Legal Alert

Increased Interest Rates May Require Special Districts to Rebate Earnings on, or Change Investments of, Tax-Exempt Bond Proceeds

by Kim Reed, Marybeth Orsini, and Anastasia Khokhryakova
March 23, 2023

Since March 2022, the Federal Reserve has gradually raised interest rates in its ongoing fight against inflation and has indicated plans to continue increasing rates through 2023. Due to this rising interest rate environment, special districts that have issued tax-exempt bonds, notes, or other obligations (the Tax-Exempt Obligations) may be more likely to earn interest at a rate above the yield on such Tax-Exempt Obligations. Districts should review and monitor the current state of their investments for any accounts holding proceeds of, or revenues pledged to the payment of, Tax-Exempt Obligations to ensure compliance with applicable yield restriction and rebate rules under Section 148 of the Internal Revenue Code of 1986, as amended (Code). Compliance with these sets of rules is required in order to ensure compliance with the covenants made by districts in their tax certificates and to maintain the exempt status of the interest on the Tax-Exempt Obligations. A brief description of these rules follows.

Yield Restriction (a/k/a Can I Earn the Money?)

This set of rules generally serves to restrict the investment of moneys associated with Tax-Exempt Obligations to earn a yield, in the taxable investment market, not in excess of the yield on such Tax-Exempt Obligations (sometimes, plus a small spread). There are some limited exceptions to the yield restriction rules.

Rebate (a/k/a Can I Keep the Money?)

This set of rules generally serves to require that amounts earned in excess of the bond yield be paid to the United States Treasury. Such payments, if due, are required to be paid every five years (or more frequently, if elected). There are some limited exceptions to the rebate requirement.

Districts should review each Tax-Exempt Obligation and the related funds and accounts carefully and in consultation with their bond counsel, general counsel, and accounting team relative to the yield restriction and rebate rules. Districts may need to provide alternative investment instructions for funds subject to yield restriction. Districts may also consider identifying now whether a rebate is anticipated to be payable in coming years, and the anticipated source of payment. At a high level, some particular areas of potential concern include:

  • Project Fund: Moneys held in a project fund are typically exempt from yield restriction requirements, as provided in the tax certificate executed at closing. However, such funds are subject to rebate, unless a spending exception is met.
  • Reserve Fund: Moneys held in a debt service reserve fund are often exempt from yield restriction to the extent such moneys do not exceed a certain dollar threshold. However, such funds are subject to rebate.
  • Surplus Fund: If your transaction included a surplus fund, it is likely that the tax certificate provides that some or all of the moneys in this fund may not be invested at a yield in excess of the yield on the Tax-Exempt Obligations. Such funds are also subject to rebate.
  • Other Trustee-Held Moneys: Some deals include intricate flow of funds provisions that apply pledged revenues to a series of funds and accounts in a specified priority, with residual moneys being retained in a subordinate or other fund held by the trustee, subject to disbursement to other uses upon the district’s direction or request. In such cases, in the event that the district does not direct the disbursement of such residual moneys promptly, retention of such moneys by the trustee may inadvertently create a fund that is subject to yield restriction (i.e., it must be invested at a yield not in excess of the yield on the Tax-Exempt Obligations).
  • Sources of Rebate Payment: While some deals provide for the funding of rebate payments from pledged revenue in the flow of funds, others (including many deals secured primarily by property tax revenues) do not and will, therefore, require funding of rebate payments from general fund mill levy or other revenue sources.

The Ballard Spahr Special District Team is available to answer any of your questions with respect to how these rules apply to your Tax-Exempt Obligations. Please contact any of our Special District Team partners listed above.

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