WASHINGTON — Several bond lawyers on Friday said they were pleased the Internal Revenue Service settled a tax dispute over a $10.2 million of Build America Bonds issued by Half Moon Bay, Calif., in 2009 by reducing its subsidy payment from the federal government to 29% from 35% of interest costs.

Half Moon Bay announced the settlement with the IRS on Thursday — the first publicly reported settlement between an issuer and the IRS over a BAB issue.

The city also agreed to pay the IRS $174,000, representing the reduction of subsidy payments it had already received on the bonds, which were issued in 2009. The IRS had claimed that since the city used the BAB proceeds to pay a court judgement of about $18 million from a lawsuit it lost against a developer in 2007, the bonds did not really qualify as BABs.

The American Recovery and Reinvestment Act of 2009, which created BABs, stipulated that the bonds only be used to finance capital expenditures. The IRS said that even though the court settlement involved a transfer of land from the developer to the city, this was not a capital expenditure.

“It’s comforting and appropriate that the IRS will do this proportionate reduction of payments in examinations and not say if its bad, the whole thing is bad,” said Mike Bailey, a partner at Foley & Lardner in Chicago.

“The settlement is significant and possibly precedent-setting in a number of respects,” he said. “It’s likely the IRS will continue to settle violations by reducing subsidy payments in general, but whether they will use this approach to determine the amount of reduction is unclear.”

The IRS said that reducing the subsidy payments to 29% would give Half Moon Bay the equivalent of a subsidy of tax-exempt bonds. The city had issued $5.8 million of tax-exempts along with the BABs but there is no requirement that tax-exempt bond proceeds be spent on capital expenditures.

Bailey pointed out that the Advisory Committee on Tax-Exempt and Government Entities recommended in a June 2010 report that the IRS consider reducing BAB subsidy payments for certain tax-law violations.

Another lawyer who did not want to be named also lauded the IRS action and said it could affect other cases.

“The point of potentially broader application is that the IRS dealt with what it thought was a violation by dropping the subsidy rate from 35% to 29% [when] the typical thing they do is to request some amount of bonds to be redeemed,” the lawyer said. “Given how unique the circumstances are in the case, it is hard to know if they would want to use the same approach again, but it does show some willingness to think outside the box.”

Almost $182 billion of BABs were issued after they were created by Congress in 2009. The program expired at the end of 2010.

The IRS began auditing the Half Moon Bay BABs in late 2010, questioning whether the bonds qualified as BABs because the proceeds were used to finance a settlement of the lawsuit, Yamagiwa v. Half Moon Bay.

The developer had sued the city in late 2007, claiming actions it took had turned the developer’s land into wetlands and rendered it undevelopable.

A court in 2008 ordered Half Moon Bay to pay the developer about $37 million, a sum later reduced to $18 million in a settlement agreement, with the city agreeing to take the property — 25 acres of land along Cabrillo Highway — from the developer.

The IRS questioned whether the property transfer that occurred under the settlement of the lawsuit qualified as a capital acquisition under the BAB program.

“As a way to resolve its concerns, the IRS proposed reducing the amount of the interest subsidy from 35% to 29%, thus placing the city in basically the same position with the Build America Bonds as the simultaneously issued tax-exempt bond issue,” the city said in a press release.

The bonds were underwritten by Piper Jaffray & Co. Orrick, Herrington & Sutcliffe was bond and disclosure counsel in the transaction. Orrick also represented the city in the dispute with the IRS.

Mayor Allan Alifano said, “I am glad this resolution allows us to move forward determining the best future use for the property, and am appreciative to legal counsel and staff that such a complex tax matter has been resolved without a protracted court battle.”

The release issued by the city said: “While the City Council is confident, based on the advice of its bond counsel, that it would ultimately have prevailed in a legal challenge to the IRS position, the approved closing agreement provides certain advantages that more than offset the reduction in interest payment reimbursements.”

It said one advantage is that, under the settlement, the city can change the use of the property by undertaking a “remedial action” under IRS rules. For example, if Half Moon Bay sold the property for cash, it would only be required to retire the bonds sufficient to cover the sale price, according to the release.

With the current bond structure, if it had sold the property or allowed it to be used by a private party, it would have risked having to retire the entire $16.68 million of tax-exempt bonds and BABs, the release said.

In addition, the settlement makes clear that only a “deliberate action,” meaning an actual sale or entering into a sales contract with all contingencies removed, would trigger the need to redeem all of the bonds.

Finally, the settlement allows Half Moon Bay to avoid the high cost and uncertainty of litigation with the IRS, the city’s release said.

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