Arbitrage penalties may be expensive, consultant warns finance officials.

WASHINGTON--Paying a penalty under the arbitrage rebate relief law may be far more costly for state and local issuers than rebating the arbitrage, a consultant from a major accounting firm warned public finance officials meeting in Orlando.

"Be sure you understand that the consequences of the penalty can be unfortunate and not real popular with your board of county commissioners," cautioned Margaret Purcell, manager of Ernst & Young's national capital markets group in Jacksonville.

The Orlando meeting was sponsored by the Florida Public Finance Network and the Florida Government Finance Officers Association.

The accountant's comments follow similar warnings by Internal Revenue Service officials at industry meetings. In the current interest rate environment, issuers may not be able to invest bond proceeds at short-term rates that are high enough to cover their debt service payments and may wind up losing money, rather than earning arbitrage.

Having to pay penalties under the rebate relief law on top of losing money "adds insult to injury," an IRS official agreed yesterday.

IRS officials and arbitrage consultants such as Ms. Purcell are warning issuers to remember that if they choose penalties over arbitrage rebate under the rebate relief law, the choice is irrevocable.

The rebate relief law generally exempts issuers financing construction projects with governmental and 501(c)(3) bonds from arbitrage rebate requirements if they spend most of their bond proceeds within two years.

Issuers who opt to issue bonds undeer the rebate relief law must choose at the time of issuance, whether they want to pay penalties or be subject to rebate requirements if they miss the spend-down targets. They must spend 10% of their proceeds within six months of issuance, 45% in one year, 75% in 18 months, and 100% in two years, but under certain circumstances are allowed to retain 5% of proceeds for an additional year.

Ms. Purcell showed public finance officials at the meeting on Monday how a hypothetical issuer, Libertyland, faced potential penalties of $1.35 million after it issued $26 million of general obligation bonds under the rebate relief law and then missed the spend-down targets.

Libertyland, which had unspent bond proceeds at the end of its temporary period, was able to limit its penalty payments to $366,603 by making a "termination" payment equal to 3% of the unspent proceeds multiplied by the number of years in the temporary period, she said. The temporary period is the three-or five-year construction period during which issuers can earn arbitrage on invested bond proceeds.

But Libertyland's $366,603 penalty payment was more than 15 times greater than the $23,157 in arbitrage profits that it would have had to rebate had it chosen the rebate instead of paying a penalty. The arbitrage profits resulted from investing the bond proceeds in a money market fund.

Ms. Purcell said record keeping presents one of the biggest challenges for issuers trying to comply with the arbitrage rebate requirements. Issuers need to keep good records on their bond transactions for many years, she said. The arbitrage rebate rules that were published in 1989 require issuers to keep closing documents until six years after their bonds mature if they reduced their arbitrage liability by making one of the elections offered under the rules, such as an election to do computations for variable-rate bonds annually instead of every five years.

Issuers doing arbitrage computations on an issue should have the official statement, the indenture, the non-arbitrage certificate, transaction reports or monthly statements on all trustee accounts, instructions from bond counsel, and detailed information about individual investments of proceeds, she said.

"For the few ostriches now appearing" that have discovered they must do arbitrage computations after years of avoiding them, "going back five years after the fact without records is tough," she said.

The accountant also said some issuers are not setting up bona fide debt service funds for their tax-exempt issues, which would be exempt from rebate requirements. Issuers can set up bona fide debt service funds to help match revenues and debt service payments during a year. These funds are exempt from rebate if the annual earnings from their investment is less than $100,000. But if they do not set up such funds, all debt service is subject to rebate requirements.

"Other pitfalls that we see on an ongoing basis," she said, include issuers with refunding escrows that have unexpectedly earned arbitrage because the escrows were invested too close to the bond yield. Transferred proceeds problems also result from advance refundings when issuers do not spend all of their earliers bond proceeds, she said.

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