arbitrage rebate basics and the arbitrage environment

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Arbitrage Rebate Basics and the Arbitrage Environment:Important Reminders for Issuers of Tax-Exempt Bonds

Presented by:Mike Steinbrook, DirectorPFM Arbitrage & Tax Compliance [email protected]

PFM AssetManagement LLC

213 Market StreetHarrisburg, PA 17101

717.232.2723pfm.com

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L E A R N I N G O B J E C T I V E S Learn the basics of arbitrage rebate calculations and compliance

Understand the difference between arbitrage rebate and yield restriction

Understand strategies to mitigate compliance issues

Be able to assess existing policies and procedures and implement best practices

Arbitrage rebate calculations basics

Compliance Strategies – Arbitrage Rebate

Compliance Strategies – Yield Restriction

Post Issuance Compliance – Best Practices

AgendaD I S C U S S I O N T O P I C S

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Arbitrage Rebate & Yield Restriction – The Basics

To prevent abuses, the tax code limits the permitted uses of tax-exempt bonds

1. Prevents issuance of more bonds than are necessary

2. Prevents issuance of bonds earlier than is necessary

3. Prevents bonds from remaining outstanding longer than is necessary

• In other words, borrow what you need, when you need it, for an appropriate duration based on what isbeing financed.

Applies to every tax-exempt borrowing and some taxable subsidy obligations

• Measured on an issue-by-issue basis

• Arbitrage Rebate begins on the issue date

• Yield Restriction begins at the expiration of a temporary period

Arbitrage % = Actual investment earnings yield (–) average borrowing rate (aka, the Arbitrage Yield)

• “Positive Arbitrage” = Actual Earnings > Earnings @ arbitrage yield

• “Negative Arbitrage” = Actual Earnings < Earnings @ arbitrage yield

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What is an Issue?

Under the Regulations (1.150-1), an issue means 2 or more bonds that meet ALL of the following requirements:

• Sold substantially at the same time – not more than 15 days apart

• Sold pursuant to common plan of finance – bonds to finance the same or similar projects

• Payable from same source of funds

Combined issues require a combined arbitrage yield calculation and an aggregate arbitrage rebate calculation

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Arbitrage Liability Example

Arbitrage is measured issue-by-issue in aggregate and over time

For each bond issue, all funds subject to arbitrage are blended together

Negative arbitrage in a fund can be used to offset positive arbitrage in other funds

($100)

($50)

($5)

($50)

$150

($55)

($150)

($100)

($50)

$0

$50

$100

$150

$200

Project Fund

Cap Int. Fund

Costs ofIssuance

Fund

Escrow Fund

Debt ServiceReserve

Fund

ArbitrageRebate Liability

Posi

tive

(Neg

ativ

e) A

rbitr

age

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Sources: Bloomberg, Thomson Reuters. See important disclosures at the end of this presentation.

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Tax Considerations Timeline

Arbitrage rebate requirements apply to every tax-exempt borrowing and certain taxable subsidy obligations

Compliance begins with pre-issuance planning and continues with post-issuance policies and procedures (does it ever end…)

Pre-Issuance• Timing• Project Draw Schedule• Evaluate available exceptions and elections• Identify investment options

Issuance• Invest bond proceeds• Purchase securities, establish FMV• Revise draw schedule• Make elections in Tax Certificate

Post-Issuance

• Arbitrage reporting• Monitor draw schedule• Monitor investments• Record retention

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Bond Proceeds Compliance Strategies: Arbitrage Rebate

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Funds Subject to Rebate

PROCEEDS + REPLACEMENT PROCEEDS = GROSS PROCEEDS

Sale Proceeds /Investment Proceeds

• Project / Construction Funds• Capitalized Interest Funds• Debt Service Reserve Funds• Escrow Funds• Costs of Issuance Funds• Interest earnings

Cash / Equity /Revenue Funded

• Debt Service Funds• Debt Service Reserve Funds• Any “Pledged” Fund

All subject to Rebate

Exceptionsmay apply

Transferred ProceedsAny of the above

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Exceptions to Arbitrage Rebate

The Small Issuer Exception

The Spending Exceptions

• 6-month spending exception

• 18-month spending exception

• 2-year spending exception

“Bona Fide” Debt Service Fund exception

Electing to pay the 1.5% penalty in lieu of rebate

Investing in tax-exempt obligations

These areexceptions to

Arbitrage Rebate Not

Yield Restriction

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Small Issuer Exception

Calendar Year Exception

• $5 million of governmental bonds for municipalities

• $15 million for public school construction

Requirements

• General taxing powers

• Governmental bonds (not private activity bonds)

• At least 95% of the proceeds must be used for local governmental activities

Exclusion of current refunding issues in certain circumstances

Still subject to Yield Restriction Requirements

Exception to Arbitrage Rebate

Only

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Small Issuer Exception – Review and Test Annually

Bond Type/Calendar Years 2017 2020 2021 (Expected)

(a) New Money/Capital Project Bonds 10,000,000 10,000,000 13,000,000

(b) Current Refunding Bonds 8,000,000 5,000,000 10,000,000

(c) Tax-Exempt Advance Refunding Bonds 6,000,000 -- --

(d) Other State Aid Notes, Leases 2,000,000 2,000,000 2,500,000

(e) Taxable Bonds -- -- 5,000,000

Total Calendar Year Bond Issuance 26,000,000 17,000,000 30,500,000

Total Bond Issuance Subject to Test (a+c+d) 18,000,000 12,000,000 15,500,000

Small Issuer Exempt? NO YES NO

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Spending Exceptions – Can Be Internally Monitored “Reward” for spending bond proceeds quickly

Allowed to keep positive arbitrage

Simple way to establish compliance (no FV, no yields)

Must meet each benchmark, no catch-up allowed

Optional to apply

* Exceptions for 5% of the proceeds of the issue if spent within one year

** De minimis (lesser of 3% or $250K) and reasonable retainage (5% spent in 12 months) exceptions may apply for last benchmark

6-Month 18-Month 2-Year (ACP)All gross proceeds All new money Construction issues

6 months 100% * 6 months 15% 6 months 10% 12 months 60% 12 months 45% 18 months 100% ** 18 months 75%

24 months 100% **


Only

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Bond Proceeds Compliance Strategies: Yield Restriction

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Exceptions to Yield Restriction

“Temporary Period”

• Generally 3-years for construction proceeds

• Can be extended to 5-years with certification

• Can also be waived entirely

Reasonably Required Reserve or Replacement Funds

Minor Portion

• Generally less than $100,000

Investing in tax-exempt obligations

These areexceptions to

Yield RestrictionNot

Arbitrage Rebate

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Arbitrage Rebate vs. Yield Restriction

Arbitrage Rebate and Yield Restriction are separate calculations

Yield Restriction only applies to proceeds that are subject to yield restriction

Yield restricted proceeds cannot earn above the “Materially Higher Yield” (arbitrage yield + .125%)

Cannot blend positive arbitrage of yield restricted proceeds with negative arbitrage of unrestricted proceeds

Could the next 5 years produce a

similar interest rate environment?

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Yield Restriction Impact: Waiving a 3-year Temporary Period

Situational Awareness – preparing for potential higher interest rates in the future

No waiver of temporary period =

• No rebate liability at year 5

• Yield Restriction Liability at year 5

• Pay IRS excess interest earned in years 4 and 5

Waiver of temporary period =

• No rebate liability at year 5

• No yield restriction liability at year 5

• Keep excess interest earned in years 4 and 5

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To Waive or not to Waive Even in today’s uncertain interest rate environment – this may still make sense

Consider the following:

Each bond issue should be examined separately with your advisors and bond counsel. Representation above is based on current market conditions and current expectations of borrowing rates and investment rates for bond proceeds.

Tax election to waive the temporary period must be made by the issuer in writing at settlement – no ability to change election after the bonds are issued.

DRAW SCHEDULE

ARBITRAGE YIELD

Low Mid High

Short (<18 mos.) NO NO MAYBE

Medium (18-24 mos.) NO MAYBE YES

Long (>24 mos.) MAYBE YES YES

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Each Bond Issue Is Unique

Questions to consider:

1. How confident are you in the draw schedule?

2. Do you expect to meet a spending exception? Should the spending exception be applied?

3. Do you expect to earn positive arbitrage?

4. Is waiving the 3-year temporary period an option?

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Additional Arbitrage Considerations –Often Overlooked

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“Bona Fide” Debt Service Fund Exception

Depleted at least annually except for greater of:

• Previous year’s earnings in the fund, or

• 1/12th of previous year’s principal and interest payments

Private Activity Bonds

• Fund has annual earnings of less than $100,000, or

• Average annual debt service does not exceed $2.5 million

Exception toYield Restriction


Excess portion of DSF is subject to both Arbitrage Rebate & Yield Restriction

• I&S Fund – Residual, Interest Reserve or Reserve Portion

• How to allocate?

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Tax Allocation

Common I&S Fund is a commingled fund

Allocated to all bond issues secured by the I&S Fund

Commingled fund allocation must be reasonable and consistently applied

Permissible ratable allocation methods:

1. Original par amount of outstanding bonds

2. Relative value of outstanding bonds

3. Remaining maximum annual debt service of outstanding bonds

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Be Aware of Refunding Impacts

May accelerate final maturity of the issue

Possible loss of temporary period on the bonds being refunded

Escrow yield cannot exceed the bond yield by more than 1/1000th of 1%

May create Transferred Proceeds

Universal Cap Issue related to Taxable Advance Refunding Escrows

Series 2011(Refunded Bonds)

Bond Yield = 3.50%

Series 2021(Refunding Bonds)

Bond Yield = 1.50%Unspent Proceeds

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Unspent Proceeds

Generally no spending deadline for proceeds

Neglecting unspent proceeds opens the door for unforeseen liabilities

• Cost of Issuance Fund outstanding longer than 6 months

• Project Fund proceeds remaining after the 3-year temporary period

• Reasonably Required Reserve or Replacement Fund exceeding the size limitation

• Overfunded Debt Service Funds

Proceeds should continue to be spent with due diligence

• Identify additional qualified expenditures

• Allocate to interest payments on the Bonds

Exception toYield Restriction


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Calculation & Filing Requirements Payment due no later than 60 days after the computation date

• No later than 5-years after the issue date, and every 5-years thereafter until the final maturity date

• At least 90% of the liability

• As of final maturity date, 100% of the liability

Submit check & IRS Form 8038-T

Do not submit calculations

No filing required if no payment is due

Late Payments

Refund Requests

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IRS – Best Practices – Written Procedures

Due diligence review at regular intervals;

Identifying the official or employee responsible for review;

Training of the responsible official/employee;

Retention of adequate records to substantiate compliance;

Procedures reasonably expected to timely identify noncompliance; and

Procedures ensuring that the issuer will take steps to timely correct noncompliance.

Many issuers and bond lawyers acknowledge that simply having

something in writing to “check the box” is not enough

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Record Retention

Life of the Bonds + 3 years

If the Bonds are refunded, life of refunding bonds + 3 years

Consider separate document collection, storage and destruction policies for bond related records

Consider electronic storage systems

Banks and other third parties may destroy records after 7 years

DO NOT DESTROY: Board minutes, resolutions Appraisals Bond transcripts Newspaper ads, misc. correspondence Investment records Expenditure histories Invoices IRS Filings Records related to acquisition of investment agreements and interest rate swaps Payments for credit facilities Arbitrage rebate and yield restriction compliance reports

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IRS TE/GE FY Work Plan

FY 2020 Program Letter

General Information

• Continuing to use data analytics to identify and address existing and emerging high-risk areas of noncompliance

• Determination Letters – focus on identifying new strategies to reduce filing burden and processing time

Audit / Examination Focus Areas

• Public Safety Bonds – Private Business Use

• Sinking Fund over-funding

• Variable rate bonds

• Claims for payments on Direct Pay Bonds – Build America Bond subsidy payments

FY 2021 Program Letter

General Information

• Examine organizations and entities using referrals and data analytics to focus on high-risk issues

• Expand e-filing of Forms 990 and 8038-CP

Fiscal Year 2021 Priorities

• Continue 2020 focus areas

• Arbitrage violations – bond proceeds invested beyond the allowable temporary period

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Concerns about Capital Project Spending

“Is the IRS extending any spending deadlines due to COVID-19?”

“COVID-19 has really pushed back the progress on our project. We won’t be able to meet the next spending benchmark.”

“We are not processing any new permits, so some projects are at a stand-still. Contractors aren’t even allowed to work.”

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No Relief from the IRS… but is it needed?

Currently no waivers or flexibility related to spending benchmarks

Missing a spending exception is not a violation, other remedies exist

Low interest rates = negative arbitrage

85% spending target in 3 years is not a requirement

Clients should consult with counsel if any change in use is being contemplated

Delayed project gets cancelled and bond proceeds need to be repurposed

Advice: earn as much interest as possible and spend with due diligence, consider other permitted capital projects and debt service interest

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Final Thoughts - Tips for Navigating Arbitrage Rebate

Determine the yield for arbitrage purposes – understand the arbitrage environment

Compile and maintain a list of bond issues in need of rebate and yield restriction calculations

Know the exceptions, consult with bond counsel and arbitrage compliance resources

Perform calculations no later than 5-year anniversary dates and final maturity or final bond redemption dates (may be earlier than 5-years). Annual reporting is better for planning purposes and helps to eliminate surprises.

Make payments no later than 60 days after computation date

Retain copies of compliance calculations and all documents in the event of an audit

Ask Questions!

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Disclaimers

Investment Advisory Services

PFM is the marketing name for a group of affiliated companies providing a range of services. All services are provided through separate agreements with each company. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation.

Investment advisory services are provided by PFM Asset Management LLC which is registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. The information contained is not an offer to purchase or sell any securities. Applicable regulatory information is available upon request.

For more information regarding PFM’s services or entities, please visit www.pfm.com.

This material is only intended for institutional and/or sophisticated professional investors. It is for informational purposes only and should not be relied upon to make an investment decision, as it was prepared without regard to any specific objectives or financial circumstances. It should not be construed as an offer to purchase/sell any investment. Any investment or strategy referenced may involve significant risks, including but not limited to risk of loss, illiquidity, unavailability within all jurisdictions, and may not be suitable for all investors. To the extent permitted by applicable law, no member of the PFM Group, or any officer, employee or associate accepts any liability whatsoever for any direct or consequential loss arising from any use of this material, including for negligence. This material is not intended for distribution to or use by, any person in a jurisdiction where delivery would be contrary to applicable law or regulation, or it is subject to any contractual restriction. No further distribution is permissible without prior consent.

Case study details were provided at your request. You should note the details provided are based on factual information from actual projects that PFMAM completed. It has been provided for general information purposes only and is not intended to provide specific advice or a specific recommendation. The results of individual projects will vary significantly depending upon the size and structure of each fund, permitted investments, prevailing market conditions at the time of the structuring and procurement process, and other events or circumstances beyond the control of PFMAM.

Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities.

The views expressed within this material constitute the perspective and judgment of PFM Asset Management LLC at the time of distribution and are subject to change. Any forecast, projection, or prediction of the market, the economy, economic trends, and equity or fixed-income markets are based upon current options as of the date of issue, and are also subject to change. Opinions and data presented are not necessarily indicative of future event or expected performance. Information contained herein is based on data obtained from recognized statistical services issuer reports or communications, or other sources believed to be reliable. No representation is made as to its accuracy or completeness.

To ensure compliance with U.S. Treasury Regulations governing tax practice, we inform you that any U.S. federal tax advice contained in this communication, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under U.S federal tax law, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. PFM Asset Management LLC cannot provide legal advice, and appropriate professionals should be consulted if such issues are involved. PFM Asset Management LLC is registered with the SEC under the Investment Advisers Act of 1940. A copy of our Form ADV, Parts 2A & 2B is available upon request.

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