Simplifying Arbitrage Rebate Compliance with Spending Exceptions

Arbitrage rebate compliance represents one of the more complex areas of bond management and spending exceptions have emerged as a key strategy for issuers to minimize their potential tax liabilities. Spending exceptions are helpful tools that allow debt issuers to keep all investment earnings upon meeting certain criteria. They also provide a strategic pathway for bond issuers to navigate IRS regulations, offering relief from potentially complex rebate calculations.

In 2025, as yields hover around 4-5%, municipalities also have a unique opportunity to leverage spending exceptions to maximize their bond financing while minimizing potential arbitrage rebate liabilities.

Why Spending Exceptions Matter

Spending exceptions provide issuers with an opportunity to retain high-quality investments that exceed the bond yield, eliminating the need for rebate payments to the U.S. Treasury. That is, if specific requirements are met. These exceptions not only simplify bond compliance but also encourage the efficient use of bond proceeds.

There are three core spending exceptions, plus the small issuer exception that we will cover:

  • 6-Month Spending Exception
  • 18-Month Spending Exception
  • 2-Year Construction Exception
  • Small Issuer Exception

6-Month Spending Exception

The 6-Month exception is one of the simplest exceptions to achieve. It requires that 100% of gross proceeds be spent within the first 6 months after bond issuance. This exception is often beneficial for short-term financing or projects with immediate capital needs, such as equipment purchases or quick-turnaround infrastructure repairs. If any proceeds remain unspent after six months, the issuer must comply with standard rebate calculations unless another exception applies.

Gross proceeds held in certain reserve and debt service funds require special consideration. Consult an arbitrage compliance specialist to verify your specific situation.

  • Available for all tax-exempt bonds
  • Must spend 100% of gross proceeds within 6 months
  • Simplest exception to achieve
  • Ideal for projects with immediate needs, such as capital improvements or short-term infrastructure projects
  • Great for refunding issues that refund outstanding bonds on a current basis

18-Month Spending Exception

For longer projects, the 18-Month spending exception allows issuers to avoid arbitrage rebate payments if gross proceeds are spent according to specific spending milestones. To qualify, the bond proceeds must be spent according to the following schedule: at least 15% within six months, 60% within twelve months, and 100% within eighteen months. 

This exception is particularly useful for capital improvement projects that require phased spending, such as school renovations or roadway expansions.

  • Spending Milestones:
    • 15% spent in 6 months
    • 60% spent in 12 months
    • 100% spent in 18 months
      • After 18-months, a limited amount of unspent proceeds in connection with reasonable retainage is allowed for a period not more than 30 months
  • Available for all tax-exempt bonds
  • Consult with ACS regarding any replacement or reserve funds connected with your bond issue
  • Ideal for projects with longer timeframes or phased spending

2-Year Construction Spending Exception

This applies specifically to bonds issued for construction projects. Similar to the 18-Month exception, this allows for specific spending milestones to be reached over the course of 24 months, with 100% of gross proceeds spent within 2 years. To be exempt from arbitrage rebate, the issuer must spend at least 10% of the proceeds within six months, 45% within twelve months, 75% within eighteen months, and 100% within two years. 

This exception is especially valuable for large-scale infrastructure projects, such as municipal buildings, water treatment plants, and transportation projects, where expenditures occur gradually over time.

  • Spending Milestones
    • 10% spent in 6 months
    • 45% spent in 12 months
    • 75% spent in 18 months
    • 100% spent in 24 months
      • A limited extension allows unspent proceeds to be allocated as reasonable retainage for up to 36 months, given that due diligence requirements are met
  • Requires at least 75% of proceeds to be used for construction; purchases of land must not exceed 25% of available construction proceeds
  • Ideal for large-scale infrastructure projects

Small Issuer Exception

The small issuer exception is more of a rebate exemption than a spending exception. It applies to smaller governmental issuers who issue $5 million or less in tax-exempt bonds annually. These issuers are automatically exempt from rebate requirements, regardless of their spending patterns, provided they meet specific requirements. For bonds financing public school construction, the limit increases to $15 million while requiring that at least $10 million is designated for construction. 

Small issuers benefit from this exemption by avoiding the administrative burden and costs associated with rebate calculations, making it an essential consideration for local governments with limited financing needs.

  • Must meet specific IRS guidelines for size and use of bond proceeds
  • Total bonds can’t exceed $5M per year
    • $15M for schools, with $10M for construction
  • Bonds must be issued by government entity with taxing powers
    • Cities, counties, school districts and more
  • 95% or more of the bond proceeds (excluding those in a reserve or replacement fund) must be used for the issuer’s local governmental activities
  • Funds must support public projects
  • No spending milestones required
  • Exempt from rebate calculations but must follow yield restriction rules & maintain documentation

Considerations for Implementing Spending Exceptions

While these exceptions may seem straightforward, their application requires meticulous documentation and careful financial planning. Each milestone must be precisely tracked, with comprehensive records maintained to demonstrate compliance. 

To effectively take advantage of these spending exceptions, issuers should establish clear expenditure timelines, maintain accurate records of fund disbursements, track all investments, and regularly review spending progress to ensure compliance with the requirements. Working with experienced arbitrage rebate consultants like ACS can also help municipalities navigate complex regulations and optimize their financing strategy.

Need Guidance?

Spending exceptions are a valuable tool in municipal bond management, but their complexity should not be underestimated. Failing to meet key benchmarks such as required spending thresholds or timelines can result in rebate liabilities, negating their intended benefits. To fully leverage these exceptions, issuers must maintain meticulous records, proactively monitor expenditures, and implement a clear strategy from initial bond issuance to ensure compliance.

Our team is dedicated to helping you navigate these complex rules so you can maintain transparent financial records that stand up to IRS scrutiny.

Our team at Arbitrage Compliance Specialists provides the expertise and guidance needed to navigate spending exceptions with confidence. We specialize in detailed compliance monitoring, milestone tracking, documentation preparation, and strategic planning to help bond issuers stay on track. 

Ensure your municipal bond compliance is handled with precision. Contact us today for a comprehensive review of your spending exception strategy.