This is Part 2. Go here for Part 1.
When we left off, the New Hampshire Health and Education Facilities Authority had shown the IRS Tax-Exempt Bond Division (“TEB”) its Old Man in the Mountain face on June 27, 2013, after TEB insisted that the Authority admit that it violated the tax-exempt bond rules before it would allow the Authority to settle under the IRS’s targeted voluntary closing agreement program (“VCAP”) for student loan bonds.
TEB claimed that when the issuer took student loans that it financed with one bond issue and allocated them to another bond issue, and the issuer could not prove which bond issue originally financed the student loans, then the bonds lost their tax-exempt status because the issuer could not prove that the bonds were “other than arbitrage bonds.” As discussed at length in Part 1, this practice of loan swapping was widespread throughout the industry, and student loan issuers did it largely for administrative reasons.
In this second and final part of this series, we’ll discuss some of the broader lessons of this tale.
Once the New Hampshire issuer pulled the bonds out of the VCAP, TEB immediately audited them. Not surprisingly, the audit seems to have been little more than a continuation of the VCAP. On November 26, 2013, the TEB audit team issued Notices of Proposed Issue for each bond issue to the New Hampshire issuer. Apparently, as in the announcement that created the targeted VCAP, there was little analysis of why TEB was taking this position.
At this point, if the New Hampshire issuer could not convince the TEB audit team to change its position, then the audit team would issue a “Proposed Adverse Determination,” which would make the New Hampshire bonds taxable unless the issuer prevailed at Appeals. The Proposed Adverse Determinations would be significant because it would mark the point at which the TEB audit team could potentially begin to contact bondholders to prepare to collect the unpaid tax on the interest of the now-taxable bonds. (And the bondholders in turn would begin to contact their lawyers, etc.)
As is always the case with a Notice of Proposed Issue, the New Hampshire issuer had 30 days to respond. In a rather nasty Christmas season surprise, before the issuer could respond, the TEB audit team instead jumped the gun and sent a Proposed Adverse Determination for the bonds on December 18, 2013. The New Hampshire issuer mailed its response to the Notices of Proposed Issue, requesting a conference and for the TEB audit team to explain its position, on December 20, 2013. The warring submissions crossed in the mail. Once the New Hampshire issuer received the Proposed Adverse Determination, all that it could do was to take the case to the IRS Appeals Office.
Importantly, Appeals actually analyzed whether the New Hampshire bonds in fact violated the arbitrage requirements. To its credit, Appeals did not simply repose in the TEB audit team’s naked assertion that an issuer that does not have records of a tax position that it did not assert must prove that its bonds are “other than arbitrage bonds” or else the issuer has, per se, violated the arbitrage requirements.
It took more than 2 years from the opening of the audit required the New Hampshire issuer to pay counsel (which in hindsight was a good investment, given the stakes), but the New Hampshire issuer finally prevailed. There were 11 total bond issues in the audit, and Appeals dropped the audit of 9 of the 11 issues. Appeals developed a novel theory for why the other two bond issues were taxable – a theory that had nothing to do with loan swapping. In a sense, Appeals “concurred in the result” of TEB’s determination as to these 2 issues. The statute of limitations had expired for one of the two bond issues that Appeals declared taxable, so the New Hampshire issuer didn’t vigorously contest Appeals’ position even though it believed that Appeals was incorrect. The taxpayer exposure on the other bond issue was $8,500, so the issuer gladly paid this amount and went home victorious.
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All in all, the IRS says that 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. As we have said before, TEB is likely to continue to use targeted VCAPs to enforce legal positions for which it has had success in forcing issuers to settle in tax-advantaged bond examinations.
The New Hampshire tale is not a tale about student loan bonds. It is a story about the dangers of TEB attempting to use these targeted VCAPs to adopt new and more restrictive legal positions without explaining its positions. There are a number of lessons we can all learn:
1. The New Hampshire Tale is a reminder to issuers that Appeals will exercise independent judgment. (At least for issuers willing to devote the time and expense, willing to risk bondholder disclosure and accompanying credit risks, and willing to continue the good fight.)
The New Hampshire case is also a reminder to issuers that the Appeals Office is not only intended to provide independent review of the TEB audit team’s decisions, but also actually functions that way. (“Now you tell us,” say all the issuers who settled.) At the very least, issuers are reminded that if they have a good argument that a targeted VCAP rests on an incorrect legal position, they can risk audit and battle on appeal. In fact, where an issuer feels that it is not getting better treatment in any VCAP – whether created by a special publication of the IRS or as part of the standard VCAP under Section 7.2.3 of the Internal Revenue Manual – than it would in an audit, then the issuer might consider withdrawing from VCAP and fighting the battle in the audit context.
In addition, Appeals applied the statute of limitations in literal fashion to one of the bond issues that it declared taxable, rather than attempting any legal gymnastics to squirm out of its grasp. Sad as it is, there is reason to be encouraged by this. The IRS shows no such ambivalence when it comes to enforcing statutes of limitations on refund recoveries by taxpayers or issuers, and the rules should apply mutually.
2. Issuers allocate bond proceeds to a particular source to avoid the tax consequences that flow from “direct tracing.” Requiring issuers to prove how the money actually flowed defeats the purpose of allowing an allocation.
Where the tax law allows bond issuers to allocate bond proceeds in a way that differs from how they spend them, TEB should not force them to prove “direct tracing.” (That’s the whole point of having an allocation rule.)
In addition, the recordkeeping rules in Section 6001 require taxpayers to keep records for the tax positions that they assert (whether on the basis of an allocation or otherwise), and not some hypothetical position that the IRS asserts.[1]
If the TEB audit team was concerned that the student loan bond issuers could not directly trace bond proceeds to student loans, the right response would have been to examine the tax position that the issuer actually took to determine whether the issuer in fact violated the arbitrage requirements. That’s what Appeals did here. It’s sad that the issuer had go through such an ordeal to get to that point. Ultimately the New Hampshire issuer could – and did! – prove that its bonds were “other than arbitrage bonds,” once it was given the opportunity to do so, even though it could not prove a tax position that it did not take.
3. It is unclear why the audit team concluded that allocations of bond proceeds to new student loans must be disregarded because they didn’t relate to the “actual disposition” of the student loans.
The arbitrage requirements allow a reallocation of student loans (or any “purpose investments” of bond proceeds, to use the broader technical term) if the issuer has disposed of them. The regulations do not use the phrase “actual disposition:” The IRS inserted the word “actual” and the requirement of an “actual” disposition in the targeted VCAP without explaining why. But it has always been the understanding in the tax-exempt bond community that an allocation of a purpose investment to a different bond issue was a “disposition” within the meaning of that regulation. The notion that it has to be an “actual” disposition cuts against the whole point of allowing issuers to make allocations, which is to avoid requiring the issuer to take actions beyond making notations in their tax records. This position is similar in its inexplicability to the IRS’s creation of a per se arbitrage rule in a situation where an issuer cannot prove direct tracing.
4. Where a targeted VCAP affects a particular industry, industry groups should band together and decide how to proceed.
As anonymous bond lawyers told The Bond Buyer back when the Pennsylvania student loan bond issuer entered into its $12.3 million settlement: “Once an issuer settles, it becomes harder for others to say ‘This isn’t a problem.’ . . . ‘When one issuer settles, it’s harder for others to hold out.’”
Targeted VCAPs will come from the TEB audit team’s experience in bond audits. Where it has success in reaching settlement on a legal issue, even one (or perhaps especially one) where it is an unclear legal issue, it makes it more likely that TEB will use that legal position as the basis of a targeted VCAP. The New Hampshire case shows that it is important for industry groups to discuss their audit experience and common approaches – is it better to concede a particular legal point, keep fighting, or something else, for example.
5. TEB should not require an issuer to admit that it violated the tax requirements in exchange for a closing agreement.
The IRS’s statutory authority to enter into closing agreements contained in Section 7121 of the Code does not require the taxpayer to admit fault or liability. Indeed, the IRS can enter into a closing agreement “even though under the agreement the taxpayer is not liable for any tax for the period to which the agreement relates.” Reg. 301.7121-1(b)(1). A closing agreement is just a settlement agreement, which, like any settlement agreement, allows parties to remove themselves from a dispute without finally determining whether the applicable legal rule was violated. In the New Hampshire case, the IRS’s insistence on an admission of violation from the New Hampshire issuer likely prolonged the audit and prevented settlement.
6. The Appeals decision is a reminder to TEB that specialized VCAPs should not be used to adopt new legal positions.
Finally, and most importantly, the New Hampshire tale shows that the IRS should not create targeted VCAPs except to resolve clear, common violations. Issuers already cannot get meaningful review of an IRS determination regarding their bonds without incurring time and expense and making required securities disclosures that damage their reputation and their credit. This problem is acute where it relates to a discrete and thus easily audited area, because the IRS’s power of coercion reaches its peak and the choice between capitulating to a possibly unfounded VCAP settlement or suffering even graver consequences in the all-but-certain audit is most stark.
Perhaps there is an argument that the tax-exempt bond community should be grateful that the IRS, by providing these targeted VCAPs, is “tipping its hand” for its planned audit activity. The argument would be that this information is better than the alternative of leaving issuers completely in the dark on where and what the IRS plans to audit. But – timeo Danaos et dona ferentes – for the good of the issuers who will not be coerced and the good of the IRS who will keep its plans to itself, the latter alternative is to be preferred.
And the IRS already has an approach to providing issuers with defined a la carte settlement terms for common legal issues, if that is what the IRS wants to do. That approach would be to add the violation to the set of “identified violations” in the Internal Revenue Manual. That is a better place for these matters rather than in separately drafted Announcements, if the goal is to provide common terms for common violations and not to induce issuers to enter VCAP via the threat that the IRS will track them down if they don’t. The important takeaway is that in the future any targeted VCAPs should be very carefully considered.
Time will tell whether and how issuers and the IRS will react to the above points and to the New Hampshire tale. But for now, it stands as an interesting and positive end to this particular targeted VCAP, with no guarantee that future recurrences will have a similarly positive end.
Special thanks to retired Squire Patton Boggs partner, the legendary Jack Browning (who is so often important to the blog that we ought to create the defined term “TLJB”), for his contribution and insights to this two-part post.
[1] What if the IRS applied its position in the New Hampshire case to your own tax return? “Sorry, sir; you cannot prove that you are entitled to the deduction for [insert your favorite deduction here – might I suggest the deduction for qualified tertiary injectant expenditures?], which you did not claim; all of your income therefore is per se taxable.”
