Keep Your Paws Off My Positive Arbitrage – “With Great Power Comes Some Responsibility”

Our previous post kicked off our Rebate Series by introducing core concepts and terms. However, for every rule there is an exception. And, as you will learn shortly, for every exception there is an exception to that exception (except when there is not).

The next two episodes will focus on the so-called timing exceptions. In the rebate world, there are three: the 6-month, 18-month and two-year spending exceptions to the rebate requirement. Two general points to keep in mind: (1) each of these exceptions is independent of the others; so an issue could qualify under more than one, and (2) the spending exceptions are not automatically applied; so an issuer can choose NOT to apply them.

This post will cover the 6-month and 18-month spending exceptions, saving the best (or honestly, the most confusing) for last.

Episode 2: Rebate & Arbitrage 101 – 6-Month and 18-Month Spending Exceptions

Exceptions to the rebate requirement requiring an issuer to rebate unpermitted arbitrage to the federal government allow an issuer to keep all interest earnings that would otherwise be subject to rebate.

Why does the federal government allow this? The faster the bond proceeds are spent, the less likely issuers can earn arbitrage profits in the first place.  Also, the possibility of retaining arbitrage profits if bond proceeds are spent quickly enough serves as a positive incentive for the rapid expenditure of bond proceeds, an outcome the Treasury favors.   

6-Month Spending Exception

The rebate requirement will be considered satisfied, i.e., arbitrage earnings will not need to be rebated to the U.S. Treasury, if:

  1. All Gross Proceeds (defined in Episode 1), subject to some exceptions, are allocated to expenditures for the governmental purpose of the issue within 6 months from the issuance date of the bonds; and
  2. Earnings on amounts that are not required to be spent within the 6-month period (except on amounts in a qualifying bona fide debt service fund) are timely paid to the United States as rebate.

And here is an exception to the 6-month spending exception: the 6-month period is extended an additional 6 months if the unexpended Gross Proceeds at the end of the original 6-month period do not exceed 5% of the proceeds of the issue.

Refunding issues are eligible as well (and, in fact, are only eligible for the 6-month exception). If all Gross Proceeds of a refunding issue (other than Transferred Proceeds) are expended within 6 months after the date of issue, any arbitrage earnings will not need to be rebated. Transferred Proceeds of refunding  bonds remain subject to rebate unless a spending exception is satisfied, with the issuance date of the refunded bonds serving as the starting point for determining whether a spending exception is satisfied. 

18-Month Spending Exception

The 18-month spending exception, which is the only one of the three spending exceptions created by the Regulations and not the Code,[1] may be applied if:

  1. All Gross Proceeds, subject to some exceptions, are allocated to expenditures for the governmental purpose of the issue in accordance with the following schedule, each measured from the issuance date:
    1. At least 15% of Gross Proceeds allocated within 6 months;
    1. At least 60% of Gross Proceeds allocated within 12 months; and
    1. 100% within 18 months, subject to reasonable retainage and a de minimis exception (discussed below); and
  2. Earnings on amounts that are not required to be spent within the 18-month period (except on amounts in a qualifying bona fide debt service fund) are timely paid to the United States as rebate.

To determine compliance with the first two milestones—6 months and 12 months—the amount of Investment Proceeds included in Gross Proceeds is based on the issuer’s reasonable expectations on the date of issue.

Retainage is the portion of payment due that is temporarily retained by the issuer to ensure the contractor completes (or substantially completes) a project correctly. If reasonable[2] retainage is allocated to expenditures within 30 months of the issue date, the issue will not fail to satisfy the 18-month spending exception. Additionally, if a de minimis amount of proceeds—equal to the lesser of 3% of available proceeds or $250,000—is not allocated to expenditures within the required 18-month timeframe (or 30-month timeframe, if there’s reasonable retainage), the issuer may still meet the 18-month spending exception.  

[1] This solved a Goldilocks issue: the 6-month spending exception was too short and the two-year spending exception was too confusing and narrow to fit most transactions. The 18-month spending exception is therefore (now bear with me) jussstt righttt.

[2] Meaning not more than 5% of available proceeds are retained.

Keep Your Paws Off My Positive Arbitrage

Reader’s Note: As this is my first post on The Public Finance Tax Blog™ let me provide a necessary introduction. My name is Natalie, an associate with the Public Finance Tax Group here at Squire Patton Boggs. A little bit about me: I have the superhuman ability of not getting mosquito bites; I hate when people pronounce the “L” in salmon; and perhaps most relevant to you, if I can learn tax and finance concepts, so can you.

Additional Reader’s Note: This post has gone through several iterations already. Not because the information missed the mark (a junior associate’s worst nightmare, I promise you), but because I needed to “fun it up.” When tax lawyers call you boring, it may be time to rethink most if not all life decisions. Short of quitting my job, changing my name and generally falling off the face of the planet, I suppose I’ll start here. With this post. On Rebate. Naturally.

Episode 1: Rebate & Arbitrage 101 – Putting the Fun in Fundamentals

Because the fundamentals are the building blocks of fun, this post introduces the rebate requirement under Section 148 of the Internal Revenue Code and the key terms necessary for the episodes to come.

To understand rebate, you must understand arbitrage. And to understand arbitrage, well, you kind of just need to understand arbitrage. As discussed more thoroughly in a recent blog post, arbitrage occurs when securities purchased from one market are used for immediate resale in another to profit from the interest rate discrepancy. This is not a concept specific to tax-exempt or tax-advantaged bond financings, but the monitoring of arbitrage by the federal government occupies considerable space in our little corner of the public finance cosmos.

Let’s break down the rebate requirement into one confusing, soupy sentence:

For an issuer of tax-exempt bonds, certain earnings resulting in positive arbitrage[1] from the investment of Gross Proceeds into Nonpurpose Investments must be rebated[2] to the U.S. Treasury if the earnings on those investments exceed the yield on the tax-exempt bonds (so-called Higher Yielding Investments).

This Rebate Amount is based on the difference between the amount actually earned on that investment and the amount that would have been earned if the investment had a yield equal to the yield on the issue. There are exceptions to this rebate requirement, which are the subject of our later episodes in this series.

Let’s unpack some of the key terms mentioned above:

Gross Proceeds in the tax-exempt bond space include (i) sale proceeds (amount paid for the bonds by the purchaser), (ii) investment proceeds (amounts received from the investment of proceeds), (iii) transferred proceeds (remaining proceeds of a prior issue when a refunding occurs), and (iv) replacement proceeds (amounts related enough to the issue or governmental purpose of the issue such that they could have been used for that purpose if the proceeds were not already).

A Nonpurpose Investment is any investment property that is acquired with the Gross Proceeds of an issue that is not acquired in order to carry out the governmental purpose of the issue. Investment property includes securities, obligations, annuity contracts and investment type property. Interestingly, investment property excludes tax-exempt bonds, so issuers may avoid rebate requirements by investing proceeds in those.

Higher Yielding Investments are investment property acquired with bond proceeds that produces a yield that exceeds the yield on the issue.

Now equipped with these handy definitions, let’s decipher our soupy sentence from above:

For an issuer of tax-exempt bonds, certain earnings resulting in positive arbitrage from the investment of [sale, investment, transferred and replacement proceeds, as applicable] into [investment property not used for the governmental purpose of the bonds] must be rebated to the U.S. Treasury if the earnings on [the investment of the bond proceeds produce an impermissibly higher yield on the issue].

The issue date of the bonds starts the clock for measuring arbitrage, using the bond yield as the arbitrage limit. Per the general rebate rules, every five years a calculation of the Rebate Amount must be made. Does the federal government really expect issuers to look into a crystal ball to determine potential arbitrage issues for bonds that mature in ten, twenty or thirty years? Well, sort of. An issuer must use its “reasonable expectations” at the time the bonds are issued in making arbitrage determinations. If there is a Rebate Amount, then such amount must be rebated to the federal government within sixty days of the computation date for that period. If the applicable amount is not rebated, the bonds will become “arbitrage bonds,” the interest on which is subject to federal income tax. 

[1] Negative arbitrage presents its own concerns, which are discussed in a previous blog. And yes, while that seminal piece of Public Finance blog canon is informative and helpful and you should absolutely read it, the best parts are the tags at the bottom. On the off chance you happen to Google “Portlandia public finance tax” (as any curious well-adjusted person might do), guess what comes up.  

[2] If you’re curious why the concept is called “rebate” when profits earned from arbitrage were never the federal government’s in the first place, check out one of our other blog posts. It does not have any fun tags. Sorry.

When Overburdening isn’t a Burden

Cindy Mog recently reacquainted us with abusive arbitrage devices, including the factors that evidence overburdening of the tax-exempt bond market (issuing bonds too early, issuing too many bonds, and issuing bonds with an excessive weighted average maturity) and factors that countervail what would otherwise constitute overburdening (bona fide cost underruns, bona fide need to finance extraordinary working capital items, and an issuer’s long-term financial distress).

The IRS released a timely private letter ruling (PLR 202309014) on March 3 that analyzes the foregoing factors. This private letter ruling deals with whether an issue of long-term working capital (re)financing bonds was subject to the proceeds-spent-last rule and whether the issue overburdened the tax-exempt bond market. The IRS concluded that the issue was not subject to the proceeds-spent-last rule and did not overburden the tax-exempt bond market, because the issue refinanced extraordinary, nonrecurring working capital expenditures that were not covered by insurance or a reserve fund.

Perhaps if Cindy writes a post on tax-exempt advance refunding bonds, Congress will enact a law that restores them.

Abusive Arbitrage Devices – It’s Time to Get Reacquainted

(Episode 3 – What Happens to the Arbitrage Sinners and the Arbitrage Saints?)

As you may remember, in Episode 1 we discussed some background regarding the prohibition against abusive arbitrage devices and the policy behind that prohibition – to encourage investment of tax-exempt bond proceeds in long-lived, tangible assets, while discouraging the generation of arbitrage on the investment of such proceeds.  In Episode 2 we discussed the three factors the federal government examines to determine whether an issuer has overburdened the tax-exempt bond market, which results in an abusive arbitrage device if the issuer has also successfully exploited the difference between taxable and tax-exempt interest rates.  In this episode, we will describe the penalties imposed upon rule-breakers and the rewards offered to rule-followers.

What happens if you have an abusive arbitrage device?  The tax-exempt bonds become taxable arbitrage bonds.   Thus, issuers of tax-exempt bonds will want to be mindful of the rules (i.e., the guardrails) set by the federal government to avoid an abusive arbitrage device.  A more fun way to think about it is that, given the serious consequences of straying off of the envisioned path, issuers will want to drive the old-fashioned cars at the amusement park that keep you on track, rather than the Dodgems. 

What happens if you follow the arbitrage rules?  The tax-exempt bonds will remain tax-exempt (assuming, of course, that all non-arbitrage rules governing tax-exempt bonds are followed).  As a bonus, the issuer may also qualify for an exception to rebate and be able to retain its positive arbitrage.  For a detailed description of the various spending exceptions to rebate, please tune in to our spin-off rebate miniseries which will be coming soon to the Public Finance Tax Blog. 

What is the moral of the arbitrage story for issuers?  Know the basic rules.  Reach out to your favorite tax-exempt bond lawyer at SPB to make sure you are complying with the finer points of the basic rules.  Invest and spend your tax-exempt bond proceeds wisely and efficiently while adhering to the rules, and you may end up with both tax-exempt bonds and arbitrage that you can keep. 

The end.

Abusive Arbitrage Devices – It’s Time to Get Reacquainted

(Episode 2 – Overburdening (Generally) Not Allowed)

As you may remember, in the first episode, we discussed how the federal government’s primary goal in subsidizing tax-exempt bonds is to encourage investment by issuers in long-lived, tangible assets. We also discussed how the federal government has tried to keep issuers on the intended path by preventing them from exploiting the difference between the tax-exempt and taxable markets. Finally, we noted that bonds will generally be taxable arbitrage bonds if the issuer has successfully exploited the difference between tax-exempt and taxable interest rates and has also overburdened the tax-exempt bond market.

This episode will discuss the three rules intended to prevent the overburdening of the tax-exempt bond market – (1) You shall not issue too early; (2) You shall not issue too much; and (3) You shall not issue for too long. 

Why would you issue too early?   To take advantage of a low interest rate environment.  For example, an issuer might not have a capital project for Year 1 when interest rates are low, but anticipates having a capital project in Year 3 when interest rates might be higher.  The rule imposed by the federal government to prevent the issuer from issuing tax-exempt bonds too early is a requirement that the issuer reasonably expect on the issuance date of the tax-exempt bonds that it will spend at least 85% of the spendable proceeds within three years of the issuance date.  Even though the test involves “reasonable expectations,” remember that hindsight is always 20/20, and thus issuers should strive to actually meet this goal.  

Why would you issue too much?  To take advantage of a low interest rate environment. If an issuer reasonably expects that the proceeds of its tax-exempt bond issue will exceed the governmental purpose of the issue by more than $100,000, that constitutes evidence that the issuer overburdened the tax-exempt bond market by issuing too many tax-exempt bonds. Thus, it is best to avoid having over $100,000 of unspent proceeds upon completion of the bond-financed project. Unexpected excess sale and investment proceeds of the tax-exempt bond issue can be used to redeem or defease bonds of the issue to comply with this $100,000 limitation on unspent proceeds.

Why would you issue for too long?  To take advantage of a low interest rate environment, and possibly for cash flow reasons (i.e., to defer principal payments).  If the weighted average maturity (WAM) of the bond issue exceeds 120% of the weighted average economic life of the assets financed by the bond issue, that is evidence that the issuer overburdened the tax-exempt bond market by letting its bonds remain outstanding too long.  In other words, the federal government does not want issuers issuing 30-year tax-exempt bonds to finance computers with a 5-year useful life (unless, of course, the amortization of the bonds is front-loaded, such that the WAM of the bond issue does not exceed 6 years).

When overburdening isn’t actually overburdening.  Even if an issuer satisfies one or more factors discussed above, the issuer’s action will be excused (meaning that no overburdening will be deemed to occur) if the issuer can demonstrate that the action was necessitated by factors such as unexpected construction delays, bona fide cost underruns, a bona fide need to finance extraordinary working capital expenditures (e.g., a litigation settlement), or the issuer’s long-term financial distress.  Exceptions.  They are what keep tax lawyers employed. 

Preview of Episode 3 – What Happens to the Arbitrage Sinners and the Arbitrage Saints?

Next week’s Season Finale will discuss what happens to issuers that violate the arbitrage rules, along with some potential rewards for the rule-followers.

Stay tuned . . .

Abusive Arbitrage Devices – It’s Time to Get Reacquainted

(Episode 1 – Background and Arbitrage Basics)

Sometimes it is a good exercise to remind ourselves of some basic rules governing tax-exempt bonds.  One such rule is that bonds are taxable arbitrage bonds if an “abusive arbitrage device” is used in connection with the bonds.  An abusive arbitrage device is any action that has the effect of: (1) enabling the issuer to exploit the difference between tax-exempt and taxable interest rates to obtain a material financial advantage; and (2) overburdening the tax-exempt bond market.[1]  (Keep in mind that an “abusive arbitrage device” is only one specific type of “arbitrage bond.”  We chose to cover abusive arbitrage devices because they are of renewed relevance and they touch on many arbitrage concepts.)  The first element of an abusive arbitrage device has been difficult (to the point of impossibility) to satisfy since Mad Men first aired.[2]  However, the Federal Reserve’s hawkish monetary policy has now made it much easier to exploit the difference between tax-exempt and taxable interest rates.  Thus, it’s time to get reacquainted (or acquainted, depending on where you are in your career) with the concept of abusive arbitrage devices.  The Public Finance Tax Blog is here to help, with a three-part mini-series of posts on this topic.

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I Know It When I See It – What is a Capital Expenditure?

Window with a view.

According to Wikipedia, the fount of all knowledge, the phrase “I know it when I see it” is a colloquial expression by which a speaker attempts to categorize an observable fact or event, although the category is subjective or lacks clearly defined parameters.   This phrase was famously used in a U.S.  Supreme Court decision to describe the threshold test for obscenity.  (See Jacobellis v. Ohio, 378 U.S. 184 (1964)).  Although this blog post will, unfortunately, likely not become as well known as the Jacobellis case, it will discuss, “What is a Capital Expenditure?”  My guess is that a lot of tax-exempt bond advisors use intuition when determining that certain expenditures qualify as “capital expenditures” for tax-exempt bond purposes.   In other words, they know a capital expenditure when they see one.   However, the question as to what constitutes a “capital expenditure” under the tax-exempt bond rules may be difficult to answer at times.

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Toll-Free Telephone TEFRA Hearings Available Permanently

The IRS will permanently allow state and local governments to hold public hearings using a toll-free telephone number to satisfy the TEFRA hearing requirement for private activity bonds.[1] No in-person option will be required to satisfy the TEFRA public hearing requirement, but state and local governments must continue to follow applicable local laws, which may require public meetings to be held in person.

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“Administrative History?” – President Releases Guidebook for Infrastructure Law

Following in the footsteps of pioneers such as Matthew Lesko, the White House has released a guidebook to the funding available under the Infrastructure Investment and Jobs Act. (It should be at least somewhat more authoritative than Gobs and Gobs of Free Stuff,[1] at least as it pertains to the legislation in question.)

The approach in the Infrastructure Investment and Jobs Act to providing funding for state and local infrastructure focused on grants and direct aid, and new borrowing programs were somewhat limited. While its precedential status in the courts remains an open question, the guidebook is an essential tool for state and local governments in determining whether their projects are eligible for federal funds and, if so, how much money they can get. The guidebook weighs in at a doorstop-y 465 pages, but the real star of the show is the sortable spreadsheet of programs, which is available here: We are known here for our unrepentant bias in favor of spreadsheets, but the efficiency of the spreadsheet of programs will be obvious to even the most ardent skeptic.


[1] 3rd ed. (August 1, 1996).

Even When it Comes to the Mundane Forms 8038, the One Constant is Change

To all of our readers, Belated Happy New Year!  We will ring in 2022 with some belated news.  Back in November of 2021, the IRS once again issued a memorandum that extends the ability to use an electronic or digital signature on Form 8038 (Tax-Exempt Private Activity Bond Issues), Form 8038-G (Tax-Exempt Governmental Obligations) and Form 8038-GC (Small Tax-Exempt Governmental Obligations).  This current extension will remain in effect until October 31, 2023.  (I have no idea why Halloween (of 2023) was selected as the deadline, but it should be easy to remember!).  In additional good news, when announcing this most recent extension on its website, the IRS stated that it is considering further extensions, but needs to balance the convenience of electronic signatures against the possibility of identity theft and fraud.   This enquiring mind is curious as to who is filing fraudulent Forms 8038, and what benefit are they getting by doing so? Continue Reading