WASHINGTON - Internal Revenue Service agents investigating bond issues should pay special attention to transactions with unusual debt service structures or investments that were not purchased at fair market value, the agency says in a training manual released yesterday.
Agents working in the new tax-exempt bond enforcement program should also pay close attention to bond transactions that "reimburse" issuers for prior expenditures or that contain "replacement proceeds," the manual says. Replacement proceeds are created when projects are financed with bonds. Because the project is bond-financed, funds that would otherwise have been used to finance it are freed up and can be invested to earn profits.
The IRS cites these four areas of potential arbitrage abuse in the training manual, which seeks for the first time to give agents in the exempt organizations branch some training on key arbitrage requirements.
The manual details major arbitrage requirements and describes these four potential areas for arbitrage abuse.
Bond issues with dramatically uneven debt service payments, such as those with a several-year window in which no interest is paid, "may be an indication that an arbitrage game is being played," the manual says. Most bond issues have level annual debt service, it says.
Agents should pay particular attention to the purchase price of investments in advance refundings, the manual says. "Purchase of investments at greater than their market value may be the greatest ~hidden' arbitrage abuse," the manual says.
The manual concedes that issuers and conduit borrowers do not have much incentive to maximize their investment return because they will have to rebate any return over the bond yield.
Warning of potential abuses with reimbursement bonds, agency officials said in the manual, "We have reason to believe that reimbursement was widely used between 1987 and 1990 as a way to avoid the new rebate requirements." In bond reimbursements, the proceeds are treated as spent and are no longer subject to arbitrage restrictions soon as they are used to reimburse the issuer for prior expenses.
In targeting replacement proceeds, the manual says that "many prior abuses have attempted to gain an arbitrage benefit by replacement." The manual notes that replacement proceeds are subject to arbitrage restrictions.
Meanwhile, in another article in the manual, agency officials discussed industry concerns about a safe harbor standard for low-income housing that was sent to agents last October and publicly released earlier this year.
The safe harbor standard is to be used by agents in determining whether a housing organization qualifies for tax-exempt status.
Under the safe harbor standard, an organization acquiring or building housing will qualify for tax-exempt status if at least 75% of the units are available for families earning 60% or less of area median income, and the remaining units are available to "persons at the lower end of the economic spectrum."
Housing industry and other federal agency officials have complained that the safe harbor standard is more restrictive than standards in the tax law and other federal housing programs.
In the manual, IRS officials stressed that the purpose of the safe harbor standard is to ensure that housing organizations will be deemed to be relieving the poor and distressed, one of several charitable purposes that can be served to achieve tax-exempt status.
Agency officials said that the safe harbor standard can "never be used to deny" an application for tax-exempt status. "The guideline should only be used as a procedural tool to allow the Service to easily identify organizations that clearly relieve the poor and distressed," the manual says.
A housing organization that does not meet the safe harbor standard need only demonstrate through a "facts and circumstances test" that its housing will still relieve the poor and distressed or will serve some other charitable purpose, the manual says.
For example, it says, if a housing organization does not meet the income targets, it can show that the residents of its housing project would have unusually high medical costs that drain their earnings.
An organization could also show that its housing project would serve some other charitable purpose such as combatting community deterioration, the manual says. In determining whether housing projects would combat community deterioration, the IRS looks at area crime, drug trafficking, graffiti, unemployment, and other factors, the manual says.
IRS officials said they are giving serious consideration" to industry and other agency concerns that the safe harbor standard is inconsistent with the standards us" in other federal housing programs. They said they will publish a notice detailing any revisions made to the safe harbor standard.