WASHINGTON - After giving issuers more than a year to voluntarily come clean, theInternal Revenue Service plans to launch an audit sweep this summer that will randomlytarget a type of arbitrage violation that can occur when issuers advance refund tax-exempt municipal bonds.
The IRS tax-exempt bond division will examine about 100 issues for the violation, whichinadvertently occurs after trustees fail to "blend down" the investment yields of thesecurities in their advance refunding escrows, said Clifford Gannett, the manager ofoutreach, planning and review in the IRS' tax-exempt bond division. The IRS plans tosend audit letters to issuers of the bonds in July.
The IRS allows issuers to reinvest refunding escrows in higher-yielding Treasurysecurities instead of State and Local Government Series securities, as long as theyeventually lower the higher yield by investing in zero-interest-rate SLGS to avoidviolating arbitrage restrictions.
In some cases, the trustees have neglected to roll the escrows into zero-interest SLGS,which would have blended down the investment yields and avoided arbitrage problems,Gannett said. If the issuer has not rebated the excess earnings to the federalgovernment as required under the Tax Reform Act of 1986, the bonds could be declaredtaxable.
Gannett said the IRS also will check for potential yield-burning, which occurs wheninvestment firms overcharge issuers that purchase open market Treasury securities forrefunding escrows, and the mark-ups reduce or "burn" the investment yield to a levelbelow the bond yield to avoid generating illegal arbitrage profit.
Working with the Treasury's Bureau of Public Debt, the IRS tax-exempt bond division hasidentified 3,900 issues out of a total of 4,400 advance refundings done in 1993 thatcould potentially have the problem because they were initially invested in open-marketsecurities. That year, there was a large number of the transactions due to low interestrates, Gannett said.
The initial audit will randomly sample 100 issues from the pool of 3,900, but more examsmay be opened in the future. "We are going to start with 1993, but we are going tocontinue to look at later years on a year-to-year basis," Gannett said. "Our expectationis we will see some problems with the reinvestment."
The audits will continue as long as the IRS sees problems with issuers buying open-market securities but failing to blend down the SLGS. "At some point due to thisinitiative, we will see greater compliance in the area," Gannett said.
Mark Scott, director of the IRS' tax-exempt bond division, first announced the plan toaudit issuers that failed to reinvest refunding escrows in a speech a year ago at theNational Association of Bond Lawyers' conference on the fundamentals of municipal bondlaw.
J. Hobson Presley Jr., a bond lawyer with Presley LLC in Birmingham, Ala., said thatgenerally, not blending down yields is probably due to issuer oversight. "Those arealways unfortunate," Presley said. "This is not some situation where the issuer istrying to gain a financial advantage."
Cases involving failures to blend down the yields have shown up both in the IRS'senforcement and in voluntary compliance agreement programs. In a case currently underaudit, the IRS found a failure to roll over SLGS that represented up to $700,000 inexcess arbitrage, said Charles Anderson, manager of field operations for the taxagency's tax-exempt bond division.
Over 50% of the bond issues that issuers bring to the IRS under the voluntary complianceagreement program are SLGS rollover violations, Gannett said. Since late 2002, 12trustees representing more than 100 issuers and over 180 bond issues reached settlementsthrough the program.
Gannett added that the door remains open for issuers that discover they have a SLGSrollover problem. "We highly encourage people to come forward when they have theproblem," he said.
