Rev. Proc. 2005-40, in Section 4.0 — 0618 Publ 4344 (PDF)

the options available to the Issuer.

If the IRS does not notify the Issuer in writing within 90 days after receiving the explanation of the lack of willful neglect, the explanation is accepted and the penalty is waived.
If, based on the explanation submitted by the Issuer, the IRS is unable to make a determination that the failure was not due to willful neglect, the IRS will notify the Issuer in writing within 90 days after receiving the explanation and describe any additional information needed, the IRS contact person, and provide the Issuer with a period of not less than 21 days to provide the information.
If the IRS is still not able to make a determination, the Issuer is entitled, upon request, to a conference with the IRS.

The Treas. Reg. Sections under 1.148-3(h) and Rev. Proc. 2005-40 will be referred to

jointly as Rebate Failure.

In June 2007, the TEB Subgroup compiled a report called “After the Bonds are Issued:

Then What?” ¹¹⁶ a voluntary Issuer assessment of post issuance tax compliance. This

report initiated the Post Issuance Compliance Policies and Procedures movement.

In June 2008, the TEB Subgroup produced a report entitled “The Streamlined Closing

Agreement for Tax-Exempt Bonds: A Cure for Common Violations.” ¹¹⁷ That report grew

116 https://www.irs.gov/pub/irs-prior/p4344--2007.pdf. 117 https://www.irs.gov/pub/irs-prior/p4344--2008.pdf.

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out of the perceived need for a simple, predictable, low-cost procedure for Issuers of

tax-exempt bonds and conduit borrowers ¹¹⁸ of tax-exempt bond proceeds to voluntarily

correct violations of federal tax law based on the TEB Subgroup’s concern that the then

current voluntary compliance program would be unable to accommodate the anticipated

dramatic increase in voluntary assessments of post issuance tax noncompliance. At that

time, the TEB Subgroup recommended that certain relatively common violations could

be dealt with on a more streamlined basis, without the need for costly, time consuming,

individualized negotiation. The possible covered violations included:

Failure to timely invest a refunding escrow in State and Local Government Series securities (SLGS).
Non-compliance with the “mixed escrow” rules of Treas. Reg. Section 1.1489(c)(2).
De minimis nonqualified use of bond-financed facilities.
Change of election as to the applicable low-income test under IRC Section 142(d) for exempt facility private activity bonds for “qualified residential rental projects.”
Excess use of bond proceeds to pay issuance costs in violation of IRC Section 147(g).
Use of bond proceeds for projects not included in original TEFRA notice.
Violation of the 120 percent economic life limitation under IRC Section 147(b).
Change in use of financed facilities without ability to take remedial action; for example, because of noncompliance with applicable time periods under the remedial action regulations.
- Change in use of financed facilities subjecting interest on the bonds to the alternative minimum tax (AMT) and not qualifying for Rev. Proc. 97-15.
- Failure to make a timely identification of a hedge under Treas. Reg. Section 1.148-4.

118 A borrower of bond proceeds in a conduit financing.

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In June 2010, the TEB Subgroup produced a report entitled “Improvements to the

Voluntary Closing Agreement Program for Tax-Exempt, Tax Credit and Direct Pay

Bonds” ¹¹⁹ (2010 Report). That report made specific recommendations with respect to

the then current TEB VCAP, including proposed forms of closing agreements and the

streamlined closing agreement program (SVCAP) for tax-exempt and tax-advantaged

bonds. The 2010 Report recommended additions and changes to make VCAP and

SVCAP more inclusive, more flexible and less costly to administer.

Effective April 1, 2017, the IRS implemented new audit procedures and best practices.

Under these procedures, the IRS will send a letter to the Issuer indicating that an audit

has commenced. The agent has the option to either include an Information Document

Request (IDR) with the letter or call the Issuer to discuss the document requirements

before sending the IDR. If the agent mails the IDR with the initial contact letter, the

agent will discuss the IDR with the Issuer during an initial call and, if necessary, tailor

the IDR and timeline.

Support for the Project

The TEB Subgroup took multiple steps to validate support for this project. The

Subgroup solicited information from representatives of constituencies within the tax

advantaged bond community and the IRS. The goal was to confirm their views as to the

worth of the project, to solicit ideas as to how an effective program might work, and to

identify substantive problems which might be appropriately addressed under such a

program. Christie J. Jacobs, Director of Indian Tribal Governments and Tax-Exempt

Bonds, and Bob C. Griffo, Tax Law Specialist/Technical Advisor, were extremely

supportive of this project and provided background information. The TEB Subgroup also

discussed this project with several tax attorneys at Issuer bond counsel firms to assess

the needs of the tax-advantaged bond community. Finally, the TEB Subgroup consulted

119 https://www.irs.gov/pub/irs-prior/p4344--2010.pdf.

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with the EP Subgroup of the ACT to discuss voluntary compliance programs which have

been implemented with respect to qualified employee retirement plans.

The Project

The TEB Subgroup believes that additional revisions are needed to the TEB VCAP to:

Contain defined rules to calculate standard Resolution Amounts agreeable to Issuers and the IRS while still allowing for negotiations in unusual fact situations;
- Use an approach based on when the violation is discovered and reported, and who discovers it;
- Incorporate the severity of the violation and the size of the Issuer;
- Ensure that the correction process is cost effective for the Issuers and efficient for the IRS;
- Encourage Issuer compliance and self-correction; and
- Provide finality for the Issuer without burdening IRS resources.

The current TEB VCAP process is defined in Section 7.2.3 of the IRM and Notice 2008

Therefore, this proposal falls within the scope of the TEB Subgroup and the IRS

TEB Group’s authority.

The Need for Change

In general, the current TEB VCAP procedures contain factors that discourage voluntary

Issuer compliance. These include:

The costs associated with making a submission.
The payment amount to resolve the violation (Resolution Amount) is based on the present value of the bondholder’s calculated tax liability if the bonds were declared taxable (referred to as Taxpayer Exposure of the bond issue). Unless specifically instructed otherwise or a more accurate measure of the particular bondholder’s tax rate is available, the average investor’s highest tax bracket is 29 percent. ¹²⁰ This rate was first defined in Rev. Proc. 97-15 and is contained in the

120 This rate should be lowered, following the enactment of Public Law No. 115-97, 131 Stat. 2054 (2017), also referred to as the Tax Cuts and Jobs Act.

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Computation of Taxpayer Exposure section (4.81.6.5.3.1) of the IRM. For purposes of determining Taxpayer Exposure, bonds that have been called for redemption and defeased by a defeasance escrow are considered outstanding until their actual date of redemption.

The Resolution Amount paid by the Issuer is equal to 100 percent of the Taxpayer Exposure if the settlement is requested within six months of the violation and increases to 110 percent if the submission is more than six months and less than one year after the violation. The IRM does not have prescribed Resolution Amounts if the settlement occurs after one year. At that point, the amount becomes subject to negotiation.
The settlement amounts are negotiated in a labor-intensive process involving the Issuer’s tax counsel and IRS resources.

The Suggestion

The TEB Subgroup suggests a general approach for increasing voluntary compliance

following the Rebate Failure previously discussed. The approach consists of:

Resolution Amounts are readily determinable.
The window to avoid an additional penalty is based on discovery rather than the occurrence of the violation.
The Resolution Amount and any underpayment interest accrues from the date of the violation.
An additional penalty amount is required if the correction is not made within a defined period after Issuer discovery.
The IRS has a defined time limit to review and approve the Issuer explanation and settlement rather than beginning negotiations.
- If the violation is discovered by the IRS while the issue is under audit, the Issuer is responsible for the maximum Resolution Amount.

The key to implementing the suggested approach for the remedial actions listed in IRM

Section 7.2.3 is to define a readily determinable Resolution Amount. While it is beyond

the scope of this document to determine the parameters of the formula for calculating

an acceptable Resolution Amount and the amount of any potential penalty, the TEB

Subgroup’s suggested approach is to have a Resolution Amount that is not subject to

negotiation except in unusual situations, so that Issuers will have a defined amount on

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which to base their correction approach. The TEB Subgroup also suggests that a

threshold be established to eliminate the filing requirement for de minimis violations.

The establishment of criteria for de minimis violations is also beyond the scope of this

report.

Issuers and the IRS benefit from a Rebate Failure approach for self-monitoring and self

correction:

Issuers can make approved corrections with minimal costs.
The IRS would not have to devote substantial resources to the program.
It would encourage self-policing and self-correction for the majority of the Issuer population without the IRS’s direct involvement.
The IRS would be able to devote more of its scarce resources to unusual situations and a data driven audit process to efficiently administer compliance violations.

The fear of an examination of a particular obligation (and the resulting potential liability

and penalties) may not be enough to ensure Issuer post issuance compliance. The IRS

should encourage self-policing by Issuers to self-correct and self-report violations. To

entice Issuers to implement compliance programs and self-report violations, the current

TEB VCAP needs to be revised to provide sufficient incentives to encourage Issuers to

participate. The correction options must be simple, cost effective and encourage self

compliance by providing an economic incentive for Issuers to actively monitor and self

correct violations.

Why Now?

For 2018, the IRS has announced that it will rely on a new data driven approach for

examining tax-advantaged obligations. The TEB Subgroup and the individuals with

whom this approach was discussed believe that the suggested changes contained in

this report together with the revised audit approach that was implemented in April 2017

would allow the IRS to focus scarce resources on Issuers with the most potential for

noncompliance. In developing an effective examination and correction program, the IRS

faces several challenges:

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Resources are Shrinking and the Workload is Increasing - TEB Field Operations, which is responsible for bond examinations, is expected to have only 19 agents conducting examinations by June 2018, down from 23 at the Oct. 1 start of the fiscal year. For comparison, in 2009 the TEB Field Operations had 60 agents, six managers, five support staff, and a technical adviser. On the enforcement side, the IRS expects to close 577 examinations in the TEB Field Operations in fiscal 2018, which began on Oct. 1, 2017 and ends on Sept. 30, 2018. That is significantly down from the 717 closed examinations in fiscal 2017, but slightly higher than the 570 concluded in fiscal 2016 and the 569 in fiscal 2015. ¹²¹ The reduction in resources and reduced number of examinations may lead some Issuers to conclude that the probability of examination is so low that instituting a compliance program or participating in the TEB VCAP is not worthwhile.
- Volume of smaller issues remains high - Tax-exempt bond issues under $10 million comprise most of the tax-exempt bond issues in recent years. As reported by the IRS Statistics of Income Division, ¹²² for reporting years 2006 – 2015 (information most readily available as of the date of this report), the number of issues of tax-exempt bonds with par values under $10 million constituted approximately 80 percent (122,296 out of 153,686) of the total number of all issues of tax-exempt bonds issued during the 10-year period. The par amount of all tax-exempt bonds with par values under $10 million comprised approximately 11 percent ($220 billion out of $1,978 billion issued) during that same 10-year time period. The large number of small issues may also lead some Issuers to conclude that the probability of examination is so low that instituting a compliance program or participating in the TEB VCAP is not worthwhile.
- Reduction in Tax Rates - As a result of the Tax Cuts and Jobs Act reduction in corporate and many individual tax rates, the Computation of Taxpayer Exposure tax rate should be reduced. The TEB Subgroup believes that the 29 percent Taxpayer Exposure rate should be revised as a result of the changes in the tax rates for exposure amounts that include the 2018 tax year and thereafter. Reduction of the potential Taxpayer Exposure could also reduce the incentive for Issuers to institute compliance programs and participate in the TEB VCAP. The TEB VCAP AMT adjustment under IRM 4.81.6.5.3.4 should also reflect the elimination of the corporate AMT by the Tax Cuts and Jobs Act for tax years beginning after 2017.

Based on these factors, the risk of an examination of a particular issue (and the

resulting potential liability) may not be sufficient to ensure post issuance compliance.

The IRS should encourage self-policing by Issuers to self-correct and self-report

121 The Bond Buyer published December 28, 2017 – 2018 Outlook: IRS implementing data driven muni bond audits. 122 https://www.irs.gov/statistics/soi-tax-stats-tax-exempt-bond-statistics.

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violations. To entice Issuers, particularly small Issuers with few resources, to implement

compliance programs and self-report violations, the TEB VCAP should be revised to

provide sufficient incentives to encourage Issuers to participate. The correction options

must be simple, cost effective and encourage self-compliance by providing an economic

incentive for Issuers to actively monitor and self-correct violations.

How Do You Get Issuers to Comply?

After digesting the due diligence, the TEB Subgroup determined that the best means to

promote compliance would be to modify the TEB VCAP to further streamline the

process and eliminate the need for costly, time consuming, individualized negotiations

on the part of the IRS, the Issuer and the Issuer’s tax counsel. The violations covered

by a revised TEB VCAP and the parameters for resolving covered violations should be

evaluated based on multiple criteria to determine an appropriate Resolution Amount

which incentivizes Issuers to implement a compliance program and self-report and self

correct violations.

The most effective way to encourage Issuers to comply is to make it more

advantageous for them to correct violations on a timely basis. That involves:

The ability to know in advance the Resolution Amount and underpayment interest amount arising from noncompliance, in other words, certainty as to treatment.
Having defined grace periods.
Having a penalty that is appropriate to the nature of the violation.
Having a fair and impartial procedure to resolve disputes

These recommendations support the IRS objectives for the TEB VCAP as outlined in

IRM 7.2.3.1.1. According to the IRM, TEB VCAP’s primary objectives are to:

Encourage Issuers to exercise due diligence in complying with federal tax requirements for tax-advantaged bonds.
Ensure others that use tax-advantaged bond proceeds exercise due diligence in complying with federal tax requirements.
Encourage Issuers to voluntarily report discovered violations to the IRS.

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Provide a way to correct these violations expeditiously.

The TEB Subgroup suggests that the IRS consider an expansion of the Self-Correction

portion of the IRM hierarchy beyond the current remedial actions. Such an expansion

would provide closure to the Issuer without significant IRS involvement based on a

standard such as the lack of willful neglect as defined in Rev. Proc. 2005-40 and a

predefined mutually agreeable Resolution Amount.

III. RECOMMENDATIONS

The TEB Subgroup recommends that the existing correction structure be modified to

include an option, similar to the Rebate Failure and reserve the TEB VCAP for unusual

fact situations. This would group the violations into three categories:

Self-Correcting

o Remedial Action

o Standard Resolution (new)

Self-Reporting

o Streamlined Voluntary Closing Agreement Program

o Voluntary Closing Agreement Program

Discovery Under Audit

This structure is similar to the programs used in the EP area and are designed to

encourage compliance, reward voluntary compliance and avoid the costly participation

in a full examination and potential discovery of other noncompliance issues leading to a

large liability arising out of the examination process.

Self-Correcting - Remedial Actions are currently prescribed by regulations or revenue

procedures. The addition of a Standard Resolution would be the Rebate Failure

equivalent for non-rebate liability violations. If the Issuer agreed to pay a predefined

Resolution Amount, with an explanation of lack of willful neglect, within a predefined

time period, the IRS would have a defined time to accept or reject the explanation. If

accepted by the IRS, the violation would be deemed to be corrected. If rejected, the IRS

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would request additional information from the Issuer and work with the Issuer on a

mutually agreeable resolution.

Self-Reporting - This approach, similar to the current TEB VCAP would be used when

the fact pattern is unique and the Issuer cannot use the remedial action provisions or

does not agree with the results of the Standard Resolution.

The Resolution Amount for correcting a violation would be based on the violation, the

timing of its discovery, and the ability to show a good faith effort to remedy the violation

in a timely manner after the violation is identified, similar to the Rebate Failure

provisions. Self-Reporting would require Issuers to file their proposed correction before

being notified by the IRS of an audit.

The Issuer Resolution Amount would consist of three components:

Economic Benefit
Late Interest
Penalty

Economic Benefit - IRM 4.81.6.5 sets forth the basis for entering into closing

agreements which include the Taxpayer Exposure, the amount of income tax liability of

a conduit borrower and the arbitrage benefit received. The TEB Subgroup believes that

the Resolution Amount should focus on a defined formula-driven amount that is

acceptable to both the Issuer and the IRS, subject to negotiations based on unusual or

extreme fact situations. The TEB Subgroup also suggests that the time period for

determining the Resolution Amount would start at the time the violation commenced and

end when the violation is corrected.

Interest - Represents the time value of the Economic Benefit. This would be calculated

based on the IRC Section 6621 underpayment rates from the time the violation

commenced and end when the violation is corrected or on a date 10 days before the

Resolution Amount is paid, to be consistent with Treas. Reg. Section 1.148-3(h)(2).

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Penalty - Any additional penalty should reflect the timing of the discovery of the

violation, whether the violation was self-reported and the good faith effort by the Issuer

to remedy the violation. The TEB Subgroup suggests a grace period of 180 days from

discovery of the violation during which the Issuer could request a waiver of the penalty if

the Issuer can show that the violation was not due to willful neglect. The TEB Subgroup

suggests that if the violation is reported outside of the prescribed time limits, minimal

penalties for self-reporting would be implemented to reward reporting outside the time

limits. These non-audit self-reporting penalties should reflect the length of time from

discovery of the violation and whether an Issuer is a small issuer. The exact penalty

amounts are beyond the scope of this recommendation; however, it should be noted

that those amounts should be minimal to incentivize self-reporting and self-correction

(for example, $1,000 for every six-month delay).

De Minimis Violations - The TEB Subgroup recommends that a standard be developed

for what constitutes a de minimis violation that would be an exception to the need for

reporting. The IRS has used such an approach in other areas relating to tax-advantaged

obligations, including in the regulations which establish the “spending exceptions” for

arbitrage rebate under IRC Section 148 and Treas. Reg. Section 148-7(b)(4). Under

these rules, the final benchmark for the 18- or 24-month spending exception is not

violated if the unspent proceeds amount is less than $250,000 or three percent of the

issue price. The TEB Subgroup suggests that the IRS consider a de minimis Resolution

Amount or a tax-advantaged obligation par amount that would exempt the Issuer from

the formal correction process.

The Resolution Amount would be based on the sum of the Economic Benefit, Interest

and Penalty that reflected who discovered the violation and when the violation was

reported. Issuer Self-Correcting violators would pay the lowest percentage of the

Economic Benefit and would not be subject to a Penalty if the discovery was reported

within the prescribed grace period. Issuer Self-Reporting would require the payment of a

higher percentage of the Economic Benefit, but not 100 percent, and would not be

subject to a Penalty if the discovery was reported within the prescribed grace period.

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Discovery on audit would require the payment of the full Economic Benefit and Penalty

as a result of being discovered by the IRS.

Benefits to the IRS

The benefits to the IRS of the proposed changes in the TEB VCAP are:

The implementation of a Standard Resolution that would limit the negotiation process and allow the IRS to review an Issuer’s explanation and approve or decline the request more efficiently.
By creating a category of De Minimis Violations, the IRS would eliminate the effort associated with small settlements and encourage self-correction for less significant failures.
The creation of the Standard Resolution and exception for De Minimis Violations would allow the IRS to devote its resources to more significant violations.
The implementation of this approach would increase Issuer compliance and selfcorrection, reduce the population of violators and allow the IRS to focus its resources on the data driven audit approach and target a smaller population of perceived violators.

The reduction of the population of potential violators would allow the IRS to stimulate

post issuance compliance by more effectively using resources and sending a message

to Issuers that it is more cost effective to be in compliance.

Benefits to Issuers and Conduit Borrowers

The benefits to the Issuers are:

The responsibility for compliance is linked directly with the benefits of compliance.
Issuers will be able to better ascertain in advance the cost of non-compliance.
The cost/penalty is reasonably based on the nature, extent and severity of the violation.
It removes the adversarial nature of existing procedures.
Issuers will have more certainty regarding their potential liability.

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If a payment needs to be made, the Issuer will be able to quantify and justify the savings realized by being proactive and will have an incentive to self-report.

The addition of the Standard Resolution and changes to the TEB VCAP will encourage

Issuers to self-monitor and be in compliance with their post issuance compliance

because of the reduction in the level of time and effort to correct violations.

Implementation

The TEB Subgroup recognizes that the revision to the existing program requires an

appropriate procedural vehicle to accomplish the revisions. The choice to use a revenue

procedure, a notice, IRM amendments or some combination of these approaches is

beyond the scope of this recommendation. However, the TEB Subgroup has

consciously limited its suggestions to those areas that would not appear to require

statutory revisions and are within the scope of the TEB Group’s authority.

The key to implementing the Standard Resolution and creating a De Minimis Violation

exception is to limit negotiations inherent in the current process and reduce the

regulatory and administrative burdens imposed on Issuers and the IRS.

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