WASHINGTON — In some of its 32 Build America Bond audits, the Internal Revenue Service has raised concerns about whether premiums paid for bond insurance could disqualify the bonds as BABs and jeopardize the federal subsidy payments made to the issuers, according to bond lawyers and IRS officials.
Allyson Dodd, an IRS tax-exempt bond field manager in Chicago, talked about the BAB audits at a recent meeting of bond lawyers. She said that half of the 32 audits have been closed with no change to the status of the bonds and that the rest are ongoing.
However, she said the IRS raised the insurance premium issue in some of the audits that were closed, and the issuers were able to avoid potential problems by reallocating the bond proceeds it spent on the premium to other capital expenditures. The IRS is still considering whether an insurance premium is a capital expense, Dodd said.
BABs, created under the American Recovery and Reinvestment Act and issued in 2009 and 2010, are taxable bonds for which the Treasury Department makes subsidy payments to issuers equaling 35% of the interest costs.
Of the total 2,354 BAB issues sold in 2009 and 2010 for $181.5 billion, at least 198 for $4 billion were insured, according to Thomson Reuters.
For bonds to qualify as BABs, all of the proceeds except those used to pay cost of issuance and a reasonably required reserve fund must be used for capital expenditures. But the IRS has questioned whether the payment of a premium for bond insurance constitutes a capital expenditure.
IRS audits of BABs show a number of issuers thought their insurance premiums were capital expenditures. Those issuers whose audits were closed without change in status to the BABs were able to avoid IRS concerns by reallocating their proceeds within certain periods of time.
Long-standing tax rules on expenditures for tax-exempt bonds, which also apply to BABs, allow issuers to reallocate how they used their bond proceeds within 18 months of when a bond-financed project was placed in service and no later than five years from when the bonds were issued.
But some BAB issuers may not be able to reallocate their insurance premium payments, the lawyers said.
A number of bond attorneys believe insurance premiums are clearly capital expenditures.
“It seems curious that they’re spending time looking at whether bond insurance on a long-term bond issue is a capital expenditure because it seems clear it is,” said Charles Cardall, a partner at Orrick, Herrington & Sutcliffe LLP in San Francisco. In the corporate bond market, insurance premiums are treated as capital expenditures that are amortized over the life of the debt, he said.
Another bond lawyer said the IRS may take the position that the issuer only gets to capitalize the portion of the premium payment allocable to the construction period.
Ed Oswald, a partner at Orrick here, said that from a policy perspective, the IRS should want to treat premiums as capital costs because bond insurance lowers interest rates for issuers and BAB payments for the government.
Linda Schakel, a partner at Ballard Spahr LLP here, said Treasury and IRS lawyers have talked about this issue for two years, saying they might issue guidance on it.
“It would be better to have guidance than to have these things come up in audits,” she said.
Several bond lawyers said it is unclear what sanctions the IRS would impose if it decides insurance premiums are not capital costs and BAB issuers with insurance are unable to comply with the capital expenditure requirement.
For a BAB issue already under audit, the IRS could disqualify the bonds as BABs and withhold subsidy payments, the lawyers said. But some attorneys did not think the IRS would go that far.
The IRS is likely to treat issuers more leniently if they come to the IRS and seek to resolve the issue under the agency’s voluntary closing agreement program, they said. In that case, the IRS could decide that if a small percentage of the bond proceeds were used for insurance premiums, then that same small percentage of the bonds would not qualify as BABs, and only the subsidy payments attributed to those bonds would be withheld.
Other Compliance Initiatives
In other compliance initiatives for fiscal 2012, which began on Oct. 1, Dodd said the IRS has begun auditing about 100 advance refunding issues and is looking at whether the investments were purchased at fair-market value as well as whether yield-restriction requirements are being met, among other things.
She also said the IRS has begun auditing about 25 pooled bonds issued after May 17, 2006, to see if the issuers are complying with tax law changes that require there be written loan commitments and that bonds are redeemed if the proceeds remained unspent after a certain period of time.
The IRS is auditing student loan bonds and has reversed its stance and decided an arbitrage compliance issue: that the consolidation-loan rebate fees can be included in the computation of yield on the program investments. However, the IRS opposes so-called loan-swapping, which occurs when a student loan bond issuer allocates bond proceeds to certain student loans then tries to reallocate those proceeds to other student loans, typically to maximize their permissible yield, Dodd said.
“We’re working with issuers to resolve that issue,” she said.
Asked by a lawyer whether this issue could arise with single-family housing bonds, Dodd said yes.
In another initiative, the IRS conducted about 100 audits of governmental issues where the issuers did not feel they needed to make arbitrage rebate or yield-reduction payments. The agency found that in a significant amount of the audits, the issuers either owed money or made errors such as miscalculating their bond yield or investment yield. In the cases involving errors, however, the mistakes were not large enough to cause the issuer to owe payments to the IRS, Dodd said. Most of these audits are closed, she said.
Steve Chamberlin, manager of compliance and program management for the IRS’ tax-exempt bond office, said the agency plans to begin auditing governmental bond issues that finance facilities such as prisons, hotels, and convention centers that result in private use. The IRS will be looking particularly at management contracts and naming rights agreements entered into for these facilities, he said.
The IRS also plans to conduct correspondent exams of small governmental financings of less than $15 million, he said. This is a followup to similar exams the agency conducted last year on 100 to 150 governmental bond issues under $1 million in size.
Chamberlin said the IRS has begun about 75 audits of tax and revenue anticipation note issues to examine whether the issuer had valid cash-flow needs, among other things.
The IRS also plans to send post-issuance compliance questionnaires to issuers of qualified school construction bonds, he said. The agency sent such questionnaires to issuers of 501(c)(3) bonds, governmental bonds, advance refundings and direct-pay bonds such as BABs. It has issued reports on the responses filed with respect to 501(c)(3) bonds and governmental bonds.
Meanwhile John Cross, associate tax legislative counsel for the Treasury, told bond lawyers meeting in Denver on Friday that next up on the regulatory agenda for muni bonds is likely to be guidance on certain arbitrage rules and final rules for TEFRA public approval requirements for private activity bonds. TEFRA is the Tax Equity and Fiscal Responsibility Act of 1982.
Asked about the status of a project to modify the allocation and accounting rules for private activity bonds, Cross said this is a “monster project” that is not on the Treasury’s business plan, but that department officials are taking a look at it. He urged members of the American Bar Association’s tax-exempt financing committee who were meeting to send him recommendations.
To those lawyers who wondered why the IRS has not moved with more speed on regulatory projects after the end of 2010 when American Recovery and Reinvestment provisions expired, Cross said, “We had pretty much of a wholesale change in all of the reviewers above us in the government in the last six months.”
Nevertheless, he said, “We are cautiously optimistic that we can start trying to move some of our guidance projects.”