(1) In general. Amounts held in a sinking fund for an issue (and receipts from investment of the sinking fund) are treated as proceeds of the issue.

(2) Sinking fund. The term "sinking fund" includes a debt service fund, redemption fund, reserve fund, replacement fund, or any similar fund, to the extent that the issuer reasonably expects to use the fund to pay principal or interest on the issue. ^{91982 U.S. Tax Ct. LEXIS 103">*114}

Petitioner recognizes that the regulations, if valid, remove the proposed bonds from the benefits of section 103(a)(1), ¹⁰ but it contends that the regulations go beyond the statute and, therefore, are not valid. The issue to be decided, then, turns on the validity of section 1.103-13(g)(1) and (2), Income Tax Regs. (sometimes referred to hereinafter as the sinking fund regulations). ^{111982 U.S. Tax Ct. LEXIS 103">*115}

In testing the validity of these regulations, we are reminded that the Supreme Court has taught that, in cases such as this one, the role of the judiciary "begins 1982 U.S. Tax Ct. LEXIS 103">*116 and ends with assuring that the Commissioner's regulations fall within his authority to implement the congressional mandate in some reasonable 78 T.C. 767">*774 manner." United States v. Correll, 389 U.S. 299">389 U.S. 299, 389 U.S. 299">307 (1967). Accord, e.g., Rowan Cos. v. United States, 452 U.S. 247">452 U.S. 247, 452 U.S. 247">252 (1981); Commissioner v. Portland Cement Co. of Utah, 450 U.S. 156">450 U.S. 156, 450 U.S. 156">169 (1981). In other words, the regulation in question "must be sustained unless unreasonable and plainly inconsistent with the revenue statutes." Commissioner v. South Texas Lumber Co., 333 U.S. 496">333 U.S. 496, 333 U.S. 496">501 (1948). Our task, then, is to examine the reasonableness of the regulation in the light of available evidence as to the will of Congress.

Respondent argues that the sinking fund regulations accord with the congressional purpose of section 103(c) to prevent municipalities from earning significant arbitrage profits. ¹² Petitioner, on the other hand, maintains that the legislative history of section 103(c) "demonstrates that it was enacted to deal with a particular type of transaction very different from that proposed by the City." Petitioner contends that, in enacting section 103(c), Congress was addressing "only those 1982 U.S. Tax Ct. LEXIS 103">*117 situations where investment profit is the motive for issuing the obligations and receipt of the amounts realized upon the sale of the obligations enables the issuer to invest."

Section 103(c) was enacted as part of the Tax Reform Act of 1969, Pub. L. 94-455, 90 Stat. 1765, ^{131982 U.S. Tax Ct. LEXIS 103">*119} For several years prior to that enactment, the Treasury Department had been concerned with the status of "arbitrage bonds." In 1966, the Treasury Department announced in T.I.R. 840 (Aug. 11, 1966), Stand. Fed. Tax Rept., par. 6701 (CCH 1966), that it would not issue advance rulings concerning the status of municipal or State bonds in cases in which --

a principal purpose 1982 U.S. Tax Ct. LEXIS 103">*118 is to invest the proceeds of the tax-exempt obligations in taxable obligations, generally United States Government securities, bearing 78 T.C. 767">*775 a higher interest yield. The profit received by the governmental units on the difference between the interest paid on the tax-exempt obligations and the interest earned on the taxable obligations is in the nature of arbitrage.

T.I.R. 840 described two categories of arbitrage bonds:

1. Where all or a substantial part of the proceeds of the issue (other than normal contingency reserves such as debt service reserves) are only to be invested in taxable obligations which are, in turn, to be held as security for the retirement of the obligations of the governmental unit.

2. Where the proceeds of the issue are to be used to refund outstanding obligations which are first callable more than five years in the future, and in the interim, are to be invested in taxable obligations held as security for the satisfaction of either the current issue or the issue to be refunded.

Subsequent to the issuance of T.I.R. 840, bills were introduced in both the House and the Senate to remove arbitrage bonds from the exemption provided by section 103(a). See H.R. 11757 and S. 2636, 90th Cong., 1st Sess. (1967). Upon introducing H.R. 11757, Representative John Byrnes stated as follows (113 Cong. Rec. 20,033 (daily ed. July 25, 1967)):

The mechanics of an arbitrage bond are simple. A State or local government issues bonds and agrees to invest the proceeds in Federal bonds which are then placed in escrow for the payment of interest and principal on the State or local bonds. The investor in these bonds has a certificate which represents neither more nor less than an interest in Federal bonds, but because the interest payments made by the Federal Government pass through the hands of the State or local government it is argued that the interest is exempt. The local government thus makes a profit from the interest differential that exists between the taxable Federal securities and the nontaxable securities which it purports to issue.

* * * Arbitrage bonds really represent an agreement by the issuer to act as a conduit or trustee for passing interest 1982 U.S. Tax Ct. LEXIS 103">*120 on Federal bonds to private persons and they are not "obligations" of a State or local government within the meaning of existing law. * * *

A similar statement concerning S. 2636 was made by Senator Abraham Ribicoff (113 Cong. Rec. 31,613 (1967)).

Neither H.R. 11757 nor S. 2636 became law, but the House of Representatives inserted a provision in the bill that ultimately became the Tax Reform Act of 1969 to the effect that, "Under regulations prescribed by the Secretary, * * * any arbitrage obligation shall be treated as an obligation not described" in section 103(a)(1). ^{141982 U.S. Tax Ct. LEXIS 103">*121}

78 T.C. 767">*776 In hearings before the Senate Finance Committee, the Treasury Department advised in a statement by Assistant Secretary Cohen that it favored the House bill's denial of tax exemption to so-called arbitrage bonds but that "the scope of the term 'arbitrage obligation' should be described with some further particularity in the bill." Hearings on H.R. 13270 Before the Senate Comm. on Finance, 91st Cong., 1st Sess. (Part 1) 619 (1969). The Senate ultimately adopted a provision almost identical to the finally enacted section 103(c). The Senate explained its amendment of the House bill in S. Rept. 91-552, at 219-220 (1969), 1969-3 C.B. 562, as follows:

Explanation of provision. -- Both the House bill and the committee amendments make provision 1982 U.S. Tax Ct. LEXIS 103">*122 for the taxation of arbitrage bonds issued by State or local governments. The House bill provided that, under regulations prescribed by the Secretary of the Treasury or his delegate, any arbitrage obligation was not to be treated as a tax-exempt State or local government bond. It was contemplated that the regulations issued by the Secretary of the Treasury would provide rules for the temporary investment of proceeds from the State or local government obligation pending their expenditure for the governmental purpose which gave rise to the issue.

The committee amendments also provide that arbitrage bonds are not to be treated as tax-exempt State or local government issues. However, under the committee amendments, arbitrage bonds are defined. They are in general defined as obligations issued where all or a major part of the proceeds can be reasonably expected to be used (directly or indirectly) to acquire securities or obligations which may be reasonably expected, at the time of the issuance of the State or local obligation, to produce a yield which is materially higher than the yield of the State or local governmental bond issue. Arbitrage bonds are also defined as including obligations 1982 U.S. Tax Ct. LEXIS 103">*123 issued to replace funds which were used to acquire (directly or indirectly) the type of securities or obligations referred to above. ¹⁵

78 T.C. 767">*777 It is true, as the city emphasizes, that Congress did not specifically consider the invested sinking fund in its deliberations concerning section 103(c). However, the legislative history which we have summarized evinces a legislative purpose to broaden the scope of the provision 1982 U.S. Tax Ct. LEXIS 103">*124 beyond the relatively narrow categories specifically described in T.I.R. 840, which initially prompted congressional action. As was recently stated in Fairfax Co. Econ. Dev. Auth. v. Commissioner, 77 T.C. 546">77 T.C. 546, 77 T.C. 546">558 (1981), on appeal (D.C. Cir., Oct. 8, 1981):

The legislative concern behind section 103(c) was to prevent local Governments from issuing bonds whose proceeds were to be invested in higher yielding securities of the United States. * * * [However,] Congress attacked the general problem rather than the narrow, triggering incidents upon which its concerns were based, in order to prevent the erosion of the Federal tax base and protect the market for genuine State and municipal bonds. * * *

In State of Washington v. Commissioner, 77 T.C. 656">77 T.C. 656, 77 T.C. 656">668-669 (1981), on appeal (D.C. Cir., Dec. 22, 1981), this Court said:

There is no indication in the legislative history of why Congress did not confine section 103(c) within a "conduit" frame of reference [see Representative Byrnes' statement, supra]. It is entirely possible that Congress, recognizing that its primary objective should be to eliminate the "profit" element which permeated the use of arbitrage bonds, did not want to dilute 1982 U.S. Tax Ct. LEXIS 103">*125 the accomplishment of that objective by excluding bonds not * * * secured [by obligations of the United States], even though the potential for "profit" was present, to say nothing of the qualifications and exemptions which might have had to have been engrafted on the statute. In this context, the anti-"profit" purpose of Congress in enacting section 103(c) becomes even more significant. In short, as finally enacted, section 103(c) was designed to deal only with the legislative concern that arbitrage profits should be eliminated. [Fn. ref. omitted.]

Thus, contrary to petitioner's contention, section 103(c) applies not only to the categories of direct investment set forth in T.I.R. 840 (see p. 774 supra), but to the use of bond proceeds 78 T.C. 767">*778 "directly or indirectly" to acquire any type of taxable security or obligation or to replace funds used "directly or indirectly" to acquire such securities or obligations. The broad language of the section, read in the context of its legislative history, shows a purpose to prevent avoidance of the force of the statute through manipulation of the form of municipal borrowing in such a way as to create arbitrage profits. We think the disputed regulations 1982 U.S. Tax Ct. LEXIS 103">*126 must be tested in the light of the broad legislative objective that significant amounts of arbitrage profits be eliminated.

Between 1970 and 1978, proposed regulations were issued, withdrawn, reissued, revised, and corrected several times without any indication that tax and other revenues deposited in a sinking fund would be subject to the section 103(c) arbitrage limitations. Petitioner contends that, therefore, the sinking fund regulations issued in 1979 represent a repudiation of the Treasury Department's original construction of section 103(c) as reflected by earlier proposed regulations. We disagree. ¹⁶

As stated in National Muffler Dealers Assn. v. United States, 440 U.S. 472">440 U.S. 472, 440 U.S. 472">477 (1979), if a regulation does not constitute a substantially contemporaneous construction of the statute by those presumed to have been aware of congressional 1982 U.S. Tax Ct. LEXIS 103">*127 intent, "the manner in which it evolved merits inquiry." It is necessary, therefore, to examine the evolution of the sinking fund regulations.

It is true, as petitioner emphasizes, that the earlier proposed regulations did not deal with sinking funds. The preamble to the proposed sinking fund regulations, first issued on May 8, 1978 (43 Fed. Reg. 19675 (1978)), states that such regulations were being adopted because --

Some issuers have avoided the restrictions on investment yield by contributing taxes or other revenues to a sinking fund. The sinking fund is then invested at a rate which allows the issuer, where the entire issue is retired at 78 T.C. 767">*779 the end of a fixed period, to make a profit on the investment of the fund. * * *

Revisions of the proposed sinking fund regulations published in 43 Fed. Reg. 39822 (1978) explained in greater detail the rationale for adopting such rules:

INVESTED SINKING FUNDS

Typically, municipal bonds have serial maturities. For example, if a city sells $ 10 million of 20-year school bonds, the city may use property taxes to pay a portion of the principal each year. Thus, for the protection of the bondholders, the bonds will be paid off gradually over 20 years 1982 U.S. Tax Ct. LEXIS 103">*128 and the $ 10 million principal amount will not come due all at once. However, if the city employs an invested sinking fund, it will not pay any principal until the bonds come due in 20 years. Instead, the city will periodically pay property taxes into a sinking fund. Amounts held in the sinking fund will be invested in high-yield Treasury notes or other high-grade investments, enabling the city to make a substantial investment profit.

The invested sinking fund was devised as a way around Treasury's arbitrage regulations. Certain State and local governments were able to gain a financial advantage from invested sinking funds. However, invested sinking funds (like other forms of arbitrage) have the long-term effect of being a burden on taxpayers and a threat to the market for municipal bonds. In particular, invested sinking funds damaged the tax-exempt market in two ways. First, bonds that used this device were left outstanding longer because they were not retired serially. Second, many refunding issues were motivated chiefly by the profit that could be earned from an invested sinking fund; these issues would not have been sold if that profit had not been available. The invested 1982 U.S. Tax Ct. LEXIS 103">*129 sinking fund device could have resulted in nearly a 50-percent increase in the amount of tax-exempt bonds outstanding without taking account of advance refundings.

Prior to the final adoption of the sinking fund regulations, Senator Bentsen introduced a bill, S. 3370, 95th Cong., 2d Sess. (1978), to declare the proposed regulations invalid. At the Senate Finance Committee hearings on the bill, representatives of the Treasury Department and of various State and local governments testified. In the course of those hearings, Assistant Secretary Lubick explained that the sinking fund regulations were adopted in response to a relatively new and widespread attempt to circumvent section 103(c) through the use of sinking funds, ^{171982 U.S. Tax Ct. LEXIS 103">*132} in part, as follows (Hearings on H.R. 78 T.C. 767">*780 13511 Before the Senate Comm. on Finance, 95th Cong., 2d Sess. (Part 4) 950 (1978)):

1982 U.S. Tax Ct. LEXIS 103">*130 The computer programed invested sinking fund is a relatively new device. We had sinking funds around for a long time. But by and large, the computer programed investment fund that we are talking about these days is about a year or two old and is an ingenious way of circumventing the arbitrage rules which were enacted by the Congress in 1969.

Typically, municipal bonds were issued with a serial maturity. After a certain period, bonds of a given issue would mature and be retired; or, they may have a single terminal date, but a certain portion of them would be called each year after being outstanding for a period of time.

Now, the invested sinking fund changes that practice by leaving the entire amount of an issue outstanding until the ultimate maturity date, and, instead of calling bonds or having a portion of the bonds mature prior to that date, the revenues from the project are put into a sinking fund and invested, usually secured by U.S. bonds, and held until the ultimate maturity date, in which case bonds are then paid off.

The result is that during this extended period, during which the sinking fund is built up and invested, you have an arbitrage profit earned by the State and local 1982 U.S. Tax Ct. LEXIS 103">*131 government. Its bonds are outstanding, for example, at 6 or 5.5 percent and the sinking fund is building up and earning interest at 7.5 or 8 percent.

It is to the advantage of the State and local government to keep the bonds outstanding as long as possible, until the ultimate maturity, because it can make this arbitrage profit.

The bill to declare the proposed regulations invalid was not enacted. ^{181982 U.S. Tax Ct. LEXIS 103">*133} the regulations were promulgated as final regulations 78 T.C. 767">*781 in T.D. 7627, effective for obligations issued after May 31, 1979. 44 Fed. Reg. 32657 (1979).

5. Validity of Sinking Fund Regulations

The foregoing history of the sinking fund regulations shows they were adopted in response to efforts by borrowing municipalities to circumvent section 103(c) by using invested sinking funds to realize profits on the difference between the interest paid on tax-exempt obligations and the interest received from taxable obligations. The municipalities could achieve this result by accumulating a sinking fund expected to be used for the repayment of bonds, holding the annually increasing fund until the entire (or most of the) bond issue became due at the end of a 20-year period, for example, and in the meantime investing the funds in Federal Government (or other) securities paying higher interest rates. ^{191982 U.S. Tax Ct. LEXIS 103">*135} Such use of a sinking fund 78 T.C. 767">*782 produces the same undesirable consequences of arbitrage as section 103(c) was intended to cure -- the issuance of an abnormally large volume of bonds in relation to municipal needs for improvements, increased public borrowing 1982 U.S. Tax Ct. LEXIS 103">*134 costs, the crowding of weaker borrowers out of the market, and a loss of Federal revenues. The sinking fund regulations designed to control this "relatively new" and "ingenious way of circumventing the arbitrage rules" (see statement of Assistant Secretary Lubick, p. 779 supra) are thus clearly consistent with the broad objectives and purposes of section 103(c).

In deciding whether the regulations are "unreasonable and plainly inconsistent" with the language of section 103(c), 333 U.S. 496">Commissioner v. South Texas Lumber Co., supra at 501, it is important to bear in mind the expansive terms of that section. It defines an arbitrage bond, which "shall be treated" as one not entitled to exemption, as an obligation which is issued where "all or a major portion" of its proceeds are "reasonably expected to be used directly or indirectly" to "replace funds which were used directly or indirectly" to acquire higher yielding obligations. Respondent argues that the moneys to be deposited in the city's sinking fund will be used directly to acquire materially higher yielding securities (which will be, in effect, pledged to the repayment of the proposed bonds) and that the proceeds of the proposed bonds are "reasonably expected" to be used "indirectly" 1982 U.S. Tax Ct. LEXIS 103">*136 to replace those moneys. He emphasizes that this argument must be viewed in the light of section 103(c)(6) in which Congress, apparently recognizing that it could not foresee all forms that arbitrage might take, directed the Secretary to prescribe regulations necessary to carry out the "purposes" of the section. See Commissioner v. Portland Cement Co. of Utah, 450 U.S. 156">450 U.S. 156, 450 U.S. 156">169 (1981); Douglas v. Commissioner, 322 U.S. 275">322 U.S. 275, 322 U.S. 275">280, 322 U.S. 275">281 (1944).

Petitioner's position, however, is that the language of section 103(c)(2)(B) will not support the regulations. The city emphasizes that section 103(c) deals with the expected use of bond "proceeds"; it argues that the literal and commonly understood meaning of that term (viz, amounts received upon 78 T.C. 767">*783 the sale of obligations) precludes characterization of the sinking fund moneys as "proceeds." Second, emphasizing the "were used" language of section 103(c)(2)(B), the city contends that the proceeds of the proposed bonds will not "replace" moneys which will be deposited in the sinking fund.

We disagree with the city's contention that the literal meaning of the term "proceeds" or the "were used" language is dispositive of the question before us. The 1982 U.S. Tax Ct. LEXIS 103">*137 sinking fund regulations do not state that sinking fund moneys are bond "proceeds"; rather, the regulations state that such moneys shall be "treated as proceeds" to the extent that the issuer reasonably expects to use the moneys to pay principal or interest on the issue. This is more than a linguistic difference. ²⁰Section 103(c)(2)(B) in defining arbitrage bonds refers to bond proceeds "reasonably expected" to be used "directly or indirectly" to replace "funds" which were used "directly or indirectly" to acquire higher yielding securities. We think the regulations reasonably implement this language in requiring that "funds" be "treated as proceeds" of bonds for purposes of section 103(c) if such "funds" are in fact "reasonably expected" to be "directly or indirectly" replaced by bond proceeds.

If a municipality accumulates funds (from sources other than bonds) to finance a public project, but then uses those funds to acquire high yielding taxable obligations and sells its own tax-exempt bonds expecting to use the 1982 U.S. Tax Ct. LEXIS 103">*138 proceeds for the public project, it seems clear that the accumulated funds have been indirectly replaced by bond proceeds and, for the purposes of section 103(c), should be "treated as proceeds" of the bonds. Economically, the municipality is in the same position it would have been had it used the accumulated funds for the public project and issued the bonds to acquire the higher yielding taxable securities.

We perceive no reason why a municipality which issues bonds to be used for a particular purpose, reasonably expecting to collect funds which otherwise would be used for that purpose but which will be invested pending the retirement of the bonds, should be treated differently from a municipality which collects and invests the funds before issuing bonds. It 78 T.C. 767">*784 seems unlikely that Congress would have given the broad direction to the Secretary in section 103(c)(6) to issue regulations "to carry out the purposes" of the subsection had it intended the language to be taken as literally and narrowly as petitioner reads it; none of the legislative history suggests that the time sequence of events producing arbitrage was to be decisive. As stated by respondent --

Under section 103(c), the 1982 U.S. Tax Ct. LEXIS 103">*139 determination of whether a bond is an arbitrage bond depends on the issuer's reasonable expectations at the time of issuance. In other words, section 103(c) is concerned with the issuer's expectations as to the future use of proceeds. In particular, section 103(c)(2)(B) is concerned that bond proceeds not be used (at some future time) to replace funds that were used to acquire obligations.

It is true that, as petitioner emphasizes, the proceeds of its proposed bonds may be used "directly" only to pay for public street improvements. It is also true that the amounts to be deposited into the sinking fund for the proposed bonds may be used "directly" only to pay debt service on those bonds. But section 103(c) is not limited to the direct use of bond proceeds. The section also covers indirect use. We think it may reasonably be said that the bond proceeds are expected to be used "indirectly" to replace moneys to be deposited into the sinking fund. ²¹ In terms of economics, due to the restrictions limiting the use of petitioner's sinking fund to payment of debt service on the bonds, the deposits into the fund will have much the same effect as a retirement of the bonds to the extent of 1982 U.S. Tax Ct. LEXIS 103">*140 the deposits. However, as long as the city chooses not to retire the bonds, it will be able to exploit the difference between taxable and tax-exempt bond interest rates, ^{221982 U.S. Tax Ct. LEXIS 103">*141} i.e., to earn an arbitrage profit by investing the sinking fund in taxable securities or obligations. ²³ In a very real sense, then, the direct use of the 78 T.C. 767">*785 bond proceeds to pay for street improvements will indirectly replace the amounts deposited into the sinking fund pledged to the repayment of the debt (and which, thus, will indirectly be used to pay for the street improvements) by freeing those amounts for investment during the period the bonds are outstanding. ^{241982 U.S. Tax Ct. LEXIS 103">*142}

In summary, the sinking fund regulations evolved in the light of Treasury's experience in administering section 103(c), as a response to efforts to circumvent that section. They serve the purpose of section 103(c) to eliminate arbitrage profits and do not conflict with the language of section 103(c). The regulations should, therefore, be sustained. We have no doubt that other reasonable 1982 U.S. Tax Ct. LEXIS 103">*143 interpretations of the statutory language in question can be advanced, but: "The choice among reasonable interpretations is for the Commissioner, not the courts." National Muffler Dealers Assn. v. United States, 440 U.S. 472">440 U.S. 472, 440 U.S. 472">488 (1979). We must therefore decline the city's request to declare that the proposed obligations are described in section 103(a)(1).

An appropriate decision will be entered.