WASHINGTON -- A top Treasury official yesterday sharply criticized an array of proposals by senators to liberalize tax law bond curbs and reiterated the department's overall distaste for tax-exempt financing.

But the Treasury might look favorably on some of the proposals -- including three that would would ease the arbitrage rebate requirement -- if modifications were made to lessen opportunities they present in their current form for engaging in arbitrage-driven deals, said Treasury Assistant Secretary for Tax Policy Kenneth W. Gideon.

Mr. Gideon's general disapproval of the measures, voiced at a hearing held by the Senate Finance Committee's subcommittee on taxation, came in sharp contrast to pleas by several senators that the bills be enacted to help state and local governments finance infrastructure improvements at a time when federal aide is dwindling.

The subcommittee's hearing focused on three bills: legislation by Sen. Max Baucus, D-Mont., to simplify and make more workable bond provisions of the Tax Reform Act of 1986; a measure by Sen. Pete Domenici, R-N.M., to remove private-activity curbs on environmental infrastructure bonds; and a bill by Sen. Daneil P. Moynihan, D-N.Y., to remove the $150 million limit on the amount of bonds any nonhospital 501(c)(3) institution may have outstanding at a given time.

Mr. Gideon said the Treasury flatly opposes three of the provisions in Sen. Baucus' bill: increasing the $5 million small-issuer exemption from the arbitrage rebate requirement to $25 million: making the 1989 rebate relief law retroactive to Sept. 1, 1986, the effective date of the tax reform law; and raising the $10 million small-issuer exemption from limits on bank deductibility to $25 million.

On raising the bank deductibility exemption, Mr. Gideon said there is "no justification for granting financial institutions additional [tax] relief." Making the rebate relief law retroactive is unnecessary because issuers that sold bonds before the law was enacted structured their issues to take the rebate requirement into account, he said.

Increasing the $5 million small-issuer rebate exemption to $25 million "would defeat in part the policy of discouraging arbitrage-motivated transactions," Mr. Gideon said. He did acknowledge, however, that "an argument can be made" for increasing the exemption to $10 million, though "absent an acceptable offset, we do not support even such a limited expansion."

Mr. Gideon said the Treasury also could be receptive to the idea of eliminating overlapping yield-restriction and arbitrage rebate requirements, another provision in Sen. Baucus' bill.

But he warned that in some cases the rebate by itself "may not be sufficient to prevent issuances with a significant purpose of earning arbitrage." Mr. Gideon suggested the proposal be modified to give the Treasury the authority to impose yield restriction requirements on issues where they are deemed necessary to curtail abuse.

Another provision in Sen. Baucus' measure would allow issuers to retain 10% of their arbitrage profits. The measure is designed to make issuers want to maximize their profits -- and thus the return to the Treasury -- and avoid going to extreme lengths to keep the yield low on their investments.

Mr. Gideon said the proposal merits "serious consideration," but the Treasury has not decided whether to support it because it would open the door to earning small amounts of arbitrage.

He said the provision needs to be formally studied to determine whether it could undermine the intent of the arbitrage rebate requirement and to figure out the correct percentage that would encourage issuers to maximize profits but not lead them to undertake arbitrage-driven deals.

One provision in Sen. Baucus' bill could receive the Treasury's support: repealing the requirement that no more than 5% of an issue be used for a reason "disproportionate and unrelated" to the purpose of the issue. The requirement "is often misunderstood by issuers and not easily administrable by the Internal Revenue Service," Mr. Gideon said.

Subcommittee Chairman Sen. David Boren, D-Okla., who sponsored the environmental infrastructure bill with Sen. Domenici, said legislation is necessary to help state and local governments finance projects needed to comply with unfunded federal mandates, particularly in the area of environmental standards.

Under the measure, municipal bonds issued for environmental infrastructure projects, such as hazardous and solid waste control facilities, would be considered governmental rather than private-activity debt regardless of the level of private participation in the project.

"I believe that we can get a greater bang for the federal buck through changes in the tax code that help state and local authorities raise the money necessary to meet these needs through the issuance of tax-exempt bonds," Sen. Boren said.

But Mr. Gideon disagreed, and he reiterated the Treasury's traditional dim view of using tax-exempt bonds as financial aid for states and localities.

"I question whether [issuance] of tax-exempt bonds would be the most efficient way to deal with that issue," Mr. Gideon said. "Any use of tax-exempt bonds results in some [revenue] loss which wouldn't go to the states but which would be felt by the federal government."

If the federal government wants to assist states in meeting various mandates, giving them the financial aid directly might be preferable to allowing them to increase their issuance of tax-exempt bonds, because "a direct subsidy might well be less expensive," he said.

In addition to removing the $150 million cap, Sen. Moynihan's bill would also recategorize 501(c)(3) bonds -- currently considered private-activity debt under the tax code -- as public-purpose bonds.

Mr. Gideon said the Treasury did not support that idea because it would "significantly expand a large class of tax-exempt obligations and would result in significant revenue loss to the federal government."

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