WASHINGTON – Internal Revenue Service auditors recently determined almost $1.26 billion of bonds issued for the Indiana-based Midwest Fertilizer Company are taxable after earlier this year retaining the tax-exempt status of bonds for a similar project in Iowa.

The bonds for both projects were rushed to market in December 2012 so they would be tax-exempt Midwestern Disaster Area Bonds before the authority for those disaster bonds expired. The bond proceeds for each project were escrowed until they could be remarketed and used for the projects.

The main issue in each IRS audit appeared to be whether the bonds qualified as Midwestern Disaster Area Bonds and whether they were issued earlier than they should have been for the projects, based on IRS documents.

IRS auditors closed their audit of the Iowa Fertilizer Co. project in April of last year with no change to the tax-exempt status of the$1.2 billion of bonds.

In contrast, the auditors sent a Notice of Adverse Determination to Midwest Fertilizer Co. recently, less than a year after it begun auditing the bonds, saying the bonds were not qualified Midwestern Disaster Area Bonds and that the bond interest paid to bondholders is therefore taxable. Midwest Fertilizer has held the bonds since 2016.

Midwest Fertilizer said in a material event notice filed on the Municipal Securities Rulemaking Board’s EMMA site on Friday that while it “cannot predict the outcome of [the IRS dispute], the company and its counsel continue to be confident that there should be no change to the tax-exempt status of the bonds or the refunded bonds.” The company said it is “considering its response” to the IRS, “which may include an administrative appeal to the IRS’s Office of Appeals.”

The outside of the Internal Revenue Service headquarters building in Washington.
The outside of the Internal Revenue Service headquarters building in Washington. Bloomberg News

Why were bonds for the two projects treated so differently by the IRS?

The $1.2 billion bonds for the Iowa Fertilizer Co. were spent within two years, the project was built, and it launched production in April 2017.

Almost all of the bonds for Midwest Fertilizer Co. in Indiana remain unspent and the project hasn’t gotten off the ground.

Under IRS arbitrage rules, bond proceeds can be invested at yields above the bond yields for a so-called three-year temporary period without becoming taxable arbitrage bonds if the issuer reasonably experts to comply with three tests, one of which to spend 85% of the proceeds within three years. There is also a five-year temporary period available.

If the issuer doesn’t expect to meet the three-year temporary period requirements, the bonds are hedge bonds and taxable unless the issuer reasonably expects to spend certain percentages of the proceeds over a five year period.

While the companies for each project may have reasonably expected to meet these requirements, Iowa Fertilizer actually met them and Midwest Fertilizer did not.

Federal officials, former Indiana Governor Mike Pence, the current vice president, and initial terrorist concerns appear to have halted the Midwest Fertilizer project soon after the bonds were issued, according to documents and press reports.

The Iowa fertilizer plan was developed by Orascom Construction Industries, which was originally based in Egypt but is now located in the Netherlands. Midwest Fertilizer is a U.S. company owned by multinational investors, the principal one of which is Fatima Group, one of the largest conglomerates in Pakistan and a leader in the south Asian fertilizer industry, according to company documents.

The Midwest Fertilizer bonds were issued in December 2012 by the Indiana Finance Authority to build a state-of-the-art nitrogen fertilizer production plant on 220 acres in Posey County, Ind.

The company chose to base the plant in Indiana because the Indiana Economic Development Corp. (IEDC) had offered an incentive package accepted by the company on Nov. 30, 2012, that included access to tax-exempt financing through the allocation of a portion of the state’s volume cap under the disaster bond program. The IEDC made clear that the company would have to create jobs and invest in Indiana to receive the incentives and the company agreed to do so.

But just before the bonds were issued, a representative of the U.S. Defense Department’s Joint-Improvised-Threat Defeat Agency (JIDA) testified during a hearing in Congress that the Fatima Group had been “less than cooperative” in implementing security for its fertilizer products to prevent them from being used in explosive devices deployed against American soldiers in Afghanistan and Pakistan.

Pence, a day after taking office as governor in January 2013, halted state support of the project and then formally dropped all state involvement in mid-May of that year, according to bond documents. His predecessor had been a big supporter of the project. The Indiana Finance Authority dropped out of the financing and Midwest Fertilizer turned to Posey County to take the state’s place.

Fatima officials met with representatives of the FIDA after the hearing and agreed on a range of voluntary cooperative measures to appease them, including by suspending fertilizer sales in two Pakistani provinces bordering Afghanistan. It also reformulated a fertilizer product that would be less susceptible to misuse as an explosive.

In October 2013, Posey County offered the company tax increment incentives valued at $144 million and up to $480,000 in employment incentives, according to bond documents.

In 2014, Pence, who was still governor at the time, announced he would reopen talks with Fatima about the bond-funded fertilizer plant and said that he was hopeful the state would be able to renew its support for the project, which it eventually did.

In January 2015, the company withdrew its request for the state incentive package and decided to devote its efforts to support Posey County in securing state funding and county incentives, according to offering documents. On July 7, 2015, Posey County and the company agreed to a revised tax incentives package.

As of late 2015, the company said in an official statement that it had spent $76.7 million to develop the project, not including expected issuance costs associated with remarketing the bonds, and that it had executed agreements for additional project expenditures totaling $280.4 million.

The bonds had been refunded or remarketed six times between July 2013 and November 2015.

Meanwhile, the state decided to support the project again. According to a company press release attached to an EMMA notice last year, the Indiana Economic Development Corp. offered Midwest Fertilizer up to $2.9 million in conditional tax credits and up to $400.000 in training grants based on the company's job creation plans. The IEDC also offered up to $300,000 in conditional incentives from the Hoosier Business Investment tax credit based on the company's planned investment. These incentives are performance-based, meaning the company must create jobs and invest in Indiana in order to be eligible to receive incentives.

“The project continues to have very strong support of county, state and federal officials,” Charles Henck, a partner with Ballard Spahr who represents Midwest Fertilizer and Posey County in the dispute with the IRS, said last week. “We believe we complied with the rules and that the IRS analysis is incorrect.”

Midwest Fertilizer’s most recent estimate, before it received the adverse determination from the IRS, was that groundbreaking of the project would be in 2018 and the plant would begin operating in 2022 to produce about 2 million tons annually of ammonia, urea ammonium nitrate solution and diesel exhaust fluid, a diesel additive that reduces diesel exhaust emissions.

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