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The Basics of Arbitrage Compliance
Summary Information
The following outline is designed to provide a brief overview of the arbitrage rebate requirements and discuss recent events in the area of arbitrage compliance. It is not intended to be a comprehensive outline of the Internal Revenue Code or Treasury regulation sections related to tax-exempt bond compliance.
Introduction to the arbitrage concept.
A. Definition of arbitrage. Arbitrage is the ability to obtain tax-exempt bond proceeds and invest the funds in higher yielding taxable securities, resulting in a profit.

B. Basic purpose of the arbitrage laws. There are two primary purposes expressed in the regulations for establishing arbitrage laws:

  1. Minimize the benefits of investing tax-exempt bond proceeds, and

  2. Remove the incentive to issue more bonds, issue bonds earlier, or to leave bonds outstanding longer than is necessary to carry out the governmental purpose of the issue.

C. Funds Subject to Arbitrage Rebate. Gross proceeds of an issue are subject to the arbitrage restriction and arbitrage rebate provisions. Gross proceeds of an issue include:

  • Sale Proceeds are amounts received from the sale of the bonds;
  • Investment Proceeds represent interest earned from investing proceeds;
  • Transferred Proceeds are created from unspent proceeds of a refunded bond issue; and
  • Replacement proceeds include reserve funds, debt service funds, sinking funds, etc.

D. Yield Reduction Payments. Yield reduction payments, introduced by the 1993 Regulations, are payments made to the United States that reduce the yield on an investment. Yield reduction payments are designed to be a solution to yield restriction complexities as it allows the issuer to rebate arbitrage earned after the permitted temporary period.

  1. A yield reduction payment is paid in the same manner and at the same time as a rebate payment (each five years and at the final redemption date).

  2. A yield reduction payment increases the "price" of the investment which, in turn, reduces the yield on the security.

  3. An issuer may use yield reduction payments in the following situations:

    a. Investments that qualified for an original temporary period (e.g., 3-year temporary period);

    b. Investments restricted to a variable yield issue;

    c. Transferred proceeds from a current refunding; and

    d. Reserve fund portion in excess of the reasonably required limits.

    An issuer cannot use yield reduction payments for advance refunding issues.

  4. Sample Yield Reduction Payments:

    Example Arbitrage Earned
    Years 1 - 3
    Arbitrage Earned
    Years 4 & 5
    Amount Due
    to IRS
    1 $ 10,000 $ 5,000 $ 15,000
    2 10,000 (5,000) 5,000
    3 (10,000) 5,000 5,000

    Note that in Example 3, the negative arbitrage earned during the three-year temporary period could not be used to offset the positive arbitrage earned in Years 4 & 5. The amount due to the IRS is the amount of the yield reduction payment.

General Arbitrage Rebate Requirements
A. Required IRS Reporting Dates for Arbitrage Rebate Payments. An issuer is required to make payments of arbitrage on both installment calculation dates and on the final computation date.

Required IRS Reporting Dates for
Arbitrage Rebate Payments

  1. Installment Calculation Dates. The first installment of rebate must be paid no later than the end of the fifth bond year. A bond year is each one year period ending on the date selected by the issuer. If no date is selected by the issuer, bond years end on each anniversary date of the issue. Selecting a bond year other than the anniversary date will result in the first installment of rebate being paid earlier than five years. Each installment must be paid within 60 days after the installment date.

  2. Final Computation Date. The final computation date of an issue is the date that all bonds of the issue have been retired (matured or redeemed early). A cash defeasance or refunding of bonds prior to their scheduled maturity may accelerate the final computation date. The final payment must be mailed no later than 60 days after the final computation date.

  3. Required Payment Amounts. On any installment date, an issuer is required to remit an amount which, when added to the future value on the computation date of previous payments, equals 90 percent of the cumulative rebate amount. On the final computation date, the issuer is required to pay 100 percent of the unpaid rebate amount.

B. Rebate Credit. An issuer is entitled to reduce the rebate amount paid to the United States by the permitted rebate credit. Under the prior regulations, the rebate credit was $3,000 every five years. Under the 1993 Regulations, an issuer is entitled to a rebate credit of $1,000 annually for each year that gross proceeds exists and on the final installment date.

C. Payments to the Internal Revenue Service. When making a payment to the Internal Revenue Service, the following procedures should be followed:

  • Make check payable to the Internal Revenue Service,
  • Complete and sign IRS Form 8038-T ``Arbitrage Rebate and Penalty in Lieu of Arbitrage Rebate,'' and
  • Send arbitrage rebate payments and yield reduction payments certified mail to the IRS Service Center, Ogden, Utah 84201

    Form 8038-T is only filed when rebate amount is positive. As stated in Form 8038-T under the heading "When to File: File Form 8038-T when paying the arbitrage rebate to the United States."

D. Penalties for Noncompliance of Arbitrage Regulations. The Internal Revenue Service has two primary alternatives for failure to comply with the arbitrage rebate requirements. The Internal Revenue Service may either declare the bonds taxable or assess penalties and interest on the issue.

  1. Failure to Pay Rebate. The failure to pay penalty when required will cause the bonds to be taxable unless the failure was not due to willful neglect, and the issuer pays a penalty to the United States.

  2. Penalty Assessment Rates. The penalty for failure to pay the correct rebate amount when due is equal to 50 percent for governmental bonds or 100 percent for private activity bonds, excluding 501(c)(3) bonds. Interest is also payable on the correction amount.

  3. Waiver of Penalty. The 50 percent penalty is automatically waived if the rebate amount, plus interest, is paid within 180 days of the failure's discovery. A waiver is not allowed if the IRS determines that the failure was due to willful neglect or the issuer is under examination by the IRS.
E. Recovery of Overpayments. The 1992 Regulations allowed recoveries of overpayments only for mathematical mistakes, not for overpayments due to market conditions. The 1993 Regulations expanded the rules to provide for recovery of overpayments by establishing that an overpayment occurred. Issuers should follow requirements of Advance Revenue Procedure 92-83 when applying for an overpayment refund. Overpayments can only be recovered to the extent that the recovery does not result in additional rebate as of the date requested. In addition, an overpayment of less than $5,000 may not be recovered before the final computation date.
Exceptions to the Rebate Requirements
A. The following exceptions provided by either the Tax Code or related regulations, will exempt all, or a portion, of the proceeds from the rebate requirements.

  • Small Issuer Exception,
  • Six-Month Spending Exception,
  • Eighteen-Month Spending Exception,
  • 24-Month Spending Exception for Certain Construction Bonds,
  • Investments in Non-AMT Tax-exempt Obligations, and
  • Debt Service Fund Exception.

B. Small Issuer Exception. The small issuer exception applies only to bonds issued by governmental units with general taxing powers. To qualify, an issuer must reasonably expect to issue $5 million or less in tax-exempt debt during a calendar year and use at least 95 percent of the net proceeds for local governmental activities. When determining whether $5 million was issued during the calendar year, an issuer must count all governmental bonds (except private activity bonds) issued by the governmental unit and its subordinate entities.

  1. Small Issuer Exception Increase for Educational Facilities. Effective January 1, 1998, the small issuer exception was increased only for governmental bonds used to finance public school capital expenditures. The small issuer exception can be increased by the face amount of bonds used to finance construction of public school facilities with the limitation that the increase cannot be greater than $5 million and must be for capital expenditures. Therefore, it is possible for the total amount of the small issuer exception for issuers of public school facility bonds to be a maximum of $10 million. However, the amount of the exception may be less than $10 million depending upon the amount of public school construction expenditures included in the amount of debt sold during the calendar year. For example, if an issuer sells $4 million of bonds for land and equipment, and $3 million for construction of public schools, the small issuer exception amount would be $7 million.

  2. The application of this special exception for public school facilities are demonstrated in the following examples:

    a. Case 1: A school district issues $7 million of debt for construction and $3 million for non-construction. Issues are exempt during calendar year since the total amount issued was $10 million or less and the non-construction portion was less than $5 million.
    b. Case 2: A school district issues $7 million of debt for construction and $5 million for non-construction. Issues are not exempt during calendar year since the total amount issued was greater than $10 million, even though the non-construction portion was less than or equal to $5 million.
    c. Case 3: A school district issues $3 million of debt for construction and $6 million for non-construction. Issues are not exempt during calendar year since even though the total amount issued was less than $10 million, the non-construction portion was greater than $5 million.

C. Six-Month Spending Exception. Gross proceeds of an issue are exempt from the rebate requirements if the proceeds (including interest earnings) are expended for the governmental purpose within six months of the date of delivery.

D. Eighteen-Month Spending Exception. This spending exception was introduced by the 1993 Regulations and is effective for all types of bonds issued after June 30, 1993. The 18-month spending exception may not be elected retroactively to any bonds issued prior to the effective date. This is the only part of the 1993 regulations which may not be elected retroactively. Under the exception, interest earned from investing gross proceeds of an issue are exempt from rebate if the gross proceeds (including interest earnings) are expended for their governmental purpose in accordance with the following expenditure schedule:

Period Cumulative
Expenditures
6 months 15%
12 months 60%
18 months 100%

E. 24-Month Spending Exception. This spending exception was introduce by Congress in late 1989 and is available only for construction bond issues delivered after December 19, 1989. The regulations do not permit retroactive election of the two-year exception to bonds issued prior to the December 1989 statutory effective date of this exception. The earnings from an issue are exempt from rebate if the gross proceeds are expended for their governmental purpose in accordance with the following expenditure schedule:

Period Cumulative
Expenditures
6 months 10%
12 months 45%
18 months 75%
24 months 100%

  1. Construction Issue. The 24-Month exception applies only to construction bonds issues which are defined as any issue that is not a refunding issue if the issuer reasonably expects, as of the date of issue, that at least 75% of the available construction proceeds will be used to finance construction expenditures (instead of land acquisitions and equipment acquisitions). The exception also applies to any qualified 501(c)(3) hospital bonds and private activity bonds issued to finance property to be owned by a governmental unit or 501(c)(3) organization.

F. Exception for Investments in Tax-Exempt Securities. An issuer can avoid paying rebate by investing all of the bond proceeds in certain other tax-exempt investments. By definition, proceeds invested in tax-exempt bonds are not subject to yield restriction or arbitrage rebate. However, for bonds issued after 3/31/88, the proceeds of which are invested in tax-exempt bonds subject to the Alternative Minimum Tax (AMT), earnings from AMT investments are subject to the arbitrage rebate requirements.

G. Bona Fide Debt Service Fund Exception. Amounts deposited into a bona fide debt service fund are exempt from rebate for long-term fixed rate issues and for short-term or variable rate issues that earned less than $100,000 in the bona fide debt service fund during each bond year.

  1. Bona Fide Debt Service Fund Definition. "A bona fide debt service fund means a fund, which may include proceeds of an issue, that is used primarily to achieve a proper matching of revenues with principal and interest payments within each bond year." The bona fide debt service fund must be depleted at least once each bond year, except for a reasonable carryover amount not to exceed the greater of: (i) the earnings on the fund for the immediately preceding bond year; or (ii) one-twelfth of the principal and interest payments on the issue for the immediately preceding bond year.

  2. Debt Service Fund Earnings Limitation. A bona fide debt service fund is exempt from the rebate requirement for long-term, fixed rate bond issues delivered after November 10, 1988 regardless of the amount of interest earned.

    A bona fide debt service fund for short-term, fixed rate issues or variable rate issues must be included in the rebate calculation is the portion of the debt service fund allocated to the issue earns more than $100,000 per bond year.

  3. Debt Service Fund Safe Harbor. An issue with an average annual debt service that is not in excess of $2,500,000 may be treated as satisfying the $100,000 limitation.
Anti-Abuse Rules
A. General Anti-Abuse Rule. In general, bonds are considered arbitrage bonds (taxable) if an abusive arbitrage device is used in connection with the issue. An abusive arbitrage device exists if the action has the effect of (1) enabling the issuer to exploit the difference between tax-exempt and taxable interest rates to obtain a material financial advantage; and (2) overburdening the tax-exempt market.

  1. Overburdening the Tax-Exempt Market. An action overburdens the tax-exempt market if it results in issuing more bonds, issuing bonds earlier, or allowing bonds to remain outstanding longer than is reasonably necessary to accomplish the governmental purpose. Reasonably necessary depends on whether the primary purpose of the transaction is a bona fide governmental purpose. One factor demonstrating an early issuance is the inability to qualify for a temporary period (e.g., 3-Year temporary period).

  2. Consequences of Overburdening the Market. In the event it is determined that an issuer has overburdened the tax-exempt market, the following special rules are imposed:
    a. Investments are restricted to a yield not greater than 1/1000th of 1 percent above the yield on the bonds. The restriction requirement applies to each investment separately and may not be blended with other investments for yield restriction;
    b. The issue is not eligible for the use of yield reduction payments; and
    c. The proceeds must be expended on a "bond-proceeds-spent-last" basis.
IRS Enforcement Program
A. Internal Revenue Service Enforcement Program. In conjunction with the release of the 1993 Regulations, the Internal Revenue Service announced a new enforcement program for tax-exempt bonds.
  1. SEC Coordination. The Office of the Assistant Commissioner of the Exempt Organizations Technical Division also stated that they will coordinate investigations with the Securities and Exchange Commission (SEC) and intend to develop a working group to address compliance problems in the tax-exempt industry. Initial areas target for possible examination are advance refunding escrows using open-market purchases of Treasury obligations and purchases of long-term guaranteed investment contracts. The SEC has used violations of the arbitrage regulations as a basis for enforcement actions against underwriting firms.

  2. Types of Audits. Four primary reasons for performing an audit have been identified by the Internal Revenue Service:

    • Random audits,
    • Issues identified by third parties (media, bondholders, etc.),
    • Issues with possible abuses (GICs, refunding escrows, etc.), and
    • Issuer refund requests.

    Field agents are being trained and procedure manuals developed to assist agents in examinations of tax-exempt bonds. Field agents have been encouraged to begin audits early to avoid the three-year statute of limitation of collecting taxes (i.e., bondholders).

B. Structure of IRS Enforcement Division. The Internal Revenue Service restructured their enforcement division in October 1999. A new division, referred to as the Tax-Exempt & Governmental Entities Operating Division, was created within the IRS to handle all matters related to tax-exempt and governmental entities.

  1. IRS Enforcement Structure. The Tax-Exempt & Governmental Entities Operating Division serves three sectors:

    • Employee Plans,
    • Exempt Organizations, and
    • Governmental Entities.

  2. Governmental Entities Sector. The Governmental Entities Section monitors compliance for:

    • Tax-exempt bonds,
    • Federal, State and Local governments, and
    • Indian tribal governments.

    Approximately 300 employees have been assigned to the Governmental Entities Sector of the Tax-Exempt & Governmental Entities Operating Division. This includes clerical and administrative personnel as well as field examiners.

1999 Yield Burning Rules
A. Yield Burning. The Securities and Exchange Commission and the Internal Revenue Service have emphasized examinations of possible yield burning cases. "Yield burning" results when the sales price of an investment exceeds the market price of the investment for the purpose of reducing ("burning") the yield to a lower level. The excess sales price is arbitrage that is being diverted to the firm selling the securities to the issuer. The practice of yield burning is illegal as the federal government is entitled to the arbitrage profits, not the securities broker.

B. Safe Harbor for Guaranteed Investment Contracts. To combat yield burning practices, the IRS issued regulations detailing the procedures and documentation that must be followed in order to demonstrate that yield burning did not occur. Effective March 1, 1999, the purchase price of a guaranteed investment contract (GIC) is treated as the fair market value if:

  1. Bona Fide Solicitation. The issuer must make a bona fide solicitation for the purchase of the investment that satisfies all of the following requirements.

    a. The bid specification are in writing and sent to potential providers on a timely basis;
    b. The bid specifications include all material terms of the bid which could directly or indirectly affect the yield or the cost of the investment;
    c. The bid specifications include a statement notifying the potential providers that, by submitting a bid, they are certifying they did not consult with any other provider, that the bid was not determined based upon an informal agreement with the issuer or any other person, and that the bid is not being submitted as a courtesy in order to satisfy the three bid rule;
    d. The terms of the bid are commercially reasonable (has a legitimate business purpose other than to adjust the rate);
    e. The terms of the solicitation take into account the issuer's reasonably expected deposit and drawdown schedules; and
    f. At least three reasonably competitive providers are solicited for bids from providers with an established industry reputation for the type of security being bid.

  2. Bids Received. The bids received by the issuer must satisfy all of the following requirements:

    a. The issuer must receive at least three bids from providers that do not have a material financial interest in the bond issue;
    b. At least one of the bids received is from a reasonably competitive provider; and
    c. If the issuer uses an agent to conduct the bidding, the agent did not bid to provide the investment.

  3. Winning Bid. The winning bid must meet all of the following requirements:

    a. If the investment is a guaranteed investment contract, the winning bid is the highest yielding bona fide bid determined net of any brokers' fees;
    a. If the investment is for a yield restricted investment or yield restricted escrow, the following conditions are met:

    (i) The winning bid is the lowest cost bona fide bid (including any broker's fees) determined on either an aggregate portfolio basis or an investment-by-investment basis; and

    (ii) The lowest cost bid is not greater than the cost of the most efficient portfolio comprised of State and Local Government Securities (SLGS) from the U.S. Department of the Treasury, Bureau of Public Debt.

  4. The winning bidder must certify as to any fees paid to third parties in connection with the investment.

  5. The issuer must retain the following records with the bond documents until three years after the last outstanding bond is redeemed:
    a. A copy of the investment contract for guaranteed investment agreements and for other yield restricted investments, the purchase agreement or contract;
    b. A record of the amount actually paid by the issuer for the investments, including any administrative costs paid by the issuer, and the certification described in (4) above;
    c. For each bid submitted, the name of the person and entity submitting the bid, the time and date of the bid, and the bid results; and
    d. A copy of the bid solicitation form and a written explanation if the terms of the solicitation deviated from the purchase agreement; and
    e. For yield restricted escrows, a copy of the cost of the most efficient portfolio of SLGS determined at the time bids were required.
  6. Bidding Agent Fees. To be deemed reasonable under the IRS regulations for yield restricted investments or yield restricted escrows, the fee may not exceed the lesser of $10,000 or 0.1% (10 basis points) of the initial principal amount invested.

This article is reprinted with the permission of:
First Southwest Asset Management
700 Pacific Avenue, Suite 500
Dallas Texas 75201
(214) 953-4031