Post-Issuance Arbitrage Compliance A Long Road Ahead · 2020. 10. 30. · Arbitrage rebate is a...

Post-Issuance Arbitrage ComplianceA Long Road AheadMatt Collins, Vice PresidentArbitrage Compliance Specialists, Inc.

Monday, November 16, 2020

Learning Objectives

Arbitrage Rebate Key Concepts & Terminology.◦ What is Arbitrage Rebate?◦ Funds & Proceeds Subject to Arbitrage Rules◦ Exceptions to Arbitrage Rebate◦ Accounting for Bond Proceeds◦ Reporting Requirements◦ Yield Restriction

Establishment of Post-Issuance Compliance Procedures.◦ Written Procedures◦ Record Retention◦ Current Case Studies◦ Tips to help issuers maintain tax-exempt status of the bonds

What is Arbitrage Rebate?HOW DOES ARBITRAGE APPLY TO TAX-EXEMPT F INANCINGS?

What is Arbitrage Rebate?

Arbitrage is taking advantage of a price difference between two or more markets (borrowing at tax-exempt interest rates and investing at higher taxable rates)

In general, an issuer cannot arbitrage by issuing tax-exempt bonds and reinvesting the proceeds in securities with a higher interest rate.

Arbitrage rebate is the profit made from investing lower yielding tax-exempt bond gross proceeds in higher yielding taxable investments and must rebate (or pay) to the federal government the amount by which its investment earnings exceed the yield of the bond(s).

Measured on an issue-by-issue basis◦ Positive Arbitrage◦ Negative Arbitrage

What is Arbitrage Rebate?

Arbitrage rebate is a federal tax law requirement - §148 of the Internal Revenue Code.

Applicable to every tax-exempt borrowing unless exceptions apply.

Established by Congress with the intention to limit use of tax-exempt proceeds from:◦ Issuance of more bonds than necessary◦ Issuance of bonds earlier than necessary◦ Prevention of bonds from remaining outstanding longer

than necessary

Borrow what you need, when you need it, and for an appropriate duration based on financing needs.

What Funds Are Subject to the Arbitrage Rules?SPECIF IC DEF INIT IONS OF PROCEEDS ARE DEF INED IN THE TAX CODE

Gross Proceeds & Funds Subject to the Arbitrage Rules

Common funds/proceeds that are generally subject to arbitrage rebate are: Project Funds

Reserve Funds

Refunding Escrow Funds

Cost of Issuance Funds

Investment Proceeds

Transferred Proceeds

Replacement Proceeds(Debt Service, Sinking, or Pledged Funds)

Disposition Proceeds


Why are some of the funds listed as proceeds?Some funds are listed as proceeds due to their specific meanings.

Project Funds

Reserve Funds



Investment Proceeds


Replacement Proceeds (Debt Service, Sinking, or Pledged Funds)

Disposition Proceeds


Investment Proceeds – Amounts received from investing the proceeds of the issue.

Transferred Proceeds – If proceeds of a refunding issue are used to pay off a prior issue, any remaining proceeds of the prior issue become, for tax purposes, transferred proceeds of the refunding issue.

Replacement Proceeds – Amounts that will be used to pay debt service on an issue. In general, amounts are replacement proceeds of an issue if they have “a sufficiently direct nexus” to the issue or its governmental purpose to conclude that the amounts would have been used for that governmental purpose if the proceeds of the issue were not used instead.

Disposition Proceeds – Any amounts, including property, derived from the sale, exchange or other disposition of the tax-exempt bond financed property.

Gross Proceeds Defined

• Though “proceeds” may refer generally to the funds received from the sale of a bond issuance, this term and several related terms have precise meanings in the context of the arbitrage regulations

• Gross Proceeds means “Proceeds” (sale proceeds, investment proceeds, transferred proceeds) and“Replacement Proceeds” (i.e. debt service/sinking funds)

• Proceeds + Replacement Proceeds = “Gross Proceeds”

PROCEEDS REPLACEMENT PROCEEDS

Project/Construction Debt Service Funds

Capitalized Interest Sinking Funds

Cost of Issuance Any other “pledged” fund

Escrow

Reserve Funds


Investment Proceeds

Are There Exceptions to Arbitrage Rebate?YES! THERE ARE “BOND LEVEL” AND “FUND LEVEL” EXEMPTIONS

Exceptions to Arbitrage Rebate

There are a number of different exceptions for issuers of tax-exempt bonds that apply on a bond or fund level

Bond Level:◦ Small Issuer Exception

Fund Level:◦ Spending Exceptions (6 month, 18 month, 24 month)◦ Bona Fide Debt Service Fund Exception◦ Available Project Proceeds Exception (Tax Credit Bonds)◦ Sinking Fund Reserve Exception (Tax Credit Bonds)◦ Investing in tax-exempt obligations


Small Issuer Exception:o $5 million of governmental bonds for municipalitieso $15 million per calendar year for public school construction

Requirements:o Must be governmental bonds (not private activity)o Issuer must have general taxing powerso At least 95% must be used for local governmental activities

Refunding considerationso Current refunding exclusionso Refunding of prior bonds (subject to arbitrage rebate,

weighted average maturity, maturity dates)

Spending Exceptions

It is essential for both issuers and borrowers of tax-advantaged financings to timely spend their Gross Proceeds.

The IRS provides incentives for issuers and/or borrowers whom spend money appropriately and these incentives are generally known as spending exceptions.

Spending exceptions can often times help retain arbitrage earnings and/or simplify the compliance process.

Spending Exceptions to Arbitrage Rebate6-month, 18-month, and 24-month Spending Exceptions

100

15

60

100

10

45

75

100

0

10

20

30

40

50

60

70

80

90

100

6 months 12 months 18 months 24 months

6-Month Exception 18-Month Exception 24-Month Exception

6 Month Spending Exception(General Purpose)

The general rule for the exception is that if 100% of gross proceeds (including interest earnings, excluding any reserve funds) are expended within the 6 months after the issuance date, then the interest earned during that period is not subject to rebate.

Extension of time period –o This extension is applied to government bonds (except tax

and revenue anticipation notes) and qualified 501(c)(3) bonds. The extension is extended to 1 year for amounts not exceeding 5 percent of proceeds. Paraphrased from IRC § 148(f)(4)(B)(ii).

18 Month Spending Exception(Non-Refunding Purpose)

If all gross proceeds are spent within 18 months according to the timetable below, the interest earned during that period is not subject to rebate.18-month expenditure test § 1.148-7(d)–

o At least 15 percent of available construction proceeds spent within 6 months (first spending period)

o At least 60 percent of available construction proceeds spent within 12 months (second spending period)

o 100 percent of available construction proceeds spent within 18 months (final spending period)

De-Minimis carryover amounts also applicable.

2- Year Spending Exception

If an issue qualifies as a construction issue where 75% of the issue is spent on actual construction, and all gross proceeds and actual and expected earnings are spent within 2 years according to the timetable below, then interest earned during that period is not subject to rebate.2-year expenditure test (Construction Only Purpose) § 1.148-7(e) –

o At least 10 percent of available construction proceeds spent within 6 months (first spending period)

o At least 45 percent of available construction proceeds spent within 12 months (second spending period)

o At least 75 percent of available construction proceeds spent within 18 months (third spending period)

o 100 percent of available construction proceeds spent within 2 years (final spending period)


“Bona-Fide” Debt Service Exceptiono Used primarily to achieve a proper matching of revenues with

debt service payments and is depleted annually to a reasonable carryover amount: The earnings on the fund for the preceding year, or

1/12 of the principal and interest payments on the issue for the preceding bond year.

How Should Issuers Account for the Bond Proceeds?THERE ARE VARIOUS METHODS DEF INED IN THE TAX CODE & TREASURY REGULATIONS

Accounting for Bond Proceeds: Reimbursements

Issuers can reimburse itself for prior expenditures paid with funds other than bond proceeds. Certain rules must be met, however:◦ The issuer must timely adopt “official intent” that the

original expenditures will be reimbursed with bond proceeds. (Official intent must not be later than 60 days after payment of original expenditure).

◦ The allocation must be made within the reimbursement period (not later than 18 months after the later of the date of the original expenditure or the date the project is placed in service, no more than 3 years).

◦ The original expenditures must be of a certain nature (mostly capital expenditures & costs of issuance).

Accounting for Bond Proceeds: Commingled Project Funds

Permitted to use reasonable, consistently applied accounting method to allocate expenditures for commingled capital project funds:◦ FIFO – Where there is more than one bond issue, treat all expenditures as

coming from proceeds of the first issue until they are fully spent, the proceeds of the second issue next, and so on.

◦ Specific Tracing - Separate accounts for each issue and expend money from each account for expenses.

◦ Ratable Allocations - Single account for all issues, allocate all expenditures proportionately from the proceeds of each issue.

◦ Gross Proceeds Spent First - Allows the issuer to count bond proceeds as spent first when the issuer’s available funds include non-bond proceeds.

These four methods apply to expenditures for capital projects only. ◦ Working Capital: Proceed spent last method

Issuers must account for the allocation of proceeds to expenditures not later than 18 months after the later of:◦ The date the expenditure is paid or◦ The date that the project that is financed by the issue is placed in service.

In any event the allocation must be made no later than 60 days after the 5 th

year anniversary date of the issue.

Accounting for Bond Proceeds: Commingled Reserve Funds

Two or more bond issues share a common reserve fund (or similar fund) it must be allocated proportionately among the issues based on any of the following:◦ Values of the issues.◦ Remaining maximum annual debt service◦ Original principal amounts.

What Are The Minimum Arbitrage Reporting Requirements?HOW OFTEN SHOULD CALCULATIONS BE COMPLETED?

What are the Minimum Reporting Requirements?

Any arbitrage rebate payments must be made no later than 60 days after the computation date.

o Computation Date: No later than 5-years after the issue date (installment date) and every five years thereafter until the final maturity date

o Payment(s): 90% or 100%

Submit check and IRS Form 8038-T.Do not send calculations!No filing requirement if no payment is due.

Filing Requirements

What if payments are not made on time?◦ Subject to interest and penalties: 50% of rebate amount, plus interest Interest computed at underpayment rate

Late payment explanation requiredIRS can consider waiving penalty (excluding interest) if:

◦ Liability plus late interest is paid within 180 days after the date the failure was discovered

◦ Bonds are not under audit◦ Late payment was not caused by “willful neglect”

Recovery & Refunds

Certain issues may be eligible for a refund of a prior arbitrage rebate payment.◦ Typically rebate payment made after the first five-year

period, offset by negative arbitrage thereafter (even with removal of future value factor)

Must be filed no later than two years after the final computation date.

Considerations for potential audit risk before filing.

What Is Yield Restriction?WHAT ARE THE DIFFERENCES BETWEEN Y IELD RESTRICTION AND ARBITRAGE?

What is Yield Restriction?

Yield restriction rules are established as part of the Tax Reform Act of 1969.

Established to discourage issuers from investing either purpose or non-purpose investments in a manner that would create an arbitrage bond.

Established exceptions based on temporary periods, materially higher yields and creation of a minor portion.

Established rules for issuers to follow that generally complement those created for arbitrage rebate.


“Yield Restriction" is the profit made from investing tax-exempt debt proceeds in higher yielding taxable investments, above a specific materially higher yield, after a designated temporary period and above the minor portion.


What does yield restriction look like?Below is a typical example of yield restriction:

The blue line represents the debt issue’s yield and the fluctuating orange line is the actual investment yield for a Local Government Investment Pool. Note the gray vertical line that represents the start of yield restriction.

What is Yield Restriction

What funds are generally subject to yield restriction reporting?The funds/proceeds that are subject to yield restriction are:

Project Funds


Reserve Funds (rarely)



Investment Proceeds

Replacement Proceeds(Debt Service, Sinking, or Pledged Funds)

What is Yield Restriction

What is materially higher yield?“Materially Higher Yield" occurs when an investment purchased with proceeds of tax-exempt bonds produces a yield which is at or above a specified percent above the bond yield after the temporary period.

Fund Type Materially Higher Yield

General rule for purpose and non-purpose investments (Typically Project and Cost of Issuance)

1/8 of 1%

Refunding Escrow 1/1000 of 1%

Replacement Proceeds (Typically Debt Service, Pledged and Unreasonable Reserve) 1/1000 of 1%

Program investments (Generally) 1.5%

Tax-Exempt Investments None


What purpose does the temporary period have?A “Temporary Period" defines the period of time for unrestricted investment per fund/proceed type.

Fund Type Temporary Period(s) Available

Project 3 or 5 YearsCost of Issuance 13 MonthsAdvanced refunding is defined as a refunding that takes place after 90 days 0 or 30 Days

Replacement Proceeds (Typically Debt Service, Pledged and Unreasonable Reserve) 30 Days

Bond Fide Debt Service 13 Months

Reasonable Required Reserve None

Minor Portion (Aggregate amount not to exceed the lesser of 5% of sales proceeds or $100,000) None


What is the minor portion?“Minor Portion" is a small amount, specifically the lesser of $100,000 or 5% of the proceeds of the issue which does not have to be yield restricted.

The Importance of Written Compliance ProceduresWHAT I S ADVISED BY THE IRS AND WHAT BOND RECORDS SHOULD I SSUERS ALSO BE KEEPING, AND FOR HOW LONG?

Written Procedures-Post Issuance Compliance

Characteristics and best practices for written compliance procedures:◦ Due diligence review at regular intervals;◦ Identify official or employee responsible for review;◦ Training of the responsible official or employee;◦ Retention of adequate records;◦ Establish procedures to timely identify non-compliance;

and◦ Procedures that the issuer will take steps necessary to

rectify non-compliance.

Not just arbitrage rebate – private business use and continuing disclosure equally important.

Record Retention-Post Issuance Compliance

Federal requirements under IRC §6001 are burdensome and may not be consistent with District or State document destruction policies.

Under §6001 records must be stored for the life of the bonds plus three years.◦ If bonds are refunded, life of the refunding bonds plus

three years.

Separate document collection, storage and destruction policies for bond related records are encouraged.◦ Electronic storage with proper back-up systems & policies.

Record Retention-Post Issuance Compliance

Examples of records to retain:◦ Bond Transcripts◦ Investment Records◦ Expenditure histories (including invoices)◦ Board Minutes & Resolutions◦ IRS Filings◦ Any investment agreements◦ Arbitrage & yield restriction compliance reports◦ Newspaper ads & correspondence◦ Appraisals

Case Studies & Compliance TipsBEST PRACTICES AND HOW TO AVOID NON-COMPLIANCE

Gross Proceeds – Debt Service Funds Not Meeting Exemption

Case Study/Example

BOND FACTS & SCENARIO:

County Issuer – $11.1MM Series 2015 Refunding Bond, issued August 2015.

The County refunded older bonds with proceeds of the 2015 bonds. Proceeds were utilized to refund the 2005 bonds shortly after issuance (Current Refunding). No other proceeds were used for any other purpose other than paying issuance costs related to the bonds.

Due to the refunding nature of the bonds, as well as a short maturity date (five years), the bond yield was 1.0859%.

The escrow fund (fund used to hold the proceeds of the bond prior to repayment of the 2005 bond) was invested below the bond yield. However, the County’s debt service fund did not meet the “Bona-Fide” fund exemption defined in the regulations, and interest earned on the fund is subject to the arbitrage rebate rules as “replacement proceeds.” Additionally, unspent construction proceeds from the 2005 bond became “transferred proceeds” of the 2015 bonds.

In turn, the cumulative investment yield on the debt service fund as well as the “transferred proceeds” was above the bond yield for the computation period (1.211%) and a positive arbitrage rebate liability of approximately $10,000 had accrued.

TAX CERTIFICATE RE: DEBT SERVICE FUND

Yield Restriction (“YR”)Payment (Difference vs. Arbitrage)Case Study/Example

BOND FACTS & SCENARIO:School District Issuer (OK) – $9.6MM Series 2015 Bond, issued August 2015 to finance capital improvements.

Due to the short-term nature of the bond and creditworthiness of the issuer, the bond yield was a low 1.3198%.

Of the $9.6M of bond proceeds for construction, only $4.2 million of the bond proceeds were spent by the end of August 2018 (The end of the temporary period for yield restriction purposes), leaving $5.4 million unspent and subject to the yield restriction rules.

The issuer did not end up owing an arbitrage rebate payment to the IRS; however, the district ended up owing a yield restriction payment of $32,465. Why?

The yield on investments purchased with bond proceeds from the issuance date (8/2015) through the end of the computation period (8/2020) was below the bond yield, in part aided by low investment rates between the years 2015-2017 so that it blended the overall arbitrage investment yield during the five-year period (0.889%) below the bond yield.

For yield restriction purposes however, proceeds can be unrestricted as to the rate of investment during the 3-year “temporary period” for project funds. Funds remaining after must be “yield restricted” and due to the nature of rates at the time, funds were invested at 2.167% between 2018-2020, causing a yield restriction payment.

SIGNIFICANCE OF TEMPORARY PERIOD YR VS. ARBITRAGE REBATE

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

TemporaryPeriod

2015-16

TemporaryPeriod

2016-17

TemporaryPeriod

2017-18

RestrictedPeriod

2018-19

RestrictedPeriod

2019-20

Arbitrage + YR Yield GraphBond Yield Investment YieldArbitrage Rebate Liability Yield Restiction Liability

Reimbursement of Bond Proceeds – Case Study/Example

BOND FACTS & SCENARIO:

• City Issuer – $26.6MM Series 2019AB GO Bond, issued April 2019.

• City records indicate that approximately $750,000 of project expenditures to be financed with the 2019 bond proceeds occurred before the issuance date of the bonds dating back to February 2018 (City planned to reimburse prior expenditures with bond proceeds).

• No reimbursement resolution was adopted, no official intent was declared, and Tax Documents also indicated no proceeds were to be used to reimburse prior expenditures.

• If $750,000 of expenditures are not considered “preliminary” expenditures, proceeds of the bonds cannot be used to reimburse the funds per 1.150-2 of the Treasury Regulations.

• ACS Calculated a positive arbitrage rebate liability of $31,445.92 for the first computation period. If ACS was able to include all $750,000 of expenditures, it would reduce the arbitrage rebate liability by nearly $14,000.

TAX CERTIFICATION RE: REIMBURSEMENTS

Post-Issuance Compliance Tips

Establish departmental policies to allow for compliance with:o Private Business Useo Arbitrage Rebateo Continuing Disclosureo Record Retention

Implement procedures and adhere to the policies.

Consider maintaining an annual checklist to support proper due diligence.

Tips for Smooth Calculation Process

Know your bond documents!◦ Including the Tax or Non-Arbitrage Certificate

Maintain organized bond records:◦ Create bond file records right after closing (Avoids having to

locate records dating back five years)◦ Consider hiring consultants when the bonds are issued.

Create internal calendars and schedule calculation dates◦ Know your exceptions and keep them in mind when creating

calendars.

Keep calculations up to date:◦ Avoids costly penalties and valuable time & resources◦ Consider calculations prepared more than every five years◦ Helps plan for possible future liabilities◦ Keeps up to date on spending exceptions that may be

available.◦ May spread out cost of completing calculations

Always ask your public finance professionals questions.

Questions?Arbitrage Compliance Specialists, Inc.(303) [email protected]

mailto:[email protected]

Post-Issuance Arbitrage Compliance A Long Road Ahead · 2020. 10. 30. · Arbitrage rebate is a...

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