The City of Industry Urban-Development Agency in California has agreed to pay $500,000 to the federal government to settle alleged tax-law violations and preserve the tax-exempt status of $68.1 million of tax allocation bonds it sold in 2003.

The agency disclosed the settlement agreement with the Internal Revenue Service in a notice that was released this week on the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access system but dated Dec. 9, 2009.

The bonds had been issued to finance the completion of a water distribution system, a highway junction-grade separation project, and the acquisition of property, according to bond documents.

But the IRS had sent the agency a “notice of proposed issue” on Dec. 18, 2008, warning that it had preliminarily determined that the interest earnings on the bonds were taxable “because the agency did not reasonably expect that the bonds could meet the three-year spending requirement” of the tax code.

Under that section of the law, which allows issuers to avoid rebating arbitrage profits, an issuer must reasonably expect to spend 10% of the bond proceeds on the project by the end of the first year after issuance, 30% by the end of the second year, 60% by the end of the third year, and 85% by the end of the fifth year.

City Controller Dudley Lang yesterday said that although the city “sternly disagreed” with the IRS’ preliminary determination of taxability, it agreed to pay the penalty and redeem a portion of the outstanding bonds.

The City of Industry, which is located near Los Angeles, had a population of 800 as of 2005, according to its Web site. However, it is home to several high-tech companies that provide jobs for 80,000 people residing in the San Gabriel Valley Area, according to bond documents.

The agency had disclosed on Jan. 14, 2009 that the IRS was planning to issue an adverse determination that, if not resolved on appeal or otherwise, would make the bonds taxable.

In the same notice, the agency said that it had hired counsel to represent it and would work with the IRS to resolve the tax dispute so that the interest earnings on the bonds would remain tax-exempt.  The notice did not identify the law firm or the lawyers it hired.

The Series B bonds were rated triple-A by Moody’s Investors Service and Standard & Poor’s at the time of the transaction.

Stone & Youngberg LLC was the lead underwriter in the transaction and Jones Hall in San Francisco was bond counsel. MBIA Insurance Corp. provided bond insurance.

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