TUCSON - Some vendor lease offerings may not be tax-exempt, as their sponsors are claiming, because they may have failed to comply with all the tax code restrictions governing such offerings, bond attorneys said at a leasing conference here Friday.

"We've got all kinds of securitizations of leases out there these days, and we here in this room are partly responsible for it," Thomas S. Hay, a partner with Dorsey & Whitney, told lease dealers gathered at a meeting of the Association for Governmental Leasing and Finance.

"I hope we don't create a bad-fact situation" that results in a court case or punitive action by the Internal Revenue Service, "and we all pay the consequences," he said.

Hay singled out as particularly questionable a type of lease offering developed in recent years by equipment vendors, leasing companies, and investment bankers that derives a security from a municipal equipment lease up to a year or two after the lease was negotiated.

The leases often have much higher interest rates than current market rates, and thus the dealers hope to make a profit by repackaging the lease payments to create lower-coupon securities. One way this may be done, for example, is by investing the municipality's monthly lease payments in interest-earning accounts that are tapped into twice a year to pay the securities, Hay said.

While the dealers are claiming that these securities are tax-exempt, the maneuvers they went through to create the securities may have jeopardized their tax-exempt status, Hay said.

The interest earned on the lease payments while in the investment account, for tax purposes, may belong to the investors, he said. Yet in some cases the dealers and other middlemen have apparently pocketed the earnings, and thereby threatened the issue's tax exemption, he said.

"We started all this engineering to improve our returns on a lease," he said, "but the question is, with such a highly engineered lease, is this an exempt security.? I'm not too sure, frankly, we have an exempt security anymore," he said.

"If the IRS saw these deals, the tax-exempt income might well be denied," he added.

Cynthia Weed, a partner with Preston, Thorgrimson, Shidler Gates & Ellis, also questioned whether many vendor lease deals have been structured properly so as to be eligible for tax exemption.

"Not every lease signed by a governmental entity is automatically tax-exempt," she told the audience, and yet some lease dealers appear to assume so. Some dealers also have been basing their claim to tax exemption solely on the filing by the municipal lessee of an 8038-G form with the Internal Revenue Service, which states that the municipality intends to use the equipment for a public purpose.

Other due diligence must be performed by bond lawyers to ensure the lease's eligibility for tax exemption, said.

"And whether or not an 8038-G is filed, you need to make sure the right people signed it," she said. "If it's not properly filed, you may lose the tax exemption." Hay agreed with her assessment.

Another way that a lease could lose its tax exemption, Weed said, is when the dealers have not properly structured the securities so as to be valid under state and local law. "An invalid lease is not tax-exempt," she said.

Larry Singer, former public finance director of New Jersey, said he also questioned the claim to tax exemption by some lease dealers, especially if they have not checked if the equipment is still being used as originally intended. In some cases, it might have been sold as surplus property, he said.

Weed said she has not heard that the IRS has any "enforcement police out" looking for tax problems with vendor lease deals. But she said tax enforcement issues are likely to come up when a state or local government exercises its right to discontinue paying a lease, which would trigger a confrontation with the dealers and investors in such issues.

If it is determined the securities did not have the proper legal documentation, she said, "the IRS may declare them taxable."

"The world is changing," she said. "Soon you will find yourselves judged by the same standards as the tax-exempt bond industry."

Hay said that lease dealers may be able to avoid major tax problems by strictly structuring their securities to pass the municipal lease payments directly through to investors.

"You can do a securitization most simply under the tax and securities laws if every investor gets a pro-rated share of the lease payments through a vertical split," he said.

More complicated issues require much more work and documentation to be legal, he said. "It's all the engineering which creates tax problems, and that in turn creates securities law problems," he added.

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