WASHINGTON — Half Moon Bay, Calif., has settled a tax dispute with the Internal Revenue Service over $10.9 million of Build America Bonds it issued in 2009 by agreeing to make a one-time payment of $174,000 and to reduce its subsidy payment to 29% from 35% of interest cost over the life of the bonds.

The city announced the settlement or closing agreement on Thursday. It appears to be first publicly announced settlement of a IRS tax dispute over a BAB issue. 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, which began auditing the BABs in late 2010, questioned whether the bonds qualified as BABs because the proceeds were used to finance a settlement that the city entered into with a developer to resolve the lawsuit, Yamagiwa v. Half Moon Bay.

The developer had sued the city in late 2007, claiming actions the city 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.

BABs were only supposed to be used to finance capital expenditures and the IRS questioned whether the property transfer that occurred under the settlement of the lawsuit qualified as a capital acquisition under the BAB program, the city said in its release.

“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.

Half Moon Bay issued the $10.9 million of judgment obligation BABs along with $5.8 million of judgment obligation tax-exempt bonds in July 2009. The bonds were underwritten by Piper Jaffray & Co. Orrick, Herrington & Sutcliffe was bond counsel and disclosure counsel in the transaction.

The city said the $174,000 one-time payment represents the reduction in subsidy payments it has received so far from the government and will come from existing risk-management reserves.

“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,” said Mayor Allan Alifano.

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 oe 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 the city to avoid the high cost and uncertainty of litigation with the IRS, the release said.

“The City Council is pleased to close this latest chapter in the Yamagiwa story that continues to visit the consequences of errant decisions of the past on the current City Council, staff and members of the public,” the notice said. “The City Council looks forward to exploring options for the property that make the most of this important community asset.”

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