PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGE ATTORNEY WORK PRODUCT
MEMORANDUM
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I. Executive Summary and Purpose
The purpose of this memorandum is to identify and analyze the federal tax requirements that must be satisfied on a continuing basis to maintain the tax-exempt status of interest on the Cascadia State Infrastructure Authority Water Treatment Revenue Bonds, Series 2023A (Tax-Exempt) (the "Series 2023A Bonds" or the "Bonds"), in the aggregate principal amount of $220,000,000, under Section 103 of the Internal Revenue Code of 1986, as amended (the "Code"). This memorandum is intended for use by the Calderwood & Harkness LLP engagement team in connection with our representation of the Cascadia State Infrastructure Authority ("CSIA" or the "Authority") and will inform the preparation of the Tax Regulatory Agreement and Certificate (the "Tax Regulatory Agreement") to be executed by CSIA, targeted for October 15, 2023, approximately nine days prior to the anticipated closing date of October 24, 2023.
The Series 2023A Bonds. The Bonds are designated as the "Cascadia State Infrastructure Authority Water Treatment Revenue Bonds, Series 2023A (Tax-Exempt)," and are being issued in the aggregate principal amount of $220,000,000, bearing interest at a fixed coupon rate of 3.25% per annum (325 basis points), with a dated date of October 24, 2023, and a final maturity date of October 1, 2053, representing a 30-year final maturity. Interest is payable semiannually on each April 1 and October 1, commencing April 1, 2024. The Bonds are being issued at an original issue discount, with an initial offering price of 99.25% of par.
Issuer. The issuer of the Bonds is CSIA, a Washington State governmental instrumentality and public body corporate created pursuant to Chapter 43.160A of the Revised Code of Washington ("RCW"). CSIA maintains its principal office at 1100 Capitol Way South, Suite 400, Olympia, Washington 98501. The Authority's Employer Identification Number is 91-2058374. CSIA was established by the Washington State Legislature for the purpose of financing, constructing, operating, and maintaining public infrastructure projects of statewide significance, including water treatment, wastewater management, and related environmental infrastructure.
The Project. Net bond proceeds will be used to fund the design, construction, equipping, and commissioning of the Puget Sound Regional Advanced Water Treatment Facility (the "PSRAWTF" or the "Project"), a 60-million-gallon-per-day ("MGD") advanced membrane-filtration and ultraviolet ("UV") disinfection water-treatment facility to be located at 7250 Deschutes Parkway, Tumwater, Thurston County, Washington 98501. The Project is expected to serve as a critical regional water-treatment asset for the greater Puget Sound region, providing wholesale treated water to 14 participating municipal water and sewer districts under long-term Wholesale Water Treatment Services Agreements.
Use of Proceeds. Bond proceeds will be used to fund the design, construction, and commissioning of the Project under a guaranteed maximum price ("GMP") contract (Contract No. CSIA-DB-2023-001) with Northtide Environmental Engineering, Inc. ("Northtide"), a licensed design-build contractor with significant experience in municipal water-treatment infrastructure. The GMP under the design-build contract is $193,500,000, encompassing all design, engineering, procurement, construction, testing, and commissioning costs for the PSRAWTF. The total estimated project cost is $237,400,000, to be funded from the following sources:
Tax Regulatory Agreement. This memorandum will serve as the primary analytical foundation for the Tax Regulatory Agreement and Certificate to be executed by CSIA on or about October 15, 2023. The Tax Regulatory Agreement will memorialize CSIA's covenants, representations, and certifications regarding ongoing tax compliance for the Series 2023A Bonds and will be a closing deliverable at the October 24, 2023 closing.
Co-Bond Counsel. Calderwood & Harkness LLP is serving as Co-Bond Counsel to CSIA in connection with the issuance of the Bonds, together with Pryor Crestfield LLP. Margaret S. Yoon is the lead partner at Pryor Crestfield, and Elliot R. Stanton is the associate assigned to the matter at that firm. George Trujillo is the lead engagement partner at Calderwood & Harkness, and this memorandum has been prepared at his direction. Co-Bond Counsel will jointly deliver the Tax Opinion dated October 24, 2023, opining that interest on the Bonds is excludable from gross income for federal income tax purposes under existing law, subject to the Authority's compliance with the Tax Regulatory Agreement.
Summary of Key Compliance Areas. The analysis contained in this memorandum addresses the following principal areas of federal tax law compliance that govern the maintenance of the tax-exempt status of the Series 2023A Bonds:
1. Governmental bond qualification and the private activity bond tests under Section 141 of the Code;
2. Arbitrage yield restriction and rebate requirements under Sections 148 and 149 of the Code;
3. Hedge identification rules under Treasury Regulation Section 1.148-4(h);
4. Temporary period and spending exceptions under Section 148(c) and the applicable Treasury Regulations;
5. Treatment of the debt-service reserve fund surety policy under Section 148(d);
6. The federal guarantee prohibition under Section 149(b);
7. Information reporting requirements under Section 149(e);
8. Change-in-use and remedial action requirements under Treasury Regulation Section 1.141-12;
9. Record retention obligations; and
10. Ongoing compliance monitoring recommendations.
Each of these areas is discussed in detail in the sections that follow.
II. Qualification as Tax-Exempt Obligations Under Section 103
A. General Rule — Section 103(a)
Section 103(a) of the Code provides the foundational rule that gross income does not include interest on any "State or local bond." For purposes of Section 103, a "State or local bond" is defined in Section 103(c) as an obligation of a State or political subdivision thereof. Interest on such a bond is excludable from gross income, however, only if the bond satisfies each of the following conditions:
(i) The bond is not a "private activity bond" within the meaning of Section 141 of the Code (unless the bond is a "qualified bond" as described in Section 141(e), which category is not applicable to the Series 2023A Bonds);
(ii) The bond is not an "arbitrage bond" within the meaning of Section 148 of the Code; and
(iii) The bond is not "federally guaranteed" within the meaning of Section 149(b) of the Code.
Additionally, Section 149(e) imposes certain information reporting requirements as a condition of tax exemption. A failure to comply with these reporting requirements may, in certain circumstances, result in the retroactive loss of tax-exempt status.
The Series 2023A Bonds are issued by CSIA, a Washington State governmental instrumentality and public body corporate created by statute. As such, CSIA constitutes a political subdivision or instrumentality of the State of Washington for purposes of Section 103 of the Code, and the Bonds are "State or local bonds" within the meaning of Section 103(c). Accordingly, the threshold requirement for tax-exempt status — that the Bonds be obligations of a State or political subdivision thereof — is satisfied.
It is noted that the State of Washington does not impose a state personal income tax. Accordingly, no separate analysis of state-level tax-exemption requirements is necessary in connection with this issuance. The analysis in this memorandum is limited to federal tax considerations under the Code and the applicable Treasury Regulations.
B. Governmental Bond Classification
The Series 2023A Bonds are intended to qualify as "governmental bonds" — that is, bonds that are not private activity bonds within the meaning of Section 141 of the Code. A governmental bond is the most straightforward category of tax-exempt obligation and is subject to fewer restrictions than qualified private activity bonds or qualified 501(c)(3) bonds.
The proceeds of the Series 2023A Bonds will be used to fund the construction of the PSRAWTF, a governmental water-treatment facility that will be owned and operated by CSIA, a public body corporate. The Project will be a capital asset of CSIA, and CSIA will operate the facility through its own employees and staff. There is no current plan or expectation that any portion of the facility will be owned, leased, or operated by a private entity.
The Project will serve 14 participating municipal water and sewer districts (the "Participating Districts"), each of which has entered into (or will enter into prior to closing) a long-term Wholesale Water Treatment Services Agreement (each, a "Service Agreement") with CSIA. Under the Service Agreements, the Participating Districts will purchase wholesale treated water from CSIA at rates established by CSIA's governing board. The revenues generated under the Service Agreements constitute the principal source of pledged revenues securing the Bonds.
A threshold question is whether the Service Agreements with the Participating Districts constitute "arrangements" that give rise to "private business use" for purposes of the Section 141 analysis. They do not. Each of the 14 Participating Districts is a municipal corporation, special purpose district, or other governmental entity organized under Washington State law. Under Section 141(b), the private business use test applies only to use by persons other than "governmental units." Because each Participating District is itself a governmental unit, the wholesale water service arrangements do not constitute private business use, and the Service Agreements do not cause the Bonds to be private activity bonds. This conclusion is consistent with Treasury Regulation Section 1.141-1(b), which defines "governmental use" as use by a state or local governmental unit. The analysis is further developed in Section III below.
III. Private Activity Bond Tests — Section 141
A. Overview of the Two-Prong Test
Section 141(a) of the Code provides that a bond is a "private activity bond" if it satisfies both prongs of a two-part test:
(1) Private Business Use Test (§ 141(b)(1)): More than 10% of the proceeds of the issue are to be used (directly or indirectly) in a trade or business of any person other than a governmental unit; and
(2) Private Security or Payment Test (§ 141(b)(2)): More than 10% of the payment of principal of (or interest on) the issue is (directly or indirectly) secured by an interest in property used or to be used for a private business use, or payments in respect of such property, or is to be derived from payments (whether or not to the issuer) in respect of property or borrowed money used or to be used for a private business use.
Both prongs must be met for the bonds to constitute private activity bonds. If only one prong is satisfied, the bonds are not private activity bonds.
In addition, Section 141(c) provides an alternative test — the private loan financing test — under which a bond is a private activity bond if the lesser of (i) 5% of the proceeds or (ii) $5,000,000 is used (directly or indirectly) to make or finance loans to persons other than governmental units. This is a standalone test; satisfaction of the private loan financing test alone, without satisfaction of the two-prong test, is sufficient to render the bonds private activity bonds.
If either the two-prong test or the private loan financing test is met, the Bonds would fail to qualify as governmental bonds and would lose their tax-exempt status under Section 103 (unless they otherwise qualify as "qualified bonds" under Section 141(e), which is not applicable to this issuance). It is therefore essential that CSIA ensure compliance with these tests both at the time of issuance and on a continuing basis throughout the life of the Bonds.
B. Private Business Use Test — Section 141(b)(1)
1. The 10% Threshold
Under Section 141(b)(1), a bond issue meets the private business use test if more than 10% of the proceeds of the issue are to be used (directly or indirectly) in the trade or business of any person other than a governmental unit. For this purpose, "use" includes ownership, actual or beneficial use pursuant to a lease, a management or service contract, an output contract, a research agreement, or any other arrangement that conveys to a nongovernmental person special legal entitlements to use bond-financed property. Treasury Regulation Section 1.141-3 provides detailed guidance on the types of arrangements that constitute private business use.
The 10% threshold is measured by reference to the "proceeds" of the issue. For this purpose, "proceeds" include the original proceeds of the issue as well as any investment proceeds and other amounts constituting "gross proceeds" under Treasury Regulation Section 1.148-1(b). For the Series 2023A Bonds, the relevant proceeds consist primarily of the net bond proceeds of approximately $215,490,000 deposited in the Project Fund for construction of the PSRAWTF.
2. Analysis of the PSRAWTF
The following analysis addresses each potential category of private business use with respect to the PSRAWTF:
Ownership. The PSRAWTF will be owned by CSIA, a governmental entity. No portion of the facility will be owned by any private person or nongovernmental entity. Governmental ownership is the most fundamental indicator that the facility is being used for a governmental purpose, and CSIA's ownership of the Project does not give rise to any private business use.
Operation. The PSRAWTF will be operated by CSIA personnel. CSIA maintains a professional staff of water-treatment engineers, operators, and administrative personnel who will be responsible for the day-to-day operation and maintenance of the facility. There is no management contract, operating agreement, or service contract with any private operator in connection with the operation of the PSRAWTF. Accordingly, no private business use arises from the operation of the facility.
Design-Build Contract with Northtide Environmental Engineering, Inc. CSIA has entered into (or will enter into) GMP Contract No. CSIA-DB-2023-001 with Northtide Environmental Engineering, Inc. for the design and construction of the PSRAWTF, with a guaranteed maximum price of $193,500,000. This contract is a construction contract, not a management or service contract. Under longstanding IRS guidance, including Revenue Procedure 97-13 (as modified and superseded by Revenue Procedure 2017-13, 2017-6 I.R.B. 787), construction contracts generally do not give rise to private business use. A construction contract involves the engagement of a private party to design and build a facility, after which the facility is delivered to and operated by the governmental issuer. The private party does not retain any ongoing right to use or operate the facility, and the governmental issuer assumes full control upon completion. The Northtide GMP contract is structured as a conventional design-build arrangement with a guaranteed maximum price, milestone-based progress payments, substantial completion requirements, and a one-year warranty period. Upon substantial completion and final acceptance, CSIA will assume full ownership and operational responsibility. Accordingly, the Northtide GMP contract does not give rise to private business use under the applicable standards.
Wholesale Water Treatment Services Agreements with Participating Districts. As discussed in Section II.B above, CSIA has entered into (or will enter into) Wholesale Water Treatment Services Agreements with 14 Participating Districts. Each Participating District is a municipal corporation, water district, or sewer district organized under Washington State law — each is a "governmental unit" for purposes of Section 141. Use of the PSRAWTF to provide wholesale treated water to governmental Participating Districts constitutes governmental use, not private business use. Treasury Regulation Section 1.141-1(b) makes clear that use by a state or local governmental unit is not private business use, regardless of the contractual terms of the intergovernmental arrangement. Accordingly, the Service Agreements with the 14 Participating Districts do not give rise to any private business use.
Output Contracts. No output contracts with nongovernmental persons are anticipated in connection with the PSRAWTF. The facility will produce treated water exclusively for distribution to the governmental Participating Districts. If CSIA were to enter into any arrangement to sell treated water directly to a private customer (e.g., a private industrial user), such an arrangement could constitute an output contract giving rise to private business use. However, no such arrangements are currently contemplated, and the Tax Regulatory Agreement will include a covenant prohibiting CSIA from entering into any such arrangement without prior bond counsel consultation.
Naming Rights, Advertising, and Other Arrangements. There are no naming rights agreements, advertising contracts, or other arrangements with private parties that would convey special legal entitlements to use any portion of the PSRAWTF. If any such arrangements were contemplated in the future, they would need to be evaluated for private business use implications under Treasury Regulation Section 1.141-3.
3. Conclusion. Based on the foregoing analysis, private business use of the PSRAWTF is expected to be 0% of the proceeds of the Series 2023A Bonds. This is well below the 10% threshold of Section 141(b)(1), and the private business use test is not met.
C. Private Security or Payment Test — Section 141(b)(2)
Under Section 141(b)(2), a bond issue meets the private security or payment test if the payment of principal of (or the interest on) more than 10% of the proceeds of the issue is (directly or indirectly) (i) secured by an interest in property used or to be used for a private business use, or payments in respect of such property, or (ii) to be derived from payments (whether or not to the issuer) in respect of property or borrowed money used or to be used for a private business use.
The security for the Series 2023A Bonds consists of a pledge of net water-treatment revenues of CSIA. These pledged revenues are derived from the following principal sources:
(a) Wholesale water treatment service charges paid by the 14 governmental Participating Districts under the Service Agreements;
(b) Connection fees assessed by CSIA in connection with new connections to the water-treatment system; and
(c) Investment earnings on pledged funds held under the Bond Indenture.
For fiscal year 2022, gross pledged revenues of CSIA were approximately $489,300,000, and net pledged revenues (after deduction of operating and maintenance expenses) were approximately $412,600,000. These revenues are derived entirely from governmental sources — the Participating Districts are all governmental entities, and no portion of the pledged revenues is derived from payments by private persons or entities in respect of private business use of the PSRAWTF or any other bond-financed property.
No property used for a private business use directly or indirectly secures the Bonds. No payments from private persons are pledged or otherwise available to pay debt service on the Bonds. Accordingly, the private security or payment test of Section 141(b)(2) is not met.
Because neither the private business use test nor the private security or payment test is met, the two-prong test of Section 141(a) is not satisfied, and the Series 2023A Bonds do not constitute private activity bonds under the two-prong test.
D. Private Loan Financing Test — Section 141(c)
Under Section 141(c), a bond is a private activity bond if an amount exceeding the lesser of (i) 5% of the proceeds of the issue or (ii) $5,000,000 is used (directly or indirectly) to make or finance loans to persons other than governmental units. For the Series 2023A Bonds, 5% of proceeds would be approximately $10,774,500 (5% of $215,490,000). Thus, the applicable threshold under Section 141(c) is $5,000,000.
No portion of the proceeds of the Series 2023A Bonds will be used to make or finance loans to any person, whether governmental or nongovernmental. All bond proceeds will be deposited in the Project Fund and disbursed to fund the design and construction of the PSRAWTF, a publicly owned capital facility. The proceeds are not being used to provide financing to any third party, whether through direct loans, installment purchase agreements, conditional sale contracts, or any other lending arrangement.
Accordingly, the private loan financing test of Section 141(c) is not met, and the Series 2023A Bonds do not constitute private activity bonds under this alternative test.
E. Ongoing Monitoring Obligations
It is critical to emphasize that the private activity bond tests are not one-time requirements to be satisfied only at the time of issuance. CSIA must monitor the use of all bond-financed property throughout the entire term of the Series 2023A Bonds, from the issue date of October 24, 2023, through final maturity on October 1, 2053 — a period of approximately 30 years.
Any subsequent change in the use of the PSRAWTF or any other bond-financed property must be evaluated for private business use implications. Without limitation, the following types of actions or arrangements could give rise to private business use concerns and must be reviewed by bond counsel prior to implementation:
• Leases or subleases of any portion of the PSRAWTF to a private party;
• Management contracts or operating agreements with private operators for the operation of all or any portion of the facility;
• Service contracts with private parties that convey special legal entitlements to use the facility;
• Output contracts with private customers for the sale of treated water;
• Naming rights agreements or sponsorship arrangements with private entities;
• Research agreements with private companies or institutions;
• Any sale, transfer, or other disposition of bond-financed property to a nongovernmental person; and
• Any other arrangement that could be construed as providing a private party with a special legal entitlement to use the financed facility.
If an unexpected private business use arises — whether through a deliberate action by CSIA or through changed circumstances — CSIA may be able to preserve the tax-exempt status of the Bonds by undertaking a "remedial action" under Treasury Regulation Section 1.141-12. The available remedial actions are discussed in detail in Section XII of this memorandum. However, the preferred approach is prevention: CSIA should establish internal compliance procedures to ensure that all proposed actions and arrangements involving the PSRAWTF are reviewed by bond counsel before they are implemented.
IV. Arbitrage Yield Restriction — Section 148(a) and (b)
A. General Arbitrage Bond Prohibition
Section 148(a) of the Code provides that a bond shall be treated as an "arbitrage bond" if any portion of the proceeds of the issue is reasonably expected (at the time of issuance) to be used directly or indirectly to acquire higher-yielding investments, or if the proceeds are intentionally used to acquire such investments. If a bond is an arbitrage bond, the interest on the bond is not excludable from gross income under Section 103(a). The arbitrage provisions are designed to prevent state and local governmental issuers from exploiting their ability to borrow at tax-exempt rates by investing the proceeds of tax-exempt bonds in higher-yielding taxable investments and earning an arbitrage profit at the expense of the federal treasury.
Bond Yield. The yield on the Series 2023A Bonds is the critical benchmark against which the yield on investments of bond proceeds is measured. The Bonds bear a stated coupon rate of 3.25% per annum. However, because the Bonds are being offered at an issue price of 99.25% of par (representing an original issue discount, or "OID," of $1,650,000), the actual yield on the Bonds for arbitrage purposes will be slightly higher than the 3.25% coupon rate.
The issue price of the Bonds is calculated as follows:
For arbitrage purposes, the "yield" on the Bonds is computed under Treasury Regulation Section 1.148-4 and is the discount rate that, when applied to all payments of principal and interest on the Bonds, produces a present value equal to the issue price of $218,350,000 (the aggregate initial offering price to the public). Because the issue price reflects the OID of $1,650,000, the yield on the Bonds will be somewhat higher than the 3.25% stated coupon. The exact bond yield will be calculated by Pryor Crestfield LLP or an independent verification agent and will be set forth in the Tax Regulatory Agreement. For purposes of this memorandum, we estimate the bond yield to be approximately 3.30% to 3.32% per annum (330 to 332 basis points), reflecting the OID adjustment.
B. Yield Restriction on Investment of Proceeds
The general rule of Section 148(a) is that gross proceeds of tax-exempt bonds may not be invested at a yield "materially higher" than the yield on the bonds. Under Treasury Regulation Section 1.148-2(d), an investment is treated as having a yield "materially higher" than the bond yield if the investment yield exceeds the bond yield by more than one-eighth of one percentage point (0.125%, or 12.5 basis points).
Accordingly, for the Series 2023A Bonds, the yield restriction threshold is approximately 3.42% to 3.44% (i.e., the bond yield of approximately 3.30% to 3.32% plus 12.5 basis points). Any investment of gross proceeds of the Bonds at a yield exceeding this threshold would, absent an applicable exception, cause the Bonds to be treated as arbitrage bonds.
The principal exceptions to the yield restriction requirement are:
(i) Temporary periods during which proceeds may be invested without yield restriction (discussed in Section V);
(ii) The reasonably required reserve or replacement fund exception (discussed in Section VI); and
(iii) The minor portion exception under Treasury Regulation Section 1.148-2(g), which permits a "minor portion" of proceeds (the lesser of 5% of proceeds or $100,000) to be invested without regard to yield restriction.
Each of these exceptions is analyzed in the sections that follow as applicable to the specific funds established under the Bond Indenture.
C. Identification of Gross Proceeds
For purposes of the arbitrage provisions, "gross proceeds" of the Series 2023A Bonds include all amounts treated as proceeds under Treasury Regulation Section 1.148-1(b). The principal categories of gross proceeds are:
(1) Original proceeds: The net proceeds of the Bonds received by CSIA at closing, comprising the issue price of $218,350,000 less the underwriters' discount of $990,000, resulting in net proceeds of $217,360,000 before costs of issuance.
(2) Investment proceeds: Any earnings (interest, dividends, capital gains) on invested gross proceeds of the Bonds.
(3) Transferred proceeds: If any prior bond issue of CSIA has been (or will be) refunded or replaced by the Series 2023A Bonds, unspent proceeds of the prior issue may be treated as "transferred proceeds" of the Series 2023A Bonds. Based on our current understanding, no prior bond issue is being refunded in connection with this issuance, and no transferred proceeds are expected.
(4) Replacement proceeds: Amounts that have a "sufficiently direct nexus" to the Bonds or the governmental purpose of the Bonds, including sinking fund amounts and certain pledged amounts. The debt-service reserve fund surety policy from Olympia Guaranty Insurance Corp. may give rise to replacement proceeds in certain circumstances (see Section VI.B below).
The following funds have been or will be established under the Bond Indenture (the "Indenture") between CSIA and Pacific Northwest Trust Company, as Trustee ("PNTC" or the "Trustee"), and are relevant for arbitrage purposes:
The CSIA equity contribution of $17,400,000 is not a component of gross proceeds of the Bonds and is not subject to the arbitrage provisions, provided it is properly identified and tracked as non-bond-proceeds equity. The Tax Regulatory Agreement should include appropriate provisions to ensure the segregation and tracking of the equity contribution.
V. Temporary Periods and Spending Exceptions — Section 148(c) and Treasury Regulation Section 1.148-2(e)
A. Three-Year Temporary Period for Construction Proceeds
Under Section 148(c)(2) of the Code and Treasury Regulation Section 1.148-2(e)(2), proceeds of a "construction issue" may be invested without yield restriction for a temporary period of three years from the issue date. For the Series 2023A Bonds, this temporary period would extend from October 24, 2023 (the issue date) through October 24, 2026.
To qualify as a "construction issue" eligible for the three-year temporary period, two conditions must be met:
(1) The issuer must reasonably expect, as of the issue date, that at least 75% of the "available construction proceeds" of the issue will be spent for "construction expenditures" (as defined in Treasury Regulation Section 1.148-7(g)); and
(2) The issue must satisfy the due diligence and spending-schedule requirements set forth in Treasury Regulation Section 1.148-2(e)(2)(i).
Analysis. Available Construction Proceeds. The available construction proceeds of the Series 2023A Bonds consist primarily of the net bond proceeds deposited in the Project Fund, which total approximately $215,490,000, plus any investment earnings thereon during the temporary period. Amounts in the Costs of Issuance Fund and the Capitalized Interest Fund are excluded from the computation of available construction proceeds for purposes of the 75% test.
75% Construction Expenditure Test. The total estimated project cost for the PSRAWTF is $237,400,000, substantially all of which constitutes construction expenditures (design, engineering, procurement, construction, testing, and commissioning of the water-treatment facility). The GMP contract with Northtide alone accounts for $193,500,000 in construction costs. Seventy-five percent (75%) of available construction proceeds of $215,490,000 is $161,617,500. The GMP contract value of $193,500,000 exceeds this threshold by a substantial margin (approximately $31,882,500, or nearly 15 percentage points above the 75% threshold). When additional construction-related expenditures beyond the GMP contract (such as owner-furnished equipment, permitting costs, and construction management) are included, the construction expenditure percentage will be well in excess of 75%.
Conclusion. The Series 2023A Bonds qualify as a "construction issue" within the meaning of Treasury Regulation Section 1.148-7(f), and the three-year temporary period is available for the investment of construction proceeds without yield restriction from October 24, 2023 through October 24, 2026.
B. Spending Schedule Requirements — Treasury Regulation Section 1.148-2(e)(2)(i)
The three-year temporary period for construction proceeds is conditioned upon the issuer meeting prescribed spending benchmarks. Treasury Regulation Section 1.148-2(e)(2)(i) requires that available construction proceeds be spent in accordance with the following schedule, measured from the issue date of October 24, 2023:
In dollar terms (based on $215,490,000 of available construction proceeds), the spending benchmarks are approximately:
A reasonable retainage, not exceeding 5% of the net proceeds of the construction issue, may remain unspent for up to 12 months following the end of the three-year temporary period (i.e., through October 24, 2027). Five percent of $215,490,000 is approximately $10,774,500, which would constitute the maximum permissible retainage.
CSIA bears the burden of demonstrating compliance with these spending benchmarks. If CSIA fails to meet any benchmark, the temporary period is terminated with respect to the unspent amounts as of the applicable benchmark date, and those unspent amounts must thereafter be yield-restricted or subject to rebate. In practice, failure to meet a benchmark does not retroactively taint the entire temporary period; it applies only prospectively to the amounts that were not spent by the applicable deadline.
Recommendation. The Tax Regulatory Agreement should include CSIA's certification of the expected spending schedule and a covenant requiring CSIA to monitor actual expenditures against the spending benchmarks on at least a quarterly basis. CSIA's Chief Financial Officer, Denise R. Whitford, should be designated as the responsible official for monitoring spending compliance, and periodic reports should be provided to bond counsel. If spending falls behind the benchmarks, CSIA should consult with bond counsel regarding the implications for the temporary period and the investment of remaining proceeds.
C. 13-Month Temporary Period for Debt Service Reserve Fund
Under Treasury Regulation Section 1.148-2(e)(3), amounts deposited in a bona fide debt service reserve fund may be invested without yield restriction for a temporary period of 13 months from the issue date. For the Series 2023A Bonds, this temporary period would extend from October 24, 2023 through November 24, 2024.
However, because the DSRF for the Series 2023A Bonds will be satisfied entirely by the surety policy issued by Olympia Guaranty Insurance Corp. (Policy No. OG-2023-MUN-4718) in the amount of $11,610,000, and no cash will be deposited in the DSRF at closing, this temporary period is not directly applicable. There are no cash proceeds in the DSRF to invest, and therefore no yield restriction concern arises. See Section VI.B below for a detailed discussion of the surety policy treatment.
If at any future date CSIA replaces the surety policy with a cash-funded DSRF, a new 13-month temporary period would not automatically apply; the availability of a temporary period for cash deposited in the DSRF at that time would depend on the specific circumstances and would need to be analyzed by bond counsel.
D. Costs of Issuance — Six-Month Temporary Period
Proceeds of the Series 2023A Bonds allocated to costs of issuance total $1,870,000 and will be deposited in the Costs of Issuance Fund at closing. Under Treasury Regulation Section 1.148-2(e)(2), these amounts may be invested without yield restriction for a temporary period of six months from the issue date (through approximately April 24, 2024).
The costs of issuance are expected to be disbursed promptly at or shortly after closing for the following items, among others:
• Legal fees (Calderwood & Harkness LLP and Pryor Crestfield LLP, as Co-Bond Counsel; disclosure counsel; underwriter's counsel)
• Rating agency fees (Lakeshore Ratings Group and Pinnacle Credit Analytics)
• Trustee acceptance fee and first-year trustee fee (PNTC)
• Printing and distribution of the Official Statement
• CUSIP assignment fees
• Financial advisor fees
• Municipal bond insurance or surety premium (to the extent classified as a cost of issuance)
• Other customary issuance costs
It is expected that substantially all costs of issuance will be disbursed within 30 days of closing, well within the six-month temporary period. Accordingly, the yield restriction provisions are unlikely to present any practical concern with respect to the Costs of Issuance Fund.
E. Capitalized Interest — Temporary Period
The $4,510,000 allocated to the Capitalized Interest Fund represents proceeds of the Bonds set aside to pay interest on the Bonds during the initial construction period. These amounts will be applied to pay interest as it becomes due, with the first semiannual interest payment date being April 1, 2024.
Amounts in the Capitalized Interest Fund benefit from a temporary period during which they may be invested without yield restriction. The temporary period extends until the earlier of (i) the end of the applicable temporary period for the proceeds class to which the amounts belong, or (ii) the date the capitalized interest is disbursed to pay debt service. In practice, the capitalized interest will be drawn down as interest payments come due — $4,510,000 is expected to cover interest due on April 1, 2024, and potentially a portion of the interest due on October 1, 2024.
Amounts remaining in the Capitalized Interest Fund after the expiration of the applicable temporary period (or after the capitalized interest period expires, if earlier) must be yield-restricted. However, given the relatively modest size of the Capitalized Interest Fund and the expectation that it will be fully spent within the first year after closing, this issue is of limited practical significance.
Recommendation. Amounts in the Capitalized Interest Fund should be invested in short-term, high-quality securities (such as U.S. Treasury bills, money market funds, or SLGS) pending disbursement for interest payments. The Tax Regulatory Agreement should include provisions governing the investment and disbursement of the Capitalized Interest Fund.
VI. Reasonably Required Reserve Fund and Surety Policy — Section 148(d)
A. Maximum DSRF Size — The "10% Test"
Section 148(d)(1) of the Code and Treasury Regulation Section 1.148-2(f) limit the size of a "reasonably required reserve or replacement fund" for a tax-exempt bond issue. The DSRF may not exceed the least of the following three amounts:
(i) 10% of the stated principal amount (par amount) of the issue;
(ii) The maximum annual debt service ("MADS") on the issue; or
(iii) 125% of average annual debt service on the issue.
The applicable calculations for the Series 2023A Bonds are as follows:
The maximum annual debt service on the Series 2023A Bonds, based on the preliminary debt service schedule, is $11,610,000. This is the least of the three tests and therefore establishes the maximum permissible DSRF size. The 10% of par test ($22,000,000) and the 125% of average annual debt service test (which, based on the 30-year amortization and fixed 3.25% coupon, will exceed $11,610,000) are both higher than MADS and are therefore not the binding constraint.
The surety policy from Olympia Guaranty Insurance Corp. is in the amount of $11,610,000, which equals MADS exactly. Accordingly, the DSRF funded by the surety does not exceed the maximum permissible amount under Section 148(d)(1), and the DSRF satisfies the "reasonably required" standard.
B. Surety Policy as a Qualified Investment of the DSRF
Under Treasury Regulation Section 1.148-2(e)(3)(iii), a surety bond, insurance policy, or letter of credit — collectively referred to as a "qualified guarantee" — may be used to satisfy the DSRF requirement in lieu of a cash-funded reserve. The use of a surety policy to fund the DSRF has significant advantages from an arbitrage perspective because, unlike a cash-funded DSRF, a surety-funded DSRF does not generate investment earnings that could give rise to arbitrage concerns.
Olympia Guaranty Insurance Corp. Surety Bond. The DSRF for the Series 2023A Bonds will be satisfied entirely by a municipal bond debt service reserve surety bond (Policy No. OG-2023-MUN-4718) issued by Olympia Guaranty Insurance Corp. ("Olympia Guaranty") in the amount of $11,610,000. The annual premium payable by CSIA for the surety policy is $23,220, representing 0.20% of the surety amount. Olympia Guaranty is rated "AA+" by Lakeshore Ratings Group and "Aa1" by Pinnacle Credit Analytics.
Tax Treatment of the Surety Policy. The surety policy is a "guarantee" for purposes of Section 148 and the applicable Treasury Regulations. The premium paid by CSIA for the surety ($23,220 per annum) is not "gross proceeds" of the Bonds; it is an operating expense of the Authority. The surety policy itself is not an "investment" that generates yield. Accordingly, because the DSRF is funded entirely by the surety and not by cash, there are no proceeds in the DSRF available for investment, and no arbitrage concern arises with respect to DSRF investments.
Draw on the Surety. If the surety is ever drawn upon — for example, because pledged revenues are insufficient to make a scheduled debt service payment — and the Trustee receives cash from Olympia Guaranty under the surety policy, such cash would become "replacement proceeds" of the Bonds. As replacement proceeds, the cash would be subject to yield restriction (i.e., it may not be invested at a yield materially higher than the bond yield) unless an applicable exception applies. If the cash received from the surety draw is used promptly to pay debt service (which is its intended purpose), the yield restriction issue would not arise because the cash would not be "invested" but rather disbursed immediately. However, if the cash is held for any period before disbursement, it must be invested in yield-restricted investments.
Recommendation. The Tax Regulatory Agreement should address the treatment of any surety draw proceeds and should include instructions to the Trustee (PNTC, attention: Alan M. Greer, Senior Trust Officer) regarding the investment of any cash received from a draw on the Olympia Guaranty surety policy. Specifically, the Tax Regulatory Agreement should provide that any such cash must be either (a) applied immediately to the payment of debt service or (b) invested in yield-restricted investments until disbursed.
C. Replacement of Surety with Cash
If CSIA ever determines to replace the Olympia Guaranty surety policy with a cash-funded DSRF — for example, because the surety provider is downgraded, the surety is terminated, or CSIA elects to substitute cash for economic reasons — the cash amounts deposited in the DSRF would constitute replacement proceeds of the Series 2023A Bonds and would be subject to yield restriction from the date of deposit. The cash in the DSRF could not be invested at a yield materially higher than the bond yield (approximately 3.30% to 3.32% plus the 12.5-basis-point tolerance).
Any such replacement of the surety with a cash-funded DSRF should be reviewed by bond counsel prior to implementation to ensure compliance with the yield restriction requirements and to determine whether any temporary period or other exception may be available with respect to the newly deposited cash. The Tax Regulatory Agreement should include a covenant requiring CSIA to consult bond counsel before making any such change to the DSRF funding mechanism.
VII. Arbitrage Rebate — Section 148(f)
A. General Rebate Requirement
Section 148(f) of the Code imposes the "rebate" requirement as an additional safeguard against arbitrage profits. Under Section 148(f), the issuer of tax-exempt bonds must pay to the United States (through the Internal Revenue Service) an amount equal to 100% of the excess (if any) of the actual earnings on nonpurpose investments over the amount that would have been earned if such investments had been invested at the yield on the bonds. This payment is commonly referred to as the "arbitrage rebate" or "rebate payment."
Rebate payments are required to be made periodically throughout the life of the bond issue. Under Treasury Regulation Section 1.148-3(e), rebate installment payments are due no later than 60 days after each "computation date," which is each fifth anniversary of the issue date. A final rebate payment is due within 60 days after the date the last bond of the issue is retired. The computation dates and rebate payment deadlines for the Series 2023A Bonds are as follows:
Each rebate installment payment must include at least 90% of the rebate amount computed as of the applicable computation date. The final rebate payment must include 100% of the remaining rebate liability.
Rebate payments are made to the IRS by filing IRS Form 8038-T (Arbitrage Rebate, Yield Reduction and Penalty in Lieu of Arbitrage Rebate), together with the payment. CSIA should establish a process for ensuring timely computation and payment of rebate amounts on each applicable date.
B. Spending Exceptions to Rebate
The Treasury Regulations provide several spending exceptions to the rebate requirement. If the proceeds of a bond issue are spent sufficiently rapidly, the rebate requirement is waived in whole or in part. The following spending exceptions are potentially applicable to the Series 2023A Bonds:
1. Six-Month Spending Exception — Treasury Regulation Section 1.148-7(c)
Under this exception, no rebate is required if all gross proceeds of the issue are spent within six months of the issue date. Given the size of the Project Fund ($215,490,000) and the anticipated three-year construction timeline for the PSRAWTF, it is not possible to spend all gross proceeds within six months. This exception is therefore not available for the Series 2023A Bonds.
2. Eighteen-Month Spending Exception — Treasury Regulation Section 1.148-7(d)
The 18-month spending exception provides that no rebate is required if gross proceeds are spent in accordance with the following schedule:
(i) At least 15% of gross proceeds spent within 6 months of the issue date;
(ii) At least 60% of gross proceeds spent within 12 months of the issue date; and
(iii) 100% of gross proceeds spent within 18 months of the issue date (with a 5% retainage permitted for up to 12 additional months).
Given the scale and complexity of the PSRAWTF construction project, achieving 100% spending within 18 months is unlikely. The design-build schedule under the Northtide GMP contract contemplates a construction period extending well beyond 18 months. Accordingly, this exception may not be achievable.
Recommendation. Notwithstanding the foregoing, CSIA should track actual spending against the 18-month exception benchmarks. In the unlikely event that construction proceeds faster than expected, this exception could provide an earlier release from the rebate obligation. However, reliance on the two-year spending exception (discussed below) is more realistic.
3. Two-Year Spending Exception — Treasury Regulation Section 1.148-7(e)
The two-year spending exception is available specifically for construction issues. Under this exception, no rebate is required on available construction proceeds if such proceeds are spent in accordance with the following schedule:
This spending schedule is more aggressive than the three-year temporary period spending schedule (which allows 36 months for 100% spending) but less demanding than the 18-month exception. If CSIA satisfies the two-year spending exception, no rebate payments would be required on earnings on the construction fund.
Realistic Assessment. The GMP contract with Northtide ($193,500,000) represents the largest component of construction costs. Achieving 100% spending within 24 months (by approximately October 24, 2025) would require an aggressive construction draw schedule. Given the total project cost of $237,400,000 and the complexity of a 60-MGD advanced membrane-filtration and UV-disinfection facility, meeting the two-year spending schedule is possible but will require active management of the construction draw process, close coordination with Northtide, and prompt processing of pay applications.
CSIA should monitor actual spending against both the two-year spending exception benchmarks and the three-year temporary period benchmarks. If spending falls behind the two-year pace, CSIA will still benefit from the three-year temporary period but will be subject to the rebate requirement on earnings during the temporary period.
C. Bona Fide Debt Service Fund Exception — Treasury Regulation Section 1.148-7(k)
Under Treasury Regulation Section 1.148-7(k), earnings on a "bona fide debt service fund" are excluded from the rebate requirement if the bond issue has a term of more than five years and the fund is used primarily to achieve a proper matching of revenues with debt service payments within each bond year. The Series 2023A Bonds have a term of 30 years (maturing October 1, 2053), which exceeds the five-year threshold.
The Bond Fund (also referred to as the "Debt Service Fund") established under the Indenture qualifies as a bona fide debt service fund. Pledged revenues are deposited into the Revenue Fund and transferred to the Bond Fund in advance of each semiannual debt service payment date to ensure timely payment of principal and interest. Amounts in the Bond Fund are held for relatively short periods and are disbursed for debt service as scheduled.
This exception applies only to earnings on the Bond Fund / Debt Service Fund. It does not relieve CSIA of the rebate obligation with respect to earnings on other funds, including the Project Fund, the Capitalized Interest Fund, or any cash in the DSRF (if the surety is drawn). Accordingly, while this exception is beneficial, it is limited in scope and does not eliminate the need for ongoing rebate monitoring.
D. DSRF Surety — No Rebate Implications
Because the DSRF is funded entirely by the Olympia Guaranty surety policy rather than by cash, there are no investment earnings on the DSRF and therefore no rebate obligation related to the DSRF. This is one of the principal tax advantages of using a surety-funded DSRF rather than a cash-funded DSRF.
However, if the surety is drawn and cash is deposited in the DSRF (see Section VI.B above), earnings on such cash would be subject to the rebate requirement unless the cash is promptly disbursed for debt service. The Tax Regulatory Agreement should address this contingency.
E. Recommendation: Rebate Analyst Engagement
CSIA should retain a qualified rebate analyst — an independent third-party calculation agent with expertise in arbitrage rebate computations — to perform the required rebate calculations on each computation date throughout the life of the Bonds. The rebate calculation requires detailed tracking of all investments of gross proceeds, including purchase prices, sale prices, interest earned, and holding periods, and the application of the future value methodology prescribed by Treasury Regulation Section 1.148-3(c).
The Tax Regulatory Agreement should include a covenant requiring CSIA to:
(a) Retain a qualified rebate analyst;
(b) Provide the rebate analyst with all necessary investment records and data;
(c) Obtain a rebate calculation report from the rebate analyst no later than 30 days before each computation date;
(d) Make timely rebate payments to the IRS by filing Form 8038-T and remitting the computed rebate amount; and
(e) Deposit estimated rebate amounts in the Rebate Fund as necessary to ensure the availability of funds for timely payment.
Failure to make timely rebate payments can jeopardize the tax-exempt status of the Bonds. While the IRS has the authority to accept late rebate payments with a penalty under Treasury Regulation Section 1.148-3(h), voluntary compliance is strongly preferred and will be required under the Tax Regulatory Agreement.
VIII. Hedge Identification and Integration — Treasury Regulation Section 1.148-4(h)
A. General Rule
Treasury Regulation Section 1.148-4(h) provides special rules for the treatment of "qualified hedges" entered into by an issuer in connection with a tax-exempt bond issue. A "qualified hedge" is a contract — typically an interest rate swap, cap, collar, or similar derivative instrument — that is entered into primarily to reduce the issuer's risk of interest rate changes with respect to a bond issue.