Cities Win One, Lose One against Uncle Sam

By Shafroth, Frank | Nation's Cities Weekly, April 13, 1998 | Go to article overview

Cities Win One, Lose One against Uncle Sam


Shafroth, Frank, Nation's Cities Weekly


Cities gained a victory and a measure of respect in two different municipal finance arenas last week, demonstrating that cities can take on the federal government, preemption, and control. The city of Columbus, Ohio, gained a win over the Internal Revenue Service (IRS) in a case where the IRS challenged the city's authority to issue $25 million worth of municipal tax-exempt bonds. Meanwhile a U.S. circuit court of appeals awarded a victory to the U.S. government over a small town in Maine, but only after the U.S. Justice Department changed its policy and promised to provide cities and towns with written notice in the future with regard to all real estate forfeiture actions.

Tax Court Win

In a victory for Columbus, a U.S. Tax Court ruled for the city that bonds it had proposed to issue in 1993 are not arbitrage bonds as the Internal Revenue Service has argued. The ruling cleared a federal hurdle that has prevented Columbus from selling more than $25 million in tax-exempt pension bonds. The city plans to wait out the 90-day appeal period and then issue 20-year tax-exempt bonds to take out $25.1 million in variable-rate taxable bond anticipation notes it has had outstanding since repaying the state in 1994.

The IRS is reviewing the decision and has 90 days to appeal the ruling to the U.S. Court of Appeals, a spokesman said.

Although the specifies of this decision have limited applicability to other cities and towns, the decision demonstrates that municipalities can successfully challenge IRS rulings. Cities and towns can fight the IRS and win.

The question in the case was whether the city would earn illegal arbitrage profit from its proposed bond sale, the proceeds of which would pay off a 1967 debt to the Ohio state pension fund. In 1967, the state had offered to take over local governments' police and firefighters' pension liabilities. In 1993, Columbus sought to sell tax-exempt bonds to pay its debt to the state.

The IRS had opposed permitting Columbus to repay its debt with tax-exempt municipal bonds. The IRS ruled that since the state allowed the city to prepay the debt at a discount, the city would receive "investment property" in the transaction. Therefore, the IRS argued, the city should only be permitted to sell its bonds as taxable, not tax-exempt. In response, Columbus successfully argued that its bond sale should be viewed as a refunding of its debt to the state, and therefore eligible for tax exemption under the Tax Reform Act of 1986.

Columbus first sought a private letter ruling on the matter in 1994. The IRS responded, saying the bonds would be arbitrage bonds and therefore taxable. The city challenged the IRS unsuccessfully in the U.S. Tax Court, but prevailed in the U.S. Court of Appeals for the District of Columbia Circuit last year. The Appeals Court, however, sent the case back to the lower court for rehearing before the original judge.

In its final decision, the Tax Court wrote: "While [the city] received an economic benefit from prepaying its debt, we do not think it was paying for property. [The city] purchased or received nothing, beyond the state fund obligation it received under the 1967 transaction, other than the discount for prepaying its obligation to the state. Such discounts normally are considered discharge of indebtedness income, not investments."

Forfeiture Loss

In a second decision, the federal government prevailed over the Town of Sanford, Maine, in a case involving back taxes, interest, costs, and attorney's fees from the seizure by the federal government of property in the town after a drug forfeiture investigation. The government seized the property - on which back taxes were owed to the town - without notice, and refused to pay those taxes or to permit a hen to be imposed upon the subsequent auction.

Sanford lost in its appeal to the U.S. Appeals Court. But the court's decision was on a narrow jurisdictional issue, which the court said should not be taken as approval of the decision by the U. …

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