WASHINGTON -- A U.S. district judge has dismissed the lawsuit filed by Galt, Calif., earlier this year to block the Treasury and the Internal Revenue Service from either collecting arbitrage or taxing investors' interest earnings from a $29.29 million bond issue.

Judge Davis F. Levi, with the U.S. District Court for the Eastern District of California in Sacramento, dismissed the suit Friday after finding that the court lacked jurisdiction over the tax dispute and that Galt had an alternative remedy to court action. Judge Levi said the city could pay the $1.1 million in arbitrage the IRS was seeking and then file for a refund of that money under an IRS rule issued in May.

The ruling in the Galt case, which comes just one month after another federal judge dismissed a similar suit brought over two other bond issues, is a major victory for the federal government.

A lawyer from the Justice Department, which represented the IRS in the case, said Judge Levi's decision is "broad" and "well reasoned" and that it should deter other issuers from filing such cases in the future.

The lawyer contended, however, that the dismissal does not bar issuers and investors from obtaining court relief in tax disputes over bond issues with the IRS. The lawyer said that if the IRS refuses to refund an arbitrage payment to an issuer, that issuer can sue the agency in the U.S. Claims Court or a U.S. district court. If the IRS tries to tax bondholders, he added, those bondholders can sue the IRS in the U.S. Tax Court to prevent the collection of those taxes.

But a lawyer representing Galt disputed that view, saying that most bondholders either do not have, or would not be willing to spend, the money to sue the government to block the IRS from taxing their interest earnings. "As a practical matter, the economic effect would precludes small investors from seeking relief," said Henry S. Klaiman, a lawyer with Brown & Wood.

Setback for Issuers

Mr. Klaiman said the dismissal is a setback for state and local issuers, like Galt, which had hoped the federal courts would prevent the Treasury and the IRS from trying to take enforcement action until the tax disputes over their bonds could be resolved.

Galt's $29.29 million governmental improvement bond issue is among the more than two dozen bond issues that Matthews & Wright Inc. rushed to market in the mid-1980s to beat new arbitrage rebate requirements enacted by Congress. In these deals, the bonds were purchased with what was in effect a rubber check and were then temporarily warehoused with an unlicensed, offshore shell bank. The bonds were not sold to public investors for cash until months later.

The IRS has contended that these bond issues are subject to arbitrage rebate requirements because they were not validly issued until after those requirements took effect. But the issuers have argued that they had no idea the bond deals were closed without cash. They claim the bonds should not be subject to rebate requirements.

The IRS demanded arbitrage from Galt's bond issue last year and threatened to tax the bondholders' interest earnings if the city did not rebate the money within 60 days. But Galt sued the Treasury and the IRS, seeking to prevent the IRS from taking any action.

In dismissing the Galt case last week, Judge Levi said his court had no jurisdiction over the tax dispute under two federal statutes, the Anti-Injunction Act and the Declaratory Judgment Act.

The Anti-Injunction Act states that "no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person." The Declaratory Judgment Act allows U.S. citizens to seek court relief from the federal government's actions, but provides an exception "with respect to federal taxes."

Judge Levi wrote that even though arbitrage rebated to the federal government is not a tax, it "is a necessary preliminary to the collection of tax" and is therefore" part of the IRS' tax collection procedures" and would fall within the Anti-Injunction Act's purview.

The judge wrote in his decision that allowing Galt to continue its suit against the IRS "would create a substantial exception to the Anti-Injunction Act" so that an "investment advisor, who had placed a client a tax shelter, could sue to halt collection of tax in the event that the IRS found the shelter invalid."

Judge Levi also said Galt has an alternative remedy to the lawsuit under a temporary rule issued by the IRS in May that allows an issuer to recover an overpayment if it was "the result of a mistake."

Galt's lawyers, with the firm of Brown & Wood, had argued that the city could not recover an arbitrage payment under this rule because the rule applied only when an issuer had made a mistake. Justice Department lawyers said, however, that the rule would apply if the IRS made a mistake.

Judge Levi found in his decision that the language was "open-ended" and "designed" to address a multitude of situations." He wrote that the "IRS' interpretation makes good sense and provides a remedy to bond issuers that is consistent with the remedies traditionally afforded to taxpayers."

A similar suit dismissed by another federal judge last month had been brought by the Riverside County, Calif., Housing Authority to block the IRS from taking enforcement action over its $17.5 million Whitewater Garden and $13 million Ironwood housing issues.

Judge Consuelo B. Marshall of the U.S. District Court for the Central District of California in Los Angeles dismissed the case after finding that the authority had an alternative to the suit under the IRS temporary rule issued on May.

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