The Pennsylvania Higher Education Assistance Agency has disclosed that the Internal Revenue Service is requesting information for an audit of $150 million of student loan revenue bonds it issued in 1997.

The agency is the second student loan issuer to disclose IRS scrutiny of its bonds in recent weeks and the specific issues under examination by the agency have some bond lawyers wondering if the audits could have widespread ramifications for all student-loan bond issuers.

The IRS action was disclosed by the PHEAA in a material event notice filed this week with the nationally recognized municipal securities information repositories.

The notice comes a month after the Vermont Student Assistance Corp. disclosed that the IRS had sent it a Form 5701-TEB, which stated that the methodology it used to track the student loans acquired with the bond proceeds, as well as its treatment of the consolidation loan rebate fee as a qualified administrative expense, could make the bonds taxable.

The PHEAA states in its notice that the IRS is asking it to explain its reallocation of student loans to and from the bonds in question, as well as why consolidation loan rebate fees paid to the federal government reduce yield on the student loans. However, the IRS has not stated at this point whether it believes the bonds could be taxable.

In particular, market participants are paying attention to the IRS' stance on the treatment of the consolidation loan rebate fees, which all Federal Family Education Loan lenders are required to pay whenever student loans are consolidated. The Pennsylvania agency dropped out of the FFEL program last summer due to market turmoil.

Bond lawyers contend it is a relatively common practice for student loan lenders to treat the fees as qualified administrative costs, which means they do not have to be included in determining the earnings on the student loans for arbitrage purposes. Student loan bond issuers typically are permitted to earn on average a 2% spread over the bond yield to cover certain program expenses. The IRS appears to be suggesting in the audits that the fees should not be used to drive down the yield on student loans.

"It's certainly getting people's notice and attention, and depending on whether the IRS prevails on this, that certainly could affect how people do their yield calculations," said one bond attorney who did not want to be identified.

The PHEAA stated in its notice it plans to fully cooperate with the IRS on the audit. It also stated it will make every effort to protect the tax-exempt status of the debt, including by appealing any adverse determination or entering into a closing agreement.

IRS tax-exempt bond office director Clifford Gannett said last year that his team planned to examine tax-exempt student loan bond issuers for compliance with tax laws and rules. Tax-exempts account for about 10% of the overall student loan bond market.

The TEB office planned to audit five to 10 student loan bond issuers. However, the notices did not state if either of the bonds under audit were selected as part of that initiative.

Obermayer, Rebmann, Maxwell & Hippel LLP of Philadelphia served as bond counsel on the PHEAA deal, according to bond documents. Cozen O'Connor was underwriter's counsel, and Bear, Stearns & Co., now part of JPMorgan, was underwriter.

Meanwhile, North Kansas City, Mo., disclosed last week that the IRS has concluded an examination of $82.3 million of hospital revenue bonds it issued in 2003 with no change to their tax exemption.

Gilmore & Bell PC was bond counsel, and Oppenheimer & Co. was financial adviser. U.S. Bancorp Piper Jaffray, now Piper Jaffray & Co., was underwriter, while Edward D. Jones & Co. also underwrote a portion of the debt.

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