Back in the 60’s and 70’s, Tammy Wynette, country music legend, had a number of classic hits like Stand by Your Man and Your Good Girl’s Gonna Go Bad. Many of her lyrics are legendary. But Tammy never wrote a technical advice memorandum (TAM). Too bad, because surely she would have made TAM’s a little less dry and technical and a lot more heartfelt. I doubt we will ever see a Tammy lyric like “there’s no Riviera in Festus, Missouri” in a TAM. Until the lawyers at the IRS stop writing less like lawyers (including this humble blogger) and more like Tammy, it won’t be hard to confuse a lyric by Tammy with a TAM.
Speaking of dry and technical, on September 18, 2015, the IRS released Technical Advice Memorandum No. 201538013 (2015 TAM) [LINK]. For those of you who wonder what the IRS numbering system is all about (and who doesn’t wonder about such things), that number indicates the TAM was released in 2015, in the 38th week of the year, and it was the 13th TAM released that week. A TAM is typically a request from an IRS Agent seeking input from the in-house counsel (technically the Associate Chief Counsel’s office) at the IRS about points of law that are uncertain and could affect the outcome of the audit. A TAM is only binding on that specific taxpayer. Nonetheless, tax lawyers will look at TAM’s, much like private letter rulings (PLR), to obtain insights into the views of the IRS as to topics that are not more fully developed elsewhere. Like a PLR, the names, amounts, and dates in a TAM are redacted so it is not possible to determine the specific facts.
FACTS: The 2015 TAM involves bonds (Refunding Bonds) payable only from an ad valorem (i.e., valuation based) property tax (Property Tax) levied on all of the property within the boundaries of the governmental issuer (Issuer). The Refunding Bonds advance refunded the outstanding bonds (Refunded Bonds) payable from the same Property Tax.
At the time the Refunding Bonds were issued, the Issuer had already collected and deposited to the debt service fund Property Tax sufficient to pay a portion of the Refunded Bond debt service due on the next debt service payment date (Current Portion). The Issuer used the Current Portion to pay the debt service on the first debt service payment date for the Refunding Bonds. After that debt service payment was made, the debt service fund, net of the Reserve Portion described below, qualified as a bona fide debt service fund, which means the amount in that fund was not greater than the annual debt service plus a reasonable carryover balance of one month’s debt service. A bona fide debt service fund is not subject to rebate.
The Issuer also had funds in the debt service fund that were treated as a debt service reserve fund (Reserve Portion). After the refunding, the Issuer continued to hold the Reserve Portion as a reasonably required reserve or replacement fund for the Refunding Bonds.
The proceeds of the Refunding Bonds were placed in an escrow fund. The escrow fund had a yield that was lower than the yield on the Refunding Bonds, as required. The Current Portion and the Reserve Portion were invested at a yield that was also lower than the yield on the Refunding Bonds.
Thus, this advance refunding was exactly like most advance refundings. There seems to be nothing the least bit unusual about it. But the Agent must have had questions or there would be no 2015 TAM.
QUESTIONS: The IRS looked at three questions. First, did the Issuer employ an abusive arbitrage device. See Reg. § 1.148-10(a)(2) [LINK]. Second, were the Current Portion and the Reserve Portion excess gross proceeds of the Refunding Bonds. See Reg. § 1.148-10(c)(2). Third, was a device employed by the Issuer to obtain a material financial advantage based on arbitrage. See Code Section 149(d)(4) [LINK].
ANSWERS: The IRS answers to the questions were, No, No, and No. In short, there were no problems. So, why was the Associate Chief Counsel asked to evaluate something so seemingly routine?
ANALYSIS: With regard to the first question, it appears the Agent was troubled by Example 3 in Reg. § 1.148-10(d), the so-called Window Refunding Example [LINK]. In the Window Refunding Example, an issuer issues refunding bonds to refund the refunded bonds, which refunded bonds were an advance refunding issue. The refunding bonds in the example are zero coupon bonds that will pay no debt service for the first five years. The proceeds of the refunding bonds are placed in an escrow and invested at a yield not higher than the yield on the refunding bonds. The escrow will only be used to pay interest on the refunded bonds.
This technique was used to avoid the transferred proceeds rule. The transferred proceeds rule says that when proceeds of a refunding issue are used to pay principal of a refunded issue, any proceeds of the refunded issued transfer to the refunding issue. If only interest on the refunded bonds is paid, the transferred proceeds rule is not triggered. If older bonds have proceeds invested in an escrow at yields higher than current yields, transferring those proceeds to newer bonds that have lower yields brings with it a cost because those higher yields have to be blended down. Avoiding transferred proceeds avoids that cost. None of this matters much anymore because there are no high yield escrows left as interest rates have been low for a long time. But the Window Refunding Example is still in the Regulations.
The TAM makes short work of this first question. The TAM states that the facts of the Refunding Bonds are not similar to the facts of the Window Refunding Example. The Issuer paid interest and principal immediately. Thus, there was no “window”. In addition, the escrow yield was below the yield on the Refunding Bonds so the Associate Chief Counsel could not detect an action to exploit the difference between taxable and tax-exempt rates.
The TAM makes even shorter work of the second question. The TAM states that the Current Portion and the Reserve Portion are not excess gross proceeds of the Refunding Bonds because both the Current Portion and the Reserve Portion are replacement proceeds in sinking funds for the Refunding Bonds and so fall within the replacement proceeds in a sinking fund exception to the excess gross proceeds rule found in Reg. § 1.148-10(c)(2)(viii). [LINK]
As to the third question, the TAM looks first to the Reg. § 1.149(d)-1(b), [LINK] which provides that an advance refunding violates the abusive device rule in Code Section 149(d) if it violates the any of the anti-abuse rules in Reg. § 1.148-10. The TAM also looks to the legislative history of Code Section 149(d) and specifically the Report of the Senate Finance Committee for H.R. 3838, the Tax Reform Act of 1986. [LINK] The Senate Finance Committee report has an example at page 850 of a type of transaction that would be a device to obtain a material financial advantage based on arbitrage. That example does talk about using replacement proceeds like the Current Portion to pay debt service on the Refunding Bonds. But there is one critical distinction. The example states that the replacement proceeds would be invested substantially longer than would have been the case if the refunded bonds had not been refunded. In the facts of the TAM, the Current Portion was not invested for a longer period and was not invested at a higher yield that the Refunding Bonds yield.
CONCLUSION: The Associate Chief Counsel reaches the correct result based on the law, which is quite clear. Once again, this is an example of the internal IRS process working as it should. Undoubtedly, the Issuer must have been quite frustrated with the audit process and the time and expense of taking what appears to be a very straightforward advance refunding to the point of a TAM. But, while the time and expense are frustrating and costly, in the end the correct result was achieved. To take a twist on Tammy Wynette, the Associate Chief Counsel chose “Not to Stand by Their Agent”. I am going to go out on a limb and predict that there will never be a song with that title.
