The difference between the interest on governmental obligations exempt from federal income tax under the Internal Revenue Code and the yield on securities and obligations that are not exempt from federal income tax in which the proceeds of the governmental obligations are invested.
earning more interest on an investment than the interest cost on the debt proceeds used to make that investment. The Internal Revenue Code regulates the amount and conditions under which arbitrage on the investment of bond proceeds is permissible and the 1986 Tax Reform Act requires, with a few exceptions, that arbitrage earnings must be rebated to the federal government.
The relationship of the interest rates on a debt issue to the interest rates achieved on the temporary investment of bond proceeds. Positive arbitrage occurs when the investment income received is greater than the interest expense on the bonds. The Internal Revenue Service has restrictions on positive arbitrage. See Rebate.