WASHINGTON — The New Jersey Health Care Facilities Financing Authority appears to be settling a tax dispute with the Internal Revenue Service over revenue bonds it issued in 1993 for Deborah Heart and Lung Center, which later entered into a total return swap.
According to the NJHCFFA's website, the agenda for an Oct. 22, 2015 meeting of the authority said it considered, in executive session, a "resolution of the [NJHCFFA] authorizing a closing agreement with the [Internal Revenue Service]."
Officials at the authority and the Deborah Heart and Lung Center would not comment on the matter. Gary Duescher, a partner at McCarter & English in Newark, N.J., who is representing the issuer and/or borrower, did not return calls.
But sources said the settlement would bring to a close the IRS' audit of Deborah Heart and Lung Center's 1993 bonds and a subsequent total return swap.
In August 2013, Deborah posted an event notice on the Municipal Securities Rulemaking Board's EMMA system stating the IRS, in July of that year, had issued a "proposed adverse determination" that the TRS entered into in connection with the bonds had caused the bonds to be reissued as taxable. The IRS said the bonds and TRS involved an "abusive arbitrage device creating additional arbitrage investment opportunities for the borrower."
Some municipal market participants are curious as to how much, if any, money the issuer or borrower will have to pay the federal government under the settlement because it was negotiated after the IRS chief counsel's office issued a favorable but limited private letter ruling in January concluding that another TRS entered into between a borrower and a bank was "not an abusive arbitrage device."
The IRS stresses that PLRs cannot be relied upon by anyone other than the taxpayers that requested them. But lawyers in the muni market typically pay close attention to them when they cover areas where there is little legal or regulatory guidance.
Mark Scott, former director of the IRS' tax-exempt bond office, recently urged the Service to revoke that PLR, arguing that TRSes are "arbitrage schemes" that have "resulted in hundreds of millions of dollars of illegal tax benefits being stolen."
Scott accused to chief counsel's office of trying to undercut, or steamroll over, TEB, which has been auditing a number of bond transactions with TRSes. Scott claims the chief counsel violated IRS standards for rulings and determination letters, by issuing a private letter ruling that seemed more like a technical advice memorandum on an already completed transaction.
TRSes, many of which have been done in the muni market over the years, involve-long term bonds and a short-term total return swap. In such deals, a borrower such as a hospital, acting through an issuer, privately places long-term bonds with a bank, which then enters into a much shorter term TRS with the borrower/hospital. The bank becomes the holder of the bonds as well as the swap counterparty.
The borrower typically swaps fixed for variable rates to lower its cost of borrowing. It also takes risk and provides price protection for the bank/bondholder/swap counterparty. When the TRS terminates, or is terminated, the bonds are valued. If the bonds' value is below par, the hospital pays the bank. If the value is above par, the bank pays the hospital. But many TRSes are rolled over or replaced and new negotiated terms during the life of the bonds. The hospital could be forced to pay if interest rates rise.
The bank/bondholder/swap counterparty makes money from the higher tax-exempt bond rate and its deduction of its loss from the swap payments.
In this case, NFHCFFA issued $37.4 million of revenue bonds in 1993 in a conduit deal with Deborah Heart and Lung Center to advance refund the authority's 1978 Series A bonds, finance an expansion and renovation project, and reimburse Deborah Hospital Foundation for prior capital expenditures.
The center, based in Browns Mills, N.J., is an 89-bed nonprofit teaching and tertiary care specialty hospital that provides inpatient and outpatient cardiac, vascular, and pulmonary services.
In November 2011, the authority received an information document request from the IRS related to the total return swap, which was entered into after the bonds were issued. Deborah's financial statements for 2013 and 2014 state the center entered into an interest rate swap in 2002 that was terminated and settled in 2008.
In December 2012, the authority received a Notice of Proposed Issue from the IRS that referred to "certain post-issuance transactions" that included a TRS and said the "transactions amounted to an amendment of the terms of the bonds, without approval of any governmental entity authorized to approve the terms of tax-exempt obligations, resulting in the 'reissuance' of taxable bonds."
The IRS also said "the transactions also utilized an abusive arbitrage device effectively modifying the yield on the bonds and creating additional arbitrage investment opportunities for the borrower."
In August 2013, the IRS issued a Proposed Adverse Determination to the authority, contending the bonds were taxable because of the reasons cited in the 2012 letter.
As of the end of 2013, about $17.6 million of 1993 bonds were outstanding. In April 2014, the authority called the bonds at a redemption price of 100% of the principal amount. In May of that year it issued bonds to refund the 1993 bonds, according to Deborah's financial statements.
There are some notable differences between the TRS the Deborah Heart and Lung Center entered into and the TRS in the PLR that did not find a TRS to be an arbitrage device. The TRS in the PLR was entered into at the same time the bonds were issued not later. The borrower and bank wanted to extend the TRS by five years.
Also, the transaction in the PLR involved bonds for which no proceeds were remaining, so the IRS could not have questioned whether rebate calculations should have been based on the bond yield or on an integrated bond and swap, which might have lowered the bond yield and therefore meant the issuer would have had to invest at a lower yield to avoid tax problems.
In the PLR, the IRS said there were no replacement proceeds. Under tax rules, if a transaction is found to be an abusive arbitrage device, the IRS Commissioner can decide that even though no bond proceeds remained, the hospital's funds could serve as replacement proceeds for the bond proceeds and cause arbitrage problems.
In the PLR, the IRS chief counsel declined to take any position on whether the extension of the TRS would cause the bonds to be considered reissued and subject to current tax law requirements.
