Municipal market participants pressing the Internal Revenue Service to pay interest on arbitrage rebate overpayments may have to turn to Congress because the IRS appears to lack the statutory authority to make such interest payments, a Treasury Department official said yesterday during a public hearing on proposed arbitrage rules.

“We are certainly sympathetic to the view that it seems unfair that the government charges interest to taxpayers, but doesn’t pay interest,” said John J. Cross 3d, an attorney with Treasury’s office of tax policy, during the 30-minute hearing on the proposed rules, which were unveiled in September. “But at the same time, to be fair to the government on this point ... the Treasury Department and the [Internal Revenue Service] are concerned about whether the IRS has the authority [to pay interest on] these rebate overpayments.”

Cross, who was on a panel with three IRS officials, told The Bond Buyer after the hearing that the IRS would need explicit permission from Congress to pay any interest on overpayments.

Cross’ comments came after the Government Finance Officers Association urged the IRS to pay interest on arbitrage rebate overpayments, noting that when the situation is reversed — when taxpayers underpay the IRS — they must pay interest.

Patrick McCoy, executive director of the New York City Municipal Water Finance Authority, who spoke on behalf of GFOA, noted that a member of the issuer group submitted an overpayment notice of $367,000 to the IRS in January 2006, but did not receive a check from the agency until November 2007. The prolonged delay warranted interest, he said. “The IRS should make every effort to pay interest on these amounts,” he said.

Cross conceded it would be “more economically fair” were the IRS to include interest on overpayments and that the Treasury would welcome clarification from Congress.

An overpayment typically occurs when bonds are refunded, making the arbitrage payment, which normally is calculated under the assumption that the bonds will be outstanding for their full term, excessive.

Also at the hearing, Scott Lilienthal, a partner at Hogan & Hartson, spoke on behalf of National Association of Bond Lawyers about the proposed rules that relate to the integration of interest rate swaps based on taxable rate indexes with bond payments.

In general, the proposed rules would make several discrete changes to the existing rules, including accommodating swaps with floating payments based on taxable rates, such as the London Interbank Offered Rate.

Libor swaps, which have become commonplace in the muni market, would be eligible for “simple integration,” under which variable-rate bonds subject to integrated floating-to-fixed rate swaps are treated as variable yield bonds. But such swaps would not be eligible for super integration, which has a separate set of requirements that allow the bonds to be treated as fixed-yield bonds.

Lilienthal urged the Treasury to either scrap or modify its proposed two-prong “snapshot” and “historical” test, which would be used to determine whether the floating rate on Libor and other taxable index-based swaps and the variable rate on their underlying bonds are “substantially the same.” The tests must show both that the rates are no more than 0.25% apart and that for a three-year period ending on the date the issuer enters into the swap, the average difference between the rates does not exceed 0.25%.

NABL contends the tests are unnecessary because the existing rules already require relatively close correlation between the floating rate on the hedge and the variable rate on the hedged bonds, Lilienthal said.

But if scrapping both tests is not possible, he said, Treasury should allow issuers to meet a modified version of the proposed historical test, which would provide more meaningful comparison of rates, better allow issuers to consider and manage the potential basis differential between the floating rates on their bonds and the floating rates on related hedges, as well as provide the IRS and Treasury a reasonable assurance of correlation.

Specifically, NABL suggested the historical test be conducted over “at least” three years, rather than exactly three years.

“A historical test would provide a more meaningful comparison of rates, and would better ensure that short term market abnormalities do not distort the comparison,” Lilienthal said. “We also see no reason that the historic look-back period be limited to three years, and recommend that issuers be permitted to use a longer period if they so choose.”

Cross asked Lilienthal if NABL was concerned that issuers would draw on up to a decade’s worth of data and come up with a “whole machination of averages” to correlate a swap, suggesting that would be problematic.

But Lilienthal said a longer period for historical comparisons would not pose a problem.

“There shouldn’t be a concern with a longer period because the more data you look at, presumably the more reliable the information you’re going to get,” he said. “There are short-term market abnormalities that could make a three-year period less reliable as a guidance of future correlations.”


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