CHICAGO - The Internal Revenue Service on Wednesday stepped into a controversial Columbus, Ohio, bond deal in the midst of its final pricing and raised serious concerns about the tax-exempt status of the bonds, forcing the city to cancel the issue.

Hugh Dorrian, Columbus' auditor, said yesterday that he decided to cancel the $27 million tax-exempt general obligation deal, which had just had its final pricing, late Wednesday after a "lengthy" phone call from IRS officials.

The phone call was the third between the IRS and the city or its lawyer this week, according to Dorrian. He said he sent the IRS, at its request, an eight-page memorandum prepared by Arter & Hadden, special tax counsel for the deal, defending its Position on the tax-exempt status of the bonds.

Dorrian said in the final phone call that the IRS raised "several questions about the tax analysis on the deal and were very concerned about us going to Market under those concens." Specifically, the IRS officials felt the deal was "clearly contrary to the spirit of the 1986 Tax Act," Dorrian said. He declined to name the IRS officials.

The IRS officials also raised questions about whether a recent ruling from the U.S. Court of Appeals for the Second Circuit - Consolidated Edison Co. of New York v. United States of America - would have any bearing on Columbus' proposed deal, according to a lawyer for the city. The appeals court found that when property taxes were prepaid in cash, the discount could not be treated as tax-exempt interest. But Columbus' advisors questioned whether the ruling could be applied to the city's proposed deal.

Dorrian said that although the IRS officials did not ask the city to cancel the deal, which involves the use of bond proceeds to Pay off the city's liability to a state pension fund, he withdrew the deal to uphold "the reputation and integrity" of Columbus.

"I don't ever want the reputation of the city of Columbus to be tarnished in any way in the investment community. We want to keep full faith with everyone out there," Dorrian said. "Equally important is we want to try to resolve the questions with the IRS."

It is rare for the IRS to press an issuer to delay a transaction that is about to go to market so that tax law concerns can be resolved through the ruling process.

In one of only two known recent cases of such IRS involvement, the bonds were never issued. The case involved Macomb County, Mich., which proposed in 1987 to issue tax-exempt bonds to reimburse itself for money spent on a jail project. But the IRS urged the county to seek a ruling and later concluded the county could not issue tax-exempt reimbursement bonds.

In the other case, bonds were issued, but the IRS eventually brought enforcement action against the deal. The IRS had urged the Guam Economic Development Authority in 1985 to postpone a multifamily housing deal because of concerns that it was arbitrage-driven. The authority's lawyers ignored the IRS and proceeded with the deal. The IRS later threatened to tax the bondholders but ultimately reached a settlement with the authority and participants.

Dorrian said the IRS "made it clear that letter rulings were available and that they'd be happy to entertain a request for a ruling."

The city sought a letter ruling or a possible deal in 1990 through its bond counsel, Bricker & Eckler, But the IRS refused to consider the ruling request because no Ohio law authorized the bond sale at the time.

But this summer the Ohio Legislature passed a bill enabling municipalities to prepay the $400 million of total liability they owe to the Ohio Police and Firemen's Disability and Pension Fund in return for having their liabilities discounted by the fund.

Columbus, which owed the fund about $41.4 million, was the first Ohio city to apply for a discount, which the fund set at $26.93 million in October. The city has structured the deal as a refunding to refinance the state loan that was made in 1967.

The city's plan was to us proceeds from the bond issue to pay off the discounted $26.93 million liability. Once the city paid off the loan to the fund, the bond proceeds would have been treated as spent and would have been freely invested by the fund at a yield high enough to make up for the discount.

The city's bond lawyers believed the deal could be done on a tax-exempt basis under current tax laws and that a letter ruling was not needed.

Dorrian said yesterday the city will probably seek an IRS letter ruling even though it could take several months. The other alternative, he said, is to Put together a taxable deal.

Columbus wanted to sell the bonds as soon a possible to take advantage of low interest rates. The city expected to save the difference between debt service on the 25-year bonds and the $2.1 million a year the city was to have paid the pension fund until 2035 to pay off its liability. Dorrian has estimated the annual savings for most of the years at about $250,000.

He said Columbus' agreement with the pension fund for the discounted liability expires in February and that he hoped to get the deal done before then. If not, another agreement can probably be obtained, Dorrian said.

Dorrian said he and David Rogers, the attorney working on the deal from Arter & Hadden, are tentatively scheduled to meet with IRS officials on Monday in Washington, D.C.

Meanwhile, Banc One Capital Corp., the bookrunning manager on the deal, contacted all buyers of the bonds by yesterday morning to tell them of the cancellation, according to Dorrian. On Tuesday, the city agreed to include at Banc One's request a provision to call the bonds at par if the IRS were to determine the bonds taxable and once the city had exhausted all its legal remedies.

Dan Rohr, a managing director at Banc One, said the provision was needed to calm market concerns over published statements from federal officials and other bond attorneys that the deal could run afoul of tax law prohibitions against using bond proceeds directly or indirectly for pension funds and investing the proceeds on an unrestricted basis.

But the tax call provision, which legal sources said is rarely used in GO bond issues, was also controversial. Richard Chirls, a lawyer at Orrick, Herrington & Sutcliffe, said such a provision can be used against bondholders. If investors are taxed, the city can try to limit its liability by saying it warned that the bonds might be taxed and called at par.

Chirls said that if he were an investor, the provision would be "a signal to me that the issuer is trying to put one over on me."

On Wednesday morning, Banc One tentatively priced the bonds, which were rated AA-plus by Standard & Poor's Corp. and Aa1 by Moody's Investors Service, with yields on the serials ranging from 3.45% in 1995 to 5.30% in 2007. A 2013 term was priced with a coupon of 5.35% for a return of 5.50% and a 2019 term was priced as 5.40s to yield 5.55%.

Dorrian said the final pricing was close to the tentative numbers

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