WASHINGTON — Tax-exempt bond issuers who determine that the payments they received for forward float agreements are more than 20% outside an Internal Revenue Service valuation have until March 1 to resolve problems voluntarily under a new closing agreement program, the agency warned yesterday. The program, which the IRS detailed on its Web site, applies to governmental and 501(c)(3) bond issuers who have done advance refundings with escrows funded by Treasuries and “floats,” which cover gaps in cash flow — transactions fairly common before the IRS pushed issuers to use State and Local Government Series securities in certain situations. Market participants praised the voluntary program yesterday, but some expressed concern about technical elements of the agency’s valuation methodology. In advance refundings, when issuers reduce borrowing costs by refinancing existing tax-exempt debt at a lower interest rate, the maturity dates of investments purchased with bond proceeds do not always match the timing of debt service payments. An issuer typically enters into a forward float contract with an investment provider to invest its cash during the “float” periods, receiving an up-front payment for earnings on the investment. The IRS has long been concerned with irregularities in float pricing because the payment an issuer receives is part of the overall escrow yield calculation, and earnings from that escrow that are above the bond yield are required to be rebated to the federal government. The arbitrage regulations include a “safe harbor” for floats that establishes fair market value for an investment that meets more than a dozen specific requirements. Float agreements that fall within that safe harbor will be treated as purchased at fair market value under the new voluntary closing agreement program, according to the IRS. “This is a supplement to the safe harbor. It does not in any way diminish or impinge upon it,” Steven Chamberlin, manager of the IRS tax-exempt bond office’s compliance and program management unit, said yesterday. For floats outside the safe harbor, the IRS’ pricing model uses implied forward interest rates derived from the U.S. Treasury Daily Yield Curve, with adjustments for costs and expenses, including the investment provider’s profit, legal and administrative costs, and hedging costs. A float will be treated as being purchased at fair market value for arbitrage purposes if it has an up-front payment equal to at least 80% of up-front payment determined under the agency’s model. If issuers discover that their floats fall outside that window, they can bring their cases to the IRS. “We considered putting in a floor or a ceiling as an absolute dollar amount, but decided simplicity” was the best approach, said Michael Muratore, tax law specialist in the TEB office. He and Chamberlin stressed that the 80% range “isn’t the only standard,” and that other facts and circumstances will be evaluated in each case. The specific percentage could be subject to change, based on what the IRS finds as issuers utilize the program, but the overall approach was “thoroughly tested and reviewed” in a number of situations with a variety of hypothetical yield curves before being finalized, Chamberlin added.“The methodology is based on sound financial theory. It has proven to be a very straightforward and accurate way to set a reasonableness gauge, and determine whether there is a likelihood of a problem,” he said. The IRS will accept closing agreement payments equal to the amount necessary to reduce the recomputed investment yield on the refunding escrow to the permissible yield. Failure to correct a violation voluntarily by March 1 could result in the related bonds being declared taxable, according to the agency. The IRS is taking a conservative approach to value float agreements that were not bid out, and the result is well-written and thoughtful, said Carol Lew, president of the National Association of Bond Lawyers, which is to hold a teleconference on the initiative on Sept. 6. “They were careful to limit the scope of the release to forward float agreements not under the safe harbor bidding procedure [and] to note that we should not use this formula in other contexts,” said Lew, a partner with Stradling Yocca Carlson Rauth in Newport Beach, Calif. “They should be applauded for adopting a type of 'intermediate sanction’ — a penalty — to correct noncompliance in these situations. The beneficiary of the noncompliance is the provider, [but] the issuer is the subject of the VCAP correction payment.” Michael Bailey, chair of the American Bar Association tax section’s subcommittee on tax-exempt financing, said the industry hopes that the IRS will be receptive to comments. “One important issue that does not appear to be expressly addressed by the release is the treatment of a forward float arrangement that is embedded in a larger investment contract to provide escrow securities,” said Bailey, a partner with Foley & Lardner LLP in Chicago. “Hopefully, the IRS will provide additional guidance or clarification on how the program would apply to that fairly common situation.” The subject of securities and floats bid together is “a well-taken issue, but one that we’re still thinking through,” Chamberlin said. Some market sources pointed out that working through the methodology could take a while, depending on issuers’ cash flows and the complexity of their float agreements. Susan Gaffney, federal liaison director of the Government Finance Officers Association, said the association is “still reviewing the details of the new voluntary closing agreement program, but commends the IRS on extending the popular and effective program to other areas in the market.” Chamberlin said yesterday that the IRS has “a number of different ideas on the drawing board” for similar VCAP initiatives such as the failure to roll over SLGS on a timely basis, or meet TEFRA or private use requirements. “Those are issues that we’ve dealt with a lot,” he said. “We have pretty set resolution methods.”
