Magazine article Government Finance Review

Yield Burning: Federal Agencies Should Pursue Violators Instead of Victims

Magazine article Government Finance Review

Yield Burning: Federal Agencies Should Pursue Violators Instead of Victims

Article excerpt

Since the summer of 1996, state and local government issuers have faced the prospect of being compelled to enter into closing agreements with the Internal Revenue Service (IRS) to protect the tax-exempt status of advance refundings because of possible overpricing by bond underwriters - yield burning - in connection with the investment of the advance refunding bond escrows. Now the IRS, along with other key federal regulators, appears to be on the right track in solving the yield-burning problem by going directly after the bond underwriters.

Yield burning refers to the practice of artificially depressing yields on Treasury securities sold to state and local governments by inflating the sale prices of those securities, thus "burning" the yield on the portfolio of securities down to the yield required for an advance refunding escrow. This practice transferred arbitrage profit to those who sold the securities to state/local governments. Arbitrage profit is earned by investing tax-exempt bond securities in higher-yielding investments. If arbitrage profit is not rebated to the U.S. Treasury, the tax-exempt bonds are so-called arbitrage bonds, and the federal tax law provides that interest earned on those bonds is not exempt.

In the case of advance refunding bond escrows, the yield-restricted rate may be arrived at in either of two ways. First, the escrow funds may be invested in U.S. Treasury's State and Local Government Series (SLGS) at the exact yield-restricted rate. Because of the inflexibility and costliness of the SLGS program, however, state and local governments have tended to use the more cost-effective open market Treasury securities. Second, escrow funds may be invested in open-market Treasury securities. Yields on these Treasury securities generally exceed tax-exempt yields, so the yield-restricted rate may be reached by blending the higher yield open-market securities with the restricted yield by the purchase of special zero-interest SLGS.

In July 1996, the IRS released Revenue Procedure 96-41, which outlined a voluntary closing agreement program for advance refunding escrows of state and local bonds. This procedure permits issuers to make a payment to the Treasury equal to the excess amount paid for the securities over the so-called "spot" price, which is defined in the Revenue Procedure as the noncontingent price on the trade date for delivery on the next date. Failure to enter into such an agreement can lead to bonds being declared taxable. The Revenue Procedure, which is intended to protect the tax-exempt status of advance refunding bond issues affected by escrow overpricing, in fact holds the victims of this practice accountable for the overpricing.

Revenue Procedure 96-41 has been severely criticized by state and local municipal bond issuers. Among other things, it 1) penalizes issuers, rather than the bond underwriters who profited from the yield-burning practices, 2) retroactively imposes new legal standards that are at odds with industry practices, 3) fails to provide any guidance on how to review escrow pricing, and 4) is still being relied upon for enforcement by IRS agents in their audits of state and local government bond issues, even though the Department of Treasury has provided no further guidance. Many issuers, on advice of counsel, followed the standard industry practice of obtaining fair market value certifications from securities providers who sold them open market Treasuries for advance refunding escrows. …

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