IRS Probing Diversion of Muni Bond Earnings

The Internal Revenue Service is looking into whether derivatives were used to divert from the U.S. Treasury investment earnings on proceeds from some 50 municipal bond issues, a top official said Tuesday.

Mark Scott, head of the IRS’ municipal bond unit, said the structures used to divert the earnings varied among the deals under audit. But he said issuers should be suspicious if, for example, underwriting banks promised that a derivative deal would pay for issuance costs.

“If it all just sounds too good to be true, you should be very suspicious about whether the derivative is being used to divert arbitrage,” Scott said.

Arbitrage in the municipal bond market means the difference between the yield of the tax-exempt bonds and the yield from investing the proceeds of the bonds. That difference must be rebated to the Treasury under federal tax laws.

Scott said the IRS had about 100 audits open into suspected schemes to divert arbitrage into bankers’ pockets, whether through derivatives or not.