WASHINGTON - The Internal Revenue Service ruled recently that an Ohio authority could not issue tax-exempt bonds under a program designed to help underground oil storage tank owners finance the cleanup of leaks and spills.

The bonds were to be special obligations of the state's Petroleum Underground Storage Tank Release Compensation Board and were to be paid from fees collected mostly from private tank owners and operators.

But the IRS concluded in its lengthy letter ruling that the bonds would be taxable private-activity bonds or arbitrage bonds.

While most lawyers agreed with the IRS' conclusion, some did not. However, most were troubled by the IRS' analysis of arbitrage issues, which they said was too far-reaching and could hurt other bond financings.

"I am concerned that some of this language will apply to other financings that are clearly legitimate," said a lawyer in New York who did not want to be identified.

Ohio officials and their bond lawyers said the IRS ruled against them because it was afraid other kinds of insurance programs would seek tax-exempt financing. "We believed that they were concerned about precedent and what other states would be doing if they gave us a favorable ruling," said Phillip Johnston, a lawyer with the firm of Vorys, Sater, Seymour and Pease in Columbus, which was bond counsel for the state board.

The letter ruling, numbered 9243051, did not mention Ohio. But state officials confirmed last week that it was their ruling. The state board had asked the IRS in January 1991 to rule that its proposed $15 million to $20 million issue would be tax-exempt, according to Rich Murray, the board's executive director.

The bonds were to be issued under a so-called state assurance program that was set up to help tank owners meet federal financial requirements. The Environmental Protection Agency requires the underground oil storage tank owners and operators to have the financial resources to handle up to $1 million of cleanup costs for each accidental release. The agency, however, permits states to set up assurance funds to help tank owners meet the requirements.

The Ohio program is one of 43 such state assurance programs. But it is the only one to have proposed that tax-exempt financing be used to help pay cleanup costs, EPA officials said. The Ohio program is one of 29 that have approved by the agency so far.

Ohio had collected about $8 million in fees from tank owners and operators for its assurance fund, Murray said. But the state board wanted to issue bonds to supplement the fund, he said.

The board, according to the IRS ruling, had proposed that the assurance fund be divided into three accounts. One would contain bond proceeds to be used to pay issuance costs and to reimburse tank owners for cleanup costs. This account was pledged as security for the bonds. Another would contain the fees that would also be used to reimburse cleanup costs, as well as to pay program administrative costs and judgments obtained by third parties. This account would be used, but not pledged, to pay debt service. The other account would be a reserve fund that had enough fees to pay 12 months of debt service. It would be pledged to pay the bonds.

The board told the IRS it would spend the fees that had accumulated before the bond proceeds at the time of bond issuance. But after that, the bond proceeds might be spent before the fees, it said. The board proposed to spend the bond proceeds within three years. It had no plans to restrict the investment of the fees to a yield that was below the bond yield.

The state board argued that the bond proceeds would not be privately used. Under the tax laws, bonds are considered private-activity debt and possibly taxable if more than 10% of the proceeds are privately used and if more than 10% of the debt service is derived from, or secured by, private payments.

But the state board said the financing would not involve private use because the bond proceeds would be used to protect the groundwater, which is owned by the state, and to clean up the soil below the ground, which is not used by the private property owners. Most of the tanks are privately owned and operated, but about 16% are governmental facilities.

The board also argued that the financing would not involve private payments or security because this was a state program with a public purpose.

But the IRS disagreed. The agency said in the ruling that the bond proceeds would be privately used even before they were disbursed because they would be providing assurance coverage to private tank owners and operators.

The IRS said the bonds would involve private payments because the debt service was secured by fees from private tank owners and by a pledge of the proceeds in the assurance fund which, it said, was to be privately used.

While most lawyers agreed with this conclusion, a few did not.

"I was surprised," said another lawyer in New York who did not want to be identified. "I thought this was a state insurance program. I thought a state could run an insurance program that was tax-exempt even if the people [who] were insured were private persons or businesses."

The IRS also concluded in the ruling that even if the bonds were not private-activity bonds, they would be arbitrage bonds under a replacement concept in tax regulations. The state board had not even asked the IRS about any arbitrage issues. The IRS said the bond proceeds would be treated as replacing the fees for two reasons. First, it said, the payment of claims would be a working capital or operating expense of the program that ordinarily would be paid from the fees. In addition, it said, the fees were dedicated by state law to the same purpose as the bond proceeds.

Several bond lawyers were concerned with this reasoning. One lawyer worried that the IRS was saying in the ruling that replacement proceeds cannot be spent, so that any financing with replacement proceeds will be a taxable hedge bond financing.

"This is going to be troublesome in the hedge bond area," he said. "Under the tax law, if you don't spend your bond proceeds in three years, you have hedge bonds that are taxable," he said, adding, however that "this ruling takes away the ability to say the money is sent."

The IRS said that bonds would violate a gross-proceeds-spent-last rule for working capital financings because the bond proceeds would be spent in some cases before the fees. It also said working capital financings do not qualify for a three-year temporary period, under which bond proceeds can be invested on an unrestricted basis.

This conclusion upset most of the lawyers, who said that IRS rules have always been unclear on this point.

"There has been a debate that has raged for years about whether working capital financings can have 13-month or three-year temporary periods," said another New York lawyer. "The IRS is taking a position for the first time that such financings can't have a three-year temporary period and this is going to upset some lawyers."

Johnston, the Vorys Sater lawyer, said the IRS asked the state board to withdraw its ruling request once it was clear it would be negative. "But we insisted they give us a written ruling. We wanted to commit them to what they were going to say," he said.

Most of the lawyers agreed with one's assessment that the IRS "really threw the book" at the state board in its ruling. The ruling, however, was requested under a special set of declaratory judgment procedures that allows the state board to challenge the IRS in U.S. Tax Court. Typically, the IRS analyzes all the tax issues in such ruling requests, not just the ones asked about.

Murray, the state board director, suggested that an appeal of the IRS ruling is not likely. He said the state will probably just issue taxable bonds to finance its program.

"Obviously, its going to cost us more to borrow money in the taxable market," he said.

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