The Virgin Islands Public Finance Authority will pay the Internal Revenue Service $13.6 million to settle a tax dispute over $219.49 million of bonds issued it in 2006.
The settlement agreement, which would preserve the tax-exempt status of the bonds, was approved by the Virgin Islands Senate on Tuesday and was first reported by The Virgin Islands Daily News.
The U. S. territory in the Caribbean issued the 2006 bonds to finance some capital development projects, pay a termination fee for a 2003 interest rate swap agreement, and advance refund a portion of its long-term working capital bonds issued in 1999, according to the official statement.
The settlement stems from a random audit of the 2006 bonds the IRS began in March 2012.
A portion of the 2006 bonds partially refunded $299.88 million of revenue bonds that the authority issued as long-term working capital bonds to address the cash flow needs of the government.
Under federal tax rules "working capital" is defined as "any expenditure that is not a capital expenditure." General arbitrage rules say that proceeds can be allocated to working capital expenditures only when there are no other available amounts.
With long-term capital bonds, the issuer has to ascertain that it does not have available funds as long as the bonds are outstanding. If the issuer has available funds, or a surplus on an annual basis, it needs to either use those funds to retire the outstanding bonds or set them aside in a restricted account.
Michela Daliana, partner with Hawkins Delafield & Wood LLP, the territory's current bond counsel, who was not involved in the original transaction, negotiated the settlement with the IRS.
"Working capital financings are fraught with peril," Daliana said. "The code looks to working capital financings in the context of a balanced budget which has to tie out at the end of the fiscal year."
Daliana said that the analysis of the territory's bonds began to break down when there was no evidence of a cash flow deficit. Based on an analysis of the audited financials, the auditor and Daliana concluded there was approximately $80 million in available funds.
Working capital funds are fungible and it's difficult to apply tax law when it's all about cash flow, she said.
"You need to go through an analysis that is very painstaking to make sure you've identified whether amounts are available or not available and what the offsets might be and justify the sizing and timing of the bond issue," she said.
Daliana said the current financial condition of the Virgin Islands government was "seriously" taken into consideration when crafting the settlement agreement with the Service.
"It's heartening to see that was given weight in coming to the settlement that was arrived at," she said.
The Virgin Islands' gross domestic product fell 13.2% in 2012, according to the Bureau of Economic Analysis, primarily due to oil refinery HOVENSA shuttering in early 2012. It was the territory's single-largest employer and primary supplier of fuel.
The territory, which is heavily dependent on tourism for revenue, saw a sharp decline in tourism in 2012.
UBS Investment Bank was underwriter for the 2006 bonds. Bank of American Securities LLC was financial advisor. Buchanan Ingersoll & Rooney PC was bond counsel.
