WASHINGTON -- Some of the participants and institutional investors connected with the $335 million Chester, Pa., resource recovery bond deal are trying to negotiate a settlement with the Internal Revenue Service to prevent the agency from taxing the interest earnings of the bondholders, sources close to the negotiations said this week.

"We've met with the IRS several times to talk," said one source who did not want to be identified. "We believe that the bonds are tax-exempt, but sometimes it's easier to go the settlement reoute because the cost of legal fees would be so great" if the bonds were taxed or if the IRS was challenged, he said.

Those negotiating with the IRS -- which do not include all of the parties to the 1986 deal -- hope some sort of agreement can be reached before the end of the year, he said.

Chester officials refused to say whether a settlement agreement was in the works. "I can neither confirm nor deny that," said John Nails, the city's solicitor.

The IRS notified Chester last February that the bonds were not tax-exempt and threatened to tax the bondholders if arbitrage profits from the deal were not rebated to the federal government by April 9.

The IRS had said the deal, which was closed without cash by Matthews & Wright Inc. on Aug. 29, 1986, was subject to arbitrage rebate requirements because it was not validly issued until after those requirements took effect for governments bonds. The bonds were sold to public investors for cash on Oct. 23, 1986, but the rebate requirements became effective for governmental bonds issued as of Sept. 1 of that year.

Chester officials had said they did not know how much arbitrage the IRS was seeking. But the arbitrage earnings from the deal have been estimated at more than $23 million, and the April 9 deadline for rebating the arbitrage passed without Chester's making any payment to the federal government. City officials had, however, already begun meeting with the IRS when the deadline passed, sources said.

Reports of the attempts to reach a settlement come after the Chester bonds were redeemed last month. The transaction was structed as a collapsible escrow deal, in which the issue would collapse and the bonds would be redeemed within five years if the resource recovery project was not built. The bond proceeds had been invested in a guaranteed investment contract with Aetna Life Insurance Co.

Chester's 1986 issue was one of 26 deals totaling $1.3 billion that Matthews & Wright rushed to market and closed without cash during the mid-1980s to beat arbitrage rebate restrictions then pending in Congress. The firm purchased the bonds with checks from the New American Federal Credit Union, which did not have sufficient assets to back the checks. The bonds were then temporarily warehoused with Commercial Bank of the Americas, an unlicensed offshore shell bank. They were not sold to investors for cash until months later when the market was calmer and the spreads between bond and investment rates had improved.

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