Arbitrage Rules for Tax-Exempt Bond Proceeds Explained

Federal arbitrage rules limit what tax-exempt bond proceeds can earn by barring invested proceeds from earning a yield materially higher than the yield of the bonds themselves and by requiring excess earnings to be paid to the U.S. Treasury unless an exception applies.

The rules sit in section 148 of the Internal Revenue Code and its regulations, and this page explains how they work inside the wider guide to investing bond proceeds.

What is arbitrage on tax-exempt bond proceeds?

Arbitrage, in the tax-exempt bond sense, is the spread between the yield an issuer earns on invested bond proceeds and the lower yield the issuer pays on the tax-exempt bonds themselves.

Section 148(a) of the Internal Revenue Code defines an arbitrage bond as a bond issued as part of an issue any portion of whose proceeds are reasonably expected, at the time of issuance, to be used directly or indirectly to acquire higher yielding investments or to replace funds used to acquire them, and it treats intentional use of proceeds that way the same way.

Under 26 U.S.C. 148(b)(1) and (2), higher yielding investments means investment property that produces a yield over the term of the issue materially higher than the yield on the issue, the arbitrage yield that the same rules compute for the bonds, and investment property includes any security, any obligation, any annuity contract and any investment-type property.

The rules reach gross proceeds, which §1.148-1(b) defines as all proceeds plus all replacement proceeds of an issue, with proceeds covering sale, investment and transferred proceeds.

Earning above the bond yield does not by itself make a bond an arbitrage bond, because section 148 builds in the exceptions covered below.

The framework goes back a long way: TreasuryDirect traces the SLGS securities program to 1972, established as the result of 1969 federal legislation that restricted state and local governments from earning arbitrage profits on bond proceeds.

What are the two arbitrage regimes, yield restriction and rebate?

Federal law tests a tax-exempt issue under two independent sets of arbitrage rules, yield restriction and arbitrage rebate, and an issue that fails either set is an issue of arbitrage bonds.

IRS Publication 5271, the IRS's non-binding overview of the arbitrage requirements, puts it directly: if the bonds are arbitrage bonds under either set of rules, they are arbitrage bonds even if they are not arbitrage bonds under the other set.

The yield restriction rules, in 26 U.S.C. 148(a) and Treas. Reg. §1.148-2, generally bar investing gross proceeds at a yield materially higher than the issue's yield once temporary periods and the other exceptions run out.

The rebate rules, in 26 U.S.C. 148(f), generally require excess investment earnings to be paid to the United States.

The two regimes are not mirror images: Publication 5271 notes that the yield restriction rules may allow the issuer to earn the arbitrage while the rebate rules do not allow the issuer to keep the arbitrage.

Compliance is judged on expectations as of the issue date: under Treas. Reg. §1.148-2(b), whether an issue consists of arbitrage bonds is measured against the issuer's reasonable expectations as of that date, and an officer of the issuer responsible for issuing the bonds must certify those expectations in good faith.

No certificate is required if no unspent gross proceeds are expected after the issue date other than a bona fide debt service fund, or if the issue price does not exceed $1 million, and the certification states facts and estimates rather than conclusions of law.

The framework also still moves: on March 12, 2026, Treasury and the IRS published proposed regulations, "Guidance on Tax-Exempt Refunding Bonds," that would update certain arbitrage rules and definitions by clarifying the time and manner for requesting refunds of overpayment of rebate, along with the transferred-proceeds transition rule, the limit on allocations to expenditures and certain definitions.

Most provisions would apply to bonds sold on or after 90 days after final regulations are published, issuers may rely now on the proposed special 90-day certificate of indebtedness provisions, and as of October 2026 the package is proposed rather than final.

Which exceptions let bond proceeds earn above the bond yield?

The exceptions are the parts of section 148 that let proceeds earn above the bond yield, or escape rebate, when an issue meets defined conditions, and each carries its own tests and limits.

The first family is the temporary period: 26 U.S.C. 148(c)(1) provides that a bond is not an arbitrage bond solely because its proceeds are invested in higher yielding investments for a reasonable temporary period until they are needed.

Net sale proceeds and investment proceeds reasonably expected to be spent on capital projects get a 3-year temporary period from the issue date, available only if the issuer reasonably expects to satisfy the expenditure test, the time test and the due diligence test under Treas. Reg. §1.148-2(e)(2)(i).

The expenditure test requires that at least 85% of net sale proceeds be allocated to capital project expenditures by the end of the 3-year period, measured on reasonable expectations at issuance.

The capital-project temporary period does not apply to refunding issues, under Treas. Reg. §1.148-2(e)(1).

A temporary period answers the yield restriction question only, so the rebate rules can still require its earnings to be paid over unless a separate rebate exception applies.

The full set of temporary periods, with their tests, is laid out in the guide to temporary periods.

On the rebate side, the spending exceptions in Treas. Reg. §1.148-7 treat the rebate requirement as met for issues whose proceeds are spent on the required schedule, with a 6-month exception, an 18-month exception and a 2-year construction exception.

The spending exceptions operate on the rebate requirement, while the temporary-period and yield restriction rules continue to govern what yield the proceeds may earn.

Reserve funds get their own sizing rule: the MSRB glossary notes that the size and investment of a debt service reserve fund generally is subject to arbitrage regulations, and Treas. Reg. §1.148-2(f)(2)(ii) caps the reasonably required reserve or replacement fund at the least of 10% of stated principal, maximum annual principal and interest, or 125% of average annual principal and interest.

Even a reserve fund that fits that sizing generally remains subject to rebate on its earnings, and the guide to the reasonably required reserve fund explains the exception in full.

The minor portion adds a small allowance on top: gross proceeds up to the lesser of 5% of sale proceeds or $100,000 may be invested in higher yielding investments without making the bonds arbitrage bonds, in addition to temporary periods and reserve funds, and it is a figure fixed in the statute and not indexed.

Like the reserve sizing, the minor portion is an exception to yield restriction, not to rebate.

One further exception works only on the rebate side: the small issuer exception treats rebate as met for an issue of a governmental unit with general taxing powers when no bond is a private activity bond, at least 95% of net proceeds go to the unit's local governmental activities, and the unit reasonably expects to issue no more than $5 million of tax-exempt governmental bonds in the calendar year, with a statutory school-construction add-on that the Form 8038-T instructions summarize as $15 million after 2001, provided no more than $5 million finances non-school purposes.

The small issuer exception exempts an issue from rebate but not from yield restriction, per IRS Publication 4079, so a qualifying issuer still needs a temporary period for project funds and must show any reserve fund is reasonably required; the guide to the small issuer exception covers the details.

How do fair market value and the safe harbors work?

The arbitrage rules value investments at fair market value, and Treasury provides safe harbors that treat certain purchases as made at fair market value when all their requirements are met.

Treasury Regulation §1.148-5(d)(6)(i) defines fair market value as the price a willing buyer would pay a willing seller in a bona fide arm's-length transaction, generally on the trade date, and it rebuttably presumes that an investment not traded on an established securities market was not bought or sold at fair market value.

That presumption is why guaranteed investment contracts and refunding escrow portfolios are competitively bid: the safe harbor in §1.148-5(d)(6)(iii) treats the purchase price of a GIC, or of an investment bought for a yield-restricted defeasance escrow, as fair market value on the purchase date if all of its requirements are met.

The requirements are a bona fide solicitation, qualifying bids, winning-bid rules, a provider certification and record retention, and they include soliciting at least three reasonably competitive providers and receiving at least three bids from solicited providers with no material financial interest in the issue, at least one of them from a reasonably competitive provider.

The safe harbor is a presumption rather than a verdict: falling short means the issuer loses the presumption of fair market value, and it does not by itself establish that the price was not fair.

The guide to the fair-market-value safe harbor works through each requirement, and the bidding pages cover bid specifications and evaluating bids.

The valuation rules are also where abuse has shown up: the MSRB glossary defines yield burning as the sale to an issuer of securities, typically Treasuries, at above-market prices to be held in escrow for the purpose of reducing the yield on those securities to avoid arbitrage regulations, and it says the SEC and IRS view the practice as illegal.

Treas. Reg. §1.148-1(b) also defines a refunding escrow as one or more funds established as part of a single transaction or a series of related transactions, containing refunding issue proceeds and any other amounts to provide for payment of principal or interest on one or more prior issues.

The definitions section also supplies what is being valued: under §1.148-1(b), a guaranteed investment contract includes any nonpurpose investment with specifically negotiated withdrawal or reinvestment provisions and a specifically negotiated interest rate, and it includes any agreement to supply investments on two or more future dates, such as a forward supply contract.

The definition says includes, so it is not exhaustive, and whether a particular repurchase agreement or forward delivery agreement is a GIC is a bond counsel determination.

What happens if an issue violates the arbitrage rules?

The core consequence is tax status: the federal exclusion of interest on state and local bonds does not apply to any arbitrage bond, because 26 U.S.C. 103(b)(2) carves out any arbitrage bond within the meaning of section 148 from the exclusion in 103(a).

Tax status turns on all of sections 103 and 141 through 150, so the arbitrage rules are one input to that conclusion rather than the whole of it.

Status can also arise after the issue date: under Treas. Reg. §1.148-2(c), a deliberate, intentional action taken after the issue date to earn arbitrage makes the bonds arbitrage bonds if the action would have done so had it been expected at issuance, and an intent to violate section 148 is not necessary for an action to be intentional.

The same regulation softens the edge for honest mistakes: §1.148-2(a) provides that bonds are not arbitrage bonds as a result of an inadvertent, insubstantial error.

Standing above the specific tests is the anti-abuse rule: under Treas. Reg. §1.148-10, bonds are arbitrage bonds if an abusive arbitrage device is used, which the regulation defines as an action that both exploits the difference between tax-exempt and taxable rates for a material financial advantage and overburdens the tax-exempt bond market.

Overburdening the market means issuing more bonds, issuing bonds earlier, or allowing bonds to remain outstanding longer than is otherwise reasonably necessary, and actions expressly permitted by the regulations are generally not abusive.

Whether a specific issue is an issue of arbitrage bonds is a legal and tax conclusion, and it belongs to bond counsel and tax counsel.

How does reinvestment strategy fit inside the arbitrage rules?

Reinvestment strategy fits inside the arbitrage rules when the investment's term, withdrawal terms and records are built around the issue's temporary periods, draw schedule and documentation requirements.

GFOA's best practice on investment and management of bond proceeds tells governments to make certain the drawdown of proceeds is planned and recorded and that the investment duration is no longer than the expected drawdown schedule, and to revisit the draw schedule periodically.

GFOA also suggests staging bond issues over the construction period and not issuing well before spending begins, to limit arbitrage liability and negative arbitrage.

The rules themselves tie the investment to the fund's needs: for GIC purchases, the safe harbor's solicitation terms must take into account the issuer's reasonably expected deposit and drawdown schedule, under Treas. Reg. §1.148-5(d)(6)(iii)(A)(5).

On records, GFOA describes keeping them for the required period, typically the life of the bonds plus three years, and the guide to the compliance file collects what an investment closing should produce.

GFOA likewise recommends formal written post-issuance compliance policies and procedures that list the key documents, such as the tax certificate, escrow documents and indenture, and it notes that governments may outsource tasks like arbitrage rebate while keeping ultimate responsibility; the guide to post-issuance compliance develops the point.

mGIC is an independent, SEC-registered municipal advisor and Bidding Agent that helps issuers structure, competitively bid and close investments of bond proceeds, with safety first, then liquidity, then yield.

Under Treas. Reg. §1.148-5(d)(6)(iii)(B)(3), if the issuer uses an agent to conduct the bidding, that agent must not have bid to provide the investment.

An independent Bidding Agent solicits qualified providers, compares bids on rate and non-rate terms, and delivers Bidding Agent and provider certifications to bond counsel.

If you want an independent look at how an existing fund lines up with the temporary periods, exceptions and valuation rules above, mGIC can check your proceeds against the rules, and a free, no-obligation review or conversation starts at contact.

Last updated 2026-10-06.

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.