IRS: AGENCY BROKE TAX LAW ON BONDS

0 Comments | Gazette, The (Colorado Springs), Nov 12, 2007 | by PAM ZUBECK

The IRS has told Colorado Springs Utilities it violated the tax code on $345 million in bonds issued in 1991, which could force the city agency to pay millions of dollars or face other consequences.

If the IRS determination stands, the city-owned enterprise could lose tax-exempt status on the 1991 bonds and perhaps on $418.2 million in bonds issued in 2001 and 2004 to pay off the 1991 bonds.

Mayor Lionel Rivera said he couldn't comment on the pending IRS investigation, but he said the city is blameless.

"I know and Utilities know that we did nothing wrong," he said. "We followed the appro- priate underwriting guidelines when those securities were placed."

He said the matter would be resolved within a year.

In a statement, Colorado Springs Utilities' attorneys said city officials are "exploring their options with the IRS."

"At this time, it's not clear what the city's exposure is on this matter, if any," the statement said.

The recent adverse determination is Utilities' second problem with the IRS in as many years.

In 2006, after Utilities miscalculated arbitrage payments on bonds issued in 1994, 1996 and 1997, it paid the IRS $402,686.

Utilities also misjudged arbitrage payments on bonds issued in 1991 for which it overpaid $1.6 million. The city asked for a refund in August 2006 and is awaiting word.

Arbitrage is the difference between the amount an entity pays to borrow and the amount it earns by investing the bond proceeds. Arbitrage isn't allowed on tax-exempt bonds issued by municipalities, because Congress doesn't want agencies issuing debt as an investment strategy.

Arbitrage, which can be viewed as profit, can be a likely outcome for government issues, because they're tax-exempt. That means investors don't pay taxes on interest earned on the bonds, which results in the issuer, in this case Springs Utilities, paying a lower interest rate to borrow. Investors are willing to take a lower rate if they're not taxed on earnings.

If a municipal entity, such as Springs Utilities, shows a profit on investing bond proceeds, it must forfeit the money to the U.S. Treasury.

Utilities officials declined to be interviewed, but Utilities financial services general manager Bill Cherrier provided a written statement in response to The Gazette's questions.

In February 2006, the IRS notified the city it was investigating the yield on the 1991 bonds -- the same bonds for which the city had sought a refund because it had overpaid, the statement said.

Thirteen months later, the IRS said its calculations showed there had been a $509,277 underpayment to the government on the 1991 bonds.

In September, the IRS told the city of its "preliminary adverse determination" on the 1991 bonds, which were re-funded with the 2001 and 2004 bonds.

"If the 1991 bonds were to lose their tax-exempt status, it is possible that the IRS could challenge the tax-exempt status of the 2001A bonds and the 2004A bonds," Cherrier wrote.

Steve Chamberlin, IRS manager of tax-exempt bonds compliance and program management in St. Louis, spoke with The Gazette about noncompliance issues and IRS procedures in general, but he didn't address specific cases.

He said when the IRS issues a preliminary adverse determination, it invites the municipality to provide information to disprove the IRS finding, if it chooses, or to open negotiations for resolving the matter.

If no resolution is reached, the IRS issues a "proposed adverse determination," which gives the issuer 30 days to request an appeal. If the matter isn't resolved on appeal, the IRS determination is final.

The IRS can take a number of steps in response to arbitrage violations, including requiring the bonds to be removed from the market. That is potentially expensive, because the issuer would have to pay off the bonds with cash. The IRS wouldn't allow a municipality to issue new bonds to pay off the questionable bonds, because the new bonds would be taxable.

Making bonds taxable adds interest cost, but how much depends on market forces.

"Every case is different," Chamberlin said. "You have different facts and circumstances on the bonds themselves and degrees of violations. All those are taken into account to find an equitable resolution."

He said it's "pretty rare" for a government to lose tax-exempt status on bonds, because the issuer is eager to resolve the problem.

Another potential consequence of a violation is a change in an agency's credit rating, which determines its cost of borrowing.

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