Puerto Rico wants to impose limits on its domestic municipal bond market that the Securities Industry Association of Puerto Rico says are too stringent and would hurt issuers.

A proposal by the Government Development Bank for Puerto Rico targets bonds that are tax-exempt only when owned by residents or businesses on the island. It would limit to 2% the issuance costs paid from the local tax-exempt bond proceeds.

Interest on the bonds, which are sold only in the commonwealth, is exempt from Puerto Rican taxes. About $500 million are issued annually, feeding an indigenous market peopled by retail investors, banks, and mainland companies seeking to shelter profits from a 10% tax on capital taken from the island.

Under Section 936 of the Internal Revenue Code, mainland-based corporations can avoid federal taxes on profits of goods they manufacture in Puerto Rico. But when they try to bring those profits home, companies face the tollgate tax -- unless they invest the profits in Puerto Rico for five years, which cuts taxes to 5%.

Mainland companies dominate Puerto Rico's market for local tax-free securities of one to 10 years, after which they may take island profits home tax-free.

The system seemed to make everyone happy, encouraging mainland companies that manufacture on the island to invest there, too.

But alarms went off recently at the Government Development Bank after an affiliate of the bank -- a financing authority known as Afica -- made loans to a hotel with proceeds of a bond issue that also paid exorbitant fees to financial advisers. Bank officials bridled at the issuance tab, and a movement to curtail bond financing of those costs was born.

The Government Development Bank's proposed cap resembles a limit on federal tax-free industrial development bonds contained in the Tax Reform Act of 1986.

But according to local securities professionals, a 2% cap on issuance costs for the bonds sold only in Puerto Rico would not work the same way the 2% cap functions in mainland deals. Most island deals are small, about $20 million, and require costly retail marketing, according to Jose Ramon Gonzalez, president of the local Securities Industry Association and director and branch manager of First Boston (Puerto Rico) Inc.

Mr. Gonzalez said a 2% cap on costs that can be paid from proceeds would prove onerous.

"Given the size of the deals," he said, "and the importance of retail distribution in this market, the general feeling is that the underwriting spread should not be held to 2%."

That holds true especially, he says, if the 2% allowance includes other costs beyond the underwriter's control. "What the [Government Development Bank] is really concerned about is costs of issuance unrelated to the underwriting spread," Mr. Gonzalez said.

The Puerto Rico Securities Industry Association submitted a complaint to the bank, explaining why securities professionals think the 2% limit proposal unjustified. The association has suggested that the 2% cap should at least be flexible.

"Two percent should be a guideline," said Leslie C. Highley Jr., an association member and the president of Dean Witter Puerto Rico Inc. He also said the association has suggested that any cap "should not include costs that are not under the control of the investment banker," such as bond counsel and financial advisory bills.

Ramon Cantero-Frau, president of the Government Development Bank for Puerto Rico, said yesterday that the bank and the association should reach an agreement by the end of this month.

"The SIA is hopeful the bank will see our point of view," Mr. Gonzalez said. "It would certainly hurt the issuers."

Bonds issued by the Carribbean Financing Authority, which serves as a financing conduit for industrial development projects outside the commonwealth but in the Caribbean, also would come under the 2% issuance cost rule.

The proposed policy changes come at a time when the commonwealth's financial commissioner, Jose A. Sosa, also seeks to raise registration fees of broker-dealers. In addition, the commissioner is reportedly preparing to audit securities houses, for which the houses will be charged $100 per hour of auditing.

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