WASHINGTON — The Internal Revenue Service has preliminarily determined that $147.18 million of revenue refunding bonds issued by the Houston Higher Education Finance Corp. in 2006 for William March Rice University are not tax-exempt.

The IRS notified the issuer in a June 25 letter. The city disclosed the letter in an event notice it filed with the Municipal Securities Rulemaking Board’s online EMMA system this week.

In the letter, the city said it received a Form 5701-TEB notice of proposed issue from the IRS. The notice “asserts a violation of qualified hedge,” the IRS said.

“The issuer and the university are cooperating with the IRS and are working together to respond to the notice,” the city said in the EMMA notice. “The university believes it has fully complied with all applicable federal tax requirements with respect to the bonds, and intends to continue to seek to resolve the matter with the IRS.”

The Form 5701-TEB notifies issuers that the IRS has preliminarily determined that bonds are taxable. It typically provides a reason for that determination and gives the issuer 30 days to respond. The IRS then decides  if the bonds are taxable. Issuers can either agree with the IRS or enter into a closing agreement.

The variable-rate demand bonds were issued to advance refund Series 1999A higher education revenue bonds and refund a of outstanding commercial paper.

The school entered into two separate interest rate swap transactions with two separate counterparties in order to hedge the university’s interest-rate exposure under the bonds and to achieve a synthetic fixed rate obligation, bond documents said.

Under the swap transaction, the university agreed to make monthly payments based on a fixed rate of interest for the term of the bonds and the counterparties agreed to make monthly floating rate payments based upon a certain percentage of the three-month Libor index.

Qualified hedge rules say when an issuer can take payments on a swap into account when calculating the bond yield. That’s important when there is an advanced refunding and an issuer invests all of the proceeds into an escrow account, said John Swendseid, partner at Swendseid & Stern.

If an issuer can’t take the qualified hedge payments into account, then the yield on the bond is lower and the arbitrage amount is lower, and so is the amount of investment earnings the issuer can keep.

The IRS concern is with “super-integration,” which allows the bonds to be treated as a fixed rate, but in order to qualify for super integration the variable rate on the bonds has to be substantially the same as the variable rate that is paid on the swap, said Perry Israel, a Sacramento attorney.

The worse case scenario is that the IRS is taking the position that the issuer can’t take the qualified hedge into account, likely using the proposed 2007 arbitrage regulations for their ruling, he said.

Vinson & Elkins LLP and Bates and Coleman PC were co-bond counsel. Greenberg Traurig LLP was underwriter and William T. Avila PC was co-underwriters’ counsel.

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