WASHINGTON -- In a groundbreaking ruling, the Internal Revenue Service has concluded that a municipal authority could use tax-exempt bonds to finance an upfront payment for a long-term contract with a private utility without running afoul of arbitrage restrictions.

Several bond lawyers said this week that the ruling, which the IRS published last week, reflects a new IRS stance and could be helpful for any financing involving an up-front payment for a long-term contract.

The private letter ruling allowed the Alabama Municipal Electric Authority to use $65 million of bonds to finance the up-front payment of capacity charges for a long-term electric power contract with Alabama Power Co., a private investor-owned utility.

"I think this is the most important arbitrage ruling in the last couple of years," said one lawyer familiar with the letter ruling.

The ruling, he said, for the first time tries to clarify that while some financings of up-front payments are arbitrage-driven, others, like the one proposed by the Alabama Municipal Electric Authority, are motivated by strong business or other reasons.

"The bottom line of the ruling," he said, "is that the mere existence of an up-front payment that is financed with tax-exempt bonds does not necessarily mean that the transaction is arbitrage-driven. If you can demonstrate strong, compelling business reasons for the upfront payment, then it won't be considered an arbitrage play."

IRS officials have been unwilling until now to permit the tax-exempt financing of up-front payments for long-term contracts with private parties because of arbitrage concerns. Once an up-front payment is made, the bond proceeds are treated as spent and can be invested on an unrestricted basis to earn arbitrage profits.

The arbitrage concerns about upfront payments stem from 1986 tax law changes that introduced the concept of "investment-type property" and suggested that it included uncustomary up-front payments for long-term contracts. Investment-type property is subject to yield restriction requirements. So if bonds are used to finance uncustomary up-front payments and the money is invested at yields higher than the yields of bonds themselves, the bonds may be taxable arbitrage bonds.

But in its recent letter ruling for the Alabama Municipal Electric Authority, the IRS for the first time clarified that not all up-front payments, or prepayments as they are also called, should be considered to be investment-type property.

"Congress recognized that prepayments may be investment property for purposes of section 148 of the code when they are made to avoid arbitrage restrictions instead of for other reasons," the IRS says in the letter. "Examples of other reasons include [customary business practices] in an industry, which may dictate a prepayment, or particular economic factors (other than investment return) that may influence one party or another to demand or make a prepayment. In these types of cases, a prepayment would not be treated as investment property," it said.

"For the Authority," the IRS continues, "motivations other than the investment return inherent in a pre-paid capacity charge are dictating the form of the transaction."

The IRS said the authority needed the additional power to fulfill its obligations to supply power to surrounding municipal utilities and that the up-frnt payment was necessary for Alabama Power because of the regulatory system under which it operates. The IRS noted also that Alabama Power made numerous, valuable concessions to the authority regarding another existing long-term power supply contract in return for the new contract.

Lawyers for the Alabama Municipal Electric Authority this week cautioned against reading the letter ruling too broadly. "I see it as a ruling that is really limited to our particular set of facts," said Robert D. Thorington, a lawyer with Thorington & Gregory in Montgomery, Ala., which represented the authority. And the IRS typically says that private letter rulings only apply to the parties that requested them.

But other lawyers insisted the ruling would be helpful to others. "I think there will be transactions that fit within that fact pattern, and people will be able to do them," said one New York lawyer.

An IRS official agreed with both assessments: "There were a lot of unique aspects to the transaction. But at the same time, I'm not surprised that others think the ruling is of broader interest."

The Alabama Municipal Electric Authority purchases bulk power to sell to 11 municipal and public power systems in the state that have their own distribution systems. The authority had obtained most of its power from Alabama Power under a long-term requirements contract. This contract allowed the authority to acquire certain amounts of additional power from other sources. The authority needed additional power and put out requests for proposals. Alabama Power, which had surplus capacity and wanted the authority's continuing business, made a proposal.

Under the proposal, Alabama woudl supply the authority with addtional power under a long-term contract. The authority would pay the capacity charges up front and the energy charges over the term of the contract. Alabama Power would make several concessions under the prior contract, such as agreeing not to increase capacity charges under that contract for five years.

"Under these circumstances, the authority cannot reasonably accept another alternative," the IRS said in its ruling. "To do so would involve heavy costs aside from, and unrelated to the investment return on the prepayment."

Lawyers for the authority said they were able to show the IRS that Alabama Power was going to spend the money from the up-front payment quickly and that that, too, was a factor in the favorable ruling.

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