IRS: Industry, Calif.'s $68M of Tax Allocation Bonds Are Taxable

The Internal Revenue Service has preliminarily determined that $68.1 million of tax allocation bonds issued by the Industry, Calif., Urban Development Agency in 2003 to finance the acquisition of property, as well as highway and water projects, are hedge bonds and therefore taxable.

Industry, located near Los Angeles, had a population of less than 1,000 as of the beginning of the decade, according to the Census Bureau. However, the city is home to several high-tech companies that provide a source of jobs for 80,000 people residing in the San Gabriel Valley Area, according to bond documents.

The development agency disclosed the IRS finding in a material event notice that it released Wednesday to the nationally recognized municipal securities information repositories.

The IRS told the agency that it plans to issue an adverse determination that, if not resolved on appeal or otherwise, will make the bonds taxable. The agency has until Jan. 30 to respond to the IRS with additional information, according to the notice.

Notices of proposed issue, which replaced preliminary adverse determination letters that the IRS used to issue under its muni bond enforcement program, are more detailed and give issuers an opportunity to respond to the allegations.

The IRS contends that the bonds are taxable hedge bonds "because the agency did not reasonably expect that the bonds would meet the three-year spending requirement" of the tax code.

The agency has hired counsel to represent it before the IRS, and plans on responding before the Jan. 30 deadline, the notice stated. The counsel was not identified and neither officials for the agency nor transaction participants could be reached for comment.

Although the development agency said it intends to work with the IRS to resolve the issue so that the interest earnings on the bonds do not become taxable, it added that it "cannot predict the outcome of its discussions and negotiations with the IRS."

To avoid having bonds declared hedge bonds under tax law, an issuer must reasonably expect to spend 85% of bond proceeds on the governmental purpose of the issue within three years, or invest less than 50% of the proceeds in nonpurpose investments with a guaranteed yield for four years or more.

An issuer meets the "reasonable expectation" spending requirement if it spends 10% of the proceeds on the project by the end of the first year after issuance, 30% by the end of the second year, 60% by the end of the third, and 85% by the end of the fifth.

The Series B bonds, which were rated triple-A by both Moody's Investors Service and Standard & Poor's at the time of the transaction, were to be used to finance an ongoing redevelopment project within Industry. The project included the completion of a water distribution system, a highway junction grade separation project, and the acquisition of property, according to bond documents.

Stone & Youngberg LLC was the lead manager on the deal and Jones Hall PLC in San Francisco was bond counsel. MBIA Insurance Corp. provided bond insurance.

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