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Traditionally, issuers have hired a rebate analyst shortly before the first rebate installment payment must be paid. Thus, the issuer usually begins focusing on rebate approximately 5 years after the bonds are issued. This approach may lead to practical difficulties, such as obtaining investment information and data on bond expenditures that are up to five years old. In addition, some issuers are surprised by the size of the rebate liability, particularly in situations where the issue was expected to qualify for a rebate spending exception, but failed to meet any of the required spending targets.
A better approach is to hire the rebate analyst at the time bonds are issued. Issuers who take this step typically benefit in several respects. First, unanticipated accounting and record keeping problems can be identified and corrected before they become a major issue. Second, lost or missing records or statements are much easier to retrieve. Finally, by periodically tracking expenditures of bond proceeds and the accrued rebate liability, issuers are in a position to make timely accounting elections or to take other corrective action that can reduce the amount of rebate that ultimately must be paid to the United States.
"Rebate" is a term used in the Internal Revenue Code to describe a governmental issuer's obligation to pay or "rebate" to the United States a dollar amount representing the "excess earnings" on the investment of proceeds of debt obligations and certain other related amounts. Rebate is not a true "tax" on state or local governments, because the IRS cannot enforce its payment. Payment of rebate (and in some cases related penalties and interest), however, is a condition to a debt obligation maintaining its tax-exempt status.
"Rebate" is a calculated dollar amount representing the difference between the amount the issuer earned from the investment of certain funds related to the bond issue and the amount the issuer would have earned had those same funds been invested at an interest rate equal to the yield on the bond issue. Funds subject to rebate are generally called "gross proceeds," which includes three broad categories of funds: (i) proceeds received from the sale of the bonds and money realized from the investment of those sale proceeds (sometimes referred to as "bond proceeds"); (ii) funds that are either expected to be used to pay debt service on the bonds or that are held pursuant to a legal or economic arrangement pursuant to which bondholders have a reasonable assurance that the money will be available to pay debt service even if the issuer has financial difficulty (sometimes referred to as "pledged funds"); and (iii) funds that were previously "bond proceeds" of another bond issue that are said to "transfer" to a bond issue that refinances the prior issue (usually referred to as "transferred proceeds").
That depends on how certain you are that you can prove that there is no rebate liability. The IRS has an ongoing bond audit program to determine compliance with tax-exempt bond requirements. As part of that audit process, the IRS generally asks the issuer for a rebate computation, or evidence that the bonds are exempt from rebate. Thus, the issuer must be able to show that the bond issue has no rebate liability. Typically, the most practical way of doing that is a completed rebate computation or spending exception analysis.
Typically the easiest way to account for the investment of gross proceeds of a bond issue is to segregate the gross proceeds in a separate account and to invest and reinvest the funds in the account separately until they are spent. Segregation and specific tracing of gross proceeds is not, however, required by IRS regulations, and in many cases is not practical (or even legal) from a governmental accounting standpoint. In any case where gross proceeds of a bond issue are to be commingled with other funds (including other bond issues), the issuer must keep accurate accounting records for all investments in the commingled fund or account.
Ideally, the issuer's records should show the following information:
- The amount, date and type of any investment that is purchased.
- The amount and date of any interest payments received on the investments.
- The amount and date of any payment received upon the sale or redemption of an investment.
- A running balance of the total funds invested in the commingled fund or account.
- A running balance of uninvested funds (if any) in the fund or account.
- The date and amount of all deposits to and withdrawals of cash from the commingled fund or account.
Issuers should not assume, however, that a bank will be able to retrieve or reconstruct investment information contained in the trust report indefinitely. Gilmore & Bell has arrangements with some trustees that, with issuer consent, provide the Firm with ongoing access to trust account investment information for purposes of updating rebate computations.
When gross proceeds of a bond issue have been "allocated to an expenditure" (spent) they are no longer subject to rebate. The vast majority of issuers account for expenditures by specifically tracing the use of bond proceeds to a particular invoice or check. This "specific tracing" method is the default rule that applies under United States Treasury Regulations if an issuer has not elected a different method of accounting for the expenditure of bond proceeds. However, in some cases specific tracing may not produce the lowest overall rebate liability for an issuer. For example, an issuer may find that gross proceeds are "spent" much faster (and thus the rebate liability is lower) if it assumes that gross proceeds of a bond issue are spent first on the project, in advance of other available funds such as grants or surplus tax revenues.
We have generally found it to be difficult to arrive at the optimal allocation method until the financed project has been completed. Fortunately, United States Treasury Regulations permit an issuer to delay any final decision on allocating gross proceeds to expenditures for a reasonable period of time (generally not more than 18 months following the project completion date).
Technically, there is only one exception an issuer can use to exclude a bond issue from the arbitrage rebate requirement. This exception applies only to certain governmental purpose "small issues" issued by "small issuers." Most bond counsel will tell the issuer whether this exception applies at the time the bonds are issued, and the arbitrage certificate and/or the tax compliance agreement will often affirmatively describe this exception as well. The small issue exception applies on an issue-by-issue basis, and the fact that one particular bond issue is exempt from rebate is not a guaranty that any other issue will qualify.
Even though there is only one exception that can exclude a bond issue from the rebate calculation, there are a number of exceptions that permit issuers to exclude certain types of gross proceeds from the rebate computation. If all funds are subject to one or more of these exclusions, then as a practical matter the bond issue will have no rebate liability. The issuer must, however, meet a number of technical rules and requirements after the bonds are issued in order to use these exceptions. Thus, it is usually impossible to know, as of the issue date of the bonds, whether a particular rebate exception will apply.
Some funds and accounts can be excluded, either in whole or in part, from the rebate computation. Here is a brief summary:
Bona Fide Debt Service Funds
Subject to certain exceptions, no rebate is paid on the investment of gross proceeds in a "bona fide debt service fund." A "bona fide debt service fund" is a fund (or a portion of a fund) that the issuer uses to match the receipt of revenues and the payment of debt service. To qualify for the exception, the fund (or portion of the fund) must be depleted at least once each year to an amount that does not exceed 1/12th of the debt service on the bonds for the year or the investment earnings in the fund (whichever is greater).
Adjusted Gross Proceeds -- The 6-Month Spending Exception
No rebate needs to be paid on the investment of the "adjusted gross proceeds" of a bond issue, if all "adjusted gross proceeds" are spent within 6 months of the issue date. "Adjusted gross proceeds" does not include amounts held in a bona fide debt service fund or a reasonably required reserve fund, and rebate must be calculated on those funds if they do not meet a spending exception.
Adjusted Gross Proceeds -- The 18-Month Spending Exception
No rebate needs to be paid on the investment of the "adjusted gross proceeds" on many bond issues if the following percentage of adjusted gross proceeds are spent by the deadlines set forth below:
| Period Following Issue Date | Percentage of Adjusted Gross Proceeds Spent |
| 6 Months | 15% |
| 12 Months | 60% |
| 18 Months | 100% |
"Adjusted gross proceeds" generally is defined in the same way as used for the 6-month spending exception. As with the 6-month spending exception, rebate must be computed and paid on any amounts that are not included in the definition of adjusted gross proceeds.
Available Construction Proceeds -- The 2-Year Spending Exception
No rebate needs to be paid on the investment of "available construction proceeds" of a "construction issue" if certain spending percentages are met. A "construction issue" is any issue (or portion of an issue) where the issuer reasonably expects to spend at least 75% of the available construction proceeds on construction expenditures for property owned by a governmental unit or non-profit, 501(c)(3) organization.
The percentages of available construction proceeds that must be spent and the spending dates are set forth below:
| Period Following Issue Date | Percentage of Available Construction Proceeds Spent |
| 6 Months | 10% |
| 12 Months | 45% |
| 18 Months | 75% |
| 24 Months | 100% |
As with the 6-month and 18-month spending exceptions, rebate generally must be paid on gross proceeds of the bonds that are not included in available construction proceeds, although no rebate needs to be paid with respect to gross proceeds used to pay costs of issuing the bonds if the 2-year spending exception is satisfied.
Gross Proceeds Invested in Tax-Exempt Obligations
Rebate does not apply to any investment of gross proceeds in certain tax-exempt obligations. Tax-exempt obligations include direct investments in tax-exempt bonds, notes, certificates, etc. as well as certain tax-exempt money market funds.
At a minimum, rebate usually needs to be calculated prior to each rebate payment date. In many cases, however, issuers can benefit from computing rebate more often -- either annually or shortly after the issuer has spent substantially all of the bond proceeds. In revenue bond issues or large complicated transactions, we recommend that rebate be computed once each year as long as there are invested gross proceeds that are subject to rebate. In an increasing number of cases, outside auditors and trustees are requiring that issuers annually compute and reserve against their rebate liability.
Not necessarily. Gilmore & Bell's charges for rebate computation services are based in large part on the number of years for which the issuer has invested gross proceeds that are subject to rebate. Thus, whether the computations are done once a year or once every five years, the aggregate cost to the issuer is usually about the same. This can be particularly true when the time and effort of finding and assembling five years of accounting information is considered. More importantly, keeping track of arbitrage compliance on an ongoing basis can cost far less in the long run, when one considers the amount of rebate the issuer must pay. The cost of failing to make a timely accounting election, or failing to make an expenditure in time to take advantage of a spending exception, because the issuer didn't know where it stood in terms of arbitrage compliance, can cost an issuer thousands of dollars in additional rebate liability.
Rebate must be paid no later than 60 days following the fifth anniversary of the issue date (60 days following the end of the fifth bond year in the case of variable rate obligations). In some cases, however, when all gross proceeds have been spent, it may be best for the issuer to pay rebate liability in advance of the due date. Typically, no further rebate computations are required.
For a fee quote or for more information about Gilmore & Bell, P.C. Arbitrage Compliance Services, contact Sandy Gulley or Heather League at (816) 221-1000 or email at sgulley@gilmorebell.com or hleague@gilmorebell.com.