Arbitrage Overview

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Arbitrage occurs when tax-exempt bond proceeds are invested in higher yielding taxable securities, resulting in a profit. 

Abuses associated with tax-exempt financing 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. 

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). 

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. 

Exceptions to the rebate requirement may apply based on how quickly the issuer spends the bond proceeds, the size of the issuer and the category of proceeds being invested.  Some of these exceptions apply only to certain types of the bonds and some of these exceptions apply only to proceeds in certain funds.  For exceptions applying to specific type of funds, the issuer's allocation of proceeds to these funds is important to determine whether a particular exception's requirement is met.  

The general steps to calculate the rebate requirement 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. 

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.