The Internal Revenue Service has stated that it will continue to invest significant resources in identifying abusive transactions in the municipal bond market in 2013. What are some examples of abusive transactions? What is a possible penalty for engaging in an abusive transaction?
I.R.C. § 149(d)(4) prescribes tax-exempt treatment of a bond if the bond is “issued to advance refund another bond and a device is employed in connection with the issuance of such [refunding] issue to obtain a material financial advantage (based on arbitrage) apart from savings attributable to lower interest rates.”
The Bond Attorneys Workshop outlines from 2010 explain that certain transactions are described as “devices” in the legislative history of I.R.C. § 149(d)(4) and in the General Explanation of the Tax Reform Act of 1986, at page 1215. Treas. Reg. 1.148-10 of the 1993 Final Regulations also sets forth five additional examples of transactions that are considered abusive. In Rev. Rul. 94-42, the IRS has indicated that another type of transaction may also cause the interest on bonds to be taxable. Collectively, such sources indicate that the following are examples of abusive transactions:
- Using refunding bond proceeds to pay debt service on the refunded bonds, which frees up revenues otherwise allocated to the payment of debt service, permitting the issuer to allocate the revenues to amounts used to pay a later installment of debt service. (Example 1 in the General Explanation)
- Using (refunding) bond proceeds to pay costs which were to be paid with proceeds of the prior issue, and the proceeds of the prior issue are invested in an escrow established to pay debt service on the prior issue payable in future years. The proceeds of the prior issue are invested at a materially higher yield that the yield on the bonds, or the issuer otherwise secured a material financial advantage from this replacement. The IRS will treat the (refunding) bonds as advance refunding bonds for purposes of the additional restrictions on advance refundings, and the issuer is considered to have employed a device in connection with the issuance of the refunding bonds to obtain a material financial advantage apart from savings attributable to lower interest rates. (Example 2 in the General Explanation)
- Receiving a direct monetary benefit with respect to the refunded bond by reason of issuance of an advance refunding bond, and the monetary benefit is not taken into account in determining the yield on the refunding bond. For example, if an advance refunding bond enables the issuer to get back a portion of a premium on bond insurance paid on the prior issue (which would have been taken into account in calculating the yield on the prior issue) (or results in a reduction in the interest payable on the prior issue and thus a reduction in the amount of refunding bonds needed to refund the prior issue), the issuer will be considered to have employed a device in connection with the issuance of the refunding bond to obtain a material financial advantage apart from savings attributable to lower interest rates unless the yield on the refunding bond is determined by taking into account the direct monetary benefit (i.e., as an increase in the issue price of the refunding bond, which lowers the yield on the refunding bond). (Example 3 in the General Explanation)
- Pursuant to a series of transactions, a prior issue is refunded by issuing (1) long-term advance refunding bonds (intended to be tax-exempt) to pay debt service on the prior issue in the early years, and (2) short-term advance refunding bonds (not intended to be tax-exempt) to pay debt service on the prior issue in the later years. Proceeds of the short-term (taxable) advance refunding issue are invested at a yield materially higher than the yield on both the short-term and the long-term advance refunding issues, or the issuer otherwise secures a material financial advantage based on arbitrage by separating the two issues. By separating the two issues, the issuer has attempted to exploit the difference between the taxable rate at which proceeds of the short-term advance refunding issue are invested and the tax-exempt rate of the long-term advance refunding issue. If a material financial advantage has been obtained by separating the two issues, the issuer has employed a device in connection with the issuance of the long-term advance refunding bonds to obtain a material financial advantage apart from savings attributable to lower interest rates. (Example 4 in the General Explanation)
- Bid rigging of investment and derivative contracts
- Mispricing of bonds
- The advance refunding bonds have “excess gross proceeds” (See Treas. Reg. § 1.148-10(c)(1) and also the heading below regarding excess issue price)
- Crossover refundings unless they are described in the special rule for “excess gross proceeds” described in Treas. Reg. § 1.148-10(c)(4)
- Gross refundings unless they are described in the special rule for “excess gross proceeds” described in Treas. Reg. § 1.148-10(c)(5)
- Mortgage sale (See example 1 in Treas. Reg. § 1.148-10(d))
- Bonds outstanding longer than necessary for yield-blending device (See example 2 in Treas. Reg. § 1.148-10(d))
- Window refundings/debt service flip flops (See example 3 in Treas. Reg. § 1.148-10(d) and more details under the next heading)
- Sale of conduit loan: Conduit issuer sells the conduit note at a premium and deposits the proceeds to an escrow that is invested above the then-determined yield of the note. (See example 4 in Treas. Reg. § 1.148-10(d))
- Re-refunding (See example 5 in Treas. Reg. § 1.148-10(d))
The examples above are only basic descriptions of the devices. The cited examples should be referred to for full fact patterns and analyses.
Congress did not intend to prevent low-to-high advance refundings that occur (a) to obtain relief from specific covenants included in the refunded bonds or (b) to restructure debt service, so long as these advance refundings do not additionally involve a device. See
The Internal Revenue Service may pursue actions under I.R.C. § 6700 against firms and individuals that violate tax laws by participating in abusive transactions. Section 6700 provides for the imposition of penalties on “any person who […] (1) organizes (or assists in the organization of) a partnership or other entity, any investment plan or arrangement or any other plan or arrangement or participates (directly or indirectly) in the sale of any interest in an entity or plan or arrangement referred to above, and (2) makes or furnishes or causes another person to make or furnish (in connection with such organization or sale) (A) a statement with respect to the allowability of any deduction or credit, the excludability of any income, or the securing of any other tax benefit by reason of holding an interest in the entity or participating in the plan or arrangement which the person knows or has reason to know is false or fraudulent as to any material matter, or (B) a gross valuation overstatement as to any material matter.” The penalty imposed by I.R.C. § 6700 is in addition to any other penalty provided by law. The burden of proof of whether or not a person is liable for the penalty in I.R.C. § 6700 is on the Secretary.
See the 2015 TAM below, which includes a discussion of abusive transactions.
See Example 3 under Treas. Reg. 1.148-10(d) for a description of window refunding and the anti-abuse rule application.
An Authority issues its 1994 refunding issue to refund a portion of the principal and interest on its outstanding 1985 issue. The 1994 refunding issue has zero-coupon bonds that pay no interest or principal for five years following issuance. The proceeds of the 1994 bonds are deposited to a refunding escrow account to pay only the interest requirements on the 1985 bonds.
The Authority then enters into a GIC with a financial institution under which the institution provides a guaranteed yield on revenues invested by the Authority during the 5-year period. The GIC has a yield that is not higher than the yield on the 1994 bonds. The “revenues” invested by the Authority under the GIC consist of the amounts that the Authority otherwise would have used to pay principal of and interest on the 1994 bonds (presumably if the 1994 bonds had not been structured as zero-coupon no principal payment bonds).
The GIC is structured to generate receipts at times and in amounts sufficient to pay the principal and redemption requirements of the 1985 bonds.
A principal purpose of the 1994 bonds is to avoid transferred proceeds (any unspent 1985 proceeds). (Transferred proceeds of the 1994 bonds would be such unspent 1985 proceeds when the 1985 bond principal amounts are paid with proceeds of the 1994 bonds. The issuer would have to restrict yield on the transferred proceeds based on the yield of the 1994 bonds. This would be disadvantageous if the 1994 bonds have a yield that is below the 1985 yield.)
The Authority will continue to invest the unspent proceeds of the 1985 issue that are on deposit in a refunding escrow for its 1982 issue at a yield equal to the yield on the 1985 issue and will not otherwise treat those unspent proceeds as transferred proceeds of the 1994 bonds.
The 1994 bonds are an issue of arbitrage bonds because those bonds involve a transaction or series of transactions that overburdens the market by leaving bonds outstanding longer than necessary to obtain a material financial advantage based on arbitrage. Specifically, the Authority has structured the 1994 refunding issue to make available for the refunding of the 1985 issue replacement proceeds rather than proceeds so that the unspent proceeds of the 1985 issue will not become transferred proceeds of the 1994 refunding issue.
(The regular approach would have been to issue the 1994 bonds as normal amortizing bonds, use the proceeds of the 1994 bonds to pay principal and interest on the 1985 bonds, transfer unspent 1985 proceeds to the 1994 issue. The unspent proceeds upon transfer would lose their eligibility to be invested at the higher 1985 yield.)
The same “flip-flop” window refundings were done with sinking fund GICs and bond funds.
TAM 201538013 (September 18, 2015): Summary: (1) There was no window refunding because, in part, there were other good reasons to structure the debt service schedule of the refunding bonds, (2) the remaining DSF moneys were not excess gross proceeds because they are “replacement proceeds in a sinking fund for the refunding issue” and (3) the transaction was not abusive because the issuer didn’t actually have any material financial advantage – it invested the “released revenues” below the refunding bond yield.
By how much may the issue price of a bond issue exceed the amount needed to finance the governmental purposes of the bonds?
This matter raises concerns relating to the abusive arbitrage devices analysis under Treas. Reg. § 1.148-10. One type of abusive arbitrage device is a transaction that overburdens the tax-exempt bond market. An overburdening in this sense occurs if the issuer issues more bonds than is otherwise reasonably necessary to accomplish the governmental purposes of the bonds, based on all facts and circumstances. Certain factors are relevant in determining the overburdening status, including:
- Is the purpose of the transaction a bona fide governmental purpose (e.g., an issue of refunding bonds to achieve a debt service restructuring that would be issued independent of any arbitrage benefit)?
- Would the action be taken if the interest on the issue were not excludable from gross income under Section 103(a) of the Code?
- Does the issuance of the bonds exceed more than a minor portion of the amount necessary to accomplish the governmental purpose of the issue?
- Do the proceeds of the issue substantially exceed the amount of sale proceeds allocated to expenditures for the governmental purposes of the issue?
- Some of the aforementioned factors may be outweighed by other factors, however, such as bona fide cost overruns or long-term financial distress.
- There are special rules on excess gross proceeds of advance refunding issues that may give rise to abusive arbitrage device status.
“Minor portion” and “substantially exceed” are not defined under the abusive arbitrage device regulations. Minor portion may be treated similarly to the general definition of “de minimis” in Treas. Reg. § 1.148-1(b), which generally means two percent of the stated redemption price at maturity. Alternatively, one might look to the excess gross proceeds explanation for advance refunding bonds in Treas. Reg. § 1.148-10(c)(2), which states that such excess constitutes gross proceeds of an advance refunding issue that exceed one percent of the sale proceeds of the issue, other than certain gross proceeds allocable, e.g., to payment of debt service on the prior issue. Some bond counsel have applied this one-percent standard before becoming concerned with possible overburdening issues.