i.4.5.3 REQUIREMENT #3 – MANAGE THE ARBITRAGE RULES
The ability to issue tax exempt debt and invest proceeds in the taxable market is called earning “arbitrage.” If investments of bond proceeds earn more interest income than the interest costs of the tax exempt debt, there is “positive arbitrage;” however, if interest income is less than the interest costs of the tax exempt debt, there is “negative arbitrage.” See Chapter 4 – Federal and State Tax Law Requirements. The arbitrage provisions of the Tax Code are designed to ensure that tax exempt bonds are not issued too early, are not issued for an amount more than is reasonably necessary, and are not outstanding too long.
In addition, the Tax Code also places strict limits on the funding of, and investment of monies held in, debt service reserve funds. A debt service reserve fund is a common feature of bonds issued by public agencies. The thrust of the IRS regulatory regime is to reduce or eliminate the opportunity for a public agency to “borrow low” and “invest high.”
In order to prevent tax exempt bonds from being outstanding too long, the Tax Code requires that bonds be issued to finance capital expenditures for which the average time of bond repayment matches up with, or is not much longer than, the average time over which the financed assets are to be enjoyed. In limited circumstances, tax exempt obligations may be used to finance working capital, generally with limits on the term over which the bonds can remain outstanding.
Like the requirements and limitations relating to the use of the financed project, the arbitrage requirements and limitations must be satisfied for the life of the debt or the debt could fail to qualify for tax exemption, retroactive to the date of issuance. As noted, the IRS encourages formal policies and procedures to ensure ongoing compliance.