WASHINGTON - The Internal Revenue Service chief counsel's office has issued a technical advice memorandum that is favorable to an issuer of advance refunding bonds.
The chief counsel's office concluded that no abusive arbitrage device was used in connection with the refunding bonds, portions of a debt-service fund were not excess gross proceeds, and there wasn't a device used to obtain a material financial advantage other than the savings attributable to lower interest rates.
The TAM, which did not identify the issuer, was dated Sept. 30, 2014 but was not publicly released until Friday. TAMs are often issued in the context of an audit and can be requested after there are disagreements between issuers and the IRS tax-exempt bond office during audits or if TEB doesn't know how to answer a question.
The issuer at the center of the TAM issued advance refunding bonds to refund a portion of its outstanding debt. By statute, the issuer has to pay debt service on the refunding bonds from property-tax revenues.
On the issue date of the refunding bonds, the issuer had a certain amount of money in a debt-service fund that was allocated to the refunded bonds. Some of that money, the "current portion," was the property-tax revenues that the issuer would have used to pay the debt service on the refunded bonds if they weren't being refunded. The rest of the money, the "reserve portion," was treated by the issuer as a reserve fund for the refunded bonds.
The issuer stated in the tax certificate for the refunding bonds that it would use the current portion to pay part of the first debt-service payment for the refunding bonds, and it would use the reserve portion as a reserve for the refunding bonds, according to the TAM.
For both the refunding and the refunded bonds, there was a certain period during which the scheduled annual debt service was notably lower than in the subsequent years. In the two years immediately after that period, maturities of the refunding bonds that are capital appreciation bonds mature. With capital appreciation bonds, investors only are paid at maturity.
The yield on the refunding bonds is lower than the yield on the refunded bonds. The defeasance escrow established with the proceeds of the refunding bonds has an earliest maturing investment with a yield of less than the yield on the refunding bonds. Between the issue date and the date of the first debt service payment on the refunding bonds, amounts in the debt-service fund were invested at yields higher than the yield of the earliest maturing investment in the defeasance escrow but lower than the yield on the refunding bonds, according to the TAM.
In the ruling, IRS chief counsel's office answers three questions about the bonds in ways that are favorable for the issuer. The first question is whether an abusive arbitrage device as defined in section 1.148-10(a)(2) of the Income Tax Regulations was used in connection with the refunding bonds.
Under federal tax law, bonds are not tax-exempt if they are arbitrage bonds. Bonds are arbitrage bonds if proceeds are reasonably expected to be used to directly or indirectly acquire higher yielding investments or to replace funds that were directly or indirectly used to acquire higher yielding investments.
Under tax rules, bonds are arbitrage bonds if an abusive arbitrage device is used in connection with them. An action is an abusive arbitrage device under section 1.148-10(a)(2) of the regulations if it a) allows the issuer to exploit the differences between the tax-exempt and taxable markets to obtain a material financial advantage and b) has the effect of overburdening the market.
The chief counsel's office found that there wasn't an abusive arbitrage device under that part of the regulations in this case because it saw "no evidence" of exploitation between the tax-exempt and taxable markets. This is because the current portion of the debt-service fund was invested at a yield lower than the yield on the refunding bonds.
Tax rules give as an example of an abusive arbitrage device an impermissible "window refunding." This occurs when the structure of a refunding bond issue is such that there is a period following the issue date when no debt service is due, and the revenues that would have otherwise been used to pay debt service on the bonds is invested so that the issuer gains a material financial advantage.
The chief counsel's office said that the refunding bonds at the center of the TAM are not this type of impermissible window refunding. While a small portion of the refunding bonds are capital appreciation bonds, the issuer made debt service payments in each year of the purported window and the debt-service schedule on the refunding bonds appears to have been structured to match the schedule for the refunded bonds, according to the ruling.
The second question that the chief counsel's office answers in the ruling is whether the reserve portion or the current portion is excess gross proceeds under certain regulations. If an advance refunding bond issue is found to have excess gross proceeds it is considered to an abusive arbitrage device.
The IRS chief counsel's office ruled that the current and reserve portions of the debt-service fund are not excess gross proceeds "because both are replacement proceeds in sinking funds for the refunding issue."
The third question answered by the chief counsel's office is whether the refunding bonds are an advance refunding in which a device was used to obtain a material financial advantage other than the savings attributable to lower interest rates.
Under federal tax law, such an advance refunding bond issue is not tax exempt. A Senate Finance Committee report on the 1986 tax reform act gives an example of this type of device. However, the chief counsel's office said that the issue at the center of the TAM differs significantly from that example.
"In the example in the Senate report … the issuer's allocations permit it to invest the replacement proceeds of the refunded issue, which are eligible to be invested at the yield of the refunded issue, a yield presumably higher than that of the refunding issue, for a longer period than would have been possible if it had allocated those amounts to the earliest possible payment of debt service on the refunded issue," the TAM said. "In the case at hand, however, the current portion was, according to the facts presented, invested at a yield lower than that on the refunding bonds."
Bond lawyers said the chief counsel's office reached the correct conclusions in the TAM and that the ruling is useful.
"I think it's a helpful ruling," said Matthias Edrich, an attorney at Kutak Rock in Denver. "The ruling confirms how the bond community seems to have interpreted the window refunding rule, the excessive gross proceeds rule and the abusive transactions rule."
Vicky Tsilas, a partner at Ballard Spahr in Washington, said TEB has used tax regulations to argue that there are abusive arbitrage devices, so the TAM is "welcome guidance."
She said the TAM is "good news" particularly because it comes on the heels of a private-letter ruling in which the IRS chief counsel's office found that a total return swap is not an abusive arbitrage device.
Richard Chirls, a partner at Orrick, Herrington & Sutcliffe in New York, said, "I have represented borrowers of tax-exempt bonds in more than one IRS audit where the IRS field agents strongly asserted that an abusive device existed due to the delay in spending bond proceeds despite the actual investment of the proceeds at yields well below the bond yield. This TAM properly states that actual arbitrage earnings must arise for an abusive arbitrage device to be found. Hopefully, this TAM will serve to redirect the field's misguided approach in these examinations."
Perry Israel, a lawyer with his own firm in Sacramento, Calif., said the ruling reached the "right answer" because an issuer has to have at least one investment above the bond yield to have arbitrage bonds.
Tom Vander Molen, a partner at Dorsey & Whitney in Minneapolis, said he agreed with the results and was not quite sure why a TEB agent may have thought there was a problem with the bonds. He wished that the chief counsel's office had more clearly explained what the agents' concerns were.
