WASHINGTON -- The Treasury did not intend its revised arbitrage rules to prohibit borrowers from using the proceeds of tax-exempt small-issue industrial development bonds to repay taxable temporary construction loans, a department official said.

"Obviously, we didn't intend to make that change," Mitchell Rapaport, the Treasury's attorney-adviser for tax-exempt bonds, told lawyers at the American Bar Association's annual meeting in New Orleans on Friday.

"If it's a problem, we'll try to fix it as soon as we can," he told the association's tax-exempt financing committee.

The problem, bond lawyers say, stems from the revised set of arbitrage rules that the Treasury issued last year, which defined refundings in a way that appears to cover taxable as well as tax-exempt financings.

In addition, the revised rules dropped a provision that said if issuers adopted inducement resolutions to issue bonds, borrowers could obtain temporary construction loans to start their projects and the loans could be repaid with the tax-exempt bond proceeds.

As a result of these revisions, if an issuer adopts a resolution of intent to issue more $1 million of smallissue IDBs, and then the borrower obtains a temporary taxable loan and the bond proceeds are used to repay the loan; the repayment may be a refunding that makes the bonds taxable, rather than a simple repayment.

Several bond lawyers' recognized the problem after the Treasury published the revised arbitrage rules in June of last year. They had hoped the Treasury would fix it in technical corrections to the rules.

Those lawyers now appear to be divided over 'whether the problem was fixed in the technical corrections that were issued in May.

Concerns about the possible glitch surfaced recently when the Georgia Housing and Finance Authority began planning a $5 million to $10 million IDB transaction to finance several projects, including expansions of two manufacturing facilities.

The authority hoped that, once it adopted an inducement resolution announcing its intent to issue the bonds, the owners of the facilities would obtain interim taxable loans so that they could start construction whenever they chose before the bonds were issued.

The authority thought that once the bonds were issued, the proceeds would be used to repay the loans.

"That's when we ran into a snag," said David Pinson, the authority's acting executive director.

The authority's bond counsel, the law firm of Troutman Sanders in Atlanta, had concerns about the proposed transaction, given the revised rules.

The firm worried that under the revised rules, the repayment of the loan would be a refunding that would make the bonds taxable.

"We think there's an ambiguity, at least, in the regulations," said Robert Enholm, a lawyer with the Troutman firm.

Enholm said that Larry Sobel, a lawyer with Orrick, Herrington & Sutcliffe in Los Angeles, had advised him that such transactions would be a problem under the revised rules. Sobel could not be reached for comment.

Long-standing Treasury regulations -- 1.103-10(c)(2) say that small-issue IDB refunding bond issues that are between $1 million and-$10 million in size are taxexempt only if they are used to redeem tax-exempt small-issue IDBs or tax-exempt small-issue IDB refunding bonds. In other words, redeeming a taxable obligation would make the refunding bonds taxable.

Most bond market participants who are aware of the possible glitch in the revised rules are worried it could cause problems for many planned financings.

"People have taken out temporary construction loans and repaid them with the proceeds of small-issue IDBs for years," said one investment banker who did not want to be identified. "This was not an intended consequence of these rules."

"It is something that had been available to us in the past," Pinson said. "If it isn't resolved soon, it will begin holding financings up."

Enholm said his firm and others connected with the Georgia authority's proposed deal are working with the Internal Revenue Service and the Treasury to try to resolve the problem.

"I'm not sure what should be done," he said yesterday. "The conversation is ongoing."

Some bond market participants want the Treasury to take action to fix the problem.

Others, however, believe that the technical corrections issued in May already solved the problem and that these kinds of financings should be able to go forward with unqualified opinions from bond lawyers.

"It would appear that the technical corrections added back the provision that said that temporary construction financing could be repaid with taxexempt bond proceeds if the financing was obtained after an inducement resolution for the bonds was adopted," said one bond lawyer who did not want to be identified.

"By analogy, a similar concept should apply in interpreting the regulations dealing with small-issue IDB refundings," he said.

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