Arbitrage Rebate is not a bad thing! It is also NOT a four-letter word! Many tax-exempt issuers have not worried about making substantial arbitrage rebate payments in nearly a generation of finance professionals. However, current investment rates continue to rise, and accompanying those rising rates are increasing arbitrage rebate liabilities and/or yield reduction liabilities. Of course, there are lots of questions – BUT there is no reason to panic! As with any liability, finance professionals manage to minimize the impacts and cash flows on their organizations. Key to these strategies is knowing how the liability can change over time. Bingham recommends several strategies which can help the finance professional tasked with this responsibility.
What is arbitrage rebate and Why is compliance reporting required?
Under the U.S. Treasury Regulations, issuers of tax-exempt bonds may not earn investment interest on bond proceeds (the “Taxable Rate”) that is in excess of the interest paid to the bondholders (the “Tax-Exempt Rate”). The difference in these rate spreads is called “arbitrage.” Internal Revenue Code Sections 103 and 148 (the sections referenced in the bond documents that are signed before you receive your tax-exempt debt proceeds) imposes investment restrictions on issuers of tax-exempt debt and requires those issuers to rebate or pay certain excess earnings (arbitrage) to the Internal Revenue Service in the form of an arbitrage rebate payment. Simply stated – it’s the law. It is essentially a 100% tax on the excess earnings and practically a financial disincentive to violate the rules.
Can I really owe a rebate payment when interest rates have been so low?
Historically low interest rates do not provide an excuse to avoid the issuer’s responsibility to complete calculations and monitor the spending of the debt proceeds. In fact, rebate payments still happen, often because of the even lower borrowing yields issuers have received in the same time period. The caution cannot be ignored – with the low yields of tax-exempt debt issued in the last several years, and as investment rates go up (and they have!), issuers will see rebate liabilities again when proceeds are not spent promptly. Many entities who issued during the last few years and have been unable to spend those proceeds for a variety of reasons (COVID-era, supply chain constriction, unavailable resources, etc.) are finding themselves with yield reduction payment liabilities – even when they have an overall negative arbitrage rebate liability. Yes-you can still owe for the yield reduction even if your arbitrage rebate calculation liability is negative. Good news though-you only pay once! Payment is made for the larger of the yield reduction or the arbitrage rebate. Bingham will prepare the required IRS Form 8038-T when it comes time to file at the end of the fifth year following debt issue.
My negative liability is becoming a positive arbitrage liability. Does that mean I will have to pay?!
Many issuers have become accustomed to seeing a negative arbitrage liability in their annual and installment calculations. The economy has changed dramatically over the last several years – and many issuers are now seeing their previous negative liabilities eroding to zero and/or turning positive. That means arbitrage earnings are now outpacing the allowed yield of return. Does that mean you will have to make a payment to the IRS? MAYBE! More importantly, it means your potential liability needs to be managed.
Where do I record the arbitrage rebate liability?
The potential arbitrage rebate liability is recorded as a current or long-term liability depending on the amount of time between the fiscal year end and the end of the installment period. Typically, this will be recorded in the capital project fund where the debt proceeds have been deposited and are being expended, for either governmental or enterprise fund types. As always, the finance officer will consider materiality thresholds when estimating and recording arbitrage rebate or yield reduction liabilities.
How do I record the arbitrage rebate liability?
There are two schools of thought in this question. Some issuers will record the rebate payment as an expense and an accrued liability. Other issuers will record the potential liability by deferring all or a portion of their investment returns earned in each fiscal period. Keep in mind that the rebate liability is occurring because of those current investment earnings. The amount of interest to defer is a matter of professional judgement. Issuers could even consider allocating the investment earnings between investment income and arbitrage rebate liability. In the current environment, the amount earned which exceeds the bond yield could be deferred from revenue and recorded instead to the balance sheet as an arbitrage rebate liability. The deferred earnings would accumulate on the entity’s balance sheet. An annual arbitrage rebate calculation report could then be used as a basis against which that account could be reconciled.
If I report an IRS payment to my Manager and/or Board, I’ll look like a bad finance officer!
Executives know the professional secret to managing bad news is to wrap it as good news! If you do have to (or choose to) report your IRS payment for arbitrage rebate, do so openly and with a smile on your face because you as the finance officer were prepared. “I am pleased to report that the entity’s investment program earned exceptional earnings, and we maximized the potential investment income we are allowed to retain. By law and regulations, the IRS does require that we return to them the excess earnings from our invested debt proceeds. We have had our earnings calculated by Bingham Arbitrage Rebate Services, our professional arbitrage rebate services firm. Because we have calculated those excess earnings annually, we have managed our income and potential liability each year as well. We have the funds set aside to make this payment without the need to request further appropriations from the governing body.” You should be able to pat yourself on the back for your job well done even if no one else will!
How much does arbitrage rebate compliance cost?
In the larger scheme of issuing debt, post-issuance compliance is not expensive. Arbitrage rebate calculation compliance services often cost less than many other services. Tax exempt debt requires post-issuance calculations until the gross proceeds are spent in full. Bingham customizes our service proposals to meet the requirements of each issue. Once Project proceeds have been fully expended, Bingham can finalize the calculation. Here is a word of caution – failure to meet the arbitrage rebate requirements could ultimately result in the loss of tax-exempt status on the issue, in addition to financial penalties.
What recommendations does Bingham share to make arbitrage rebate easier?
Bingham has a tried-and-true formula to make it easier. We have shared Six Easy Tips for a Smooth Arbitrage Rebate Calculation in our earlier website post here. A couple of key ideas:
- 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 (804) 288-5312 or send an email to [email protected] for answers.