Department of State Treasurer
Policy Manual for Local Governments
Section 95: Arbitrage
Issued: October 2010
Department of State Treasurer – Policy Manual for Local Governments
Section 95: Arbitrage
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 ................................................................................ 3
1. Small Issuer Exception............................................................................................ 3
2. 6-Month Spending Exception .................................................................................. 4
3. 18-Month Spending Exception ................................................................................ 4
4. 2-Year Spending Exception ..................................................................................... 4
5. De Minimis Exception and Reasonable Retainage ................................................. 5
6. 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 ....................................................................................... 8
1. No Willful Neglect ................................................................................................... 8
2. Willful Neglect ......................................................................................................... 8
Part IV – Reference Materials .................................................................................................. 9
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Department of State Treasurer – Policy Manual for Local Governments
Section 95: Arbitrage
Table of Contents
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Department of State Treasurer – Policy Manual for Local Governments
Section 95: Arbitrage
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.
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Part I – Introduction
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Department of State Treasurer – Policy Manual for Local Governments
Section 95: Arbitrage
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.
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Section 95: Arbitrage
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.
3. 18-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.
4. 2-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.
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Section 95: Arbitrage
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. 159-30. Refunding bonds are subject
to provisions of G.S. 159-84. 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
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Section 95: Arbitrage
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.
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Section 95: Arbitrage
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
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Department of State Treasurer – Policy Manual for Local Governments
Section 95: Arbitrage
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.
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Department of State Treasurer – Policy Manual for Local Governments
Section 95: Arbitrage
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 9-2005)
The current editions of IRS publications can be accessed at their web site,
http://www.irs.gov/, or by calling, 1-800-TAX-FORM.
IRS Tax Exempt Bonds Web Site, http://www.irs.gov/bonds
ABCs of Arbitrage 2007 Edition: Tax Rules for Investment of Bond Proceeds by Municipalities,
Frederic L. Ballard, Jr., (American Bar Association, 2007)
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Part IV – Reference Materials
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