This section will provide you with a brief overview of what arbitrage is and of the arbitrage rebate requirements set forth in the IRS regulations. This is not meant to serve as legal advice. These IRS regulations are very complex and you should consult competent bond counsel concerning the arbitrage requirements.

What is Arbitrage?

Arbitrage, in the context of municipal bonds, is the difference between the rate at which the proceeds were borrowed and the rate at which the proceeds were invested. Most local governments can borrow funds at tax-exempt rates by issuing municipal bonds. They can invest the funds received from issuing bonds into taxable securities such as U.S. Treasury securities, which typically earn higher rates than comparable tax-exempt securities. With the rate advantage offered by taxable securities over tax-exempt securities, the local government issuing municipal bonds could, depending on market conditions, position itself to earn positive arbitrage, or earning a rate higher than the borrowing rate, on the bond proceeds.

• In general, any arbitrage earned on the investment of tax-exempt bond proceeds must be rebated or remitted to the IRS. Proceeds subject to this arbitrage rebate requirement include sale, investment, transferred and replacement proceeds.

Why is Arbitrage Important?

Because the Internal Revenue Service (IRS) says it is. That may sound flippant but the calculation, monitoring, and reporting of arbitrage is complex and, as with most issues regulated by the IRS, not to be taken lightly.

Penalties for Noncompliance

Complying with the legal and administrative requirements of the arbitrage regulations can be complicated and expensive. The penalties for noncompliance depend on the nature of the assessment. If the noncompliance is determined to be due to willful neglect, the penalty could be that an issuer’s bonds are retroactively declared taxable.

Plan Ahead – It Could Allow Your Local Government to Keep Arbitrage Earnings

The local government should be examining arbitrage compliance issues during the early structuring of the bond issue. This could permit the local government to take advantage of rebate exceptions that could allow for the retention of all or part of the arbitrage earnings. The local government should consult with its bond counsel and financial advisor on these issues.

Your Bond Issue May Qualify for Exceptions From Arbitrage Rebate

The exceptions from arbitrage rebate pertain to the size of the issue and period of time over which the proceeds are spent. These are brief summaries of the exceptions. Each exception contains many qualifications and technical nuances and you should consult with your bond counsel and financial advisor regarding these exceptions.

• Small Issuer Exception:
  This exception applies to municipalities with general taxing powers that, together with their subordinate or related entities, issue $5 million or less of tax-exempt debt during a calendar year (up to $15 million under certain circumstances for school districts).

• 6 Month Spend-down Exception:
  All gross proceeds (other than gross proceeds held in a bona fide debt service fund or a reserve fund) and earnings thereon are spent within six months.

• 18 Month Spend-down Exception:
  All gross proceeds (other than gross proceeds held in a bond fide debt service fund or a reserve fund) and earnings thereon spent as follows:

6 months 15%
12 months 60%
18 months 100%

Each of these percentage expenditure requirements must be met for the issuer to qualify for the spend-down exception.

• 2 Year Spend-down Exception:
  This exception applies to issues when at least 75% of the "available construction proceeds" are to be used for "construction expenditures" and are spent as follows:

6 months 10%
12 months 45%
18 months 75%
24 months 100%

Each of these percentage expenditure requirements must be met for the issuer to qualify for the spend-down exception.

Available construction proceeds is generally calculated as the amount received from the underwriter from selling bonds to the public, less amounts (if any) deposited in a reasonably required reserve, plus amounts earned on the proceeds, and on the amounts in any reasonably required reserve not funded from the issue, plus earnings on all of the forgoing earnings.

In limited circumstances, the issuer is allowed a reasonable retainage of 5% after the 24 month period and may still qualify for the exception as long as the retainage is spent within three years of the issue date and the 6, 12, 18 and 24 month expenditure benchmark requirements are met.

• Exception for Investment in Tax Exempt Securities:
  All proceeds must be invested in certain qualifying tax-exempt investments.
• Debt Service Fund Exception
  Applies to issues that have average annual debt service not in excess of $2.5 million on long term governmental bonds issued after 11/10/88.

Investment Strategy for Issues Qualifying for an Exception

The local government should aim to maximize yield utilizing only investments that are allowable under the applicable local government investment statute and investment policy and that do not jeopardize safety or liquidity.

Issues That Are Subject to Rebate Require A Different Investment Strategy

Earning positive arbitrage is encouraged by the IRS. But remember safety first. The local government should be concerned with the rating of the investment issuer, fully understanding any guarantees on the investment, structure the investment to provide the necessary liquidity and, keeping out of pocket fees and expenses at a minimum because they are not deductible for purposes of calculating arbitrage rebate.

Out of pocket fees and expenses associated with the investment of bond proceeds include the investment management fees (other than those related to external commingled funds or a regulated investment company), security transaction fees and bank custody fees.

Legal Investments for Arbitrage Rebate Compliance?

Legal investments for bond proceeds generally include U.S. Treasury Bills, Notes, and Bonds, Short-term Federal Agencies, Repurchase Agreements (Repos), Certificates of Deposit (CDs), collateralized in accordance with Act 72, and Local Government Investment Pools. While all of the investments listed above are legal, some may not always be appropriate. For example, a 30 year U.S. Treasury is legal but if you need to sell it early you will be subject to possible loss of principal if interest rates have risen.

Rebate Payments Schedule

Unless your bond issue qualifies for an exception from rebate, you MUST remit to the IRS all arbitrage earnings generally at the end of every fifth bond year or the final maturity date of the bond issue, whichever is earlier.

Arbitrage Earnings Calculations

Please keep in mind that this calculation is complex and requires the expertise of individuals or firms who are familiar with the arbitrage rebate regulations. However, in general, arbitrage earnings are calculated by determining the difference between the issuer’s actual interest earnings on the proceeds and the interest earnings that would have been received if the issuer had invested the proceeds at the same yield of the bond issue.

The Pennsylvania Local Government Investment Trust (PLGIT) has developed an Arbitrage Primer for Local Government Officials to assist in educating municipal employees and board members about arbitrage regulations.

To request a free copy please call 1-800-572-1472.