3 Accounting
3.4 Liabilities
3.4.6 Arbitrage Rebates
Overview
3.4.6.10 Any local government may engage in arbitrage by borrowing funds at one interest rate and investing those same funds at a higher rate. The primary reason for arbitrage is that the rates of interest paid on tax exempt debt normally are lower than those paid on taxable securities and it is possible for local governments to profit from this disparity in interest by temporarily reinvesting the proceeds of lower interest tax exempt borrowings in higher yielding taxable securities. The proceeds from those transactions are called arbitrage earnings.
3.4.6.20 When governments reinvest tax-exempt proceeds at a higher, taxable yield, the excess earnings must be remitted to the federal government as arbitrage rebate. There are some important exceptions to this general rule. These special situations are known as safe harbors (e.g., small issuer safe harbor, six-month expenditure safe harbor, eighteen-month expenditure safe harbor, twenty-four month expenditure safe harbor).
3.4.6.30 If a government fails to qualify for one of the safe harbors, it must calculate and rebate arbitrage earnings to the federal government. The tax code requires that arbitrage amounts be calculated and remitted every five years and upon maturity of the debt. For accounting and reporting, the calculation should be performed annually to determine whether a liability needs to be reported on the Schedule of Liabilities (Schedule 09), even if payment is not made to the federal government.
Financial accounting and reporting for arbitrage
3.4.6.40 Rebatable arbitrage should not be recognized in cash basis financial statements as an expenditure until the rebatable amounts are actually paid to the federal government.
3.4.6.50 Each year a liability may be reported on the Schedule 09 with an appropriate increase or decrease as the government calculates the arbitrage rebate annually with a full reduction of this liability in the year of payment. When calculating the amount of the liability, it should be remembered that excess earnings of one year may be offset totally or in part by lesser earnings in a subsequent year. Therefore, the ending liability amount reported on the Schedule 09 for the year should be only the current years calculated amount of the estimated future payment to the federal government.
3.4.6.60 When the arbitrage rebate is paid to the federal government, the reduction of cash and recognition of an expenditure would be reported in the appropriate fund.
592PP80 Expenditures – Arbitrage Rebate Tax $1,000
111.10 Cash $1,000
(To record the payment of arbitrage rebate.)