Arbitrage Compliance

Arbitrage is the profit made from buying something in one market and selling it in another. In the case of municipal bonds, it is the profit made using tax-exempt bond proceeds and investing them in taxable investments. In other words, any interest earned or gains on taxable investments in excess of the arbitrage bond yield is considered arbitrage.

Generally, arbitrage is prohibited by the IRS Codes; however, there are a few exceptions and allowances in certain limited circumstances. Any arbitrage generated cannot be kept and must be paid to the US Treasury in the form of Arbitrage Rebate and Yield Reduction Payments. These payments are due every five years and on the final redemption date or maturity of the bond issue.

Non-compliance of arbitrage rebate can have stiff penalties, and it may affect the tax-exempt status of the bonds. Furthermore, the IRS reserves the right to audit any tax-exempt bond for arbitrage compliance up to 3 years after the bonds have matured. In the event of a refunding, the IRS can audit both the refunding and refunded bonds up to 3 years after the final maturity of the refunding bond.

K&G Public Finance evaluates bond funds subject to the arbitrage regulations and prepares arbitrage compliance reports to determine any payment liability for our clients.