Tax Exempt &
 

Government Entitites
 

Tax-Exempt Governmental Bonds
 

Publication 4079 (Rev. 9-2019) Catalog Number 34663R 

Department of the Treasury Internal Revenue Service www.irs.gov 
Contents 

Introduction .............................................................................................................................1
 

Background .............................................................................................................................2
 

Tax-Exempt Governmental Bonds .........................................................................................2
 

Other Governmental Bond Requirements .............................................................................6
 

Post-Issuance Compliance Monitoring................................................................................14
 

What To Do When You Discover a Violation —
 

TEB Voluntary Closing Ageement Program .......................................................................16
 

More Information...................................................................................................................16
 
Introduction 

This publication provides an overview of the federal tax law rules that apply to municipal 

financing arrangements commonly known as “governmental bonds.” It is intended to help 

issuers meet federal tax law requirements to ensure that interest earned by bondholders is 

exempt from taxation under Internal Revenue Code (IRC) Section 103. 

This publication is an overview of the rules; it isn’t official guidance that you may rely on for 

planning purposes. It refers to IRC sections, Income Tax Regulations (Treas. Regs.), revenue 

procedures and other official guidance. Please refer to the official guidance for the rules that 

apply to governmental bonds. Unless otherwise indicated, references in this publication to 

section numbers are references to sections of the IRC. 

For publications that discuss the general rules that apply to qualified 501(c)(3) bonds or other 

qualified private activity bonds, see IRS Publication 4077, Tax-Exempt Bonds for 501(c)(3) 

Charitable Organizations, and IRS Publication 4078, Tax-Exempt Private Activity Bonds. 

For an overview of an issuer’s responsibilities in a conduit financing arrangement, see IRS 

Publication 5005, Your Responsibilities as a Conduit Issuer of Tax-Exempt Bonds. For an 

overview of an issuer’s responsibilities with respect to arbitrage, See IRS Publication 5271, 

Complying with Arbitrage Requirements: A Guide for Issuers of Tax-Exempt Bonds. The IRS 

also provides more detailed information at IRS.gov/bonds. See also More Information, at the 

end of this publication. 

1
 
Background 

State and local governments receive direct and indirect tax benefits under the IRC that lower 

borrowing costs on their valid debt obligations. Because interest paid to bondholders on these 

obligations is not includable in their gross income for federal income tax purposes, bondholders 

are willing to accept a lower interest rate than they would accept if the interest was taxable. 

These benefits apply to many different types of municipal debt financing arrangements including 

bonds, notes, loans, lease purchase contracts, lines of credit and commercial paper (collectively 

referred to as “bonds” in this publication). 

To receive these benefits, issuers must ensure that the requirements under the IRC are met, 

generally for as long as the bonds remain outstanding. These requirements include, but are not 

limited to, information filing and other requirements related to issuance, the proper and timely 

use of bond-financed property, and limitations on how bond proceeds (funds derived from 

the sale of bonds) may be invested. This publication describes these rules as they relate to 

governmental bonds. 

This publication also addresses practices and steps the issuer can take to protect the taxexempt status of the bonds. For example, because the requirements and limitations generally 

apply at the time the bonds are issued and throughout the term of the bonds, this publication 

encourages issuers and beneficiaries of tax-exempt bonds to create procedures for monitoring 

compliance throughout the life of the bonds. For more information, see Post-Issuance 

Compliance Monitoring. 

Tax-Exempt Governmental Bonds 

Governmental bonds are bonds that do not meet the private activity bond tests. Proceeds 

of these bonds may be used to finance activities of, or facilities owned, operated or used 

by, the issuer for its purpose or another state or local government for its own purposes. This 

can include financing the construction, maintenance or repair of public infrastructure such as 

highways, schools, fire stations, libraries or other types of municipal facilities. To be tax-exempt, 

governmental bonds must comply with the requirements that define governmental bonds and 

requirements that apply to tax-exempt bonds generally. 

In this section, we discuss the tests for determining whether a bond is a governmental bond 

or a private activity bond. These tests apply at issuance and after the bonds are issued. This 

discussion includes remedial action provisions that apply when a deliberate action causes 

governmental bonds to become private activity bonds. If a deliberate action that results in a 

violation of any of the federal tax requirements cannot be corrected under the remedial action 

provisions, issuers may be able to enter into a closing agreement under the TEB Voluntary 

Closing Agreement Program (TEB VCAP) described in Notice 2008-31, 2008-11 I.R.B. 592 (see 

What To Do When You Discover a Violation — TEB Voluntary Closing Ageement Program). 

2
 
Testing for Governmental Bonds: The Private Activity Bond Tests 

IRC Section 141 sets forth tests to determine if a bond is a private activity bond. These tests 

identify arrangements that actually, or are reasonably expected to, transfer benefits of taxexempt financing to a nongovernmental person. A “nongovernmental person” is a person 

other than a governmental person. A governmental person means a state or local government 

as defined in Treas. Reg. Section 1.103-1 or any instrumentality of such entity. Governmental 

persons do not include the United States or any agency or instrumentality of the United States. 

A state or local bond will be a private activity bond if, as of the issue date of the bonds or at any 

time while the bonds are outstanding, the bond issue exceeds the limits set forth in either: 

 the private business tests of Section 141(b), which consist of the private use test and the 


private security and payment test, and certain special private business rules (see Special 


Private Business Test Rules and Special Rules for Certain Utility Financings, below), or
 

 the private loan financing test of Section 141(c). 

The bond issue exceeds the private activity bond tests limits as of the issue date if the issuer 

or a conduit borrower of the bond proceeds reasonably expects that the issue will exceed the 

limits while the bonds are outstanding. A bond issue also exceeds the private activity bond tests 

limits after the issue date if a deliberate action is taken that causes those limits to be exceeded. 

If a bond is a private activity bond, interest on the bond may still be excludable from federal 

income tax if the bond issue meets the additional requirements that apply to qualified private 

activity bonds. For a discussion of these additional requirements, see Publication 4078, TaxExempt Private Activity Bonds. 

Private Business Tests 

Under IRC Section 141(b), a bond issue exceeds the limits of the private business tests, and 

therefore does not qualify as a governmental bond issue, if the issue exceeds the limit of the 

private business use test and also exceeds the limit of the private security or payment test. 

Private Business Use Test. A state or local bond issue exceeds the limit of the private business 

use test if more than 10% of the proceeds of an issue are to be used for any private business 

use. Use of bond proceeds or bond-financed property by a nongovernmental person (individual 

or entity) in furtherance of a trade or business activity is considered private business use for taxexempt bond purposes. For this purpose, any trade or business activity of a natural person is 

treated as a trade or business, and any activity carried on by a person (including a governmental 

entity or corporation) other than a natural person is treated as a trade or business. 

Indirect uses of proceeds must also be considered in determining whether more than 10% of the 

proceeds of an issue will be used in a private business use. For example, property is treated as 

being used for a private business use if it is leased to a nongovernmental person and then subleased to a governmental person if the nongovernmental person’s use is in a trade or business. 

Many types of arrangements can result in private business use under IRC Section 141 at 

issuance or later, including management and service contracts and research agreements. 

Management and Service Contracts. Contracts for a private entity to manage a bond-financed 

facility may cause the private business use test to be met. For example, a management 

contract between a governmental entity and a nongovernmental person under which the 

nongovernmental person receives compensation for services provided with respect to bondfinanced property may result in the bonds meeting the private business use test. 

3 
 

The IRS has provided safe harbors protecting against private business use for management 

and service contracts between a private entity and a governmental entity when the service 

is provided in connection with bond-financed property. For more information, see Revenue 

Procedure 2017-13. Contracts that fail the safe harbor do not automatically meet the private 

business use test; all facts and circumstances are considered to determine whether the contract 

meets the test. 

Research Agreements. Research agreements may also cause the private business use test 

to be met. For example, when private entities or the federal government sponsor research at 

a facility financed with tax-exempt bonds, the research agreements may result in the bonds 

meeting the private business use test. However, the IRS has provided safe harbors for research 

agreements. For more information, see Revenue Procedure 2007-47, 2007-29 I.R.B. 108. As 

with management contracts, failure to meet the safe harbors does not automatically cause the 

private business use test to be met. 

NOTE: If an issuer determines that its bonds meet the private business use test, the bonds have 

not met the private business tests unless the bonds also meet the private payment or security 

test. 

Private Security or Payment Test. A state or local bond exceeds the limit of the private 

security or payment test if more than 10% of the proceeds of the bond issue is (under the terms 

of the issue or any underlying arrangement) directly or indirectly (1) secured by any interest in 

property used or to be used for a private business use or payments in respect of the property, or 

(2) to be derived from payments (whether or not to the issuer) in respect of property, or borrowed 

money, used or to be used for a private business use. For example, lease payments made by 

private businesses to a city for the lease of property in a blighted area that was rehabilitated with 

proceeds of the city’s bonds would be treated as private payments. 

NOTE: If an issuer determines that its bonds meet the private security or payment test, the 

bonds have not met the private business tests unless the bonds also meet the private business 

use test. 

Special Private Business Test Rules. Additional limits on private business activity apply 

when private business use is unrelated to the governmental use, when private business use is 

disproportionate to the governmental use, and when the “nonqualified amount” exceeds $15 

million. 

Unrelated and Disproportionate Use. IRC Section 141(b)(3) provides an additional limit for 

unrelated and disproportionate business use, which is lower than the limits in Sections 141(b)(1) 

and 141(b)(2). In particular, it limits unrelated or disproportionate private use of assets financed 

with governmental bonds to 5% of the proceeds of the bonds. The rule also reduces the private 

security or payment test limit to 5%. For this purpose, only payments, property and borrowed 

money with respect to the unrelated or disproportionate use are taken into account. 

Unrelated use is private use that isn’t related to the governmental use of the issue. Whether 

a private business use is related to a government use financed with the proceeds of an issue 

is determined on a case-by-case basis, emphasizing the operational relationship between the 

government use and the private business use. In general, a facility that is used for a related 

private business use must be located within, or adjacent to, the governmentally-used facility. 

Example: A county issues bonds with proceeds of $20 million and uses $18.1 million of 

the proceeds for construction of a new school building and $1.9 million of the proceeds for 

4 
 

 

construction of a privately operated cafeteria in its administrative office building, which is 

located at a remote site. The bonds are secured, in part, by the cafeteria. The $1.9 million of 

proceeds is unrelated to the governmental use (that is, school construction) financed with 

the bonds and exceeds 5% of $20 million. Thus, the issue exceeds the limit under the private 

business tests. 

A private business use is disproportionate to a related government use only to the extent that 

the amount of proceeds used for that private business exceeds the amount of proceeds of 

the issue used for the related government use. For example, a private use of $100 million of 

proceeds that is related to a government use of $70 million of proceeds results in $30 million of 

disproportionate use. 

When unrelated use and disproportionate use occur in the same bond issue, the two uses are 

aggregated to test against the 5% limit. Additional examples of the unrelated or disproportionate 

private use limits may be found in Treas. Reg. Section 1.141-9(e). 

Remedial Actions for Unrelated or Disproportionate Use. A deliberate action that occurs after 

the issue date does not result in unrelated or disproportionate use if the issue meets the 

remedial action provisions in Treas. Regs. Section 1.141-12(a), discussed in Remedial Actions for 

Nonqualified Use. 

The $15 Million Limit on the Nonqualified Amount. An additional limit may apply even though 

the “nonqualified amount” of proceeds does not exceed 10% of the proceeds of the bonds (or 

a lesser amount of unrelated or disproportionate use of proceeds), and therefore the private 

activity limits discussed above have not been exceeded. The nonqualified amount is the lesser 

of the amount of proceeds used in private business use or the amount of proceeds with respect 

to which there are private payments or security. Section 141(b)(5) provides that an issue of 

bonds will be private activity bonds if the nonqualified amount exceeds $15 million, unless the 

issuer applies state volume cap under Section 146 to the excess of the nonqualified amount 

over $15 million. For additional information on the state volume cap limit under Section 146, see 

Publication 4078, Tax-Exempt Private Activity Bonds. 

Special Rules for Certain Utility Financings. There are two additional limits that issuers of 

bonds for utility projects should consider. The first limit, under Section 141(b)(4), applies if 5% or 

more of the proceeds of the issue are to be used to finance any “output facility,” as defined in the 

regulations (other than a facility for the furnishing of water). Section 141(b)(4) limits the nonqualified 

amount of proceeds of a governmental bond issued to finance the output facilities to $15 

million. This rule applies in addition to the tests under Section 141(b)(1) and (2). In applying this 

limit, issuers must include the nonqualified amounts on any prior outstanding tax-exempt bond 

issues for which 5% or more of the proceeds of the prior issue are or will be used for either the 

same output facility or another output facility that is part of the same project. If the nonqualified 

amount exceeds $15 million, the bonds are private activity bonds. 

Under the second limit, bonds will be private activity bonds if the amount of the proceeds of 

the issue that are to be used (directly or indirectly) for the acquisition by a governmental unit 

of nongovernmental output property exceeds the lesser of 5% of the proceeds or $5 million. 

“Nongovernmental output property” means any property (or interest therein) which before the 

acquisition was used (or held for use) by a person other than a governmental unit in connection 

with an output facility (other than a facility for the furnishing of water). The rule has several 

exceptions, which are beyond the scope of this publication. 

5 
Private Loan Financing Test 

A state or local bond exceeds the limit of the private loan financing test if the amount of 

proceeds of the issue which is to be used (directly or indirectly) to make or finance loans to 

persons other than governmental entities exceeds the lesser of 5% of the proceeds or $5 million. 

A bond that exceeds the private loan financing test limit is a private activity bond, even if it does 

not also meet the private business tests. 

Exceeding the Private Activity Bond Tests Limits after Issuance 

Even if the bonds comply with the limits of the private activity bond tests at issuance, a 

governmental bond issue can lose its tax-exempt status (from the time of issuance) if the issuer 

or a conduit borrower of the bond proceeds takes a “deliberate action” after the issue date 

that causes the issue to exceed those limits. A deliberate action is any action taken by the 

issuer or conduit borrower that is within its control; intent to exceed the limits is not necessary 

for an action to be deliberate. A deliberate action occurs on the date the issuer or conduit 

borrower enters into a binding contract (that is not subject to any material contingencies) with 

a nongovernmental person for use of the bond-financed property in a manner that causes the 

limits of the private activity tests to be exceeded. 

Remedial Actions for Nonqualified Use. The regulations provide that an issuer and, in 

conduit financings, a conduit borrower that engages in a deliberate action causing the limits 

of the private activity bond tests to be exceeded may, in certain cases, cure that deliberate 

action. Treas. Reg. Section 1.141-12 provides that an issuer may take remedial actions to cure 

a deliberate action that would otherwise cause the bonds to lose their tax-exempt status. The 

remedial actions include redemption or defeasance of nonqualified bonds, alternative use of 

disposition proceeds and alternative use of bond-financed property. 

Example: A city enters into an agreement through which it sells a building financed with 

governmental bond proceeds to a corporation and leases the same building back from that 

corporation, with the result that the corporation owns the building for federal income tax 

purposes. This change in ownership of the property results in private business use and is a 

deliberate action. However, the city may remediate the deliberate action by redeeming the 

nonqualified bonds within 90 days of the action. 

Other Governmental Bond Requirements 

Other rules an issuer must meet for a governmental bond to be tax-exempt include: 

 rules a governmental bond must meet for interest to be excluded from federal income tax, 

including rules that relate to issuance of the bonds (including elections that need to be made 

when the bonds are issued) and rules that apply at issuance and throughout the life of the 

bonds; 

 rules that apply when modifications are made to bond terms; and 

 recordkeeping requirements. 

6
 
 

Requirements Related to Issuance 

The following is an overview of several general rules related to the issuance of governmental 

bonds. 

Issuers Must File an Information Return. Issuers of governmental bonds must comply with 

certain information filing requirements under IRC Section 149(e). The size of the issuance 

dictates which information return an issuer must file. The chart below describes what form 

is required and when it must be filed. The IRS Forms listed below are available on the TEB 

website. 

Information Reporting Under Section 149(e) 

Information Return Due Date Where to File 

Form 8038-G, Information 

Return for Tax-Exempt 

Governmental Bonds, 

for a governmental bond 

issue with an issue price of 

$100,000 or greater. 

Form 8038-GC, Information 

Return for Small Tax-Exempt 

Governmental Bond Issues, 

Leases, and Installment 

Sales, for a governmental 

bond issue with an issue 

price of less than $100,000. 

May be filed for a single 

issue or on a consolidated 

basis for all “small” issues in 

a calendar year. 

Generally, both returns are due on or 

before the 15th day of the 2nd calendar 

month after the close of the calendar 

quarter in which the bonds were 

issued. 

Example: The due date of the return 

for bonds issued on February 1 is May 

15. 

Alternatively, Form 8038-GC may 

be filed annually on a consolidated 

basis for all bond issues of less than 

$100,000 that are not reported on 

a separate Form 8038-GC and that 

are not construction issues electing 

to pay a penalty in lieu of rebate. 

Consolidated returns are due on or 

before February 15 following the 

calendar year in which the bonds were 

issued. 

Example: An issuer issues three 

governmental bond issues with issue 

prices and dates as follows: $50,000 

Issue A - March 1, 2018; $75,000 Issue 

B - June 15, 2018; and $30,000 Issue 

C - October 5, 2018. This issuer can 

file one consolidated Form 8038-GC 

by February 15, 2019 for all three bond 

issues. 

File Form 8038-G and Form 

8038-GC information returns 

at: 

Department of the Treasury 

Internal Revenue Service 

Center 

Ogden, UT 84201 

An issuer may request an extension of time to file Forms 8038-G or 8038-GC if the failure to file 

the return on time wasn’t due to willful neglect. To request an extension, the issuer must follow 

Revenue Procedure 2002-48, 2002-37 I.R.B. 531. These procedures generally require that the 

issuer: (1) attach a letter to the Form 8038-G or Form 8038-GC briefly explaining when the return 

was required to be filed, why the return was not timely submitted, and whether the bond issue is 

under examination; (2) enter on top of the letter “Request for Relief under section 3 of Rev. Proc. 

2002-48” and (3) file the letter and return at the Internal Revenue Service Center, Ogden, UT 

84201. 

Bonds Must Be in Registered Form. IRC Section 149(a) generally provides that any tax-exempt 

bond, including governmental bonds, must be issued “in registered form” unless the bond is not 

of a type offered to the public or has, at the date of issue, a maturity of not more than one year. 

7 
The regulations describe what it means to be in “registered form.” Treas. Reg. Section 5f.103­

1(c)(1) provides that an obligation issued after January 20, 1987, pursuant to a binding contract 

entered into after January 20, 1987, is in registered form if: 

 the obligation is registered as to both principal and any stated interest with the issuer (or 

its agent) and that the transfer of the obligation to a new holder may be effected only by 

surrender of the old instrument and the issuer must either reissue the old instrument or issue a 

new instrument to the new holder, or 

 the right to the principal of, and stated interest on, the obligation may be transferred only 


through a book-entry system maintained by the issuer (or its agent); or 


 the obligation is registered as to both principal and any stated interest with the issuer (or its 

agent) and may be transferred through both the above methods. 

Issuers Must Make Certain Elections at Issuance. When an issuer considers actions it must 

take when it issues bonds, it should consider whether it wants to make any elections. Various 

provisions of the IRC and regulations require that the issuer make certain elections in writing and 

retain elections as part of the bond documents. Many elections have to be made on or before 

the issue date of the bonds. Some elections may be made by either the issuer or a conduit 

borrower. Others must be made by the actual issuer of the bonds. The IRS frequently observes 

that issuers make the written elections in the arbitrage certificate prepared pursuant to Treas. 

Reg. Section 1.148-2. Once made, elections cannot be revoked without IRS permission. 

Examples of elections include: 

 waiving the right to treat a purpose investment as a program investment 

 waiving the right to invest in higher yielding investments during any temporary period 

 the issuer of a pooled financing issue electing to apply rebate spending exceptions separately 

to each conduit loan 

 applying actual facts rather than reasonable expectations for certain provisions under the twoyear spending exception from rebate 

 excluding the earnings on a reasonably required reserve fund from available construction 


proceeds under the two-year spending exception from rebate
 

 treating a portion of an issue as a separate construction issue under the two-year spending 

exception from rebate 

 electing to pay 1.5% penalty in lieu of arbitrage rebate 

 electing to treat portions of a bond issue as separate issues 

Requirements that Apply at Issuance and Throughout the Life of the Bonds 

Proceeds Must Be Timely Allocated to Expenditures. Issuers and conduit borrowers must 

follow the rules for allocating bond proceeds. The issuer or other entity controlling expenditure 

of the proceeds of a governmental bond issue must allocate those proceeds among the various 

expenditures or other purposes of the issue in a manner demonstrating that the private activity 

bond tests are not met. These allocations must generally be consistent with the allocations 

made for determining compliance with the arbitrage yield restriction and rebate requirements, 

as well as other federal tax filings. See Proceeds are Subject to Investment Restrictions: the 

Arbitrage Yield Restriction and Arbitrage Rebate Requirements for an overview of those rules. 

8 
 

 

An issuer must allocate proceeds to expenditures not later than 18 months after the later of 

the date each expenditure is paid or the date the project, if any, that is financed by the issue is 

placed in service. This allocation must be made in any event by the date 60 days after the fifth 

anniversary of the issue date or the date 60 days after the retirement of the issue, if earlier. 

Proceeds are Subject to Investment Restrictions: the Arbitrage Yield Restriction and 

Arbitrage Rebate Requirements. Issuers of tax-exempt bonds, including governmental bonds, 

are generally subject to investment or arbitrage limitations under IRC Section 148. Failure to 

comply with those arbitrage limitations will result in the bonds being arbitrage bonds and interest 

on the bonds being taxable. 

In general, arbitrage is earned when the gross proceeds of an issue are used to acquire 

investments that earn a yield that is materially higher than the yield on the bonds of the issue. 

Earning arbitrage is permitted in certain circumstances. In some circumstances arbitrage may 

be earned but must be paid, or rebated to the U.S. Department of the Treasury. In some cases, 

an issuer may be able to reduce the yield on an investment for arbitrage purposes and thereby 

avoid an arbitrage violation by making a yield reduction payment to the U.S. Treasury. See 

Where and When to File Arbitrage Rebate Yield Reduction Payments, for information on how 

to make yield reduction payments. 

An issuer must comply with two general sets of arbitrage rules: (1) the yield restriction 

requirements of Section 148(a) and (2) the rebate requirements of Section 148(f). An issuer may 

meet one of these rules but still have arbitrage bonds because it failed to meet the other. Even 

though interconnected, both sets of rules have their own distinct requirements. The following 

is an overview of the basic requirements of these two general rules. Additional requirements or 

exceptions, beyond the scope of this publication, may apply in certain instances. 

An issuer’s reasonable expectations on the issue date regarding the amount and use of gross 

proceeds of the issue are used to determine whether an issue consists of arbitrage bonds. In 

addition, if an issuer or any person acting for the issuer takes a deliberate, intentional action to 

earn arbitrage after the issue date, that action will cause the bonds of an issue to be arbitrage 

bonds if that action, had it been reasonably expected on the issue date, would have caused the 

bonds to be arbitrage bonds. Intent to violate the requirements of Section 148 is not necessary 

for an action to be intentional. 

Yield Restriction Requirements. The yield restriction rules of IRC Section 148(a) generally provide 

that the direct or indirect investment of the gross proceeds of bonds in investments earning a 

yield materially higher than the yield of the bond issue causes the bonds to be arbitrage bonds. The 

chart below describes when the yield on particular investments will be “materially higher” (the 

chart shows the permitted yield spread between the yield on the bond issue and the yield on the 

particular investment; any spread beyond that stated is materially higher): 

9 
“Materially Higher” Limits 

Type of Investments Materially Higher 

General rule (when other rules below don’t apply) 1/8 of one percentage point 

Investments in a refunding escrow 1/1000 of one percentage point 

Investments allocable to replacement proceeds 1/1000 of one percentage point 

Program investments 1.5 percentage points 

Investments in tax-exempt bonds that are not 

subject to the alternative minimum income tax 

No yield limitation 

Certain exceptions are available under the yield restriction rules. The investment of proceeds 

in materially higher yielding investments does not cause the bonds of an issue to be arbitrage 

bonds: (1) during a temporary period (for example, three-year temporary period for capital 

projects and 13 months for restricted working capital expenditures); (2) as part of a reasonably 

required reserve or replacement fund; and (3) as part of a minor portion (an amount not 

exceeding the lesser of 5% of the sale proceeds of the issue or $100,000). Whether the arbitrage 

yield restrictions rules apply, issuers should consider whether the rebate requirements apply. 

Rebate Requirements. The rebate requirements of IRC Section 148(f) generally provide that, 

unless certain earnings on “nonpurpose investments” allocable to the gross proceeds of an 

issue are rebated to the U.S. Treasury, the bonds in the issue will be arbitrage bonds. Generally, 

nonpurpose investments are investment securities such as Treasury bonds, bank deposits or 

guaranteed investment contracts, and so on, and do not include “purpose investments.” A 

purpose investment is an investment that the issuer acquires to carry out the governmental 

purpose of an issue. An example of a purpose investment is the loan obligation created when an 

issuer loans bond proceeds to another governmental unit, such as in a pooled or “bond bank” 

financing. 

The arbitrage that must be rebated is based on the excess (if any) of the amount actually earned 

on nonpurpose investments over the amount that would have been earned if those investments 

had a yield equal to the yield on the issue, plus any income attributable to the excess. Under 

Treas. Reg. Section 1.148-3(b), the future values (as of the computation date) of all earnings 

received and payments actually or constructively made on nonpurpose investments are included 

in determining the amount of rebate due. 

See Where and When to File Arbitrage Rebate Yield Reduction Payments for information on 

how to make rebate payments. 

There are, however, two types of exceptions to the general rebate requirements that apply to 

governmental bonds: the small issuer exception and the spending exceptions. 

Small Issuer Exception. This exception provides that governmental bonds issued by small 

governmental issuers with general taxing powers are treated as meeting the arbitrage rebate 

requirement. A governmental entity has general taxing powers if it has the power to impose 

taxes of general applicability which, when collected, may be used for its general purposes. 

10 
An issue (other than a refunding issue, for which other rules apply) qualifies for the small issuer 

exception only if the issuer reasonably expects as of the issue date to issue, or in fact issues, 

$5 million or less in tax-exempt governmental bonds during the calendar year. The aggregation 

rules of Section 148(f)(4)(D) should be considered when determining whether this exception 

applies. The $5 million limit is increased by the aggregate face amount of bonds attributable to 

financing the construction of public school facilities, up to an additional $10 million. For example, 

the small issuer exception could apply if the qualifying issuer issued $5 million in tax-exempt 

governmental bonds for street improvements and $5 million in tax-exempt bonds to finance 

construction of public school facilities in the same calendar year. 

An issue meeting the small issuer requirements is exempt from rebate for all gross proceeds. 

However, the small issuer exception is an exception from rebate and not from the arbitrage rules 

altogether. The yield restriction rules still apply. Therefore, an issuer qualifying for this exception 

needs to establish a temporary period for project fund investments and needs to establish that 

any reserve fund is reasonably required. 

Spending Exceptions. There are three spending exceptions to the rebate requirements. Whether 

these exceptions apply depends on the timing of expenditures of required amounts of proceeds, 

as follows: 

Spending Exceptions 

Spending 

Period 

Spending Exception 

6 months Treas. Reg. Section 1.148-7(c) provides an exception to rebate if the gross proceeds 

of the bond issue are allocated to expenditures for governmental or qualified 

purposes that are incurred within 6 months after the issue date. 

18 months Treas. Reg. Section 1.148-7(d) provides an exception to rebate if the gross proceeds 

of the bond issue are allocated to expenditures for governmental or qualified 

purposes which are incurred within: (1) at least 15% within 6 months after the issue 

date; (2) at least 60% within 12 months after the issue date; and (3) 100% within 18 

months after the issue date. 

2 years Treas. Reg. Section 1.148-7(e) provides an exception to rebate for construction issues 

financing property to be owned by a governmental entity or 501(c)(3) organization 

when certain available construction proceeds are allocated to expenditures: (1) at 

least 10% within 6 months after the issue date; (2) at least 45% within 12 months 

after the issue date; (3) at least 75% within 18 months after the issue date; and (4) 

100% within 24 months after the issue date. 

Note: Issuers may still owe rebate on amounts earned on nonpurpose investments allocable to proceeds 

not covered by one of the spending exceptions, which may include earnings in a reasonably required 

reserve or replacement fund. 

11 
Where and When To File Arbitrage Rebate and Yield Reduction Payments. Issuers of tax-exempt 

bonds file Form 8038-T, Arbitrage Rebate, Yield Reduction and Penalty in Lieu of Arbitrage 

Rebate, to make: 

 yield reduction payments 

 arbitrage rebate payments 

 payments of a penalty in lieu of rebate 

 payment in connection with the termination of the election to pay a penalty in lieu of arbitrage 

rebate 

 payment of the penalty for failure to pay arbitrage rebate on time 

A yield reduction payment or arbitrage rebate installment payment is required to be paid no 

later than 60 days after the “computation date” to which the payment relates. An issuer of a 

fixed yield issue may treat any date as a computation date. An issuer of a variable yield issue 

may treat the last day of any bond year ending on or before the latest date for making the first 

rebate payment (generally not later than five years after the issue date) as a computation date. 

Thereafter, the issuer must consistently treat either the end of each bond year of the end of each 

fifth bond year as a computation date. Generally, a “bond year” is a one-year period that ends 

on the date that the issuer selects. If the issuer does not make a timely selection, the bond years 

for the issue end on each anniversary of the issue date and on the final maturity date. 

Recovering an Overpayment of Rebate. If an issuer pays more than the required rebate, it may 

ask to recover the overpayment. In general, an issuer may request an overpayment of arbitrage 

rebate when it can establish that an overpayment occurred. An overpayment is the excess of 

the amount paid to the U.S. Treasury for an issue under IRC Section 148 over the sum of the 

rebate amount for the issue as of the most recent computation date and all amounts that are 

otherwise required to be paid under Section 148 as of the date the recovery is requested. The 

request can be made with the IRS by completing and filing Form 8038-R, Request for Recovery 

of Overpayments Under Arbitrage Rebate Provisions. An issuer must file a Form 8038-R no 

later than the date that is two years after the final computation date for the issue. For more 

information, see Treas. Reg. Section 1.148-3(i). 

Special Remedial Action for Failure to Timely Pay Arbitrage Rebate. An issuer that fails to timely 

pay arbitrage rebate will be excused from having its bonds be arbitrage bonds if the failure isn’t 

due to willful neglect and the issuer submits a Form 8038-T with a payment of the rebate amount 

owed, plus penalty and interest. The penalty may be waived under certain circumstances. For 

more information, see Treas. Reg. Section 1.148-3(i)(3) and Revenue Procedure 2005-40, 2005­

28 I.R.B. 83. 

Bonds May Not Be Federally Guaranteed. IRC Section 149(b) provides that any tax-exempt 

bond, including a governmental bond, will not be treated as tax-exempt if the payment of 

principal or interest is directly or indirectly guaranteed by the federal government or any agency 

or instrumentality of the federal government. Exceptions to this general rule include guarantees 

by certain quasi-governmental entities administering federal insurance programs, and federal 

guarantees for qualified residential rental projects, home mortgages and student loans. Additional 

exceptions apply for the investment of bond proceeds that are invested in U.S. Treasury securities 

or held in a bona fide debt service fund, a reasonably required reserve or replacement fund or a 

refunding escrow, and investments during a permitted initial temporary period. 

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A Bond May Not Be a Hedge Bond. IRC Section 149(g) states that hedge bonds will not be 

tax-exempt unless certain requirements, described below, are satisfied. A “hedge bond” is any 

bond that is part of a bond issue that fails either of the following requirements: 

 The issuer must reasonably expect that 85% of the spendable proceeds of the issue will be 

used to carry out the qualified purpose within the three-year period beginning on the date the 

bonds are issued (“spendable proceeds” means proceeds from the sale of the issue, less the 

portion invested in a reasonably required reserve or replacement fund or as part of a permitted 

“minor portion”). 

 Not more than 50% of the proceeds of the issue are invested in nonpurpose investments 


having a substantially guaranteed yield for four or more years. 


Section 149(g)(3)(B) provides an exception to the general definition of a hedge bond if at least 

95% of the net proceeds of the issue are invested in tax-exempt bonds that are not subject 

to the alternative minimum tax. For this purpose, amounts held either: (1) in a bona fide debt 

service fund, or (2) for 30 days or less pending either reinvestment of the proceeds or bond 

redemption, are treated as invested in tax-exempt bonds not subject to the alternative minimum 

tax. Additionally, a refunding bond issue does not generally consist of hedge bonds if the prior 

issue met the requirements for tax-exempt status and issuance of the refunding bonds furthers a 

significant governmental purpose (for example, realize debt service savings, but not to otherwise 

hedge against future increases in interest rates). 

Even if an issue otherwise meets the definition of a hedge bond, it will generally still be taxexempt if two requirements are satisfied. First, at least 95% of the reasonably expected legal 

and underwriting costs associated with issuing the bonds must be paid within 180 days after 

the issue date and the payment of such costs must not be contingent upon the disbursement of 

the bond proceeds. Second, on the date of issuance the issuer must reasonably expect that the 

spendable proceeds of the issue will be allocated to expenditures for governmental or qualified 

purposes within the following schedule: 

 10% within 1 year after the date of issuance; 

 30% within 2 years after the date of issuance; 

 60% within 3 years after the date of issuance; and 

 85% within 5 years after the date of issuance. 

Limitations on Refunding Governmental Bonds. Governmental bonds may be currently 

refunded. The Tax Cuts and Jobs Act (2017) repealed the exclusion from gross income for 

interest on bonds issued to advance refund another bond. The repeal applies to advance 

refunding bonds issued after December 31, 2017. A bond is classified as an advance refunding if 

it is issued more than 90 days before the redemption of the refunded bonds. Under Treas. Reg. 

Section 1.150-1(d)(1), a refunding bond issue is an issue the proceeds of which are used to pay 

principal, interest, or redemption price on another issue (a prior issue), as well as the issuance 

cost, accrued interest, capitalized interest on the refunding issue, a reserve or replacement fund, 

or any similar cost properly allocable to that refunding issue. 

Refunding issues generally derive their tax-exempt status from the prior issue they refund; if the 

prior issue was not tax-exempt, the refunding bonds generally cannot be tax exempt. 

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Bonds May Not Be Used for Abusive Tax Transactions 

The IRS, is engaged in extensive efforts to curb abusive tax shelter schemes and transactions. 

What Happens When the Terms of a Bond are Modified? 

If the terms of a governmental bond are sufficiently modified, the bond will be treated as 

reissued. When bonds are reissued, either actually or in a deemed reissuance, the new bonds 

must be retested as of the date of the reissuance to determine if all the federal tax requirements 

are met for the “new” issue. These include the requirements that apply when bonds are issued, 

such as timely filing of the Form 8038-G or 8038-GC. See Requirements Related to Issuance – 

Issuers Must File an Information Return. 

A deemed reissuance may arise if sufficient changes are made to the bond terms, such as when 

a bondholder and issuer agree, directly or indirectly, to a significant modification of the terms of 

any bonds. See Reissuance of Tax-Exempt Obligations: Some Basic Concepts for examples 

of significant modifications. If deemed reissued, the modified bonds are deemed exchanged 

for the original bonds. In general, the date the issuer and bondholder enter into the agreement 

to modify the terms of the bonds is treated as the date of issuance of the new bonds, even if 

the modification is not immediately effective. At reissuance, the modified bond must meet any 

tax law requirements that apply upon its early retirement in connection with the reissuance, 

including the acceleration of any arbitrage rebate or yield reduction payment that is due. See 

Where and When To File Arbitrage Rebate and Yield Reduction Payments. 

Issuers Must Retain Records to Show that Requirements are Satisfied 

IRC Section 6001 and Treas. Reg. Section 1.6001-1(a) generally provide that any person subject 

to income tax, or any person required to file a return of information with respect to income (for 

example, the issuer filing information returns relating to its bond issues), must keep any books 

and records as are sufficient to establish the amount of gross income, deductions, credits 

or other matters required to be shown by that person in any return. See Frequently Asked 

Questions for more information. 

Post-Issuance Compliance Monitoring 

In this section, we discuss the importance of issuers monitoring compliance with the IRC 

requirements and suggest steps an issuer may take to monitor its bond issues. 

Protecting Against Post-Issuance Violations 

Issuers may be concerned with how they can further protect the tax-exempt status of their 

bonds. Reliance solely on bond documents and tax certificates provided when the bonds are 

issued will not likely provide the assurance an issuer desires. To gain greater confidence that 

bonds are in compliance with federal tax laws, an issuer may adopt post-issuance monitoring 

procedures. Issuers that establish and follow comprehensive written monitoring procedures 

to promote post-issuance compliance generally are less likely to violate the federal tax 

requirements related to its bonds, and are more likely to find any violations earlier, than those 

without procedures. Early discovery of a violation is a factor IRS considers in determining the 

appropriate resolution under its TEB VCAP. 

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Steps to Better Monitoring 

In formulating its procedures, an issuer may consider: 

 designating one or more officials to assist in post-issuance compliance; 

 designating one or more officials to assist with and respond to examinations of the bond issue; 

 providing training or other technical support to designated officials; 

 designating time intervals within which compliance monitoring activities will be completed; and 

 timely completing remedial actions (including requests under TEB VCAP) to correct or 


otherwise resolve identified noncompliance.
 

The chart below identifies particular areas for compliance monitoring procedures. 

Compliance Procedures 

Type of 

Procedures 

Description of Procedures for 

Post Closing Matters 

Where Responsibility Is 

Discussed in this Publication 

Information 

Return Filing 

Procedures to ensure timely filing 

of information returns, including 

procedures concerning amended 

and late filed returns 

Other Governmental Bond Requirements – 

Requirements Related to Issuance – Issuers 

Must File an Information Return 

Private Use of 

Proceeds or 

Bond-Financed 

Property 

Procedures to timely identify and 

remediate deliberate actions 

Tax-Exempt Governmental Bonds – Testing for 

Governmental Bonds: The Private Activity Bond 

Tests 

Reissuance Procedures to satisfy tax 

requirements when a significant 

modification in terms results in a 

reissuance for federal income tax 

purposes 

Other Governmental Bond Requirements – 

What Happens When the Terms of a Bond Are 

Modified? 

Elections Procedures for timely federal 

income tax elections 

Other Governmental Bond Requirements – 

Requirements Related to Issuance – Issuers 

Must Make Certain Elections at Issuance 

Allocation of 

Proceeds 

Procedures for the timely 

expenditure and accounting 

for use and investment of bond 

proceeds 

Other Governmental Bond Requirements – 

Requirements that Apply at Issuance and 

Throughout the Life of the Bonds – Proceeds 

Must be Timely Allocated to Expenditures 

Arbitrage 

Compliance 

Procedures for the timely 

computation and payment 

of arbitrage rebate and yield 

reduction payments 

Other Governmental Bond Requirements – 

Requirements that Apply at Issuance and 

Throughout the Life of the Bonds – Proceeds 

are Subject to Investment Restrictions: the 

Arbitrage Yield Restriction and Arbitrage Rebate 

Requirements 

Record 

Retention 

Procedures for the maintenance 

of records 

Other Governmental Bond Requirements – 

Issuers Must Retain Records to Show that 

Requirements are Satisfied 

IRS Contacts Procedures concerning contacts 

from the IRS 

Post-Issuance Compliance Monitoring – Steps to 

Better Monitoring 

See Post-Issuance Compliance for additional information. 

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What To Do When You Discover a Violation — TEB Voluntary Closing Ageement 

Program 

The IRS is committed to resolving federal tax violations with the issuer. The TEB Voluntary Closing 

Agreement Program (TEB VCAP) provides remedies for issuers of tax-exempt bonds, tax credit 

bonds, and direct pay bonds that voluntarily come forward to resolve a violation that cannot be 

corrected under self-correction programs described in the regulations or other published guidance. 

Notice 2008-31, 2008-11 I.R.B 592, provides information and general guidance about TEB VCAP. 

Internal Revenue Manual (IRM) section 7.2.3 provides general procedures under which TEB will enter 

into closing agreements. Closing agreement terms and amounts may vary according to the degree of 

the violation as well as the facts and circumstances surrounding it. 

Issuers must use IRS Form 14429, Tax Exempt Bonds Voluntary Closing Agreement Program 

Request, to submit a request and provide the required information. See IRM section 7.2.3.2.1 

about completing the March 2013 version of the form. 

For more information about this program, including request submission requirements, case 

processing procedures, and resolutions standards, see IRM section 7.2.3. See Voluntary 

Compliance (for more information on TEB VCAP administrative procedures and resolution 

standards). 

More Information 

You can find information about the tax laws that apply to municipal finance arrangements, 

including tax forms and instructions, revenue procedures and notices, and publications at 

IRS.gov/bonds. 

If you have account specific questions, call Customer Account Services toll-free at 877-829-5500. 

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