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:
- 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
- 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, may be applied if:
- 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:
- At least 15% of Gross Proceeds allocated within 6 months;
- At least 60% of Gross Proceeds allocated within 12 months; and
- 100% within 18 months, subject to reasonable retainage and a de minimis exception (discussed below); and
- 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 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.
 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.
 Meaning not more than 5% of available proceeds are retained.