New Internal Revenue Service rules contain a surprise provision that the IRS says is necessary to keep investment contract broker fees reasonable, but that some industry officials say will drive such brokers from the municipal market.
The provision, which was included in the final allocation and accounting rules issued last week, requires that the fee paid to the investment contract broker must be added to the issuer's investment income even if the fee is paid by the investment contract provider and not the issuer.
The increase in the issuer's investment income makes it more likely the issuer would earn arbitrage that would have to be rebated to the federal government.
One industry official explained the effect of the provision this way: if an issuer with a bond yield of 6% obtains an investment contract with a yield of 6% from an investment contract provider that paid a firm $20,000 to help broker the contract, the issuer would have to rebate $20,000.
The provision, which was not in the proposed version of the rules published earlier this year, was discovered by bond lawyers meeting here last week.
Several of the bond lawyers, who were attending a meeting last week of the American Bar Association's committee on tax-exempt financing, said they traditionally viewed such fees as not having any impact on issuers because the fees are usually paid by investment contract providers and not the issuers.
But an IRS official said after the meeting, "We didn't buy that."
He said the IRS included the fee requirement in the final rules, after easing other restrictions on investment contracts, to ensure that the fees paid to investment contract brokers are reasonable.
"This requirement says, in effect, that investment contract broker fees are going to be tested economically because issuers are going to be held accountable for them," he said.
A Treasury Department official said a similar requirement was in the arbitrage rebate rules that were published in May 1989 and that were recently issued in final form. Bond lawyers, however, said those rules were never very clear.
The fee requirement has drawn mixed reactions from investment contract brokers. Some warn it will be fatal to investment contract brokers business and others say it may not hurt their business.
James O'Connor, a managing director of FSA Financial Services in Los Angeles, said that while he was initially pleased that the final rules had eliminated or eased many of the troubling restrictions on investment contracts that were in the proposed rules, he was upset upon learning about the fee requirement.
"The effect of this section will moot all of the benefits given regarding investment contracts throughout these regulations," he said. "The supposition by the IRS must be that either issuers don't need brokers to get the highest yields or, that because there have been abuses in the past, issuers will not be permitted to use a broker unless they are willing to pay the fees twice."
But Mary Packer, president of PackerKane & Co. in New York, said she believes her firm will be able to provide issuers with such good investments at such reasonable costs that this will mitigate any negative impact from the requirement. "I would hope issuers continue to feel the service is valuable enough that this will not negatively impact our business," she said.
Meanwhile, most market participants said this week that they were pleased with the final rules on allocation and accounting, transferred proceeds, and the two-year rebate relief law that the IRS issued May 12.
They said the final rules addressed many of the concerns that industry officials raised about the proposed rules in written comments and a public hearing earlier this year. Several lawyers and issuers said they were shocked and impressed that the IRS was able to revise the rules so quickly.
"I was really surprised," said Terence Burke, a vice president with First Southwest Co. "I thought the changes were good. They mechanically made these rules a lot easier to comply with."
"This is a good set of regulations. It's the best set of regulations that we've had in 20 years," said Frederic Ballard, a lawyer with the firm of Ballard, Spahr, Andrews & Ingersoll in Washington, D.C.
The three sets of rules were issued along with a final set of arbitrage rebate rules. The rebate rules had been issued in temporary form in 1989 but were due to expire May 12 under a congressionally imposed deadline. The IRS gave all the rules a June 30, 1993, expiration date, saying it was committed to simplifying and reproposing the rules before then.
Several lawyers and issuers lauded the IRS for its self-imposed goal of simplifying the arbitrage rules in a year. "I've never heard of final rules with a sunset date," said Mr. Ballard, adding he was "impressed with the idea."
