THE SHORT ANSWER
A yield reduction payment is an amount paid to the United States that is treated as a payment for an investment reducing its yield, under Treas. Reg. §1.148-5(c)(1). It lets an issuer satisfy yield restriction without restricting the actual investment rate, but only for the investment categories listed in §1.148-5(c)(3), paid on the rebate installment schedule and reported on Form 8038-T.
A yield reduction payment is an amount paid to the United States that the Treasury regulations treat as a payment for an investment and that reduces the yield on that investment, under Treas. Reg. §1.148-5(c)(1), and it lets an issuer satisfy yield restriction without restricting the actual investment rate.
The payments are available only for the investment categories listed in §1.148-5(c)(3), they are due on the rebate installment schedule under §1.148-5(c)(2)(i), and the IRS collects them on Form 8038-T.
They sit inside the federal arbitrage rules for bond proceeds, which test an issue independently for yield restriction and rebate.
The stakes come from the Code itself: section 148(a)(1) treats a bond as an arbitrage bond when any portion of the issue's proceeds are reasonably expected, at the time of issuance, to be used to acquire higher yielding investments, with intentional use treated the same, and 26 U.S.C. §103(b)(2) denies arbitrage bonds the interest exclusion that §103(a) provides.
Earning a higher yield is permitted in several circumstances, including temporary periods, the reserve fund and the minor portion, so the question is whether a particular investment sits outside those allowances.
What is a yield reduction payment?
Under Treas. Reg. §1.148-5(c)(1), any amount paid to the United States in accordance with paragraph (c), including a rebate amount, is treated as a payment for the investment that reduces the yield on that investment.
The mechanism substitutes a payment for a rate: rather than moving proceeds into investments that stay under the permitted line, the issuer pays an amount the regulation treats as reducing the investment's yield, leaving the investment's rate unchanged.
The permitted line for most investments comes from Treas. Reg. §1.148-2(d)(2)(i), which provides that materially higher means one-eighth of 1 percentage point above the bond yield, or 12.5 basis points, for investments not otherwise described in that paragraph.
A payment addresses the yield restriction test only: IRS Publication 5271, which states on its face that it is not formal guidance, explains that bonds are tested under both the yield restriction rules of section 148(a) and the rebate rules of section 148(f), and that bonds failing either set are arbitrage bonds.
The payment also stays in the rebate arithmetic, because Treas. Reg. §1.148-3(d)(1) counts yield reduction payments among an issue's payments, alongside amounts paid to buy nonpurpose investments, the value of investments first allocated to the issue and any computation credit.
Which investments are eligible for a yield reduction payment?
Treas. Reg. §1.148-5(c)(3) lists the categories eligible for the payment route, and an investment outside those categories has no yield reduction payment available.
| Category in §1.148-5(c)(3) | Where the rule is |
|---|---|
| Nonpurpose investments of proceeds that qualified for the capital project, working capital, pooled financing or investment-proceeds temporary periods | §1.148-5(c)(3) |
| Certain variable-yield issues | §1.148-5(c)(3) |
| Certain transferred proceeds | §1.148-5(c)(3) |
| Reserve fund investments, subject to the §1.148-5(c)(3)(v) limits described below | §1.148-5(c)(3)(v) |
| Investments agreed to when SLGS sales are suspended | §1.148-5(c)(3)(viii) |
The regulation lists other categories as well, and that list is the boundary of the payment route.
For a reserve fund, the route is open only to the extent the value of the fund's nonpurpose investments is not greater than 15 percent of the stated principal amount of the issue, or the fund is not expected to pay debt service except as the required balance declines, under §1.148-5(c)(3)(v)(A)-(B).
The suspension category covers investments the issuer agreed to buy on a date when it was unable to subscribe for State and Local Government Series (SLGS) securities because the U.S. Department of the Treasury, Bureau of the Fiscal Service, had suspended sales of those securities, under §1.148-5(c)(3)(viii).
The companion bidding rule, §1.148-5(d)(6)(iii)(C)(2)(iii), also provides that the fair-market-value safe harbor's lowest-cost-versus-SLGS comparison is not required for those investments.
The route is not available for every investment: §1.148-5(c) generally excludes gross proceeds of advance refunding issues except as expressly provided, and the Instructions for Form 8038-T direct issuers with ineligible excess yield, such as an incorrectly invested advance refunding escrow, to the Voluntary Closing Agreement Program (VCAP).
When are yield reduction payments due, and how are they filed?
Treas. Reg. §1.148-5(c)(2)(i) requires yield reduction payments to be made on or before the date of the required rebate installment payments described in §§1.148-3(f), (g) and (h), and they are filed on Form 8038-T.
The installment dates themselves are the dates the rebate rules set, which the rebate requirement page covers in detail.
For purpose investments, §1.148-5(c)(2)(ii) delays the schedule: nothing is due until the earlier of the end of the 10th bond year or 60 days after the issue is retired, and interim payments need not exceed 75 percent of the amount otherwise payable.
The Instructions for Form 8038-T (Rev. 10/2021) say issuers of tax-exempt bonds and other bonds subject to section 148 use the form to make arbitrage rebate and related payments: the rebate itself, yield reduction payments, the penalty in lieu of rebate, the penalty to end that election, and late-payment penalties and interest.
A separate form is used for each issue, and the Rev. 10/2021 instructions route the form to the Internal Revenue Service Center, Ogden, UT 84201-0027, with the check payable to United States Treasury.
The address above comes from the Rev. 10/2021 instructions, and IRS.gov/Form8038T is where to check for any newer revision of the form.
How does a yield reduction payment compare with restricting the investment?
When an investment's yield runs above the permitted line, two routes are available: restricting the investment so its yield is not materially higher than the bond yield, or, if the investment falls in a §1.148-5(c)(3) category, making a yield reduction payment.
| Restricting the investment | Yield reduction payment | |
|---|---|---|
| What satisfies the yield restriction rule | Holding investments at yields not materially higher than the bond yield | An amount paid to the United States, treated as reducing the investment's yield |
| Governing rule | §1.148-2 | §1.148-5(c) |
| Availability | Wherever the yield restriction rules apply to the investment | Limited to the §1.148-5(c)(3) categories |
| Yield reduction payment to the United States | None (the rebate rules of section 148(f) apply separately) | Paid on the rebate installment schedule, on Form 8038-T |
On either route the rebate computation still applies: Treas. Reg. §1.148-3(d)(2) counts the investment's earnings and return of principal among receipts, §1.148-3(d)(1) counts any yield reduction payment among payments, and the Instructions for Form 8038-T caution that any cash flow representation to the contrary may result in the understatement of the rebate amount.
The instrument choice on the restriction route, between a competitively bid investment agreement and a SLGS subscription, is taken up on the GIC or SLGS comparison page.
For a position that has been invested above the permitted line, mGIC can check your proceeds against the rules and set out how the investment sits against the eligibility categories, timing rules and bidding requirements described above.
That review is part of a free, no-obligation reinvestment review or conversation, and mGIC is an independent, SEC-registered municipal advisor and Bidding Agent whose fee is paid by the winning provider, not the issuer, at or below the safe-harbor maximum in the Treasury arbitrage regulations and disclosed.
Whether a yield reduction payment is available for a particular investment, how its amount is computed, and when it must be paid are legal and tax determinations that belong to bond counsel and tax counsel.
Frequently asked questions
Can gross proceeds of an advance refunding issue use a yield reduction payment?
Only as the regulation expressly provides. Treas. Reg. §1.148-5(c) generally excludes gross proceeds of advance refunding issues from the payment categories, and the Instructions for Form 8038-T direct issuers with ineligible excess yield, such as an incorrectly invested advance refunding escrow, to the Voluntary Closing Agreement Program (VCAP).
What is VCAP?
The Tax Exempt Bonds Voluntary Closing Agreement Program lets issuers of tax-exempt, tax credit and direct pay bonds voluntarily resolve violations that cannot be fixed under self-correction programs. Requests go to the IRS on Form 14429, guided by Notice 2008-31 and IRM 7.2.3.
Does a SLGS suspension lift yield restriction by itself?
No. Treas. Reg. §1.148-5(c)(3)(viii) makes investments agreed to on a suspension date eligible for yield reduction payments, and §1.148-5(d)(6)(iii)(C)(2)(iii) removes the bidding safe harbor's lowest-cost-versus-SLGS comparison, but neither provision suspends the yield restriction rules themselves.
What if a reserve fund holds more than 15 percent of stated principal?
The 15 percent line is only the first prong. Treas. Reg. §1.148-5(c)(3)(v)(A)-(B) also covers a reserve fund that is not expected to pay debt service except as the required balance declines, and whether a fund meets that alternative prong is a determination for bond counsel and tax counsel.
Sources
This page is general educational information about municipal finance and federal and state rules as of the date shown. It is not legal, tax or investment advice, and it is not a recommendation about any particular investment. Product availability, legality and suitability depend on the issuer, jurisdiction, governing documents and transaction-specific facts. Final legal and tax determinations remain with the issuer's bond counsel, tax counsel and other advisors.
