WASHINGTON -- The short-term tax-exempt note market would have been hurt by a recently discovered change in tax rules if the IRS had not acted to fix the problem, market sources said yesterday.

The problem, which lawyers from Orrick, Herrington & Sutcliffe discovered last week in connection with a California note issue, occurred when the IRS dropped a cross-reference in its final original-issue discount rules that would have assured certain provisions would not apply to tax-exempt notes with maturities of less than a year.

The final rules were issued in January 1993 and took effect after April of the same year, but Orrick's George Wolf appears to have been the first to notice that the cross-reference was dropped.

As a result of the change, investors who purchased tax-exempt notes maturing in one year or less in the secondary market at a price that was par or greater but less than the initial issue price, would wind up with taxable capital gains as well as tax-exempt interest.

That would have been disastrous for tax-exempt money market funds, which promise shareholders tax-exempt returns and strive to maintain portfolios with stable net asset values.

Wolf and Richard Chirls, who is also with Orrick, brought the problem to the Treasury's attention on July 26. A day later the IRS issued a notice announcing that certain provisions of the final original-issue discount rules would not apply to notes with maturities of less than a year.

While a number of market participants praised the Orrick lawyers for discovering and helping to fix the problem, others complained that they needlessly created controversy in the one-year-and-under note market by focusing on something that should not have been a problem.

But several lawyers and tax experts said yesterday that Orrick deserves credit for discovering a problem that could have disrupted the short-term note market if it had not been fixed.

"Blaming Orrick is kind of like shooting the messenger," said one lawyer in New York who did not want to be identified.

"There was a problem with the regs," said Dale Collinson, a lawyer with Willkie Farr & Gallagher in New York.

Cathy Heron, vice president and senior counsel for the Investment Company Institute, and Peter Cinquegrani, an assistant counsel, said the IRS notice was very helpful to the short-term note market.

The Treasury and the IRS officials "were concerned that reasonable people could read [the final original-issue discount] rules in a way that they hadn't intended," Cinquegrani said.

The problem arose because the final rules said "in the case of a debt instrument with a term that is not more than one year from the date of issue, no payments of interest are. treated as qualified stated interest payments."

That provision meant that, for any note with a term of one year or less, the payments had to be treated as part of the redemption price rather than as qualified stated interest.

The proposed original issue discount rules had contained similar language but had cross-referenced section 1283 of the Tax Code, which says in subparagraph (B) that "the term short-term obligation shall not include any tax-exempt obligation."

Treasury and IRS officials reportedly dropped the cross reference in the final rules because of concerns about its use in a court case that had nothing to do with tax-exempt bonds. They did not realize the change would affect the tax-exempt short-term note market.

It was easy for bond lawyers to miss the dropped cross-reference, several lawyers said, particularly since it was not mentioned in the preamble to the final rules, which typically highlights significant revisions.

A few market participants also criticized Orrick for missing a similar problem with tax-exempt notes with maturities of more than a year that do not pay interest at least annually. These notes, which are covered by IRS original-issue discount and market discount rules, are subject to market discount. Under a tax law change made last year, market discount is treated as taxable ordinary income that can be offset with losses.

But several lawyers and tax experts said yesterday that most of the tax-exempt note market seems to have missed this problem.

Market participants said yesterday that they were still wrestling with how to resolve this tax problem for the several billions of dollars of more than one-year notes that have been issued since April 1993. Roughly $7.2 billion of tax-exempt notes with maturities ranging from 13 months to two years have been issued since May 1994, according to Securities Data Co.

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