Penalties; Burdens of Proof

December 28, 2012

Penalties Overview

§ 6662:  Imposition of accuracy-related penalty on underpayments:  Underpayment penalty of 20% attributable to (a) negligence or disregard (careless, reckless or intentional disregard) of rules or regulations, (b) any substantial understatement of income tax (if amount of understatement exceeds greater of 10% of tax required to be shown or $5,000 – special rule for corporations), (c) any substantial valuation misstatement under chapter 1, (d) any substantial overstatement of pension liabilities, (e) any substantial estate or gift tax valuation understatement, (f) any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of § 7701(o)) or failing to meet the requirements of any similar rule of law, and (g) any undisclosed foreign financial asset understatement.

§ 6662A:  Imposition of accuracy-related penalty on understatements with respect to reportable transactions: Underpayment penalty of 20% with respect to reportable transactions.

§ 6663:  Imposition of Fraud Penalty: Fraudulent underpayment penalty of 75%.

Penalties for Promoting Abusive Tax Shelters (I.R.C. 6700)

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.

Penalties for Failure to Show or Furnish Original Issue Discount Information on Debt Instruments (I.R.C. 6706)

Information required to be set forth on the face of the debt instrument (Non-Publicly Offered Instruments):

In the case of failure to set forth on a debt instrument the information required to be set forth thereon under I.R.C. 1275(c)(1) (unless it is shown that the failure is due to reasonable cause and not willful neglect), the issuer must pay a penalty of $50 for each instrument with respect to which the failure exists.  For debt instruments not publicly offered, Treas. Reg. 1.1275-3(b) requires that the issuer:

  • legend the instrument by stating on the face of the instrument that the instrument was issued with OID; and
  • Either:
    • Set forth on the face of the instrument the issue price, the amount of OID, the issue date, the yield to maturity and, if the instrument is subject to the rules of Treas. Reg. 1.1275-4(b), the comparable yield and projected payment schedule; or
    • Provide the name or title and either the address or phone number of a representative of the issuer who will, beginning no later than 10 days after the issue date, promptly make available to holders upon request the information described in the prior paragraph.

The legending described above must occur when the bond issue first issued in physical form, but is not required before the first holder of the debt instrument disposes of the instrument.

The legend must survive reissuance.

Legending is not required for debt instruments described in I.R.C. 1272(a)(2) (tax-exempt obligations, United States savings bonds, short-term obligations, obligations issued by natural persons, loans between natural persons), debt instruments issued by natural persons, REMIC regular interests or other debt instruments subject to I.R.C. 1272(a)(6) (regular interest in a REMIC or qualified mortgage held by a REMIC, any other debt instrument if payments under such debt instrument may be accelerated by reason of prepayments of other obligations securing such debt instruments, or any pool of debt instruments the yield on which may be affected by reason of prepayments), or stripped bonds and coupons within the meaning of I.R.C. 1286.

Information required to be reported to the Secretary upon issuance (Publicly Offered Instruments):

Any issuer who fails to furnish information required under I.R.C. 1275(c)(2) with respect to any issue of debt instruments on the date required must pay a penalty equal to one percent of the aggregate issue price of the issue, unless it is shown that the failure is due to reasonable cause and not willful neglect.  The amount of the penalty imposed with respect to any issue of debt instruments may not exceed $50,000 for the issue.

The issuer of the instrument must make an information return prescribed by the Commissioner (IRS Form 8281) within 30 days after the issue date of the issue.  The information reporting requirement does not apply to substantially the same debt instruments referred to in the exceptions paragraph for non-publicly offered instruments (with some changes).

Burdens of Proof

“Preponderance of the evidence” = The degree of relevant evidence that a reasonable person, considering the record as a whole, would accept as sufficient to find that a contested fact is more likely to be true than untrue. 51%

“Clear and convencing evidence” = Standard required by the IRS to prove fraudulent understatement for purposes of the penalty under § 6663.

Commercial Paper Provisions

December 12, 2012

Provisions Relevant to Commercial Paper Financings:

Treas. Reg. 1.150-1(c)(4)(ii):  Special rule to determine an “issue” of commercial paper

Treas. Reg. 1.149(e)-1(e)(2)(ii):  Special rule for determining what the issue of commercial paper is for purposes of information reporting

Notice 2011-63:  Discusses issue date determination for draw down loans and commercial paper (among others)

Notice 2011-63:

Under Notice 2010-81, the IRS determined that bonds are considered issued on the “issue date” of the particular bond, not the “issue date” of the issue of bonds.  The IRS subsequently received comments stating that this definition of issue date for purposes of, e.g., volume cap administration, is not workable and is inconsistent with prior interpretation of the issue date rules.  For instance, it is impractical for draw-down loans and commercial paper, which might be issued in various years – each time a draw is made or each time the commercial paper is issued.  In Notice 2011-63, the IRS corrects its determinations in Notice 2010-81 and provides that an issuer may now treat a bond as issued in either of the following cases:

  1. on the issue date of the bond under the general (problematic) interpretation of Notice 2010-81; or
  2. on the issue date of the issue so long as the issuer meets the following additional requirements:
    • all of the bonds of the issue must be issued no later than the earlier of:
      • the statutory deadline for issuing the bonds; or
      • the end of the maximum carryforward period for unused volume cap under the applicable statute, treating all of the unused volume cap for the issue as volume cap arising in the year in which the issue date of the issue occurs.

If the second alternative is used, the issuer must make a special marking on the IRS Form 8038/-G information return to identify the use of the alternative for, e.g., draw-down bonds or commercial paper.

Note that, for example, “if the bonds were small issue bonds under § 144(a), the alternative option would not be available because under § 146 there is no carryforward period for unused volume cap for small issue bonds.”

General I.R.C. 148 Matters

December 10, 2012

Outline of Issues:

Reasonable Expectations:

Generally, the issuer’s officer must, in good faith, certify the issuer’s expectations as of the issue date.  The certification must state the facts and estimates that form the basis for the issuer’s expectations.  The certification usually takes the form of a Tax Regulatory Agreement, a No-Arbitrage Certificate, a Tax Compliance Certificate or similar document or documents.  Bond counsel do not have a standard method of documenting these expectations, and documents differ from firm to firm.

There are two exceptions in Treas. Reg. 1.148-2(b)(2)(ii), which states that an issuer is not required to make a certification for an issue if either:

  1. The issuer reasonably expects as of the issue date that there will be no unspent gross proceeds after the issue date, other than gross proceeds in a bona fide debt service fund (e.g., equipment lease financings in which the issuer purchases equipment in exchange for an installment payment note); or
  2. The issue price of the issue does not exceed $1,000,000.

Assume proceeds of an issue of certificates of participation finance projects for two different issuers (such as a “composite issue”).  Assume further than the total issue price is $1,100,000, with the issue evenly split between the issuers.  Each issuer may be eligible for the $1,000,000 exception to the certification requirement, in reliance on the multipurpose issue allocation provision in Treas. Reg. 1.148-9(h).

There used to be a rule in Treas. Reg. 1.103-13(a)(2)(iv) that forbade an issuer from certifying reasonable expectations if the issuer has been notified of a listing or proposed listing (“blacklisting”) by the Internal Revenue Service to the effect that the issuer is an issuer of obligations whose arbitrage certifications may not be relied upon.  This rule is no longer in effect.  See, e.g., reference to the provision in Harbor Bancorp v. Commissioner of Internal Revenue, 105 T.C. 260.

General Definition of Proceeds

Under Section 1.148-2(a) and 1.148-3(a) of the Regulations, “proceeds” for 148 purposes means “gross proceeds.”  Section 1.148-1(b) defines “gross proceeds” to include proceeds and replacement proceeds of an issue.

Replacement Proceeds

Section 1.148-1(c)(1) of the Regulations defines “replacement proceeds” as amounts that have a sufficiently direct nexus to a tax-exempt bond issue or to the governmental purposes of a tax-exempt bond to conclude that the amounts would have been used for that governmental purpose.

Replacement proceeds include, as described in Section 1.148-1(c)(1), (a) sinking funds, (b) pledged funds and (c) other replacement proceeds described in Section 1.148-1(c)(4) to the extent that such funds or amounts are held by or derived from a substantial beneficiary of the issue.  A substantial beneficiary of an issue includes the issuer, any related party to the issuer and the State in which the issuer is located (if the issuer is not a state).  A person is not a substantial beneficiary simply by virtue that it is a guarantor under a qualified guarantee.

In PLR 8128057, the Internal Revenue Service claims that a seller that pledges security for the buyer’s bonds is a substantial beneficiary.

There is a December 6, 1994 letter ruling in the pension bond context relating to the definition of “substantial beneficiary.”

(a) Sinking Funds

Sinking funds, to the extent qualifying as bona fide debt service funds (i.e., used to pay debt service on the bonds and expended within 13 months of deposit) are eligible for the bona fide debt service fund exception stated in Treas. Reg. 1.148-2(e)(5)(ii).  To the extent not qualifying for the bona fide debt service fund exception, such amounts are restricted to a temporary period of 30 days and thereafter may not bear a yield in excess of one one-thousandths of one percent, as further described in Treas. Reg. 1.148-2(e)(5)(i).

(b) Pledged Funds

See IRS Notice 2010-5 for a discussion of what constitutes “pledged funds.”  Pledged funds are described in Section 1.148-1(c)(3).

See Priv. Ltr. Rul. 8334103 and Priv. Ltr. Rul. 8841027 concerning pledged funds/replacement funds with respect to a collateral account required to be held by a university, and a “building and equipment reserve fund” that could be used to pay debt service on the issue.

See Rev. Rul. 78-348 concerning when funds constitute pledged funds – and the nexus/relationship requirement.  The issue therein concerns “Will certain securities pledged as collateral for municipal bonds be subject to arbitrage yield restrictions?” “An issuer that borrows to invest in higher-yielding securities and one that borrows against such securities already owned are in virtually the same economic position. […] There must be a reasonable assurance that the collateral will be available if needed to pay debt service, even if the issuer encounters financial difficulties. Thus, for example, an arrangement will not have the effect of a pledge of collateral if the issuer has discretion to defeat the ‘pledge’ merely by liquidating the ‘collateral’ and disposing of the proceeds.”

Negative Pledges as described in Section 1.148-1(c)(3)(ii) of the Regulations:  An amount is treated as pledged to pay principal or interest on an issue if it is held under an agreement to maintain the amount at a particular level for the direct or indirect benefit of bondholders or a guarantor of the bonds.  An amount is not treated as pledged under this paragraph, however, if (A) the issuer or a substantial beneficiary may grant rights in the amount that are superior to the rights of the bondholders or the guarantor; or (B) the amount does not exceed reasonable needs for which it is maintained, the required level is tested no more frequently than every 6 months and the amount may be spent without any substantial restriction other than the requirement to replenish the amount by the next testing date.

Frederic L. Ballard, Jr., in his book ABCs of Arbitrage (ed. 2007) (page 55), explains negative pledges as follows:

The regulations define a negative pledge for this purpose as a fund held under an agreement to maintain the amount at a particular level for the direct or indirect benefit of the bondholders or a guarantor of the bonds.  In other words, a fund is covered by a negative pledge if the issuer has promised the bondholders that it will maintain the fund free of encumbrances – that is, that it will not pledge the fund to any other creditor. […] The “superior rights” rule has not been frequently relied upon in practice, since a fund as to which creditors may have superior security interests is generally not useful in transaction planning.  The “six-month testing” rule appears to mean that the following would not create replacement proceeds:

1. An amount maintained for some reasonably purpose, typically designated as liquidity maintenance.

2. The borrower covenants that on the last day of each semiannual period, it would have the agreed-upon amount of unencumbered cash, including cash equivalents.

3. Between the semiannual testing dates the borrower would be unrestricted in its use of the cash.  Its only obligation would be to have the required amount on hand at the next testing date.

4. A failure by the borrower to hold cash in the required amount on a testing date would be a default and could therefore trigger normal commercial remedies such as rights of cancellation.

A 2009 Bond Attorneys Workshop publication suggests that, to “meet the ‘reasonable needs’ requirement, some counsel attempt to tie the covenants to business requirements, as opposed to debt service requirements, e.g. ‘sufficient cash for 35 days operating needs,’ or to industry standards, such as rating agency requirements” (emphasis added).  Covenants can, however, still be reasonable based on facts and circumstances even if based on debt service requirements.

As described in a recent April 2010 CBO report on arbitrage by colleges and universities, “if assets are not specifically pledged to pay the debt service on a tax-exempt bond or if the assets have no other direct connection to the bonds, the arbitrage restrictions do not apply.”

Pledged funds can also include a fund of the borrower pledged to the provider of a letter of credit [or a fund that the borrower must maintain from which debt service can be paid and that is tested more than twice a year].

A covenant does not necessarily need to relate to restriction on “investment” type property to constitute a negative pledge issue. However, if the assets restricted consist of only assets used in the trade or business (e.g., buildings, equipment) then the property is not reasonably within the scope of the negative pledge. Such property would not be “investment type” property (or property held principally as a passive vehicle for the production of income) under section 1.148-1(e) for purposes of 148(a) and (b).

Gifts can give rise to replacement proceeds concerns.

(c) Other Replacement Proceeds

Other replacement proceeds arise to the extent that an issue is outstanding longer than necessary, and the issuer expects there to be “available amounts.”  The 1993 Regulations explain that an issue does not give rise to other replacement proceeds if (1) it is a working capital issue that is outstanding no longer than two years, (2) the bonds (including a refunding bond) meet the bond maturity limitation in Section 147(b) of the Code relating to economic life of assets financed (120% test), or (3) in the context of a refunding, the WAM of the refunding bonds is not longer than the WAM of the refunded bonds (and the refunded issue satisfied one of the above two tests).

Note the relationship between the “other replacement proceeds” definiton and the anti-abuse rules of Treas. Reg. 1.148-10(a)(4) of the 1993 Regulations.  See Rev. Proc. 2002-31 for a discussion of “outstanding longer than necessary” in the context of tax and revenue anticipation notes.


School Provisions

December 5, 2012

Provisions Relevant to Schools:

I.R.C. 142(a)(13): Qualified public educational facilities

I.R.C. 144(b): Qualified school loan bonds

I.R.C. 147(h)(3): Limitation on use for land acquisition does not apply to exempt facility bonds for public-private schools.

I.R.C. 148(f)(4)(D)(vii):  Increase in small issuer rebate limitation for public school facilities.