WASHINGTON -- Many bond market participants hope that a California authority's lawsuit against the Internal Revenue Service and the Treasury will lead to a public debate about how far these agencies can go in holding issuers or bondholders responsible for tax law violations that may have been committed by other parties in a bond deal.

But they worry that the suit -- which the Riverside County Housing Authority filed last Friday to block the IRS and Treasury from collecting arbitrage or taxing interest earnings from the $17.5 million of Whitewater Gardens issue -- will never get past the question of whether an issuer can seek court protection against the agencies' enforcement actions.

"Because we've never had any tax-exempt bond enforcement activity, we have a statute that's been in a vacuum," said one bond lawyer in New York. "This case presents a lot of important technical issues such as whether the IRS has the procedural tools to force an issuer to rebate arbitrage. But the nature of litigation is that the parties try to present all of the procedural bars that they can before they get to the substantive issues."

"If this case gets past the jurisdictional issues it could be constructive said a bond lawyer in the Midwest. "It could illustrate that the issuers and the bondholders are often the innocent parties in these deals and it could lead to more consideration of alternative penalties for the IRS."

He added, "Let's face it, the whole IRS enforcement system of going after the issuer or the bondholders is really awkward. It just doesn't work."

Several bond lawyers, however, said that the authority's lawsuit is so narrowly focused, the only substantive issue it might resolve is what constitutes a valid bond issuance.

The IRS has contended that the Riverside Authority must rebate $2.25 million in arbitrage profits from the Whitewater Gardens deal because the bonds were not validly issued until after arbitrage rebate requirements took effect.

The deal was rushed to market and closed without cash by Matthews & Wright Inc., on Dec. 31, 1985. The bonds were not sold to public investors for cash until weeks after the closing. The IRS has threatened to tax the bondholders if the authority does not rebate the arbitrage to the government.

But the authority contends that the bonds were validly issued on Dec. 31, 1985, because that is the date that they were exchanged for a check for Matthews & Wright. It does not matter that the check was backed with insufficient funds, the authority's lawyers told the court. In any case, they said, the authority had no reason to question the validity of the closing of the deal because it relied on bond counsel and other bond firms in the deal, including Matthews & Wright, which was forced out of the securities business by the Securities and Exchange Commission.

If the Riverside authority's lawsuit gets thrown out of the court on jurisdictional grounds, there will be no debate in any substantive issues, bond lawyers and issuers said.

U.S. attorneys already have asked the U.S. District Court for the Central District of California to dismiss the Riverside authority's suit on grounds that a federal law, the Anti-Injunction Act, generally prevents taxpayers from suing to restrain the assessment or collection of a tax.

The U.S. attorneys told the court it lacked jurisdiction to hear the case in two sets of documents filed last Friday, just hours from when the authority asked for a temporary restraining order. The authority, the U.S. attorneys said, "simply hopes to suspend the determination and collection of taxes."

Judge Consuelo B. Marshall granted the temporary restraining order against the IRS and Treasury, despite the U.S. attorneys' pleas.

But she scheduled a July 1 hearing on the authority's request for a preliminary injunction that would bar the agencies from applying the arbitrate rebate requirements to the Whitewater Gardens issue. And lawyers involved in the case said the jurisdictional issues may be more fully debated at that hearing.

Bond industry lawyers and issuer groups are surprised that the U.S. attorneys in the Riverside case appear to be arguing that arbitrage rebate is a tax. The Justice Department took exactly the opposite view in documents filed in 1988 with a U.S. District Court in Georgia that was considering the constitutionality of arbitrate rebate requirements and the alternative minimum tax, they said.

In that case -- Government Finance Officers Association et al v. Treasury Secretary James A. Baker 3d -- U.S. attorneys asked the U.S. District Court for the Northern District of Georgia to reconsider its findings that arbitrate rebate constitutes "a direct tax on state and local governments," that rebate is "assessed" against issuers and that issuers "have avenues open to them to contest the "legality" of rebate.

"We respectfully submit that these findings do not accurately describe the relevant statutes and should be corrected," the attorneys said documents filed with the court in Georgia. "Since payment of the rebate is not mandatory, the rebate cannot properly be classified as a 'tax,'" they told the court. Judge Robert H. Hall dismissed that lawsuit at the request of the finance officers association, despite the pleas from the U.S. attorneys.

The Riverside case "brings back all of the memories of those debates about whether arbitrage rebate is a tax," said Catherine Spain, director of the association's federal liaison center.

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