Tax-exempt bonds are an excellent way for municipalities, such as schools, cities, or counties to pay for projects. These projects, or capital expenditures, may be buildings or other new construction, or even renovations to existing structures.
When the municipality issues these bonds — called municipal bonds — the bonds’ tax-exempt status makes them attractive to investors. It’s a win-win scenario for investors and municipalities alike.
After abuse of the tax-exempt system led to an Internal Revenue Code overhaul in 1986, any profit or arbitrage gained from municipal bonds was required to be paid back to the federal government in the form of rebates.
How to Calculate Arbitrage
There are several bond documents necessary for calculating and reporting arbitrage:
- The official statement, colloquially known as the OS
- The tax certificate
- The trust indenture
- IRS Form 8038 or 8038-G
- CPA verification report
- Trustee statements
In addition, the yield on the bonds must be calculated. We present value all unconditionally payable debt service payments, line of credit fees, and swap payments on integrated hedges back to the bond’s issuance date.
Using your daily investment records and our knowledge of the IRS rules and regulations (Section 148), your actual return on investments is compared to your expected return on investments at the calculated bond yield. Positive arbitrage means that you earned more than the IRS would expect. Negative arbitrage means that you could have invested your money a little bit better. The positive arbitrage must be remitted to the IRS with a report at each filing date.
These reports are required to be filed at least once every five years. If the reports are not filed, the issuer faces fines, penalties, late interest charges and the loss of its tax-exempt status. A bond issue losing its tax-exempt status is the IRS’ version of the “death penalty”. The debt is treated as taxable from the date of issuance, which may result in a surprise bill the issuer is not prepared to pay. Future borrowings by the issuer are subjected to increased scrutiny and higher borrowing rates, with bondholders expecting a higher return for the additional risk. If your municipality relies on tax-exempt debt to fund its present-day growth plans, it’s important to stay in compliance.
Why Calculate Arbitrage?
Positive arbitrage is not something that should scare you. You should always plan to invest the best you can. If your investment is earning above your bond issue’s calculated yield, you are likely earning positive arbitrage on that investment. However, that single investment is blended together with all other investments funded with proceeds of the issue in determining your rebate liability.
As market conditions are always changing, it’s best to calculate arbitrage sooner rather than later. ACS recommends completing an arbitrage report with us annually, so that potential liability payments to the IRS are budgeted for well in advance of required IRS filing deadlines.
Why Arbitrage Compliance Specialists?
If you’re wondering how to calculate arbitrage, you’re not alone. It’s a complicated procedure, and no municipality or investor wants to be caught out of compliance. The IRS expects this calculation to be exact, and it’s best done by experienced professionals like Arbitrage Compliance Specialists.
Our hands-on, individualized approach ensures you’re getting the attention you need when making these crucial calculations. Every one of our clients gets the same treatment, and no stone is left unturned. Our services include:
- Arbitrage rebate calculations
- Yield restriction calculations
- Spending exception calculations
- Assistance with Form 8038-Ts
From issuance to maturity, we’ll be there for all your bonds. We’ll keep track of your filing deadlines and calculate the lowest liability allowable by law.
Reach out to one of the experts at Arbitrage Compliance Specialists today. Don’t handle the IRS yourself! We’ll crunch the numbers and keep you in compliance with all the latest IRS rules and regulations.
We look forward to working with you.