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Taxation

IRS to Focus on Abusive Transactions in 2013

DEC 27, 2012 2:40pm ET
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WASHINGTON — The Internal Revenue Service's tax-exempt bond office plans to continue to invest significant resources in identifying abusive transactions in the municipal bond market in 2013.

Four IRS officials highlighted the agency's goals in an in-depth interview about the outlook for tax enforcement and compliance for the coming year.

"Our true interest is to really go after the most abusive arrangements and make sure those are taken off the market and addressed appropriately," said Cliff Gannett, acting director of government entities at the IRS since April 2011.

The abuses involve transactions where bid rigging of investment contracts or mispricing of bonds occurred, IRS officials said.

This isn't the first time, nor is it likely to be the last that the IRS has been concerned with the mispricing of investments and bonds in the muni market.

The IRS was involved in numerous settlements over yield burning during the past decade and is currently considering enforcement actions over bid-rigging of bond-related investment and derivatives contracts as part of massive criminal and civil probes that began in 2005.

As The Bond Buyer previously reported, the TEB office plans to pursue Section 6700 investigations of firms and individuals that violated the tax laws by participating in schemes to rig the bids for guaranteed investment contracts, or GICs, and other investment contracts for municipal bond proceeds.

IRS officials would not say exactly how many 6700 examinations the IRS will reopen in 2013. But they have said that once the Justice Department is finished with its criminal pursuit of a particular firm and its individuals, the IRS is free to start 6700 probes.

Section 6700 of the Internal Revenue Code allows the IRS to take enforcement action against any muni transaction participants who caused tax-law violations. Violators face fines equal to the lesser of $1,000 per bond denomination or 100% of the gross income derived from the activity. A bond denomination is typically $5,000.

"Beyond the big-rigging cases, TEB continues to be concerned with the mispricing in tax-exempt bond financings," said Bob Henn, acting director of the TEB office, who will retire at the end of the year. "We are going to continue to pursue issue price cases."

VCAP
Steve Chamberlin, manager of compliance and program management for the TEB office, summarized the office's successes of the past year. "We did really well on all of our metrics this year," he said.

The TEB office executed 30 closing agreements under the voluntary closing agreement program and obtained about $10 million in settlement payments, Chamberlin said.

"Ever since VCAP was officially created back in 2001, we've had a nice, steady growth of interest in the program and in requests coming in," Chamberlin said. "That's a really good development."

Chamberlin attributes most of the recent "exceptionally high levels of volume" in large part to the special student loan VCAP that the IRS initiated.

The IRS unveiled the student loan VCAP in March and gave issuers until the end of July to apply for relief under the settlement program. Chamberlin said they have been working with 16 issuers under the program.

The program was for issuers that violated tax rules by reallocating student loans to bonds other than the ones used to finance them so they could avoid having to make yield-reduction payments to the federal government.

Chamberlin said the student loan VCAP is a great development in response to the work of the TEB office to promote voluntary compliance.

"It presents a challenge for us going forward of thinking how to ensure we can effectively process an ever growing number of requests," Chamberlin said. "But that's a great problem for us to have."

Some market participants praised the IRS' work on the student loan VCAP program.

"We recognize that we and our clients aren't perfect, we make mistakes and it's great to have a program where you go in and say we violated a rule and we are willing to pay a penalty for it and come up with something everyone thinks is fair," said John Swendseid, chair of the American Bar Association's tax-exempt financing committee and a bond attorney with Swendseid & Stern, the Nevada arm of Sherman & Howard.

In addition, the field entered into 20 closing agreements for fiscal 2012 and reclaimed payments totaling $36.3 million. About $20.1 million of that was related to bid rigging, according to Henn.

While not typically high in number, TEB views these agreements as a very effective and efficient tool to resolve noncompliance during the examination process, said Allyson Belsome, formerly Dodd, field manager for the office.

These closing agreements generally require not only the payment of the settlement amount but very often the redemption of all or a portion of the bonds for which tax violations occurred.

In the current fiscal year, which started on Oct. 1, field closing agreements have resulted in the redemption of over $1 billion of nonqualifying tax advantaged debt, Bellsome said.

"The redemption or defeasance is probably the more significant outcome than even the settlement amount," Chamberlin said. "The removal of bonds from the marketplace and the removal of that subsidy is such a huge positive outcome from our work."

The TEB office has some Build America Bond examinations underway and will be initiating some new examinations in 2013 where issue price will be a consideration, Belsome said. She and other IRS officials would not say how many new BAB exams will be initiated.  BAB issuers receive subsidy payments from the Treasury equal to 35% of their interest costs.

Chamberlin said BAB and other direct-pay issuers received more than $4.89 billion in subsidy payments in fiscal year 2012, which ended on Sept. 30.

Exams
Henn also said that, as part of the IRS' commitment to providing good customer service, TEB field agents were able to improve the cycle time, or the average time from start to close of an exam. It now takes agents approximately 150 days or five months on average — one month shorter than last year.

Chamberlin said the TEB office is also wrapping up a report on the advanced refunding questionnaires that were sent out to 300 randomly selected issuers who had issued bonds between July 1, 2009 and June 30, 2010. He anticipates that report will be published next year.

With advanced refundings, the IRS is concerned with whether or not escrowed securities meet yield restriction requirements and are invested at a yield below the bond yield.

While the TEB office hasn't been operating under a hiring freeze like last year, officials there still do not know what their hiring authority will be in 2013, Gannett said.

"I wouldn't completely rule out at this point some attrition hiring, but we will find out as we go through the year," Gannett said.

The TEB office has made their fiscal 2013 program initiatives based on a flat budget but is still confident that they will be able to achieve all of their goals set for the coming year. They have a staff of approximately 85, slightly less than last year. With Henn retiring as field manager and Belsome replacing him, it leaves two major slots within the program vacant — acting director of the TEB office and group manager of field operations for the TEB office in Chicago.

Another goal the TEB office intends to address in fiscal 2013 is the accuracy of form 8038-T, which issuers must file when making an arbitrage payment. The form is due at the end of an issuer's computation period.

At least 100 correspondence exams will be sent out regarding the accuracy of form 8038-T.

"The exam will be initiated with an examination of that filed form 8038-T to determine whether or not the correct rebate or yield reduction payment was paid pursuant to that filing," Belsome said.

Although the muni market has been anxiously awaiting regulations on issue price, the officials weren't able to provide a timetable for when the regulations would be published.

Issue price is one of the regulatory priorities for the Treasury Department and the IRS this year and next.

Chamberlin said he is "highly optimistic" that regulations will be released next year.

Issue price is key to determining the bond yield for tax purposes. The determination of bond yield has a bearing on whether an issuer of tax-exempt bonds is meeting arbitrage requirements or, in the case of BABs, receiving the correct amount of subsidy from the Treasury.

Under IRS rules, the issue price for each maturity of bonds is the first price at which a substantial amount of them are sold to the public, with 10% considered to be a substantial amount. However, the rule only applies if all bonds of a specific maturity are offered to the public at that price.

Market participants have been eager to see issue price guidance rather than enforcement actions from the IRS.

Michael Decker, a managing director and co-head of the municipal securities division at the Securities Industry and Financial Markets Association, said the public discourse has affected the way that some bond attorneys are providing opinions with regard to issue price.

"The market really needs to hear from Treasury and the IRS on this," Decker said. "I know they know that and I just hope it comes sooner rather than later."

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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