Attorney Seeks Exemption of Municipal Bonds From Tax Shelter Opinion Standards

[1] The Investment Company Institute (the "Institute")¹ is submitting this comment letter to express the concerns of its members regarding the impact that the proposed revisions to Circular 230's definition of tax shelter opinions would have on them, both directly and indirectly, as purchasers of municipal bonds² (i.e., as "the buy-side"). The Institute's members are particularly concerned about the effect of the proposed revisions to Circular 230 removing an exception from the definition of tax shelter that currently exists for "municipal bonds."

[2] We understand that the proposal to remove this exception arises from concerns that tax shelter promoters have been creating structures involving tax-exempt bonds to inappropriately avoid taxes and because, in certain limited circumstances, bond counsel have been providing unqualified tax opinions on deals where the very high National Association of Bond Lawyers ("NABL") standard for issuing such opinions has not been met. As you may know, the Institute has strongly supported your efforts to prevent tax shelter abuses in comment letters filed on various aspects of the tax shelter regulations.³ We submit, however, that a complete elimination of the municipal bond exception for Circular 230 purposes will not effectively address the Government's concerns and will harm investment companies purchasing municipal bonds, the shareholders investing in these companies, and the municipal bond market more generally.

[3] Instead, we urge a targeted exception from the definition of tax shelter opinion for unqualified tax opinions that interest on a municipal bond is tax-exempt under section 103.⁴ This exception would have no impact on the use of Circular 230 to address "structure" abuses and any abuses involving qualified tax opinions; our proposed exception would merely prevent the use of Circular 230 for a purpose that it cannot effectively serve.

I. Municipal Bond Funds Rely on Unqualified Tax Opinions

[4] Investment companies that purchase municipal ("muni") bonds (collectively referred to as "muni bond funds") are designed to invest only in bonds paying interest that is tax-exempt (at the federal and, sometimes, state level) when distributed to the funds' investors. This investment objective is prominently disclosed in the funds' offering documents, which are relied upon by investors seeking tax-exempt income. To meet this objective, a fund's adviser must constantly evaluate new bond issues as well as those trading in the secondary market; this evaluation must occur whether the funds are organized as mutual funds, closed-end funds, or unit investment trusts ("UITs").⁵

[5] A muni bond fund generally makes monthly or quarterly distributions of tax-exempt income to its many hundreds or thousands of investors. Each distribution may include interest income attributable to hundreds of different tax-exempt bonds.

[6] Any dispute about the tax-exempt status of a bond typically will occur years after the interest income has been distributed to investors and reported as tax-exempt; recipients may no longer be investors in the fund. Any determination that a bond is not exempt will result in taxability to the fund investors retroactively to the date the bond was acquired by the fund (subject to the statute of limitations). In many cases, the per-investor amounts of additional tax liability with respect to any taxable bond will be quite small. Because of the shareholder relations difficulties arising from sending many hundreds or thousands of IRS Forms 1099-DIV years after the income was distributed (leading to many hundreds or thousands of amended IRS Form 1040 tax returns) and/or the cost to the fund's adviser of otherwise resolving a dispute regarding the tax-exempt status of a muni bond, muni bond funds are particularly averse to bonds that may later be determined to be taxable.

[7] To satisfy their investment objectives and protect their shareholders' interests, muni bond funds seek bonds that provide the highest possible degree of confidence that all interest income is exempt under section 103.⁶ However, the volume of bond deals that must be reviewed on an ongoing basis and the very detailed and technical nature of the factual and legal analysis that must be undertaken to determine that a bond's interest is exempt under section 103 force fund advisers to rely heavily on bond counsel issuing unqualified tax opinions. By design, these opinions typically run to muni bond funds through the bond trustee or otherwise.

[8] The Institute's members have been vigilant in seeking unqualified tax opinions and in reviewing the offering documents; with the Institute's involvement, the Institute's members also have been vigilant in ensuring that the highest standard for providing unqualified tax opinions is maintained. To that end, we applaud NABL for establishing and maintaining an extremely high standard for issuing unqualified tax opinions.

[9] To render an unqualified tax opinion under the NABL standard, counsel must be "firmly convinced that, upon due consideration of the material facts and all of the relevant sources of applicable law on federal income tax matters . . . the Supreme Court would reach the federal income tax conclusions stated in the opinion or the IRS would concur or acquiesce in the federal income tax conclusions stated in the opinion."⁷ Bond counsel is required to conduct the detailed factual and legal analysis necessary in order to deliver an "unqualified" opinion at an extremely high level of confidence. In essence, bond counsel performs a "gate- keeping" function to ensure the issuance of bonds that appropriately meet the requirements for tax-exemption.

II. The Proposed Revisions Would Negatively Impact the Muni Bond Market

A. Proposed Revisions to Circular 230

[10] The proposed revisions to Circular 230 would make two changes to the definition of "tax shelter,"⁸ which presently has an express exclusion for municipal bonds, that are relevant to muni bond funds. First, the definition of what constitutes a tax shelter would be expanded to cover "any . . . arrangement, a significant purpose of which is the avoidance or evasion of any tax imposed by the Internal Revenue Code."⁹ Second, the exception for municipal bonds would be eliminated.

[11] We fully appreciate the need to broaden the definition of tax shelter from the definition presently contained in Circular 230 to address a wide range of potentially abusive situations. Nevertheless, it seems counter-intuitive that a bond paying interest exempt from federal income tax pursuant to a section of the Internal Revenue Code could be treated as a tax shelter precisely because of the federally-provided tax exemption. Yet, this reading seems to follow from the broadened definition of tax shelter and the elimination of the exception for municipal bonds.

B. Impact on Tax Opinion Disclosure

[12] The proposed revisions to Circular 230, if adopted, would radically change the nature of the tax opinion disclosure presently received by the buy-side. As noted above, the muni bond funds that constitute 40 percent of the market strive to eliminate tax risk by buying only bonds with unqualified tax opinions. The unqualified opinion that interest on the bond "is" or "will be" excludable from gross income for federal income tax purposes is, at present, typically no longer than a paragraph or two in a larger opinion of two to three pages overall. In contrast, just the tax opinion disclosure on interest paid by a muni bond, as would be required under the proposed revisions to Circular 230, could itself run 15 to 30 pages or longer.

[13] Under the proposed revisions, the opinion would be required to "identify and consider all relevant facts."¹⁰ There are numerous facts that counsel delivering tax-exemption opinions must consider in determining whether the criteria for tax- exempt treatment are satisfied and whether, where applicable, "private use" of bond-financed facilities is within permissible limits, "arbitrage" restrictions are (or will be) satisfied, and a plethora of other detailed requirements are met. Factual certificates from issuers and/or conduit borrowers required by counsel in connection with delivery of a tax opinion on a municipal bond transaction often run from 30 to over 100 pages, when all exhibits are taken into account. While individual counsel might differ in their conclusions regarding the extent to which all such subsidiary facts must be disclosed, the factual exposition inevitably would be a lengthy one.

[14] The proposed revisions also would require the opinion to include an evaluation of "all material federal tax issues,"¹¹ which would be defined as "any federal tax issue for which the Internal Revenue Service has a reasonable basis for a successful challenge" and which could significantly impact the tax treatment of the interest.¹² In theory, under the currently prevailing NABL standard, counsel could conclude that there are no material federal tax issues that require discussion under the proposed Circular 230 requirements. The Institute is concerned, however, that practical considerations will cause counsel to err on the side of over-disclosure in the opinion. The reason is simple: if counsel delivers an opinion and the IRS challenges the conclusion, even if the opinion is ultimately upheld, the IRS challenge might be deemed reasonable and counsel might be deemed to have violated Circular 230 by not discussing the issue or issues questioned by the IRS. Violation of the Circular 230 requirements may result in censure, suspension or disbarment of counsel from practice before the IRS.¹³ Self-preservation instincts will militate heavily in favor of discussion in the opinion of some or all legal issues analyzed by counsel, however remote counsel believes the likelihood of an IRS challenge. Again, this would result in lengthier opinions.

[15] An additional impact of the proposed revisions to Circular 230 arises because virtually all opinions used in connection with the issuance and sale of municipal bonds would be considered "marketed tax shelter opinions." ¹⁴ Thus, these opinions would need to prominently disclose that, with respect to any material federal tax issue, (1) the opinion may not be sufficient for the purpose of avoiding tax penalties and (2) taxpayers should seek advice based on their individual circumstances with respect to those material federal tax issues from their own tax advisors.¹⁵

[16] The cumulative effect of the lengthy factual exposition and the likely lengthy legal analysis and disclaimers that would follow from application of Circular 230 to municipal bond opinions would be to dilute the clarity of the "clean" and "unqualified" opinions that are currently the norm on such transactions.

[18] Any buy-side participants seeking to thoroughly review and analyze the additional disclosure arising from the proposed revisions to Circular 230 would have a difficult time (at best) effectively processing the information. This difficulty would arise in part because the ability to fully appreciate the tax risks described in the additional disclosure requires a complete understanding of the facts. Even if all of the facts were provided, the buy-side analyst (and/or counsel) would need to review and understand those facts and make appropriate legal judgments. Each of these steps would take time, which could delay purchasing decisions. Lower demand for bonds, caused by delayed purchasing decisions, could impact bond liquidity and prices.¹⁶ Delayed purchasing decisions could also result in funds having uninvested cash on hand. Buy-side costs could increase as a result.

[19] Another possible impact of the proposed changes (and any attempt to discern, based upon a review of lengthy tax opinions, which deals are the "cleanest") relates to shifting of tax risk. At present, for all of the reasons discussed above, tax-exempt bonds issued with unqualified tax opinions effectively trade as if the risk of taxability is zero. One reason for this phenomenon is the general market perception that bond purchasers would have a strong case against the issuer and/or the bond counsel who issued a "clean" opinion on a bond later determined to be taxable. Consequently, these bonds are issued with a yield that assumes no tax risk.

[20] If the market cannot easily distinguish the "cleanest" bonds, because most or all bonds are accompanied by lengthy tax opinions, yields presumably will rise to compensate for the tax risk uncertainty.¹⁷ To the extent that the market also reflects a view that the issuer and/or the bond counsel will somehow be held less responsible if a bond issued with an unqualified tax opinion is determined taxable (because the risks were disclosed somewhere in a lengthy tax opinion), tax risk will be transferred effectively from the issuer and/or the bond counsel to the buy-side. This shifting of tax risk also would affect yields.

III. The Proposed Revisions Will Not Achieve Their Objective and Should be Modified

[21] The proposed revisions to Circular 230 appear to contemplate either that (1) the prospect of additional disclosure of tax issues will prevent bad deals from ever being brought to the market or (2) the buy-side can act as an effective gate-keeper to prevent these bad deals from being purchased. This result theoretically could occur if the buy-side's counsel had (1) sufficient resources and time, (2) complete and timely access to all of the relevant facts that must be understood and evaluated (i.e., access to all of the information presently known to the bond counsel to the deal), (3) complete and timely access to all relevant parties (e.g., the issuer and all of the counsel involved in the deal) and (4) the overall ability to ensure that an issuance is structured in compliance with the tax laws.

[22] Since these four conditions will never exist, the proposed revisions will not achieve their objective. The party in the best position to make the final analysis of a bond's tax-exempt status is the party that presently makes that determination -- bond counsel to the deal.

[23] Ironically, the increased disclosure contemplated by the proposed revisions to Circular 230 (and the resulting over-disclosure on what would otherwise be short unqualified opinions) could encourage the proliferation of bad deals on the market. The buy-side will have an extraordinarily difficult time attempting to distinguish between "good" unqualified opinions and "bad" unqualified opinions since bond counsel to the deal will have an incentive to be overly- cautious and disclose all facts about every issue, even issues that were clearly low-risk under existing rules. Thus, the buy-side will have even less ability than it otherwise might to serve as a gate- keeper.

[24] The Institute appreciates the Treasury's tax shelter concerns regarding certain transactions involving muni bonds. However, we believe that completely eliminating the municipal bond exception from Circular 230's definition of tax shelter would adversely impact muni bond purchasers, and the muni bond market more generally, and could increase the number of questionable deals that make their way into the market.

IV. Proposal

[25] Accordingly, the Institute urges Treasury to modify Circular 230 in a manner that allows it to become an effective, additional tool against abusive tax shelter transactions without unduly disrupting the muni bond market. Specifically, the Institute recommends that Circular 230 be revised to provide that an unqualified tax opinion -- concluding that interest on a municipal bond is exempt to the recipient under section 103 -- is not a tax shelter opinion for Circular 230 purposes.¹⁸ The premise for this proposal is that the tax exemption provided by section 103 does not, in and of itself, convert a muni bond into a tax shelter. Clarification of this point would permit the overwhelming, clearly non-abusive, portion of the muni bond market to continue to function as status quo. Bond counsel to muni bond deals would continue to be permitted to provide "short-form" unqualified tax opinions on muni bond deals without the risk of violating Circular 230.

[26] We also recommend that opinions with respect to those synthetic municipal investments meeting the requirements of Revenue Procedure 2003-84 (or the grandfathering provisions of the Revenue Procedure), whereby the partners generally take into account each month their share of partnership income, be exempt from the definition of tax shelter opinions. While we understand that Treasury has some concerns about income stripping of muni bonds, the transactions covered by the Revenue Procedure are so non- controversial and were so thoroughly (and recently) examined that they should not raise any tax shelter concerns.

[27] We acknowledge that our approach -- which focuses the Circular 230 tax shelter opinion rules on structure issues (including income stripping) and qualified tax opinions -- does not affirmatively address situations where counsel knowingly provides an unqualified opinion on a questionable offering. Nevertheless, for all of the reasons discussed above, we submit that Circular 230 is not an effective instrument for addressing these situations. Instead, the Treasury Department should use other, more effective, available tools for addressing such offerings.

[28] The Investment Company Institute fully supports your efforts to prevent taxpayers from inappropriately reducing their tax liabilities through the acquisition of tax shelters. Abuses involving municipal bonds should not be outside the scope of your efforts merely because of the tax exemption provided by section 103. Nevertheless, efforts to attack these abuses should be targeted, to ensure that the benefits arising from the effort outweigh the costs. We submit that the proposal advanced above achieves that balance. We would be pleased to discuss with you at your convenience our proposal and steps that could be undertaken, if necessary, to address areas of concern to you that would be covered by our proposal.

²Investment companies (organized as mutual funds, closed-end funds and unit investment trusts ("UITs")) held approximately 40 percent of the $1.84 trillion in outstanding municipal bonds (as of September 2003). Of this amount, mutual funds held $623 billion ($289 of which was held by money market funds), closed-end funds held $92 billion and UITs held approximately $17 billion.

³See, Institute comment letters dated September 5, 2002, December 20, 2002, and August 1, 2003.

⁴This proposal, which also covers a few related issues, is discussed in detail in Part IV., below.

⁵Mutual fund advisers are constantly evaluating bonds because mutual funds have actively managed portfolios and are continuously offered to new investors. Closed-end fund advisers also are constantly evaluating bonds for their fund portfolios because these funds also are actively managed, although their shares trade on exchanges and hence are generally fixed in number. While UITs have fixed pools, new trusts are constantly being brought to market; UIT sponsors therefore engage in essentially the same bond analysis as advisers to mutual funds and closed-end funds.

⁶All references to sections, unless indicated otherwise, are to sections of the Internal Revenue Code.

⁷Model Bond Opinion Report, National Association of Bond Lawyers Committee on Opinions and Bond Documents, page 8 (February 14, 2003).

⁸31 CFR § 10.33(c)(2) (proposed).

⁹31 CFR § 10.35(c)(2) (proposed).

¹⁰31 CFR § 10.35(a)(1) (proposed).

¹¹31 CFR § 10.35(a)(3)(i) (proposed).

¹²31 CFR § 10.35(c)(7) (proposed).

¹³31 CFR § 10.50(a).

¹⁴A "marketed tax shelter opinion" is one "that a practitioner knows or has reason to know will be used or referred to by a person other than the practitioner . . . in promoting, marketing or recommending the tax shelter to one or more taxpayers." 31 CFR § 10.35(c)(6) (proposed).

¹⁵31 CFR § 10.35(d)(2) (proposed).

¹⁶The extent to which liquidity and prices would be impacted in the long run would depend on how the market adapted to any new disclosure requirements.

¹⁷In addition, money market muni bond funds -- funds designed to trade at a constant net asset value ("NAV"), typically $1.00 per share -- could have difficulties determining if a bond meets the stringent requirements of SEC Rule 2a-7, which are designed to preserve the shares' constant NAV. If concerns arise about the tax-exempt status of a bond, the value of the bond could drop -- possibly causing the fund to "break the buck" -- even if the bond's tax-exempt status is later confirmed.

¹⁸Our proposal would apply to opinions delivered in connection with both the original issuance of bonds (including refundings thereof) and remarketings. A later IRS challenge of the bond's status would not convert a previously-issued unqualified opinion into a tax shelter opinion.