Bear, Stearns & Co. said the Internal Revenue Service will face a fight over its attempt to retroactively close a tax loophole for issuers of so- called step-down REIT preferred securities.

Frederick Khedouri, senior managing director of Bear Stearns' financial institutions group, said his firm is not alone in trying to save the loophole for securities that have already been issued. The issuers, the law firms that advised them, and investors also have joined the battle, he said.

"We haven't seen the last word on this," Mr. Khedouri said. "A lot of people will be harmed by the Treasury's actions. The issuers themselves are very large and capable enterprises and many of them are quite actively seeking ways to bring this issue into broader debate."

Bear Stearns, which had missed out on the flurry of trust-preferred security deals that started last fall, marketed the step-down REIT preferred securities aggressively, hoping to cash in on issuers' desire for a tax-advantaged financing. More than $10 billion of the securities have been issued by industrial companies and banks.

Wall Street observers said the IRS' pronouncement was especially damaging to Bear Stearns, which has underwritten 14 deals for about $7 billion. Morgan Stanley & Co. also has underwritten a number of issues.

The majority of issuance has come from industrial companies, but Republic New York Corp., which did two deals, and Norwest Corp. have issued as well.

Barnett Banks Inc. reportedly withdrew its deal just before the IRS made its announcement. The Federal Home Loan Mortgage Corp.-Freddie Mac-has issued between $3.5 billion and $4 billion.

"A large number of tax lawyers reviewed this structure and we issued it based on the law as it was understood," said Mr. Khedouri. "That is why we have a high degree of confidence in the validity of the structure ... a major issue is that the Treasury's position is one that is not supported by existing law."

One trader who declined to be identified said that Morgan Stanley & Co., another underwriter of step-down REIT preferred, plans to bring the shelved Barnett issue back to market, because of its confidence in its legal staff.

Morgan Stanley declined to comment.

To issue the securities, companies create and capitalize a Real Estate Investment Trust. The REIT then issues preferred stock, which is offered to investors with a 13% to 14% dividend. In the 10th year the dividend "steps down" to 1%.

The proceeds from the preferred are used to buy a mortgage-backed note or similar instrument with a fair-market coupon. Investors receive a 13% to 14% dividend for 10 years, while the parent company deducts the interest on the underlying note.

One Treasury official bluntly described it as "something that is taxable and is being shifted to a nontaxable entity or vice versa."

Other critics charge that the structure enables companies to deduct both interest and principal off the securities.

Mr. Khedouri fumes at such statements.

"No one is deducting principal. People are saying that because they are looking at this on an economic basis," he said. "Looking at this on an economic basis is irrelevant because the instrument is preferred stock, it is genuine equity, and the payments received are dividends and not interest payments."

Mr. Khedouri also argues that the blow that step-down REIT preferreds have taken is not much different from the hit that other securities could take if Congress rules in favor of an anti-hybrid securities proposal, which wants to eliminate the tax deductibility of many securities.

"The best parallel is the trust-preferred," said Mr. Khedouri. "The Treasury said we don't like this, we don't want you claiming this tax advantage. And I would observe that all the preferred in most of the proposals says to grandfather these transactions."

Naysayers, however, say that Bear Stearns and other investment firms are unlikely to win their battle to get the securities grandfathered.

A Treasury Department official acknowledged that there is no specific language in the law that bans deducting principal, but added "it is a fundamental precept of the law that you cannot deduct principal."

The bottom line, the official said, is that "This was an abuse of the system and you don't grandfather abuses of the system."

Bear Stearns, however, isn't ready to take no for an answer.

Market sources note that the issue can be pursued in the courts in Congress and through the rule-making procedure that the Treasury undertakes.

"There are a variety of ways the issue can be addressed," said Mr. Khedouri. "The Treasury is not the only actor involved in tax policy."

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