WASHINGTON — The Internal Revenue Service has told the Nebraska Public Power District that $10 million of the $50.36 million of Build America Bonds it issued in June 2009 may not qualify for the 35% interest subsidy it receives from the Treasury Department because of a dispute over the issue price of the bonds.

The NPPD disclosed the information — the first public disclosure of an IRS challenge of a BAB subsidy — in an event notice posted with the Municipal Securities Rulemaking Board’s EMMA system. The district said the dispute arose from a routine examination of the bonds.

The district estimated the 35% subsidy on the $10 million of bonds is about $260,000 per year, or $6.5 million over the life of the bonds, if applied back to the date of issuance. The dispute revolves around $10 million of the $32.89 million of the BABs in the issue that are to mature on Jan. 1, 2035, the NPPD said.

The district said it “does not agree with the service’s position and may contest any formal action taken by the service.”

Christine Pillen, deputy assistant treasurer at the NPPD, Nebraska’s largest electric utility, declined comment, as did James Marlin, a partner at Fulbright & Jaworski LLP in New York. The firm was bond counsel for the BAB deal and is representing the district in the dispute.

BAB issuers are prohibited from issuing bonds with more than a de minimis amount of premium, with de minimis defined as one-quarter of 1% of the stated redemption price at maturity for the bond, multiplied by whichever comes first: the number of complete years to the maturity date or the first optional redemption date.

Sources said NPPD’s BABs are callable in 10 years, so it appears the bonds could not be initially offered to the public at more than 102.5 — 0.0025 multiplied by 10 equals 2.5, which when added to the initial offering price of 100 equals 102.5.

But an examination of the data on EMMA shows that most of the BABs traded at 103 most of the first day they were publicly offered, June 11, 2009. The first trade was at 103 at 12:13 p.m. The bonds then traded between 99.12 and 101 through 2:16 p.m. But from 2:17 p.m. through 5:40 p.m., the last trade of the day, almost all of the trades were at 103, higher than the de minimis amount of premium.

The 103 is also much higher than the initial offering price of the bonds, which was 100, EMMA says. Under IRS rules, the issue price for each maturity of bonds is the first price at which a substantial amount of them are sold to the public, with 10% considered to be a substantial amount.

IRS officials have been concerned that, in some cases, BABs or other bonds are initially issued at one price and then almost immediately begin trading at higher prices. Flipping occurs when bonds are issued at one price and are almost immediately sold to dealers or institutional investors at higher prices before being sold to retail investors at even higher prices.

The determination of the issue price has a bearing on whether an issuer of BABs is both receiving the correct level of subsidy payments from the federal government and meeting arbitrage requirements. Even though BABs are taxable, they must still comply with the same tax laws and rules as tax-exempt bonds, the idea being that the issuer is getting a subsidy and should not be able to earn arbitrage as well.

If the IRS concludes an issuer set the issue price too low, it could force the issuer to reset the price to a higher amount. That would lead to a recalculation of the bond yield, with possible resulting arbitrage problems, as well as a recalculation of the issue’s size, which could also cause tax problems, muni bond tax experts said.

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