A large property and casualty insurance company may have contributed to the settlement of a tax dispute between the Internal Revenue Service and a municipal bond issuer.

Chicago-based CNA Financial Corp., one of the nation's largest multiline insurers, participated in the settlement between the IRS and Chester, Pa., over an allegedly illegal $335 million bond issue the city sold in 1986, according to yesterday's Wall Street Journal

Although CNA's participation in the settlement may mark the first time that a large institutional investor has contributed to such an agreement, sources familiar with the settlement said CNA's contribution was much less than what it would have had to pay in back taxes had the IRS taxed the interest it earned from the bonds.

A spokeswoman for CNA declined to comment.

Under a settlement signed about two weeks ago, the Chester bonds will retain their tax-exempt status and the IRS will not pursue bondholders for taxes on interest income paid on the securities.

The $335 million deal was issued in August 1986 for the Chester Resource Recovery Authority for a resource recovery plant that was never built. The offering was one of about two dozen questionable bond deals that were closed without cash by the former Matthews & Wright Group Inc. in the mid-1980s. Matthews & Wright has since changed its name to Helmstar Group Inc. and is no longer in the municipal bond business.

In a Feb. 8, 1991, letter to Chester, the IRS charged that the issue violated arbitrage rebate requirements. The IRS told the city that the bondholders' interest on the bonds would be taxed if the city did not rebate nearly $20 million in arbitrage profits that it allegedly earned on the issue.

According to the Journal, CNA subsidiaries at one time held more than $125 million of the bonds.

CNA officials told The Bond Buyer in 1991 that while they had held some Chester bonds, they sold them before the IRS action was brought.

As of Dec. 31, 1992, CNA Financial units did not hold any of the Chester bonds, according to Bond-Watch, a database of CDA/Spectrum, which is a division of CDA investment Technologies in Rockville, Md.

Although the companies do not currently hold any Chester bonds, they would be liable to pay taxes on the securities if the IRS decided to tax bondholders.

"If you declared interest on the bonds as being tax-exempt, it could be that the IRS would come back to the fund looking for taxes on the interest paid," one institutional investor said.

IRS officials declined to comment on the matter, saying the are prohibited from disclosing taxpayer information or any details of enforcement actions.

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