Governmental and nonprofit entities have the benefit of being able to issue debt at tax-exempt rates, but that benefit only goes so far. If an issuer earns a higher yield than its borrowing cost, it could owe money to the IRS.
Arbitrage refers to the excess interest income that issuers may earn through investing tax-exempt bond proceeds in higher yielding taxable securities. It’s a complex process with substantial regulations, so we turned to an expert to help guide us through its intricacies.
Ray Bentley is president and owner of American Municipal Tax-Exempt Compliance Corp. (AMTEC), an independent firm that specializes in arbitrage and refunding verification agent services. AMTEC has helped state and local governments, school districts, colleges and universities, and 501c(3) entities calculate and prepare arbitrage calculations for over 30 years. Below, Bentley shares insights for tax-exempt issuers on the best ways to navigate arbitrage compliance.
If you’re an issuer of tax-exempt debt, the general rule of thumb is that investment earnings on your bond proceeds can’t exceed the interest you’re paying on your debt. For years, entities did exactly that - they borrowed at lower rates subsidized by the federal government and then invested the proceeds in higher-yielding investments to earn a profit. In response, the federal government introduced arbitrage rules in 1986 to address this controversial practice.
“In the early 1980s, issuers were taking advantage of the interest rate difference in the tax-exempt and taxable markets,” Bentley said. “Issuers would borrow in the tax-exempt market at, say, 5%, invest the proceeds in the taxable market at 8%, earn the 3% difference, pay back the debt, and keep the interest earnings. They were taking advantage of the system, although at the time this was not illegal.”
Section 148 of the Internal Revenue Code of 1986 curbed this practice of earning money on debt. Since then, entities are required to calculate arbitrage no later than on a five-year cycle. The concept is relatively simple but requires an in-depth look at financial records pertaining to the bond issuance. To prepare the calculation, an entity must analyze its bond proceeds cash flows, determine the overall rate of return, and compare it against the allowable arbitrage yield (or borrowing cost) of the bonds.
“If the rate of return is below the arbitrage yield, or threshold at which an issuer may earn income, negative arbitrage is generated,” Bentley said. “There’s nothing to be done, other than file the arbitrage analysis away in case of an IRS audit. However, if the issuer invests the proceeds above its borrowing cost, positive arbitrage is generated, which must be paid to the IRS in the form of a rebate.”
Even in a low yield environment when issuers are unlikely to earn any positive arbitrage on their investments, entities must continue to meet the ongoing calculation and verification obligations imposed by the IRS, according to Bentley.
“This calculation is required under the bond documents the issuers sign at closing,” Bentley said. “They agree to adhere to the arbitrage regulations. It’s something issuers have to comply with, regardless of the prevailing interest rate market.”
When an entity issues tax-exempt debt, the purpose is not to earn a profit – the federal government subsidizes the interest rate on tax-exempt debt to encourage investment in projects that confer some public benefit for the community. Entities value stability over returns and are restricted to less risky investment vehicles such as money market funds and government-backed securities, like U.S. Treasury Notes or Bills.
But state and local projects are frequently undertakings with massive amounts of investments, resulting in substantial arbitrage potential. For instance, an entity that earns 1.00% on $100 million of tax-exempt proceeds with an arbitrage yield of 0.75% would generate up to $250,000 of arbitrage profit that would need to be paid to the federal government. Bentley said AMTEC has encountered some large rebate amounts in the past.
“We’ve seen millions of dollars paid to the IRS because of the size of the entities we’re working with,” Bentley said. “If you’re dealing with a substantial investment of proceeds, you can generate a significant liability. But more important than the investment amount, it’s a matter of yield versus yield. Is my investment yield higher or lower than my arbitrage yield?”
Entities that fail to comply with arbitrage requirements risk IRS penalties, including late interest with daily compounding, in addition to the original positive arbitrage liability. Blatant violations could result in the IRS revoking the debt’s tax-exempt status, which may require the issuer to make a large settlement payment to the IRS to make up for the federal government’s foregone tax revenues on the bondholder’s interest income.
“Arbitrage payments can be significant, and that can be a big deal for a school district, small town, or nonprofit entity,” Bentley said. “They may not have extra money laying around. It’s important to be proactive and know the arbitrage status of your bonds, at least annually, so you can plan accordingly.”
A surprise tax bill often has a negative connotation. In actuality, when an entity pays an arbitrage rebate to the IRS, it’s a positive outcome because the entity earned more income.
“The reality is you maximized your earnings,” Bentley said. “You earned above your arbitrage threshold, which means more money for your project. Whereas negative arbitrage represents additional dollars that could have been earned. You may have to pay back the quantitative difference between your investment yield and arbitrage yield, but you earned as much as legally possible. That’s a good thing, so long as you stay on top of your obligations and avoid any penalties.”
Because arbitrage calculations represent a small, but specialized, field of public finance, issuers often choose to work with a third-party consultant firm, such as AMTEC, that has the required expertise. These firms are well-versed in both the legal framework and the process of calculating and remitting potential rebate payments.
“Arbitrage is such a small niche of the Internal Revenue Code, and it’s very specific,” Bentley said. “There are limits to how much you can make on borrowed money. There are a lot of rules and intricacies that an issuer may not be familiar with.”
Bentley recommended that entities pay attention to their arbitrage obligations and be timely with their calculations. He said there are a handful of nationwide firms such as AMTEC that can help with arbitrage compliance.
“Issuers just need to get it done,” Bentley said. “Hire an arbitrage consultant during the bond issuance process, which should alleviate most of the responsibility going forward. It’s much better to be proactive than reactive.”
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