The Internal Revenue Code’s (IRC) arbitrage rules govern how tax-exempt bond proceeds, as well as revenues for debt service payments, may be invested. Generally, the investment earnings on tax-exempt bond proceeds that earn a higher interest rate than the interest rate on the original bond issue are called “arbitrage” earnings. Bond issuers may be limited in the arbitrage they can earn and keep without the related bonds becoming taxable.
When a school district levies taxes to make bond payments (e.g., principal and interest), the tax revenues are deposited into a debt service fund that holds the tax revenues until they are used to make debt service payments. A school district also may, subject to IRC requirements, invest monies held in a debt service fund.
One exception to the IRC’s arbitrage limitation rules is the use of a “bona fide debt service fund,” which allows an issuer to invest funds that will be used to make debt service payments for a temporary period without any investment yield restrictions. Under the IRC, a bona fide debt service fund is used primarily to ensure that tax revenues from the debt levy will match with principal and interest payments within each bond year (for school districts, the bond year is generally May 1 through the following April 30). Tax revenues held in a debt service fund may be invested at an unrestricted yield for 13 months after deposit.
A debt service fund, in order to be considered “bona fide,” must meet certain key requirements. First, the fund must be used primarily to achieve a proper matching of revenue (e.g., debt levy) and debt service payments within each bond year. To ensure proper matching, the debt levy rate should be analyzed each year and adjusted as necessary to generate revenue sufficient for the upcoming principal and interest payments.
Second, at least once each bond year, the fund must be depleted, except for a reasonable carryover amount. To be considered reasonable, the carryover amount cannot exceed the greater of either: (1) the earnings on the fund for the immediate preceding bond year; or (2) one-twelfth (8.3%) of the principal and interest payments that were made during the immediately preceding bond year.
Given those requirements, one common issue that can jeopardize a debt service fund’s “bona fide” status is the over-levy of debt millage. If a school district levies significantly more debt millage than is needed to satisfy upcoming debt service payments, it risks not sufficiently depleting the debt service fund as required by the IRC. If not sufficiently depleted, the fund may no longer be considered “bona fide.” Without the “bona fide” status, the investment of money in the fund would need to be capped at 1/1000 of a percentage point above the “arbitrage yield” on the bonds or risk the IRS designating the bonds (and the interest) as taxable. Losing the tax-exempt designation on bonds would likely violate covenants and representations made by the school district when it issued the bonds. That would also result in the school district facing legal challenges from bond holders as well as scrutiny from the IRS.
Because we have been in a historically low interest rate environment, the risk of non-bona fide debt service funds generating arbitrage has been negligible for many years. If interest rates climb in the future, that risk will increase. We recommend that school officials ask the district’s financial advisory firm to review their debt levy each year to ensure that the millage rate corresponds to anticipated debt service payments for the current bond year. If there is an over-levy, school districts should contact bond counsel to determine what adjustments are necessary to comply with the IRC’s arbitrage rules.