WASHINGTON — The Internal Revenue Service has told the Pennsylvania Higher Education Assistance Agency that if it wants to settle a bond-related tax dispute, the settlement will have to cover all $700 million of its outstanding student loan debt.

In the dispute, which has ramifications for other student loan bond issuers, the IRS has taken the position that student loans should not be reallocated to different bond issues and that consolidation-loan rebate fees should not be considered as qualified expenses for rebate purposes. Market participants have noted that the IRS’ concerns about the PHEAA’s bonds would also apply to many other student-loan bond deals.

The authority disclosed that the IRS had told it any settlement would have to cover all of its outstanding debt in a material event notice filed late Monday with the Municipal Securities Rulemaking Board’s EMMA system. The PHEAA filed it for 111 bond issues with an original aggregate principal amount of $7.4 billion, only $700 million of which remain outstanding.

However, the agency also stated in the notice that the IRS has taken no adverse position on the audited bonds or made a “formal demand of any particular sum to settle the audit.”

In addition, the PHEAA made clear that it has not offered to pay the IRS as part of any closing agreement to resolve the audit, but said that could be an option in the future, as well as an appeal to the IRS Office of Appeals of any adverse determination.

The IRS audit, which began in May 2008, has focused on $150 million of student loan revenue bonds the PHEAA issued in 2002. Given the concerns that the IRS is scrutinizing common practices in the student-loan bond market, some market participants speculated yesterday that the IRS may be attempting to set a settlement template for future examinations in the sector.

“What I’m assuming is happening here is that the IRS is going to try and negotiate a settlement … and then they’re going to basically go out to the world,” said one bond lawyer who did not want to be identified. “It’s on everybody’s radar screen.”

The PHEAA said in the notice that it has complied with three information document requests from the IRS, and that the service is specifically taking issue with how the authority reallocated student loans to and from various bond issues and how the consolidation-loan rebate fees it paid the Treasury Department determined the yields on the student loans.

Specifically, an IRS agent told the PHEAA that it should disregard its reallocations of student loans to other bond issues and asked if it would be able to reestablish the original loan allocations made when the bonds were issued “for settlement purposes,” according to the material event notice.

But market participants said the reallocation of loans among various bond issues is fairly common among student-loan bond issuers, and that it would be very difficult if not impossible for student loan issuers to unwind them and return to the original allocations.

The IRS also disagreed with the PHEAA’s treatment as qualified administrative costs the consolidation loan rebate fees, which all Federal Family Education Loan lenders are required to submit to the Department of Education whenever student loans are consolidated. The FFEL program was eliminated in July after the health care law enacted in March required all federally guaranteed student loans to be originated by the federal government.

Bond lawyers said it is a relatively common practice for student loan lenders to consider the fees qualified administrative costs, meaning they do not have to be included in determining the earnings on the student loans for arbitrage purposes. Student loan bond issuers typically are permitted to earn on average a 2% spread over the bond yield to cover certain program expenses.

The PHEAA disputes the IRS’ position in the notice. Authority officials declined to comment.

IRS tax-exempt bond office director Clifford Gannett said in 2008 his group was specifically targeting tax-exempt student loan bond issuers. The TEB office planned to audit five to 10 student loan bond issuers. It is unclear if the Pennsylvania authority’s audit is part of that initiative.

Obermayer, Rebmann, Maxwell & Hippel LLP of Philadelphia was bond counsel on the PHEAA’s $150 million bond deal, according to bond documents. Cozen O’Connor was underwriters’ counsel. There were five underwriters on the deal: UBS PaineWebber Inc., now UBS AG, Wachovia Bank NA, now part of Wells Fargo & Co., NatCity Investments Inc., Siebert Brandford Shank & Co., and Bear, Stearns & Co. and RRZ Public Markets, now both part of JPMorgan.

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