Bar News - June 18, 2014
Municipal & Governmental Law: Treasury Department Cracking Down on Municipal Compliance
By: J. Paul Giuliani and Keith A. Roberts
As a general proposition, income received by municipal corporations and state political subdivisions isn’t subject to state and federal taxation. Accordingly, one could argue that, in the absence of federal income tax liability exposure, there is little need or incentive for a municipality to maintain extensive tax records, because those deductions, credits, allowances and the like, which are available to individuals and other taxpaying entities, have no relevance in a municipal setting.
However, Section 6001 of the Internal Revenue Code calls upon “every person liable for any tax imposed by” the Code to maintain records deemed by the commissioner of Internal Revenue to administer the tax laws of the United States. The record retention requirement isn’t “tax specific,” but instead is “person” directed. That is, if “any” federal tax is implicated, the person liable for the tax has a recordkeeping responsibility for all of its activities. For example, municipal liability for federal payroll and excise taxes is sufficient predicate for municipal record retention under Section 6001.
Why is municipal record retention generating so much interest today? The Treasury Department has embarked on a comprehensive initiative designed to examine and test the level of code compliance by issuers of tax-exempt and tax-advantaged obligations. The scope of the inquiry is national and extends from very small, single-purpose utility districts to states and state agencies. The transactions under examination include traditional general obligation and revenue bonds, capital financing leases, short-term cash flow and anticipatory notes and refunding of outstanding debt.
Most of Treasury’s efforts are focused on ascertaining issuer compliance with Sections 141 and 148 of the Code. These provisions, and related Treasury regulations, deal with the tax treatment of private-activity bonds and arbitrage bonds, respectively. A municipal issuer finding itself in a situation in which any of its obligations are characterized as a private activity or an arbitrage bond faces the prospect of having those obligations classified as fully taxable, retroactive to the date of issue. Needless to say, the holder of those obligations is going to be unhappy facing the prospect of paying income tax (and perhaps interest and penalties) on what was represented by the issuer to be tax-exempt interest.
Fortunately, in recent years, some clarity has developed regarding the steps a municipal issuer needs to take to ensure that its obligations enjoy continuous tax-exemption under federal law. For the municipal issuer to establish that its obligations are tax-exempt, it needs to be able to document a number of events relating to the expenditure of its bond and note proceeds, and the use to which the bond-financed property is put.
Code Section 141 establishes a number of tests to determine if a municipal issuer’s obligation is a taxable “private activity bond.” In addition to establishing whether any of the tests are met when the obligation is issued, the inquiry continues for so long as the obligation remains outstanding. That is, bonds issued to finance improvements dedicated to a purely governmental enterprise (e.g., an elementary school) invariably remain tax-exempt from issuance through maturity. However, if that bond-financed improvement should be sold, leased or otherwise disposed of before the bonds mature, there is a risk that the obligations will be classified as private-activity bonds under Section 141, rendering the interest paid subject to federal taxation.
For Section 141 compliance purposes, Treasury wants to know if issuers have in place a mechanism involving regular testing to ensure that bond-financed improvements remain under governmental control and that no private person is afforded any preferential use or occupancy. Treasury also is interested in learning if the issuer has a remediation procedure that’s triggered if the bond-financed property should be transferred to a private person.
Code Section 148 establishes a number of different “temporary periods” during which bond and note proceeds can be retained and invested pending disbursement for the purposes for which the obligations were issued. During the applicable temporary period, the net interest earned on invested proceeds may be retained by the issuer, if the issuer’s records establish that one or more of the arbitrage rebate exceptions are available. In addition, there are Section 148 regulations controlling the timing and sizing of borrowing for short-term working capital and cash-flow-deficit financings. Treasury is interested in determining the amount, nature and quality of records the issuer relies on to demonstrate that its borrowings conform to Section 148 in all material respects.
In the Treasury information gathering and examination process, the first inquiry is whether the municipal issuer has adopted a formal policy addressing compliance with Sections 141 and 148 after bonds and notes have been issued. Questions they might ask include: Are there procedures to ensure that bond proceeds are spent in a timely manner for the purposes for which the bonds were issued? Are there procedures to ensure that the bond-financed improvements continue to be used exclusively for public purposes? Are there procedures to remedy the consequences of bond-financed improvements being transferred to a private person?
Ultimately, standard post-issuance compliance procedures are neither complex nor onerous and need be adopted only once, usually coincident with an issue of a municipal bond or note. The procedures in general use today are intuitive in application and integrate well with existing municipal management practices. However, regardless of what form these compliance measures take, they need to be integrated into a formally adopted set of procedures. Even for very small municipalities whose only obligations may be a series of revenue anticipation notes, having previously adopted post-issuance disclosure policies will certainly pay dividends in the event of any Treasury Department inquiry.
Paul Giuliani and Keith Roberts are shareholders at Primmer Piper Eggleston & Cramer. Giuliani counsels clients on general obligation and revenue bond financing, short-term municipal financing, project financing, municipal lease financing, and federal tax law relating to public finance. Roberts focuses on corporate law, healthcare law, and commercial transactions.