The Internal Revenue Service is reviewing several taxable Build America Bonds issued in 2009 and 2010 to make sure they complied with tax law, according to a notice on the agency's website.
The IRS is also seeking to understand "practices in the relatively new market for BABs," the notice said.
Build America Bonds were created in last year's economic stimulus plan to spur investment in infrastructure. The bonds have become popular with cities and local governments because they pay a federal rebate equal to 35 percent of interest costs.
BABs have developed a large market share, accounting for nearly a quarter of new debt issues this year. Their success has inspired the U.S. Congress to change other bonds included in the stimulus plan to the same model — taxable debt that pays a federal rebate.
This new model of debt is called "direct pay."
The IRS notice, which is dated Oct. 25, says it is looking into whether issuers complied with limitations on premiums, capital spending requirements and limits on issuance costs. It is also looking into when BABs may be retired.
States and local governments selling the bonds are concerned about losing the federal rebate or having the payments delayed if the U.S. government says they have violated securities laws.
The IRS offered some reassurance in the notice, saying it is "committed to further developing its compliance programs for direct pay bonds similar to its compliance programs for tax-exempt bonds."
The tax authority expects "examinations of direct pay bond issues will be roughly proportional in its overall examination program for tax-exempt bonds."
Currently, if the IRS suspects an issuer has violated tax laws on traditional municipal bonds — which pay interest that is exempt from taxes — it will work with the issuer to bring the bonds in line with the law.
Usually it deems the interest payments taxable only as a last resort. That strips the debt of its most attractive feature to potential buyers.
The IRS said it will create new resolutions for violations of securities laws that are unique to direct-pay bonds, and is considering how to "resolve violations on a basis proportional to the violation."
In an interview with Reuters last week, the Securities and Exchange Commission's head of municipal bond enforcement, Elaine Greenberg, said that agency is also concerned with the tax treatment of the bonds.
"Disclosures relating to the tax treatment of municipal securities, whether you are dealing with tax-exempt bonds or taxable BABs, are of great interest to the SEC," she said.
The SEC, Treasury Department and IRS are all working together to identify potential problems with the new debt, specifically how the bonds were priced for offering.
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