2. Invest the Proceeds: The district invests the money raised from issuing bonds or other debt in short-term investments or other financial instruments. These investments might earn a return, such as interest on a U.S. Treasury Bond.
3. Earn Arbitrage: The district typically borrows the money at a certain interest rate (the debt's interest rate). If the district can invest the borrowed money at a higher return rate (for example, in short-term investments), it makes a “profit” from the difference. This “profit” is arbitrage.
If borrowed funds are spent quickly enough, the arbitrage earned may be maintained by the district, which profits from the gap between borrowing costs and the returns on investments.
Example:
- The district issues bonds at a 1.75% interest rate.
- The funds raised are invested in a short-term instrument that gives a 4.00% return.
- The difference, 4.00% – 1.75% = 2.25%, is considered arbitrage under IRS regulations.
Generally, a school district would have to pay this amount back to the IRS on the five-year anniversary of the debt; however, exceptions allow districts to keep the arbitrage. These exceptions involve how quickly the district spends the money. If borrowed funds are spent quickly enough, the arbitrage earned may be maintained by the district, which profits from the gap between borrowing costs and the returns on investments.
We’ve seen investment returns increase significantly in recent months. This has allowed many school districts that borrowed beginning in 2020, when long-term borrowing rates were at all-time lows, to take advantage of increased investment rates, but it is essential to keep these exceptions in mind; otherwise, the district may have an unexpected arbitrage rebate payment due to the IRS five years after the borrowing.
Expert Guidance
The good news is that experts and professionals are always available to analyze your district’s information and assess if arbitrage may be an issue, often at no cost to the district.
Contract with a firm to perform this analysis within two to three years of the bond issue. To complete a basic assessment, the firm may ask you to provide a copy of the Tax Certificate and Agreement for the bond issue and a copy of Form 8038-G executed during the bond's closing.
Based on the firm’s assessment, your district may decide to enter into a formal agreement with the firm to review the information and calculate what amounts may be owed to the IRS for your arbitrage profit.
When you formally enlist the help of a firm to analyze your district’s information related to the bond issue and investment earnings, you’ll be asked to provide a few items. From my experience, I suggest gathering these documents along the way and saving them in anticipation of the review process. It was difficult for us to gather documentation up to three years old on accounts that had been closed during a bank buyout and pull old paper files to make copies during our district’s initial assessment.
The items you should gather and keep up with electronically are:
- Bank statements of bond proceeds (from initial deposit forward) are held in a segregated account.
- Investment statements of bond proceeds.
- Banking analysis statements showing fees associated with the bond proceeds account.
After the firm has reviewed the information, they will likely provide a formal report detailing your district’s arbitrage profit, what will be owed to the IRS, and when.
Working with a credible professional and having your documentation organized and ready for review can make all the difference in easing this process.