Gannett Outlines Audit, Notification Changes

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The Internal Revenue Service is in the process of making changes to its audit procedures and how it notifies issuers that it has tax law or regulatory concerns about their tax-exempt bonds, Cliff Gannett, director of the IRS' tax-exempt bond office, said in a recent interview.

Instead of sending an issuer a preliminary adverse determination that bonds may be taxable, the IRS will send the issuer a form with a list of tax issues that need to be resolved regarding the bonds.

Gannett said the proposed Form 5701-TEB, will help streamline the process and make issuers aware of potential problems earlier. He said the change has been called for from both sides of the muni market.

"This kind of came up from both the bond community and our agents and managers, that this would probably streamline the process as far as timing goes," he said. "There was a lot of back and forth that was associated with the preliminary, and many times you'd end up in a situation where all of a sudden there's a whole bunch of issues identified in the preliminaryadverse that probably should have been handled all along before you came up with this large document."

If the issues in the form cannot be resolved, the IRS will send the issuer a proposed adverse determination. In addition, the agency for the first time will start sending issuers final adverse determinations. Gannett said the issuance of the final determinations will provide better closure to enforcement cases, since currently a proposed determination simply becomes a final one after a period of 30 days unless it is appealed.

"I think it's probably best for everybody - something that finally and conclusively says, 'We're done,' " he said.

In a two-hour interview, Gannett addressed the audit procedure changes as well as other issues in the tax-exempt bond area, several of which he discussed at the American Bar Association's tax-exempt financing committee meeting in Las Vegas late last month.

With the changes in the audit procedures still in the works, Gannett said he expects another busy year for the tax-exempt bond office. He said he anticipates that in fiscal 2008, which began Oct. 1, bond agents will complete about 460 audits. Of that amount, 280 will be general examination audits, 100 will be claims of arbitrage rebate overpayments, and another 80 will be audits related to arbitrage issues.

Despite a full docket, the TEB office will have to make do with fewer new hires than originally expected. Gannett told the ABA tax-exempt financing committee in Las Vegas that while he originally expected to be able to hire 20 new people for the office, budget setbacks shrunk that number to just three.

Gannett said that the hiring reduction came as a result of broader budget cuts within the tax-exempt/government entities department of the IRS. "I think that was a result of an across-the-board budget decision," he said.

The cutback will mostly affect the compliance and program management program, or CPM, which oversees the voluntary closing agreement program, sets up exam initiatives, and selects potential audit cases for field agents. Gannett said CPM typically has between 10 and 12 staffers, but currently only has six. However, two of the three new hires will go to that office, and three agents are being transferred into the office to bring its workforce to 11 people.

He said they have already filled the three new slots. And while hiring for this year is lower than once expected, Gannett said the office should still be able to manage 2008's workload fairly well, since fewer experienced staffers will be needed to train the new hires.

"Because of the amount of training we'd have to do with the respect to new people, we'd have to take experienced people and have them training the new people," he said. "This year, it's kind of a wash."

But the reduction in hires could come be problematic in 2009, he said.

"Next year [2009] is going to be hard," he said. "Right now, we're not expecting a whole lot more than what happened this year, so it could be very challenging for us."

Gannett said he hopes the hiring situation will improve in 2010.

"We'll be asking for it. We'll see what happens," he said.

While TEB may not be getting the manpower it would like, Gannett said that in terms of experience, the office is in better shape than it has been in a long time. For the first time in several years, TEB has its managerial staff entirely in place, with five branch managers heading up offices nationwide.

"Even though our numbers are down a bit as far as workforce goes, I do think we have a very experienced team in place," Gennett said.

That team includes Derek Knight in Denver, Allyson Dodd in Chicago, Carl Scott in Little Rock, and Tanya Kryah and Paul Kline in Independence, Ohio.

Gannett said that in fiscal 2007, the IRS reached 49 closing agreements with issuers totaling $40 million Of that amount, $25 million was paid over abusive transactions. The IRS also reached 23 agreements totaling $5.3 million under the voluntary closing agreement program. Under VCAP, issuers can approach the IRS when they discover compliance problems with outstanding bonds in hopes of obtaining more lenient sanctions.

Thus far in 2008, which began Oct. 1, the IRS has already concluded some 12 closing agreements totaling $23 million, with over half that amount - $12 million - paid in connection with abusive transactions, Gannett said. VCAP has resulted in agreements totaling about $3.9 million so far this fiscal year.

TEB became more efficient in closing cases in fiscal 2007, according to Gannett. The average time from opening a case to closing it was only 177 days, compared to 310 days in 2006.

However, Gannett pointed out that the marked improvement can be attributed in part to an upsurge in arbitration rebate claims, which are typically quicker to process.

"Part of what happened this last year was that we had an upsurge in claims. ... We closed 135 claims, compared to the year before when we closed 75, so that makes a difference," he said. "Those are cases that will have a shorter cycle, there's no question."

TEB's plans for the coming year include issuing Notice 2001-60 in the next couple of months, which will expand VCAP to include tax-credit bonds and update the administrative requirements of the program.

Additionally, the office expects an advisory committee, which includes three TEB members, to release a report this summer on how to further develop the VCAP.

TEB also has a team, led by Scott in Arkansas, that expects to open five to 10 examinations of student loan bonds this year. While most student loans are handled privately, TEB will look at the roughly 10% of the market that exists within the public sphere. Gannett said he will be interested to see what the examinations turn up.

"There are some really significant arbitrage requirements, and clearly some of the issues that we need to take a look at [are] where you have these tiers, where basically you have a large bond issue and then there is lending out of that," he said. "Are these instrumentalities? Are these conduit issuers? Are these governmental issuers?"

TEB also is developing a more focused initiative to examine qualified hedges, specifically swap and cap agreements entered into in connection with tax-exempt bond deals. Gannett said TEB opened about 30 examinations in this area in 2006 and 2007 and is now developing a larger, more focused initiative to address three main concerns that have evolved from these exams.

"One is whether or not it is a qualified hedge. That's a basic requirement," he said. "Secondly, whether it is accounted for properly within the bond yield calculation, and then thirdly, whether it is valued properly."

He said that while TEB hopes to conclude the initial initiative by March 30, "we already know we have problems in all three areas."

The office also is finalizing a report on the results of surveys sent out to 208 charitable organizations that focused on such issues as how they used their bond proceeds, how bond-financed facilities were used, whether arbitrage was earned, and whether records were retained.

Gannett said TEB hopes to use the findings from the survey to develop another survey that will be sent to issuers of governmental bonds.

"My thinking is that we'll see what the results were of the charitable financing survey, and then we'll make decisions about the content of the governmental bond survey," Gannett said. "A lot of the same questions I suspect will be also on the governmental survey."

He said he hopes TEB will issue the governmental survey sometime in the fourth quarter of fiscal 2008, and added that the office has not ruled out issuing another, broader survey to charitable organizations, depending on the results it obtains from the initial survey.

Finally, Gannett weighed in on the issue of whether or not the IRS should pay interest on arbitrage rebate overpayments, which occur when issuers submit arbitrage rebate payments to the agency, only to discover later that they paid too much.

Gannett said that there are two different overpayment issues and that he is concerned that the controversy over one of them may overshadow and threaten consideration of the other one, which he thinks is a more legitimate concern.

Currently, the IRS does not pay interest on overpayments, even though it requires interest payments on any arbitrage paid late by issuers. The Government Finance Officers Association has criticized the agency, saying the slow turnaround in processing overpayment requests from issuers makes the interest payments necessary.

Treasury and IRS officials said at a recent hearing on proposed arbitrage rules that they would need explicit permission from Congress to pay interest on such overpayments, as the law currently does not permit it.

Gannett said he can see why regulators would try to discourage such a practice. If an issuer overpaid arbitrage rebate and did not discover it until five years later, "it almost encourages someone to be asleep at the switch and get it wrong, and then come in for interest," he said.

This is the issue that GFOA has focused on and the one that has gotten most of the public attention recently.

But there is another issue in this area that deserves more attention, he said, one that is currently being pursued by the National Association of Bond Lawyers.

In a letter to the IRS regarding its proposed arbitrage regulations - which currently does not include any interest overpayment provisions - the association described a situation in which the issuer makes an arbitrage rebate overpayment and discovers it while the bonds are still outstanding. Typically, rebate calculations are made on a "future value" basis, meaning they are calculated under the assumption that the bonds will be outstanding to maturity.

NABL's question to the IRS is, if arbitrage payments are future valued, then shouldn't overpayments be future-valued in the same way by the IRS? Gannett said that issue is one that could merit from further discussion and consideration.

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