The Hazleton, Pa., Area School District has entered into a closing agreement with the Internal Revenue Service over $64.2 million of general obligation bonds it issued in 1997 after appealing the agency's 2006 decision that the debt was taxable because it involved yield burning.

The school district disclosed the agreement in a material event notice filed recently with the nationally recognized municipal securities information repositories.

Under a closing agreement, an issuer typically makes a payment to the IRS for alleged loss revenues in return for the agency's retaining the tax-exempt status of the bonds.

The terms of the agreement were not disclosed and Bradley S. Waterman, the Washington, D.C.-based tax controversy lawyer representing the district, declined to comment on it.

The IRS tax-exempt bond branch initiated an audit of the debt in early 2004, and on June 8, 2006, issued a proposed adverse determination that the bonds were taxable because of a defeasance escrow, funded by a portion of the 1997 bonds, that contained a put option, which may have been used in an abusive yield-burning strategy.

The Hazleton district filed a protest and requested a review from the IRS' office of appeals on July 6 of that year, according to the notice.

The deal involved three sets of general obligation bonds that were sold in 1997 - $10.8 million of Series A, $19.4 million of Series B and $34 million of Series C - to fund capital projects that were later refunded.

Pittsburgh-based attorney Ira Weiss was bond counsel and Milt Lopus Associates Inc. was financial adviser. Commonwealth Securities and Investments Inc. was underwriter and Chase Securities Inc., now part of JPMorgan, was escrow agent.

The IRS opened an audit of the bonds in June 2004 and issued a preliminary adverse determination in July 2005 that said the transaction's defeasance escrow contained a put option that appeared to have been counted as an investment cost.

The cost of the put, combined with the cost of the Treasuries purchased for the escrow, brings down or "burns" the yield on the Treasuries so that it equals the yield of the refunding bonds and does not generate any illegal arbitrage.

Issuers sometimes buy put options to lower escrow yields and normally purchase open-market Treasuries with the option to put either the entire escrow or a set percentage at a certain price. However, since a put option is not required for an investment escrow, the IRS has argued in several audits that it cannot be included in investment costs.

IRS officials targeted a number of similar deals in the past, and encouraged issuers to come forward on their own through the agency's voluntary closing agreement program. But issuers lose the ability to enter the VCAP once the bonds are under audit, which appears to have been the case with Hazleton.

Weiss was forced to pay a $9,000 penalty to the IRS in 2004, stemming from his role as bond counsel for $9.6 million of Neshannock Township, Pa., School District notes. In that transaction, he gave an unqualified opinion that the notes were tax-exempt, even though the transaction was arbitrage-driven.

Weiss also was forced to pay $9,000 to settle Securities and Exchange Commission charges that he violated the securities fraud laws in the same transaction.

Meanwhile, Denver disclosed on June 9 that the IRS closed a seemingly random audit of $149.2 million of excise tax revenue refunding bonds issued in 2005 with no change to their tax-exempt status. The IRS had initiated the examination on Jan. 15.

Sherman & Howard LLC and Trimble Tate Nulan & Evans PC, now Trimble Nulan & Evans PC, was co-bond counsel on the deal.

Stifel, Nicolaus & Co. underwrote the bonds and Kutak Rock LLP was underwriter's counsel. The bonds were insured by Financial Security Assurance Inc. and Piper Jaffray & Co. was financial adviser.

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