General Information on the Federal Arbitrage Rebate Requirements
Arbitrage occurs when tax-exempt bond proceeds are invested in higher yielding taxable securities, resulting in a profit.
Basic Purposes of the Arbitrage Regulations
Abuses associated with tax-exempt financings have led the Federal Government to issue regulations to restrict the use of tax-exempt bond proceeds. The two primary purposes expressed by the regulations for establishing the arbitrage laws are: 1) to minimize the benefits of investing tax-exempt bond proceeds, and 2) to 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.
What are the Arbitrage Laws?
The arbitrage laws are issued by either Congress or the Treasury Department. The hierarchy of these laws are: the Internal Revenue Code of 1986 as amended (“Code”), Treasury Regulations, Revenue Procedures, and Private Letter Rulings. To minimize the benefit of investing tax-exempt bond proceeds, the arbitrage rebate requirements were imposed by Code Section 148(f)(2).
What are the Arbitrage Rebate Requirements?
Generally, tax-exempt bond issues issued on or after September 1, 1986 are subject to the arbitrage rebate requirements. Such requirements detail that any profit or “arbitrage” be “rebated” (or paid back) to the Federal Government (The Treasury Department).
The rebate amount due to the Federal Government is equal to the excess of the amount earned on all nonpurpose investments purchased with gross proceeds of the bonds over the amount that would have been earned if such nonpurpose investments were invested at a rate equal to the yield on the bonds.
How is the Rebate Amount Due Calculated?
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 activity 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.
When is the Rebate Liability due to the IRS?
A rebate computation and payment to the Federal Government, if applicable, is generally 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 rebate 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 the Rebate Requirements
Failure to comply with these Federal Income Tax Rebate Requirements could lead to substantial late filing penalties, underpayment interest, and potential retroactive loss of tax-exempt status for the bonds.
In addition to the many intricacies of the Code and underlying Regulations, there are various exceptions and elections that can be made, which will have an impact on both the rebate calculation and due dates for any applicable rebate payments.