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IRS compliance checks and audits continue.

The Internal Revenue Service (IRS) is continuing its compliance checks of organizations with tax-exempt bonds. It has been reported that qualified hedges were one of the spotlighted concerns.

The benefit of "qualified" hedges (or an interest rate swap transaction) is that additional interest payments made by the borrower are included in the interest rate (bond yield) calculation. It thereby increases the bond yield and potentially sheltering positive arbitrage amounts that you would otherwise have to rebate to the Treasury.

Specifically, the IRS has looked at qualified hedges within advance refunding transactions and found most troubling the failure to file IRS Form 8038-T along with the rebate, including underpayment interest. The IRS continues to question Section 501(c)(3) organizations that are a party to tax-exempt bonds for new capital projects. Their initiative likely involves the IRS's inquiry into whether or not the conduit borrower transactions have adhered to the variety of post-issuance compliance requirements including record retention, arbitrage rebate and yield restriction and qualified use of bond proceeds to gauge compliance.

Although a compliance check is not an audit, the IRS has the option of opening a formal examination if you fail to comply. More importantly you could risk the overall exempt status of your organization if you fail to timely and accurately respond to the IRS's requests in this regard. In addition to these specific audit-type initiatives, the IRS is continuing the use of compliance check questionnaires in the context of more traditional governmental entities and for student-loan bond issuers.

Given the rising interest rate environment during the past several years and outstanding bond issues with relatively low tax-exempt interest rates, you cannot overemphasize proactive arbitrage rebate (and yield restriction) compliance, including adequate mathematical substantiation of exceptions to the rules, to ensure preservation of the bonds' underlying tax-exempt status.

Voluntary compliance is strongly suggested, including payment of required rebate (and where also applicable, yield reduction) for past positive arbitrage earned along with IRS Form 8038-T to prevent steeper penalties should the IRS discover the same on random or targeted audits. Although the IRS attempts to avoid taxation of bondholders, it is possible they will be taxed in the future, although to date the IRS has imposed the majority of penalties on the Section 501(c)(3) (and other) conduit borrowers and direct issuers.


The arbitrage rules and related existing (and proposed) regulations under Section 148 are complex and challenging with a financial spin even for experienced practitioners. The changing environment has made this difficult area even more complex. You should make sure you are in full compliance with all of the rules, both old and new.

Ignoring the IRS and legal requirements imposed upon issuers (and conduit borrowers) for the privilege of issuing or receiving tax-exempt debt is not something to take lightly. Steeper penalties, along with interest, will result should the IRS catch you before you voluntarily notify them of problems.

A self-check on post-issuance compliance in this area is not only prudent, but likely a necessity, given the current regulatory environment in the United States, coupled with the continued national presence of the IRS' tax-exempt bond group.

A recent joint publication, issued by the National Association of Bond Lawyers and the Government Finance Officers Association, offers a suggested post-issuance compliance check list to adhere to minimum IRS and related bond covenant requirements at

All of the post-issuance requirements should not cause you to avoid the substantial financial advantages of tax-exempt financing. However, you must obtain the appropriate advice to ensure that you comply with all of the post-closing requirements of Code Section 148. Failure to do so can cause substantial headaches, which you can avoid by prudent action.
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Author:Berger, Harvey
Publication:The Non-profit Times
Date:Feb 1, 2008
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