WASHINGTON -- David A. Walton advocated a series of proposals to ease tax law and regulatory restrictions on municipal bonds just before he stepped down as the Treasury's attorney-adviser on tax-exempt bonds.
But he said in an interview before his June 26 departure that he was optimistic that some of these proposals would yet be considered by agency officials and Congress as part of their ongoing effort to simplify tax laws and rules in the bond area.
That should bode well for bond market participants, who credit Mr. Walton with helping to usher in a new era of cooperation between the bond industry and the government and with helping to write simpler and more workable tax regulations.
Mr. Walton, who will return to private practice, said Congress should allow all issuers to retain some of their arbitrage profits, increase the small-issuer exemption, and expand the definition of private-activity bonds.
He also said lawmakers should broaden the rebate relief law and give the Internal Revenue Service more enforcement authority, including the ability to share information with the Securities and Exchange Commission.
Giving his personal views on a number of other issues affecting the municipal market, Mr. Walton further said:
* Treasury and IRS officials have changed their attitude about tax-exempt financing and now view it as a legitimate subsidy rather than a tax scam. * The idea behind rebate is "good," but the rebate requirements are tough to put into practice and may not be cost-effective for many issuers. * Bond lawyers should re-examine their long-standing tradition of giving unqualified bond opinions, one that may no longer be appropriate given the increased complexities of tax laws and regulations. * The Supreme Court's Cottage Savings decision probably will not result in new reissuance standards for tax-exempt bonds. * It might be useful to open the revenue-estimating process to public scrutiny, in part because economists from the Treasury and Congress's Joint Tax Committee often differ on their revenue estimates for bond and other tax proposals. * The IRS needs to give bond lawyers guidance on new financial products, like interest rate swaps, that are becoming more widely used. * Issuers should avoid doing "on the edge" deals that have been "shopped around."
Mr. Walton said he told Fred T. Goldberg, the Treasury's assistant secretary for tax policy, that increasing the small-issuer exemption to $25 million would simplify bond regulation. He made the recommendation after Mr. Goldberg had asked Treasury lawyers for simplification proposals.
Under the current tax law, small issuers are exempted from rebate requirements if they expect to sell no more than $5 million in governmental bonds per year. Mr. Walton said if that limit were raised to $25 million, "you could take a lot of smaller issuers out of rebate without removing a lot of the dollar bond volume from the rebate requirements." About 50% to 75% of all bonds issues sold annually are $25 million or less, yet those issues account for only 33% of the total dollar volume, he said.
Mr. Walton, who joined the Treasury in June 1990 after one and a half years as IRS counsel to the assistant chief counsel for financial institutions and products, also said he supports legislation that would allow issuers to retain a certain percentage, perhaps 10%, of their arbitrage earnings. He is convinced that this would stop issuers from "yield burning," or trying to avoid rebate by investing bond proceeds at a yield below the bond yield.
However, one problem with such a proposal, he said, is that while the Treasury's economists believe permitting issuers to retain some arbitrage profits would generate additional federal tax revenues, the Joint Tax Committee's economists think it would initially result in a decrease in tax revenues.
Some Fear Overissuance Under Arbitrage Rebate Proposal
The Treasury economists contend that while some arbitrage would no longer be rebated under the proposal, that would be more than offset by gains from issuers investing at a higher yield so that they could keep some of their arbitrage profits, he said.
The Joint Tax Committee economists, however, say that the proposal would cause issuers to begin overissuing bonds for projects and would therefore result in a loss of revenues during the five-year window in which revenues are estimated. They concede the proposal might ultimately result in some revenue gains because it would lead issuers to increase their arbitrage earnings, but say those gains would come after the five-year window because most issuers do not rebate until five years after they issue the bonds.
Mr. Walton called the revenue-estimating process "a politically charged issue." He said Treasury and Joint Tax Committee economists often differ on their revenue estimates for bond proposals. The estimates are key to getting legislation enacted because typically a revenue loser is only considered if there is an offsetting revenue gainer.
He said the two sets of economists met recently to try to resolve differing revenue estimates for some bond proposals. "I think we had a useful dialogue," he said, "but I'm afraid that we have different approaches and different views and interpret the data differently. On some of these issues we agreed to disagree."
Though the Treasury's data is based on IRS statistics and input from tax policy officials, "the only revenue estimates that count as far as the Hill is concerned are the estimates made by the Joint Tax Committee," Mr. Walton said. "Its's a little disturbing that the revenue-estimating process is not open to the public and that no one has a chance to challenge it. On the other hand, it's a very difficult job and this may be the best of an imperfect system," he said.
Mr. Walton, who will return to his native California next month to become a partner at Jones Hall Hill & White, a small law firm in San Francisco that specializes in municipal finance, said he believes Congress should "be more expansive" with the tax law definitions of facilities that can be financed with tax-exempt private-activity bonds.
"Since there's already a volume cap" on the amount of these bonds that issuers can sell each year, "why complicate things more by having ambiguous definitions " he said, adding, "Give issuers more freedom in how to use their allocations under the cap." He said, for example, the industry needs to know the difference between sewer facilities, which can be financed with tax-exempt bonds, and water pollution control facilities, which cannot.
Mr. Walton also said he had urged IRS officials to come up with ideas for legislative proposals to expand and simplify the two-year rebate relief law.
"I really see no reason not to extend it to all bonds rather than just construction issues," he said. "We can do away with a lot of the elections. We can simplify the penalty provisions and we can handle any possible abuses that would result from a lack of detail by general anti-abuse rules."
Mr. Walton said he supports providing issuers with more relief from rebate requirements because they do not currently appear to be cost-effective, particularly for small issuers. "The notion of rebate isn't bad, the idea that the government will give municipalities a subsidy in the form of a reduced interest rate, but it doesn't want the subsidy to go any further than that," he said. But in practice it is difficult to identify and capture arbitrage.
"If everyone out there were a highly trained financial expert who could pick up the rebate regulations as they now exist and easily understand them and put the whole system into a spread sheet on their computer and devote full accounting to it, it might work pretty well. But we have to face the fact that many issuers don't have the financial expertise to deal with the complex calculations and the record keeping imposed by the rebate rules," he said.
Though Mr. Walton said the rebate rules probably will be significantly simplified when IRS rewrites and consolidates the arbitrage-related rules next year, "I'm not sure they can ever be made simple enough," he said.
He said he expects the rewrite will lead to some "major fundamental changes" to the rebate rules, such as a new and possibly simpler definition of bond yield.
On another matter, Mr. Walton said "there's a lot of room for improvement on enforcement efforts by the IRS." He said the IRS should create a "national tax-exempt bond enforcement task force" in Washington, D.C., to coordinate and oversee enforcement actions on bonds, which currently are initiated and carried out by IRS district and regional offices.
He also said Congress should give the IRS enforcement authority to focus on the issuer rather than the bondholders, impose lesser penalties than the loss of tax exemption, and share information about abuses with the SEC.
Under current law, he said, the only penalty the IRS really has for bond abuses is to revoke the tax-exempt status of the bonds and tax the interest earnings of the bondholders. But then each bondholder can challenge the IRS in separate court action. It would be better if "the issuer is the party [the IRS] can go after. Then the service can litigate the taxability of the bond with the issuer and that would be binding on all of the bondholders" or the IRS could impose some lesser penalty on the issuer, he said.
Though IRS and SEC officials have said they would like to share information on municipal bond abuses, he said the IRS is currently prohibited from giving out any tax-payer information.
Chief Accomplishment Was a Shift in Attitude
Mr. Walton said his " biggest major accomplishment" at the IRS and Treasury "was not anything we published, but the change in attitude" among agency officials. He said he and other agency officials were able to foster the view that "tax-exempt municipal finance is a legitimate industry. It is not a tax loophole ... We don't assume that all tax-exempt finance is a tax scam."
Mr. Walton said his biggest frustration was not seeing Congress enact legislation allowing some issuer retention of arbitrage. Another frustration, he said, was that the government was not more timely in getting out guidance on issues such as whether the Supreme Court's Cottage Savings decision creates a "hairtrigger" standard for bond reissuance under which almost any change to a bond issue would cause the issue to be reissued and subject to stricter tax law. The high court's ruling, in Cottage Savings Association v. Commissioner of Internal Revenue, focused on thrifts but also touched on Section 1001 of the tax code, which governs bond reissuance.
"I don't think you're going to see a hairtrigger test adopted," he said. "You have to remember that these rules apply to more than just bonds. They apply to when taxpayers recognize gains or losses on the securities they hold, and if you have a hairtrigger test, taxpayers can recognize losses when they feel like it and defer gains."
Though Mr. Walton has railed at particular abusive transactions over the years, he said he thinks the majority of bond transactions are done for legitimate governmental needs. But he is not happy that bond counsel give unqualified opinions for new financial products, where there is no federal guidance yet, or on other tax issues that the IRS has not resolved.
"I've felt since I came here that it would be nice if the industry and tax-exempt bond profession could get away from unqualified opinions, and give opinions like every other tax lawyer gives, basically a lawyer's opinion with all of the limitations and conditions" that exist for tax-exempt bonds. Qualified opinions are accepted in other areas of the tax law, he said.
Mr. Walton said that if he had to give any advice to industry upon leaving the Treasury, it would be to caution issuers against doing questionable deals. "Be very careful about squeezing an extra buck out of a transaction that is nontraditional and that has been shopped around quite a bit," he said. "This is a federal subsidy and I think it should be treated as such, not as a game to see how much you can squeeze out of it."