WASHINGTON - The Bond Market Association's long-awaited study on the market impacts of Internal Revenue Service audits shows that when audits of variable-rate bonds are disclosed, issuers face higher prices and substantially reduced demand for those bonds.
The Bond Buyer obtained a draft of the soon-to-be-released study yesterday which also showed that no statistical conclusions can be drawn about the effects of audits on long-term municipal bonds because there were not enough trades to produce data.
However, the draft said that anecdotal information suggests the announcement of an IRS audit of a long-term bond issue reduces the liquidity for those bonds. Some mutual funds, for example, refuse to buy or hold bonds under IRS audit, the draft pointed out.
TBMA officials said that the study's findings have been made available to muni market groups and the regulators, but the association does not expect to follow up the study with any policy recommendations of its own.
This appears to represent somewhat of a retreat from a release TBMA issued in May 2001 that promised the study would show whether IRS audits "interfere with the efficient functioning of the market" and whether "the IRS should reconsider its approach to the audit process."
"I think it confirms what market participants have maintained in their communications with the IRS, that in the variable-rate market, rates spike noticeably to taxable rates when the news of an audit is announced," said Michael Decker, TBMA's senior vice president of research and policy analysis. "It's consistent with the claims that people have made and what we've tried to do is document and validate what everybody's been saying."
"I don't really think it's a bombshell of a study because it sort of confirms what everybody had expected," agreed Ben Watkins, Florida's bond finance director and a key member of the Government Finance Officers Association's debt committee.
William Noth, the president of the National Association of Bond Lawyers, hailed the study as providing support for NABL's proposed reforms to the IRS' municipal bond enforcement program. Under those proposals, the IRS would be prohibited from taxing bondholders and liability for tax law violations would be shifted from the bondholders to the issuer or conduit borrower. At the same time, the IRS would be required to adopt a new system of penalties for issuers that vary, depending on the seriousness of the violation, and issuers would get the right to appeal to a federal court any adverse findings by the IRS.
"I'm gratified to see this," said Noth, a partner at Ahlers, Cooney, Dorweiler, Haynie, Smith & Allbee in Des Moines. "This report establishes that there is an adverse market penalty that issuers pay when audits are disclosed. It's an important piece in convincing people that our current tax law needs to be reformed."
"I think it points out why we, as issuers, should care about the inefficiencies created by the existing tax enforcement system," Watkins agreed. The GFOA's debt committee, led by Watkins, is forming a group to work with NABL to try to reach some common areas of agreement on NABL's reform proposals for the IRS.
But IRS officials said yesterday that they do not think any immediate changes need to be made in their muni bond enforcement program, based on the study's results. They said the study contains some flaws and does not take into account several steps taken by the IRS recently to mitigate the market impacts of audits.
Mark Scott, the IRS' national director for tax-exempt bonds, said he had concerns about the draft of the study that was sent to him. Eight of the bond issues listed in the study were never under audit, he said. Instead, they apparently were included in the study for other reasons, such as because the IRS' exempt organization division was examining the tax-exempt status of the nonprofit organization that was to benefit from the bond financing. Removal of the organization's nonprofit status could jeopardize the tax-exemption of the bonds. But Scott said his bond enforcement division was not involved in any of those eight examinations.
Scott would not identify the eight bond issues. But asked whether they were in the college housing area, he hinted that some of them were. Collegiate Housing Foundation, a nonprofit college housing developer that has several bond issues outstanding, has disclosed that the IRS is questioning its nonprofit status-- a move that has affected the price of some of its bonds.
Scott also noted that the study analyzed the impacts of audits disclosed between 1999 and 2001, before the IRS took steps to mitigate the market impact of its audits. In 2001, the IRS developed new standardized letters that explain, in fairly broad terms, the reason for the audit, he said. The letters, which are sent to issuers at the opening of an examination, explain whether the audit is part of a broad look at a certain sector of the market or is the result of a specific concern about that bond issue. Issuers have applauded the standardized letters, saying they make it easier for them to decide whether they need to publicly disclose the examination.
"A lot of the study was prior to the new letters being used," Scott said. "So it's unclear whether the market impact is as significant, now" that the new letters are in use.
The IRS has taken other steps aimed at reducing the adverse market impact on audited variable-rate bonds, Scott said. Under a requirement that took effect earlier this year, Charles Anderson, who supervises the bond group's field managers, must approve a preliminary adverse determination letter before it can be sent to an issuer with variable rate bonds under audit. This change was made to address some concerns among market participants that lower-level IRS managers were sending out preliminary adverse letters prematurely.
Scott stressed also that his group rarely taxes bondholders for tax law violations. Usually, the IRS will try to reach a closing agreement with the issuer, under which the issuer will make a payment and the bonds remain tax-free.
Scott said he wants to continue to reduce hassles as much as possible for issuers. "If someone has specific suggestions on what the IRS can do to lessen the impact on issuers, then we're ready to listen," he said.
The principle author of TBMA's study was Lori Trawinski, a former member of the association's research staff. To conduct the study, the group reviewed news reports and information vendor data for audit disclosures and found 45 issuers with 49 different issues and 461 Cusip numbers, for which audits were disclosed between 1999 and 2001, according to the draft study. Seventeen of the Cusips were for variable-rate bonds. TBMA scrutinized the trade data for these bonds six months before and after audits were disclosed. Interest rate data was available for 14 of the 17 bonds. The study found that the average spread of interest rates for these bonds rose to 106 basis points after the disclosure of an audit, compared to 26 basis points in the months preceding the disclosure.
During the study, one of the issuers -- Memphis City Center -- entered into a closing agreement with the IRS to preserve the tax-exempt status of some of its variable-ate bonds. TBMA found the interest rate spread on those bonds narrowed by 207 basis points after the resolution of the audit.
