Third IRS audit of Puerto Rico bonds may indicate enforcement initiative

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WASHINGTON -- The Puerto Rico Municipal Finance Agency reported Tuesday that $59 million in 2005 Series B Refunding Bonds are under audit by the Internal Revenue Service, marking the third IRS audit of tax-advantaged bonds involving the commonwealth announced over the last six weeks.

The bonds were sold to refund a 1997 MFA issuance and were issued pursuant to a trust indenture between the agency and Banco Santander Puerto Rico, as trustee.

Kristin Franceschi, an attorney at DLA Piper who is representing Puerto Rico in all three audits, said in an email Wednesday, “it appears from recent audit activity that there may be a new initiative in enforcement involving Puerto Rico.”

The latest audit was announced in a public event notice filed with the Municipal Securities Rulemaking Board that reported IRS notified the agency in a letter dated March 28 that it is examining MFA’s Series B Bonds.

The Puerto Rico MFA reported the IRS letter stated, “We routinely examine municipal debt issuances to determine compliance with federal tax requirements. “There are several ways we select a municipal debt issuance for examination.

“We may select it as part of an initiative, project or referral, due to a questionable or unusual item on the return, or as a random selection.

“We use a centralized case selection and review process to enhance consistency of enforcement activities, and to focus resources on areas having the most positive impact on municipal debt issuances.

“Our tasks include identifying areas of noncompliance, developing corrective strategies, and assisting with those strategies.”

Puerto Rico’s MFA said it “intends to respond to all correspondence from the IRS and intends to cooperate fully with the IRS in connection with the examination.

"MFA has not undertaken to provide any further information regarding this examination except to the extent that it may be obligated to give notice of any future adverse tax opinions or other material events affecting the tax status of the Series B Bonds in accordance with the applicable continuing disclosure agreement.”

As for the other two Puerto Rico audits, the first announcement came in late February when the Puerto Rico Public Buildings Authority said $877.9 million in school bonds it issued in 2011 were under IRS audit.

That audit includes $121.5 million in Series 2011 T direct-pay qualified zone academy bonds and four Series 2011 R taxable of school construction bonds that totaled $756.4 million.

The second audit involves IRS Form 8038-CP filed by the Puerto Rico Electric Power Authority in connection with its Series YY Build America Bonds. The $320.2 million in 30-year BABs were issued by PREPA in April 2010 with a coupon rate of 6.125%.

BABs receive a 35% federal subsidy on their interest payments, although that subsidy is subject to a federal budget sequestration reduction which varies each year. In the current 2019 federal fiscal year the cut is 6.2% of the 35% subsidy. That shaves 2.17 percentage points off the subsidy, reducing it to 32.83%.

The federal tax issue that is at stake with the BABs audit involves the federal payments for the direct-pay subsidy.

None of the three Puerto Rico audits involve the IRS audit priorities for the current 2019 fiscal year.

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

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.

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Tax audits Muni tax exemption Tax credit bonds Build America Bonds Puerto Rico Electric Power Authority Puerto Rico Public Buildings Authority Commonwealth of Puerto Rico IRS Washington DC Puerto Rico