BY MIKE SOLET
The much-publicized IRS audit of the Mission Ridge project in Montana has been resolved favorably, with the IRS concluding that the bonds are not “arbitrage bonds” and remain tax-exempt. The IRS audit had focused on CCRC entrance fees and the technical issue of whether the CCRC erred in not treating its accumulated entrance fees as “replacement proceeds”, which would have required the investment of such funds in a manner that did not produce a yield exceeding the yield on the audited bonds. On February 8, the IRS Chief Counsel’s office issued a Technical Advice Memorandum (TAM) holding that, although the entrance fees were pledged as collateral for the bonds as part of a general revenue pledge, the bondholders did not have reasonable assurance that the accumulated entrance fees would be available to pay debt service on the bonds in the event that the borrower encountered financial difficulties, and accordingly were not subject to investment restrictions. This audit has been in the works for over four years and was followed by a number of other audits of similar arrangements around the country.
The fact that the tax-exemption of these bonds was challenged by the IRS had puzzled many practitioners, issuers and bondholders, as such facts as were known about this CCRC did not suggest that this was anything other than a garden variety revenue pledge. Moneys that are affirmatively pledged as collateral generally are not considered to be subject to investment restrictions under the arbitrage rules if the borrower can use such funds to pay operating or other expenses without the consent of other parties so that the bondholders cannot count on such amounts being available to pay debt service – this is what bond counsel sometimes refer to as a “defeatable pledge.”
A TAM is like a private letter ruling, except that it arises in the context of an audit, not before. This TAM will resolve this audit. Will the IRS now retreat in the other pending cases? Perhaps not. These cases are inherently fact-specific. Here the IRS audit staff made numerous arguments based on the documents as well as accounting principles, all of which seem to have been rejected by the Chief Counsel’s office. However, a different deal will have different documents and restrictions. In addition, an important factor here was that the borrower in fact was using a substantial amount of the accumulated funds to pay operating expenses. In other cases it may be less clear that the borrower is not relying upon the accumulated entrance fees to pay debt service. How much accumulation is too much accumulation? That could be the battleground in future cases.
While this audit was about entrance fees, the final paragraph of the TAM, in which the favorable conclusion is delivered, refers to a nexus between “the entrance fees (and other revenues) and the Bonds” (emphasis added), thereby making clear that this issue is presented by every revenue pledge, not just entrance fees in a CCRC deal.