SAN ANTONIO — Treasury Department and Internal Revenue Service officials are trying to figure out how to apply long-standing tax requirements to Build America Bonds that, if interpreted broadly, could have major ramifications for certain BABs held by public pension funds and other governmental entities, possibly leading to their extinguishment.
Officials also are putting the finishing touches on a revenue procedure clarifying that the IRS could suspend BAB subsidy payments to an issuer during an audit once it says the bonds do not qualify as BABs under tax law requirements.
Federal officials fielded questions from bond attorneys about BABs at the National Association of Bond Lawyers’ annual Bond Attorneys Workshop here Wednesday and Thursday.
The attorneys specifically asked the officials about a question on the IRS’ BAB audit information document request that asks issuers to provide a record of any acquisition of the BABs in the primary or secondary market by or on behalf of the issuer; any agency, instrumentality, fund, or affiliated person related to the issuer; or any pension plan sponsored by the issuer or in which the issuer participates.
The question is targeted at whether related parties buying BABs could result in the bonds being extinguished. Federal tax requirements stipulate that if an individual or organization buys back its own debt, that debt is considered to be extinguished and no longer outstanding. But the topic gets murkier when dealing with related parties.
“The more tangential you get, the more difficult and gray it is,” said James Polfer, chief of the IRS’ tax-exempt bond branch in the associate chief counsel’s office. “At this point, unfortunately the answer is, we don’t know. … We understand this is a complicated issue and we’re looking at it.”
Perry Israel, a bond lawyer with his own practice in Sacramento, said the inclusion of pension funds on the list of potentially related parties is troubling, and could make things difficult for localities issuing BABs whose employees participate in a state pension plan. He pointed to the California Public Employees Retirement System as an example.
“It would be very troublesome to me to think that, if CalPERs decided to buy BABs in the secondary market from the city of Podunk, Cali … those would be treated as being extinguished,” he said.
Israel was speaking hypothetically. Asked about the issue on Thursday, a spokesperson with CalPERs said the system has not purchased any BABs issued within the state of California.
John Cross 3d, the Treasury’s associate tax legislative counsel, pointed out that this issue does not emerge often with tax-exempt bonds, given that tax-exempt entities and their related parties have no reason to purchase tax-exempt debt.
However, according to the flow of funds report for the second quarter that was published by the Federal Reserve on Sept. 17, state and local governments own $6 billion of municipal securities, and public pensions own $1.5 billion, though it is not clear if any, or how many, of the purchases were by affiliates of the issuers.
Cross also said he hopes to release guidance in early November clarifying when a bond is considered issued. This issue emerged recently with regard to “draw down bonds,” wherein an issuer agrees to sell a certain amount of bonds to a bank in a private-placement transaction. The bank, in turn, agrees to loan the bond proceeds to the issuer in several small periodic amounts. The issuer is only obligated to pay interest on the amounts that have been tapped.
Attorneys have questioned what happens if the issuer makes a draw on a bond relying on a temporary tax provision, like the one authorizing BABs, after that provision has expired.
He said the Treasury is also looking into whether it could provide a “more tailored” advance notice system to inform BAB issuers when one of their subsidy payments is going to be offset to pay off an outstanding tax liability.
ISSUE PRICE
The debate over how to determine issue price surfaced again at the conference, with federal officials saying they are hard at work on guidance clarifying the matter, while attorneys questioned what steps they should be taking to verify the pricing of their clients’ bonds.
“We really are looking actively at the topic and the goal is to see if there’s anything we can do that will increase certainty in the area and at the same time encourage good practices,” Cross said. “Is there a better mousetrap?”
While the IRS has encouraged issuers to track their bond prices via the Municipal Securities Rulemaking Board’s EMMA system, attorneys wondered what exactly they should do if they find odd pricing of a client’s bonds.
“If you see a couple sporadic trades of that same bond … how tight do you have to get about that?” asked Clifford Gerber, a partner at Sidley Austin LLP.
“My experience is you’re not looking at a smoking gun and it is at best gray,” added Thomas Vander Molen, a partner at Dorsey & Whitney LLP. “I’ve never had an underwriter say, 'Vander Molen, you caught us.’ … They’re going to have a good explanation.”
Clifford Gannett, director of the tax-exempt bond office, during a separate panel, pushed back against some criticism the IRS has received for asking issuers if they are using publicly available resources like EMMA to track the pricing of their bonds.
The IRS asked in a questionnaire sent to all BAB issuers last year if they were looking at the pricing of their bonds on a system like EMMA. The question was met with some controversy and criticism since issuers are not legally obligated to do so.
But Gannett argued that public officials should be interested in obtaining any information they can about the pricing of their bonds as a way to ensure they are getting the best deal possible on behalf of taxpayers.
“One of the things that really surprised me was that there was a sense that there were some in the bond community that really didn’t think that the info that is so readily available would be useful or helpful to issuers,” he said. “When you have info available that could help you identify potential fraud and abuse … to not be interested … seems strange to me as a tax administrator.”
While market participants are still waiting for guidance clarifying the issue price matter, Polfer pointed out that the IRS recently announced on its website that it is looking into allowing BAB issuers to enter into the voluntary closing agreement program to resolve minor issues without losing the entire subsidy payment.
“You would be able to have a remedy that would be commensurate with the offense and you wouldn’t have this nuclear option,” he said.
ENFORCEMENT
Meanwhile, Gannett said that a revenue procedure outlining when BAB payments could be disrupted is “in its last stages,” and will detail how the IRS plans to handle BABs and other direct-pay bonds in the context of an audit. He made his comments just days after the IRS kicked off an initial round of BAB audits that is expected to climb to nearly 30 deals.
“What you’ll see, in fact, is probably a more structured, a more pronounced effort to provide whatever protections issuers might need with respect to our process,” he said.
The revenue procedure also is expected to state that issuers will have their subsidy payments suspended after receiving a proposed adverse determination from the IRS, according to Carl Scott, the IRS group manager charged with handling BAB payments.
A proposed adverse determination comes after the IRS initiates an audit of the bonds, provides the issuer with a notice of proposed issue form that details any problems it has found with the bonds, and the issuer has been given a chance to respond to the identified issues. The payments could resume with interest on those that were suspended if the IRS resolves the issues with the BABs, Scott said.
He also said that an issuer who defaults on an interest payment would not automatically block a BAB subsidy payment, since the statute detailing BABs states the subsidy is based on “interest payable,” not interest paid.
But in cases where there are several defaults, the IRS would look into whether the bonds should still technically be considered outstanding and eligible for subsidies, he added.
Gannett said that about 16 BAB audits have been opened in recent weeks and another dozen could be opened in the near future.
Depending on what the IRS finds, it could audit more BABs or even open a targeted initiative on the bonds, he said. Other direct-pay bonds like recovery zone economic development bonds could also be examined, but so far none have been, he added.
