The Advisory Committee on Tax-Exempt and Government Entities provided its annual set of recommendations to the IRS recently. Among other things, the panel recommended that the IRS implement electronic filing of Form 8038s and decrease the frequency of random audits, shifting instead to more targeted audits of tax-advantaged bond issues.
Although this blog post has nothing to do with tax advantaged bonds, it does involve taxpayers, large sums of money, allegations of deceit and a strange saga in which the IRS has become embroiled. The story begins in 1999, when William Esrey, the CEO of Sprint Corporation at the time, and Ronald LeMay, COO of Sprint at the time, engaged in a Contingent Deferred Swap (“CDS”) transaction being promoted by Ernst & Young (“EY”). The two high ranking executives then each engaged in a second CDS transaction in 2000, and in a Contingent Deferred Swap Add-On (“CDSA”) transaction in both 2000 and 2001, that were also being promoted by EY.
As a tax-exempt bond lawyer, I do not understand how the CDS or CDSA transactions were supposed to work. However, the tax positions they involved must have been fairly egregious, because in 2002, both the civil and criminal divisions of the IRS and the U.S. attorney’s office located in the Southern District of New York began investigating EY’s role as a promoter of these transactions. At some point during 2002, the IRS also began to audit entities owned by Esrey and LeMay through which they engaged in the CDS and CDSA transactions. The two executives initially chose to have EY represent them during these audits.
Read below for coverage of the recent hearing on the proposed regulations that would redefine the term “political subdivision” and the 127 comments submitted so far on the same topic. Plus learn more about a private letter ruling addressing a management contract that concludes there was no private business use even though payment of an incentive fee was triggered in part by meeting a target that was a “variant” of net profits.
Generally, a person that pays interest on a debt to another person must report the amount of interest, usually on IRS Form 1099-INT. In the past, payments of tax-exempt interest did not have to be reported in this way; however, beginning in 2006, the statutory exclusion from information reporting for interest on tax-exempt obligations was eliminated. Since that time, interest on tax-exempt obligations has been reported in the same manner as taxable interest. Mercifully, for information reporting purposes, the amount of tax-exempt interest that must be reported has been limited to qualified stated interest (a fancy term which typically refers to the coupon on a debt instrument). Bond trustees and other payors of tax-exempt interest found refuge in a line item in the instructions to the Form 1099-INT that says “[n]o information reporting for tax-exempt OID under section 6049 [of the Internal Revenue Code] will be required until such time as the IRS and Treasury provide future guidance.”
If you read the title of this post and your internet server has frozen so that you are unable to navigate away from this page, you have probably guessed that this “future guidance” has now arrived. The Treasury Department recently finalized Treas. Reg. § 1.6049-10 in TD 9750 (the “Final Regulations”). The Final Regulations, among other things, will now require bond trustees and other payors to report original issue discount on tax-exempt obligations. This post will discuss the motivations behind the change as well as the ramifications that the Final Regulations will likely have on the tax-exempt bond community.
The flexibility to reallocate proceeds to expenditures using an accounting method other than direct tracing has been a well-recognized and much-appreciated opportunity under the allocation and accounting rules of IRC section 141. The former proposed section 141 regulations (REG-140379-02, Sept. 26, 2006) (“Proposed Regulations”), now replaced by the final section 141 regulations issued October 27, 2015 (“Final Regulations”) on which we reported here, here, here, and here and cross-referenced the arbitrage allocation rules in 1.148-6 in allowing the reallocation of proceeds away from the expenditures for which the proceeds were actually spent to different expenditures producing more favorable tax results. If the expenditures to which the proceeds were reallocated were paid later than the proceeds were actually spent, the reallocation raised the question of whether the proceeds had to be treated as spent later for arbitrage purposes, resulting in additional, “phantom” (because they were never actually earned) investment proceeds that were deemed to arise during the time between the date when the issuer originally spent the proceeds, and the date of the expenditure to which it later reallocated proceeds. Fortunately, the Proposed Regulations included an explicit exception from the otherwise applicable consistency rule between the section 141 and section 148 allocation and accounting rules, thereby avoiding phantom investment proceeds. The Final Regulations do not include this rule. So where are we now? Might we have phantom investment proceeds?
With the recent issuance of the proposed regulations that would redefine the term “political subdivision” for purposes of determining which entities can issue tax-exempt bonds under Section 103 of the Internal Revenue Code, as amended (the “Code”), the answer to this seemingly rhetorical question is “yes,” at least according to the Treasury Department. This is a significant, and startling, departure from the current Treasury regulations that define “political subdivision” for purposes of Code Section 103.
Current Treasury regulation § 1.103-1(a) provides that interest on an obligation issued by a political subdivision of a State is, except as otherwise provided, excluded from gross income of the holder of the obligation under Section 103(a) of the Code. Current Treasury regulation § 1.103-1(b) further provides that “the term ‘political subdivision’ . . . denotes any division of any State or local governmental unit which is a municipal corporation . . . .” A municipal corporation is therefore by definition treated as a political subdivision for purposes of Code Section 103. Although the term “municipal corporation” is not defined for this purpose, it has been interpreted, as illustrated by Revenue Ruling 80-136, 1980-1 C.B. 25, with deference to the laws of the applicable State to mean a city, village, town, or borough that is treated under the constitution or laws of the applicable State as a municipal corporation and imbued under such constitution or laws with the powers of self-government.
As we have discussed here before, we may be coming to the point where there are no new ideas in public finance tax law. Yet another example: The recent proposed political subdivision regulations hearken back to a similar regulation project on a related topic many years ago, which suffered from many of the same drawbacks found in the proposed political subdivision regulations.
That is, according to certain U.S. lawmakers, who believe that private colleges and universities with 501(c)(3) status that have at least a $1 billion endowment should be subject to some extra rules and regulations. If these well-endowed private colleges and universities fail to abide by such extra rules and regulations, under the proposed legislation (which is still being drafted), they will be subject to penalties and may even lose their 501(c)(3) status. A private college or university that does not have 501(c)(3) status cannot be the beneficiary of qualified 501(c)(3) bonds issued by a state or local governmental unit. In addition, a private college or university that loses its 501(c)(3) status will be required to start paying federal income tax on its taxable income, and donors to such institutions of higher learning will no longer be able to receive a charitable deduction for their generosity.
The federal government has brought the first ever criminal securities fraud charges in connection with a municipal bond financing, following an investigation by U.S. Attorney for the Southern District of New York Preet Bharara, according to recent news reports. (NYT, Reuters.)
So what lessons are there to be learned from this?
Rep. Steve Russell, R-Okla., recently introduced a bill (H.R. 4838) in the House to prohibit tax-exempt financing of professional sports stadiums and for-profit entertainment facilities. This is only the most recent in a string of similar proposals, including by President Obama and former Senator Tom Coburn. In this case, tax-exempt financing would be prohibited for any “stadium or arena for professional sports exhibitions, games, or training” and for any “venue for any entertainment event (i) the live audience for which exceeds 100 individuals, and (ii) any net earnings from which inure to the benefit of an individual or any entity other than [the United States or any State or local governmental entity or certain tax-exempt organizations, including but not limited to 501(c)(3) organizations],” in each case if the facility is used for such purpose at least five days during any calendar year. (This post won’t address the over-breadth of “entertainment facilities” included in this prohibition other than to note that, for example, many if not most public and private college arenas, theaters, etc. would be precluded from tax-exempt financing as a result of hosting performances, lectures, concerts, etc. provided by groups or individuals who are paid for their services.) The question considered in this post is not so much the propriety of permitting tax-advantaged financing of these sports and entertainment facilities but whether it is good policy to create targeted rules for certain facilities that may currently be out of favor rather than to rely on the fundamental principles of industrial development bond/private activity bond status that have limited the availability of tax-exempt financing for facilities with private involvement for almost 50 years.