WASHINGTON – Internal Revenue Service examiners in fiscal 2018 plan to focus on municipal securities market compliance with certain arbitrage and private activity bond requirements, according to the work plan recently released by the IRS’ Tax Exempt and Government Entities Division.

The 14-page document deals mostly with tax-exempt nonprofit organizations, employee plans, and Indian tribal governments, with less than two pages devoted to tax-exempt bonds.

The “Fiscal Year 2018 Compliance Program” for Indian tribal governments and tax-exempt bonds lists areas of examination only for tax-advantaged bonds and not tribal governments. Tax-advantaged includes tax-exempt, taxable tax credit, and taxable direct-pay bonds. The latter two types of bonds, while taxable, still have to meet tax-exempt bond requirements under the tax law.

IRS spokespersons were unable to provide any IRS officials to be interviewed or any other help, despite repeated requests.

The outside of the Internal Revenue Service headquarters building in Washington.
The outside of the Internal Revenue Service headquarters building in Washington. Bloomberg News

The document says IRS auditors will examine arbitrage compliance for tax-advantaged bonds where the proceeds have been invested in guaranteed investment contracts and/or qualified hedges as well as bonds with investments beyond a temporary period.

The tax law gives issuers a three-year temporary period during which they can invest bond proceeds at unrestricted yields and either rebate arbitrage that is generated or make yield reduction payments.

Some bond lawyers were surprised to see the reference go GICs, saying that there have not been many investments in in them since the 2008-2009 financial crisis.

Qualified hedges involve a hedge contract like an interest rate swap. If it satisfies an eight-part test, then it will constitute a qualified hedge and both the payments and receipts on the hedge can be taken into account or “integrated” in calculating the bond yield.

“I don’t think there’s been anything new in these areas in about 20 years,” said one lawyer who did not want to be named.

But a couple of lawyers said that IRS examiners could be looking at tax-credit or direct-pay bonds like qualified school construction bonds and qualified zone academy bonds. Sometime these bonds are issued with a long bullet maturity and the issuer periodically sets aside money in a sinking fund to pay the principal at maturity. The IRS sets a monthly rate at which sinking funds can be invested. Arbitrage is generated but is allowed under the American Recovery and Reinvestment Act. The IRS could be looking at whether sinking funds have met the investment rate restrictions.

Another area of focus for examiners will be determining whether the rehabilitation requirement was met for private activity bonds in acquisition financings. Under the tax law, when the proceeds of PABs are used to acquire existing property, a certain percentage of the proceeds or other money must be used on rehabilitation of the property. The percentage is usually 15% of the amount used to acquire the existing facility.

Examiners also will look at whether any remedial actions have been taken, or have been taken correctly, when bond-financed facilities had an excessive amount of private use. Under the tax law, if tax-exempt bonds are sold in a conduit transaction to finance the construction of an office and the conduit borrower later sells the bond-financed building to a private user so that the PAB tests are exceeded, the issuer can take one of several actions to protect the tax-exempt status of the bonds. It can redeem or defease the bonds, or use the bond proceeds or bond-financed property for a public rather than private purpose.

Bonds are PABs and possibly not tax-exempt if they do not fall within certain categories, if more than 10% of the proceeds are used by private parties and more than 10% of the debt service is paid or secured by private parties.

In addition, examiners will look at both bonds issued with deep discounts and PABs that have excessive weighted average maturities. Under tax requirements, if PABs are sold at too much of a discount, for example at more than a 5% discount, a number of tax restrictions or limitations take effect. Also, the average weighted maturities of PABs cannot be more than 120% of the reasonably expected economic life of the facilities being financed.

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