In recent years, low interest rates have essentially mitigated any realization of positive net yield from the investment of bond proceeds. However, arbitrage earnings are beginning to return after nearly a ten year absence. Are you and your organization adequately prepared?

Weeks, even months, of planning and negotiating go into issuing tax-exempt debt. After several meetings with bond counsel, financial advisors, and leadership teams, closing a bond issue can feel like the end of the process. At closing, a bond counsel opinion describes that interest on the bonds is properly excluded from the gross income of the bondholders. Counsel opinion is based upon a reasonable expectation that tax law requirements will be fulfilled throughout the life of the debt. Bond documents include pledges by issuers as to post-issuance tax law compliance. Yet costly mistakes can be made when tax-exempt issuers do not follow post-issuance compliance.

All tax-exempt bond issues must comply with two separate sets of post issuance requirements: arbitrage rebate and yield restriction. Both sets of rules limit earnings on the investment of tax-exempt bond proceeds. Federal arbitrage rules are designed to prevent issuers of tax-exempt debt from obtaining excessive or premature debt and profiting from the investment of bond proceeds. Under the arbitrage rebate rules, an issuer investing bond proceeds and earning a positive net yield on that investment may be required to rebate (i.e., pay) that positive yield to the United States Government. While arbitrage rebate requirements begin on the bond’s issue date, yield restriction requirements do not apply until the end of an applicable “temporary period,” which is three years for most project funds. It is important to note that the calculations for both arbitrage rebate and yield restriction are separate and do not offset each other.

The Internal Revenue Service believes procedures are important for an issuer to address tax rules effectively. Included among the procedures are:

  • Due diligence review at regular intervals. The frequency and timing of due diligence reviews often depend upon the complexity of the issuer’s outstanding bond issues. Bingham Arbitrage Rebate Services, Inc. strongly recommends that reviews be conducted annually versus waiting until the installment date (typically five years). Less frequent reviews are not recommended because of the potential for discovering tax issues later when it may be more difficult to take needed corrective actions. The completion of annual reports provides time to set aside the accruing rebate amount and have the funds available for the installment due date. Annual reporting is also an integral part of an annual audit.
  • Adequate record retention. A strong records retention program is critical to substantiate compliance and to ensure institutional memory. Bingham suggests that records be maintained throughout the life of the bonds plus three to six years.

To learn more about these and other post-issuance tax compliance procedures the IRS believes are important, please consult IRS Publication 5091, dated March 2016.

Proper planning will prevent unanticipated rebate payments. If you are prepared for the arbitrage rebate payment, you won’t be caught off guard and not ready for the payment. Also, pay closer attention to the allowable spending exceptions. If met, you most likely will be able to avoid a rebate payment and instead keep the arbitrage earnings.

Finally, if you are an issuer of tax-exempt bonds, or an obligated party in a tax-exempt issue, consider the value of conferring with an outside agency that has demonstrated expertise with the complexities of post issuance compliance.