By Robert Provost, CPA, RMA, PSA Partner
It is important for local governments to understand the intricacies of arbitrage rules to avoid costly financial pitfalls and ensure full compliance with Internal Revenue Service (IRS) regulations. Arbitrage is the difference between the yield and interest earned on tax-exempt bonds. Arbitrage rules are in place to prevent governments from undermining the original intent of tax-exempt bonds by investing in and profiting from the gross proceeds of higher-yielding investments.
IRS Regulation 1.148-0(a), Section 148, prohibits a local government from earning an investment profit by investing at a materially higher rate than the bond’s yield. The investment return generally should not exceed the borrowing costs. Additionally, the arbitrage rules aim to remove the incentives for:
- Issuing more bonds than necessary or earlier than required.
- Keeping bonds outstanding longer than needed to fulfill the governmental purposes for which they were issued.
Interest rates on tax-exempt bonds are generally lower than taxable bonds because investors are willing to accept lower rates in exchange for the tax-exempt interest earned. This can lead to potential arbitrage issues, however, for state and local governments, as they can borrow at tax-exempt rates and invest in higher-yielding taxable markets.
What is Classified as an Arbitrage Bond?
Under Internal Revenue Code (IRC) Section 148, a bond is deemed an “arbitrage bond” if it fails to meet specific requirements designed to protect its tax-exempt status. A bond becomes an arbitrage bond when it violates the IRS’ yield restriction rules, potentially leading to the revocation of its tax-exempt status. Specifically, an arbitrage bond occurs when bond proceeds are used in a way that generates arbitrage profits contrary to the intended purpose of the tax-exempt issuance.
Bonds must be tested under two independent sets of rules to determine whether they are arbitrage bonds. Both address yield from the issuer’s perspective by comparing the borrowing yield to the investment yield. They aim to eliminate incentives for issuing bonds solely to generate arbitrage profits, though they do so in distinct ways.
- Yield restriction rules under IRC Section 148(a) – An issuer of tax-exempt bonds cannot invest borrowed funds at a yield that is materially higher than the yield on the bonds.
- Rebate rules under IRC Section 148(f) – Mandates that any investment profit above the bond yield be paid to the U.S. Treasury.
In both cases, bond proceeds cannot be used for investment purposes to generate profit but must be directed toward funding the designated governmental projects.
Yield Restriction Rules
The yield restriction rules limit the investment yield that may be earned on bond proceeds. Bonds are considered arbitrage bonds if the issuer expects to or actually does invest all or part of the bond proceeds at a yield materially higher than the bond yield. Issuers are permitted to invest in higher-yielding investments under certain exceptions. If no exception applies, however, the issuer must limit the yield on its investment of bond proceeds to a yield that is not materially higher than the yield on the bonds.
According to IRS Regulation Section 1.148-2(d)(2)(i), an investment yield is generally considered materially higher if it exceeds the bond yield by more than one-eighth of 1%. However, the definition of “materially higher” can vary depending on the type and class of investment and the general uses of the bonds.
In accordance with IRC Sections 148(c), (d) and (e), exceptions to the yield restriction requirement include:
- Held during temporary periods, depending on the purpose for which the bonds were issued and the type of investment that holds the proceeds.
- Held in a reasonably required reserve or replacement fund, generally limited to 10% of the proceeds of the issue.
- Representing a minor portion, which is generally the lesser of $100,000 or 5% of the proceeds of the issue.
Even if an exception applies and allows the issuer to legally earn arbitrage, the proceeds may still be subject to rebate requirements and the issuer may have to make a payment to the U.S. Treasury. While the yield restriction rules may allow an issuer to earn arbitrage, the rebate rules may not permit the issuer to keep the arbitrage earnings. If an issuer is required to pay the rebate under these rules but fails to do so, the bonds will be classified as arbitrage bonds. If the local government fails to make the required rebate payment, the IRS can impose penalties for noncompliance. Additionally, if the local government fails to adhere to the IRS requirements, it could also face penalties for not meeting the yield restriction rules (i.e., investing proceeds at a yield materially higher than the bond yield).
Rebate Rules
In general, IRC Section 148(f) mandates that any earnings on non-purpose investments (i.e., investments of bond proceeds that are not used for the intended governmental project) must be rebated to the U.S. Treasury. This means that if the bond issuer invests bond proceeds in a way that generates earnings above the bond’s yield, they must pay those earnings back to the U.S. Treasury. Under IRC 148(f)(3), rebate payments must be made at least once every five years during the life of the bonds. The last rebate payment is due no later than 60 days after the last bond is redeemed. Except for the final payment, the amount of each required installment payment is 90% of the total rebate amount.
The general rules for calculating the rebate are outlined in IRC 148(f)(2) and IRS Regulation Section 1.148-3, but essentially include the following steps:
- Determine the arbitrage profit: Calculate the excess earnings that result from investing bond proceeds at a yield higher than the bond’s yield.
- Subtract the bond yield: The bond’s yield is used as the baseline for comparison.
- Rebate payment: The issuer must pay to the U.S. Treasury the difference between the actual earnings from the investments and the amount that would have been earned if the proceeds were invested at the bond’s yield rate.
- Additionally, any earnings on the excess amount must also be rebated.
IRC Section 148(f) also establishes the following exceptions to the rebate requirement:
- Spending, which depends on the issuer allocating certain proceeds to expenditures within specified time periods.
- Small issue, which typically refers to the aggregate of all tax-exempt bonds that is less than $5 million.
A local government may be exempt from the yield restriction and rebate rules if the gross proceeds are maintained in a bona fide debt service fund that matches revenues to the principal and interest payments. To qualify, however, gross earnings must not exceed $100,000 and there is a fixed interest rate on the bonds with a maturity of at least five years.
Staying Compliant
In conclusion, understanding and adhering to the IRS yield restriction and rebate requirements is crucial to avoid penalties and ensure that bond proceeds are used appropriately for their intended purposes. By working closely with debt service advisors, bond counsel or specialists in arbitrage calculations, local governments can effectively manage the risks associated with arbitrage. This proactive approach helps ensure that financial strategies are not only compliant and effective but also strike a balance between efficiently funding public projects and upholding the highest standards of transparency and accountability in managing public funds.
Contact Us
The Public Sector team at PKF O’Connor Davies brings extensive experience and insight to assist you in navigating the in-depth rules and complexities of arbitrage. If you have any questions, contact your client service team or:
Robert Provost, CPA, RMA, PSA
Partner
rprovost@pkfod.com | 908.967.6857