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IRS Opens, Closes S. Dakota Arbitrage Audit

WASHINGTON - In what appears to be the first publicly disclosed case under its new arbitrage rebate compliance initiative, the Internal Revenue Service opened an audit of $59.6 million of South Dakota Health and Educational Facilities Authority's 2002 revenue bonds and then closed it in less than five weeks without a change to the bonds' tax-exempt status.

The IRS also opened a seemingly routine examination of $40 million of revenue bonds that were issued in 2002 by the Illinois Health Facilities Authority for the Riverside Health System.

The examinations were disclosed yesterday in material event notices the issuers sent to the nationally recognized municipal securities information repositories.

The South Dakota authority's notice, which disclosed both the opening and closing of the examination, included a copy of the letter announcing the examination and the "information document request" form the IRS sent under the arbitrage rebate compliance initiative, providing a glimpse into how much detailed information issuers must provide to comply with such audits.

Some market participants had been concerned that the relatively quick three-week deadline, coupled with the comprehensive information requirements, could present challenges to an issuer and force it to hire outside help to ensure a prompt and accurate response.

However, several bond attorneys said yesterday that, thanks to a flexible IRS and strong record retention, issuers are up to the challenge.

David Caprera, a partner at Kutak Rock LLP in Denver, said he anticipates issuers who receive these requests will handle them mainly in-house, relying on bond counsel as more of a safety net or if extenuating circumstances arise.

"Most of it's record collection ... If the issuer collects the initial information and sends it in and the IRS says it's fine, then that's fine, but if the IRS comes back [with questions], then at that time, if the issuer hasn't contacted their bond counsel already, that's probably a good time to pick up the phone," he said. "I would think generally that's how issuers and their bond counsel would interact on these sorts of things."

Caprera said that while none of his clients have received one of the roughly 200 arbitrage rebate information requests that the IRS has sent out thus far, he would not be surprised if some of them did eventually.

Concerns about the three-week deadline were assuaged earlier this month when Clifford Gannett, director of the IRS' tax-exempt bond office, told the American Bar Association's tax-exempt financing committee that the agency will try to remain flexible on the deadline and will "most likely" approve extension requests.

The complexity of the transaction under audit will probably play a role in how quickly the issuer can respond to the IRS' information request, lawyers said. But the five-week turnaround of the audit of the South Dakota authority's bonds may also serve as an indication that the IRS is simply doing checks of appropriate record-keeping for arbitrage rebate calculations, rather than extensive in-depth investigations.

Mark Scott, a partner at Vinson & Elkins LLP and former head of the IRS tax-exempt bond office, wondered if the audits are intended, in part, to help the IRS lower its average examination time, which can be driven up by prolonged audits lasting several years.

"I'm assuming that one of the purposes behind this examination program is to reduce their overall cycle time on ongoing examinations," he said. "If they can close, let's say, 75% of these within four to seven weeks, then that's going to substantially reduce the amount of cycle time for this fiscal year, which is always important ... because that's the number that they always hand out to the public."

In the form it sent the South Dakota authority, the IRS asked for information about the bonds in question, such as a description of the project they were meant to finance, the status of the project, and the dates on which arbitrage rebate was calculated. Also, the form requests copies of certain documents tied to arbitrage, such as expenditures tied to the project, rebate computations, yield restriction analysis, and-or rebate overpayment claims.

The letter the IRS field agent sent the authority states that the examination is part of a specific initiative, and it has "no reason to believe that your debt issuance fails to comply with any of the applicable federal tax requirements."

However, the letter adds, "We reserve the right to expand this examination to any aspect of your debt issuance."

Don Templeton, executive director of the South Dakota authority, declined to comment on the audit. Other transaction participants included Jones, Day, Reavis & Pogue, now Jones Day, as bond counsel, and the now-defunct Altheimer & Gray as underwriter's counsel. The underwriter on the deal was Dougherty & Co.

Meanwhile, the Illinois Health Facilities Authority disclosed that the IRS has begun an examination of $40 million of its revenue bonds, the proceeds of which were lent to Riverside Health System.

In the notice, the authority stated the IRS told it that the audit was part of a series of routine examinations and that, at this point, there was no reason to assume the bonds were in violation of federal tax requirements.

Jones Day also was bond counsel on this deal, and Gardner, Carton & Douglas, now part of Drinker Biddle & Reath LLP, was underwriter's counsel. Cain Brothers & Co. was the underwriter. Authority officials could not be reached for comment.

 

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