tax exemption, municipal bonds, municipal arbitrage, Section 103(c) Internal Revenue Code, regulation, Internal Revenue Service, Revenue Ruling 80-328, State of Washington v. Commissioner


The federal tax exemption afforded to municipal bonds makes them a desirable investment, but the tax exemption is a costly preference in the federal tax system, that has caused a loss of $9.4 billion in federal revenues in the fiscal year of 1981. Legislation has been enacted to regulate the use of the tax exemption for municipal bonds when their issuers engage in arbitrage practices. Arbitrage bonds are defined under Section 103(c) of the Internal Revenue Code as municipal securities which are issued for the purpose of investing the majority of the proceeds in higher yielding securities, or to replace funds invested at a higher yield, and disqualifies them from tax exemption. The Internal Revenue Service has established regulations governing municipal arbitrage practices, which is discussed by this Note. This note emphasizes arbitrage regulations which are designed to control problems associated with advance refunding bonds- securities issued and invested for the purpose of retiring a prior, outstanding issue. The Note considers the effects of Revenue Ruling 80-328, preventing state housing authorities from simultaneously issuing notes and bonds to finance the same low cost housing projects. It also examines the IRS's restrictive application of the arbitrage regulations in light of a recent Tax Court decision, State of Washington v. Commissioner, which invalidates an arbitrage regulation prohibiting the recovery of expenses incurred in the issuance of bonds. The author suggests that the effects of Revenue Ruling 80-328 concerning state housing construction, and the court's decision in State of Washington v. Commissioner indicate that the IRS may have exceeded its authority in administering the arbitrage provisions of the Code.

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