Best Practices for Arbitrage Rebate Compliance
Tax-exempt debt issuers must have a written post issuance compliance program as part of their debt management function, including using written practices for arbitrage rebate compliance. Failure to do so jeopardizes the issuer’s ability to access the tax-exempt capital markets! Infrequent issuers need to have similar procedures and practices. This article addresses some basic principles for an effective post issuance compliance program.
Yes – Written Procedures ARE Required
One of the documents signed at closing is the IRS Form 8038-G. On the second page, Line 44 says “If the Issuer has established written procedures to monitor the requirements of Section 148, check the box.” Many issuers do not examine the form that closely. Are you certifying there is a written program for compliance? This is too easy for the IRS to check! Do you want to risk sending a flag? While arbitrage rebate calculation can be complex, a written post issuance compliance program IS NOT COMPLEX!
The essentials of a written post issuance compliance program will include:
♦ Procedures are written (are you seeing a theme?)
♦ Educate staff for their responsibilities
♦ Place procedures where they are easily accessed
♦ Assign someone to be responsible
♦ Include documents covered and records retention
♦ Plan for succession
The last one is important! Why? Because many of you will retire or change jobs before the bonds being issued are paid off upon final maturity!
What Are Best Practices for Arbitrage Rebate Compliance?
The Internal Revenue Code was not written to be read easily. Honestly, some lawyers might admit they have trouble following and understanding it completely. That is why the interpretations of tax law are sometimes challenged and the Tax Court rules and clarifies their decisions. The following points will help a tax-exempt debt issuer prepare to meet the complexity of post-issuance compliance and arbitrage rebate compliance.
• Inform your Arbitrage Rebate Firm of changes to the Issue, such as a Refunding (Evaluation dates are sometimes affected)
• Maintain good records! Keep investment records, general ledger expenditure bond project transactions, trust statements for bond-related accounts (reserve funds, debt service funds), bond transcript, past arbitrage rebate calculations and reports
• Keep all records of tax-exempt issues at least 3-6 years after the bonds are paid in full (this is an IRS requirement)
• Conduct annual arbitrage compliance reviews
o On bond anniversary, or
o Right before or right after annual audit
Benefits include:
♣ Implement any changes timely
♣ Book liability if needed
♣ Less costly to make changes
♣ Records more accessible
♣ Minimal disruption to staff’s many other responsibilities
Compliance with arbitrage rebate and Internal Revenue Code Section 148 can be complicated. Even so, having written procedures is a simple and direct practice, and essential to good debt and financial management. If you are an issuer of tax-exempt debt, or an obligated party in a tax-exempt issue (from a conduit authority), consider the value of conferring with a professional outside agency that has demonstrated expertise with the complexities of arbitrage rebate compliance.
Is It Arbitrage Rebate? Or Yield Restriction?
Post issuance compliance is a complex arena with multiple facets to explanations. This is why almost all tax-exempt debt issuers rely on specialists to review the bond documents, related accounts, and complete these calculations.
There are TWO sets of rules that issuers must comply with: Arbitrage Rebate Rules AND Yield Restriction Rules.
Let’s try to keep this simple!
General Rules When it Comes to Capital Projects
The federal government allows borrowing at tax exempt rates with certain expectations. First, the IRS expects the borrower to spend those loan or bond proceeds promptly. But if the project proceeds are held greater than 3 years from receipt, the outstanding project proceeds at that time are to be yield restricted and earn limited income. This is when the yield restriction calculation becomes a factor for capital projects compliance purposes.
Arbitrage Rebate?
Technically, ARBITRAGE is taxable investment earnings in excess of the declared tax-exempt bond yield which must be rebated to the Federal Government. The federal government doesn’t mind the issuer making money on its tax-exempt bond proceeds, but they do not want you to make a “profit” on those proceeds by not spending the debt on the projects they were issued for!
Arbitrage Rebate Calculations should be performed, at the latest, every 5 years over the life of the Issue.
“Well, I don’t think I should have to hire someone and spend money on this compliance rule!” you say? Issuers spend a lot of money to issue debt – bond attorneys, financial advisors, rating agencies, other professional services, etc. On-going post-issuance compliance is a small price over the life of the bond issue – and it is expected and required by regulation. Failure to comply with the rebate requirements could ultimately result in the loss of tax-exempt status on the issue, and financial penalties.
Yield Restriction?
Remember the general rule discussed above? The IRS provides a “Temporary Period” for Capital Projects of three years to spend those proceeds. Once the temporary period ends, project proceeds are “yield restricted” to its bond yield + .125%. If the interest earned on those proceeds is yielding above the bond yield + .125%, a yield reduction payment is due.
An Arbitrage Rebate Payment AND a Yield Reduction Payment?!
Let’s be clear… arbitrage rebate payments and yield restriction only become a hassle for the issuer when the tax-exempt proceeds are not spent promptly. Becoming familiar with your bond documents, and especially the Non-Arbitrage Certificate, can provide you spending benchmarks which can avoid these concerns. However, for those requiring calculations, the good news is that you do not owe BOTH payments! Only one payment is due, but the HIGHER amount is due.
Still have questions? Bingham has answers!
The more you understand about your rebate calculation, the better. Don't hesitate to call a Bingham professional at (888) 900-5312 or send an email to info@bingham-ars.com for answers.
Six Easy Tips for a Smooth Arbitrage Rebate Calculation
The Internal Revenue Code was not written to be read easily. Honestly, some lawyers might admit they have trouble following and understanding it completely. That’s why the interpretations of tax law are sometimes challenged and the Tax Court rules and clarifies with more specificity. Exactly how does a tax-exempt debt issuer prepare to meet the complexity of post-issuance compliance and arbitrage calculation?
Here’s some GOOD NEWS! Bingham has a tried and true formula to make it easier.
- Be familiar with your documents, especially the Non-Arbitrage Certificate in your bond documents binder.
- Create a file to avoid backtracking through five years of "cold" paper trails when it's time for calculation. You'll be ready for the arbitrage rebate calculation immediately after your bond closing and prepared for the written procedures required by the IRS Form 8038-G.
- Schedule your calculation by notifying Bingham at least 60 days before each fifth-year anniversary to avoid late payment interest charges.
- Know your exceptions. If your bond counsel advises you that your issue meets an exception, find out which one. The most common are: Small Issuer, Six Month, Eighteen Month, and Two Year. Bingham can review your statements and provide a report demonstrating your compliance.
- Keep your calculations current to be aware of the amount of arbitrage you are earning. This affords you the option to restructure your investments accordingly. Bingham recommends to our clients to have calculations performed annually which saves you time, effort, and has proven less costly over the years a calculation is required.
- Ask questions. The more you understand about your rebate calculation, the better. Don't hesitate to call a Bingham professional at (888) 900-5312 or send an email to info@bingham-ars.com for answers.
Post Issuance Compliance in a Rising Interest Rate Environment
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.