Memorandum

City of Lawrence

Finance Department

TO:	Diane Stoddard, Interim City Manager
FROM:	Bryan Kidney, Finance Director
Date:	August 24, 2015
RE:	Arbitrage liability for the 2005 Revenue Bonds

When the City issues tax-exempt debt, proceeds are invested to earn interest in an effort to help keep project costs low. Tax-exempt issuers are limited to earning interest up the amount of interest expense on that outstanding debt. Over the life of the tax-exempt bonds we are required to track and remit to the IRS any excess interest earned on investments. Interest earned over the amount of interest paid on outstanding debt is referred to as arbitrage. Positive arbitrage occurs on tax-exempt debt due to the interest rates on tax-exempt debt being much lower than the interest rate on taxable debt.

Arbitrage is a normal occurrence but having an arbitrage liability due to the IRS has typically not been a concern for any debt issued after 2008. This is because interest rates on debt proceeds dropped dramatically after that time. However, debt issued prior to 2008 and still held by the City could have had an arbitrage liability for the first several years after the bonds were issued as shown on the following chart.

IRS rules require for a calculation be done on all tax-exempt debt at least every five years over the life of the bonds. If it is determined that an arbitrage liability exists at any of the five-year periods, the excess arbitrage earnings are remitted to the IRS. At the end of the life of the bond, a final calculation will be done. If no liability exists, a refund for previous arbitrage remitted is obtained from the IRS. 

From 2005-2010 the City earned a large amount of interest income on the proceeds of the 2005 bonds. While earning the interest is allowed, the City earned $44,101 more than interest expenditures requiring a remittance to the IRS. However, the City did not do the five-year calculation for the 2005 Revenue Bonds as required in 2010. The overall liability for the life of the bonds is zero. However, there should have been $44,101 of positive arbitrage liability remitted to the IRS in 2010 for the excess earnings for the period 2005-2010.

This omission was discovered this month when the City’s financial advisor prepared the final arbitrage calculation as part of closing the refunded 2005 bonds. Staff is preparing an arbitrage liability remittance to the IRS in the amount of $44,101 originally due in 2010. There is also an additional $7,358 of interest is owed to the IRS for the missed remit in 2010. From 2010-2015 the City incurred negative arbitrage of $575,504. As a result the total liability for the 2005 bonds is zero. Therefore, staff is preparing a tax refund request for the $44,101.

Since the City should have remitted the arbitrage rebate to the IRS in 2010 we have no choice but pay the interest due for the missed remit. The City is also liable for a penalty up to 50% of the liability owed. Staff is preparing a request to the IRS to waive any and all penalties that the City may be subject to. The penalty is generally waived if the remit amount plus interest is paid within 180 days of discovery of the failure.

A comprehensive arbitrage liability review began this past spring and will be completed by the end of October. We are working with, Springsted Inc. our finance advisor, to ensure compliance with arbitrage rules. Springsted Inc. will prepare the arbitrage calculations and review all outstanding issues for compliance. It is likely there will be additional arbitrage compliance issues throughout this review. However, due to the low interest rates earned on investments it’s expected that the financial impact would be minimal.