WASHINGTON -- The Internal Revenue Service can continue examining the tax liability of investors who purchased the Riverside County Housing Authority's Whitewater Garden bonds, even though it is under a temporary restraining order issued by a U.S. district court, U.S. attorneys said this week.

"We can continue to do our thing up to the point of formally including the [bond] interest as taxable income" one U.S. attorney said. The IRS must stop short of actually taxing the holders of the $17.5 million Whitewater Garden issue under the restraining order, he said.

Lawyers from Brown & Wood, which represents the authority, agreed. "Our understanding is that the IRS can do whatever internal investigation or examination it wants to do, short of sending out notices" to bondholders, said Michael Danko, a Brown & Wood lawyer.

The temporary restraining order was issued last month and then extended last week by Judge Consuelo B. Marshall of the U.S. District Court for the District of Central California. It bars the IRS and Treasury from either collecting arbitrage profits from the Whitewater Garden issue or revoking the tax-exempt status of the bonds.

The order was obtained by the authority after the IRS asked for $2.25 million of arbitrage profits from the deal and then warned that the bondholders would be taxed if the authority failed to rebate the arbitrage.

U.S. attorneys told the court the order was hampering efforts by the IRS to examine and audit the tax returns of five corporations, three trusts, and 25 individuals who earned interest from the bond issue in 1988, 1989, or 1990.

But the judge said at a July 1 hearing that the IRS could continue to investigate bondholders so it does not lose ground under a three-year statute of limitations that restricts it from collecting taxes after three years from when income was reported.

The temporary restraining order was due to expire last week but was extended by Judge Marshall at the July 1 hearing after U.S. attorneys argued that federal laws would allow the Riverside authority to rebate the $2.25 million of arbitrage profits and then file a suit to obtain a refund.

Lawyers from Brown & Wood have argued that since arbitrage rebate is not a tax, the traditional remedies for resolving a dispute with the IRS are not available. But the U.S. attorneys argued at the July 1 hearing that federal laws would permit the authority to use the refund procedure for any kind of payment to the govermnment that is in dispute.

Judge Marshall told the authority's lawyers to file arguments on the issue by July 8. She gave the U.S. attorneys until July 15 to respond and said she expects to rule on the request for a preliminary injunction on July 22.

The U.S. attorneys and IRS and Treasury officials last week were reluctant to discuss the case but said that there is general agreement within the government that arbitrage rebate is not a tax. Arbitrage rebate is a condition for a federal subsidy, the federal subsidy being tax-exemption, several government officials said.

"If the issuer refuses to comply with the condition, which is rebate, then the subsidy -- tax-exemption -- doesn't apply any more," one government official said.

The U.S. attorneys have argued in the Riverside case that the government cannot be sued because federal laws prohibit lawsuits from restraining federal tax collection activities. They say the authority has no right to sue the government to stop federal tax collection activities against the bondholders.

"This could be precedent-setting stuff," said one government official. "The question is: Is there any way an issuer can prevent the IRS from going after its bondholders?"

The tax dispute underlying the case centers on whether the bonds were validly issued before arbitrage rebate requirements took effect.

The Whitewater Garden deal was closed on Dec. 31, 1985, by Matthews & Wright Inc., which is no longer a municipal underwriter. The bonds were purchased with checks from an undercapitalized credit union and then temporarily warehoused with an unlicensed, offshore shell bank. They were not sold to public investors for cash until Feb. 20, 1986.

The authority and its lawyers say the bonds were validly issued on Dec. 31, 1985, because that is when they were purchased with a check and that, under IRS rules and case law, bonds are "issued" when they are exchanged for a check regardless of whether that check is backed with sufficient funds.

The IRS, however, contends that the bonds were not validly issued until Feb. 20, 1986, because only then did the deal have any economic substance.

Whitewater Gardens is one of 26 deals totaling $1.3 billion that Matthews & Wright, the former municipal bond underwriting firm, closed without cash in the mid-1980s in a rush to market to beat the arbitrage rebate restrictions, which were then pending in Congress.

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