WASHINGTON - The Internal Revenue Service has notified the Okahoma City School District that it may owe more than $1 million in arbitrage profits, interest, and penalties from a $30 million cash-flow financing that appears to have violated tax laws.

The school district issued the $30 million of tax-exempt tax and revenue anticipation notes in 1990 to help cover an expected short-term cash flow deficit during the 1990-1991 school year.

But, in a letter sent to the school district in July, an IRS official said that the bonds appeared to be taxable arbitrage bonds because the city's cash flow deficit projections "were not reasonable."

The agency's preliminary findings show that the city did not end up with enough of a deficit to both justify the size of the financing and to guarantee that it would be exempt from arbitrage rebate requirements, said Mahlon E. Blagg, the IRS official, in the letter to Anne Hsieh, the school district's new finance director.

Hsieh joined the school district in July.

Under IRS regulations adopted in 1979 and in effect until last year, issuers doing short-term cash flow deals could earn arbitrage if they sized their financings based on the maximum cumulative cash flow deficit they expected for the year, plus one month's expenditures.

Issuers would be exempt from rebate under tax laws enacted in 1986, if within six months of issuance, they had an actual deficit that was at least 90% of the size of their note issue.

The IRS said the school district would have needed a cash flow deficit of $27 million within six months of issuance to avoid rebate requirements on the $30 million issue, but did not have it and " therefore, is not excepted from paying arbitrage rebate."

Blagg said that if the city cannot refute the charges, it must pay the IRS about $1.1 million, a figure that represents about $621,800 in arbitrage profits earned on the notes and $477,076 in interest and penalties.

A refusal to make the payment, if it is found to be due, could result in the IRS' taxing the interest earnings of the note holders, Blagg said.

The IRS' letter to the school district and an IRS memo showing how the arbitrage and penalty amount were calculated were obtained by The Daily Oklahoman, which first reported that the school district was under investigation by the IRS.

The oklahoma City district is the second school district in the state to be threatened with IRS enforcement action over a 1990 cash flow borrowing.

Earlier this summer, the IRS told Tulsa public school officials that they would have to pay up to $1.65 million in arbitrage, interest, and penalties to preserve the tax-exempt status of a $50 million note issue that was sold in 1990 to finance an expected deficit during the 1990-1991 school year.

The IRS is making similar claims in the financing for the Tulsa schools: that the deficit projections were faulty and that too many notes were issued to cover the schools' cash flow needs.

Cleeta John Rogers and Jon Sellers, lawyers for the Oklahoma City School district, said this week that they are looking into the IRS allegations.

"We're in the process of doing the calculations to see what, if any, responsibilities we have," said Sellers.

Sellers said the school district does not want to see the tax-exempt status of the notes revoked.

"We're not going to surrender our bond exemption. We're going to do whatever is necessary to reconcile this problem," he said.

Sellers and Rogers said they could not comment on the IRS allegations at this point.

But sources familiar with the financing said Stifel, Nicolaus & Co., the financial advisor and underwriter, the deficit calculations to size the 1990 cash flow deal.

Stifel, in a written statement, said that it "does not wish to comment about a specific school district, especially one that is having current discussions with the IRS."

However, stifel said that in general its cash management program seeks information from school districts about "any and all funds" that would be available to pay their expenses during a school year. All of the information provided by the school districts is used to size the note issues, stifel said.

Jim Joseph, the state bond advisor and member of a three-person commission that was set up in 1991 to oversee the cash flow financings of all the school districts in the state, said the IRS' problem with the Oklahoma City schools may revolve around some invested funds that the school district was treating as unavailable for cash flow needs in determining its expected deficit during the school year.

Joseph said that years ago, when school districts wee issuing tax-exempt warrants to cover their cash flow shortfalls, the assistant attorney general issued some guidance indicating that certain invested funds did not have to be treated as available in determining deficits. Joseph said the guidance was aimed at clarifying state law requirements and did not address federal laws or rules.

"I think some of the districts misunderstood and extended that opinion," Joseph said in a recent interview.

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