Department of State Treasurer. Policy Manual for Local Governments. Section 95: Arbitrage

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1 Department of State Treasurer Policy Manual for Local Governments Issued: October 2010

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3 Table of Contents Part I Introduction... 1 A. Purpose of Section... 1 B. What is Arbitrage?... 1 C. A Word of Caution... 1 Part II Arbitrage Compliance... 3 A. Planning for Arbitrage Compliance... 3 B. Items to Consider in the Compliance Planning... 3 C. Exceptions from Arbitrage Rebate Small Issuer Exception Month Spending Exception Month Spending Exception Year Spending Exception De Minimis Exception and Reasonable Retainage Exception for Investment in Tax Exempt Securities... 5 D. Tax Certificate and Form 8038-G... 5 E. Investing Proceeds... 5 F. Accounting and Record Retention... 6 Part III Rebate and Yield Restrictions... 7 A. Rebate Requirements... 7 B. Calculation of Arbitrage Earnings... 7 C. Yield Restriction Requirements... 7 D. Refund Rules... 8 E. Penalties for Non-compliance No Willful Neglect Willful Neglect... 8 Part IV Reference Materials... 9 LGC i Issued: October 2010

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5 Part I Introduction A. Purpose of Section The planning, calculation, monitoring and reporting of arbitrage and yield restriction is complex, regulated by Section 148 of the Internal Revenue Code and the regulations thereunder and requires professional advice. All tax-exempt debt is subject to the arbitrage rebate and yield restriction requirements of the tax code. The arbitrage and yield restriction rules are intend to prevent abuse of the federal subsidy inherent in the tax-exemption of municipal bonds. The subsidy could be abused if local governments issued more bonds than necessary, issued bonds earlier than required or allowed the bonds to remain outstanding longer than necessary. Some tax-exempt financings will meet an exception to the rebate regulations. Some taxexempt financings will meet an exception to the rebate requirement, but will still require a yield reduction payment. All units will be subject to the possibility of an audit, at which time proof that no payment is due will be required. The purpose of this section is to provide general understanding of the topic to allow units of government as issuers of bonds to properly plan and engage the necessary professional assistance to assure compliance with these complex rules and regulations. B. What is Arbitrage? Arbitrage is the profit from buying something in one market and simultaneously selling it in another. In the context of the issuance of tax-exempt bonds, arbitrage is the difference between the rate at which tax-exempt debt proceeds were borrowed and the rate at which the proceeds were invested. Most local governments borrow funds at tax-exempt rates and invest at taxable rates. Local governments issuing municipal bonds could, depending on market conditions, position themselves to earn positive arbitrage, or earn a rate higher than the borrowing rate, on the bonds. Unless an exception is available, the IRS requires a payment to the US Treasury equal to all investment earnings on the bond proceeds in excess of what the investments would have earned if invested at the bond yield. C. A Word of Caution The federal income tax laws and regulations related to tax exempt bonds are extremely complex, and subject to change and varying interpretations. All information provided herein should be qualified by reference to the tax laws and regulations as well as the bondspecific documents. There are significant consequences from the failure to follow these rules sufficiently serious violations could result in the issuer s bonds being declared taxable bonds. Therefore, any concerns should be promptly addressed with bond counsel. LGC Page 1 of 10 Pages. Issued: October 2010

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7 Part II Arbitrage Compliance A. Planning for Arbitrage Compliance A local government must consider arbitrage compliance issues during the early structuring of the capital projects budget and at the initial stages of the debt issuance process. Proper preparation is essential in budgeting of proceeds, interest earnings and rebate payments. Planning can allow the unit to take advantage of any rebate exceptions that allow for part or all of the arbitrage to be retained and possibly avoid yield reduction payments. Keep management and the governing board informed of the strategy employed, especially if it will require a payment to the US treasury. Remember, every year your auditors will require that you document compliance with the spending requirements or have recorded the estimated arbitrage liability. B. Items to Consider in the Compliance Planning The following are items that should be addressed in the arbitrage compliance planning process: Select your arbitrage calculation professionals before bonds are issued to help set up tracking of proceeds and investment earnings, record keeping, record retention and investment strategies. Decide if you will be trying to meet a spending exception. This could affect timing of debt issuance. Determine the critical maturity dates for investments of bond proceeds. Identify elections contained in the Tax Certificate and schedule dates to monitor. Schedule regular review dates to evaluate the pace of spending proceeds and propriety of proceeds investments. Properly train staff involved in monitoring investing and spending of bond proceeds. C. Exceptions from Arbitrage Rebate There are several exceptions to the rebate requirements that are centered on the size of the issue and period of time over which the proceeds are spent. 1. Small Issuer Exception This exception applies to units with general taxing powers that issue $5 million or less on tax-exempt debt during a calendar year. There is also an exception for bonds for schools for issuers with general taxing powers that issue $10 million or less of taxexempt debt during a calendar year, provided $5 million or less is spent for purposes other than constructing or renovating public school facilities. There are different requirements for refunding bonds. LGC Page 3 of 10 Pages. Issued: October 2010

8 Part II Arbitrage Compliance 2. 6-Month Spending Exception All gross proceeds (other than gross proceeds held in a bona fide debt service fund or debt service reserve fund) are spent within the six-month period beginning on the issue date Month Spending Exception The IRS allows an exception if the following percentages of all gross proceeds (this includes any interest earnings on debt proceeds) are spent on the purposes for which bonds were issued within the various time periods. The unit must meet each of the spending requirements outlined below in 1, 2, 3a, 3b and 3c. For example, if unit fails the 6-month and 12-month spending requirement but meets the 18-month percentage, they will not qualify for this spending exception. To meet the 18-month spending exception, the following rules apply: a. All of the gross proceeds qualify for an initial temporary period (e.g. three year); and b. The rebate requirements is met for all amounts not required to be spent in accordance with the 18-month expenditure schedule; and c. All gross proceeds including earnings (other than gross proceeds held in a bona fide debt service fund or debt service reserve fund) are spent as follow: 1) 15% within 6 months 2) 60% within 12 months 3) 100% within 18 months This exception is not available for refunding bonds Year Spending Exception This exception applies to debt issues where at least 75% of the available construction proceeds are to be used for construction expenditures and construction must be on property that is governed by a governmental unit or 501(c)(3) not-for-profit corporation. To meet the 2-year spending exception, the funds are spent as follows: a. 10 % within 6 months b. 45 % within 12 months c. 75 % within 18 months d. 100 % within 24 months Each of these percentage expenditure requirements must be met for the available construction proceeds of the issue to qualify for the exception. Available construction proceeds is generally defined and calculated by taking amount received from the underwriter from selling bonds to the public, earnings thereon, less amounts (if any) deposited in a reasonably required reserve and amounts applied to issuance costs, plus amounts earned on the proceeds, and on the amounts in any reasonably required reserve not funded from the issue, plus earnings on all of the forgoing earnings. LGC Page 4 of 10 Pages. Issued: October 2010

9 Part II Arbitrage Compliance 5. De Minimis Exception and Reasonable Retainage The 18-month and 24-month exceptions allow for additional time if following criteria is met. a. Reasonable Retainage In limited circumstances, the issuer is allowed a reasonable retainage of 5% after the 24 month period and may still qualify for the exception as long as retainage is spent within three years of the issue date and the 6-18 month expenditure benchmark requirements are met. This exception is not available for refunding bonds. b. De Minimis Exception If issuer has exercised due diligence to complete the project and lesser of 3% of issue price or $250,000 the issuer might still qualify for spending exception. 6. Exception for Investment in Tax Exempt Securities There is also an exception if all proceeds are invested in tax-exempt investments. If any of the tax-exempt investments are bonds the interest on which is subject to the Alternative Minimum Tax, they are to be included in the arbitrage rebate computation unless proceeds invested are from certain private activity bonds issues. Tax-exempt securities would include most municipal bonds. Because taxable securities generally provide greater returns than tax-exempt securities, most local governments do not invest bond proceeds in tax-exempt securities and therefore, this exception is rarely used. D. Tax Certificate and Form 8038-G The finance officer of the issuer will be asked to sign a Tax Certificate or No Arbitrage Certificate and to execute IRS Form 8038-G, Information Return of Tax-Exempt Governmental Bonds, as part of the closing documents for each debt borrowing. The Tax Certificate or No Arbitrage Certificate is a document executed at the time of initial issuance certifying as to various matters and undertaking certain obligations relating to the arbitrage rules under federal income tax laws. The finance officer should understand all the provisions, covenants and elections of outlined in the certificate. Bond counsel should explain in detail what will be necessary to meet the requirements of the federal income tax laws and comply with the covenants in this document. Form 8038-G is filed by the issuer of the tax-exempt debt to provide the IRS with the information required to monitor the requirements of the provisions of the Internal Revenue Code. It is completed on the basis of available information and reasonable expectations as of the issue date. E. Investing Proceeds Bond proceeds are subject to investment statutes G.S Refunding bonds are subject to provisions of G.S For further discussion of investing statutes please consult Section 30: Cash and Investments of this policy manual. Investment strategy will be different depending on whether the local government will meet any of the exceptions for arbitrage rebate. When investing debt proceeds, units of LGC Page 5 of 10 Pages. Issued: October 2010

10 Part II Arbitrage Compliance government should always put safety and liquidity first as the proceeds must be available to pay construction cost as they come due. The IRS encourages earning positive arbitrage; however, units will want to keep out of pocket expenses to a minimum because they are not deductable for purposes of calculating arbitrage rebate. Out of pocket fees include: Investment management fees Security transaction fees Bank custody fees Many units invest proceeds and, if a net amount of positive arbitrage is earned, that amount is refunded to the federal government at the time due. This strategy is used as overhead cost incurred in trying to limit investment earnings to bond yield can be more expensive than returning excess yield to the treasury. Units of government should have bond counsel approve purposes for which bond proceeds will be spent, purposes for which investment earnings will be spent and investment plans for proceeds. F. Accounting and Record Retention The key to successful use of bond proceeds is to have detailed accounting procedures, investment plan, record retention policies and spending plans prepared in advance and approved by bond counsel. Written documentation of the above and proper training of employees is also critical to success. Staff turnover makes written procedures essential especially considering that record retention can be 30 years or longer. Most units separate funds into individual bank accounts and general ledger accounts by purpose and issue to simplify accounting and tracking. Since bond records are required to be kept much longer than other financial records a written procedure is essential to making sure documents are set aside for long term storage. It is also important to prepare worksheets that help staff who are tracking use of proceeds that will highlight any red flags to ensure spending requirements as outlined in IRS code are being met. Units will have to report any estimated rebate liabilities on their financial statements. Depending on the number of bond issues subject to calculation and the complexity of calculation, units might contract for an annual rebate calculation even though the payment is due to IRS at 5 year intervals. The records required to be retained are defined in the bond documents, usually in the Tax or No Arbitrage Certificate. The records are required to be kept until the final maturity of the bonds plus three years or more, as required by the bond documents. LGC Page 6 of 10 Pages. Issued: October 2010

11 Part III Rebate and Yield Restrictions A. Rebate Requirements Unless all bond proceeds of your bond issue qualify for an exception from rebate, you must remit to the IRS the net amount of positive arbitrage earnings not later than the end of every fifth bond year, the final maturity date of the bond issue, or the date that the issue is discharged, whichever is earlier. Five year payments require 90% payment due within 60 days, while final maturity payments require 100% due within 60 days. IRS Form 8038-T, Arbitrage Rebate, Yield Reduction and Penalty in Lieu of Arbitrage Rebate, is only filed when there is a positive liability or yield reduction payment needed. The amount due is payable to the U.S. Treasury and mailed to the IRS payment center in Ogden, UT. B. Calculation of Arbitrage Earnings In general, arbitrage earnings are calculated by determining the difference between the issuer s actual investment earnings on the proceeds and the investment earnings that would have been received if the issuer had invested the proceeds at the arbitrage yield of the bond issue. Negative earnings (investment earnings returning a yield less than the bond yield) may offset positive earnings. Please keep in mind that the calculation is complex. For these reasons, the bond documents may require the issuer to engage the services of a firm or individual experienced in the calculations and familiar with the relevant tax regulations to provide the calculation services. Total cost of arbitrage rebate services for a bond issue can vary so soliciting competitive bids from qualified professionals is recommended. Professionals hired to calculate arbitrage will normally need, for each debt borrowing, the following: Official Statement; Tax Certificate and Form 8038-G; Trust Indenture or other bond authorizing document; Escrow Verification Report, if a refunding; Cash flow of all transactions dealing with proceeds and investment of proceeds; Asset Statements; and Other documents required by the bond documents. C. Yield Restriction Requirements A second major set of rules under IRS code, section 148 discusses yield restriction. In general, the proceeds from a tax-exempt bond issue, except for a minor portion, must be invested at a yield not materially higher (usually 12.5 basis points or.125%) than the yield LGC Page 7 of 10 Pages. Issued: October 2010

12 Part III Rebate and Yield Restrictions on the bond issue unless the proceeds qualify for a temporary period. Once the temporary period ends the proceeds become subject to the yield restriction requirement. The most common instance of yield restriction is for bond proceeds that are not expended within three years after the bonds are issued. Units may encounter yield restriction issues when debt service funds retain higher fund balances. Under IRS regulations reasonable required reserve funds should not exceed the lesser of the following: 10% of principal amount; Maximum annual debt service; or 125% of the average annual debt service. Yield reduction payments are payments made to the IRS on yield restricted funds and are paid at the same time and manner as a rebate payment. Units of government involved in yield restriction calculations should be advised by qualified professionals. An advance or current debt refunding could effect the yield restriction calculations. For advance refunding the temporary period for the refunded bonds would end, while a current refunding would allow the temporary periods to continue. Bond issues that are exempt from the rebate requirements under one of the expenditure or size limitations may still be subject to yield restriction if there are any unexpended yield restricted funds in the bond issue. This could occur, among other times, if the issue was entitled to the $5 million exception or if the reserve funds were too large. D. Refund Rules For bonds issued prior to June 30, 1993 for which a mathematical error occurred, form 8038R may be used to file for a refund. In 1993 the IRS regulations changed and allow refunds whenever an overpayment can be demonstrated. E. Penalties for Non-compliance 1. No Willful Neglect If the Commissioner determines that the failure to pay was not caused by willful neglect, the issuer can promptly pay a penalty to the United States (50% of the rebate amount not paid plus interest; 100% for certain private activity bonds) and the bonds will most likely remain tax-exempt. The penalty is automatically waived if the rebate amount that the issuer failed to pay plus interest is paid within 180 days after the discovery of the failure unless the commissioner determines that the failure was due to willful neglect or the issue is under examination with the IRS during a prescribed period. 2. Willful Neglect If the noncompliance is determined to be caused by willful neglect, the penalty could be that an issuer s bonds are retroactively declared taxable. LGC Page 8 of 10 Pages. Issued: October 2010

13 Part IV Reference Materials Transaction specific bond documents, including the Tax or No Arbitrage Certificate, etc. Internal Revenue Service: Publication 4079, Tax-Exempt Governmental Bonds Compliance Guide. (Revised ) The current editions of IRS publications can be accessed at their web site, or by calling, TAX-FORM. IRS Tax Exempt Bonds Web Site, ABCs of Arbitrage 2007 Edition: Tax Rules for Investment of Bond Proceeds by Municipalities, Frederic L. Ballard, Jr., (American Bar Association, 2007) LGC Page 9 of 10 Pages. Issued: October 2010

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