Arbitrage, Yield Restriction and the Rebate Owed
Borrowing at a tax-favored rate and investing the money at a higher one is the arrangement the arbitrage rules exist to prevent. Two mechanisms do the work: a restriction on the yield at which proceeds may be invested, and a requirement to pay excess earnings to the government.
The rule in short
Interest on an obligation is not excluded from gross income if the obligation is an arbitrage bond. Proceeds may be invested above the bond yield only within temporary periods, a reserve allowance and a minor portion. Earnings that exceed what the bond yield would have produced must be rebated, with interim payments of at least ninety percent at computation dates no more than five years apart and a final payment of one hundred percent.
The arbitrage rules answer a structural problem. A government that borrows at a tax-favored rate can, in principle, invest the borrowed money at a market rate and keep the spread, which converts a subsidy meant for public capital into a trading profit. Federal law removes the incentive by denying the exclusion to arbitrage bonds and then, for issues that stay within the yield limits, by requiring that any excess earned be paid over to the government.
The definition that starts the analysis
An obligation is an arbitrage bond if a portion of the proceeds is reasonably expected, at issuance, to be used directly or indirectly to acquire higher yielding investments, or to replace funds so used. The test is expectational rather than retrospective, which is why the tax certificate signed at closing records the issuer's expectations about the timing of spending and the investment of proceeds. Actual conduct still matters, because deliberate action inconsistent with the stated expectations is treated as evidence about what was really expected.
Two computations sit underneath every question in this area. The bond yield is the discount rate that equates the present value of payments of principal and interest with the issue price, computed under prescribed conventions. The investment yield is computed on the same basis over the same period. Yield restriction compares one to the other and asks whether investments exceed the bond yield; rebate asks how much more they produced than investment at the bond yield would have.
Temporary periods and permitted allowances
Unrestricted investment is permitted while proceeds are genuinely waiting to be spent. A bond is not an arbitrage bond merely because proceeds may be invested above the bond yield for a reasonable temporary period until they are needed for the purpose of the issue. The regulations set the periods by category, with a three-year period commonly available for capital projects where the issuer reasonably expects to meet expenditure, binding obligation and due diligence conditions, and shorter periods for working capital and for pooled financings.
Beyond temporary periods, two allowances apply. A reasonably required reserve or replacement fund may be invested without restriction within statutory limits. A minor portion of proceeds may also be invested above the bond yield, capped at the lesser of a stated dollar figure or a small percentage of the issue. These allowances are cumulative with the temporary periods, and they exist to avoid forcing issuers to manage genuinely small balances at a loss of administrative sanity.
Meeting one does not discharge the other. An issue can be fully yield restricted and still owe nothing in rebate, and an issue can invest entirely within a temporary period, breaching no restriction, and still owe a substantial rebate on the earnings that period produced. Compliance programs that treat the two as a single item routinely miss the second, because the first is the one that appears in the closing documents.
How the rebate amount is built
The rebate amount is the excess of the future value of all receipts on nonpurpose investments over the future value of all payments for them, both computed at the bond yield as of the computation date. Expressed plainly, the calculation asks what the issuer actually earned and subtracts what it would have earned had every dollar been invested at exactly the bond yield. The difference belongs to the government. Because the amounts are future valued, timing matters as much as rate: money earned early compounds inside the computation.
Only nonpurpose investments enter the computation. Amounts spent on the governmental purpose of the issue leave the calculation when they are spent, and investments acquired to carry out that purpose, such as a loan made with the proceeds of a conduit financing, are purpose investments governed by their own rules. Identifying which category an asset falls into is therefore the first step, and it depends on the allocation of proceeds to expenditures rather than on the label attached to any account.
Computation dates structure the exercise. For a fixed yield issue the issuer may treat any date as a computation date. For a variable yield issue the choices are constrained, and after the first required payment date the issuer must consistently use either the end of each bond year or the end of each fifth bond year. The date an issue is discharged is the final computation date, subject to a limited accommodation for issues retired within three years.
| Mechanism | What it limits | Consequence of falling outside it |
|---|---|---|
| Temporary period | How long proceeds may be invested above the bond yield | Yield restriction applies from the period's end |
| Reserve fund allowance | Size of a reserve that may be invested without restriction | Excess is subject to yield restriction |
| Minor portion | A small balance investable above the bond yield | Amounts above the cap are restricted |
| Spending exception | Whether rebate is owed at all | Ordinary rebate computation resumes |
| Small issuer exception | Whether a taxing unit computes rebate | Rebate is computed and paid in the normal way |
Paying, and the penalty for getting it wrong
The first installment must be made for a computation date no later than five years after the issue date, and later installments for dates no more than five years apart. Each interim payment must equal at least ninety percent of the rebate amount as of that date when added to the future value of earlier payments. The final payment must bring the total to one hundred percent. Every payment is due no later than sixty days after the computation date it relates to, and a payment made inside that window is treated as made on the date itself.
Failure to pay the correct amount when required makes the bonds arbitrage bonds unless the failure was not caused by willful neglect and a penalty is promptly paid. The penalty is fifty percent of the unpaid amount plus interest for issues containing no private activity bonds other than qualified charitable bonds, and one hundred percent plus interest otherwise, with an automatic waiver where the amount and interest are paid within one hundred eighty days after discovery and the issue is not under examination.
Where the obligation sits after closing
Nothing about rebate is administered by the parties who assembled the financing. Bond counsel's conclusion at closing rests on the issuer's expectations and on covenants to comply thereafter, as described in what bond counsel actually opines on. After closing the record belongs to the issuer: the investment statements, the draw schedules, the allocation of proceeds to expenditures, and the computations performed at each date.
Overpayment is recoverable, within limits. An issuer may recover an excess paid for an issue by establishing to the satisfaction of the tax authority that an overpayment occurred, but only to the extent that recovery on the date first requested would not itself produce an additional rebate amount. Amounts below a stated threshold may not be recovered before the final computation date, and a claim must be made within two years after that date. The practical lesson is that the records supporting a computation have to survive the bonds.
Two adjacent obligations use the same records. A remedial action taken after a change in the use of financed property depends on tracing proceeds to costs, which is the analysis described in the limits on private business use. An escrow funded in a refunding is itself an investment of proceeds subject to these rules, which is why the computations described in refunding an outstanding issue are verified by an independent accountant before closing.
Points to carry away
- An obligation is an arbitrage bond if proceeds are reasonably expected to be used to acquire higher yielding investments beyond permitted limits.
- Temporary periods allow unrestricted investment while proceeds are genuinely needed for the financed purpose.
- The rebate amount is the excess of actual earnings over what investment at the bond yield would have produced.
- Interim rebate payments must equal at least ninety percent of the amount as of each computation date.
- Each payment is due no later than sixty days after the computation date it relates to.
Questions readers ask
What is the small issuer exception to rebate?
A governmental unit with general taxing powers is relieved of the rebate requirement for an issue if it reasonably expects that the aggregate face amount of all tax-exempt bonds other than private activity bonds it issues during the calendar year will not exceed five million dollars. Certain refunding bonds are left out of that computation, and an issue by a subordinate entity qualifies within limits measured against the parent unit. The exception removes the rebate computation but not the yield restriction rules.
What are the spending exceptions?
The regulations relieve an issue of rebate where gross proceeds are spent within prescribed periods at prescribed rates. The familiar forms are a six-month exception, an eighteen-month exception with interim benchmarks, and a twenty-four month exception for construction issues with benchmarks at six-month intervals. Meeting an exception depends on actual expenditure against those benchmarks rather than on intent, so the analysis is performed after each period closes and documented with the draw records that support it.
What happens if a rebate payment is missed?
A failure to pay the correct amount when required causes the bonds to be arbitrage bonds unless the failure was not the result of willful neglect and the issuer promptly pays a penalty. The penalty equals fifty percent of the unpaid amount plus interest where no bond of the issue is a private activity bond other than a qualified charitable bond, and one hundred percent otherwise. The penalty is automatically waived if the amount plus interest is paid within one hundred eighty days after discovery, subject to stated conditions.
Sources
- 26 U.S. Code § 148 — ArbitrageSets the arbitrage bond definition, temporary periods, minor portion and the rebate requirement.
- 26 CFR § 1.148-2 — General arbitrage yield restriction rulesStates the reasonable expectations standard and the temporary period rules.
- 26 CFR § 1.148-3 — General arbitrage rebate rulesSets computation dates, the ninety and one hundred percent payment amounts and the sixty day term.
- 26 CFR § 1.148-7 — Spending exceptions to the rebate requirementContains the six, eighteen and twenty-four month spending exceptions and their benchmarks.
- 26 CFR § 1.148-4 — Yield on an issue of bondsDefines how the bond yield against which earnings are measured is computed.
- 26 CFR § 1.148-5 — Yield and valuation of investmentsGoverns valuation of nonpurpose investments in the rebate computation.
- IRS — About Form 8038-TThe return that accompanies a rebate, yield reduction or penalty payment.
Pinnacle Law Review is a publication, not a law firm. This article states general rules and cites its sources; it is not advice about any particular case, and the law differs by state and changes over time.
More in Public Finance
Material Event Notices and the Ten Business Days
A continuing disclosure undertaking obliges the obligated person to give notice of listed events to the municipal repository in a timely manner not in excess of ten business days after the occurrence. Some entries are absolute, such as payment delinquencies, defeasances and rating changes. Others apply only if the event is material, which requires a judgment recorded before the period expires rather than after it.
General Obligation and Revenue Bonds Compared
A general obligation bond is secured by a pledge of the issuer's taxing power, sometimes unlimited and sometimes capped by the same law that authorized the borrowing. A revenue bond is secured only by receipts of an identified enterprise, applied through a flow of funds set out in the indenture. The pledge determines the covenants, the remedies on a shortfall, and the financial information the issuer must keep publishing.
The Official Statement and Who Is Responsible for It
An official statement is the issuer's own disclosure document. The federal rule requires an underwriter to obtain and review a version the issuer deems final before bidding, permitting only a short list of omissions, and to obtain copies of the final document within seven business days of the purchase agreement. Liability runs under the general antifraud provisions rather than under a registration statute, because municipal securities are exempt from registration.