I.R.S. ELIMINATES RESTRICTIONS ON CONDUIT ISSUER FEES

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Marcus Maxwell
5 years ago
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1 By: Mark Scott I.R.S. ELIMINATES RESTRICTIONS ON CONDUIT ISSUER FEES In a stunning reversal of more than 30 years of existing law and its own Publication 5005, Your Responsibilities as a Conduit Issuer of Tax Exempt Bonds, the I.R.S. Office of Tax Exempt Bonds, with the presumed assistance of the Office of Chief Counsel, has determined to not apply any limits on the amount of fees a government conduit issuer may be paid out of bond proceeds. 1 Although this is not a common tax issue for tax counsel, it is certainly a tax issue that has been wrestled with before on numerous occasions, especially in New York State due to the high fees charged by that State for bond issuances. It has also become a more frequent topic of discussion as governments have realized that its conduit issuers may be a source of general revenue. The I.R.S. has also greatly expanded its definition of a minor violation with respect to issuance costs. (These 2 issues should not be confused. The first issue, which I will refer to as the issuer fee question, relates to the arbitrage spread allowed on an acquired purpose obligation, and the second, which I will refer to as the issuance cost question, relates to the 2% issuance cost limit applicable to private activity bonds.) The I.R.S. has not released any formal or informal guidance. But, by (now publicly) ignoring the single largest issuer fee question that has ever been encountered, the I.R.S. has taken a firm position. And, by doing so, the U.S. Government has effectively given up any right to enforce the same law on any other State, City, County or local government. Mark is the former Director of the I.R.S. Office of Tax Exempt Bonds and currently represents whistleblowers before the I.R.S. and in courts of law. The I.R.S. stands by the principle that every taxpayer may be treated differently and, in fact, every year for every taxpayer may be treated differently. The I.R.S. has taken inconsistent positions on the same issues in the past, and they will again in the future. Perhaps the only consistent aspect of this right to be inconsistent is the many rulings by courts of law permitting this inconsistency. But bonds are different. In enforcing the rules governing municipal bonds (I.R.C. 103, ), the I.R.S. cannot rely on this general principle of tax law. First, the I.R.S. has few options, and none which they presently take advantage of, to push a tax issue arising in a bond examination to a court of law. Second, and more importantly, we re talking about the U.S. Government enforcing a particular rule on state or local governments. In other words, government-to-government relations. Any member of Congress worth his or her mettle would not allow their state or local government agencies to be penalized for behavior that the I.R.S. has openly permitted to a much larger degree for another government agency. And no instance can be larger than the current one, where I.R.S. officials are ignoring upwards of $30,000,000 in issuer fees. It is the single largest violation of this provision I have ever seen, and I think it would be extremely unusual to see a violation anywhere approaching this size again. Third, we re not talking about 1 agent and his or her local manager who have made an incorrect decision. I can document that the decision-making process in this instance involved multiple I.R.S. officials, including at least 2 senior Bond Agents, a Field Manager, multiple Senior Managers, multiple Senior Analysts, and multiple Executives within TE/GE. Personnel in the Office of Chief Counsel were also apparently involved. 2 Based on this level of review, the Office of Tax Exempt Bonds, which goes out of its way to state how it applies the law consistently, will find it extremely 1

2 difficult to explain any contrary action with another issuer. The standard for opening an examination is historically less than the standard for pursuing an adjustment. Sufficient exam resources are available. 3 And claim work has been given a high priority. 4 Accordingly, the decision to not examine known violations carries the same weight as a decision to not pursue the same adjustments during an examination. As such, I would argue that the issuer fee issue, and in particular how such issuer fee should be included in the computation of yield on an acquired purpose obligation, can be mostly ignored. Practicalities simply do not permit I.R.S. bureaucrats to enforce a tax law on any state or local government as long as these same bureaucrats have decided to not address the worst offender. Additionally, and of interest to many defense counsel working in this area, the I.R.S. has significantly lifted the bar for excusing minor violations of the 2% issuance cost limit. When I was in charge of the program, we instituted a soft 2% test, allowing de minimis violations of up to several thousand dollars to go unpunished. In my view, I did not believe it was appropriate to tax bondholders (or to try to squeeze money out of state and local governments) for what I considered to be minor, foot fault violations. I was upfront with this position, publicly describing the office s view on multiple occasions in multiple forums to a variety of attendees. Current management is much more secretive, but I have reason to believe they take a similar minor, foot fault stance when applying strict limits, such as the 2% limit on bond-financed issuance costs. What is surprising about the instant situation is the extent of what current management in the Office of Tax Exempt Bonds now considers a minor foot fault. In particular, the 2% issuance cost limitation was exceeded by $2,628,220. Although the I.R.S. has a history of enforcing the 2% limit, and will continue to do so, they have, by their lack of action in this instance, clearly signaled a significant widening of the permitted gap allowed when applying the 2% limitation. And, as with its complete waiver of enforcing the previously-described issuer fee limit, the I.R.S. will be hard pressed to walk back 2 this broader waiver policy now that it is publicly known. THE FACTS The bonds in question are the $228,085,000 City of Syracuse Industrial Development Agency PILOT Revenue Bonds, Series 2007A (Carousel Center Project) issued to finance a not-so-green shopping mall. The bonds were issued under the newly-enacted green bond provisions, a class of bonds permitted due to a law change pushed by Secretary Hillary Clinton when she was Senator of New York. In fact, then Senator Clinton specifically pushed the change in law for this particular mall financing. The mall owner, in turn, has significant and deep ties to Secretary Clinton and is considered an FOB ( Friend of Bill ) for his significant contributions to the Clinton Foundation. The mall, once built, may not have produced the requisite green benefits, but this is irrelevant to the tax-exempt status of the bonds due to the vagaries of the enacted law, which requires only intended, not actual, green benefits. Embedded within the original mall financing was the use of over $30 million in tax-exempt bond proceeds to pay issuer fees to the City of Syracuse and the County of Onondaga. The I.R.S. has been informed about these fees. The I.R.S. has been told, for instance, that on the closing date, $11,000,000 in tax-exempt bond proceeds were distributed to the Syracuse Industrial Development Agency ( SIDA ) as the first installment of the conduit issuer s SIDA Fee. Additionally, it has been told that $18,600,000 of tax-exempt bond proceeds were deposited into an irrevocable escrow for the payment of future installments of such fee. 5 When received by SIDA, SIDA immediately dispersed 89% of the SIDA Fee payments to the City, and the remaining 11% of the SIDA Fee payments to the County of Onondaga. The I.R.S. has been given incontrovertible proof that the $29,600,000 SIDA Fee was a negotiated cost of doing business in the City of Syracuse and the County of Onondaga. This cost was not for bricks or mortar, or for intangible rights. The evidence clearly reflects that this cost was incurred in connection with the issuance of the

3 bonds in order to gain the support of the City and County. SIDA and the City are related parties. SIDA was established by the City of Syracuse under New York law and is completely controlled by the City through the Mayor s rights to appoint and remove all members and officers of SIDA, either with or without cause. SIDA and the City are related parties per section (b) of the regulations, as the City has direct control over SIDA per section (c) and SIDA does not have substantial amounts of each of the three sovereign powers. Therefore, per the I.R.S. s own regulations, there is simply no distinction between SIDA receiving a fee or the City receiving the fee, and consequently, the portion of the SIDA Fee paid to the City may be treated as being paid to and retained by SIDA. And the I.R.S. must recognize that the portion of the SIDA Fee transferred to the City did not qualify as a qualified administrative cost on a purpose investment, per section (e)(3) of the regulations. The City did not use these proceeds to cover the costs or expenses to purchase, carry, sell or retire a purpose investment. Nor did it use the bond proceeds to pay costs of issuing, carrying, or repaying the issue. The City, instead, allocated the bond proceeds to other economic projects, mostly downtown parking garages. The payments to the City, in their own words, helped eliminate a shortfall in the City s fiscal year and contributed favorably to no tax increase projected in the City s budget. 6 The I.R.S. is also aware that, in addition to the SIDA Fee, SIDA also received bond proceeds totaling $5.4 million for a Lakefront Development Fee. And the I.R.S. is aware that [the Lakefront Development Fee] funds were unofficially earmarked for investment in the Syracuse Lakefront Area to both support economic development projects and pay for the City s share of infrastructure projects. (Emphasis added.) 7 The bonds were sold as a single issue of private activity green bonds. The weighted average maturity limitation for these green bonds was computed by only taking into account the $134,000,000 in green bond project financing for the Carousel Center expansion and related projects, and not any of the improvements undertaken by SIDA, the City or the County with the SIDA Fee and Lakefront Development Fee. Similarly, the net benefit test under section 142(l) of the Code was based solely on this same $134,000,000 green bond portion. Therefore, the bonds constitute a single financing of only the Carousel Center expansion and related improvements. And, SIDA is bound by this form of the transaction. 8 Per the Tax Compliance Agreement, the proceeds of the exempt bonds also funded $4,770,763 in underwriters discount, a bond insurance premium in the amount of $8,404,154, and a State Bond Issuance Charge in the amount of $1,418, The State Bond Issuance Charge was imposed pursuant to New York PBA Law section 2976, which states that this charge will be paid to the state department of taxation and finance. The issue price of the 2007A bonds was $238,538,135. The issuance cost limitation under section 147(g) of the Code for the bonds equals 2% of that amount, or $4,770,763. The entire 2% limit was utilized by SIDA to pay the underwriters discount out of bond proceeds. 10 SIDA did not, therefore, treat any portion of the SIDA Fee, the Lakefront Development Fee or the State Bond Issuance Charge as a cost of issuance. The I.R.S. might suggest that this deal is different because SIDA refers to the bonds as payment in lieu of tax ( PILOT ) revenue bonds, and because the payments of debt service on the 2007A bonds are derived from certain payments in lieu of real property taxes... made under a Payment-in-Lieu-of-Tax Agreement. 11 But the I.R.S. should not be allowed to wiggle out of its position so easily. Notwithstanding the use of PILOT terminology, the bonds were not sold as tax-exempt governmental bonds, but as exempt facility bonds pursuant to green bond provision, section 142(a)(14) of the Code. The reason for this is obvious: the City s bond counsel appropriately recognized that the bond issue did not comply with the PILOT rules of section (e)(5) of the regulations. For instance the PILOT payments match the debt service and bear no relation to the foregone taxes. And SIDA has not provided any evidence or statements that 3

4 would suggest that the PILOT payments are, in fact, true PILOT payments. As such, this transaction is a typical exempt facility bond issue. The 2007A bond proceeds were loaned to the developer. The developer, in turn, has been making payments equal to the amount of principal and interest on the 2007A bonds. And, therefore, the developer s obligation to repay the borrowing is an acquired purpose obligation. And this fact was recognized by SIDA s bond counsel in the Tax Compliance Agreement. 12 And there is no pretense that the payments to SIDA are something other than fees. SIDA, the borrower, the City, the County, and all of the attorneys involved consistently refer to these amounts as fees and, in the case of the SIDA Fee, paid to the governmental units to allow the issuance of the bonds to move forward. And, although SIDA and the borrower suggest that the Lakefront Development Fee is a fee in the nature of an impact fee with respect to the Project and the adjacent lakefront and... was not negotiated as a fee to the Agency in consideration of the agreement of the Agency to issue bonds or as compensation to the Agency for issuing bonds, the distinction is irrelevant. 13 In particular, for purposes of determining the yield to SIDA on its purpose investment, the long-standing I.R.S. position is that all of SIDA s receipts are included unless specifically excluded under the regulations. 14 Under existing I.R.S. guidance and its own Publication 5005, receipts on this purpose investment would include both the SIDA Fee and the Lakefront Development Fee to the extent those the fees were paid to SIDA from bond proceeds and retained by SIDA or a related party. In other words, for computational purposes, SIDA is receiving both the debt service payments for the 2007A bonds plus these bond financed fees. Therefore, all of these receipts are used for determining the yield on its acquired purpose obligation. SIDA did not, however, treat either the SIDA Fee or the Lakefront Development Fee as yield on its acquired purpose obligation. When the City s 89% share of the $29,600,000 SIDA Fee is included in the computation of the yield on SIDA s purpose investment, the arbitrage spread between the yield earned by SIDA on the purpose 4 obligation and the yield paid on the bonds equals approximately 92 basis points or more than 79 basis points over the permitted 12½ basis point yield spread. This spread grows to 113 basis points when the Lakefront Development Fee is also included in the yield calculations. The I.R.S. can easily verify these calculations, and probably has. I.R.S. officials, therefore, know that an enormous yield spread exists, but have simply chosen to not address it. Practically speaking, the I.R.S. has chosen not to enforce the restrictions in yield on acquired purpose obligations when the yield spread is violated due to payments of fees to a conduit issuer. The I.R.S. is also permitting a significant variation from the 2% issuance cost limit. As SIDA and the County are not related parties, the portion of the SIDA Fee paid from bond proceeds to the County is a cost of issuance. The upfront payment to the County from bond proceeds was $11,000,000 (the portion of the SIDA Fee paid on the date of issue) times 11%, or $1,210,000. The $1,418,220 State Bond Issuance Charge should have also been treated as an issuance cost. It was paid out of exempt bond proceeds and, although typically, I would include the New York State Bond Issuance Charge within the conduit purpose obligation permitted spread, in this instance, as SIDA and the State of New York are unrelated under the tax rules, the amount is properly treated as a cost of issuance. It should have, therefore, been included within the 2% issuance cost limit. As the full 2% issuance cost limit of $4,770,763 was paid to the underwriters, this means that the 2% limit was exceeded by $2,628,220, or the combination of the above bond-financed payments not taken into account. This is a significant deviation in dollar terms. And it is a significant deviation in terms of percentage, raising the permitted issuance cost percentage from the statutory 2% cap to over 3%. It is not a deviation I would have permitted under my tenure as a minor, foot fault violation. But, in order to show consistency, it is a deviation now permitted by the I.R.S. The I.R.S. audited the bond issue in 2011/2012. The issuer fee and issuance cost problems were not raised or addressed and the audit was closed no-change. But the I.R.S., as recently as January

5 of this year, has confirmed its long-standing position that it has both the authority and the intent to re-examine bond issues when the result of the prior audit was incorrect. 15 The I.R.S. cannot, therefore, hide from its failure to take action in this instance by claiming that a re-examination is not permitted. THE IMPACT The I.R.S. has effectively walked away from restricting the amount of fees charged by conduit issuers and has greatly expanded the scope of minor deviations normally permitted as excused violations of the issuance cost limit. In a day or so, the SIDA will be issuing refunding bonds for the purpose of refunding the 2007A bonds. The issuer fee violation will almost certainly run to and taint the tax-exempt status of the refunding issue. And both existing violations will continue to taint the tax-exempt status of the interest paid to holders of the 2007A bonds for at least 3 more years. FINAL THOUGHT The I.R.S. is charged with the duty to protect the fairness and integrity of the federal tax system. Being both forthcoming and open plays a key role in that duty. As of today, no one in TE/GE or the Office of Chief Counsel has made a public statement or released any formal or informal guidance regarding these important developments. 3 This particular examination would have dwarfed in terms of both size and significance almost all of the work currently being assigned to field personnel. 4 See FY 2016 and FY 2017 work plans issued by TE/GE. 5 Official Statement, Sch. D-5, SIDA Fee Escrow Account. 6 Philip J. LaTessa, Office of Syracuse City Auditor, An Economic Model: No Cost or Risk? An Evaluation of Destiny USA, p. 15 (Jun. 2008). 7 LaTessa at See Williams v. Commissioner, 429 U.S. 569 (1977) ( while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so he musts accept the tax consequences of his choice, whether contemplated or not ). 9, Schedule F, Estimated All-In Sources and Uses. 10 Tax Compliance Agreement, Section 7.1(a)(v) and (c), and Schedule A, Use of Bond Proceeds. 11 Official Statement for the 2007A bonds, cover page. 12 Tax Compliance Agreement, Section Tax Compliance Agreement, Section 7.2B. 14 Treas. Reg (b); see, e.g., Priv. Ltr. Rul (Jul. 7, 1989). 15 See, e.g., I.R.M ( ) (permitting re-examination when there is clear evidence that an incorrect determination has been reached with regard to the tax-favored status of the issuance under examination. ). The timing of this revision suggests I.R.S. officials may try to make the ridiculous argument that their hands were tied from re-examining a politically-connected, enormous violation because the violation was not flagged during an I.R.M. process they revised after making their decision. 1 IRS Publication 5005, Your Responsibilities as a Conduit Issuer of Tax Exempt Bonds, p. 5 (Apr.2012) (which states that section 148 limits the yield on purpose investments to the yield on the bonds plus a spread. This limitation effectively limits the size of the fees that may be charged by the conduit issuer regardless of whether paid periodically or up front. In addition, it states that these restrictions apply to both fees payable out of the bond proceeds or by the conduit borrower. ). 2 I have withheld the names of those involved in the decision-making process. Many of these names were obtained through the FOIA process, which is ongoing. I will share the specific names of the individuals involved, upon request, on a case-by-case basis. NOTICE The views contained herein are my own. No other party, including those with direct financial interests in any filed claim(s), significantly participated in the formulation of these views, including the legal analysis of the documents provided and/or collected. The legal analysis contained herein has not been shared with the issuer, borrower or any other party to the 2007A bond transaction or scheduled refunding of such bonds, including bond counsel, whom should be expected to disagree with my analysis. I welcome all questions, opinions, and dissent, including via 5

Law Office of W. Mark Scott, PLLC

Law Office of W. Mark Scott, PLLC The Resurgence of Whistleblowers in IRS Bond Enforcement By: W. Mark Scott I. THERE AND BACK AGAIN The IRS Office of Tax Exempt Bonds received a significant number of whistleblower tips during my tenure