Santa Maria, Calif., has settled an audit of its $30 million in waste and wastewater certificates of participation after the Internal Revenue Service determined that the COPs were arbitrage bonds and should be declared taxable, according to the city.
Processing Content
The closing agreement protects the tax-exempt status of the debt, but it was not clear yesterday how much Santa Maria was required to pay the IRS to settle the investigation.
The city issued $30.3 million of subordinate COPs in 1997 to advance-refund certain outstanding obligations of the city and to finance new capital projects, according to the city, which announced the closing agreement in a material event notice filed Wednesday with the nationally recognized municipal securities information repositories.
Bruce M. Serchuk of Nixon Peabody LLP, Santa Maria's legal representative before the IRS, said yesterday that he could not disclose any further information about the settlement. Gilbert A. Trujillo, the city's attorney, could not be reached for comment.
Santa Maria received notice at the end of 2004 that the COPs had been selected for examination. It subsequently disclosed last October that the IRS had preliminarily determined interest on the COPs to be taxable because the debt qualified as "arbitrage bonds." The IRS believed that proceeds from the COPs had been invested in an advance refunding escrow at a materially higher yield through the use of a forward supply contract that provided a put option, the city said.
Issuers are allowed to purchase put options for advance refunding escrows if they use them to lower their interest rates. In these transactions, issuers typically buy open-market Treasuries and a put option that allows them, after a certain date, to sell either the entire escrow or a set percentage of it at a fixed price.
The IRS in 2005 started auditing so-called yield-burning deals in which the issuer counts the cost of a put option as an investment cost. Since a put is not required for advance refunding escrows, the IRS says it is purchased with monies owed to the federal government.
The transaction can "burn" yield because the cost of the put, combined with the cost of the Treasuries, brings down the yield on the escrow to equal that of the refunding bonds; the "arbitrage limit," which is the most the IRS allows issuers to earn on the investment of bond proceeds.
If interest rates go up, the bonds will trade at a deep discount. In some cases the issuer can exercise its put option, sell back the Treasuries, and buy its own bonds with the proceeds, while keeping the profits.
The Santa Maria transaction appears to differ from traditional yield-burning cases, which involved excessive markups on open-market Treasuries, because the IRS questioned whether it should have purchased the put option rather than whether it paid an above-market rate for the investment.
Charles Anderson, field operations manager of the IRS tax-exempt bond office, could not be reached for comment yesterday. Earlier this year he said that put-option escrows are very common enforcement issues, and that the IRS had about 15 such cases open at that time.
George K. Baum & Co. of Kansas City, Mo., was underwriter on the Santa Maria transaction and Jones Hall of San Francisco was bond counsel.
The IRS has also been investigating a group of Baum deals for various arbitrage abuses, including several in which the agency claims the firm worked with banks to rig bids for guaranteed investment contracts. Additionally, in recent months the IRS has expanded its inquiry into allegedly abusive yield-burning strategies used by CDR Financial Products, formerly Chambers Dunhill Rubin & Co., and Bear Stearns Capital Markets Inc., in a handful of deals.
In Santa Maria's case, the settlement with the IRS did not involve an admission of wrongdoing in its disclosure.
"The city believes that all of the requirements for interest on the COPs to be tax-exempt have been satisfied," it said in the material event notice. "However, the city determined that it would be in the best interests of the city and the holders of the COPs to resolve the audit through execution of the closing agreement with the IRS."
The closing agreement provides that the holders of the COPs are not required, and will not be required, to include in their gross income any interest earned on the COPs, and that the IRS will not treat the settlement as income to the COPs holders, the city said. The closing agreement also does not require any of the COPs to be redeemed. (c) 2006 The Bond Buyer and SourceMedia, Inc. All rights reserved. http://www.bondbuyer.com http://www.sourcemedia.com
