The Vallejo City Unified School District in California this week disclosed that the Internal Revenue Service preliminarily determined that its $61.06 million of Series A 2002 general obligation refunding bonds are arbitrage bonds and therefore taxable.

The district sent a material event notice to nationally recognized repositories on Jan. 8 saying it had received the adverse preliminary determination from the IRS on Oct. 12, 2007. The school district is the 11th to disclose it received such a notice from the IRS for similar forward-delivery advance refunding bonds.

The 11 transactions are among 26 that involved roughly $800 million of bonds and were done from 1993 to 2003, with Kinsell, Newcomb & De Dios Inc. as underwriter and Best Best & Krieger LLP as bond counsel. Both firms are based in California.

The IRS also has opened an investigation of the Kinsell firm and its executive vice president, J. Jeffrey Kinsell, under Section 6700 of the tax code, which enables the IRS to penalize individuals and firms who promote abusive tax shelters.

Kinsell has denied the charges. In an interview last month, he said it had been months since his lawyers had any contact with the IRS and that he did not think the agency’s officials really understood the deals. He also said he wanted to settle the charges with the IRS and “wipe the slate clean” for investors.

Yesterday, Kinsell said there has been some recent communication with the IRS.

“We want to settle this as quickly as we can,” he said. “I think the people really being hurt are the districts and particularly the investors and the cost to them is pretty great.”

Kinsell developed the forward-refunding program in the early 1990s for California school districts with outstanding debt that carried fairly low interest rates. Under the program a district, such as the Vallejo City Unified School District, would enter into a forward agreement to sell advance refunding bonds at a future date and use the proceeds to defease outstanding bonds to their maturity dates.

A third party bidding agent would take bids on Treasury securities for the escrow. The Kinsell firm was one of several bidders that competed to become provider of the escrow securities, and always won the bid.

The Kinsell firm also canvassed at least three potential purchasers of the bonds to establish the bonds’ issue price.

Then, at the forward-delivery date, six to 15 months later, the Kinsell firm would purchase the refunding bonds from the district and sell them to the public at prevailing market rates, which tended to be higher due to the interest rate movements during the forward periods.

Kinsell claimed that the low-to-high transactions provided the districts with cash-flow savings via the restructuring of the underlying debt because the principal was repaid faster, semianually instead of annually.

But in its letter to the Vallejo district, the IRS contended that the escrow securities were purchased at above fair market value and that the district received less than fair market value for the forward supply agreement. In addition, the IRS alleged that the bond yield was computed based on an incorrect issue price and that the correct price would have lowered the yield. Had correct yields been used, the IRS said, the escrow yield would have been higher than the bond yield, causing the bonds to be taxable arbitrage bonds.

The district said in its material event notice that it has retained counsel and is working to resolve these issues with the IRS so that owners of the bonds are not adversely affected. “However, the district cannot predict the outcome of this audit,” the notice said. School district officials were unavailable for comment.


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