Compliance with the arbitrage rebate provisions of Internal Revenue Code (IRC) Section 148 has become significantly more important for issuers of tax-exempt bonds than it was during the low-interest-rate environment that prevailed from approximately 2010 through 2021.
The rapid increase in short-term and intermediate-term investment yields since 2022 has materially increased the likelihood that bond proceeds, debt service reserves, and other gross proceeds of tax-exempt bond issues may generate positive arbitrage earnings subject to rebate payments to the U.S. Department of the Treasury.
The What: IRC §148
IRC §148 is intended to prevent issuers from borrowing at tax-exempt rates and investing the proceeds in higher-yielding taxable investments for profit. A tax-exempt bond generally becomes an arbitrage bond if proceeds are invested in materially higher-yielding investments unless specific exceptions or remedial provisions apply.
Under §148(f), issuers generally must calculate and periodically remit to the Treasury the excess earnings generated from investments whose yield exceeds the bond yield. Treasury regulations require rebate computations at least every five years and upon final redemption of the issue.
The Why: Increased Risk
The federal fund rates from 2020 to 2021 were near 0%, and short-term interest rates and yields offered by Treasury and other eligible investments were extremely low.
As a result, the economic incentive to invest bond proceeds was limited since available reinvestment rates were often below bond yields. For example, temporary investment of construction funds often generated minimal earnings. Debt service reserve funds produced little excess return. Negative arbitrage was also common, particularly for long-term fixed rate municipal issues. Finally, many issuers primarily focused on spend-down exceptions instead of significant rebate liabilities.
| Environment | Typical Reinvestment Opportunity | Rebate Risk |
|---|---|---|
| 2015-2021 | Near 0% to 1% | Low |
| 2023-2026 | Approximately 4% to 5%+ | Elevated |
However, with current Treasury, money-market, and investment-grade yields materially higher than those observed during the post financial crisis low-rate period, rebate liabilities can accumulate quickly, especially for construction funds, debt service reserve funds, bond anticipation note proceeds, delayed project spend-downs, and refunding escrows.
Given the fundamental shift in today’s market, and how many tax-exempt municipal bond issues outstanding today had originated during periods when borrowing costs were substantially lower than current reinvestment opportunities, issuers may find themselves earning investment returns meaningfully in excess of bond yields.
This creates positive arbitrage that may result in rebate liabilities, yield restriction concerns, increased record-keeping requirements, and greater IRS examination exposure.
It is important to note that although variable-yield bonds are subject to the arbitrage rebate requirements similar to fixed-rate bonds, there are several rules under IRC §148 that are particularly relevant to the former, and in some cases provide relief that fixed-rate issues do not have.
In general, and as illustrated below, variable-rate bonds often have a higher practical arbitrage rebate risk than fixed-rate bonds, although it depends on the interest rate environment, at the time of issuance and measurement, along with the underlying investment strategy.
| Bond Type | Rebate Risk Exposure |
|---|---|
| Fixed-rate bonds issued during low-rate periods | Very High |
| Variable-rate bonds with long spending periods | High |
| Variable-rate bonds with construction exceptions and rapid spending | Moderate |
| Fixed-rate bonds with immediate spending of proceeds | Low |
The Where: Areas Most Affected
Construction Funds
Large capital projects frequently involve multiyear expenditure schedules. Unspent proceeds may remain invested for extended periods while earning yields significantly above the bond yield. Even when spending exceptions are expected to apply, issuers must carefully monitor compliance because failure to satisfy an exception may trigger substantial rebate obligations.
Debt Service Reserve Funds
Reserve funds that historically generated negligible earnings can now earn several hundred basis points more than in prior years. Over time, these earnings can create meaningful arbitrage balances, particularly for large transportation, education, healthcare, and utility financings.
Refunding & Escrow Investments
Where escrows remain outstanding, the spread between historical bond yields and current reinvestment opportunities may require careful yield restriction analysis. Although state and local government securities (SLGS) continue to provide compliance solutions for many transactions, issuers must document ongoing compliance throughout the life of the issue.
Increased IRS Compliance Focus
The IRS Tax Exempt Bonds program continues to emphasize post-issuance compliance, including arbitrage rebate and yield restriction requirements. IRS guidance specifically identifies understanding and monitoring rebate obligations as a critical component of maintaining tax-exempt status. Failure to comply can jeopardize the tax-exempt treatment of interest on the bonds or require costly closing agreement remedies.
Given the current interest rate environment, issuers that historically had little or no rebate exposure may now accumulate significant rebate liabilities over relatively short periods.
The Next Steps: Practical Recommendations for Issuers
In the current market environment, issuers should consider the following practices to help reduce the risk of unexpected rebate liabilities and demonstrate robust post-issuance compliance procedures.
- Assessing eligibility for available normal scope exceptions, which could include six-month and 18-month spending, two-year construction spending, small issues, or bona fide service funds.
- Performing annual rebate monitoring rather than waiting for the five-year computation date.
- Applying rules and exceptions specific to variable-rate issues.
- Reviewing investment policies for bond proceeds and reserve funds.
- Tracking spending exception requirements in real time.
- Evaluating potential yield reduction payment requirements.
- Maintaining detailed investment and expenditure records.
- Engaging qualified rebate specialists to perform interim liability estimates.
How Forvis Mazars Can Help
The resurgence of higher interest rates has fundamentally altered the arbitrage landscape for tax-exempt bond issuers. During the low-rate years preceding 2022, rebate liabilities were often minimal because reinvestment opportunities rarely exceeded bond yields by meaningful amounts. Today, with short-term and intermediate-term investment rates in the 4 to 5% range, unspent bond proceeds and reserve funds are more likely to generate positive arbitrage.
As a result, arbitrage rebate compliance under IRC §148 has evolved from a routine administrative requirement into a significant financial and tax risk management function. Issuers that proactively monitor rebate exposure, maintain strong records, and perform periodic computations may be better positioned to preserve the tax-exempt status of their bonds and avoid costly compliance issues.
The arbitrage rebate services team at Forvis Mazars can help issuers monitor and compute potential arbitrage rebate exposures. For more information, please reach out to a professional at the firm.