DALLAS - The Internal Revenue Service has notified the Tulsa, Okla., public schools that the district may owe as much as $1.6 million in interest and penalties on excessive arbitrage profits earned in a 1990 cash-flow borrowing, district officials confirmed.

Tulsa officials said they were notified by the IRS in February that the agency believed the district owed between $1 million and $1.6 million because it overestimated its cash-flow borrowing needs by selling $50 million of notes three years ago.

While the IRS requested documents from the Oklahoma City schools two years ago, none of the 280 other issuers that participated in the $524 million cash-flow pool program underwritten by Stifel, Nicolaus & Co. have been contacted yet by the IRS, bond lawyers and state officials say.

"I think the IRS is probably just going after the big fish because most of those participating made little if any arbitrage profit." said one Oklahoma bond dealer.

IRS officials in Washington, D.C., and Oklahoma declined to comment, and a lawyer representing the Tulsa school district declined to make copies of the IRS letters available.

But several bond lawyers said they thought this might be the first time the IRS has taken enforcement action on a cash-flow financing.

"We are cooperating with and discussing this with the IRS," said Debra Jacoby, division manager for financial services for Tulsa schools. "What they have sent to us is not a final amount owed by any means."

The district's local tax lawyer, Jerry Zimmerman, said, "There has not been any formal levy made against the district." Asked the reason for the notice from IRS officials in Oklahoma City, he said, "The IRS does not think we fell under the safe harbor allowances of the tax code."

The tax law contains a safe harbor that exempts short-term tax-exempt notes issued to finance cash-flow needs from arbitrage rebate requirements if, within six months of issuance, the issuer has a deficit that is at least 90% of the size of the note issue. If an issuer does not realize this kind of deficit, the notes are subject to rebate requirements.

In addition, another tax law provision requires issuers to size their note issues properly to avoid having to restrict the yield on the investment of their bond proceeds to the bond yield.

Under this provision, issuers must size the issue so that it is not larger than the largest expected deficit during the period of financing plus the next month's expenditures. If an issuer over-sized its note issue and the IRS found its deficit projections were unreasonable, the notes might lose their tax-exempt status.

These provisions were written into the tax code to allow government agencies to sell short-term notes to maintain adequate cash balances but to prevent them from generating more profits than necessary from these borrowings.

However, critics of the program have said that some participants engaged in over-issuance by erroneously projecting cash-flow needs that never materialized.

A statewide newspaper, The Oklahoman, reported this week that Oklahoma City schools were contacted in late 1991 by the IRS, but that the district has never been notified if their 1990 borrowing was within federal guidelines. District officials did not return numerous telephone calls for comment.

The Tulsa school district was first contacted by the agency in May 1991 following published reports that many participants in the Stifel-run program were abusing the program by overestimating their cash-flow needs. Program officials, including Stifel, have denied that deliberate efforts were made to earn illegal arbitrage.

Stifel officials said in a statement yesterday that the dispute with the IRS "does not relate to the cash management progmm itself, but to its implementation by one of the participants." and that "the cash management program was carefully designed, based on advice of counsel, to meet all federal and state guidelines and regulations.

Publicity over the program prompted legislation in 1991 that requires a state agency, the Oklahoma Commission on School and County Funds Management, to approve the planned cash-flow borrowings of issuers. The commission must verify the calculations of those who want to participate in note programs.

Since the new oversight began, the size of the mid-summer borrowing is about half what it was at its peak in 1990. This year, for instance, the commission approved borrowings totaling $272 million by 207 schools, 11 vocational-technical centers, and two counties. The notes are generally sold in late June.

Even Tulsa, which sold some $50 million in notes three years ago, has authorized only $13 million in borrowings this summer. One Oklahoma market watcher said that state oversight is just one factor that has caused participation to grow.

"The margins last year and this year are razor thin," said one financial adviser. "The potential permissible [arbitragel profits under that program have waned. In my opinion, the risk is not worth the reward."

Still, at least two firms, Stifel and Leo Oppenheim & Co. of Oklahoma City, may structure programs that deliver cash to participating schools and counties on July 1.

Jim Joseph, the state's bond adviser, who also sits on the cash management commission, said that a soon-to-be-released audit report found that some districts apparently sold more notes than necessary last year. The IRS requires an issuer to include invested funds as part of its available moneys, even if the investments are not immediately available to use.

"It's a common mistake, but all of that has to be calculated." Joseph said.

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