WASHINGTON - The Internal Revenue Service has concluded audits of two 1992 bond transactions involving forward-float agreements that the agency claimed were purchased below fair market value, making the bonds taxable arbitrage bonds.

In a closing agreement, Minnesota agreed to pay the IRS $20,000 to settle tax law charges surrounding the forward-float agreement in connection with $243.1 million of general obligation refunding bonds it sold. In the other, however, the IRS reversed an earlier preliminary determination that $422.7 million of revenue refunding bonds issued by the New Jersey Highway Authority were taxable, and closed the audit with no change to the bonds' tax-exempt status. The highway authority has since merged with the New Jersey Turnpike Authority.

Both audits centered around fees that Sakura Global Capital Inc., now part of SMBC Capital Markets Inc., paid to each issuer for its participation in the float agreements.

A forward-float contract is used in an advance refunding to cover the cash-flow gaps between the time securities in the issuer's refunding escrow mature and the time funds are needed to pay debt service on the related bonds. The issuer receives an upfront payment for its participation in the contract.

In these deals, the IRS claimed that if the forward agreements had been purchased at fair-market value, then the investment yields would have been materially higher than the yields on the bonds, making them arbitrage bonds and therefore taxable.

Sakura has faced past allegations of rigging bids in other bond transactions to ensure it would be chosen as a float provider, then undervaluing upfront payments to lower the investment yield.

In the Minnesota deal, the state received an upfront payment of $1.8 million from Sakura on Aug. 4, 1992, and in exchange gave the firm the right to invest the securities during the float period. The IRS claimed that the fee was $539,411 below fair-market value.

The IRS initiated its investigation of the Minnesota bonds on March 24, 2006, according to Tom Vander Molen, a partner at Dorsey & Whitney LLP in Minneapolis, who served as tax counsel to the Minnesota Department of Finance during the audit. The IRS was in the process of drafting a preliminary adverse determination that the bonds were taxable when the settlement agreement was reached, he said.

The $20,000 state payment cited by the Minnesota Department of Finance in its release announcing the agreement is less than a quarter of the $95,000 that Colorado Springs, paid in January to settle tax law charges on a similar deal that involved $344.875 million of 1991 utilities system refunding bonds.

Minnesota's relatively small payment was likely a result of difficulties the IRS faced in proving that the statute of limitations had not expired on the Minnesota bonds, the last of which were redeemed Aug. 1, 2002, said Vander Molen.

The statute of limitations for tax law violations generally is three years. As a result, the IRS can pursue a taxpayer for up to three years after it files a tax return for the year the violations occurred. For example, a tax law violation occurring in 2000 could be challenged by the IRS for up to three years after the tax return for that year was filed, usually in 2001.

But in cases involving tax-exempt bonds, the IRS manual dictates that investigators should assume the three-year statue of limitations starts when the last of the bonds are redeemed. The three-year period could be extended if some of the bondholders, such as a large corporation, still had outstanding tax returns from previous years.

"It's always possible that some of the taxpayers have extended the three-year period," Vander Molen said, adding that the IRS had not determined who the bondholders were or if they had taken an extension to file their returns. "It might have been a lot of work for them to do that, and it would have taken time, and the clock would have kept ticking on the statute of limitations," he said.

Instead, the IRS and the state reached a "mutually agreed upon" amount in order to close the audit, Vander Molen said.

In New Jersey, the IRS completely reversed itself on the $422.7 million of Series 1992 parkway revenue refunding bonds that were issued by the New Jersey Highway Authority.

Last October, the agency told the Turnpike Authority that it had preliminarily determined the bonds were taxable because the forward-float agreement associated with the bonds was allegedly undervalued by nearly $1 million.

The IRS claimed that Sakura paid the authority a below-fair market value fee for its participation in the float agreement.

"When the adjusted value of that forward purchase and assignment agreement is properly included in the investment yield on the advance refunding escrow, the escrow yield is materially higher than the yield on the 1992 bonds and, therefore the 1992 bonds are arbitrage bonds, the interest on which is not excludible from the gross income of the bondholders," the IRS had said in its Oct. 5 letter to the authority.

The IRS made the determination using a new valuation methodology that it developed for a voluntary closing agreement program for float agreements that encourages issuers to determine whether they received appropriate valued upfront payments.

But the New Jersey Turnpike Authority's lawyers were able to convince the IRS to reverse its preliminary finding that the bonds were taxable.

Jeffrey Kramer, a lawyer with DeCotis, FitzPatrick, Cole & Wisler LLP in Teaneck, N.J., which represented the issuer in the dispute, said the IRS eventually agreed with the authority's argument "that when the deal was initially done, the safe harbor was met, and that once the safe harbor was met, the forward float is basically presumed to have been sold at market rate."

IRS regulations that took effect in May 1992 state that if three arm's-length bids for investment contracts such as guaranteed investment contracts and forward-float agreements are obtained, the contracts or agreements presumably are purchased at fair market value.

Kramer said transaction participants were able to provide all of the necessary bond and bid documents to the IRS. Roughly $53 million of the bonds are still outstanding.

Meanwhile, several similar IRS audits of transactions that involve Sakura forward-float agreements are underway, according to muni market participants who would not quantify or identify the transactions.


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