the Temporary Regulations provide that an issuer must 
both reasonably expect to spend and actually spend at least 95 percent 
of the proceeds of an issue of QZABs within the five-year period 
beginning on the issue date of the issue of QZABs (or be subject to the 
additional requirement to redeem bonds from unspent proceeds at the end 
of that five-year period). The Temporary Regulations clarify that the 
various requirements relating to ``reasonable expectations'' for the 
use of proceeds of QZABs and actual actions to proceed with ``due 
diligence'' to spend such proceeds on qualified purposes are based on 
objective reasonableness standards, as used in the definition of 
``reasonable expectations or reasonableness'' in Sec.  1.148-1(b) of 
the arbitrage regulations.
2. Proceeds Spent for Rehabilitation, Repair or Equipment
    Section 1397E(d)(5)(A) and (B) provides that the term ``qualified 
purpose'' with respect to any qualified zone academy includes 
rehabilitating or repairing the public school facility in which such 
academy is established, and providing equipment for use at such 
academy. The 2004 Proposed Regulations specify that, if proceeds of an 
issue are spent for a purpose described in section 1397E(d)(5)(A) or 
(B) with respect to a qualified zone academy, then those proceeds are 
treated as used for a qualified purpose with respect to the academy 
during any period after such expenditure that (1) the property financed 
with those proceeds is used for the purposes of the academy and (2) the 
academy maintains its status as a qualified zone academy. For this 
purpose, the retirement from service of financed property due to normal 
wear or obsolescence does not cause the property not to be used for a 
qualified purpose with respect to a qualified zone academy.
    The Temporary Regulations provide guidance on the applicable 
standard for determining whether proceeds of QZABs are used for a 
qualified purpose of ``rehabiliting'' a public school facility under 
section 1397E(d)(5)(A), based on a known existing standard used for 
purposes of the rehabilitation tax credit under section 47. In 
particular, in determining whether proceeds of QZABs are used for a 
qualified purpose of ``rehabilitating'' a public school facility under 
section 1397E(d)(5)(A), rules similar to those used for purposes of the 
rehabilitation tax credit in section 47(c) (other than sections 
47(c)(1)(B) and 47(c)(2)(B)(v)) shall apply. Set forth in this preamble 
is a general description of certain aspects of this rehabilitation 
expenditure standard. In general, the rehabilitation standard under 
section 47 requires a substantial rehabilitation involving a building 
that already has been placed in service and a rehabilitation process 
that preserves specified portions of the existing walls of the 
building. Specifically, at least 50 percent of the existing external 
walls of the rehabilitated building must be retained as external walls, 
at least 75 percent of the existing external walls must be retained as 
internal or external walls, and at least 75 percent of the

[[Page 38771]]

existing internal structural framework must be retained. Under this 
rehabilitation standard, eligible rehabilitation expenditures include 
some expenditures for reconstruction, subject, however, to the 
foregoing restrictions on retention of certain percentages of the 
existing walls. In addition, however, under this rehabilitation 
standard, eligible rehabilitation expenditures do not include 
expenditures to enlarge existing buildings or expenditures to acquire 
existing buildings. In adopting the rehabilitation standard used in 
section 47 for purpose of section 1397E, the IRS and the Treasury 
Department declined to adopt one public comment which suggested that 
rehabilitation should include complete reconstruction of a building. 
Here, the IRS and the Treasury Department determined that such a broad 
interpretation of rehabilitation effectively to include new 
construction would be beyond Congressional intent.
3. Proceeds Spent to Develop Course Materials or Train Teachers
    Section 1397E(d)(5)(C) and (D) provides that the term ``qualified 
purpose'' with respect to any qualified zone academy includes 
developing course materials for education to be provided at such 
academy, and training teachers and other school personnel in such 
academy. The 2004 Proposed Regulations provide that, if proceeds of an 
issue are spent for a purpose described in section 1397E(d)(5)(C) or 
(D) with respect to a qualified zone academy, then those proceeds are 
treated as used for a qualified purpose with respect to the academy 
during any period after such expenditure. Commentators supported this 
provision of the 2004 Proposed Regulations. The Temporary Regulations 
retain this provision.
4. Special Rule for Determining Status as Qualified Zone Academy
    Section 1397E(d)(4)(A)(iv) provides that a public school (or 
academic program within a public school) is a qualified zone academy 
only if, among other requirements, the public school is located in an 
empowerment zone or enterprise community, or there is a reasonable 
expectation (as of the issue date of the issue) that at least 35 
percent of the students attending the school or participating in the 
program (as the case may be) will be eligible for free or reduced-cost 
lunches under the school lunch program established under the Richard B. 
Russell National School Lunch Act.
    For purposes of determining whether an issue complies with section 
1397E(d)(4)(A)(iv), the 2004 Proposed Regulations provide that a public 
school is treated as located in an empowerment zone or enterprise 
community for the entire term of the issue if the public school is 
located in an empowerment zone or enterprise community on the issue 
date of the issue. Commentators agreed with this provision of the 2004 
Proposed Regulations relating to empowerment zones and enterprise 
communities. The Temporary Regulations retain this provision.
    Commentators also requested clarification of the relevant time 
period for determining compliance with the 35-percent free or reduced-
cost school lunch program test. The Temporary Regulations provide that 
the test looks to whether there is a reasonable expectation (as of the 
issue date of the bonds) that at least 35 percent of the students 
attending the school or participating in the program (as the case may 
be) will be eligible for free or reduced-cost lunches during the one-
year period following the date the bonds are issued.

C. Remedial Actions

1. In General
    Prior to the issuance of the 2004 Proposed Regulations, comments 
were received requesting guidance specifying remedial actions that may 
be taken to cure a violation of the 95-percent test in section 
1397E(d)(1)(A). The 2004 Proposed Regulations specify two remedial 
actions that may be taken in certain circumstances if less than 95 
percent of the proceeds of an issue actually are used for a qualified 
purpose with respect to a qualified zone academy. These remedial 
actions are available only if the issuer reasonably expected on the 
issue date of the bonds that: (1) The issue would meet the requirements 
of section 1397E(f)(1)(A), (B), and (C); and (2) at least 95 percent of 
the proceeds of the issue would be used for a qualified purpose with 
respect to a qualified zone academy for the entire term of the issue 
(without regard to any redemption provision).
    As discussed in this preamble, the two remedial actions specified 
in the 2004 Proposed Regulations are (1) redemption or defeasance of 
the nonqualified bonds, and (2) alternative use of the disposition 
proceeds. If the applicable requirements are met, the redemption or 
defeasance remedial action is available to cure any failure to satisfy 
the 95-percent test that was not reasonably expected as of the issue 
date. The alternative use of disposition proceeds remedial action 
applies only to certain dispositions of financed property for cash.
    Commentators recommended that the 2004 Proposed Regulations be 
amended to provide additional flexibility for issuers if the failure to 
properly use proceeds is based on a loss of status of the public school 
or academic program as a qualified zone academy. Consistent with the 
2006 Act, the Treasury Department and the IRS have concluded that the 
remedial actions of redemption and defeasance in the 2004 Proposed 
Regulations will adequately address situations where there has been a 
disqualifying change in the status of an academy. The Temporary 
Regulations retain these two remedial actions with certain 
modifications relating to the amendments to section 1397E introduced by 
the 2006 Act.
2. Redemption or Defeasance of Nonqualified Bonds
    Under the 2004 Proposed Regulations, a redemption or defeasance 
remedial action is taken if: (1) All of the nonqualified bonds of the 
issue (determined by applying the principles of Sec.  1.142-2(e)) are 
redeemed within 90 days after the date on which the failure to properly 
use proceeds occurs; (2) if any nonqualified bonds of the issue are not 
redeemed within 90 days after the date on which the failure to properly 
use proceeds occurs (the unredeemed nonqualified bonds), a defeasance 
escrow is established for the unredeemed nonqualified bonds within 90 
days after the date on which the failure to properly use proceeds 
occurs; or (3) if the failure to properly use proceeds is a disposition 
of financed property described in section 1397E(d)(5)(A) or (B) and the 
consideration for the disposition is exclusively cash, all of the 
disposition proceeds (as defined in Sec.  1.141-12(c)(1)) are used 
within 90 days after the date of the disposition to redeem, or 
establish a defeasance escrow for, a pro rata portion of the 
nonqualified bonds of the issue.
    The Temporary Regulations retain the remedial actions described in 
this preamble but, in accordance with new section 1397E(f)(3), the 
Temporary Regulations limit defeasance of nonqualified bonds to bonds 
the proceeds of which have actually been spent for a qualified purpose 
with respect to a qualified academy within the 5-year period beginning 
on the issue date of the bonds. For proceeds that have not been spent 
within the 5-year period, the only remedial action available to the 
issuer is redemption of nonqualified bonds under the principles of 
section 142.

[[Page 38772]]

3. Failure to Properly Use Proceeds
    For unspent proceeds, the 2004 Proposed Regulations provide that a 
failure to properly use proceeds occurs on the earlier of: (1) The 
first date on which the public school (or academic program within the 
public school) fails to constitute a qualified zone academy; or (2) the 
first date on which the issuer fails to have a reasonable expectation 
to proceed with due diligence to spend at least 95 percent of the 
proceeds of the issue for a qualified purpose with respect to a 
qualified zone academy.
    The Temporary Regulations retain the provisions concerning the 
failure to properly use unspent proceeds but implement section 
1397E(f)(1)(A) by adding a provision that improper use also occurs if 
95 percent of the bond proceeds have not been properly spent within the 
5-year period beginning on the day the bonds are issued.
    For proceeds that have been spent for rehabilitation, repair or 
equipment described in section 1397E(d)(5)(A) or (B) with respect to a 
qualified zone academy, the 2004 Proposed Regulations provide that a 
failure to properly use proceeds occurs on the earlier of: (1) The 
first date on which the public school (or academic program within the 
public school) fails to constitute a qualified zone academy; and (2) 
the first date on which an action is taken that causes the issuer to 
fail actually to use at least 95 percent of the proceeds of the issue 
for a qualified purpose with respect to a qualified zone academy. If 
proceeds have been spent for course materials or training described in 
section 1397E(d)(5)(C) or (D) with respect to a qualified zone academy, 
no event subsequent to such expenditure shall constitute a failure to 
properly use such proceeds under the 2004 Proposed Regulations.
4. Defeasance Escrow
    The 2004 Proposed Regulations define ``defeasance escrow'' as an 
irrevocable escrow established to retire bonds on the earliest call 
date after the date on which the failure to properly use proceeds 
occurs in an amount that is sufficient to retire the bonds on that call 
date. At least 90 percent of the weighted average amount in a 
defeasance escrow must be invested in investments (as defined in Sec.  
1.148-1(b)), except that no amount in a defeasance escrow may be 
invested in any investment the obligor (or any person that is a related 
party with respect to the obligor within the meaning of Sec.  1.150-
1(b)) of which is a user of proceeds of the bonds. All purchases or 
sales of an investment in a defeasance escrow must be made at the fair 
market value of the investment within the meaning of Sec.  1.148-
5(d)(6).
    Under the 2004 Proposed Regulations, the issuer must pay to the 
United States, at the same time and in the same manner as rebate 
amounts are required to be paid under Sec.  1.148-3 (or at such other 
time or in such other manner as the Commissioner may prescribe), 100 
percent of the investment earnings on amounts in the defeasance escrow. 
For this purpose, the first computation period begins on the date on 
which the failure to properly use proceeds occurs.
    Under the 2004 Proposed Regulations, proceeds of QZABs (other than 
unspent proceeds of the issue for which the failure to properly use 
proceeds occurs) are not permitted to be used to redeem or defease the 
nonqualified bonds. In addition, the issuer must provide written notice 
to the Commissioner of the establishment of the defeasance escrow 
within 90 days of the date the defeasance escrow is established.
    Commentators suggested various modifications to the requirement 
that issuers rebate to the United States 100 percent of the investment 
earnings on amounts in a defeasance escrow. Alternative approaches 
suggested by commentators included: (1) Limiting the rebate requirement 
to investment earnings in excess of the yield on the issue of QZABs; 
(2) limiting the rebate amount to investment earnings in excess of the 
total debt service requirements to be paid out of the defeasance 
escrow; and (3) limiting the rebate amount to the amount of the QZAB 
credit.
    The IRS and Treasury Department have concluded that the rebate 
requirement should only apply to earnings in excess of the yield on the 
issue of QZABs. Thus, the Temporary Regulations provide that the issuer 
of QZABs with a defeasance escrow must rebate to United States any 
investment earnings in the defeasance escrow that are in excess of the 
yield, as defined in Sec.  1.148-1(b), on the issue of QZABs. For this 
purpose, the credit rate for the QZAB issue is not included in the 
yield on the issue.
    Some commentators suggested that the first computation period for 
rebate purposes begin on the date the defeasance escrow is established, 
rather than the date on which the failure to properly use proceeds 
occurs. These commentators noted that the 2004 Proposed Regulations 
create a possible 90-day period during which an issuer would be 
required to compute yield on an escrow that is yet to be established. 
The Temporary Regulations adopt the change in start date for the 
computation period in accordance with this comment.
    One commentator recommended that certain small, low-wealth local 
education agencies be exempt from the rebate requirement. The IRS and 
the Treasury Department have considered this recommendation and have 
concluded that the rebate requirement is appropriate to ensure 
compliance with the 95-percent use-of-proceeds requirement of section 
1397E(d)(1)(A), regardless of the size or wealth of the local education 
agency. Thus, the Temporary Regulations do not adopt this 
recommendation.
    Some commentators suggested that the regulations provide that a 
defeasance of a QZAB in the context of taking a remedial action not be 
treated as a significant modification (within the meaning of Sec.  
1.1001-3) and reissuance of the QZAB. The Temporary Regulations do not 
address the circumstances in which a reissuance of a QZAB will occur. 
The Temporary Regulations do provide, however, that, for purposes of 
determining whether the establishing of a defeasance escrow as a 
remedial action results in an exchange under Sec.  1.1001-1(a), the 
QZAB is treated as a tax-exempt bond under Sec.  1.1001-
3(e)(5)(ii)(B)(1). Section 1.1001-3(e)(5)(ii)(B)(1) provides that a 
defeasance of a tax-exempt bond is not a significant modification even 
if the issuer is released from any liability to make payments under the 
instrument if the defeasance occurs by operation of the terms of the 
original bond and the issuer places in trust government securities or 
tax-exempt government bonds that are reasonably expected to provide 
interest and principal payments sufficient to satisfy the payment 
obligations under the bond.
5. Alternative Use of Disposition Proceeds
    The alternative use of disposition proceeds remedial action in the 
2004 Proposed Regulations has four requirements. First, the failure to 
properly use proceeds must be a disposition of financed property 
described in section 1397E(d)(5)(A) or (B) and the consideration for 
the disposition must be exclusively cash. Second, the issuer must 
reasonably expect as of the date of the disposition that: (1) All of 
the disposition proceeds, plus any amounts received from investing the 
disposition proceeds, will be spent within two years after the date of 
the disposition for a qualified purpose with respect to a qualified 
zone academy; or (2) to the extent not expected to be so spent, used 
within 90 days after the date of the disposition to take a redemption 
or defeasance remedial action. Third, the disposition

[[Page 38773]]

proceeds, plus any amounts received from investing the disposition 
proceeds, must be treated as proceeds for purposes of section 1397E. 
Fourth, if all of the disposition proceeds, plus any amounts received 
from investing the disposition proceeds, are not actually spent for a 
qualified purpose within the two-year period beginning on the date of 
the disposition (or used within 90 days after the date of the 
disposition to take a redemption or defeasance remedial action), the 
remainder of such amounts must be used within 90 days after the end of 
that two-year period for a redemption or defeasance remedial action.
    Some commentators recommended that the alternative use of 
disposition proceeds remedial action be modified to provide that the 
amounts relating to a disposition that are required to be spent for a 
qualified purpose be capped at the principal amount of the QZAB 
outstanding at the time of the disposition. The IRS and Treasury 
Department have considered this comment and have concluded that the 
requirement in the 2004 Proposed Regulations that all of the 
disposition proceeds, plus any amounts received from investing the 
disposition proceeds, be spent for a qualified purpose is appropriate 
to ensure that QZABs are issued for qualified purposes. Thus, the 
Temporary Regulations do not adopt this comment.
D. Payment of Principal, Interest or Redemption Price
    The 2004 Proposed Regulations provide that the use of proceeds of a 
bond to pay principal, interest, or redemption price of the bond or 
another bond is not a qualified purpose within the meaning of section 
1397E(d)(5). Thus, the use of proceeds of a bond to refund another bond 
is not a qualified purpose under the 2004 Proposed Regulations. In 
addition, the use of proceeds of a bond to fund a sinking fund to repay 
the bond is not a qualified purpose under the 2004 Proposed 
Regulations.
    One commentator recommended that the 2004 Proposed Regulations be 
modified to permit proceeds of a QZAB to be used to repay an interim 
bridge loan incurred with the explicit intent to be refinanced with a 
subsequent issuance. In response to this comment, the Temporary 
Regulations provide an exception to the general rule that the use of 
proceeds of a bond to pay principal, interest, or redemption price of 
the bond or another bond is not a qualified purpose under section 
1397E(d)(5).

IV. Arbitrage Investment Restrictions

    New section 1397E(g) added by the 2006 Act provides that the 
arbitrage requirements of section 148 applicable to tax-exempt state or 
local governmental bonds under section 103 also apply to QZABs. The 
Temporary Regulations provide guidance regarding the application of the 
arbitrage requirements to QZABs.
    In general, under section 148, subject to various prompt spending 
exceptions (for example, the 18-month prompt spending exception to 
arbitrage rebate for capital projects under Sec.  1.148-7(d) and the 2-
year construction spending exception to arbitrage rebate under section 
148(f)(4)(C) and Sec.  1.148-7(e)) and other specified exceptions (for 
example, the bona fide debt service exception for certain long-term 
tax-exempt governmental, non-private activity bonds under section 
148(f)(4)(A)), the arbitrage investment restrictions, including the 
yield restrictions and the arbitrage rebate requirement, apply broadly 
to ``gross proceeds'' of tax-exempt bonds. ``Gross proceeds'' 
represents a broad catch-all category of bond proceeds which includes 
various subsidiary types of proceeds, including, among others, ``sale 
proceeds'' derived from the sale of bonds, ``investment proceeds'' 
derived from investing proceeds of bonds, and ``replacement proceeds'' 
with a reasonable nexus to a bond issue (for example, sinking funds 
reasonably expected to be used to pay debt service on bonds and pledged 
funds used to secure bonds).
    The Temporary Regulation provide that, except as otherwise 
provided, the arbitrage investment restrictions under section 148 and 
the exceptions to those restrictions apply to gross proceeds of QZABs 
issued under section 1397E to the same extent and in the same manner as 
they apply to gross proceeds of tax-exempt state or local governmental 
bonds issued under section 103. For this purpose, references in the 
arbitrage restrictions to tax-exempt bonds generally shall be deemed to 
refer to QZABs and, to the extent that any particular arbitrage 
restriction depends on whether bonds are private activity bonds under 
section 141, the determination of whether QZABs are private activity 
bonds shall be based on the general definition of private activity 
bonds under section 141.
    The Temporary Regulations provide limited guidance to tailor the 
application of the arbitrage investment restrictions to QZABs in 
certain specific respects. Thus, the Temporary Regulations provide that 
a five-year temporary period exception to the arbitrage yield 
restriction requirement applies to proceeds of QZABs if an issuer 
reasonably expects to spend 95 percent of the proceeds of an issue of 
QZABs for qualified purposes within the 5-year period beginning on the 
issue date of the QZABs.
    The Temporary Regulations provide that, in determining the yield on 
an issue of QZABs for arbitrage purposes, the QZAB credit is 
disregarded. Here, yield focuses on yield paid by the issuer on the 
QZABs rather than the tax credit benefit to the investor.
    The Temporary Regulations provide that the yield restriction rules 
are inapplicable to amounts placed in defeasance escrow as a remedial 
action. The Treasury Department and IRS have a concern that QZAB 
issuers may be unable to find appropriate investments of the amounts in 
the escrow at or below the yield on the bonds.
    The Temporary Regulations provide that the exception to arbitrage 
yield restriction for certain investments in non-AMT tax-exempt bonds 
is inapplicable to QZABs. The IRS and the Treasury Department have a 
concern about the clear arbitrage investment potential associated with 
investing zero-yielding QZABs in non-AMT tax-exempt bond investments at 
materially higher yields.
    The Temporary Regulations provide that, in determining whether an 
issue of QZABs qualifies for the small issuer exception to the 
arbitrage rebate requirement under section 148(f)(4)(D), both QZABs and 
tax-exempt bonds (other than private activity bonds) that are 
reasonably expected to be issued or actually issued by the QZAB issuer 
(and other covered on-behalf-of entities and subordinate entities) 
within a calendar year are taken into account in measuring the 
applicable size limitation.
    Finally, consistent with the treatment of defeasance escrows for 
purposes of yield restriction, in applying the small issuer exception 
to the rebate of earnings from investments of amounts in a defeasance 
escrow, the Temporary Regulations provide that the issuer is not 
treated as a small issuer and amounts earned from such investments must 
be rebated to the United States.

V. Information Reporting Requirement

    Issuers of QZABs must submit information reporting returns to the 
IRS similar to the information reporting returns required to be 
submitted to the IRS under section 149(e) for tax-exempt State or local 
bonds at the same time and manner as those reports are required to be 
submitted to the IRS on

[[Page 38774]]

such forms as shall be prescribed by the Commissioner for such purpose.

Effective/Applicability Dates

    In general, except as otherwise provided, the Temporary Regulations 
apply to bonds sold on or after September 14, 2007.
    In general, except as otherwise provided, Sec.  1.1397E-1(h)(2), 
(i), and (j) of the Temporary Regulations regarding the five-year 
spending period, the arbitrage investment restrictions, and the 
information reporting requirement added by the 2006 Act apply to bonds 
issued pursuant to allocations of the national qualified zone academy 
bond volume cap authority arising in calendar years after 2005 and sold 
on or after September 14, 2007.
    Issuers and taxpayers may apply the Temporary Regulations in whole, 
but not in part, to bonds sold before September 14, 2007.
    Certain other special effective dates apply to particular 
provisions under Sec.  1.1397E(m).

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. For 
applicability of the Regulatory Flexibility Act, please refer to the 
cross-reference notice of proposed rulemaking published elsewhere in 
this Federal Register. Pursuant to section 7805(f) of the Code, this 
regulation has been submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Drafting Information

    The principal authors of these regulations are Timothy L. Jones and 
Zoran Stojanovic, Office of Division Counsel/Associate Chief Counsel, 
IRS (Tax Exempt and Governmental Entities). However, other personnel 
from the IRS and the Treasury Department participated in their 
development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding an 
entry in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.1397E-1T also issued under 26 U.S.C. 1397E. * * *


0
Par. 2. Section 1.1397E-1 is amended by:
0
1. Redesignating paragraphs (i), (j) and (k) as (k), (l) and (m), 
respectively.
0
2. Adding new paragraphs (i) and (j).
0
3. Revising newly-designated paragraph (m).
    The additions and revisions read as follows:


Sec.  1.1397E-1  Qualified zone academy bonds.

* * * * *
    (i) and (j) [Reserved]. For further guidance, see Sec.  1.1397E-
1T(i) and (j).
* * * * *
    (m) Effective/applicability dates. Except as provided in this 
paragraph (m), this section applies to bonds sold on or after September 
26, 2000. Each of paragraphs (c) and (k) of this section may be applied 
by issuers to bonds that are sold before September 26, 2000.


0
Par. 3. Section 1.1397E-1T is added to read as follows:


Sec.  1.1397E-1T  Qualified zone academy bonds (temporary).

    (a) In general--(1) Overview. In general, a qualified zone academy 
bond (QZAB or QZABs) is a taxable bond issued by a state or local 
government the proceeds of which are used to improve certain eligible 
public schools. An eligible taxpayer that holds a QZAB generally is 
allowed annual Federal income tax credits in lieu of periodic interest 
payments. These credits compensate the eligible taxpayer for lending 
money to the issuer and function as payments of interest on the bond. 
Accordingly, this section generally treats the allowance of a credit as 
if it were a payment of interest on the bond. This section also 
provides other rules for QZABs, including rules governing the credit 
rate, the private business contribution requirement, the maximum term, 
use and expenditure of proceeds, remedial actions, eligible issuers, 
arbitrage investment restrictions, and information reporting.
    (2) Certain definitions--(i) In general. For purposes of this 
section, except as otherwise provided in this section, the following 
definitions apply: the definitions set forth in this section; the 
definitions used for general tax-exempt bond purposes in Sec.  1.150-1; 
and the definitions used for purposes of the arbitrage investment 
restrictions on tax-exempt bonds in Sec.  1.148-1(b).
    (ii) Applicable definition of proceeds--(A) Use and expenditure 
provisions. Except as provided in paragraphs (a)(2)(ii)(B) and 
(a)(2)(ii)(C) of this section, for purposes of all applicable 
requirements regarding use and expenditure of proceeds of QZABs under 
section 1397E and this section, proceeds means ``sale proceeds,'' as 
defined in Sec.  1.148-1(b), plus ``investment proceeds,'' as defined 
in Sec.  1.148-1(b).
    (B) Private business contribution requirement. For purposes of the 
private business contribution requirement of section 1397E(d)(2), 
proceeds means ``sale proceeds,'' as defined in Sec.  1.148-1(b).
    (C) Arbitrage investment restrictions. For purposes of the scope of 
application of the arbitrage investment restrictions under section 
1397E(g) and paragraph (i) of this section, proceeds generally means 
gross proceeds, as defined in Sec.  1.148-1(b). In addition, in 
applying the arbitrage investment restrictions under paragraph (i) of 
this section and section 148, the various applicable definitions of the 
various types of proceeds of tax-exempt bonds under Sec.  1.148-1(b) 
shall apply.
    (b) and (c) [Reserved]. For further guidance, see Sec.  1.1397E-
1(b) and (c).
    (d) Maximum term. The maximum term for a QZAB is determined under 
section 1397E(d)(3) by using a discount rate equal to 110 percent of 
the long-term adjusted applicable Federal rate (AFR), compounded semi-
annually, for the month in which the bond is sold. The Internal Revenue 
Service publishes this figure each month in a revenue ruling that is 
published in the Internal Revenue Bulletin. See Sec.  
601.601(d)(2)(ii)(b) of this chapter. A bond is sold on the sale date, 
as defined in Sec.  1.150-1(c)(6), which is the first day on which 
there is a binding contract in writing for the sale or exchange of the 
bond.
    (e) through (g) [Reserved]. For further guidance, see Sec.  
1.1397E-1(e) through (g).
    (h) Use of proceeds--(1) In general. Section 1397E(d)(1) provides 
that a bond issued as part of an issue is a QZAB only if, among other 
requirements, at least 95 percent of the proceeds of the issue are to 
be used for a qualified purpose with respect to a qualified zone 
academy established by an eligible local education agency (as defined 
in section 1397E(d)(4)(B)), and

[[Page 38775]]

the issue meets the requirements of section 1397E(f) and (g). Section 
1397E(d)(5) defines qualified purpose, with respect to any qualified 
zone academy, as rehabilitating or repairing the public school facility 
in which such academy is established, providing equipment for use at 
such academy, developing course materials for education to be provided 
at such academy, and training teachers and other school personnel in 
such academy. Section 1397E(d)(4)(A) defines qualified zone academy as 
any public school (or academic program within a public school) that is 
established by and operated under the supervision of an eligible local 
education agency to provide education or training below the 
postsecondary level and that meets the requirements of section 
1397E(d)(4)(A)(i), (ii), (iii) and (iv).
    (2) Use of proceeds requirements. An issue meets the requirements 
of sections 1397E(d)(1)(A) and (f) only if--
    (i) The issuer reasonably expects, as of the issue date of the 
issue, that--
    (A) At least 95 percent of the proceeds from the sale of the issue 
are to be spent for 1 or more qualified purposes with respect to 
qualified zone academies within the 5-year period beginning on the 
issue date of the QZAB;
    (B) A binding commitment with a third party to spend at least 10 
percent of the proceeds from the sale of the issue will be incurred 
within the 6-month period beginning on the issue date of the QZAB;
    (C) At least 95 percent of the proceeds from the sale of the issue 
will be spent for a qualified purpose with respect to a qualified zone 
academy with due diligence (with due diligence measured by the 
reasonableness standard under Sec.  1.148-1(b); and
    (D) At least 95 percent of the proceeds of the issue will be used 
for a qualified purpose with respect to a qualified zone academy for 
the entire term of the issue (without regard to any redemption 
provision); and
    (ii) Except as otherwise provided in paragraph (h)(7) of this 
section, at least 95 percent of the proceeds of the issue are actually 
used for a qualified purpose with respect to a qualified academy for 
the entire term of the issue (without regard to any redemption 
provision).
    (iii) Extension of 5-year period. The Commissioner may extend the 
period described in paragraph (h)(2)(i)(A) of this section if the 
issuer, prior to the end of such period, submits a private ruling 
request, and establishes to the satisfaction of the Commissioner that--
    (A) The failure to satisfy the 5-year spending requirement is due 
to reasonable cause; and
    (B) The expenditure of at least 95 percent of the proceeds from the 
sale of the issue will be spent for a qualified purpose with respect to 
a qualified zone academy will proceed with due diligence.
    (3) Unspent proceeds. For purposes of paragraphs (h)(2)(i)(D) and 
(h)(2)(ii) of this section, during the period described in paragraph 
(h)(2)(i)(A) of this section, including any extension under paragraph 
(h)(2)(iii) of this section, unspent proceeds are treated as used for a 
qualified purpose with respect to a qualified zone academy if the 
issuer reasonably expects to proceed with due diligence to spend those 
proceeds for a qualified purpose with respect to a qualified zone 
academy during that period.
    (4) Proceeds spent for rehabilitation, repair or equipment--(i) In 
general. Under section 1397E(d)(5)(A) the term qualified purpose with 
respect to any qualified zone academy includes rehabilitating or 
repairing the public school facility in which such academy is 
established. For this purpose, in determining whether proceeds are 
spent for rehabilitation, rules similar to those under section 47(c) 
(other than sections 47(c)(1)(B) and 47(c)(2)(B)(iv)) shall apply. 
Under section 1397E(d)(5)(B) the term qualified purpose also includes 
providing equipment for use at such academy. If proceeds of an issue 
are spent for a purpose described in section 1397E(d)(5)(A) or (B) with 
respect to a qualified zone academy, then those proceeds are treated as 
used for a qualified purpose with respect to the academy during any 
period after such expenditure that--
    (A) The property financed with those proceeds is used for the 
purposes of the academy; and
    (B) The academy maintains its status as a qualified zone academy 
under section 1397E(d)(4).
    (ii) Retirement from service. The retirement from service of 
financed property due to normal wear or obsolescence does not cause the 
property to fail to be used for a qualified purpose with respect to a 
qualified zone academy.
    (5) Proceeds spent to develop course materials or train teachers. 
Section 1397E(d)(5)(C) and (D) provides that the term qualified purpose 
with respect to any qualified zone academy includes developing course 
materials for education to be provided at such academy, and training 
teachers and other school personnel in such academy. If proceeds of an 
issue are spent for a purpose described in section 1397E(d)(5)(C) or 
(D) with respect to a qualified zone academy, then those proceeds are 
treated as used for a qualified purpose with respect to the academy 
during any period after such expenditure.
    (6) Special rule for determining status as qualified zone academy. 
Section 1397E(d)(4)(A)(iv) provides that a public school (or academic 
program within a public school) is a qualified zone academy only if, 
among other requirements, the public school is located in an 
empowerment zone or enterprise community (as defined in section 1393), 
or there is a reasonable expectation (as of the issue date of the 
issue) that at least 35 percent of the students attending the school or 
participating in the program (as the case may be) will be eligible for 
free or reduced-cost lunches under the school lunch program established 
under the Richard B. Russell National School Lunch Act. For purposes of 
determining whether an issue complies with section 1397E(d)(4)(A)(iv)--
    (i) A public school is treated as located in an empowerment zone or 
enterprise community for the entire term of the issue if the public 
school is located in an empowerment zone or enterprise community on the 
issue date of the issue; and
    (ii) The determination of whether there is a reasonable expectation 
(as of the issue date of the issue) that at least 35 percent of the 
students attending the school or participating in the program (as the 
case may be) will be eligible for free or reduced-cost lunches under 
the school lunch program established under the Richard B. Russell 
National School Lunch Act is based on expectations regarding the one-
year period following the issue date.
    (7) Remedial actions--(i) General rule. If less than 95 percent of 
the proceeds of an issue are properly used (as determined under 
paragraph (h)(7)(ii)(D) of this section), the issue will be treated as 
meeting the requirements of section 1397E(d)(1)(A) if the issue met the 
requirements of paragraph (h)(2)(i) of this section and a remedial 
action is taken under paragraph (h)(7)(ii) or (iii) of this section.
    (ii) Redemption or defeasance--(A) In general. A remedial action is 
taken under this paragraph (h)(7)(ii) if the requirements of paragraphs 
(h)(7)(ii)(B) and (C) of this section are met.
    (B) Retirement of nonqualified bonds--(1) In general. The 
requirements of this paragraph (h)(7)(ii)(B) are met if--
    (i) All of the nonqualified bonds of the issue (determined by 
applying the

[[Page 38776]]

principles of Sec.  1.142-2(e)) are redeemed within 90 days after the 
date on which the failure to properly use proceeds occurs; or
    (ii) To the extent of proceeds of the issue that have been actually 
spent for a qualified purpose with respect to a qualified zone academy, 
if any nonqualified bonds of the issue are not redeemed within 90 days 
after the date on which the failure to properly use such proceeds 
occurs (the unredeemed nonqualified bonds), a defeasance escrow is 
established for the unredeemed nonqualified bonds within 90 days after 
the date on which the failure to properly use proceeds occurs.
    (2) Special rule for dispositions for cash. If the failure to 
properly use proceeds is a disposition of financed property described 
in section 1397E(d)(5)(A) or (B) and the consideration for the 
disposition is exclusively cash, the requirements of this paragraph 
(h)(7)(ii)(B) are met if all of the disposition proceeds (as defined in 
paragraph (h)(7)(iv) of this section) are used within 90 days after the 
date of the disposition to redeem, or establish a defeasance escrow 
for, a pro rata portion of the nonqualified bonds of the issue.
    (3) Definition of defeasance escrow. For purposes of this section, 
a defeasance escrow is an irrevocable escrow established to retire 
nonqualified bonds on the earliest call date after the date on which 
the failure to properly use proceeds occurs in an amount that is 
sufficient to retire nonqualified bonds on that call date. At least 90 
percent of the weighted average amount in a defeasance escrow must be 
invested in investments (as defined in Sec.  1.148-1(b)), except that 
no amount in a defeasance escrow may be invested in any investment the 
obligor (or any person that is a related party with respect to the 
obligor within the meaning of Sec.  1.150-1(b)) of which is a user of 
proceeds of the bonds. All purchases or sales of an investment in a 
defeasance escrow must be made at the fair market value of the 
investment within the meaning of Sec.  1.148-5(d)(6).
    (C) Additional rules--(1) Limitation on source of funding. Proceeds 
of an issue of QZABs (other than unspent proceeds of the issue for 
which the failure to properly use proceeds occurs) must not be used to 
redeem or defease nonqualified bonds under paragraph (h)(7)(ii)(B) of 
this section.
    (2) Rebate requirement. The issuer must pay to the United States, 
at the same time and in the same manner as rebate amounts are required 
to be paid under Sec.  1.148-3 (or at such other time or in such other 
manner as the Commissioner may prescribe), any investment earnings on 
amounts in a defeasance escrow