arbitrage compliance overview...arbitrage rebate - irc section 148(f): mandates when you must rebate...

Pinnacle Arbitrage Compliance LLC

Arbitrage Compliance Overview

Pinnacle Arbitrage Compliance LLC© copyright 2009

Definition

Arbitrage is the ability to obtain low-yielding tax-exempt bond proceeds and invest the funds in higher yielding taxable securities, resulting in a profit.

Arbitrage Rebate is the dollar profit earned from arbitrage which must be paid back (rebated) to the federal government.

The Rebate Amount is defined as the excess of the future value of receipts from nonpurpose investment over the future value of all payments on nonpurpose investments. The computation date may be selected by the issuer.


Arbitrage Rebate from 2002-2009

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Unrestricted Temporary Period Restricted Period


Goal of IRS Arbitrage Rules

Eliminate any arbitrage incentive to:

• Issue more bonds than needed,

• Issue bonds earlier than needed, and

• Leave bonds outstanding longer than needed

to accomplish the governmental purpose of the bond issue.


Calculation and Reporting Requirements


When are Calculations Due?

• Required Calculation Dates:– Installment Calculation Dates (ICD), or

– Final Calculation Date.


Installment Calculation Dates

• Installments must be paid at least every 5th bond year.

• Bond year is each one-year period ending on the date selected by the Issuer.

• If no date is selected by the Issuer, bond year ends on each anniversary date of the issue.

• Installment payable within 60 days.

• Installment of at least 90% of cumulative rebate is due.


Final Computation Date

• Date all bonds of an issue have been retired

– matured or

– redeemed early.

• Cash defeasance or refunding may accelerate final computation date.

• Final payment due within 60 days.

• 100% of remaining arbitrage rebate amount is due.


Payments to the IRS

• Make check payable to United States Treasury Department.

• Complete Form 8038-T.

• Mail Rebate Payments to IRS Center in Ogden, UT.

• Form 8038-T only filed when rebate amount is positive, under current law.


Exceptions to the Rebate Requirements


Exceptions to the Rebate Requirements

• Small Issuer Exception

• Investments in Non-AMT Tax-Exempt Obligations

• Debt Service Fund Exclusion

• Spending Exceptions:– 6-Month Exception– 18-Month Exception– 24-Month Exception


Small Issuer Exception

• Must be a governmental entity with general taxing powers (no private activity bonds).

• Issues a total of $5 million or less in tax-exempt debt during a calendar year.

• All tax-exempt debt issued during the calendar year are counted (bonds, notes, certificates, leases, etc.).

• Current refunding not counted if principal amount of refunding does not exceed the principal amount being refunded.

• Subordinate entity debt included.


Spending Exceptions


6-Month Spending Exception

• Gross proceeds (including earnings) spent for governmental purpose within six months.

• Minor portion (less than 5% of issue size) given additional six months.

• Reserve Fund/Debt Service Fund ignored for test. (Reserve subject to rebate from delivery)

• Be careful of Cost of Issuance funds remaining too long!



• Applies only to bonds issued after June 30, 1993.

• Gross proceeds exempt from rebate if all semi-annual spending requirements are met (including reasonably expected earnings).

• Must meet each of the following spending requirements:



PeriodCumulative

Expenditures

6 months

12 months

18 months

15 %

60 %

100 %

Exception fails if any semi-annual period is missed.


Final Spending Period Exceptions

• Proceeds deemed spent on the final spending date iffollowing occurs:

– Only Reasonable Retainage remains in an amount lessthan 5% net sales proceeds, or

– A “De Minimis Amount” equal to the lesser of 3% of issueprice or $250,000 remains.



• Applies only to construction bond issues delivered after December 19, 1989.

• Gross proceeds exempt from rebate if all semi-annual spending requirements are met (including reasonably expected earnings).

• Must meet each of the following spending requirements:



PeriodCumulative

Expenditures

6 months

12 months

18 months

24 months

10 %

45 %

75 %

100 %

Exception fails if any semi-annual period is missed.


Construction Expenditures

• At least 75% of the Available Construction Proceeds will be used to finance construction expenditures.

• Applies to private activity bonds issued to finance property to be owned by a governmental unit (e.g., airport terminal).

• Construction Expenditures:

– Applies to capital expenditures charged as part of the basis of real property.

– Excludes land and equipment costs.


Final Spending Period Exceptions

• Proceeds deemed spent on the final spending date iffollowing occurs:

– Only Reasonable Retainage remains in an amount lessthan 5% net sales proceeds, or

– A “De Minimis Amount” equal to the lesser of 3% of issueprice or $250,000 remains.


Yield Restriction Rules


Two Separate RulesYield Restriction – IRC Section 148(a): Governs when you may legally

earn arbitrage from investing bond proceeds.

Arbitrage Rebate - IRC Section 148(f): Mandates when you must rebatearbitrage earned to the federal government.

Prior to 1986, only yield restriction applied. After 1986, both rules apply to a bond issue.

Arbitrage Rebate

Requirement

Yield Restriction

Rules


General Yield Restriction Rule• In general, “gross proceeds” of an issue may never be

invested at a yield that is materially higher than the yield on the bonds.

• Materially higher defined as: Above Bond Yield

– General restriction 1/8th of 1%– Advance refunding escrows 1/1000th of 1%– Program investments (housing) 1.5% on loans– Student loans 2.0% on loans

• Certain exceptions to this rule are available during “temporary periods”


Temporary Periods

• Temporary periods are time periods in which investing proceeds at a materially higher yield will not cause the bonds to become “arbitrage” bonds.

• Yield restriction is determined over time, not by investment.

• When determining compliance with yield restriction, all yield restricted (same “class”) are blended together.– Lowest available materially higher yield is used for two types

of restricted money.– Sample: Construction fund (after 3 years) and escrow fund,

use 1/1000th of 1% limit.


Other Temporary Periods

• Pooled Financing (loan programs) 6 Months

• Debt Service Funds 13 Months

• Interest Earnings (from date of receipt) 1 Year

• Replacement Proceeds (e.g. defeasance escrow) 30 days


Other Temporary Periods

• Reserve or Replacement Funds. Life of the Issue - size limitation

Limited to the Lesser of:– 10% of par amount of bond issue,– Maximum annual principal and interest, or– 125% average annual principal and interest.

• Minor Portion equal to lesser of: Life of the Issue

– 5 percent of sale proceeds; or– $100,000


After the Temporary Period

• Yield restrict remaining proceeds; or

• Yield reduction payment may be permitted under 1993 Regulations

• Yield Reduction Payments:– 1993 regulations administrative solution to yield restriction.

– Yield Reduction Payments (YRPs) are payments made to the IRS on yield restricted funds.

– Paid at same time and manner as a rebate payment.


Rebate vs. Yield Restriction

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Investment Yield Bond Yield

Unrestricted Temporary Period Restricted Period


Remember!

Remember, the small issuer exception exempts an issue or issues from the arbitrage rebate requirements.

However, the issue must still meet the yield restriction requirements!


Allocation and Accounting Rules


Allocation of Gross Proceeds to an Issue

• An issuer may use any reasonable, consistently applied accounting method for bond proceeds.

• Consistently applied uniformly within a fiscal period and between fiscal periods.

• Bona fide deviations permitted (e.g., accounting for grants).


Allocation of Proceeds to Expenditures

• Reasonable, consistently applied accounting method used:– Specific tracing method;– gross proceeds spent first method;– first-in, first out method; and– ratable allocation method.

• 5-Day cash outlay requirement for expenditure posting.

• Commingled Interest Earnings:– Interest earnings are deemed spent when deposited with

substantial tax or revenues if expected to be expended within 6 months.


Allocation of Proceeds to Expenditures

• An issuer must account for the allocation of bond proceeds to expenditures not more than 18 months after the later of the date:

- the expenditure is paid, or

- the financed project is placed in service.

• Regardless, allocation must be made no later than 60 days after fifth anniversary of the issue.

• This limits period to make allocations for spending exceptions.


Record Retention


Record Retention

• Record retention burden centers around:– Very little published guidance on record retention– Length of the retention period that must be met to facilitate

tax compliance administration– Issuers are required to retain all records related to the

investment and expenditure of the gross proceeds of the bond issue for life of examination period

– Examination period can be decades

• Record retention rules:– Based mainly on IRC Section 6001– IRS Tax Exempt Bond (TEB) Q&A section provides some

unofficial guidance


Section 6001

• IRC Section 6001:

– “Every person liable for any tax imposed by this title, or for the collection thereof, shall keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary may from time to time prescribe.”

– Treasury Regulations also state: “The books and records required by this section shall be kept at all times available for inspection by authorized internal revenue officers or employees, and shall be retained so long as the contents thereof may become material in the administration of any internal revenue law.”

• Time period for record retention may be increased by a refunding. Extends requirement until three years after refunding issue final maturity.


Record Retention

• Other regulation guidance:

– 1992 arbitrage regulation section 1.148-8(h)(2) required certain elections regarding arbitrage calculation be kept in their books and records for six years after computation date.

– 1994 amendment to the 1993 arbitrage regulations related to investments in GICs and escrows requires records be retained until three years after the final maturity of the bond issue.

– IRS issued Notice 2006-63 soliciting comments from issuers and the industry as to what who be appropriate record retention standards. 11 responses were received.


Record Retention

• What Documents must be Retained:– Basic records relating to the bond transaction– Documents evidencing expenditure of bond proceeds– Use of bond financed property by public and private sources

(management contracts and research agreements)– Documents evidencing any investment of bond proceeds

• What format must the records be kept in?– Kept in a manor that ensures complete access to the IRS– Either hardcopy or electronic


Record Retention

• Electronic Records (Rev. Proc. 97-22)– Electronic Storage must be indexed and be able to

reproduce the stored records– Must exhibit a high degree of legibility– Cannot limit or restrict the IRS’s access– At the time of examination must reproduce the records and

provide the IRS with resources to locate, retrieve, and reproduce the records

– Use of a third party does not relieve the issuer of these responsibilities


Record Retention

• How long must records be maintained?– As long as the bonds are outstanding plus three years– If refunded, the records must be maintained until three years after

the final redemption of both bonds

• What if they are not maintained?– Possible loss of tax-exemption– Additional rebate may due– Conduit borrower not entitled to certain tax deductions.


Record Retention


• Advisory Committee on Tax-Exempt and Government Entities (the “ACT”) established by IRS in 2001.

– 2005 ACT report addressed need for special record retention rules.

– 2007 ACT report discussed need for developing post-issuance compliance procedures.

– 2009 ACT report expanded in great detail on record retention needs.

Recent Record Retention Projects


2005 ACT Report

• The 2005 ACT Report recommended:

– Development of a Revenue Procedure specialized to tax-exempt bonds.

– Establish an exception for certain arbitrage rebate record retention requirements (investment and expenditure records).

– Establish a voluntary certification program for record retention.


2007 ACT Report

• The 2007 ACT Report recommended:

– Development of post-issuance compliance procedures.

– Develop a system to monitor post-issuance compliance

– Establish record retention specific to the entity


2009 ACT Report

• The 2009 ACT Report:– Very extensive report detailing the need for record retention rules for

tax-exempt bond issues.

– Recommends publication of a revenue procedure that establishes safe harbors for certain record retention practices.

– Revenue Procedure draft recommends procedures for:• Assignment of compliance responsibilities• Establishment and maintenance of books and records• Records for investment of bond proceeds• Rules for review and allocation of bond proceeds• Monitoring qualified use of financed property


IRS Enforcement Update


IRS Enforcement Program

Random audits

Issues identified by third parties

Issues with possible abuses (GICs, Escrows, etc.)

Correspondence audits

Issuer refund requests (refund only)

Coordination with the SEC

Form 8038-T questions


2005 Revised Form 8038-T

• In January 2005, the IRS revised Form 8038-T.– This form must accompany any arbitrage related

payment to the Treasury Department

– The revised form included a number of questions designed to identify possible areas for audit.

– See “Part VI – Miscellaneous” on Form 8038-T


IRS Audit Results in 2008

• IRS collected over $45 million in settlements– $40 million from 49 audits (includes $25 million for

abusive transactions)

– $5.3 million from 23 Voluntary Closing Agreements

• Closed 437 cases in 2008– 365 audits

– 49 refund requests

– 23 voluntary closing agreements


IRS Enforcement

Correspondence Examination Results (2003) No calculations performed Calculations performed incorrectly Non-compliance from conduit borrowers

IRS Compliance Checklist for 501(c)(3)– August 2007

IRS Checklist for Governmental Entities – January 2009


2009 Compliance Checklist

• In January 2009, IRS sent a questionnaire similar to 2007 version to 200 governmental entities.

• 2009 questionnaire not only asks if written procedures exist, but WHEN the procedures were adopted.

• Checklist is IRS Form 14002 – available on IRS web site.

• NABL/GFOA joint checklist a good resource for developing written procedures.


IRS Arbitrage Audits in 2008

• The IRS began audits in late 2008 focused only on arbitrage compliance.

• IRS is testing both arbitrage rebate AND yield restriction.


IRS Arbitrage Audit Questions


Areas of Interest in 2010

• IRS has budgeted for 460 audits during FY 2009– 280 general audits (100 - 200 for arbitrage rebate

checklist)– 100 refund requests– 80 discrete audits (abusive transactions)

• Section 6700 promoter violations (yield burning)

• IRS has assigned one senior specialist to assist U.S. Justice Department on examining external bond participants (underwriters, investment advisors, attorneys)

• SWAP transactions


NABL/GFOA Joint Compliance Checklist


www.irs.gov