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Treasury and IRS Release Arbitrage Bond Regulations

On July 18, 2016, the United States Department of the Treasury and the Internal Revenue Service published a package of regulations revising and updating the “arbitrage bond” rules of Section 148 of the Internal Revenue Code. With certain exceptions, Section 148 of the Code generally prohibits the investment of proceeds of tax-exempt bonds at a yield higher than the yield on the bonds and in some cases, when investment at a higher yield is permitted, this provision of the Code also requires the issuer of the bonds to rebate excess earnings to the United States Treasury. The new regulations, which finalized proposed rules that had been circulated in 2007 and 2013, are evolutionary in nature and provide tweaks and modifications to the arbitrage bond regulatory framework that has been in place since the early 1990s.

The new regulations are generally applicable to bonds sold after October 16, 2016, and to interest rate hedging arrangements on tax-exempt bonds that are entered into or modified after that date. In many cases, the provisions of these regulations can also be applied by issuers and borrowers to bonds sold on or before October 16, 2016. It should be noted that this package of regulations does not finalize or otherwise address the proposed regulations on the “issue price” of bonds, which were promulgated by Treasury and the IRS in June 2015.

The following are a few highlights of the new regulations:

Long-Term Working Capital Financings

One of the key aspects of the new regulations is the treatment of long-term tax-exempt working capital financings. Historically, there has been a lack of explicit guidance regarding the structuring of working capital financings with a final maturity beyond a year or two. The new regulations provide additional guidance in this area, setting forth procedures for the monitoring of available cash flows that may be required to be used for the early redemption of bonds issued on a long-term basis for working capital purposes.

This new guidance will be helpful to issuers who are considering issuing bonds to fund structural deficits or otherwise require longer-term principal amortization to fund critical working capital needs.

Interest Rate Hedging Arrangements

Another highlight of the new regulations is the treatment of hedging arrangements with respect to the interest on tax-exempt bonds. Currently, the arbitrage rules permit payments made and received by issuers and borrowers with respect to a “qualified hedge” (i.e., generally, an arrangement entered into primarily to modify an issuer’s risk of interest rate changes on bonds) to be taken into account when computing the yield on the bond issue to which the hedge relates. The new regulations provide a number of improvements in the “housekeeping” associated with qualified hedges, including:

(1) the timing for documenting the so-called “identification” by an issuer that is required under the arbitrage rules (extended from three to 15 days);

(2) continuation of qualified hedge treatment in connection with a refunding of bonds in cases where the terms of the hedge are not being modified at the time of the issuance of refunding bonds; and

(3) specification of certifications required to be obtained from a hedge provider as part of the documentation for a qualified hedge.

The regulations also clarify that a qualified hedge may be based on a taxable index such as the London Interbank Offered Rate (LIBOR).

These new provisions relating to qualified hedge treatment appear by and large to be beneficial to bond issuers and borrowers and should improve the reliability of computing the yield on an issue of tax-exempt bonds with respect to which a hedge has been executed.

Yield Reduction Payments for Advance Refunding Bonds

The new regulations also provide that “yield reduction payments” may be made with respect to a variable yield advance refunding issue in connection with which a qualified hedge has been entered into. This provision, which departs from an historical regulatory paradigm generally mandating fixed-yield advance refundings, offers issuers and borrowers a flexible structuring option permitting them to make payments in the nature of arbitrage rebate payments if and to the extent the investments in a refunding escrow prove to be higher than the yield on the advance refunding bonds funding the escrow.


The preceding is a very brief summary of Treasury’s recently released arbitrage regulations under Section 148 of the Internal Revenue Code. Please contact Antonio Martini at (617) 378-4136 or any other member of Hinckley Allen’s public finance practice group if you would like more information about these regulations, or if you have any tax-exempt bond compliance matter you would like to discuss.