4.8.1 General
The Tax Code provides that any bond will be a taxable “arbitrage bond” if the issuer reasonably expects to use the proceeds of the bond, directly or indirectly, either (1) to acquire securities or obligations with a yield materially higher than the yield on the bond, or (2) to replace funds used to acquire higher yielding securities or obligations. Thus, the Tax Code restricts the rate of return on investments made with bond proceeds to a yield that is not materially higher than the yield on those bonds.
However, the Tax Code provides exceptions to yield restriction for the portion of the bond proceeds held in a reasonably required reserve fund during the life of the bond issue and for other proceeds of the bonds deposited during a “temporary period.” Key for purposes of arbitrage analysis are determining what funds constitute “bond proceeds” and the “yield” on the bonds and on investments of bond proceeds. Compliance with arbitrage yield restrictions is an important post issuance compliance requirement. See Section 8.3.4, Monitoring Investment Income and Arbitrage Compliance.