WASHINGTON -- Columbus, Ohio, is poised to sell $27.12 million of tax-exempt refunding bonds tomorrow in a controversial transaction to prepay, at a discount, money it owes a state pension fund.

The transaction is controversial because federal officials and some lawyers have warned it could run afoul of 1986 tax law changes enacted to prohibit tax-exempt bond proceeds from being directly or indirectly used for pension funds and invested on an unrestricted basis

"This is clearly inconsistent with the purpose of the arbitrage rules and clearly inconsistent with what Congress was trying to do in 1986," One federal official said this week.

"Unless the IRS gives some indication that they do not have a problem with this, we are not willing to approve issuances of these kinds of bonds," said William Conner, a lawyer with Squire, Sanders & Dempsey in Cleveland.

A lawyer not involved in the deal who did not want to be identified warned that the transaction could cause members of Congress, who are considering changing the tax law provisions that affect such financings, to adopt further restrictions. "It's dangerous for them to be doing this now when there's pending legislation," he said.

But Arter & Hadden, the Cleveland-based law firm that is serving as special tax counsel for the deal, and another lawyer familiar with the refunding are adamant that the transaction does not violate the 1986 tax law provisions or any other current laws or regulations.

Arter & Hadden issued an eight-page memorandum last week that analyzed the tax issues raised by the transaction and concluded that the bonds would clearly qualify for tax exemption.

Michelle Kelly-Underwood, executive assistant to Columbus' auditor. said Wednesday that the city agrees with the legal opinion and is prepared to sell the bonds today. However, she said that could change if anything happens that would change the city's belief in the opinion.

Meanwhile, state and local governments across the nation are waiting to see if the transaction goes to market so that they might be able to issue tax-exempt bonds to pay off their past accrued pension liabilities.

Lawyers at Arter & Hadden claim that the transaction is unique and could not be replicated by most other issuers.

But if Columbus proceeds with the transaction, about 69 other cities and towns in Ohio may also want to prepay the pension liabilities they owe the state under the same circumstances as Columbus. The pension liabilities of the cities and towns total about $360 million. Lawyers involved with the Ohio deal concede that other issuers could do such transactions if, before 1986, they borrowed money to make pension payments and then invested the money at a yield that would be below the yield of whatever tax-exempt refunding bonds it would issue today to prepay the debt.

Under the proposed transaction. Columbus would issue tax-exempt bonds to prepay an obligation to the State of Ohio Police and Fireman's Disability and Pension Fund. In 1967, the state pension fund took over the unfunded pension liabilities of local communities that had accrued as of the end of 1966. The state pension fund determined the amounts the communities would have to repay based on actuarial assumptions and an interest rate of 4.25%. The state gave the communities the option of repaying their obligations in one lump sum payment at any point or in installment payments through 2035.

While some 30 communities made lump sum payments, Columbus and about 69 other cities opted to repay the state over time. Columbus owes the state about $41.44 million, but state pension officials agreed recently to discount the amount to about $26.93 million if Columbus prepaid the liability this year. Ohio passed a law this summer allowing the pension board to discount the cites' liabilities and the cities to issue general obligation bonds to pay them off.

Columbus wants to issue tax-exempt refunding bonds to make the lump sum payment based on the rationale that once its obligation to the state is paid, the bond proceeds can be treated as spent and freely invested by the state pension fund at a yield high enough to make up for the discount.

Moody's Investors Service confirmed the city's Aa1 GO rating for the deal on Wednesday. A rating from Standard & Poor's Corp. is pending.

The co-senior managers on the deal are Banc One Capital Corp. and Kemper Securities Inc.

The Arter & Hadden memo makes several technical arguments in favor of the transaction.

"The memo is trying to say we do not believe that there are any proceeds left from the 1967 obligation," said David Rogers, a lawyer with the firm. "We think there was only an exchange of assets for liablities in 1967.

"However, the memo assumes for argument's sake that there was an investment of the proceeds of the city's obligation and that the investment purchased was the liability assumed by the state. That liability had a yield of 4.25%. So when the transferred proceeds rules are applied to the 1993 refunding bonds, you could argue the investment would transfer, but there would not be an arbitrage problem because the yield on the investment would be less than the yield on the bonds."

Federal officials are concerned about the interest rate that the state pension fund used to discount the city's obligation and the rate the city could get in investing the bond proceeds to earn back the discounted amount. These interest rates, they said, would be higher than the bond yield.

"Although we have not made any final determinations based on the memo, it certainly appears that this is an arbitrage-motivated transaction because the prepayment is significantly discounted and would be invested at a yield above the bond yield," another federal official said.

The federal officials also have other concerns about the transaction. They question, for example whether the city's obligation to the state is debt. If it is not debt, the city cannot issue tax-exempt refunding bonds.

The arbitrage concerns about the deal stem from 1986 tax law changes Congress made to ensure that bonds would be taxable arbitrage bonds if their proceeds were used to acquire an annuity contract or other "investment-type property" that had a yield above the bond yield. The aim was to stop issuers from using tax-exempt bonds to acquire annuity contracts or similar investments to fund pension liabilities. The Internal Revenue Service had already outlawed the direct use of tax-exempt bonds for pension investments.

Earlier this year, the IRS defined investment-type property to also include certain prepayments.

"Look, I don't know whether this transaction can be done or not," said the lawyer who not involved in the deal. "But if the IRS decides it doesn't like it, it can find a way to stop it."

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