What is Arbitrage Rebate Compliance?

Why is Arbitrage Rebate Compliance Important?

When a borrower issues a taxable bond issue, they can reinvest the proceeds in any security allowed under the organization's investment policies, earning as high a return as possible. 

However, because tax-exempt securities naturally represent lost revenue to the IRS, tax-exempt borrowers must meet certain federal guidelines, as designed by the IRS, in order for the issue in question to remain tax-exempt. One of those guidelines is to restrict the yield that can be earned on  proceeds from a tax-exempt issuance to the borrowing cost of the financing, or if excess return is earned, it must be remitted to the IRS.

For example, a tax-exempt borrower cannot issue a bond with a 3.00% arbitrage yield, and then invest the bond proceeds in a 5.00% yielding treasury security. If there are excess earnings above the issue’s borrowing cost, the earnings are considered arbitrage and the excess earnings must be returned to the federal government. The arbitrage rebate calculation is the calculation that determines if the borrower has earned too much return and must rebate the excess to the government.

Example:

A borrower issues tax-exempt bonds with an arbitrage yield of 3.00%. In theory, it may be able to invest the proceeds in an investment that is returning 5.00%. However, yield-restriction rules cap the allowable interest rate to 3.00% or below. In this case, the borrower would send any profits above the 3.00% limit to the federal government in a rebate payment, or risk having their bonds losing tax-exempt status.

A lease can be for any term, but a lease must have a term over a definite period of time with a particular starting and ending date.

What’s important here?

Two sets of overlapping arbitrage restrictions govern arbitrage rebate compliance:

• Yield restriction rules impose limitations on how a security’s bond proceeds can be invested. To determine this limit, the issuer calculates investment returns on all bond proceeds covered by this rule to see if the reinvestment return is greater than the bond series arbitrage yield. This calculation defines the arbitrage dollar amount, which if positive means the issuer over-earned on their investments.
• Arbitrage rebate rules require issuers to pay any earnings above the permitted arbitrage yield return – the arbitrage dollar amount is greater than zero – to the U.S. Treasury. These payments are called arbitrage rebates.

If an issuer intentionally invests the bond proceeds for a profit and fails to remit arbitrage rebate payments, the IRS may label their bonds as arbitrage bonds, per IRC Section 148(a) and they become taxable bonds to the holders of the bonds, which would cause a slew of both legal and reputation repercussions for the issuer.