Tax-exempt financing: traps for the unwary executive. (Taxing Issues).

Has your organization ever utilized tax-exempt bonds to finance a facility? Are you contemplating cheaper tax-exempt borrowing alternatives to help cover various improvements? if the answer is (or has been) "yes," there are a number of tax rules you must comply with to preserve the bonds' tax-exempt status.

Perhaps the most critical requirement is that you pay any arbitrage income to the Internal Revenue Service (IRS), unless an exception applies. This requirement is contained in Code Section 148 and applies to almost all issuers of tax-exempt bonds. However, it is often overlooked, which can lead to serious consequences for you and the holders of the bonds.

Most bond documents that issuers (and conduit borrowers) execute contain an ongoing covenant that requires them to do everything in their power to preserve the debt's tax exemption. Here is an example of such a covenant:

"...pursuant to the Bond's authorizing resolution, the Company will establish a separate and distinct fund from all other funds for the purpose of calculating and remitting over to the Internal Revenue Service ("IRS") as detailed and required in Internal Revenue Code ("IRC" or "Code") Section 148(f), and related Treasury Regulations promulgated there under, any excess earnings resulting from the investment of gross proceeds prior to expenditure on the specified and allowable bond purpose."

If your organization has been the beneficiary of a prior tax-exempt bor- rowing or is weighing the benefits and costs of a future one, you must fully understand these tax requirements, which apply after closing. If you don't comply, you can jeopardize the ongoing tax-exempt status of the debt. This may also result in assessment of interest and penalties.

Problem areas

In an effort to encourage certain types of "blessed" construction projects, such as new school construction, water and sewer improvements, manufacturing facility expansions, etc., Code Section 103(a) provides an exclusion for interest earned on state and local bonds. Code Section 103(b), however, revokes the exclusion if the bonds are determined to be either private activity bonds (not the subject of this article) or arbitrage bonds.

Code Section 148 begins by explaining the meaning of "arbitrage bonds." Code Section 148(a) defines an arbitrage bond as "any bond issued as part of an issue a portion of the proceeds of which are reasonably expected ... to be used directly or indirectly to acquire higher yielding investments." However, even if you temporarily invest bond proceeds in higher yielding investments, you will not jeopardize tax exemption if you satisfy the rebate requirements discussed below.

In essence, arbitrage in the tax-exempt financing context occurs when you invest low cost, tax-exempt bond proceeds in higher yielding taxable securities, thus yielding a profit. Because municipalities (and other conduit borrowers) often receive bond proceeds that they don't need to spend immediately, they often invest the idle funds in higher yielding taxable securities, resulting in "arbitrage."

For example, if an educational organization borrowed at a 3.5 percent yield and prior to expending all the funds, earned an investment yield of 4 percent, the 0.5 percent difference is positive arbitrage. As detailed in Code Section 148(f), arbitrage rebate rules generally require that these excess earnings be paid back to the IRS. Not doing so, or doing so inaccurately, often results in lost tax-planning opportunities, inadequate budgeting, and violations of tax laws and bond covenants.

The "rebate" rules apply to issuers and conduit borrowers of all tax-exempt debt, including general obligation bonds, revenue bonds, tax and revenue anticipation notes, certificates of participation, industrial development bonds, single and multi-family mortgage revenue bonds, and student loan bonds. These rebate rules are generally applicable to tax-exempt bonds issued subsequent to August 31, 1986. After the bonds' closing date, issuers and conduit borrowers are required to monitor the investment and expenditure of tax-exempt bond proceeds.

Originally, Congress was concerned that sophisticated borrowers would issue more debt than otherwise was required for a particular governmental project and leave the debt outstanding longer than otherwise necessary. To deal with this perceived abuse, the first "yield restriction" rules were created. These rules defined when the investment of bond proceeds in "materially higher" yielding investments would result in them becoming arbitrage bonds. See Code Section 148(b) and Regulation 1.1482(d) for the full rule.

Today, an issuer that invests bond proceeds in materially higher yielding investments may cure this error via a "yield reduction payment." See Regulation 1.148-5(c), for details concerning how such yield reduction payment amounts are treated as payments that otherwise reduce an investment's yield. In other words, an issuer (or conduit borrower) will get a corresponding credit on the overall rebate amount that is otherwise due for yield reduction payments that have been made. (See Regulation 1.148-5(c)(1).)

Because it was believed that these earlier yield restriction rules were not a strong enough, deterrent, Congress promulgated the additional rebate rules and regulations found today in Code Section 148(f) and corresponding Treasury Regulations 1.148-0 through 1.148-11A. The rebate rules provide extremely detailed financial conventions that you must follow in calculating the borrowing rate or bond yield and any resulting excess investment returns. They supplement the existing yield restriction rules.

The two sets of rules work together in the following manner: "yield restriction" rules detail when and if an issuer may earn above the borrowing rate or yield; whereas the "rebate" rules specify when and if any earned arbitrage must be paid back to the IRS. Failure to adhere to either or both sets of rules, will in fact place the outstanding bond issue in risk of being deemed taxable, thereby risking retroactive taxation of what would have otherwise been tax-exempt bondholder interest income.

Ignoring rules creates additional risks

If your organization has issued tax-exempt bonds, you likely have your financial statements audited. if you are facing an obligation to repay arbitrage gains to the IRS, there is a liability that you need to reflect in those statements. Therefore, you should compute any rebate exposure that you have to avoid having a material undisclosed liability.

Your independent auditors should question you on this matter, and you want to be ready to respond. Otherwise, you can face a significant problem when you have to make the five-year filing with the IRS.

There are budgetary risks as well, which can arise from an unexpected liability to the IRS. Your organization must know what is coming down the road to manage its finances appropriately.

Certainly, if you are a chief financial officer or finance director, you will be prudent in having these calculations prepared on an annual basis. Failure to prepare annual calculations can also result in contractual violations of non-arbitrage certificates, loan agreements, and trust indentures.

For example, it's not uncommon for a trust indenture to require a segregated rebate account to be funded within 45 days of each bond year for future IRS payment. To determine the proper amount required for deposit, a supporting rebate calculation by a qualified expert is often required. At a minimum, failure to rebate positive arbitrage not otherwise covered by allowable exceptions at the five-year or final calculation date will result in non-contractual compliance and breach of IRS. tax law.

The rules and regulations of Section 148 are quite Byzantine and are a challenge even for experienced practitioners. A simple review of the tax code and regulations should be enough of a deterrent to self-monitoring and rebate calculations. Even if you can technically determine the excess investment yield, knowing when and if positive arbitrage that is technically calculated must otherwise be remitted to the IRS comes with experience.

There are numerous special rules and exceptions that apply. For example, certain "small" issuers may otherwise be exempt from rebate altogether. See Code Section 148(C)(4)(D) for details. If your bonds contain a variable borrowing rate, there are a number of special provisions that can increase or decrease the amount of the rebate due. Navigating these rules is a challenge.

Other tax planning alternatives do, in fact, exist directly in the tax code and regulations. For example, you can technically keep any positive rebate otherwise earned provided you spend your bond proceeds quickly enough. Special rules apply if you spend the proceeds in six, 18 or 24 months in certain cases.

Determining if you have satisfied one of these exceptions is complicated in and of itself. However, planning opportunities exist to minimize total rebate otherwise due. For example, utilization of these spending exceptions is not mandatory. Also, forecasting your progress toward satisfaction of a particular spending exception prevents future unexpected surprises.

Further, the existence of commingled funds, which presents a headache in attempting to reconcile when and how much bond proceeds were in fact allocated to proper expenditures, presents a potential tax saving opportunity in the choice of alternatives to separate the funds.

Ignoring the IRS and legal requirements imposed upon issuers (and conduit borrowers) for the., privilege of issuing tax-exempt debt is not something you should do lightly. Not only will you be responsible for the understated rebate liability, but interest at the underpayment rate will also be due, along with potential penalties for "willful neglect."

Given the current federal regulatory environment, coupled with the recent national presence of the IRS's national Tax Exempt Government Entities (TEGE) group, which audits municipal tax-exempt debt, issuers and conduit borrowers are being practical in having timely rebate calculations prepared. At a minimum, these calculations can be filed along with their other bond documents to substantiate issuer and conduit borrower rebate obligations.

Although the potential for an IRS random audit may be minimal; it's better to be safe than sorry. The simple creation of the IRS's national TEGE group sends a strong message that the IRS is and will continue to closely monitor tax-exempt arbitrage rebate compliance. Furthermore, agreements regarding overall rebate covenants, do create a real future risk of a bondholder lawsuit for non-complying issuers and conduit borrowers.

All of these requirements should not cause you to avoid the substantial financial advantages of tax-exempt financing. However, you must obtain the appropriate advice to ensure that you comply with all of the post-closing requirements of Code Section 148. Failure to do so can cause substantial headaches, which you can avoid by prudent action.

Harvey Berger is a partner and national director of not-for-profit tax services in Vienna, Va., for the accounting and management consulting firm Grant Thornton LLP. His email address is [e-mail]. Gregg Ichel is a manager in the Public Finance practice of Grant Thornton, based in Philadelphia. His email is [e-mail].