CDFA Spotlight: IRS Audits Increase Interest Rates By Stan Provus

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This article covers the market effects of municipal bond tax audit disclosures. This subject has become of greater interest over the past decade as the IRS has increased the number of audits. The article rests on research by Lori Trawinski, formally of the Bond Market Association research staff.

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This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel.

Research conducted by the Bond Market Association (BMA) shows that interest rates on variable-rate demand obligation tax-exempt bonds clearly rise when news of an IRS audit is made public. Empirical evidence on long-term, fixed rate bonds is inclusive on the question of the market effects of IRS bond issue audits. However, there a considerable amount of qualitative information that supports the notion that an announcement of an IRS audit leads to a reduction in liquidity for long-term, fixed rate issues as outstanding investors chose not to sell bonds to wait out audits and secondary market investors like bond funds elect not to purchase bonds subject to the uncertainty of IRS audits.

It should recognized that just the announcement of an IRS audit increased rates on variable-rate demand obligation bonds. Most IRS audits are closed with no change in the tax-exempt status of the bond. Where the IRS finds an issue taxable, the issuer almost always reaches a settlement with the IRS in order to keep the bonds from becoming taxable, protecting bondholders from having to pay taxes retroactively to the date of issuance.

The BMA research examined eleven variable rate issues for which there was market interest rate data several months before and after the announcement of an IRS audit. The average spread over the BMA variable rate index (“Swap Index”) before the announcement of an audit was 26 basis points. The average spread of the eleven issues examined after an announcement of an audit increased to 106 basis points or more than four times the pre-audit spread.

The BMA research could not find similarly conclusive evidence for long-term, fixed rate bonds. This is largely because, unlike VRDO bonds that trade weekly or daily, long-term, fixed rate bonds trade much less frequently. There were not enough secondary market trades before and after an audit to statistically make conclusions on the market effects of audits on longer, fixed rate issues.

In addition, due to the complexities of quantifying the many factors that drive new issue pricing, the MBA could not draw any conclusions on the effects of audit disclosure on new issue costs in the primary market for issuers who had other bonds under audit. However, some issuers have reported audits on outstanding bonds made it difficult to place new issues at reasonable cost.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.