WASHINGTON — The Internal Revenue Service’s tax-exempt bond office has formed a seven-person team that is using EMMA and other data from the Municipal Securities Rulemaking Board to determine if muni bonds were initially offered at prices that raise questions about tax-law compliance.
IRS officials talked about this initiative as well as one focusing on financial restructurings and their risk assessment exam program last Wednesday in an interview about the outlook for tax enforcement and compliance for this year.
But first, Cliff Gannett, who has been acting director of government entities at the IRS since April when he was head of TEB, summarized the office’s successes of the past year and goals going forward.
He said that while the TEB office has been operating under a hiring freeze since last year, it still has a staff of more than 90 and exceeded goals in many areas for the past fiscal year, which ended on Sept. 30.
The TEB office executed about 46 closing agreements under its audit and voluntary closing agreement programs, or VCAP, obtaining about $110 million from those settlements, he said.
The office closed 129 cases under the voluntary closing agreement program, 49 more than the goal of 80 and previous annual high of 83, according to Gannett and Steve Chamberlin, manager of TEB compliance and program management.
“We’ve made significant strides in closing cases in inventory,” said Chamberlin.
In addition, the TEB office closed 1,481 audits, 81 or 6% over its goal of 1400 for the past fiscal year. It closed 453 compliance checks of advance refundings and Build America Bonds.
BAB issuers have received more than $6 billion in subsidy payments since the program began in early 2009 after the IRS processed about 4,000 requests for such payments, he said.
Gannett and Chamberlin said, thus far, no BAB issuers have been disqualified from receiving federal subsidy payments. However, there have been some cases in which violations occurred and there are ongoing discussions with issuers about how to adjust their subsidy payments downward.
“We continue to emphasize the abusive transaction area and have a lot of work going on in that area. We have seen a number of settlements related to abusive transactions this year,” Gannett said. He would not give specific figures, but said the cases generally relate to the pricing of bonds or investments.
“I really do think this is going to be a significant piece of the work of this office going forward,” he said.
Gannett talked about the importance of the memorandum of understanding that the IRS signed with the MSRB that gave the board access to detailed trade data it makes to other regulators for compliance and enforcement purposes.
Chamberlin, who oversees the seven-person team looking at pricing, said: “We’ve been performing various research queries using that database with an eye towards moving … to make contact with some issuers where we notice trading activity during the initial public offering that raises some concerns about whether or not the actual issue price of the bonds is what they are purporting it to be and whether or not there might be tax consequences.”
“Also there’s an educational focus … about how we can use that research to try to alert issuers out there who may be unaware [of how] their bonds were trading,” he said.
Chamberlin said while the group is still fleshing out how the initiative will be rolled out during the year, he expects its members will begin contacting issuers “in the not-too-distant future.”
“The point is to enter into a dialogue with the issuer to say, 'Hey, we saw this trading dynamic going on and we’d like to give you an opportunity to explain to us what was happening that caused this result,’ ” Chamberlin said.
He stressed that this effort is more focused on research than enforcement at this point. “We’re still at the stage of doing research on trading practices immediately after” the closing of bond transactions, he said.
The IRS has been concerned about flipping and other pricing practices that raise questions about whether the correct issue price was set for the bonds. The issue price is key to determining the bond yield for tax purposes.
The determination of the bond yield has a bearing on whether an issuer of tax-exempt bonds is meeting arbitrage requirements or whether an issuer of BABs is receiving the correct level of subsidy payments from the federal government.
BAB issuers receive subsidies equal to 35% of their interest costs and cannot sell their BABs at more than a de minimis amount of premium.
The lower the issue price for bonds bearing a stated interest rate, the higher the yield. So if the issue price for the bonds is set too low, then the bond yield is likely too high and results in the issuer retaining impermissible arbitrage from taxable investments of the bond proceeds.
In the case of BABs, a too-low issue price may mean the subsidy payment is too high or that the issuer violated the de minimis premium requirement, causing the bonds to lose their BAB status, and consequently, their subsidy payments from the federal government.
IRS rules specify that the issue price for each maturity of tax-exempt bonds is the first price at which a substantial amount of the bonds is sold to the public — not the underwriters— with 10% considered to be a substantial amount.
But IRS officials have been concerned that some bonds are initially issued at one price and then almost immediately begin trading up right after issuance at higher prices. In flipping, bonds are initially issued at one price and then almost immediately sold to dealers or institutional investors at higher prices before being sold to retail investors at even higher prices.
Typically, the underwriter certifies the issue price for bonds. But last year, IRS officials suggested issuers monitor the pricing of their bonds. Issuers and lawyers lashed back at them, saying they are not pricing experts.
Chamberlin said during the interview that issuers “have a responsibility for ongoing compliance monitoring” and that an increasing number of them, as well as the lawyers that advise them, are becoming proactive in this area and are checking their prices to see if there is a problem they need to fix or to voluntarily take to the IRS.
Meanwhile, market participants said they would like to see guidance rather than enforcement action from the IRS.
“I still think, and deeply hope, that we will get something on issue price,” said Kristin Franceschi, president of the National Association of Bond Lawyers and a partner at DLA Piper LLC in Baltimore.
“It would be nice to get some additional guidance from the IRS on that,” agreed Michael Decker, a managing director and co-head of the municipal securities division at the Securities Industry and Financial Markets Association.
Chamberlin’s group also plans to focus on compliance issues relating to financial restructurings.
“There are a lot of state and local governments that are under significant financial stress and because of that, or for other reasons, might be looking to restructuring their debt,” Chamberlin said.
“We recognize that when an issuer or a conduit borrower in a conduit financing finds themselves under severe financial distress and they’re just trying to keep their head above water, ongoing tax compliance may not be the first thing on their minds in that environment. And we just want to make sure that we take steps to try to help them understand that the actions that they take to deal with their current financial position could have long-term tax consequences. We want to make sure that they are aware of those so that they can plan accordingly.”
Certain modifications that issuers or borrowers make, such as changes in interest rates, creditworthiness or extension of maturities, can cause the bonds to be reissued and subject to the most recent tax law requirements. Even more of a concern is that, under a reissuance, the bonds no longer exist and become new bonds. The early retirement of bonds could cause compliance problems for an issuer that had planned to blend down investment yields for arbitrage purposes or limit private use over the long term to ensure the bonds remained tax-exempt.
The IRS has put some educational guidance on these issues on its website and plans to conduct a webinar in late spring or early summer.
Additionally, Chamberlin said his group also is planning to reach out and send letters to some issuers that may be at risk of having a reissuance. The letters would “just be a little friendly, 'Here’s some issues you need to be aware of,’ ” he said.
“It’s going to be one of our major educational efforts this year,” Chamberlin said, who added that Bob Griffo is the leader of the team focusing on this area. The team is no longer called the distressed government entities team and is now the financial restructuring compliance team, which is considered to be more inclusive.
Bob Henn, acting director of the TEB office, said that the field office could initiate some audits down the road if the Griffo team has reached out to certain issuers and tried to educate them about the pitfalls of financial restructurings, but the issuers have not taken steps to ensure they are in compliance with the tax laws and rules.
Muni market groups also want to see guidance from the IRS and the Treasury Department on reissuance, which has not been consolidated and updated in years.
Chamberlin’s compliance and program management group also plans to send about 100 post-compliance questionnaires to issuers of qualified school construction bonds.
The IRS has already sent such questionnaires to issuers of 501(c)(3) bonds, governmental bonds, advance refunding bonds, and direct-pay bonds such as BABs, and has issued reports summarizing the results of the 501(c)(3) and governmental surveys. Franceschi said bond lawyers have found the reports very helpful in pinpointing problem areas that need more attention.
Risk Assessment Exams
Chamberlin’s group also plans to continue conducting risk assessment exams under a program it began last year. Under the program, the group conducts a significant number of correspondence exams, limited in scope, of certain types of bonds or bonds in a certain sector. It refers the deals that appear to have a high risk of noncompliance and to the field office, where revenue agents follow up with audits.
“Risk assessment is beginning to play a larger and larger role,” said Henn, who formerly headed the field office, “because it gives us the opportunity to spend our time with issuers who have the highest potential of being noncompliant.”
Chamberlin’s group conducted risk assessment audits of about 75 multifamily housing bond issues and about 75 tax and revenue anticipation note issues last year. It is in the process of closing out many of these exams and transferring some of them over to the field office for follow-up, Chamberlin said.
The group is planning this year to examine about 180 issues of governmental bonds that have been used to finance such facilities as prisons, hotels, and convention centers that may result in excessive private use or payments. These audit letters will be rolled out over time, not all at once.
Bonds are private-activity bonds if more than 10% of the proceeds are privately used and more than 10% of the debt service is paid for or secured by payments from private entities.
They also are PABs if the lesser of 5% or $5 million of the bond proceeds is loaned to a private party. PABs are only tax-exempt if they are “qualified” and fall within certain categories.
The group also plans to audit small bond issues below $15 million. Chamberlin said these audits will be “educational as much as anything else” and will try to “raise awareness” among the issuers as to the importance of post-issuance compliance.
Also slated for these risk assessment exams will be more than 30 issues of qualified 501(c)(3) bonds that are used by nonprofit organizations. The audits will focus on whether there has been excessive private business use.
Henn said the field office is auditing a number of student loan bonds, less than 20, with the key concern being whether the bond proceeds were allocated to student loans financed with other bonds.
The office is also auditing multi-functional district financings, or developer-driven deals, and is looking at where the issuer is really an issuer and how the developer turned over its assets to the district that issued the bonds. In many of the community development districts in Florida, the boards are made up mostly of representatives of the developer.
The field office is examining two dozen or less of tax increment financings. “We didn’t find much in the way of noncompliance,” Henn said.
It also has audited 32 BAB issues, with roughly half closed. For the audits still open, examiners are trying to determine whether premiums paid for bond insurance could disqualify the bonds as BABs and jeopardize the federal subsidy payments made to the issuers.
Also at issue is whether the bonds might have been extinguished if they were purchased by a pension fund or other entity considered to be an instrument of the issuer.
The field office has been auditing about 25 pooled financings since September. It also began auditing about 100 advance refundings as well as governmental and 501(c)(3) issues.
At least one issuer recently complained that while the IRS has moved to a so-called soft contact approach, it is conducting more audits that require issuers to hire lawyers or other advisers who can provide reams of documents and information to the agency.
However, Henn said: “We have a responsibility to ensure that the community is compliant with the provisions of the Internal Revenue Code and the regulations.
The IRS is actually trying to reduce the burdens on issuers and borrowers by using correspondent exams to try to winnow out transactions with a higher risk of noncompliance and focusing on conducting full-blown audits on those.”
“Yes, it requires some kind of involvement, and it requires that there be responses to these [information document requests] and/or questionnaires,” he said, “but the burden is so significantly less than it would be if we did a full-scope examination, that we believe that it’s in the best interest of the community for our monitoring to take this kind of approach.”