Understanding Arbitrage California Debt and Investment Advisory Commission March 14th 2008 Anne Pelej, MuniFinancial “Muni Interest Tax Exemption to Cost Government $35B in ’09” … The Bond Buyer 2/5/08 2 Taxable Bonds Tax-Exempt Bonds Bondholder Bondholder Interest Interest IRS IRS 3 Proceed Tax-Exempt Bonds Investment Arbitrage Yield Discount Rate at which Investment Earnings PV of Total Debt Service Taxable Securities Equals Issue Price Arbitrage Rebate IRS 4 Consequences of Noncompliance • Stiff penalties are imposed if arbitrage payments are late or yield restrictions are violated. • Non-payment of arbitrage rebate may affect the tax-exempt status of the bonds. • IRS reserves the right to audit any tax-exempt bond for arbitrage rebate compliance even after the bonds have been fully redeemed. 5 Advantages to Implementing an Effective Arbitrage Reporting Program • Paying rebate means investment earnings are maximized, which provides additional funds to complete projects or to pay debt service. • Being prepared for refinancings and IRS audits which can occur at any point during the life of the bond or beyond. • Being in compliance with bond document covenants. 6 7 “It’s funny how two intelligent people can have such opposite interpretations of the tax code!” Proposed Regulatory Changes • Changes to accommodate certain hedges • Electronic GIC Bidding • Recovery of Overpayments • Yield Reduction Payments Allowed on Advance Refunding Escrows • Increased Computation Credit 8 Hedge Rules • Makes taxable-index hedges eligible for simple integration but not super-integration • Creates a two part qualifying test – Difference between the variable bond rate and the taxable index hedge is not greater than .25% – 3 year retrospective comparison of actual variable rate and the floating rate on the hedge 9 What is Arbitrage Rebate?