WASHINGTON — The Internal Revenue Service is questioning the tax-exempt status of $9.95 million of industrial development revenue bonds that were issued by the New York City Industrial Development Agency in December 2007 in a conduit transaction so that Metro Biofuels LLC could finance the construction of a biodiesel plant.

The IRS sent the issuer a “Notice of Proposed Issue” on July 25, warning that the bonds might not be tax-exempt qualified small-issue IDBs because Metro Biofuels may have violated a tax law limit of $20 million on capital expenditures made in the county, according to an event notice the NYCIDA filed with the Municipal Securities Rulemaking Board’s EMMA system.

The event notice says Metro Biofuels entered into a binding agreement to comply with the provisions of the Internal Revenue Code to preserve the tax-exempt status of the bonds, when they were issued in 2007.

“The borrower believes that the $20 million limitation has not been violated and has recently submitted documentation in support of such belief,” the notice said.

“The borrower will continue to vigorously contest any assertions by the IRS with respect to the 2007 bonds, and will seek to resolve and bring finality to the IRS audit as soon as possible,” it said.

Lawyers at Nixon Peabody LLP, which appears to be representing the issuer and-or company, did not return calls, and there was no official statement on file at EMMA for the $9.95 million of IDBs.

But the dispute revolves around a complex provision of the tax code that pertains to small-issue IDBs, according to tax and financial documents.

Under Section 144(a)(4)(G) of the federal tax code, for bonds issued after Dec. 31, 2006, to be tax-exempt small-issue IDBs, neither the borrower nor two or more related entities can have made more than $20 million in capital expenditures on facilities in the surrounding county.

The provision was designed to make sure that only small companies could take advantage of tax-exempt financing for projects, several lawyers said.

But Mike Bailey, a partner at Foley & Lardner in Chicago and a former IRS official, said, “It’s been perceived to be very difficult for borrowers to monitor” compliance with the provision because the $20 million limit applies not just to capital expenditures made for the bond-financed project, but also to capital expenditures that are unrelated to the project.

The limit covers all capital expenditures made by a borrower or two or more related entities for projects in that county.

According to Bailey, when the IRS muni enforcement program was initiated in 1993 by IRS’ exempt organizations division, this provision was cited as one of the three most likely areas of noncompliance for muni issuers and borrowers.

The other two potential areas of noncompliance were yield burning and zero-coupon bond issues. The enforcement group decided to look into these areas.

According to the financial statements for Metro Fuel Oil Corp. and its affiliates, Metro Terminals Corp. borrowed the proceeds from the $9.95 million of IDBs to construct a biodiesel plant.

Metro Terminals owns and operates a petroleum terminal and also sells petroleum products.

The $1.55 million of Series 2007A bonds had an interest rate of 5.5% and a maturity date of Nov. 1, 2013.

The $8.41 million of Series 2007B bonds had an interest rate of 6% and a maturity date of Nov. 1, 2028.

“The financing is secured by the facility and is guaranteed by the stockholders of Terminals as well as Metro Fuel and Biofuels, the Metro Fuel said in the financial statement.

Event notices filed with EMMA show that $875,000 of the bonds were redeemed from 2009 through 2011.

However, the IRS has a three-year statute of limitations in tax enforcement cases.

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