Introduction

would then publish a notice in the Internal Revenue Bulletin that the
abusive issuer is disqualified from certifying tax-exempt bond issues in the
future, a letter we received on September 17, 1992, from IRS' Chief Counsel
stated that "[c]onsistent with the position that bond compliance data is
confidential return information," the provision allowing IRS to publish a
notice of an issuer's disqualification in the Internal Revenue Bulletin "has
little vitality." However, because the issuer's future bond offerings would
not include the usual certifications assuring investors that the bonds were
not reasonably expected to earn arbitrage, if such an issuer were able to
continue to sell tax-exempt bonds, it presumably would be at a higher
cost.

For certain types of noncompliance, IRS also can impose less severe sanctions. For example, the IRC requires operators of qualified residential rental projects financed with tax-exempt bonds to certify annually that the project continues to rent a certain percentage of units to low-income tenants. If an operator fails to file the certification, the operator must pay a penalty.5 The penalty is $100 for each failure to file.

Another less severe sanction is the penalty in lieu of loss of tax exemption.
This penalty provides that when issuers of governmental and qualified
501(c)(3) tax-exempt bonds fail to rebate to the Treasury any arbitrage
due, issuers can avoid retroactive taxation of bondholders if they pay the
arbitrage rebate owed and a penalty. The penalty is 50 percent of the
rebate owed plus interest on the rebate.6 IRS also can use IRC section 6700
to penalize parties who knowingly promote abusive tax shelters, including
abusive tax-exempt bonds.

IRS Can Negotiate Closing
Agreements to Settle
Tax-Exempt Bond Cases

IRS has the option to resolve tax-exempt bond noncompliance by negotiating a closing agreement with the issuer that may require the issuer to pay IRS an agreed-upon amount. According to the Internal Revenue Manual's (IRM) Closing Agreement Handbook, such an agreement can be used by IRS to settle tax disputes if "there appears to be an advantage in having the case permanently and conclusively closed, or if good and sufficient reasons are shown by the taxpayer for desiring a closing agreement and it is determined by the Commissioner that the United

"Failure to comply with this certification requirement does not affect the tax-exempt status of the related bond.

"Treasury regulations also provide that a tax-exempt bond issue including a private activity bond other than a qualified 501(c)(3) bond can also qualify for a penalty in lieu of loss of tax exemption, but in this situation the penalty is 100 percent plus interest.

Introduction

States will sustain no disadvantage through consummation of such an agreement."

According to IRS officials, IRS calculates a tax-exempt bond settlement offer on the basis of a variety of factors, including the amount of tax lost, the likelihood that IRS would win a court case, a determination of a fair offer, how much the issuer had benefited from the deal, the strength of IRS' position, and the cost of pursuing the bondholders. The amount of the closing agreement can be, and usually is, less than the amount of forgone tax and any other revenues lost because of the bond (e.g., illegal arbitrage not rebated to IRS). If a closing agreement can be reached, the bond issue retains its tax-exempt status and the retroactive taxation of interest paid to bondholders is prevented. If an acceptable closing agreement cannot be reached, IRS can require bondholders to pay taxes on interest earned from the bond.

Regulation of
Tax-Exempt Bonds by
Other Organizations

Besides IRS, other organizations also are involved in regulating securities.
The Municipal Securities Rulemaking Board is an independent,
self-regulatory body for municipal securities brokers and dealers. Its
purpose is to prevent fraud, promote fair markets, and protect investors
and the public interest. Although its rules have the force of law, the
Municipal Securities Rulemaking Board has no inspection or enforcement
powers. The National Association of Securities Dealers is a self-regulatory
organization for its members that can take disciplinary actions against
members for violating its rules or Municipal Securities Rulemaking Board
rules.

The Securities and Exchange Commission has broad regulatory responsibilities over the securities markets; organizations within the securities markets, including the Municipal Securities Rulemaking Board and the National Association of Securities Dealers; and persons doing business in securities. Regulation of municipal securities dealers that are also banks ordinarily is provided by the appropriate bank regulatory agency. The regulatory responsibilities of the above organizations for securities are not focused on tax-exempt bond tax law requirements.

States also provide some constitutional and statutory restrictions over tax-exempt bonds. Generally, state laws focus on protecting investors from fraud by (1) prohibiting specified fraudulent practices by market

"These include the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation.

Introduction

participants, (2) requiring that persons and entities selling or offering securities be registered, and (3) requiring that securities be registered before public offering. For the most part, when state authorities review municipal tax-exempt bond issues they check for compliance with the state's constitution and statutes authorizing or limiting the issuance of debt obligations. The checks and balances these state efforts provide for tax-exempt bonds are focused on requirements other than those reflected in the IRC.

Objectives, Scope,

and Methodology

At the request of a former Chairman of the Subcommittee on Human
Resources and Intergovernmental Relations, House Government
Operations Committee, we addressed issues related to IRS' oversight of
tax-exempt bonds. Our objectives were to (1) review the Internal Revenue
Service's (IRS) efforts to oversee compliance with tax-exempt bond
requirements and determine whether they need to be improved and
(2) determine whether policy changes would enhance IRS' ability to
increase compliance with these requirements.

To accomplish our objectives we did the following:

• We identified and reviewed the tax-exempt bond provisions contained in the IRC as of the Tax Extension Act of 1991.

• We reviewed Federal Reserve Board of Governors' data to obtain

information on the growth of tax-exempt bond usage and to calculate the percentage of outstanding tax-exempt bonds that were issued for private activities.

• We analyzed data contained in the Budget of the United States Government to obtain information on tax expenditures attributable to tax-exempt bonds.

We reviewed existing literature on tax-exempt bonds to obtain information
on how the tax-exempt bond market operates and on changes that have
occurred in the market.

• We reviewed relevant congressional reports and other congressional
documents and interviewed current and former congressional staff
members who were involved in Congress' tax-exempt bond efforts to
obtain information on Congress' views on tax-exempt bonds and to gain an
understanding of how Congress reacted to changes in the usage of
tax-exempt bonds.

• We interviewed program officials and other cognizant officials at IRS'
National Office and the Department of the Treasury to obtain information
on IRS' tax-exempt bond oversight practices, its role in ensuring

Introduction

compliance with tax-exempt bond provisions, and potential improvements. Our discussions involved officials from the Department of Treasury's Offices of the General Counsel and Tax Analysis and the following IRS Offices: Office of the Assistant Commissioner (Examination), Office of Examination Programs; Office of the Assistant Chief Counsel (Financial Institutions and Products); Office of the Assistant Chief Counsel (Employee Benefits and Exempt Organizations); Office of the Assistant Chief Counsel (Disclosure Litigation); Internal Audit Division; Statistics of Income Division; Office of the Assistant Commissioner (Criminal Investigation); Office of the Assistant Commissioner (Employee Plans and Exempt Organizations); Legislative Affairs Division; Office of Disclosure; Office of the Assistant Commissioner (Returns Processing); Office of the Assistant Commissioner (Taxpayer Services); and Office of the Assistant Chief Information Officer (Information Systems Management).

• We interviewed IRS officials and gathered documentation from IRS' Southeast and Southwest regions and Atlanta, Nashville, New Orleans, and Houston districts to obtain examples of the extent and nature of tax-exempt bond oversight activities in the field. We selected the Nashville, New Orleans, and Houston districts because revenue agents assigned to tax-exempt bond oversight in these districts were actively pursuing tax-exempt bond cases and because of either the significance or the number of open cases under review. The Atlanta District was included in our selection because two revenue agents were assigned to work in the District on tax-exempt bonds, whereas one revenue agent was assigned in most of the other districts.

• We reviewed judgmentally selected tax-exempt bond abuse cases closed by IRS' Office of Chief Counsel to obtain information on abuses involved and examples of closing agreements. We selected for review (1) cases with more recent closing dates to reflect IRS' more recent activities and (2) at least one case for each tax-exempt bond revenue ruling where closing agreements had been reached.

We obtained and reviewed IRS tax-exempt bond program documentation to determine the nature and extent of IRS' tax-exempt bond oversight practices.

• We interviewed IRS officials and gathered documentation and Information Return for Tax-Exempt Bond Issues (Form 8038) data from IRS' Philadelphia Service Center and Statistics of Income Division to obtain information on IRS' processing and analysis of tax-exempt bond returns and their relationship to tax-exempt bond oversight.

• We interviewed various public and private sector tax-exempt bond representatives and experts to obtain information on the process used to issue tax-exempt bonds and their roles in the process, to obtain their

Introduction

views on tax-exempt bond oversight and constraints faced by IRS, and to discuss possible options to enhance voluntary compliance. Our discussions involved officials from the Government Finance Officers Association; the National Association of Bond Lawyers; the National Association of State Auditors, Comptrollers, and Treasurers; the Public Securities Association; the state of Maryland; Howard County, Maryland; and the Securities and Exchange Commission. In addition, we spoke with a specialist in public finance at the Congressional Research Service of the Library of Congress.

• We interviewed and obtained documentation from state officials in three states coinciding with IRS districts we visited (Georgia, Tennessee, and Texas) to obtain information on their tax-exempt bond oversight roles. We interviewed selected bond counsels at the state level who were active in providing tax-exempt bond opinions and certified public accountants to obtain examples of their respective roles in tax-exempt bond oversight. We interviewed selected issuers who had been involved in negotiating tax-exempt bond closing agreements with IRS to obtain their perspectives on the process.

We did our review in accordance with generally accepted government auditing standards. We obtained oral comments from IRS, which we have included where appropriate.