WASHINGTON — The Internal Revenue Service has told the city of Bell, Calif., that $35 million of general obligation bonds issued in 2007 may not be tax-exempt because the agency believes the bond issue is a hedge bond.

The city disclosed the IRS decision in a material event notice filed with the Municipal Securities Rulemaking Board's EMMA system late last week.

The IRS launched two audits in January 2011 with respect to $15 million of Series 2004 general obligation bonds and $35 million of Series 2007 general obligation bonds the city had issued.

The IRS notified the city that it had closed the audit for the Series 2004 bonds without changing the tax-exempt status of the $15 million issue. The IRS is still conducting the audit for the Series 2007 bonds.

The 2007 GO bonds financed municipal improvements and facilities, including those to the Bell Sports Complex.

"The IRS believes that the 2007 bond issue is a hedge bond under the Internal Revenue Code and does not qualify for an exception to such treatment under Section 149(g)(2) of the IRC because the city did not reasonably expect to spend the proceeds of the 2007 bonds within a five year time period from the issuance of the 2007 bonds," the notice said.

Under federal tax law, a hedge bond is any part of a bond issue that meets two requirements: the issuer reasonably expects that less than 85% of the net proceeds of the issue will be used to finance its qualified purpose within three years of the date the bonds are issued and if more than 50% of the proceeds of the issue are invested in nonpurpose investments having a substantially guaranteed yield for four or more years.

The IRS provides an exception to the definition if at least 95% of the net proceeds of the issue are invested in tax-exempt bonds that are not subject to the alternative minimum tax. Amounts held in a bonafide debt service for 30 days or less pending reinvestment of the proceeds or bond redemption are treated as invested in tax-exempt bonds not subject to AMT.

"The city is cooperating with the IRS audit and hopes to resolve the audit in a manner that does not adversely affect the interest exemption to bondholders," the city said in the notice. "However, the city cannot predict the outcome of the audit."

If the IRS issues an adverse determination for the Series 2007 GO bonds, interest on the bonds could be taxable and that could apply retroactively to the date of issuance, the city warned in the EMMA notice.

The 2007 bonds were insured by CIFG Assurance North America, Inc. Nixon Peabody, LLP was bond counsel. Fieldman, Rolapp & Associates was financial advisor.

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