DALLAS — The Internal Revenue Service is withholding up to $1.2 million of direct-payment subsidies for Build America Bonds issued by Austin last year, said Treasurer Art Alfaro.

The federal offset was imposed in a dispute over payroll taxes, and the city is challenging the IRS letter. In the meantime, the city comptroller’s office has shifted funds to the debt-service sinking fund, avoiding any impact on investors, Alfaro said.

In the letter, the IRS says it is withholding $617,284 in interest subsidies due last month, he said. But based on the amount that appears to be in dispute, Alfaro expects the agency to also withhold $673,401 due in September.

“The amount in dispute was in that range,” he said.

Because the 2009 deal was Austin’s first BAB issue, Alfaro said he did not include the federal subsidy in his budget for the debt service. Even without the subsidy, the yields on the 2009 bonds came in well below his target net interest cost of about 5.2%, Alfaro said.

“I figure we saved about $7 million in net interest cost,” he said.

However, he has warned Austin Energy about the offset as the city-owned utility prepares to issue $100 million of BABs to take out commercial paper next month.

“If the offset is citywide, they’re going to withhold your payment,” Alfaro said he told them.

However, the Austin Energy bonds likely would not be subject to the same offset applied to the 2009 bonds.

Ultimately, “we think this is something we’re going to win,” Alfaro said.

He said he has received calls from five or six other cities in the past week asking about the problem.

“I told a couple of people and it’s spread like wildfire,” he said.

Austin is not the first city to encounter the offset problem with BABs.

Marla Bleavins, the debt and treasury manager for Los Angeles World Airports, said recently that the agency’s  BAB payment in April for $307 million of BABs it sold last fall was also reduced to offset employment tax.

After Los Angeles’ accounting staff discovered the subsidy payment was $28 smaller than expected, Bleavins contacted an IRS agent, who told her about the offset and that she was supposed to have received a letter about it.

Alfaro said that the letter came about a week before the subsidy payment was expected.

“At first it was a shock,” he said. “Now that I’ve talked to the attorneys, I’ve kind of calmed down. It’s just a computer-driven formula.”

About 1% of all BAB payments were affected by offsets in 2009, and they only occurred on “past due, legally enforceable debts,” according to John Cross 3d, the Treasury Department’s associate tax legislative counsel.

BAB issuers will likely just have to adapt to the “very limited and minor risk” that their subsidy payments could be offset to pay off outstanding debts owed the federal government, Cross told The Bond Buyer earlier this month.

“If you wanted a statutory change, I think it’s a politically heavy lift,” he said.

Cross said the major potential offsets for issuers are payroll taxes, an issuer default on a federal grant that must be repaid, or if a state or local government provided group health insurance with Medicare as the secondary provider and Medicare paid when the primary provider should have and the payment must be reimbursed.

Austin Energy’s BABs are expected to price June 10 along with $99 million of tax-exempt refunding revenue bonds.

Analysts have affirmed their ratings on the bonds. Moody’s Investors Service rate them A1, while Standard & Poor’s and Fitch Ratings rate them AA-minus. The outlook is stable from all three agencies.

Austin Energy’s sales declined for the first time in 2009, although at a pace similar to that of other power providers, analysts noted.

“While lower-than-average debt-service coverage may be buoyed by a strong cash position, Fitch has concerns regarding the utility’s plans to draw down cash below the AA-minus median levels,” analysts wrote. “Significant deterioration could lead to negative rating action.”

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