Arbitrage compliance: a primer for finance officers.

• Author: Eichhoff, Gay

Finance officers should be aware of issues of arbitrage rebate compliance. Arbitrage compliance is one of those topics that can sift its way to the bottom of the in-basket, until those five-year anniversaries creep up and throw the agency into a panic. Procrastination is never healthy, and could actually be dangerous in terms of managing tax-exempt bond proceeds. Designing and maintaining a fitness program for tax-exempt debt will save the finance officer sleepless nights, his or her staff precious time and headaches, and possibly save the agency thousands of dollars.

Arbitrage Health History

Finance officers must ask how healthy and fit is their arbitrage compliance program? The "Arbitrage Health History" questionnaire in Exhibit 1 addresses this. If your agency can answer most of these questions, it is in reasonably good shape. If not, a fitness program for arbitrage compliance is definitely in order.

A healthy compliance program is your best defense should the Internal Revenue Service (IRS) make a house call. So what steps should be taken to maintain a healthy compliance program? A good fitness program includes basic training, knowing the warning signs, and, avoiding the diseases that threaten the health of arbitrage compliance. Once these steps are mastered, it is easy to design a fitness routine to maintain the health of the agency's tax-exempt debt.

Basic Training

Education is the best medicine. Finance officers should educate themselves and their staff with the basic knowledge of the arbitrage compliance regulations. They should learn the difference between the arbitrage yield restrictions and the arbitrage rebate requirements. Both must be complied with. It is important to understand the various exceptions to these requirements. Only then can one identify which of the tax-exempt debt issues are subject to rebate and when you need to be concerned about restricting the yield on your investments. The following discussion provides a basic understanding of these concepts.

What is Arbitrage? Arbitrage is the excess profit earned from the investment of tax-exempt bond proceeds in higher-yielding taxable securities. Simply put, arbitrage is the difference between what the proceeds actually earned and what the proceeds could have earned had they been invested at the same rate as the bond yield. If actual earnings exceed potential earnings calculated at the bond yield, the issue is in "positive arbitrage." If actual earnings are less than the bond yield, the issue is in "negative arbitrage."

What is Rebate? Unless an exception is met, rebate is a 100 percent tax on this excess profit. For issues subject to rebate, all net earnings above the bond yield must be remitted to the federal government. Ninety percent of rebate liability must be paid to the IRS within 60 days of each fifth bond year. Subsequent payments must be submitted every five years, and the full amount of the aggregate liability must be paid within 60 days after the final bond is retired.

Yield Restriction. Tax-exempt bond proceeds also are subject to arbitrage "yield restriction" requirements. These requirements were introduced in 1969 and define when investment in higher-yielding securities is allowed. An issuer must comply with both the arbitrage yield restrictions and the arbitrage rebate requirements. The rebate requirements are an addition to the yield restriction...