Tax-exempt bonds - questions and answers on arbitrage rebate.

• Author: Gardner, John C.

The Tax Reform Act of 1986 added Sec. 148, relating to arbitrage bonds and the rebate of permissible arbitrage to the United States. The following questions and answers highlight some of the concerns that issuers and users of tax-exempt financing must keep in mind to avoid the pitfalls surrounding arbitrage earnings. Q1. If an issuer rebates all arbitrage profits to the Federal Government, will the bond issue retain its tax-exempt status? A1. Not necessarily. Two sets of rules must be considered.

First, it must be determined whether an "artifice or device" is employed in connection with the issuance of the obligation, thus making the bond an arbitrage bond. Income earned on an arbitrage bond is not exempt from tax. An artifice or device refers to a transaction or series of transactions enabling the issuer to exploit the difference between tax-exempt and taxable interest rates to gain a material financial advantage. Examples include selling more obligations than necessary, issuing obligations sooner and allowing them to be outstanding longer than would otherwise be necessary, and investing the proceeds in higher yielding investments.

A bond may also be classified as an arbitrage bond if the issuer intentionally uses any portion of the proceeds of the issue f or these purposes. The existence of such intentional use is determined on a case-by-case basis and could include both direct and indirect use.

The term "higher yielding investments" means any investment that produces a materially higher yield than the issue yield. Investments are deemed to have a materially higher yield for these purposes if their yield over the term of the bond exceeds the bond yield by 0.125%. The earning of unlimited arbitrage is permissible, however, during the temporary period (usually the first three years of construction), on a 10% bona fide debt reserve fund and on a minor portion (i.e., the lesser of 100,000,or 5%) of bond proceeds.

Second, it must be determined if permissible arbitrage was earned and whether it must be rebated to the Federal Government. In general, all permissible arbitrage profits must be rebated to the Federal Government. Failure to do so will cause the bond to be treated as an arbitrage bond, the interest on which will not be excludible from income. The rebate rules do not apply to --governmental and Sec. 501(c)(3) bonds issued by "small issuers" with general taxing powers; --bona fide debt service funds if earnings for the bond year are...