WASHINGTON — The Internal Revenue Service’s initiative to determine whether municipal bonds are being initially offered at prices that fail to comply with tax requirements has left issuers upset and confused about the definition of issue price and what specific abuses the IRS is looking for.

IRS officials recently disclosed that they have formed a seven-person team that is using the online EMMA system and other data from the Municipal Securities Rulemaking Board to monitor bond prices.

But at the Government Finance Officers Associaton’s winter meeting here, members of the group’s debt committee were perplexed about why the IRS has placed a strong focus on issue price and vented their frustration, saying they would like to see guidance rather than enforcement action from the IRS on the issue.

“We need clarity on what the rules are,” Ben Watkins, Florida’s director of bond finance, said after an IRS official described the initiative. “We know what the rules are currently, and suggesting that there might be a change in the rules without the formal process for promulgating guidance and then using the examination and enforcement mechanism — to do that is not appropriate and misguided.”

Watkins said the lack of IRS guidance will create a lot of unnecessary angst and confusion in the municipal market.

“If they are changing the rules, they have a responsibility to say how they are changing the rules rather than these vague references to abusive transactions and collusion and inappropriate pricing of bonds,” Watkins said. “For someone who is pricing bonds every day, and we’ve got to be spot on with tax compliance, this is a little disconcerting.”

Cliff Gannett, acting director of government entities at the IRS since April when he was head of the tax-exempt bond office, told members of the GFOA committee that the IRS will be beating the drum this year for issuers to have procedures and practices on issue price that market participants can all embrace. He said his agency will be engaged in continual education and outreach efforts.

Gannett emphasized that the IRS is still in the research stages rather than enforcement of the new initiative.

Issue price is key to determining the bond yield for tax purposes, which has a bearing on whether an issuer of tax-exempt bonds is meeting arbitrage requirements and whether an issuer of a Build America Bond is receiving an appropriately sized federal subsidy payment. BAB issuers receive subsidy payments equal to 35% of their interest costs.

IRS rules specify that the issue price for each maturity of tax-exempt bonds is the first price at which a substantial amount of the bonds is sold to the public, with 10% considered to be a substantial amount.

The lower the issue price for bonds, the higher the yield. If the issue price is set too low, then the bond yield is likely too high. That results in the tax-exempt bond issuer retaining impermissible arbitrage from taxable investments of the bond proceeds and the BAB issuer receiving federal subsidy payments that are too high.

“We are in the process of evaluating the information we are looking at,” Gannett said. “I will say we are looking at more information than we ever have. We don’t know what it will tell us exactly. We’re hoping it will tell us what you’re surmising, in that most times there weren’t crimes.”

Typically, the underwriter certifies the issue price for bonds. But Gannett suggested that issuers can’t rely on such certificates. The IRS is concerned that some of the underwriters are potentially repeat offenders of abusive market behavior. Gannett said it is in the IRS’ interest to look at early trading of the bonds to see what kind of practices are going on.

“Everyone is hung up on the definition of issue price,” Gannett said. “Let me say I have more serious concerns. I have concerns about collusion, misbehavior and fraud. Yes, we can change the definition and improve the definition, and yet those kinds of practices are what tear at the opportunities of this market.”

Gannett said the IRS wants to continue talking with market participants about best practices in this area and what more it needs to do to prevent abuses. “I think we all are invested in seeing this market work as it ought. And we at the IRS, those who work for me, have been charged with trying to work with the municipal bond community in particular with other public officials to strengthen the integrity of the market,” he said.

But many GFOA members weren’t sold on Gannett’s pitch that the agency wants to work with market participants.

Frank Hoadley, Wisconsin’s capital finance director, said he wants to determine the IRS’ definition of issue price, but Gannett didn’t seem to shed any light on that during the committee’s meeting Tuesday. “It was a continuation of my lack of understanding,” Hoadley said.

Several panel members also complained the informational questionnaires the tax-exempt bond office has been sending out to issuers of certain bonds are burdensome and time-consuming. They said they would prefer friendlier avenues of obtaining information, such as through a state liason.

Gannett disagreed. He said TEB doesn’t send out an unreasonable amount of questionnaires and that they are far less burdensome than full-blown audits. Enforcement through informal questionaires is part of the office’s educational effort, he said.

“The percentage of examinations we undertake in this area is minuscule compared to the individual percentage of examinations as far as typical taxpayers are concerned,” he said, noting the IRS has completed only 35 exams for direct-pay bonds such as BABs. “We need to have a presence. That presence is not always huge. Often times it’s fairly minuscule.”

Jennifer DePaul writes for The Bond Buyer.


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