WASHINGTON — Pendleton County, Ky., yesterday announced that it entered into a closing agreement with the Internal Revenue Service regarding a $100 million blind-pool deal done in 1993, after appealing a proposed adverse determination issued by the IRS from a second audit of the bonds.
The first audit examining the same issues had found the bonds were compliant with the tax law.
The county disclosed the agreement in a material event notice filed with the nationally recognized municipal securities information repositories. Under closing agreements, issuers typically make a payment to the IRS for alleged loss revenues in return for the agency’s retaining the tax-exempt status of the bonds. The terms of the agreement were not disclosed and county officials and their advisers would not comment on them.
The 1993 bond proceeds were issued by the county and the proceeds were available to be loaned to counties and other public agencies in Kentucky to provide long-term, fixed-rate financing or refinancing of capital projects.
The Kentucky Association of Counties Leasing Trust administered the program. It consisted of $90 million of Series A multi-county lease revenue bonds, which were redeemed in 2005, and $10 million of Series B bonds scheduled to be redeemed on March 1, 2019. The blind pool deal is one of several in Kentucky that the IRS has audited during the past decade for arbitrage violations.
Rauscher Pierce Refsnes Inc., now RBC Capital Markets Inc., was underwriter on the transaction and Kutak Rock LLP was bond counsel. Fulbright & Jaworski LLP was underwriter’s counsel.
In 1998, the IRS initiated an audit of the bonds. The agency issued a letter on Jan. 27, 2000, stating that it had “closed the examination with no change to the position that interest received by holders of the bonds is excludible from gross income” under the tax code, according to the county. The disclosure did not cite the matter or matters at issue in the examination.
But the IRS initiated a second audit of the bonds on Sept. 16, 2004, revisiting the same issues as in the original audit, sources said. On May 9, 2006, it issued a proposed adverse determination that the bonds were taxable. The county filed a protest with the IRS Office of Appeals on June 9, 2006.
The two audits illustrate an ongoing debate among market participants about whether the IRS should be able to examine an issuer a second time for the same reasons after having found no tax law violations in the first audit.
Generally, the IRS treats municipal issuers as taxpayers for most administrative and examination purposes and does not deal with bondholders. An exception to that, however, appears to be in section 7605 of the tax code, which was created by the Revenue Act of 1921.
Section 7605(b) states that no taxpayer “shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer’s books of account shall be made for each taxable year.”
IRS officials in the past have argued that the section is not applicable to issuers because the audit is technically of bondholders, who are ultimately liable if bonds are declared taxable. If the agency reaches a “no-change” conclusion for a particular tax year of the bonds’ life, it is not precluded from examining subsequent tax years for the same issues, officials have said. IRS officials could not be reached for comment yesterday.
Bond lawyers acknowledged that the IRS has the ability to change its mind in a second audit, but questioned whether they should be able to revisit the exact same issues.
“They could audit for interest that was paid in 2000, and then they could close it, and then they could change their mind and audit for interest paid in 2001,” said Perry Israel, who has his own Sacramento firm.
Thomas Vander Molen, a partner at Dorsey & Whitney LLP in Minneapolis, added that the IRS typically has some sort of reason for revisiting already examined deals.
“I don’t get the sense that they just pull deals out of the hat and say, 'Let’s go back,’ ” he said.
Bradley S. Waterman, the Washington-based tax controversy attorney representing the county before the IRS, declined to discuss the specific settlement yesterday but said the agency’s ability to revisit issues previously audited is troublesome.
“There is a concern regarding the manner in which the IRS applies the limitation on multiple examinations in the tax-exempt bond context,” he said. It “seems to be inconsistent with the spirit of the provision, particularly in view of the treatment of the issuer as 'the taxpayer’ for purposes of the examination process.”
Nonetheless, Vander Molen pointed out that when the IRS closes an audit with no change to the tax-exempt status of the bonds, it typically notifies the issuer that “if the need to open another examination arises on this bond issue, any change resulting from that future examination may affect all open years of bondholders from the issue date of the bond.”