Hopefully, in the course of debt management, treasurers will find themselves earning yield on their loan proceeds. And that’s great, but if the loan is tax-exempt, you may owe the IRS a rebate on investment income.
DebtBook recently hosted a panel discussion for the North Carolina Local Government Budget Association (NCLGBA) featuring several experts in the area of debt management, including Kim Hoyt, president of Bingham Arbitrage Rebate Services. In her segment, she offered a helpful introduction to arbitrage rebate and yield restriction payments. You can watch the video for a more complete breakdown, or continue reading for a brief synopsis.
To complete projects, local governments can borrow funds at tax-exempt rates, though this flexibility does come with certain expectations and compliance requirements.
First and foremost, the IRS expects borrowers to spend loan proceeds in a timely manner, but sometimes, life gets in the way. Project delays happen. Sometimes a local government can find itself holding funds for a considerable amount of time and earning more yield than they expected.
Earning more money on a tax-exempt loan than is allowed under IRS rules is a form of arbitrage. If, as a treasurer, you have outstanding proceeds three years after the issuance date, you are required to cap yields on your investments and pay an “arbitrage rebate” to the federal government. This circumstance can arise when borrowing rates (generally longer term rates) are low and reinvestment rates (generally shorter term) are higher. This recently happened when the effective federal funds rate had increased up to more than 2% prior to COVID-19.
Arbitrage rebates should be calculated in installment periods no longer than every five years over the life of the loan. If your investment yield is greater than your bond yield over that five-year window, you would pay the difference to the IRS.
In addition to arbitrage rebates, yield restriction calculations should be performed once you have completed the three-year temporary period on your loan. You are allowed to earn investment yield equivalent to your bond yield plus 0.125%. Any amount in excess of that limit should be paid to the IRS as a yield reduction payment.
Navigating these requirements is part of why it’s essential to practice smart debt management. For instance, depending on market returns from year to year, it is possible that you can owe a yield reduction payment for one year and not owe an arbitrage rebate over the five-year window. There are small issuers and spending exceptions, and it’s important to review these requirements to verify if you qualify.
In rare instances, the federal government may deem that the tax exempt debt you’ve issued should be deemed taxable due to improper management. While this is unlikely, it is certainly something you should avoid.
To prepare for arbitrage rebate compliance, be sure to practice consistent record keeping and document your processes. The IRS requires governments to retain records on tax-exempt issues long after the bonds have been entirely paid off. Hang on to your bond transcripts, investment statements and any rebate reports or calculations, and be sure to consult requirements before disposing any documents.