IRS Arbitrage and Rebate Rules Return to the Forefront
Issuers of tax-exempt bonds are subject to investment or arbitrage limitations under the Internal Revenue Code (IRC). Failure to comply with those arbitrage limitations will result in the bonds being arbitrage bonds and interest on the bonds being taxable. For over a decade, it has been almost impossible for an issuer to earn positive arbitrage (i.e., the investment yield exceeds the bond yield) on its tax-exempt bond issues. However, with an inverted yield curve and short-term taxable rates in excess of 4% (the CT STIF Fund was earning 4.49% as of January 31, 2023), it is now likely that the investment returns on bond proceeds sitting in an account will exceed the yield on the bonds. As a result, issuers must be aware of the available temporary periods and rebate spending exceptions included in the IRS regulations.
Arbitrage Rebate and Yield Restriction
General tax rules prohibit the investment of bond proceeds at a yield materially higher than the yield on the bonds. To implement this general rule, there are 2 separate arbitrage requirements included in the Internal Revenue Code – arbitrage rebate and yield restriction. First, arbitrage rebate refers to the positive arbitrage earnings that are required to be rebated to the federal government. Second, yield restriction rules provide specifically defined temporary periods during which bond proceeds are permitted to be invested at a yield materially higher than the bond yield. For example, bond proceeds earmarked for capital costs have a 3-year temporary period.
Calculating Arbitrage Rebate and Rebate Spending Exceptions
The IRS regulations require that arbitrage be calculated at least every 5 bond years. Unless the bond issue meets any of the exceptions described below, any positive arbitrage earned over any such arbitrage period must be rebated to the federal government within 60 days after the end of the period. However, if an issuer can satisfy any of the 4 rebate exceptions described below, the issuer is permitted to keep any positive arbitrage:
- Small Issuer Exception – applies if the issuer (and any subordinate entity, like a district) issues less than $5 million of tax-exempt bonds in a calendar year. The exception is increased to $15 million if at least $10 million is issued for school construction projects.
- 6-month Spending Exception – applies if the issuer spends all of the bond proceeds within 6 months of the issue date.
- 18-month Spending Exception – applies if the issuer spends at least 15% of the bond proceeds within 6 months of the issue date, 60% within 12 months, and 100% within 18 months.
- 24-month Construction Spending Exception – generally applies if the issuer spends at least 10% of the “available construction proceeds” within 6 months of the issue date, 45% within 12 months, 75% in 18 months, and 100% within 24 months.
Yield Restriction and Yield Reduction Payments
The IRS regulations permit unspent bond proceeds for capital projects to be invested at a yield in excess of the bond yield for the first 3 years after the bonds are issued. However, such excess earnings are still subject to the rebate rules described above.
If bond proceeds remain unspent after the end of the 3-year temporary period and are earning an investment return in excess of the bond yield, the issuer is required to make “yield reduction” payments to the federal government to effectively reduce the investment return to a yield not materially higher than the bond yield. Any required yield reduction payments must be made by the issuer to the federal government on the same schedule that it is required to make arbitrage rebate payments to the federal government.
Compliance with the arbitrage rebate and yield restriction rules is necessary in order for the interest on bonds to remain tax-exempt. With some forward planning and good record keeping, issuers should be able to make sure that they have satisfied these rules. Should you have questions relating to arbitrage or your bonds, please don’t hesitate to reach out to any of our Public Finance attorneys.