January 9, 2024

Since March 2022, the Federal Reserve has raised its benchmark rate 11 times in an effort to curb inflation. For issuers and borrowers of tax-exempt debt, rising interest rates have a direct impact on the reinvestment of tax-exempt debt proceeds invested in interest-bearing vehicles such as money market funds, local investment pools, and treasury securities and, therefore, on corresponding arbitrage rebate and yield restriction liabilities.

Higher interest rates can be especially problematic for yield restriction compliance. Yield restriction limits the investment yield on certain yield restricted gross proceeds allocable to a bond issue, such as amounts remaining beyond applicable “temporary periods,” sinking funds, and amounts in excess of what is considered a “reasonably required reserve”. Instead of literally restricting the rate at which these amounts are invested, issuers and borrowers, in most instances, can make a yield reduction payment (similar to an arbitrage rebate payment) in order to reduce the overall yield on the investments to the allowable yield.

Because yield restriction starts later in the life of a bond issue, and at the end of the various temporary periods (3 years after the issue date of the bonds for project funds is the most common), the potential for a mismatch in rates is higher than for arbitrage rebate. For example, if an issuer issued bonds in 2021, at a very low rate, prior to when the Fed began raising interest rates, and has a large balance still invested after the temporary period at high investment rates, it is very likely that the issuer will incur a yield restriction liability. Furthermore, because arbitrage rebate and yield restriction apply to similar, but not the exact same proceeds, and for differing periods of time, it is possible for an issuer or borrower to not have positive arbitrage rebate yet still incur a positive yield restriction liability.

The nuances noted above, coupled with the fact that yield restriction has not been a concern for issuers and borrowers for almost 15 years, make this area of tax compliance especially tricky to navigate. Additionally, increased IRS enforcement in this area is expected. To help prepare for potential yield reduction payments and IRS scrutiny, issuers and borrowers of tax-exempt debt should ensure that they are current on their arbitrage rebate and yield restriction analyses, especially for bonds that were issued in the 2019 – 2022 timeframe.

If your organization needs assistance with respect to yield restriction, arbitrage rebate, or any other aspect of post-issuance tax compliance, please contact us.

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