CDFA Spotlight: Arbitrage and Rebate By Stan Provus

Preview

This article explores the world of arbitrage and rebate. Arbitrage and rebate violations in various forms account for a very large percentage of issues audited by the IRS and, in turn, found to have violations. Learn the basics of arbitrage and rebate to avoid these pitfalls and begin to use these tools to your bond portfolio's advantage.

What is Arbitrage

Generally, tax-exempt bonds have lower interest rates than taxable bonds or other comparable fixed or variable rate investments, because interest income is not generally subject to federal taxation and in many cases, and where applicable, state and local taxes as well. Therefore, investors are willing to accept and lower tax-exempt rate than an equivalent taxable rate. For example, a city may be able to issue a tax-exempt bond at 4% but might need to pay 6% if the bond were taxable to bondholders. A city that borrows at 6% by issuing tax-exempt bonds may be able to invest the amount borrowed in a taxable instrument and earn 8%. In this example, the city would make a 2% investment profit and would not have to pay taxes on this profit because they are not a taxable entity. The spread between the rate on the bonds and the higher investment rate is called “arbitrage” in the municipal finance industry—(in the securities industry generally “arbitrage” refers to buying securities on one market and immediately reselling them in another for a profit.) Arbitrage rules are designed to keep issuers from issuing more bonds than otherwise necessary to take advantage of investment opportunities or arbitrage; i.e. to make money from arbitrage profits.

Without these rules, issuers could simply issue hundreds of millions of bonds for little or no public purpose and profit from the difference in the tax-exempt bond yield and the investment rate. IRS rules governing arbitrage are designed to minimize arbitrage benefits by investing the proceeds of tax-exempt bonds in higher interest rate investments and to remove the arbitrage incentives to issue more bonds, to issue bonds earlier, or to leave bonds outstanding longer than is otherwise reasonably necessary to accomplish governmental purposes for which the bonds were issued in the first place. The arbitrage rules are easier to understand if you think about them in light of the motivations to earn arbitrage (and arbitrage profits).

Rebate

In the 1980’s Congress determined that the reasonable expectation/yield restriction approach of the former IRC (Internal Revenue Code) section on arbitrage was not adequate to stop abuses. The reasonable expectation rule basically said that if an issuer did not reasonable expect to earn arbitrage profits on the day the bonds were issued—the no arbitrage certificate—the bonds would not be considered arbitrage bonds even if arbitrage profits were earned.

To take away more of the investment incentives of issuers, a new set of yield restriction rules were added to the IRC during the 1980’s. These were and are still called the rebate rules. These rules require that arbitrage profits be rebated to the federal government, with a few exceptions discussed below. It is very important to recognize that the arbitrage and rebate rules are separate and distinct rules. While there may be some exceptions under both, an issuer must comply with both. For example, an issuer can fund a debt service reserve fund that does not have to be yield restricted. On the other hand, the issuer cannot keep excess arbitrage profits under the rebate rules, unless an exception for rebate applies.

The 1986 Tax Act extended the rebate rules to all categories of bonds and instead of the “reasonable expectation” test, the IRC now looks the actual investment of bond proceeds. In other words, what really happens not what issuers expect to happen?

Overview of Exceptions to Rebate

Small Issuer ( $5,000,000; $15 million for public school facilities) Exception:

This is not available for private activity bonds, only governmental bonds.

Exceptions to Rebate--Spending Tests:

The spending exceptions are underpinned by the concept that if bond proceeds are spent fast enough, there will be little opportunity for earning arbitrage profits. In addition, if proceeds are spent soon after bonds are issued, there is less of a likelihood that bonds were issued early just to earn an arbitrage profit. Also keep in mind that the spending exceptions usually do not apply to all of the proceeds of an issue; e.g. they do not apply to funds held in a reasonably required reserve fund. The term “gross proceeds” also does not include a reasonably required reserve fund.

6-Month Exception to Rebate (all bonds):

Rebate need not be paid to the federal government if all of the proceeds of the bonds are spent within six months following the issue date of the bonds with an additional six months for governmental or 501 (c)(3) bonds.

18-Month Exception to Rebate (all bonds):

Alternatively, rebate need not be paid to the federal government if the bond proceeds are spent in accordance with the following semi-annual spending requirements:

• At least 15 percent within 6 months;
• At least 60 percent within 12 months; and
• 100 percent within 18 months.

• Semi-annual spending requirements of 10%, 45%, 75%, and 100% of “available construction proceeds.”

• Reasonably required retainage not to exceed 5% and must be spent within an additional 6 months.

• De minimus amount for final semi-annual spending period for amounts not in excess of the lesser of $250,000 or 3% of the issue amount.

• At least 75% of the “available construction proceeds” will be used for “construction expenditures.”

• Can elect to pay a penalty in lieu of rebate if spending benchmarks are not met, but generally this is not done much because it is very expensive.

• Defined as a fund used primarily to achieve proper matching of revenues with bond payments during the year (this is not the debt service reserve fund but rather the fund created to make debt service payments, often semiannually; conduit issuers may make monthly payments to this fund to meet semi-annual debt service payments).

• Must be depleted annually, with a reasonable carryover amount equal to the lesser of 1/12 of debt service for the bond year or one year’s earnings on the fund.

• Fund is exempt from rebate if less than $100,000 earnings, with safe harbor for meeting test without having to actually measure if average annual debt service does not exceed $2.5 million.

1. Yield Burning: “Yield burning” refers simply to the artificial lowering of a security’s yield by pricing it in excess of its fair market value. Yield and price have an inverse relationship: as the price of a security goes up, its yield goes down. Securities purchased with the proceeds of tax-exempt municipal bonds must (1) be priced no higher than “fair market value,” and (2) earn an aggregate yield that does not exceed that earned on the tax-exempt municipal bond. For example, an issuer may purchase securities with bond proceeds. These securities include Guaranteed Investment Contracts (GICs), and Open Market Treasury Securities (OMTS), among other investments. These securities may be purchased to invest construction funds or debt service reserve funds. Other securities may be purchased for refunding escrows. Overstating the fair market value of GIC, OMTS, or other investments, using unreasonable collateralization requirements and/or charging excessive administrative costs (i.e. broker’s commissions) to artificially reduce the yield and, in effect, divert otherwise rebateable arbitrage from these investments to investment professionals/providers constitutes “yield burning” which is an abuse of IRS arbitrage rules and subject to penalties.
   
   
2. Unusual debt service structures: Most issues are structured with level annual debt service. An issue with dramatically uneven debt service may be an indication that an arbitrage game is being played.
   
   
3. Replacement Proceeds: The IRS will determine if amounts other than bond proceeds were directly or indirectly pledged to or expected to pay debt service or earmarked for the project financed with bond proceeds. If so, these amounts may be replacement proceeds and subject to arbitrage restrictions. Cash and investments on hand that have been specifically identified to pay for a project, either through donor restrictions or through internal accounting (unless only on an interim basis) cannot be replaced with tax-exempt bond proceeds issued to finance the same project costs. The bond size must be reduced to take into account such restricted funds. Restricted funds, which are received after bonds are issued, must be applied to retire the bonds or must be subject to arbitrage investment restrictions (which may act to lower investment earnings on such funds).
   
   
4. Reimbursement for prior expenditures: The use of bond proceeds to reimburse prior expenditures is permitted in many circumstances. There needs to be objective evidence of the intent to finance a project with tax-exempt bonds before making the original expenditure—a declaration of intent or Inducement Resolution. The more time that elapses between expenditures and the reimbursement of prior expenditures, the more suspect the reimbursement becomes.
   
   
5. All Investments must be purchased at fair market value: This is a particular concern for advance refundings, because bond proceeds may be invested for a long time until the prior bonds can be called. Also see “Yield Burning” above.