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Arbitrage FAQ

Arbitrage is the ability to obtain tax-exempt bond proceeds and invest the funds in higher yielding taxable securities, which often results in a profit.

Abuses associated with tax-exempt financings led the Federal Government to promulgate regulations to place restrictions on the use of tax-exempt bond proceeds. The two primary purposes expressed by the regulations for establishing the arbitrage laws were to: 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 necessary to carry out the governmental purpose of the issue.

Congress enacts statutes, and the Internal Revenue Service (IRS) within the Treasury Department promulgates rules and regulations relating to tax-exempt bonds and arbitrage. These laws include: the Internal Revenue Code of 1986 as amended (the "Code"), Treasury Regulations, Revenue Procedures and Private Letter Rulings. Section 148(f)(2) of the Code was implemented to minimize the benefit of investing tax-exempt bond proceeds at a profit.

Generally, tax-exempt bond issues that were issued on or after September 1, 1986 are subject to the arbitrage rebate requirements. The arbitrage rebate requirements require that any profit or "arbitrage" be "rebated" to the Federal Government. The rebate amount due to the Federal Government is equal to the excess of the amount earned on all non-purpose investments purchased with gross proceeds of the bonds over the amount, which would have been earned if such non-purpose investments were invested at a rate equal to the yield on the bonds.

The code and IRS Regulations require that tax-exempt bond proceeds must be used for project construction within a specified time, generally, not more than 36 months (the ”temporary period”). Thus, OCIA must take steps to assure bond proceeds are promptly used for the purposes described in the bond documents.

The general steps to calculate the rebate liability are: 1) calculate the yield on the bonds; 2) calculate the actual earnings on all non-purpose investment instruments purchased with gross proceeds of the bonds; 3) calculate the allowable earnings on the non-purpose investment activity assuming the investments were earning at a rate equal to the bond yield; and, 4) future value the difference from the actual payment or receipt date to the computation date at a rate equal to the yield on the bond issue.

A rebate computation and payment to the Federal Government, if applicable, is required to be made at least every five years or each "Rebate Installment Computation Date" and upon final redemption or maturity of the bonds, "Final Rebate Computation Date". The payment is due to the Federal Government within 60 days from either each Rebate Installment Computation Date or Final Rebate Computation Date.

Failure to comply with Federal Rebate Requirements could lead to substantial late filing penalties and interest and/or, potentially the loss of tax-exempt status for the bonds. The loss of tax-exempt status on a state bond issue could have very serious consequences, as it would likely decrease the state’s credit rating applicable to all bond issues. 

In addition to the many intricacies of the Code and Regulations, there are various exceptions to rebate for which an Issuer may qualify. Also, there are various elections that can be made by the Issuer that will have an impact on the rebate calculation and the timing of any payments due to the Federal Government.

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