The Pennsylvania Higher Education Assistance Agency (PHEAA) has paid $12.3 million to settle tax-law violations and protect the tax-exempt status of its student loan bonds.
Municipal market participants said the closing agreement with the Internal Revenue Service is the first publicly dislosed settlement related to charges that an issuer violated tax requirements by swapping or transferring student loans to different bond issues.
The PHEAA described the agreement in a recent event notice filed with the Municipal Securities Rulemaking Board.
Observers said the agreement could have a domino effect and lead other issuers to reach similar settlements with the IRS.
The issue of swapped or transferred loans has become an increasing concern of the agency during the past three years, even though some bond lawyers have urged issuers to challenge the IRS’ position.
“Once an issuer settles, it becomes harder for others to say, 'This isn’t a problem,’ ” said a tax lawyer who did not want to be identified.
“When one issuer settles, it’s harder for others to hold out,” said another tax lawyer, who also did not want to be named.
Swapping or transfers of student loans occur when an issuer allocates loans to student loan bonds other than the ones used to finance those specific loans.
Under federal tax rules, the yields on student loans cannot be more than 2% above the yields of the bonds that were used to make the loans. The IRS has become concerned that issuers have been tying higher-yielding student loans to higher-yielding student loan bonds to ensure they stay under the 2% limit and are not forced to make yield reduction payments to the federal government.
Lawyers pointed out that historically many student loan bonds were auction-rate securities where the proceeds were used to make student loans that were guaranteed by the federal government under the Federal Family Education Loan program.
The issuers received special allowance payments from the U.S. Department of Education so they could make loans to students at lower rates, with the payments varying according to short-term Treasury rates. The program was eliminated in June of last year, but many FFEL loans are still outstanding.
In some cases, issuers have trouble matching the floating-rate bonds and loan payments. Swaps or transfers also can occur if an issuer sells refunding bonds and uses the proceeds to redeem previously issued higher-yielding bonds, then transfers loans made from the refunding bonds to other bond issues that have more cash than needed to pay principal and interest — cash that was obtained from loan repayments or sales of loans.
In its notice, the Pennsylvania agency said the $12.3 million covered $5.4 million already on its books from student loan yields over the 2% limit.
“The balance was paid from nonindenture funds pursuant to the original $3 million loss contingency [accrued in its financial statements as of Dec. 31, 2010] and an additional lost contingency of $3.9 million recorded during the three months end[ing] Sept. 30, 2011,” the PHEAA said.
The IRS began auditing about $150 million of the agency’s tax-exempt student loan bonds in May 2008. Almost a year and a half later, in November 2010, the IRS expanded its audit to cover all of the PHEAA’s tax-exempt student loan bonds issued in August 1997. The agency had issued about $7.4 billion of student loan bonds, only about 10% of which were tax-exempt.
All of the bonds were in the form of auction-rate certificates. Last year, about $639 million of the tax-exempt bonds were still outstanding. But the PHEAA issued a tender offer for most of the bonds that was completed in July. As a result, only about $205 million of the tax-exempt bonds remain outstanding.
Because the IRS has a three-year statute of limitations, the closing agreement only covers the tax-exempt bonds outstanding from 2008 until they mature or are redeemed, sources said. In other words, the tender offer significantly reduced the time frame of tax liability for many of the bonds.