WASHINGTON — The Cherokee County, Ga. School System is negotiating with the Internal Revenue Service to settle a tax dispute, after an IRS agent said there was an arbitrage problem based on an audit of some 2007 bonds.
The school system, which is located in the northwestern part of Georgia, disclosed the audit and settlement discussions in an event notice posted on the Municipal Securities Rulemaking Board's EMMA site last week.
The IRS proposed settling the arbitrage problem in a closing agreement that would require the school system to make a rebate payment of $10,820.96 plus a 100% penalty. The school system made a counter-proposal to settle with a payment of $10,820.96 plus a 50% penalty. The counter-proposal is pending at the IRS for possible administrative approval, according to the event notice.
The school system issued $125 million of series 2007A bonds and $41.92 million of series 2007B bonds.
The proceeds of the series 2007A bonds were to be used to finance school facilities, according to the official statement. The series 2007B bonds were originally issued to advance refund bonds sold in 2001 and 2003. Some of the proceeds of the 2007B bonds were used to purchase Treasuries that were deposited into an escrow fund. Some of the Treasuries were to be rolled over on specific dates and used to purchase zero-coupon state and local government series securities, the school system said in the event notice.
Under tax rules, the composite yield on an advance refunding escrow cannot be materially higher than the yield on the bonds or the bonds could become taxable arbitrage bonds.
The Treasuries purchased with the bond proceeds had higher yields than the bonds, and the SLGS would have lowered the yield on investments over the duration of the escrow, said Roger Murray, bond counsel for the school system and a partner at Murray Barnes Finister LLP.
The IRS started a random audit of both 2007 bond series earlier this year. During the course of the audit, the school system determined that the roll-over scheduled for Feb. 1, 2011 did not happen on that date as scheduled because the escrow agent, The Bank of New York Mellon Trust Company, N.A., did not subscribe for the SLGS in a timely manner. Instead, the SLGS were settled on Feb. 7, 2011. From Feb. 1 through Feb. 7 of 2011, roughly $18.34 million was held in the escrow fund uninvested, according to the event notice.
The IRS agent conducting the audit told the school system in early November that the yield needed to be imputed for the uninvested money, and that yield should be the bond yield. "The IRS agent indicated that after imputing this yield its calculations showed that the yield on the escrow obligations was materially higher than the yield on the bonds (greater than one-thousandth of one percent)," the event notice stated.
Murray said that even though the issuer did nothing wrong, it was planning to settle because the settlement amount would be far less than the amount of attorneys' fees the school system would rack up if it fought the IRS. Additionally, the school system hopes that the escrow agent will reimburse it for the settlement amount, he added.
If a settlement is not executed, the IRS could take the position that the bonds are taxable, the event notice stated.
Citigroup was underwriter of the bonds, and Government Funding Advisory Associates was financial advisor.