WASHINGTON -- The interest earnings of bondholders will not be taxed under a settlement signed yesterday between the Internal Revenue Service and parties to a Chester, Pa., bond issue that the IRS charged violated the arbitrage rebate rules.

The $335 million deal, issued in August 1986 for a resource recovery plant that was never built, was one of two dozen issues underwritten by Matthews & Wright Group Inc. in the mid-1980s.

In 1991, the IRS charged that the issue violated the restrictions against arbitrage earnings contained in the Tax Reform Act of 1986. In a letter, the IRS told the city that the interest income on the bonds would be taxed if the city did not rebate nearly $20 million in arbitrage profits that it has allegedly earned on the issue.

Attorneys for the transaction's participants threatened to litigate the tax law issues raised by the IRS. The bonds were redeemed in full in August 1991 under terms of the bond documents.

Under the settlement, "the IRS agreed not to go after the bondholders on the theory that the bonds were taxable, and it agreed not to pursue the arbitrage issue," said Saul Fisher, Chester's settlement attorney.

The IRS in the settlement is recovering some funds from parties to the bond issue, but far less than the $20 million in arbitrage earnings it originally sought, Fisher said. Under terms of the agreement, the exact amount of the monetary settlement cannot be disclosed, he said.

Attorneys connected with the deal declined to say which of the deal's original participants contributed to the monetary settlement. Fisher said Chester was not a contributor.

"The city of Chester and the people who bought the bonds are innocent parties" to the deal, even if one were to concede that the IRS allegations were true, Fisher said. He said the IRS investigation had focused on Matthews & Wright.

"It's a very fair deal to Chester," Fisher added, since the city will neither be penalized nor disqualified from issuing tax-exempt bonds in the future.

Matthews & Wright, which turned in its broker-dealer license in settlement of a Securities and Exchange Commission case involving other so-called black box deals, and is now doing business under the name Helmstar Group Inc. Helmstar is a holding company for merchant banking firms that focus on real estate.

According to a Dow Jones News Service report, Helmstar is not contributing to the settlement with the IRS. Fisher and other attorneys familiar with the settlement declined to say whether Helmstar was a contributor.

Berkman Ruslander Rohl Lieber & Engel, the bond counsel on the 1986 deal, was identified by Dow Jones as a contributor to the settlement. Kenneth Luttinger, a Berkman attorney, and David Smith, an attorney representing the Berkman firm, declined to comment.

A federal source said the IRS must weigh several factors in determining whether to litigate a case or negotiate a closing agreement such as the one in the Chester case.

The probable innocence of the bondholders, "respect for the role of the issuer," and the cost of litigating the case are among the factors that influence the IRS, the source said.

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