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Figure 1.1: Changes in Estimated Tax Expenditures Related to Outstanding Tax-Exempt Bonds in 1990 Dollars, 1975-1990

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The growth in tax-exempt bond issuances over the years concerned Congress, not only because of the forgone tax revenue, but particularly because an increasing volume of tax-exempt bonds were issued primarily to benefit private parties and organizations (such as private recreational facilities and fast food restaurants) rather than to fulfill traditional government purposes. According to the Federal Reserve Board of Governors' data, the percentage of long-term outstanding tax-exempt




bonds used for private activities gradually increased from 5 percent in 1975 to a peak of about 33 percent in 1985.

Congress was also concerned that issuers were issuing tax-exempt bonds primarily to earn profits by investing the proceeds in taxable securities at interest rates higher than the tax-exempt bond rate. This type of profit is referred to as arbitrage. These profits represented a federal subsidy for state and local governmental expenditures without any federal controls on how the money could be used. Because earning arbitrage profits entailed almost no direct costs to issuers, incentives to issue bonds to earn these profits were great. Congress was concerned that as more of these bonds were issued, forgone federal revenues would increase.

As a result of its concerns, Congress passed a number of laws intended to better target the use of tax-exempt bonds for public purposes by restricting their use for nonpublic purposes and to deter issuers from earning arbitrage profits. These restrictions began in the late 1960s and have continued through 1990.4 For example, Congress first restricted the use of tax-exempt bonds for private activities in 1968. Basically, this restriction provided that interest on bonds that were issued to benefit private persons was generally taxable unless the proceeds were used for purposes specified in the IRC, such as sports facilities, sewage and solid waste facilities, airports, parking facilities, and small-issue bonds (initially, bonds issued for $1 million or less) for private activities. In 1969, Congress limited the ability of state and local governments to issue tax-exempt bonds to earn arbitrage profits.

Over the following 15 years, Congress continued to revise the tax-exempt bond laws. In some cases, Congress expanded permissible uses by specifying additional types of private activity projects that would be eligible for tax-exempt bond financing (e.g., certain mass-commuting vehicles) and increasing the dollar limit for the small-issue exception under certain situations. In most cases, however, Congress added restrictions to help eliminate what it believed to be inappropriate uses of tax-exempt bond financing and to reduce the volume of tax-exempt private activity bonds.

For example, in 1982, Congress eliminated the tax exemption for certain small-issue private activity bonds in which more than 25 percent of the bond proceeds went to finance activities such as fast food facilities and

*See Dennis Zimmerman, The Private Use of Tax-Exempt Bonds (Washington, D.C.: The Urban Institute, 1990), pp.175-191, for a more detailed discussion of the changes to the tax-exempt bond laws.

IRS Has Primary
Responsibility for
Administering the
Tax-Exempt Bond


car dealerships. Congress also eliminated the tax exemption if any bond proceeds were used to finance specified recreational facilities, such as racetracks, golf courses, and skating rinks. In 1984, Congress further restricted small-issue tax-exempt bonds issued for private purposes and placed a volume cap limiting the issuance of tax-exempt bonds for certain private activities and student loans within a state. Moreover, Congress added further arbitrage restrictions including a requirement that certain tax-exempt bonds for private activities earning arbitrage profits on obligations not acquired to carry out the purpose for which the bonds were issued be rebated to the federal government.

The Tax Reform Act of 1986 further targeted tax-exempt bond financing to recognized public rather than private purposes. For example, Congress prohibited tax-exempt private activity bonds for certain uses, such as sports and parking facilities. The act placed more types of private activity bonds under a volume cap and reduced the dollar limit of the cap. Again, new arbitrage restrictions and procedures were added, including requirements that generally meant that arbitrage profits earned from all tax-exempt bonds had to be rebated to the federal government.

Congressional restrictions that have been placed on tax-exempt bond
financing appear to have reversed the growth in outstanding long-term
tax-exempt bonds issued for private activities. Since 1985, when about
33 percent of these outstanding long-term tax-exempt bonds were for
private activities, the Federal Reserve Board of Governors' data show that
the proportion gradually decreased to about 23 percent in 1990.

The IRC authorizes the Secretary of Treasury to establish regulations to administer and enforce the IRC. Treasury delegates most responsibilities for administering and overseeing federal tax-exempt bond provisions to the Internal Revenue Service (IRS). Tax-exempt bond regulations, which are issued by Treasury, usually are developed jointly with IRS.

In addition, IRS issues revenue rulings and letter rulings related to
tax-exempt bonds. The revenue rulings interpret tax-exempt bond statutes
and regulations for taxpayers, IRS personnel, and other concerned
individuals as related to a particular tax issue. These rulings do not have
the force and effect of regulations. However, they are published to provide
precedents for disposing of other cases. IRS employees and taxpayers,
among others, rely on the revenue rulings in determining the tax treatment
of various types of transactions. IRS also issues tax-exempt bond-related


letter rulings. Letter rulings are applicable only to the specifics of one case and cannot be generalized to other situations. Nonetheless, letter rulings provide insight into IRS' position on a particular type of bond or transaction.

IRS' Expanded Bond Audit Program, within the Office of Examination Programs, Office of the Assistant Commissioner (Examination), is currently IRS' primary effort to oversee the tax-exempt bond market. This program began informally in March 1989 when IRS' Office of the Assistant Chief Counsel (Financial Institutions and Products), which at that time was leading a joint oversight effort with Examination, asked Examination to take the lead. The Assistant Commissioner of Examination formally authorized the Expanded Bond Audit Program in November 1990 to extend through 1993 to gather information on and review industrial development bond issuances to determine whether they should retain their tax-exempt status. However, program officials said that this program would continue to be IRS' ongoing tax-exempt bond compliance effort.

According to program officials, since 1990 the Expanded Bond Audit Program has had up to 27 Examination revenue agents located in 24 districts assigned to work on the program intermittently. In 1991, agents spent approximately 2 staff years total on tax-exempt bond examinations. Under the Expanded Bond Audit Program, district revenue agents are responsible for pursuing tax-exempt bond cases identified by the Office of Chief Counsel and Examination's National Office as well as identifying, developing, and reviewing related new cases. Specifically, revenue agents are responsible for determining and gathering the information needed to resolve cases and making initial compliance determinations. According to IRS officials, the primary considerations in assigning priority to a case are the significance of the abuse and whether counsel can support the government's position in litigation.

The tax-exempt bond-related efforts of other IRS organizations are subsidiary to their primary functions. Employee Plans and Exempt Organizations conducts tax-exempt bond oversight and enforcement efforts in conjunction with its oversight of tax-exempt organizations. Employee Plans and Exempt Organizations has a coordinated examination program for tax-exempt organizations that have substantial income or assets. As part of these examinations, the organizations' tax-exempt bond financing is reviewed. In addition, Employee Plans and Exempt Organizations reviews applications by organizations seeking tax-exempt status. Employee Plans and Exempt Organizations revised this process to

Mechanisms IRS Uses
for Dealing With
Tax-Exempt Bond

IRS Can Penalize
Noncompliant Bond


consider more carefully whether such organizations intend to make use of tax-exempt financing and, if so, whether the planned use complies with tax-exempt bond requirements.

Although they do not have actual tax-exempt bond enforcement and oversight responsibilities, some other IRS organizations perform activities that potentially contribute to enforcement and oversight. The Criminal Investigation Division investigates suspected criminal activities related to the IRC, which can include activities related to tax-exempt bonds. In addition, the Philadelphia Service Center processes tax-exempt bond information returns and arbitrage rebates, the Statistics of Income Division analyzes tax-exempt bond information returns data for volume and use trends, Tax Forms and Publications develops the forms and publications issuers use, and Information Systems Management designs automated support systems.

Noncompliance with tax-exempt bond law may occur unintentionally because the individuals involved do not understand federal tax requirements. In other cases, bond participants might take new approaches, such as using sophisticated financing strategies, that IRS subsequently may judge to violate the IRC or Treasury regulations. Other cases of noncompliance may be deliberate. For example, some parties involved in the bond issue may know that the planned project is not feasible but nevertheless they portray it as feasible in bond documents. If it identifies any noncompliance, IRS has the authority to impose certain sanctions or negotiate closing agreements with the issuer.

The basic sanction for a bond that IRS determines does not satisfy federal requirements for tax exemption is for IRS to tax interest earned by bondholders from the bond. This severe sanction is generally available for any violation, including those that might be considered minor. IRS can impose this sanction by determining who the bondholders are and recomputing their taxes by including interest income received from the bond that was formerly considered to be tax exempt. Issuers of such bonds, however, are not barred from issuing bonds in the future.

When a bond is issued accompanied by a materially misrepresentative certification that the bond is not reasonably expected to earn arbitrage, Treasury regulations give IRS the authority to disqualify an issuer from certifying future bond issuances. Although the regulations state that IRS

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