Arbitrage Rebates

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 financial statements and on the Schedule of Liabilities (Schedule 09).

Financial accounting and reporting for arbitrage

3.4.6.40 Arbitrage rebates are treated in the same way as any other claims or judgments and are not recognized in the governmental fund financial statements as a liability and expenditure until the rebatable amounts are actually due. [1] For full accrual financial statements, the government wide and proprietary fund statements, report the liability and recognize the expenditure for the calculated arbitrage rebate amounts.

3.4.6.60 The rebatable arbitrage is treated as a tax payment to the federal government, since the earning of interest revenue and the incurrence of a tax liability are considered two separate transactions.

Recording transactions in a governmental fund, following the modified accrual basis of accounting:

When the arbitrage rebate is determined to be payable (every five years or upon maturity of the debt), the governmental funds would recognize a liability and expenditure in the appropriate governmental fund.

592PP80                       Expenditures – Arbitrage Rebate Tax                           $900
                   231.20                           Arbitrage Rebate Tax Payable                                  $900
(To record the accrued arbitrage rebate expenditure.)

When the arbitrage rebate is paid, the governmental funds would recognize a liquidation of the liability and outflow of cash in the appropriate governmental fund.

231.20                           Arbitrage Rebate Tax Payable                                        $900
                   111.10                                Cash                                                                         $900
(To record the payment of accrued arbitrage rebate expenditure to the federal government.)

3.4.6.70 In the full accrual basis of accounting, the rebatable arbitrage is reported as a long-term liability on the government-wide and proprietary statements of net position until due and payable to the federal government.  When the payable is due within one year, the liability would be considered a current liability.

592PP80                       Expense – Arbitrage Rebate Tax                                     $1,000
                   263.72                        Non-current Arbitrage Rebate Tax Payable                 $1,000
(To record the current period accrued arbitrage rebate expense and add to liability)

Note: in a year where the arbitrage rebate tax liability is less than previously reported due to accumulative lower excess earnings as discussed in 3.4.6.50 the entry would be as follows:

263.72                           Non-current Arbitrage Rebate Tax Payable                     $100
                   592PP80                        Expense – Arbitrage Rebate Tax                                $100
(To record the current period arbitrage rebate liability reduction)

263.72                           Non-current Arbitrage Rebate Tax Payable                     $900
                   111.10                        Cash                                                                                    $900
(To record the payment of 5-years of accrued arbitrage rebate expense to the federal government.)

Footnotes

[1] Under the modified accrual basis of accounting, claims and judgments are recognized as liabilities in governmental funds only when they become due for payment (GASB Cod. Sec. 1600, “Basis of Accounting”).
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