WASHINGTON — The Internal Revenue Service plans to audit one of every two Build America Bond transactions, Steve Chamberlin, a senior manager in the IRS’ tax-exempt bond office, said during a teleconference Tuesday sponsored by the National Association of Bond Lawyers.
That means the IRS will conduct more than 672 BAB audits just based on the number of issues sold as of Tuesday — 1,345 issues totaling $104.78 billion, according to Thomson Reuters.
Chamberlin’s remarks led Ben Watkins, Florida’s bond finance director, to warn yesterday that the forthcoming audits, combined with the IRS’ push for issuers to track primary-market trading and pricing of their BABs despite of a lack of clear guidance on pricing, should make issuers think twice about issuing the new taxable debt.
Issuers could lose their subsidy payments, he added.
“These are risks that issuers need to consider and evaluate before embracing BABs as a tool,” Watkins told The Bond Buyer.
He expressed surprise at the number of planned BAB audits. “I think that’s a very high number,” he said. “Issuers need to be aware that if they use BABs, there is a one in two chance that they will be audited.”
IRS officials made clear during the NABL teleconference that they will be scrutinizing the primary-market pricing of BABs during the audits and that they want issuers of the bonds to check the trade data on the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access system for primary market pricing irregularities.
Bond lawyers said it’s not surprising the IRS is concerned about BAB prices. Because prices and yields on bonds move in opposite directions, the lower the price, the higher the yield.
The federal subsidy on BABs is based on 35% of the interest cost. If the interest rate is higher, the subsidy will cost the federal government more over the life of the bonds.
The subsidy is distributed by the IRS as a form of a tax refund. In addition, the tax law states that BABs cannot be sold at more than a de minimis amount of premium, with the implication that if the sales premiums were too high, issuers’ bonds would not qualify as BABs and then would not qualify to receive subsidy payments.
But lawyers said they are surprised and dismayed at the agency’s push for issuers or their advisers to track BAB pricing because issuers also want low interest rates for their BABs and want to comply with tax law requirements.
“Both issuers and the IRS have skin in the game,” said one bond lawyer who did not want to be named.
“I don’t have the training as a tax lawyer to go through [the EMMA data] and say, 'Well this doesn’t look right,’ ” said Thomas Vander Molen, a lawyer at Dorsey & Whitney LLP in Minneapolis. He questioned how the IRS can expect issuer officials to have the skills to do so on their own.
And what, he asked, if the issuer finds primary market bonds were issued at prices higher than the initial or list offering price on the official statement, which has generally been viewed as the issue price?
“It puts the issuer in the untenable position of having to essentially accuse the underwriter of lying,” Vander Molen said, because it’s the underwriter who certified the bonds were all offered at the initial offering price.
If the issuer suspects the underwriter is responsible for pricing problems, he asked, is the issuer expected to “blow up the deal?”
The underwriter could challenge the issuer legally if it tried to cancel the deal after the underwriter sold the bonds, according to Vander Molen.
“Markets move, prices change,” said David Caprera, a partner at Kutak Rock LLP. “Even if we can see the prices on EMMA or elsewhere, that doesn’t give us sufficient information to conclude the initial determination of the issue price was incorrect or that the representations of the underwriter cannot reasonably be relied upon.”
Chamberlin said during the teleconference that if issuers find pricing irregularities with their bonds, they should enter into the IRS’ voluntary closing agreement program to try to resolve the associated tax-law issues.
But Watkins said, “I think it’s unreasonable to place this burden on issuers.”
He told IRS officials during the teleconference that Florida generally tracks primary market pricing, and has the resources to do so, to make sure the state gets the best deal it can for taxpayers.
But the state “doesn’t want to be second-guessed through the audit process about whether we’ve done our job well enough,” and it doesn’t want to risk losing its BAB subsidy payments, he said.
Florida has issued $1.6 billion of BABs since they were created last year, but decided to stop issuing them in March because of uncertainty over whether the federal government might offset the state’s subsidy payments for any money owed to Washington under a number of programs unrelated to the bonds.
The offsets are another risk with BABs, Watkins said.
But the pricing issue is especially significant because the IRS has challenged the way municipal market participants have historically determined issue price, but not provided any new guidance on how such determinations should be made instead, according to Watkins.
“We need to know very clearly what the requirements are,” he said.
The tax rules state that “the issue price of bonds that are publicly offered is the first price at which a substantial amount of the bonds is sold to the public” and that “10% is a substantial amount.”
The rules also state that the issue price “does not change if part of the issue is later sold at a different price” and that if there is “a bona fide public offering” of the bonds, the issue price can be determined “as of the sale date based on reasonable expectations regarding the initial public offering price.”
As a result, issuers in tax-exempt and BAB deals have typically relied upon underwriters’ certifications that the bonds were offered to the public at a price equal to the initial offering price.
“It is the underwriter’s responsibility to offer the entire issue at the initial offering price,” Leslie Norwood, associate vice president and general counsel of the Securities Industry and Financial Markets Association, confirmed Wednesday.
But George E. Gurrola, an IRS tax-exempt bond tax law specialist, said during the NABL teleconference that the IRS is troubled because it is seeing, in some cases, “an upward trend in prices” of BABs and some public purchasers “buying [the] bonds in excess of the initial offering price.”
He urged issuers to review primary market trading of their BABs on EMMA to check for pricing irregularities and said they should question their underwriter to obtain an explanation.
Gurrola suggested that if a number of their bonds were not sold at the initial offering price in the primary market, then the underwriter did not have a bona fide sale of bonds and could not base its issue-price determination on its reasonable expectations at the sale date.
Gurrola said issuers should conduct due diligence and try to verify the accuracy of their underwriters’ price certifications.
“It sounds to me like they are putting pressure on the underwriters to keep them honest about their certifications and making issuers feel very uncomfortable during the process,” said Frank Hoadley, Wisconsin’s capital finance director, who stressed he had not listened to the teleconference.
Asked about Gurrola’s remarks, Norwood said: “We would like to continue to discussions with Treasury, the IRS, and the MSRB on issue price and the rules relating to issue price. We have concerns about EMMA data being potentially misinterpreted and would like to ensure that that data is properly understood by all parties.”
“Dealers do their best to place bonds with the appropriate investors,” she said. “However, they cannot control the bonds in the secondary market after they have traded away from the underwriter.”
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