Issuers vexed by arbitrage

As interest rates remain high and the yield curve remains inverted some bond issuers are exploring the complexities of arbitrage for the first time. 

"Arbitrage is back," said Kathy Kardell, senior debt administrator in the Office of Budget & Finance of Hennepin County, Minnesota. "You may be able to invest the proceeds of your bonds at a rate that is higher than your bond yield for the first time in many years. I think there's a whole universe of debt managers out there that never experienced this." 

The comments came during a panel discussion held at the Government Finance Officers Association MiniMuni conference last Friday that explored a number of tax issues swirling through the muni bond market.   

Kutak Rock

The National Association of Bond Lawyers explains arbitrage as the difference between the rates of the issuance of bonds at a lower tax-exempt rate and investment of the proceeds in obligations paying higher taxable rates.

While interest rates were low, arbitrage was off the table for issuers. It's now come back along with multiple strings of regulations attached by Congress as interpreted by the Internal Revenue Service. The agency discourages against tax-exempt arbitrage bonds, but there are exceptions and remedies, including  what the agency calls "rebates." 

"For those certain exceptions where you can still earn arbitrage, we're (IRS) going to take that arbitrage from you in the form of rebate payments," said Matthias Edrich, a partner at Kutak Rock. "Even if you are allowed to earn arbitrage, you're going to have to pay it back to the federal government."  

According to Edrich, exceptions to the rebate rule include using the proceeds to prop up reserve funds and using them for specific projects as long as the issuers expects the money to be spent in three years. 

Not spending the money on time leads to problems. "The reimbursement rules say if you have a declaration of intent, which was made not long after you spent your money, we (Congress) will allow you to use the bond proceeds to reimburse yourself," said Edrich. "A declaration of intent can be a resolution or letter from the city." 

Issuers can also create a certificate to provide documentation. "One of the key things that's going to help you drive your planning is what you're going to put into a tax arbitrage certificate that's going to represent your reasonable expectations of what you're spending the money on," said Kardell. "Whether or not you're reimbursing yourself for any prior expenditures that you might have made from bonds, minimum proceeds, and how long do you reasonably expect to take to spend down those dollars." 

Unresolved expectations about spending the money fast enough can lead to the IRS declaring the proceeds to be taxable and looking for a rebate. In August the agency did just that in a ruling against the Port of Port Arthur Navigation District of Jefferson County, Texas. Despite the Port's claims, the IRS ruled that a 2017 $55 million bond issuance is now considered taxable. The dispute hinges on expectations about the spend and is tied to  the complexities of IRS Rule 149. 

Tax attorneys have been wrangling with the agency over 149 for years believing that cases can come down to judgment calls about whether the issuer had the correct reasonable expectations at closing.  

During the panel Jian Grant, an attorney with the U.S. Department of the Treasury revealed that clarifications on 149 are under review. "I'm not going to talk about the specifics of these because some of them are in the works," she said. "This is a new guidance resulting from the various comments we received over the years both internally and externally." 

In the meantime, successful arbitrage relies on diligent bookkeeping. "You have to keep all of these records for the life of the bond," said  Kardell. "When Mr. Auditor comes calling, you don't want to have to go find something that is in a box somewhere."