National Association of State Treasurers

1
National Association of State Treasurers
Arbitrage Rebate
David M. Panico, Esq. Robinson Cole LLP (860)
275-8390 dpanico_at_rc.com
Laurie Scott Integrity Public Finance Consulting
LLC [phone] lscott_at_integritypfc.com
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Arbitrage Rebate What is it ?

• Tax exempt bonds rob Treasury of revenue so their
  use should be minimized.
• Tax exempt bonds should be issued only when bond
  proceeds are needed to finance project
  expenditures.
• Proceeds should be spent quickly for projects.

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Arbitrage Restrictions

• Yield Restriction - limits the time period bond
  proceeds can be invested above the Yield on the
  Bonds.
• Time periods
• Capital projects?3 years
• Working capital?13 months
• DSRFs unlimited, but size limited to lesser of
  3 measure
• No longer significant restriction since adoption
  of arbitrage rebate

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• Arbitrage Rebate If Issuer fails to meet
  spending tests, earnings in excess of Yield on
  the Bonds are rebated to US Treasury.
• Rebate Amount is excess of amount earned on the
  investment of Gross Proceeds over the amount
  earned if invested at the Yield on the Bonds.
• Spending tests generally occur sooner than
  temporary periods end, so arbitrage rebate more
  important.

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Arbitrage

• Bonds
• Principal payments
• Interest payments
• Guarantee/Hedge fees
• Bond yield

• Investments
• Principal payments
• Interest payments
• QACs
• Investment yield

vs.
5.0 Arbitrage 5.5
5.0 No Arbitrage 5.0
5.0 Negative Arbitrage 4.5
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Spending Tests

• Six months
• 18 months
• Two Years (for Construction Issues)
• Tests can be applied independently, if applicable
• Use of spending exception not mandatory
• For multipurpose issues (e.g., new money and
  refunding), tests apply to each separate portion

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Gross Proceeds Subject to Rebate

• Sales proceeds
• Investment proceeds
• Transferred proceeds
• Replacement proceeds

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Six Month Test

• Spending Requirement
• 95 of Gross Proceeds in six months
• 100 in one year
• Excludes DSF, DSRF, unexpected Gross Proceeds
• Rebate applies to excluded amounts absent
  exception.
• Only test applicable to refundings

9
18 Month Test

• Spending Requirement
• 15 of Gross Proceeds in six months
• 60 in one year
• 100 in 18 months
• (95 in 18 months and 100 in 30 months if
  unexpended 5 represents Reasonable Retainage)
• Lesser of 3 or 250,000 de minimis exception
• Similar exclusions
• Applies to new money not qualifying as
  Construction Issue

10
Two Year Test for Construction Issue

• Spending Requirement
• 10 of Available Construction Proceeds (ACP)
  in six months
• 45 in one year
• 75 in 18 months
• 100 in two years
• (95 in two years and 100 in three years if
  unexpended 5 represents Reasonable Retainage)
• Lesser of 3 or 250,000 de minimis exception
• For six month, one year and 18 month spending
  periods, Investment Proceeds are estimated.
• Applies to new money qualifying as Construction
  Issue

11
ACP

• ACP equals Issue Price
• Less (DSRF) (Costs of Issuance)
• Plus Investment Proceeds
• Election available to exclude earnings on DSRF
  for construction period up to two years
• If excluded, rebate applies from Issue Date

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Construction Issue

• 75 of ACP expended for Construction Expenditures
• Based on expectations on Issue Date
• Construction Expenditures
• construction, reconstruction, rehabilitation of
  real property (buildings, structures, component
  of buildings and structures)
• not acquisition of interests in land
• constructed personal property
• specially developed computer software

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Rebate Calculation Procedure

• Determine Gross Proceeds
• Obtain Investment Records
• Calculate (confirm) Yield on Bonds - fixed vs.
  variable - qualified guarantees (bond
  insurance, LC fees) - qualified hedges
  interest rate swaps - yield-to-call bonds,
  deep-discount bonds
• Computation of Rebate Amount

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Rebate Amount

• Excess of
• Future Value of receipts from investments
• over
• Future Value of payments for investments
• Future Value PV x (1i) n
• Universal Cap limitation
• Transferred Proceeds from refunded bonds

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Rebate Compliance

• Calculation dates
• Cumulative calculation at least every 5 years
• Payments
• 90 every five years
• 100 after retirement
• Credit
• 1,000 per year
• Filing Requirement
• Payment is made using Form 8038-T

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Penalties

• Loss of tax-exempt status
• 50 penalty plus interest on that amount
• Waiver of penalty for innocent failure if
  corrected within 180 days of discovery

17
Filing Requirements

• Every fifth bond year
• Bond year does not always mean anniversary
  of issue date
• At final redemption, including early call or
  reissuance
• Special due dates for short-term obligations

18
Unexpected Arbitrage

• Debt Service Funds
• Escrow reinvestments
• Yield Restriction

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Debt Service Funds

• Bona-fide debt service funds are required to
  deplete at least once each bond year, except for
  a reasonable carryover amount not to exceed the
  greater of
• Draw down balance to 1/12th of annual principal
  and interest payments
• Or
• Earnings on the fund for the immediately
  preceding bond year

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Escrow Reinvestment Example

• Bond Yield 5.35
• Escrow Yield 5.32
• Escrow 50,000,000T-Note due 6/1/2006, 6
  coupon, purchased 6/1/2005 _at_ 100
  scheduled 0 reinvestment of 51,500,000
  6/1/2006-7/1/2006

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Escrow Reinvestments Timely
7/1/2006 5.35 Future Value (53,067,581)
1,550,550 51,848,607 (51,848,607) 51,500,000
____________ (17,031) Negative Arbitrage
Date Description Transaction
6/1/2005 Purchase T-Note
(50,000,000) 12/1/2005 Interest Receipt
1,500,000 6/1/2006 T-Note Mat Int
51,500,000 6/1/2006 Purchase 0 SLG
(51,500,000) 7/1/2006 0 SLG Maturity
51,500,000
22
Escrow Reinvestments Late
7/1/2006 5.35 Future Value (53,067,581)
1,550,550 51,848,607 (51,757,440) 51,500,000
____________ 74,136 Positive Arbitrage
Date Description Transaction
6/1/2005 Purchase T-Note
(50,000,000) 12/1/2005 Interest Receipt
1,500,000 6/1/2006 T-Note Mat Int
51,500,000 6/13/2006 Purchase 0 SLG
(51,500,000) 7/1/2006 0 SLG Maturity
51,500,000
12 Day Delay in purchase results in
91,342 arbitrage (74,13617,206)
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SLG Window Closure

• Closure of SLG window precludes investment in 0
  securities
• Do not leave funds in cash! (results in
  positive arbitrage)
• Purchase alternative investment (almost
  anything)
• Pay all interest earned to IRS within 180 days of
  receipt using 8038-T (Rev Proc 95-47)

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Yield Restriction

• Definition of Yield Restricted Investments
• Financial instrument required to be invested at a
  yield that is not materially higher than the
  yield on the issue.
• Temporary Periods
• Possible Yield Restriction Issues
• Bond Yield vs. Investment Yield
• Series 2000-2002 bond issues requiring IRS
  calculations face yield reduction payments

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Avoid These Pitfalls

• Commingled Funds
• Including Commingled Reserve and Debt Service
  Funds
• Transfers of funds to other accounts not pledged
  or related to the issue
• Deposits other than interest income
• Unreasonable interest income
• Withdrawals that are not expenditures without
  proper description