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

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 less than $100,000; --bonds whose gross proceeds are expended for a governmental purpose within six months of the issue date; --bonds, the proceeds of which are invested in other tax-exempt bonds or state and local government series (SLGS) bonds; --certain construction bonds. Q2. Does the two-year construction bond exception for governmental and Sec. 501(c)(3) bonds (Sec. 148(f)(4)(C)) apply to bonds issued in 1988? A2. No. This exception only applies to bonds issued after Dec. 19, 1989. This exception from the arbitrage rebate requirements was expanded from six months by the Revenue Reconciliation Act of 1989 for governmental and Sec. 501(c)(3) bonds sold to finance construction projects. Issuers are exempt from the rebate requirement if they spend 10% of the proceeds of an issue within six months of issuance, 45% by the end of the first year, 75% within 18 months, 95% within two years and 100% within three years. Q3. What happens if the construction bond exception is applicable and the spending schedule is not met? A3. The issuer must elect at the time of issue to be subjected to either of the following. * Comply with present law arbitrage rebate requirements, or * Pay a penalty equal to 1.5% of the difference between the unexpended proceeds and the required expenditure amount.

If all proceeds are not spent on the project within the required periods, issuers will be required to continue paying a penalty every six months or rebating arbitrage profits on those proceeds until the bonds are retired. An option is available to terminate this penalty in certain cases by paying a special 3% penalty. Q4. Are there investments available to avoid arbitrage and the rebate requirements? A4. Yes. Proceeds can be invested in certain instruments to avoid classification as arbitrage bonds: * SLGS: State and local government series bonds issued by the Treasury Department to enable issuers to yield restrict their investments and avoid earning arbitrage profits. * Tax-exempt bonds. * Qualified regulated investment company (RIC) stock: A qualified RIC is a corporation that has only one class of stock and, to the extent practicable, invests all its assets in tax-exempt bonds. In addition, at least 98% of its gross income is derived from interest on or gains from the sale or other disposition of tax-exempt bonds, or at least 98% of the weighted average value of its assets is represented by investments in tax-exempt bonds. Q5. Are there any problems associated with avoiding the complexity of the arbitrage rebate calculations by investing bond proceeds in guaranteed investment contracts (GICs)? A5. GICs do present problems. Typically, the GIC pays the same rate as the bond yield. Consequently, the issuer does not have to track earnings and perform rebate calculations. The provider of the GIC is able to purchase higher yielding investments and keep the profit. However, the temporary regulations provide that the rebate requirement is not met if a prohibited payment is made. A prohibited payment is defined as the payment, or agreement to pay, an amount required to be paid to the United States for entering into a transaction that reduces the rebate amount, since the transaction results in a smaller profit or a larger loss than would have resulted if the transaction had been at arm's length and the yield on the issue had not been relevant to either party. Q6. What are the procedures for making rebate payments? A6. Issuers of tax-exempt bonds are required to rebate 90% of permissible arbitrage earnings to the Federal Government every five years. The amount of rebatable arbitrage is computed as of each installment computation date and as of the final computation date. Rebate installments are due 60 days after each installment computation date. The first computation date is the last day of the fifth bond year. Each following computation date occurs five years after the preceding installment computation date. The final computation date is the date the last bond is discharged.

Temp. Regs. Sec. 1.148 - 1T makes it clear that the 90% requirement operates so that, as of a rebate installment computation date, the issuer will have paid 90% of all rebatable arbitrage it has earned since the date of the bonds' issuance. Thus, on a rebate installment date, an issuer must pay to the Federal Government an amount that when added to all previous rebate payments equals 90% of the total rebatable arbitrage due on the issue computed from the date of issue. (This is different from the rule in the initial regulations that failed to take into account previous rebate installment payments.)

Rebate payments are made to the IRS's Philadelphia Service Center and Form 8038-T, Arbitrage Rebate, should be used. Q7. What are the consequences of missing a rebate payment? A7. Failure to properly rebate arbitrage profits can result in a loss of tax exemption for the bond issue retroactive to the date of issuance (Temp. Regs. Sec. 1.148-1T(c)).

An innocent failure to pay a required rebate of $50,000 or more may be corrected without penalty by paying the rebate amount plus interest within 60 days of the due date (or date discovered). The correction period is 180 days for amounts less than $50,000.

If the failure to meet a rebate payment is deliberate, a penalty of 50% of the rebate payment amount plus interest may be paid to retain the bond's exemption. The penalty for a private activity bond other than a Sec. 501(c)(3) bond is 100%; interest accrues on any late payments, underpayments and on the penalty amount. The penalty, however, may be waived by the Service.

According to IRS procedures, for a missed payment involving an amount of $50,000 or more to be considered innocent, the issuer must pay the correction amount within 60 days and attach a statement explaining the circumstances; the Service will use this statement to determine whether the failure was innocent. in addition, extensions of the 60-day or 180-day period can be requested.

The arbitrage rebate rules are complex and require the maintenance of detailed records to make sure that required rebate payments are made. Failure to track the necessary information could result in additional payments plus penalties and interest, and could ultimately result in retroactive loss of tax exemption f or the bond issuance.