The Montana Facility Finance Authority is appealing an Internal Revenue Service proposed adverse determination that concluded the interest earned from $14.15 million of variable-rate demand revenue bonds it issued to finance an expansion of a nursing home would be taxable.
The appeal, which the authority announced Thursday will be made to the IRS Office of Appeals, is of particular interest to continuing care retirement facilities nationwide, because the IRS is alleging that its refundable entrance fees, which are common in the industry, constitute "replacement proceeds" whose investment should have been yield-restricted for arbitrage purposes.
"Virtually all CCRCs have some kind of an entrance fee that they receive from residents on move-in. It's a standard provision of any CCRC," said Steve Maag, director of assisted living and continuing care for the American Association of Homes and Services for the Aging, a national organization of 5000 nonprofit retirement facilities. "We continue to be concerned with the direction the IRS is heading and support our member in trying to resolve this in a manner favorable to the community."
"I'm disappointed that we were unable to resolve the case at the examination," said Bradley S. Waterman, the tax controversy attorney representing the Montana authority, who declined to discuss the audit further Friday.
The authority announced its intentions to appeal in a material event notice filed Feb. 5 with the nationally recognized municipal securities information repositories.
The Montana agency stated in the notice that it and the conduit borrower, Missions United Inc., "strongly disagree with the conclusion expressed in the PAD and intend to file a protest and request for review of the PAD by Appeals."
However, it could be several months before the appeals process is concluded. Under the appeals process, an issuer has within 30 days of receiving a proposed adverse determination to file a protest and request for a review, at which point the IRS' tax-exempt bond branch will review the case, close it, and send it to the appeals office.
The appeals office will then review the case and prioritize it based upon its workload and ongoing appeals cases. It could take months for a decision to come out of the office.
The Montana agency states in the notice it received the adverse determination on Jan. 22, at which point the IRS stated that it had completed its examination and determined that the 2002 bonds were taxable arbitrage bonds. The bonds had been issued by the authority to finance an expansion to a CCRC called Mission Ridge.
On Oct. 1, the IRS issued a "notice of proposed issue," which has replaced the preliminary adverse determination in the IRS' muni bond enforcement program.
The IRS contends that the entrance fees the CCRC collects when a resident moves in, but refunds when they vacate, are technically replacement proceeds, whose investment should be yield-restricted in accordance with arbitrage regulations.
Treasury Department regulations define replacement proceeds as having "a sufficiently direct nexus to the issue or to the governmental purpose of the issue to conclude that the amounts would have been used for that governmental purpose if the proceeds of the issue were not used or to be used for that governmental purpose."
The IRS' interpretation of these rules is that bondholders could reasonably assume that the fees would be available for debt service payments if needed.
However, Mission Ridge contends that it does not set aside the fees for debt service, and in fact spends them on its day-to-day operations like the rest of its revenue.
The bonds were issued by the authority to finance the expansion of Mission Ridge, which consists of an independent-living facility, an assisted-living facility, and a nursing home with full-time care. According to bond documents, bond proceeds financed the construction and equipping of 37 additional independent-living units and 20 additional assisted-living units, together with common areas and parking.
The IRS began the examination on March 19, 2007, as part of a project initiative looking into 501(c)(3) bond issues, according to the authority's material event notice.
Gottlieb, Fisher & Andrews PLLC in Seattle was bond counsel on the deal. Ziegler Capital Markets was remarketing agent. The letter of credit was provided by Lasalle Bank National Association, which is now part of Bank of America.