Proposed Regulations on Arbitrage Rules for Tax-Exempt and Tax-Advantaged Bonds

IRS Proposes Sweeping Updates to Arbitrage Rules for Tax-Exempt Bonds

The IRS on Friday unveiled proposed regulations that would overhaul longstanding arbitrage rules governing tax-exempt bonds, introducing sweeping changes to compliance mechanisms under Section 148 and Section 150 of the Internal Revenue Code. The proposal—published in IRS Bulletin 2026–14—aims to clarify long-debated ambiguities in refund overpayment rules, refine treatment of transferred proceeds, and expand the definition of tax-exempt bonds to include SLGS special 90-day certificates, among other technical updates. For issuers of tax-exempt bonds, the stakes are high: the changes could reduce compliance burdens and unlock cost savings, but they also introduce new documentation requirements and potential audit triggers.

At the heart of the proposal is a retooling of the arbitrage rules, which prevent issuers from profiting by investing tax-exempt bond proceeds at yields higher than the bond’s tax-exempt rate. Under Section 148, issuers must either spend bond proceeds within strict timeframes or rebate excess earnings to the U.S. Treasury. The proposed regulations seek to modernize these rules in response to evolving market practices, particularly in refunding transactions and the use of state guarantee funds. The IRS emphasized that the updates are designed to align regulatory language with current market realities while preserving the integrity of the tax-exempt bond system.

The 1993 Treasury regulations under Treasury Decision 8476 established the modern arbitrage framework, but they have not kept pace with changes in bond market practices, such as the rise of state guarantee funds and the increased use of SLGS demand deposits during debt limit contingencies. The proposed changes reflect a recognition that the existing rules are overly prescriptive for short-term investments and do not adequately address the role of state perpetual trust funds in guaranteeing tax-exempt bonds.

The Delta: Old Rules vs. New Proposals

The proposed regulations under Section 148—which governs arbitrage restrictions for tax-exempt bonds—seek to modernize longstanding ambiguities and align regulatory language with current market practices. Below is a side-by-side comparison of the existing rules and the proposed amendments, with a focus on the most consequential changes for issuers, investors, and compliance professionals.

Refund Overpayments (§ 1.148-3(i)(3)(i))

The arbitrage rules under Section 148(f) require issuers to rebate excess earnings from investments of bond proceeds to the U.S. Treasury if those investments yield more than the bond’s tax-exempt rate. The rebate calculation is based on the weighted average yield of nonpurpose investments held in a yield-restricted fund, such as a debt service reserve or construction fund. Historically, issuers faced strict deadlines for filing rebate claims, which created practical challenges when rebate calculations were delayed or when overpayments were discovered after the original filing deadline.

The current rule under § 1.148-3(i)(3)(i) required issuers to file claims for refunds of overpaid rebates within two years from the final computation date, typically the bond’s maturity or redemption. This deadline created practical challenges for issuers who made rebate payments after the final computation date, as the old rule did not account for post-computation overpayments. The IRS recognized that this rigid deadline could result in issuers forfeiting legitimate refund claims due to administrative delays or complex refunding transactions.

Under the proposed change, the IRS aligns the regulation with Revenue Procedure 2024-37, extending the filing deadline to two years from the date 60 days after the final computation date or two years from the date the overpayment was made to the U.S. Treasury, whichever is later. This ensures issuers have a reasonable window to recover overpayments, particularly in refunding transactions where rebate calculations may be complex or delayed. The extension reflects the IRS’s acknowledgment that rebate computations can be time-consuming and that issuers should not be penalized for administrative delays.

The significance of this change cannot be overstated. Rebate overpayments can result from miscalculations in arbitrage yield computations, particularly when dealing with variable-rate investments or hedged positions. In Private Letter Ruling 2022-15, an issuer misclassified a hedged investment as yield-restricted, leading to a $1.2 million rebate liability. The new rule provides issuers with greater flexibility to correct such errors without risking forfeiture of legitimate refund claims.

Transferred Proceeds (§ 1.148-5(d)(4))

When proceeds from a prior bond issue are transferred to a refunding issue, the value of investments allocated to the transferred proceeds is subject to arbitrage restrictions under Section 148. The existing regulation under § 1.148-5(d)(4) did not clearly define the term "arbitrage restrictions," leading to divergent interpretations among issuers. Some issuers applied the rule only to yield restriction rules under Section 148(a), ignoring rebate requirements under Section 148(f), while others argued the rule applied to both yield restrictions and rebate rules. This ambiguity created compliance risks and audit triggers.

The proposed change explicitly clarifies that the transition rule applies to all purposes of Section 148, including yield restrictions, rebate requirements, and arbitrage yield computations. This ensures consistency in valuation methods for transferred proceeds, preventing issuers from cherry-picking valuation approaches to avoid rebate liabilities. The clarification is particularly important for refunding transactions, where transferred proceeds are common and valuation methods can significantly impact arbitrage compliance.

The IRS’s focus on transferred proceeds reflects its increased scrutiny of refunding transactions, particularly advance refundings, which were restricted for private activity bonds under the 2017 Tax Cuts and Jobs Act. The proposed rule provides much-needed clarity for issuers navigating complex refunding structures, ensuring that transferred proceeds are valued consistently across all arbitrage calculations.

Allocations to Expenditures (§ 1.148-6(d)(1)(ii))

To allocate bond proceeds to an expenditure, issuers must demonstrate a "current outlay of cash," defined as an outlay expected to occur within five banking days of the allocation. However, the regulation was silent on whether funds received after the cash outlay but before the allocation deadline could be used for the allocation. This ambiguity led to confusion about whether an issuer could allocate proceeds from a new deposit to an earlier expenditure, particularly when funds were received after the cash outlay but before the allocation deadline.

The proposed change explicitly states that funds must be held by the issuer on the date of the cash outlay to qualify for allocation. This means no retroactive allocations are permitted, and the allocation must reflect the actual sources of funds available at the time of the cash outlay. The new rule provides a bright-line standard for expenditure allocations, reducing audit risk by eliminating ambiguity in the timing of fund allocations.

This change is particularly relevant for issuers managing multiple bond issues with overlapping expenditure schedules. The IRS’s focus on allocation timing reflects its broader effort to ensure that bond proceeds are spent for their intended purposes in a timely manner, preventing issuers from manipulating allocation dates to avoid arbitrage restrictions.

State Guarantee Funds (§ 1.148-11(d)(1))

State perpetual trust funds, such as the Texas Permanent School Fund and the Alaska Permanent Fund, play a critical role in guaranteeing tax-exempt bonds issued by state and local governments. These funds provide credit enhancement, lowering borrowing costs for public projects like schools and infrastructure. However, the IRS had not clearly defined whether these funds could invest in nonpurpose assets to enhance returns or whether they could guarantee bonds beyond their original scope.

The proposed regulation expands the capacity of state guarantee funds by permitting broader investment authority for funds that meet Section 148 compliance standards. This includes yield restriction compliance, rebate requirements, and segregated accounting. The rule also clarifies that guarantee funds can support private activity bonds if the underlying loans qualify under Section 148, providing flexibility for issuers in the student loan and higher education sectors.

The IRS’s recognition of state guarantee funds as compliant investments reflects its acknowledgment of their role in public finance. However, the rule also imposes strict requirements to ensure that these funds operate within the guardrails of Section 148, preventing arbitrage violations and maintaining the integrity of the tax-exempt bond system.

Tax-Exempt Bond Definition (§ 1.150-1(b)(2))

The definition of a "tax-exempt bond" under Section 150 did not explicitly include State and Local Government Series (SLGS) special 90-day certificates, which are Treasury securities used by issuers to comply with arbitrage restrictions during debt limit contingencies. SLGS are non-marketable Treasury securities issued exclusively to state and local governments, designed to help issuers avoid arbitrage violations by providing yield-restricted investments.

The proposed regulation adds SLGS special 90-day certificates to the definition of tax-exempt bonds, recognizing their role in debt limit contingencies and market disruptions. This change provides regulatory certainty for issuers relying on SLGS during debt ceiling standoffs, such as the 2011, 2013, and 2023 debt limit crises. The inclusion of SLGS in the definition of tax-exempt bonds ensures that issuers can avoid unintended arbitrage violations due to lack of clarity in the bond definition.

The significance of this change is underscored by the IRS’s Notice 2024-32, which provided temporary relief for issuers during debt limit contingencies. The proposed regulation codifies this relief, providing a permanent solution for issuers facing temporary disruptions in the SLGS program.

Refunding Issue Definition (§ 1.150-1(d)(2)(iii)(C) and (d)(6))

The definition of a "refunding issue" under Section 150 was unclear in two key areas. First, the IRS had not explicitly addressed whether refunding bonds used to refinance qualified student loans qualified for tax-exempt status. Second, the rule did not provide clear guidance on whether "cross-calling" practices—where proceeds from one bond issue are used to repay another issue with a different obligor—qualified as a refunding.

The proposed regulation clarifies and expands the definition of a refunding issue to explicitly include refinancing of qualified student loans, such as those under the Federal Family Education Loan Program. It also permits cross-calling if the refunding bonds are issued by the same obligor or a related party, ensuring flexibility for issuers restructuring debt without triggering arbitrage violations or loss of tax-exempt status.

This change is particularly important for issuers in the higher education sector, where refunding bonds are commonly used to refinance student loans. The clarification ensures that these transactions comply with arbitrage rules while providing issuers with the flexibility to restructure debt.

Winners and Losers: Industry Impact

The proposed arbitrage rule updates carry significant implications for issuers, financial institutions, and taxpayers. Below is a breakdown of the key stakeholders and how they may be affected.

Winners

Issuers of tax-exempt bonds stand to benefit significantly from the proposed regulations, which provide much-needed clarity and flexibility. The extended deadline for refund claims under § 1.148-3(i)(3)(i) aligns with Revenue Procedure 2024-37, giving issuers a clearer, more generous two-year window to recover overpayments of arbitrage rebates, penalties, or yield reduction payments. This change mitigates the risk of forfeiting overpayments due to ambiguous deadlines and provides issuers with greater flexibility to correct errors in rebate calculations.

The proposed amendments to § 1.148-5(d)(4) and § 1.148-6(d)(1)(ii) eliminate confusion around valuation methods for transferred proceeds and the timing of fund allocations. Issuers can now confidently use consistent valuation approaches—such as fair market value, present value, or par value—for all arbitrage compliance purposes, reducing the risk of arbitrage violations. The clarification of allocation timing ensures that funds are allocated to expenditures based on the actual sources of funds available at the time of the cash outlay, providing a bright-line standard for compliance.

State perpetual trust funds, such as the Texas Permanent School Fund and the Alaska Permanent Fund, also gain expanded capacity under the proposed changes to § 1.148-11(d)(1). These funds, which guarantee tax-exempt bonds issued by state and local governments, can now invest in higher-yielding assets to enhance returns while complying with Section 148 standards. The rule permits broader investment authority for funds that meet yield restriction compliance, rebate requirements, and segregated accounting, providing states with greater flexibility to support bond issuances without triggering arbitrage violations.

Conduit borrowers for student loans benefit from the proposed amendments to § 1.150-1(d)(2)(iii)(C) and the addition of § 1.150-1(d)(6), which clarify that refunding bonds used to refinance qualified student loans qualify for tax-exempt status. The definition of "proceeds" now explicitly excludes investment proceeds from qualified student loans, preventing issuers from inadvertently triggering refunding rules through cross-calling. This ensures that the interest on refinancing bonds remains tax-exempt, providing flexibility for issuers in the higher education sector.

Losers

Issuers who relied on ambiguities in the old rules may face stricter compliance requirements under the proposed regulations. The clarification of valuation methods for transferred proceeds under § 1.148-5(d)(4) eliminates loopholes that allowed issuers to cherry-pick valuation approaches to avoid rebate obligations. Similarly, the proposed changes to § 1.148-6(d)(1)(ii) make it clear that funds must be held by the issuer on the date of the cash outlay to qualify for allocation, preventing issuers from retroactively allocating funds received after the fact to avoid arbitrage restrictions.

Taxpayers may also face uncertainty during debt limit contingencies, despite the proposed inclusion of special 90-day SLGS certificates in the definition of tax-exempt bonds under § 1.150-1(b)(2). The involuntary conversion of Demand Deposit SLGS into special 90-day certificates during a debt limit contingency could still lead to yield restriction violations under § 148, as the yield on these certificates may not align with the bond’s yield. Taxpayers may face arbitrage violations if the IRS does not provide further guidance on how to account for these involuntary conversions.

The Context: Arbitrage Rules and Tax-Exempt Bonds

The IRS’s proposed updates to arbitrage rules under § 148 and § 150 of the Internal Revenue Code arrive at a critical juncture for state and local governments, nonprofit organizations, and financial institutions that issue tax-exempt bonds. These bonds—issued by governments or qualified 501(c)(3) organizations—carry tax-exempt interest, a benefit Congress designed to lower borrowing costs for public projects like schools, hospitals, and infrastructure. But this tax advantage comes with a catch: the IRS strictly prohibits issuers from profiting from the difference between the bond’s tax-exempt yield and higher-yielding investments made with bond proceeds. This prohibition is enforced through the arbitrage rules, which include two core components: the yield restriction rules and the rebate rules.

The yield restriction rules under § 148(a) through (e) and (g) generally require that proceeds from tax-exempt bonds be invested at a yield no higher than the bond’s yield. The goal is to prevent issuers from earning arbitrage profits—essentially, using tax-exempt borrowing to fund higher-yielding investments. These rules apply during the temporary period—typically six months for construction projects or three years for other purposes—when proceeds are expected to be spent, and beyond that period, any excess yield must be rebated to the U.S. Treasury under the rebate rules in § 148(f). Failure to comply with either set of rules can result in the bonds being reclassified as arbitrage bonds, stripping them of their tax-exempt status and exposing issuers to significant tax liabilities and penalties.

The historical foundation for these rules was laid in 1993, when the Treasury Department and IRS issued comprehensive final regulations in Treasury Decision 8476. These regulations, which have been amended only in limited respects since, established the framework for how bond proceeds could be invested, how rebates were calculated, and how exceptions—such as for reasonably required reserve funds—applied. The 1993 regulations also introduced key definitions that remain central to arbitrage compliance today, including nonpurpose investments, transferred proceeds, and purpose investments.

A nonpurpose investment is any investment not directly tied to the governmental purpose of the bond, such as hedge funds or corporate bonds. These investments are subject to strict yield restrictions and rebate requirements because they pose a higher risk of arbitrage. Transferred proceeds, on the other hand, refer to bond proceeds from a prior issue that are allocated to a new issue—common in refunding transactions. These proceeds must be tracked separately and valued consistently across all arbitrage calculations to prevent issuers from manipulating valuation methods to avoid rebate obligations. Purpose investments are those directly related to the bond’s intended use, such as construction costs or reserve funds, and are generally subject to less stringent restrictions.

The IRS enforces these rules through audits, examinations, and the threat of reclassifying bonds as arbitrage bonds. When bonds lose their tax-exempt status, issuers face not only the loss of the tax benefit but also potential penalties and the need to repay investors who relied on the tax-exempt status. The stakes are particularly high in refunding transactions, where issuers replace existing bonds with new ones to take advantage of lower interest rates. In these cases, proceeds from the new bonds (the refunding issue) are often used to pay off the old bonds (the refunded issue), and the proceeds of the refunded issue become transferred proceeds of the refunding issue. The IRS has long scrutinized these transactions to ensure that transferred proceeds are not used to generate arbitrage profits, particularly through improper valuation methods or misallocation of investments.

The proposed regulations issued in March 2026 aim to clarify longstanding ambiguities in these rules, particularly around the treatment of transferred proceeds, the recovery of overpaid rebates, and the allocation of proceeds to expenditures. These clarifications respond to real-world challenges faced by issuers, such as how to value investments when proceeds are transferred between bond issues or how to recover overpayments made to the Treasury. The IRS’s goal is to modernize the regulations to reflect statutory changes, such as the repeal of the 150 percent debt service limitation in § 148(d)(3), and to address gaps left by the 1993 regulations, which did not fully anticipate the complexity of contemporary bond structures or the rise of sophisticated investment vehicles.

For issuers, the consequences of noncompliance are severe. Bonds reclassified as arbitrage bonds lose their tax-exempt status retroactively, meaning interest payments become taxable to bondholders. This can trigger disputes with investors, reputational damage, and financial penalties. The IRS’s enforcement posture has grown more aggressive in recent years, with increased audits targeting refunding transactions, state guarantee funds, and nonpurpose investments. The proposed regulations seek to reduce this uncertainty by providing clearer rules for compliance, but they also introduce new complexities, such as revised deadlines for rebate refund claims and stricter valuation methods for transferred proceeds.

In essence, the arbitrage rules under § 148 and § 150 are the IRS’s mechanism for ensuring that the tax benefits of tax-exempt bonds are not exploited for private gain. The proposed updates reflect the agency’s ongoing effort to adapt these rules to the evolving landscape of public finance while maintaining the integrity of the tax system. For issuers, staying ahead of these changes is not just a matter of regulatory compliance—it is essential to preserving the financial benefits of tax-exempt financing.

Applicability Dates and Reliance Provisions

The IRS’s proposed updates to arbitrage rules under § 148 and § 150 introduce staggered applicability dates, each tied to the publication of final regulations in the Federal Register. These dates are critical for issuers to align compliance strategies with regulatory deadlines.

Most of the proposed regulations—including amendments to yield restriction rules, rebate calculations, and investment definitions—would apply to bonds sold 90 days after the publication of final regulations. This delayed applicability provides issuers with a transition period to adjust compliance systems and investment strategies. However, certain provisions take effect immediately upon publication of final regulations, including the removal of § 1.148-2(f)(2)(iv), which eliminates a longstanding exception to yield restriction rules.

For refund overpayment claims under § 1.148-3(i)(3)(i), the IRS proposes that these rules apply to claims filed on or after the date of publication of final regulations. This change accelerates compliance for issuers seeking refunds of excess rebate payments, requiring immediate attention to documentation and filing procedures. Similarly, the proposed amendments to filing notices and elections under § 1.150-5(a)—which streamline administrative processes—would apply to notices and elections filed 30 days after publication of final regulations. This shorter window reflects the IRS’s intent to modernize procedural requirements without imposing undue burdens.

The IRS also includes a reliance provision allowing issuers to act on two key proposals before final regulations are published. Specifically, issuers may rely on the proposed addition of special 90-day SLGS certificates to the definition of "tax-exempt bond" under § 1.150-1(b)(2), as well as the expanded safe harbor for longer-term working capital financings under § 1.148-1(c)(4)(ii)(E)(3). This early reliance mechanism provides flexibility for issuers to adopt these changes in advance, particularly for transactions involving short-term financing or refundings where SLGS play a critical role.

For compliance planning, these dates underscore the need for issuers to monitor the Federal Register for the publication of final regulations to trigger the 90-day and 30-day clocks, prepare systems updates for refund claims and notice filings to meet the accelerated deadlines, and leverage reliance provisions where applicable to align transactions with proposed rules before finalization. The phased approach balances the need for regulatory clarity with operational practicality, but issuers must act promptly to avoid compliance gaps.

Public Comment Period and Next Steps

The Treasury Department and IRS have opened a 60-day public comment period for the proposed arbitrage rule updates under § 148 and related regulations. Stakeholders are encouraged to submit feedback to shape the final rules before they are finalized.

The Treasury Department and IRS will consider all comments submitted before finalizing the regulations. Stakeholder input is critical to ensuring the rules reflect operational realities while maintaining compliance integrity. Issuers and advisors should review the proposed changes carefully and submit feedback to avoid unintended consequences in future transactions.

Regulatory Flexibility and Federalism: No Significant Impact Expected

The Treasury Department and IRS certified under the Regulatory Flexibility Act (5 U.S.C. chapter 6) that the proposed arbitrage rule updates would not impose a significant economic impact on a substantial number of small entities, including small governmental jurisdictions. While state and local governments issuing tax-exempt bonds are not classified as small entities under the Act, small jurisdictions with populations under 50,000 are considered small entities. The Treasury and IRS acknowledged uncertainty about the number of affected small jurisdictions but concluded that even if a substantial number were impacted, the economic burden would remain insignificant. The proposed regulations primarily clarify existing rules, incorporate statutory changes, and integrate prior guidance—such as Revenue Procedure 2024-37 and Notices 2023-39 and 2024-32—without creating new obligations or meaningful economic burdens for small issuers.

Under the Unfunded Mandates Reform Act of 1995 (UMRA), the proposed regulations were evaluated for federal mandates exceeding $100 million (adjusted for inflation). The analysis determined that no federal mandate would result in expenditures by state, local, tribal governments, or the private sector that meet or exceed the statutory threshold. The rules do not impose new financial obligations on these entities, ensuring compliance with UMRA’s cost-benefit requirements.

Regarding federalism implications under Executive Order 13132, the Treasury and IRS found that the proposed regulations do not have federalism implications as defined by the order. The rules do not impose substantial direct compliance costs on state and local governments, nor do they preempt state law. The proposed changes are administrative in nature, focused on clarifying existing arbitrage rules under Section 148 and related regulations, and do not alter the balance of authority between federal and state governments. This conclusion supports the view that the regulations will not disrupt state-level tax-exempt bond programs or impose undue burdens on governmental issuers.

These analyses collectively indicate that the proposed updates are designed to streamline compliance without creating new barriers for issuers, particularly small entities and state governments. Stakeholders are encouraged to review the proposals and submit feedback to ensure the final rules align with operational realities while maintaining the integrity of the tax-exempt bond system.

What’s Next for Issuers of Tax-Exempt Bonds?

For issuers of tax-exempt bonds, the proposed regulations represent a pivotal moment to reassess compliance strategies and capitalize on new flexibilities. The IRS’s clarifications—particularly regarding refund overpayment claims, transferred proceeds, and allocations to expenditures—demand proactive planning to avoid unintended arbitrage violations or rebate liabilities.

Issuers should prioritize compliance planning by reviewing the proposed changes to Section 1.148-3(i)(3)(i) (refund overpayment claims), Section 1.148-5(d)(4) (transferred proceeds), and Section 1.148-6(d)(1)(ii) (allocations to expenditures). The IRS’s expanded definition of tax-exempt bond to include special 90-day SLGS certificates under Section 1.150-1(b)(2) offers a compliance shortcut for issuers relying on Treasury securities to meet arbitrage restrictions. Before the final regulations take effect, issuers may rely on these proposed rules to structure transactions, such as refundings or working capital financings, with greater certainty.

The proposals also present opportunities for issuers to refine their strategies. The expanded capacity for State guarantee funds—now explicitly subject to yield restrictions but with clearer segregation requirements—could enhance credit ratings for governmental bonds without triggering arbitrage penalties. Similarly, the flexibility to refinance qualified student loans under Section 1.150-1(d)(2)(iii)(C) may provide issuers with a pathway to lower borrowing costs for higher education initiatives, provided proceeds are deployed within the two-year window.

Stakeholders are strongly encouraged to submit public comments to shape the final regulations. The IRS’s request for feedback underscores the agency’s openness to operational realities, particularly for small governmental jurisdictions that may lack the resources to adapt to overly prescriptive rules. Comments should address practical challenges in tracking transferred proceeds or documenting allocations to expenditures, which could otherwise lead to inadvertent violations.

For issuers weighing their next steps, the reliance provisions offer a critical window to act. The proposed addition of SLGS special 90-day certificates to the definition of tax-exempt bond for Section 148 purposes is available for immediate use, even before the final regulations are published. This allows issuers to restructure escrow investments or refunding transactions with confidence, knowing they are operating under rules the IRS has signaled it will adopt.

The path forward requires diligence but also presents strategic advantages for those who engage early. Issuers should review the proposed regulations in full, assess their impact on current and future bond issues, and consider how to leverage the new flexibilities—whether through optimized refunding structures, expanded guarantee fund strategies, or streamlined compliance processes. The IRS’s emphasis on clarity and operational feasibility suggests these changes are designed to support, not hinder, the tax-exempt bond market. Now is the time to ensure your practices align with that vision.