In past years, the Internal Revenue Service has promised a strong new enforcement program for tax-exempt financing. The first installment of this program has surfaced in hospital acquisition financings. The 1990's explosive growth of health care industry acquisitions, mergers and consolidations ("M&A transactions") has recently become the focus of intense scrutiny by the IRS in a number of transactions which involved tax-exempt financings. These hospital acquisition financings have been targeted for retrospective review by the IRS Bond Enforcement Program.
In its Fiscal Year 2000 Employee Plans/Exempt Organizations workplan, the IRS stated that, in the tax-exempt bond area, it would examine the acquisition of one health system by another and mergers between not-for-profit health systems where the transaction involved use of tax-exempt financing to refinance existing tax-exempt debt. Historically, the IRS has been slow in commencing action on workplan items. However, this is one workplan item on which the IRS has already moved.
In the last few weeks, a number of large and prestigious non-profit health systems have announced that their bond issues are being examined by the IRS. The speed with which the IRS has begun implementing its FY 2000 workplan shows that the newly restructured TE/GE Division of the IRS, especially the Tax-exempt Bond Segment, is sending a message that it will be aggressive in examining novel financing techniques before they become commonplace. Mark Scott, the National Director of Bonds, recently stated that the IRS will probably audit 10 or more transactions in this area.
Of course, each M&A transaction has its own facts and circumstances and whether bonds issued in connection with an M&A transaction are tax-exempt will necessarily depend upon the structure of that particular transaction. The M&A transactions have generated considerable publicity and affected the secondary market for the bonds. Therefore, although the IRS is sensitive to the need for a quick resolution of the audits, it also wants to be cautious in formulating its legal position regarding such transactions. Accordingly, the IRS believes that it must examine a number of M&A transactions before determining whether a particular transactional structure violates the tax-exempt bond rules.
The audits have caused nervousness in the bond market and have resulted in immediate increased interest costs to the affected health systems; thus, depriving them of much needed cash. Also, audit responses are time-consuming and costly to defend.
Initiation of the Audits
In the Spring of 1999, the IRS initiated an examination of approximately $583 million principal amount of bonds issued on behalf of MedStar Health in connection with the merger between Medlantic Healthcare and Helix Health. The size of the transaction, the unique legal issues and use of tax-exempt financing to accomplish the merger and acquisition, generated considerable publicity. As a result, the IRS began an audit of this transaction almost immediately after the bonds were issued. Since the IRS commenced the audit, the interest rates on Medstar's variable rate bonds increased about 1.5 percent, costing the system approximately $4.5 million in additional financing costs.
Last month, Ascension Health disclosed that the IRS was examining a least a portion of the $2.4 billion principal amount of bonds issued to finance the merger between Daughters of Charity National Health System and Sisters of St. Joseph Health System. The yield on the variable rate bonds has been affected by the examination, resulting in higher interest costs of about $50,000 per week to Ascension Health.
Last month, two prominent Texas-based health systems announced that the tax-exempt bonds used by them to accomplish a merger were under IRS scrutiny. Texas Health Resources, Irving, Texas, used $703 million of tax-exempt bond proceeds in connection with the merger between Presbyterian Healthcare Resources and Harris Methodist Health System. Christus Health, Irving, Texas, used $499 million in tax-exempt bond proceeds for its creation as a result of the merger between Incarnate Word Health System, San Antonio, and Sisters of Charity Health Care System, Houston.
Despite statements issued by health systems, issuers and their bond counsel that such M&A transactions are fairly standard, the IRS does not share their assessment. IRS personnel, through speeches and interviews, have said that the IRS has significant questions about the tax-exempt status of some of the bond issues.
Although the structure of each transaction varies, typically, two unrelated not-for-profit health systems, each involving a number of subsidiaries and hospitals, merge into each other, creating a new health care system (the "new system"). Each system has tax-exempt bonds outstanding that were used to finance its facilities. As a result of the consolidation, the new system determines that it is prudent to refinance the existing bonds and restructures all of the existing debt. To accomplish the restructuring, the new system uses tax-exempt bond proceeds either to purchase the membership interest in the two systems or to acquire the assets of the two health systems. Simultaneously with the merger, the new system uses the proceeds of the new bond issue to prepay or defease the outstanding bonds.
The Internal Revenue Code provides that tax-exempt bonds may be advance refunded only once. If the prior bonds have previously been advance refunded, the new system may not advance refund them again with tax-exempt bonds. However, if the new system acquires the assets and liabilities (including the prior bonds) of the two prior health systems and refinances the prior bonds, the new bonds are not treated as refunding bonds. Rather, the new tax-exempt financing is treated as an acquisition financing. Therefore, the limitation on advance refundings is not applicable. For the new financing to be an acquisition financing, however, the new system must be unrelated to the two prior health systems.
In examining an M&A transaction, the IRS is essentially determining whether the transaction is an impermissible advance refunding or a permissible acquisition financing.
An Examination Begins With the Issuer
The IRS conducts examinations of bond issues at the issuer level, and for purposes of the examinations, treats issuers as the taxpayers. This is true even if the proceeds of the bond issue have been loaned by the issuer to a health system as the borrower. Consequently, all letters initiating an examination of a bond issue are sent to the issuer, not to the health system. Nonetheless, because the bonds were issued to benefit the health system, if the IRS determines that the interest on the bonds is not excludable from gross income, the party that bears the most financial risk (other than the bondholders) is the health system. Additionally, as with Ascension and Medstar, until the examination is resolved, the health system may be burdened with increased interest costs on its variable rate debt. Because the issuer is merely a conduit, the health system also can be liable for the legal fees and expenses caused by the audit.
Because the IRS treats the issuer as the taxpayer, the IRS is not permitted to disclose any information regarding the audit to third parties, including the health system, unless the issuer has executed a disclosure waiver consenting to such disclosure. Therefore, as soon as the health system learns of an audit of its bond issue, it should request that the issuer execute a disclosure waiver permitting the IRS to directly communicate with the health system. Considering that the health system will bear the financial costs associated with the audit — including any closing agreement amount paid to the IRS — it is crucial that the health system secure for itself a primary role during the negotiations with the IRS.
The health system should also consider retaining independent audit counsel. In an audit of a bond issue, the IRS focuses solely on the interpretation of the tax laws; this will require bond counsel to defend its legal analysis underlying the opinion. At some point during the course of the audit, the interests of bond counsel and the issuer may diverge from those of the health system, thus resulting in an uncomfortable and improper conflict of interest situation. The health system is best served if it retains counsel that solely will serve the interest of the health system.
If the IRS makes a preliminary determination that the bond issue is not tax-exempt, it will convey such determination to the issuer (and the health system if the issuer has consented to such disclosure). At this stage of the audit, the health system needs advice from an objective party on how to proceed. The health system must determine whether it is financially prudent for it to enter into a closing agreement or to continue with the audit. If the health system decides that a closing agreement serves its purposes, it must, with the advice of its counsel, determine the terms and the penalty with which it can live.
As noted at the outset, the acquisition financing audits currently being undertaken are only the first installment of a more stringent enforcement program. As additional audits unfold, health systems can expect additional issues to arise. The audit process itself also is developing and is unfamiliar to many tax professionals.