Episode 1: Rebate & Arbitrage 101 – Putting the Fun in Fundamentals

Because the fundamentals are the building blocks of fun, this post introduces the rebate requirement under Section 148 of the Internal Revenue Code and the key terms necessary for the episodes to come.

To understand rebate, you must understand arbitrage. And to understand arbitrage, well, you kind of just need to understand arbitrage. As discussed more thoroughly in a recent blog post, arbitrage occurs when securities purchased from one market are used for immediate resale in another to profit from the interest rate discrepancy. This is not a concept specific to tax-exempt or tax-advantaged bond financings, but the monitoring of arbitrage by the federal government occupies considerable space in our little corner of the public finance cosmos.

Let’s break down the rebate requirement into one confusing, soupy sentence:

For an issuer of tax-exempt bonds, certain earnings resulting in positive arbitrage^[1] from the investment of Gross Proceeds into Nonpurpose Investments must be rebated^[2] to the U.S. Treasury if the earnings on those investments exceed the yield on the tax-exempt bonds (so-called Higher Yielding Investments).

This Rebate Amount is based on the difference between the amount actually earned on that investment and the amount that would have been earned if the investment had a yield equal to the yield on the issue. There are exceptions to this rebate requirement, which are the subject of our later episodes in this series.

Let’s unpack some of the key terms mentioned above:

Gross Proceeds in the tax-exempt bond space include (i) sale proceeds (amount paid for the bonds by the purchaser), (ii) investment proceeds (amounts received from the investment of proceeds), (iii) transferred proceeds (remaining proceeds of a prior issue when a refunding occurs), and (iv) replacement proceeds (amounts related enough to the issue or governmental purpose of the issue such that they could have been used for that purpose if the proceeds were not already).

A Nonpurpose Investment is any investment property that is acquired with the Gross Proceeds of an issue that is not acquired in order to carry out the governmental purpose of the issue. Investment property includes securities, obligations, annuity contracts and investment type property. Interestingly, investment property excludes tax-exempt bonds, so issuers may avoid rebate requirements by investing proceeds in those.

Higher Yielding Investments are investment property acquired with bond proceeds that produces a yield that exceeds the yield on the issue.

Now equipped with these handy definitions, let’s decipher our soupy sentence from above:

For an issuer of tax-exempt bonds, certain earnings resulting in positive arbitrage from the investment of [sale, investment, transferred and replacement proceeds, as applicable] into [investment property not used for the governmental purpose of the bonds] must be rebated to the U.S. Treasury if the earnings on [the investment of the bond proceeds produce an impermissibly higher yield on the issue].

The issue date of the bonds starts the clock for measuring arbitrage, using the bond yield as the arbitrage limit. Per the general rebate rules, every five years a calculation of the Rebate Amount must be made. Does the federal government really expect issuers to look into a crystal ball to determine potential arbitrage issues for bonds that mature in ten, twenty or thirty years? Well, sort of. An issuer must use its “reasonable expectations” at the time the bonds are issued in making arbitrage determinations. If there is a Rebate Amount, then such amount must be rebated to the federal government within sixty days of the computation date for that period. If the applicable amount is not rebated, the bonds will become “arbitrage bonds,” the interest on which is subject to federal income tax. 

FOOTNOTES

^[1] Negative arbitrage presents its own concerns, which are discussed in a previous blog. And yes, while that seminal piece of Public Finance blog canon is informative and helpful and you should absolutely read it, the best parts are the tags at the bottom. On the off chance you happen to Google “Portlandia public finance tax” (as any curious well-adjusted person might do), guess what comes up.  

^[2] If you’re curious why the concept is called “rebate” when profits earned from arbitrage were never the federal government’s in the first place, check out one of our other blog posts. It does not have any fun tags. Sorry.