arbitrage rebate basics and the arbitrage environment
TRANSCRIPT
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Arbitrage Rebate Basics and the Arbitrage Environment:Important Reminders for Issuers of Tax-Exempt Bonds
Presented by:Mike Steinbrook, DirectorPFM Arbitrage & Tax Compliance [email protected]
PFM AssetManagement LLC
213 Market StreetHarrisburg, PA 17101
717.232.2723pfm.com
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L E A R N I N G O B J E C T I V E S Learn the basics of arbitrage rebate calculations and compliance
Understand the difference between arbitrage rebate and yield restriction
Understand strategies to mitigate compliance issues
Be able to assess existing policies and procedures and implement best practices
Arbitrage rebate calculations basics
Compliance Strategies – Arbitrage Rebate
Compliance Strategies – Yield Restriction
Post Issuance Compliance – Best Practices
AgendaD I S C U S S I O N T O P I C S
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Arbitrage Rebate & Yield Restriction – The Basics
To prevent abuses, the tax code limits the permitted uses of tax-exempt bonds
1. Prevents issuance of more bonds than are necessary
2. Prevents issuance of bonds earlier than is necessary
3. Prevents bonds from remaining outstanding longer than is necessary
• In other words, borrow what you need, when you need it, for an appropriate duration based on what isbeing financed.
Applies to every tax-exempt borrowing and some taxable subsidy obligations
• Measured on an issue-by-issue basis
• Arbitrage Rebate begins on the issue date
• Yield Restriction begins at the expiration of a temporary period
Arbitrage % = Actual investment earnings yield (–) average borrowing rate (aka, the Arbitrage Yield)
• “Positive Arbitrage” = Actual Earnings > Earnings @ arbitrage yield
• “Negative Arbitrage” = Actual Earnings < Earnings @ arbitrage yield
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What is an Issue?
Under the Regulations (1.150-1), an issue means 2 or more bonds that meet ALL of the following requirements:
• Sold substantially at the same time – not more than 15 days apart
• Sold pursuant to common plan of finance – bonds to finance the same or similar projects
• Payable from same source of funds
Combined issues require a combined arbitrage yield calculation and an aggregate arbitrage rebate calculation
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Arbitrage Liability Example
Arbitrage is measured issue-by-issue in aggregate and over time
For each bond issue, all funds subject to arbitrage are blended together
Negative arbitrage in a fund can be used to offset positive arbitrage in other funds
($100)
($50)
($5)
($50)
$150
($55)
($150)
($100)
($50)
$0
$50
$100
$150
$200
Project Fund
Cap Int. Fund
Costs ofIssuance
Fund
Escrow Fund
Debt ServiceReserve
Fund
ArbitrageRebate Liability
Posi
tive
(Neg
ativ
e) A
rbitr
age
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Sources: Bloomberg, Thomson Reuters. See important disclosures at the end of this presentation.
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Tax Considerations Timeline
Arbitrage rebate requirements apply to every tax-exempt borrowing and certain taxable subsidy obligations
Compliance begins with pre-issuance planning and continues with post-issuance policies and procedures (does it ever end…)
Pre-Issuance• Timing• Project Draw Schedule• Evaluate available exceptions and elections• Identify investment options
Issuance• Invest bond proceeds• Purchase securities, establish FMV• Revise draw schedule• Make elections in Tax Certificate
Post-Issuance
• Arbitrage reporting• Monitor draw schedule• Monitor investments• Record retention
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Bond Proceeds Compliance Strategies: Arbitrage Rebate
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Funds Subject to Rebate
PROCEEDS + REPLACEMENT PROCEEDS = GROSS PROCEEDS
Sale Proceeds /Investment Proceeds
• Project / Construction Funds• Capitalized Interest Funds• Debt Service Reserve Funds• Escrow Funds• Costs of Issuance Funds• Interest earnings
Cash / Equity /Revenue Funded
• Debt Service Funds• Debt Service Reserve Funds• Any “Pledged” Fund
All subject to Rebate
Exceptionsmay apply
Transferred ProceedsAny of the above
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Exceptions to Arbitrage Rebate
The Small Issuer Exception
The Spending Exceptions
• 6-month spending exception
• 18-month spending exception
• 2-year spending exception
“Bona Fide” Debt Service Fund exception
Electing to pay the 1.5% penalty in lieu of rebate
Investing in tax-exempt obligations
These areexceptions to
Arbitrage Rebate Not
Yield Restriction
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Small Issuer Exception
Calendar Year Exception
• $5 million of governmental bonds for municipalities
• $15 million for public school construction
Requirements
• General taxing powers
• Governmental bonds (not private activity bonds)
• At least 95% of the proceeds must be used for local governmental activities
Exclusion of current refunding issues in certain circumstances
Still subject to Yield Restriction Requirements
Exception to Arbitrage Rebate
Only
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Small Issuer Exception – Review and Test Annually
Bond Type/Calendar Years 2017 2020 2021 (Expected)
(a) New Money/Capital Project Bonds 10,000,000 10,000,000 13,000,000
(b) Current Refunding Bonds 8,000,000 5,000,000 10,000,000
(c) Tax-Exempt Advance Refunding Bonds 6,000,000 -- --
(d) Other State Aid Notes, Leases 2,000,000 2,000,000 2,500,000
(e) Taxable Bonds -- -- 5,000,000
Total Calendar Year Bond Issuance 26,000,000 17,000,000 30,500,000
Total Bond Issuance Subject to Test (a+c+d) 18,000,000 12,000,000 15,500,000
Small Issuer Exempt? NO YES NO
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Spending Exceptions – Can Be Internally Monitored “Reward” for spending bond proceeds quickly
Allowed to keep positive arbitrage
Simple way to establish compliance (no FV, no yields)
Must meet each benchmark, no catch-up allowed
Optional to apply
* Exceptions for 5% of the proceeds of the issue if spent within one year
** De minimis (lesser of 3% or $250K) and reasonable retainage (5% spent in 12 months) exceptions may apply for last benchmark
6-Month 18-Month 2-Year (ACP)All gross proceeds All new money Construction issues
6 months 100% * 6 months 15% 6 months 10% 12 months 60% 12 months 45% 18 months 100% ** 18 months 75%
24 months 100% **
Exception to Arbitrage Rebate
Only
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Bond Proceeds Compliance Strategies: Yield Restriction
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Exceptions to Yield Restriction
“Temporary Period”
• Generally 3-years for construction proceeds
• Can be extended to 5-years with certification
• Can also be waived entirely
Reasonably Required Reserve or Replacement Funds
Minor Portion
• Generally less than $100,000
Investing in tax-exempt obligations
These areexceptions to
Yield RestrictionNot
Arbitrage Rebate
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Arbitrage Rebate vs. Yield Restriction
Arbitrage Rebate and Yield Restriction are separate calculations
Yield Restriction only applies to proceeds that are subject to yield restriction
Yield restricted proceeds cannot earn above the “Materially Higher Yield” (arbitrage yield + .125%)
Cannot blend positive arbitrage of yield restricted proceeds with negative arbitrage of unrestricted proceeds
Could the next 5 years produce a
similar interest rate environment?
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Yield Restriction Impact: Waiving a 3-year Temporary Period
Situational Awareness – preparing for potential higher interest rates in the future
No waiver of temporary period =
• No rebate liability at year 5
• Yield Restriction Liability at year 5
• Pay IRS excess interest earned in years 4 and 5
Waiver of temporary period =
• No rebate liability at year 5
• No yield restriction liability at year 5
• Keep excess interest earned in years 4 and 5
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To Waive or not to Waive Even in today’s uncertain interest rate environment – this may still make sense
Consider the following:
Each bond issue should be examined separately with your advisors and bond counsel. Representation above is based on current market conditions and current expectations of borrowing rates and investment rates for bond proceeds.
Tax election to waive the temporary period must be made by the issuer in writing at settlement – no ability to change election after the bonds are issued.
DRAW SCHEDULE
ARBITRAGE YIELD
Low Mid High
Short (<18 mos.) NO NO MAYBE
Medium (18-24 mos.) NO MAYBE YES
Long (>24 mos.) MAYBE YES YES
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Each Bond Issue Is Unique
Questions to consider:
1. How confident are you in the draw schedule?
2. Do you expect to meet a spending exception? Should the spending exception be applied?
3. Do you expect to earn positive arbitrage?
4. Is waiving the 3-year temporary period an option?
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Additional Arbitrage Considerations –Often Overlooked
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“Bona Fide” Debt Service Fund Exception
Depleted at least annually except for greater of:
• Previous year’s earnings in the fund, or
• 1/12th of previous year’s principal and interest payments
Private Activity Bonds
• Fund has annual earnings of less than $100,000, or
• Average annual debt service does not exceed $2.5 million
Exception toYield Restriction
Exception to Arbitrage Rebate
Excess portion of DSF is subject to both Arbitrage Rebate & Yield Restriction
• I&S Fund – Residual, Interest Reserve or Reserve Portion
• How to allocate?
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Tax Allocation
Common I&S Fund is a commingled fund
Allocated to all bond issues secured by the I&S Fund
Commingled fund allocation must be reasonable and consistently applied
Permissible ratable allocation methods:
1. Original par amount of outstanding bonds
2. Relative value of outstanding bonds
3. Remaining maximum annual debt service of outstanding bonds
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Be Aware of Refunding Impacts
May accelerate final maturity of the issue
Possible loss of temporary period on the bonds being refunded
Escrow yield cannot exceed the bond yield by more than 1/1000th of 1%
May create Transferred Proceeds
Universal Cap Issue related to Taxable Advance Refunding Escrows
Series 2011(Refunded Bonds)
Bond Yield = 3.50%
Series 2021(Refunding Bonds)
Bond Yield = 1.50%Unspent Proceeds
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Unspent Proceeds
Generally no spending deadline for proceeds
Neglecting unspent proceeds opens the door for unforeseen liabilities
• Cost of Issuance Fund outstanding longer than 6 months
• Project Fund proceeds remaining after the 3-year temporary period
• Reasonably Required Reserve or Replacement Fund exceeding the size limitation
• Overfunded Debt Service Funds
Proceeds should continue to be spent with due diligence
• Identify additional qualified expenditures
• Allocate to interest payments on the Bonds
Exception toYield Restriction
Exception to Arbitrage Rebate
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Post Issuance Compliance: Requirements & Best Practices
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Calculation & Filing Requirements Payment due no later than 60 days after the computation date
• No later than 5-years after the issue date, and every 5-years thereafter until the final maturity date
• At least 90% of the liability
• As of final maturity date, 100% of the liability
Submit check & IRS Form 8038-T
Do not submit calculations
No filing required if no payment is due
Late Payments
Refund Requests
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IRS – Best Practices – Written Procedures
Due diligence review at regular intervals;
Identifying the official or employee responsible for review;
Training of the responsible official/employee;
Retention of adequate records to substantiate compliance;
Procedures reasonably expected to timely identify noncompliance; and
Procedures ensuring that the issuer will take steps to timely correct noncompliance.
Many issuers and bond lawyers acknowledge that simply having
something in writing to “check the box” is not enough
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Record Retention
Life of the Bonds + 3 years
If the Bonds are refunded, life of refunding bonds + 3 years
Consider separate document collection, storage and destruction policies for bond related records
Consider electronic storage systems
Banks and other third parties may destroy records after 7 years
DO NOT DESTROY: Board minutes, resolutions Appraisals Bond transcripts Newspaper ads, misc. correspondence Investment records Expenditure histories Invoices IRS Filings Records related to acquisition of investment agreements and interest rate swaps Payments for credit facilities Arbitrage rebate and yield restriction compliance reports
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IRS TE/GE FY Work Plan
FY 2020 Program Letter
General Information
• Continuing to use data analytics to identify and address existing and emerging high-risk areas of noncompliance
• Determination Letters – focus on identifying new strategies to reduce filing burden and processing time
Audit / Examination Focus Areas
• Public Safety Bonds – Private Business Use
• Sinking Fund over-funding
• Variable rate bonds
• Claims for payments on Direct Pay Bonds – Build America Bond subsidy payments
FY 2021 Program Letter
General Information
• Examine organizations and entities using referrals and data analytics to focus on high-risk issues
• Expand e-filing of Forms 990 and 8038-CP
Fiscal Year 2021 Priorities
• Continue 2020 focus areas
• Arbitrage violations – bond proceeds invested beyond the allowable temporary period
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Concerns about Capital Project Spending
“Is the IRS extending any spending deadlines due to COVID-19?”
“COVID-19 has really pushed back the progress on our project. We won’t be able to meet the next spending benchmark.”
“We are not processing any new permits, so some projects are at a stand-still. Contractors aren’t even allowed to work.”
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No Relief from the IRS… but is it needed?
Currently no waivers or flexibility related to spending benchmarks
Missing a spending exception is not a violation, other remedies exist
Low interest rates = negative arbitrage
85% spending target in 3 years is not a requirement
Clients should consult with counsel if any change in use is being contemplated
Delayed project gets cancelled and bond proceeds need to be repurposed
Advice: earn as much interest as possible and spend with due diligence, consider other permitted capital projects and debt service interest
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Final Thoughts - Tips for Navigating Arbitrage Rebate
Determine the yield for arbitrage purposes – understand the arbitrage environment
Compile and maintain a list of bond issues in need of rebate and yield restriction calculations
Know the exceptions, consult with bond counsel and arbitrage compliance resources
Perform calculations no later than 5-year anniversary dates and final maturity or final bond redemption dates (may be earlier than 5-years). Annual reporting is better for planning purposes and helps to eliminate surprises.
Make payments no later than 60 days after computation date
Retain copies of compliance calculations and all documents in the event of an audit
Ask Questions!
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Disclaimers
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Thank you!Please feel free to reach out:
Mike [email protected]
PFM Arbitrage & Tax Compliance Group