After the Bonds Are Sold:
Arbitrage Rebate Considerations

By Dave Frederick, Partner

Any issuance of tax-exempt bonds is the end result of many weeks of fact gathering, planning, negotiating and procedures leading to the sale and closing of the bonds. However, the work is not over when the bonds are issued.

At closing, bond counsel will deliver an opinion that interest on the bonds is properly excluded from gross income of the bondholders. That opinion is based on reasonable expectations that the issuer will comply with tax law requirements throughout the term of the bonds. One of these requirements is arbitrage rebate considerations on those bonds.

Generally, arbitrage is the excess earnings resulting from the ability to obtain tax-exempt bond proceeds and invest those funds in higher yielding taxable securities resulting in profit. Under certain circumstances a rebate computation and payment of any excess arbitrage earnings (profit) to the Federal Government may be required.

Arbitrage compliance procedures after issuance of the bonds include:

• A meeting between the issuer, bond counsel and financial advisor to discuss arbitrage rebate and other tax compliance issues.
   
• Obtain and review relevant documents including the following (from the bond transcript): 

o        the Arbitrage Certificate

o        IRS Form 8038G

o        computation of the "yield" of the bonds used to track investment returns and determine arbitrage rebate payments

• Establish methods for proper accounting for construction proceeds and other funds subject to rebate to facilitate arbitrage rebate calculations, if required.
   
• Set up procedures to monitor compliance with "temporary period" expectations for expenditure of bond proceeds. Typically, if bond proceeds are not spent in three years (the temporary period), funds may need to be yield-restricted or the IRS will require yield reduction payments.
   
• Monitor compliance with six-month, 18-month or two-year spending exceptions to rebate. If you spend funds fast enough to meet these spend-down exceptions to rebate, you may be able to retain your investment earnings in excess of the "bond yield" and avoid rebate payments.
   
• And finally, arrange for timely computation of rebate liability. Rebate is ordinarily due five years after the issuance of the bonds and at five-year intervals thereafter. 

Arbitrage rebate and other tax compliance issues are important steps in the issuance of tax-exempt bonds. The professionals at Umbaugh, along with your bond counsel, will be glad to discuss these matters and assist you in this complicated process. Please contact us at footnotes@umbaugh.com if you would like assistance.