WASHINGTON - The Internal Revenue Service has agreed to close 26 examinations of roughly $800 million of bonds issued by several California school districts without finding the bonds taxable in exchange for $5 million from the lead banker on the controversial deals.
J. Jeffrey Kinsell, executive vice president of Kinsell, Newcomb & De Dios Inc., told The Bond Buyer Friday the firm reached a settlement with the agency late Thursday, bringing to a close a series of examinations dating back to 2006. The issuers are currently in the process of disclosing the agreement to the nationally recognized municipal securities information repositories.
Under the settlement, KND agreed to pay $4 million immediately and another $1 million over the next three years. In exchange, the IRS will not declare the bonds taxable, there will be no costs assessed to the issuers, and all parties involved will not be subject the future penalties from the IRS as a result of these deals.
The final provision is significant because the IRS had previously been considering a Section 6700 investigation of Kinsell, which enables the IRS to penalize individuals and firms that promote abusive tax shelters. However, Kinsell's attorney, John R. Larson with Messerli & Kramer PA, said the agency never formally began an investigation, and the agreement precludes any future investigations.
The 26 audits resulting in 15 preliminary adverse determinations involve $800 million of advance refunding bonds sold by 20 school districts between 1993 to 2003; the IRS contended the deals had problems with bond and escrow security pricing.
The transactions were part of a forward-refunding program developed by KND in the early 1990s for California school districts with outstanding debt that carried fairly low interest rates. Under the program, a district would enter into a forward agreement to sell advance refunding bonds at a future date and use those proceeds to defease the outstanding bonds to their maturity dates.
A third party agent would take bids on Treasury securities for the escrow, but Kinsell always won the bid. The firm also canvassed at least three potential purchasers of the bonds to establish the bonds' issue price.
At the forward delivery date, six to 15 months later, the firm would purchase the refunding bonds from the district and sell them to the public at prevailing market rates, which typically were higher due to interest rate movements during the forward period.
In the preliminary determinations, the IRS contended that the escrow securities were not purchased at a fair-market value and that the yields on the bonds were computed based on an incorrect issue price, resulting in bond yields that were below the yields of the escrow securities, making the debt arbitrage bonds and taxable.
Despite the settlement, Kinsell maintained, as he has in the past, that the "unique" deals, although "very complicated," are fully compliant with all tax regulations.
"Absolutely," he said, adding that he had been told in the past by a number of regulators that the deals properly adhered to the tax code.
Instead, he contended that the IRS examination process drove negotiations to the settlement table and its public nature made it difficult to make a strong case against a preliminary adverse determination. When a preliminary adverse determination is publicized, he said, the market reacts negatively towards the bonds, hurting issuers and bondholders.
"The problem is that with this process, we're not the only ones who are affected by the regulatory examination. It's other innocent bystanders, it's the investors, it's the issuers who really get whacked," Kinsell said. "Trading $5 million for fixing the problem ... from that perspective, it's reasonable."
"Because of the public damage done to the issuers and the bondholders, frankly, you write a check when you wouldn't normally be disposed to do it," Larson added. "If we didn't do that, we probably would have been knocked out of business."
However, a source familiar with the deals strenuously disagreed with their claims that they were legitimate.
"It's just not true," the source said. "They wanted to protect the bondholders because they didn't want the bondholders to sue them for bad deals."
Also, Kinsell told The Bond Buyer in a December interview that the deals' forward-delivery structure, which came under IRS scrutiny, did not serve a business purpose from the district's perspective.
"There really isn't any advantage to [the districts with a forward program], other than allowing us to do the purchase of the call provision," he said at the time. "We simply wanted to know where the bonds were, so we'd know there would be value."
Regardless of the legitimacy of the deals, other bond attorneys supported the claim that the current examination process gives the IRS an edge, especially because it is so hard to take the IRS to court to challenge adverse determinations.
"The realities of the situation effectively preclude a judicial challenge which, in other areas of the tax law, would be much more common," said Tom Vander Molen, a partner at Dorsey & Whitney LLP in Minneapolis. "Ideally, I'd like to see a procedure for issuers and conduit borrowers to go to court and challenge IRS proposed determinations."
"Generally speaking, I think that the process does limit the ability of people to litigate certain types of issues," said Mark Scott, a partner at Vinson & Elkins LLP here and former head of the IRS tax-exempt bond office. "It's definitely tilted in favor of the IRS."
Kinsell said in December that when Scott headed up TEB, he told him in a private meeting that he did not like the deals, but they followed the rules. Scott declined to comment on the case.
IRS officials also declined to comment on the settlement. A representative for Best Best & Krieger LLP of Riverside, Calif., who served as bond counsel on all the deals, did not return calls for comment.
Kutak Rock LLP's David Miller and Bradley S. Waterman, a Washington-based tax controversy attorney, represented the school districts in the audits.
"My clients are extremely pleased that the settlement occurred and are very appreciative of the work that Kinsell and the IRS both did to make this happen," said Miller, who represented ten of the districts. Waterman declined to comment.