IRS to focus on excessive cost of issuance, defeasance, jail bonds

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WASHINGTON – The muni market starts 2019 facing an updated Internal Revenue Service enforcement plan with new priorities for its auditors while market participants are hoping it will also bring guidance from the Treasury Department and IRS on how to handle the replacement for Libor.

Richard Moore, president-elect of the National Association of Bond Lawyers, said he was hopeful Libor guidance would be forthcoming. Libor, an acronym for the London interbank offered rate, is being phased out in 2021 probably largely in favor of SOFR (secured overnight financing rate). The New York Federal Reserve began publishing SOFR in April 2018.

“I am optimistic we will see something along those lines,” said Moore, a tax partner at Orrick Herrington & Sutcliffe in San Francisco.

Absent regulatory relief, a switch from Libor to a new benchmark could create tax issues, such as reissuance. If floating rate bonds based on Libor switch to another benchmark rate, the switch may be considered a material change to the bonds that causes them to be considered newly reissued. A reissuance would make the bonds subject to the latest tax laws and rules and could even make them taxable.

Treasury Associate Tax Legislative Counsel John Cross has said Treasury and IRS are working on SOFR-based relief.

“People don’t want to wait until 2021 to start amending,” said Moore. "I don’t think there’s any urgency today but I think there might be on Dec. 31, 2019, if we don’t have more clarity by then.”

On the enforcement side of the municipal bond market, the IRS auditors' plan to focus on excessive cost of issuance for private activity bonds, defeasance, and public safety or jail bonds represents a new set of priorities compared to the enforcement plan issued a year earlier.

A year ago the enforcement work plan for Tax Exempt Bonds office included hedge terminations; economic life and weighted average maturity (WAM); safe harbors for guaranteed investment contracts; and rules for qualified hedges.

Treasury and the IRS removed much of the uncertainty about their 2019 regulatory actions by publishing not only a proposed reissuance regulation on Dec. 31, but also a final regulation that updates and modernizes the public notice requirements for issuing private activity bonds.

The proposed regulation on reissuance would be the IRS's first covering that topic for the tax-exempt bond market by consolidating notices the service issued during the financial crisis.

The final regulation on the public notice requirement for issuing private activity bonds published the same day marked a long-overdue update to the 1982 Tax Equity and Fiscal Responsibility Act (TEFRA) that first imposed the public notice and approval requirement for PABs. The final regulation simplifies the public notice and approval requirements for PAB issuance to require publication on an issuer’s website seven days prior to a public hearing.

The proposed TEFRA regulations issued in September 2017 would have required a longer notice period of 14 days and publication at a second location such as a community bulletin board.

The final regulations do not – as some in the muni industry requested – drop the requirement for a public hearing if there are no advance requests to speak at the hearing nor does it allow hearings to be held by teleconference or webcast.

Those two Dec. 31 actions left only five regulatory priorities remaining on the Treasury and IRS work plan in 2019 for the municipal bond market.

Moore described the five remaining work items as “mostly very specific niche items except for item No. 1 which is revisiting the private activity bond rules under [Sections] 141, 142 and 147.”

“Every quarter century or so it’s good to take a look at those rules and to attempt to tweak them to reflect modern times,” he said. “But I don’t have any great sense what they might specifically do with those.”

In addition, the IRS plans to finalize proposed arbitrage investment restrictions published in June that clarify that “investment-type property” excludes investments in bond-financed capital projects.

The clarification means if a state or local government pension fund wants to invest in a tax-exempt bond-financed highway project, any bonds issued at that time or in the future would not be considered as taxable arbitrage bonds.

“This is a clarification of original legislative intent that’s intended to facilitate investment in public infrastructure,” Cross told The Bond Buyer in June when the proposed regulations were published.

Moore said most bond attorneys haven’t felt a need for the clarification. “I’m not holding my breath on the finalization of a proposed regulation that is saying something that I don’t think is clarifying anything we are concerned about,” he explained.

The audit priorities set by the Internal Revenue Service for 2019 for the municipal market make sense to outside experts.

The IRS expects to close 500 audits in its Tax Exempt Bonds office in the current fiscal year, up slightly from 480 in the 2018 fiscal year that ended Sept. 30.

IRS auditors plan to focus on excessive cost of issuance for private activity bonds, defeasance, and public safety or jail bonds.

Last year the 2018 IRS work plan for the division included hedge terminations; economic life and weighted average maturity (WAM); safe harbors for guaranteed investment contracts; and rules for qualified hedges.

The other remaining regulatory items on the IRS work plan involve guidance and do not specify the nature of the guidance beyond the general topics. The planned guidances include corrective actions for escrow investments under §148 and another for current refundings of tax-advantaged bonds under §7871(f); and disaster relief provisions.

The last planned guidance would be on tax-advantaged bond appeals procedures.

One pending IRS regulation that is not directly related to municipal bonds but does have an impact on the ability of local governments and school districts to raise revenue, involves the $10,000 cap on state and local deductions enacted in December 2017 as part of the Tax Cuts and Jobs Act.

A final proposed rule could come at any time and would be useful to taxpayers if it is released prior to tax filing season.

The IRS received 7,761 comments and also held a November public hearing on its proposal that would curtail efforts by New York and other high-tax states and communities from using workarounds to bypass the $10,000 cap.

The IRS TEB office does not make forecasts of how many cases will be settled under its voluntary closing agreement program (VCAP) for tax-exempt and other tax advantage bonds. But VCAP settlements have been on the decline, falling to 27 cases in fiscal 2018 from 44 in the 2017, 67 in 2016 and 122 in 2015.

The number of auditors assigned to tax exempt bonds has shrunk to 20 from 23 in October 2017.

The IRS has highlighted the last couple of years how a significant part of compliance strategy is data driven.

But Christie J. Jacobs, who heads the consolidated offices of Tax Exempt Bonds and Indian Tribal Affairs, said employees also are invited to offer suggestions that are reviewed and decided on by a board for approval.

“We have done some public safety exams and we have found significant issues there,” Jacobs said. “That’s part of why that one is on the list. We have recently issued a couple of issue snapshots around that strategy. One about management contracts and one about federal use for federal housing of prisoners. We have tried to put the information out to the community so they can see where we have concerns plus it’s mentioned in the program letter.”

Defeasance will be the focus of audits for the first time in at least a long period of time. Notices of defeasance are required to be filed with the IRS.

Excessive cost of issuance for private activity bonds that might adversely impact their tax-exempt status was the topic the IRS most recently published an issue snapshot on its website.

The July 27 issue snapshot provided 10 examples of costs that are subject to the 2% limitation as well as several audit tips.

The 2% cost of issuance limitation for PABs could be “a fruitful area” for IRS enforcement, Ed Oswald, a tax partner at Orrick Herrington & Sutcliffe in Washington, said in an October interview.

“Given that the 2% limit is a bright line, for a regulator to look at it, is certainly reasonable,” Oswald said.

Violations of the 2% limitation may be most likely for smaller issuances, according to Oswald. But Jacobs said the IRS won’t know if that’s the case “until we do the exams.”

“With cost of issuance, I believe some number of years ago there were some things done about that but it hasn’t been done lately,” Jacobs said.

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