The IRS Appeals office has dropped the examination of nine student loan bond issues of the New Hampshire Health and Education Facilities Authority. The examination had begun after the Authority entered but then withdrew from the IRS specialized “voluntary closing agreement program” for student loan bonds. The IRS created this targeted VCAP in 2012 as a standalone VCAP outside of its general voluntary closing agreement program.

The student loan bond minutiae in this tale might not interest you. But the Appeals office’s decision, which profoundly undermines the central premise of this specialized VCAP, has broader implications.

We’ll approach this in two parts. In Part 1, below, we’ll discuss the background of how the New Hampshire case came about. In Part 2 , to come later, we’ll discuss some of the broader implications of the audit for the tax-exempt bond world.

The IRS Tax-Exempt Bond Division (“TEB”) announced recently that it will ramp up its use of “targeted VCAPs” (or “specialized VCAPs”) as one of its enforcement tools. You will immediately understand why the IRS is “very excited” about doing so. As we’ve said before on this blog, targeted VCAPs will inevitably persuade issuers to come forward and pay up, because it presents issuers with an obvious, if unstated choice: pay up, or be audited and suffer the consequences. This effect is made worse where the targeted VCAP focuses, as it did in the student loan bond VCAP, on a widespread practice in a narrow, easily identifiable (so that it is easily audit-able) corner of the tax-exempt bond world. Indeed, the targeted student loan VCAP was a big revenue-raiser for the IRS – according to The Bond Buyer (quoting TEB director Rebecca Harrigal), the targeted student loan VCAP accounted for the vast majority of the nearly $67 million in total VCAP settlements in the tax-exempt bond area in the fiscal year during which the targeted student loan VCAP occurred.

The rebuke by the Appeals office in the New Hampshire matter should serve as a reminder to TEB that it should limit its use of specialized VCAPs to situations where issuers have clearly violated the tax-advantaged bond rules. It also provides hope for issuers who feel compelled to enter into a specialized VCAP even when they know they’ve done nothing wrong – if they are audited, Appeals can serve as a backstop to specialized VCAPs that assert novel violations of tax law. In particular, as strange as it is to praise an organization for “just doing its job,” Appeals also should be praised here for actually reviewing the facts and the law, and analyzing whether the New Hampshire entity actually violated the arbitrage rules. There are other implications, which we will explore.

Background – The IRS Looks Underneath the Rocks of Student Loan Bonds

In 2007, at the National Association of Bond Lawyers’ Bond Attorneys’ Workshop in Chicago, the IRS announced that it would conduct “a small sample of student loan bond” examinations. The manager of field operations for the IRS at the time (Bob Henn) noted that the IRS hadn’t looked closely at student loan bonds before. The IRS Work Plan for fiscal year 2008 similarly noted that the IRS was working to “develop a strategy for assessing compliance in the student loan bond market segment” and that “TEB has created a project team to initiate planning and research activities with respect to this market segment.”

Despite the limited investigation done by the IRS, the Work Plan already warned that student loan bonds “have been determined to have a medium level of risk of noncompliance,” because “student loan bonds involve complex arbitrage calculations and the ability to earn and divert illegal arbitrage.” The Work Plan also prescribed a 16-hour “Special Emphasis Training” for IRS agents, to provide “agents assigned qualified student loan bond cases with the knowledge of the structure and requirements related to qualified student loan bond cases.”  At a December 2007 briefing to cover the workplan, the IRS reiterated its plan to begin student loan bond exams in 2008.

And they didn’t waste any time. On May 30, 2008, the IRS opened an exam of a 1998 issue of student loan bonds of the Vermont Student Assistance Corp. As the examination progressed, on March 3, 2009, the IRS asserted that these bonds were taxable arbitrage bonds in part because of the issuer’s “methodology for tracking student loans acquired with proceeds” of the bonds. The Vermont authority disclosed the audit to investors, saying that “the IRS position is inconsistent with applicable law and practice,” and that the authority had “performed yield calculations for the bonds” that showed that “in the aggregate, the yield on the loans . . . is substantially below the yield permitted for the loans.” When The Bond Buyer wrote about the Vermont disclosure, it noted that “[m]arket participants said . . . that it is not clear if this particular audit carries broader implications for tax-exempt student loan lenders.”

A Brief Aside into the Student Loan Bond Requirements 

At this point, we must make a brief foray into the student loan bond requirements. What was the arbitrage issue – the “methodology for tracking student loans” that worried the IRS in the case?

The proceeds of a student loan bond issue are used either to make student loans or to acquire  student loans that were originally made by other lenders. The tax rules combine these two concepts in the verb “finance” – student loan bonds must be used to “finance” student loans.

To take advantage of economies of scale, the proceeds of a student loan bond issue will be used to make or acquire a large portfolio made up of many student loans.  Each student loan bond issuer also will have many different bond issues, compounding the number of student loans in each issuer’s overall portfolio.

Student loan bond issuers have always routinely allocated loans to different bond indentures to simplify tracking and repayment of the underlying student loans by student borrowers.

For a wide variety of reasons, student loan bond issuers have always routinely “allocated” student loans financed by a bond issue from one bond issue to another.

For example, in 1999, participants in the NABL Bond Attorneys’ Workshop panel on student loan bonds were told that student loan bond issuers “can swap loans between issues if loans are above yield limit for one issue and below it for other,” subject to the time limits for making allocations under the arbitrage rules. These timing rules allow the allocation of loans through the date that is 18 months after the issuer purchases or makes the student loan, as long as it wasn’t more than 5 years and 60 days after the student loan bonds were issued. This same Bond Attorneys’ Workshop panel told attendees that if student loans “are pledged in common under [a] parity indenture,” then the swap of student loans from one bond issue to another “can be accomplished through accounting entries.”

For example, assume that a student loan bond authority issued Bond Issue 1 to finance Loans 1 through 500, and Bond Issue 2 to finance Loans 501 through 1,000. The student loan bond issuer may choose to allocate a portion of the proceeds of Bond Issue 1 to Loans 750-1,000, and such an allocation is perfectly permissible under the tax rules, so long as the student loan authority meets the timing requirements above. Student loan bond issuers would generally reallocate loans for administrative convenience. For example, a college student who takes out loans for undergraduate and graduate studies might have 10 different student loans, each financed with different bond issues. Rather than requiring the student to send separate checks for each loan to make each month’s payment, the issuer would prefer to allocate all of the loans to a single bond indenture, and require the student to send one check and to have the funds processed and tracked with a single bond issue.

Student loan bond issuers are permitted to earn arbitrage spreads to help cover the high administrative costs of a large student loan portfolio. 

In addition, student loan bond issuers are allowed to earn some arbitrage, in an amount designed to cover the  significant administrative cost of managing a large portfolio of many small loans. They can earn a “spread” between the yield on the  student loan bonds and the yield on the repayments on the  student loans – generally a yield spread of 2%. (Formerly, issuers could earn a 1.5% spread, with certain modifications compared to the current calculations that could have caused the permitted arbitrage to be even greater than under the current 2% standard.)

As discussed below, even though student loan bond issuers routinely were allocating student loans among different bond issues for non-tax reasons related to complex administrative burdens, and even though student loan bond issuers are permitted to earn an  arbitrage spread to cover their costs, the IRS was concerned that student loan bond issuers were keeping insufficient records to establish that “the bond issues involved were other than issues of arbitrage bonds.”

Back to the Story – The IRS Expands the Scope of Student Loan Bond Audits 

Other audits soon followed the Vermont audit.  The IRS opened an audit of student loan bonds issued by the Massachusetts Education Financing Authority on February 9, 2010, but closed the audit on May 19, 2010, with no change to the tax-exempt status of the bonds.

The IRS also opened an audit of a 2002 issue of student loan bonds of the Pennsylvania Higher Education Assistance Agency. After discovering that the Pennsylvania issuer had also moved loans among different bond issues, the IRS expanded the audit to include all of the Pennsylvania authority’s auction-rate student loan bonds. On November 17, 2011, the Pennsylvania issuer announced that it had settled with the IRS, and entered into a closing agreement requiring it to pay the IRS $12.3 million.

By this time, the tax-exempt bond community had taken notice. The IRS made its concerns from the Vermont audit even clearer in the course of the Pennsylvania audit. The IRS told the Pennsylvania issuer that it should disregard its allocations of student loans to different bond issues. Because the Pennsylvania issuer could not establish the original allocations of student loans to bonds, it apparently could not prove that the bonds being audited were “other than arbitrage bonds.”  But, as unnamed bond attorneys noted at the time, of course the Pennsylvania issuer couldn’t establish the “original allocations” of student loans to bonds – that’s the whole point of making an allocation in the first place. What’s more, issuers generally are not required to prove that their bonds are “other than arbitrage bonds” – an arbitrage calculation must be performed, comparing the earnings on investments of bond proceeds to the yield on the bonds, to determine whether or not issuers have complied with these requirements.  

Others noted: “It’s certainly getting people’s notice and attention, and depending on whether the IRS prevails on this, that certainly could affect how people do their yield calculations.” Bond attorneys continued to refuse to have their quotes attributed to them, highlighting how seriously everyone was taking the unfolding events.


Based on its experience in these student loan bond audits, the IRS created the Specialized Student Loan Bond VCAP

In an August 2010 article about the Pennsylvania audit, one bond lawyer (again anonymous) said: “What I’m assuming is happening here is that the IRS is going to try and negotiate a settlement . . . and then they’re going to basically go out to the world.” That bond lawyer proved to be prophetic.

In 2012, just after the Pennsylvania audit ended, the IRS announced the specialized student loan VCAP, in Announcement 2012-14.[1] We can’t be totally sure, but the general consensus is that the parameters of the specialized VCAP followed the IRS settlement with the Pennsylvania student loan bond issuer.

In the Announcement, the IRS described the facts of the Pennsylvania audit: “The issuers were unable to establish the bond issues to which the student loans were properly allocable as purpose investments and, as a consequence, the issuers could not establish that the bond issues involved were other than issues of arbitrage bonds.” The IRS apparently concluded that the allocations were improper because the allocations of loans to different bond issues “were not due to a refunding” or the universal cap rule. Moreover, the IRS noted: “The issuers did not sell, discharge, or otherwise actually dispose of the student loans.”

It is difficult to discern the logic behind the Announcement, but one can infer that the IRS thought that a student loan bond issuer could not allocate a student loan from one bond issue to another unless it refunded the original bonds, unless the universal cap rule required it, or unless the issuer sold, discharged, or disposed of the underlying student loans. If the allocations were invalid, then the issuer was stuck with direct tracing of loans to bonds. Because the issuer couldn’t establish what student loans were originally made or acquired directly with the student loan bond proceeds, it couldn’t prove that the bonds were “other than arbitrage bonds.”

Under the VCAP, student loan bond issuers could resolve the “violation” of allocating student loans among different portfolios by agreeing to stop doing that and making a payment. The payment equaled 40% of the taxpayer exposure on the bonds (see here for what that is), and an additional amount equal to the “excessive arbitrage profit” on the bonds. Any lawyer who worked with a student loan bond authority in the VCAP can tell you that the calculation required extensive spreadsheet jiu-jitsu, usually resulting in an impenetrable Excel file.

The Announcement set a deadline of July 31, 2012. The specialized VCAP prompted criticism (almost all anonymous) from the tax-exempt bond community. The Announcement didn’t come right out and say this, but the unspoken and looming consequences were clear – the student loan bond community is small, and student loan bond issues are easily identifiable by combing through 8038 filings. And, worse, thanks to the student loan bond authorities that had been audited and that had defended themselves by telling the IRS that the practice of allocating loans was ok because it was widespread, the IRS knew that there was a good chance that any particular student loan bond issue would have this “problem,” and the IRS could collect. Indeed, the settlement amounts through the student loan VCAP ended up being huge, threatening to bankrupt student loan issuers that otherwise might have been interested in participating in the program.

And now we return to our New Hampshire student loan bond authority from the beginning of the story. Like many other issuers scrambling to enter the program, the New Hampshire authority filed its request the day before the deadline. According to comments from its counsel (the estimable Brad Waterman), the New Hampshire authority was willing to settle the matter and move on with life.  But the IRS’s repeatedly insisted that the New Hampshire issuer admit that it had violated the tax law. It’s impossible not to smell at least a whiff of the legendary New Hampshire spirit embodied in its state motto in the authority’s response – it withdrew from the VCAP on June 27, 2013.

Everyone knew what was coming next. We’ll tell you all about it in Part 2.

(Go here for Part 2.)


[1] Given that this whole saga began in Vermont, it is somewhat interesting to note that the author of the Announcement, Mark S. Westergard, had been named general counsel of the Vermont Housing Finance Agency on February 27, 2009, before joining the IRS at some point before drafting the Announcement. Soon after, it appears that Mr. Westergard left the IRS.