The Vermont Student Assistance Corp. has been notified by the Internal Revenue Service that $165 million of education loan revenue bonds it issued in 1998 may be taxable because of issues related to its tracking of loans and treatment of fees.

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

The bonds are auction-rate securities.

The corporation said in the notice that it received a Form 5701-TEB from the IRS on March 3. These forms, which replaced preliminary adverse determination letters, identify IRS concerns that could make bonds taxable.

The IRS told VSAC it is concerned about both 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 paid to the U.S. Department of Education as a qualified administrative expense. All Federal Family Education Loan lenders are required to pay that fee to the Education Department whenever student loans are consolidated.

But the agency stated in the notice that it believes the IRS' position is "inconsistent with applicable law and practice" and that both its methodology and computations are in accordance with the tax code.

"VSAC is vigorously contesting the IRS assertions in Form 5701 and is in the process of responding to the IRS," the corporation stated in the notice.

The IRS inquiry into the bonds began on May 30, 2008, when it opened a random audit of the debt, according to the notice.

Market participants said yesterday that it is not clear if this particular audit carries broader implications for tax-exempt student loan lenders. However, it is not uncommon for issuers to treat the consolidation loan rebate fee as a qualified administrative expense, they said.

The bonds were issued to finance the origination or purchase of student loans, according to bond documents.

Kutak Rock LLP served as bond counsel on the deal. PaineWebber Inc., now UBS Securities LLC, and Lehman Brothers, now part of Barclays Capital, were underwriters. Government Finance Associates Inc. was financial adviser. All but $10 million of the bonds were insured by Ambac Assurance Corp.

IRS tax-exempt bond office director Clifford Gannett said last year that his team planned to examine tax-exempt student loan bonds 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 notice did not state if VSAC's bonds were selected as part of that initiative.

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