The Morning Report
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Thursday, January 26, 2006 | The Internal Revenue Service has requested documents related to city of San Diego bonds issued in 1993 and 2003, an indication that the tax regulators have joined the Securities and Exchange and the Justice Department in their inquiries into city finances.
The requests seek documents related to the release of tax-exempt bonds for the Old Town trolley extension. The city first issued $19 million in bonds for the construction in 1993 and then refinanced the debt with another round of $15.3 million in bonds 10 years later at a time when interest rates for municipal bonds were at record lows.
The tax-exempt status affords municipalities the ability to borrow money from Wall Street at lower interest rates, as investors avoid paying federal or California state income taxes on their returns.
The inquiry by the IRS signals that it will evaluate how the bonds were issued and if the proceeds were spent for the proper purposes. If the IRS were to deem the bonds taxable, investors would be forced to pay federal income tax on their income – past and future – from the investment. Such a ruling could spark litigation against the city by harmed investors, some experts said.
“From time to time the IRS will look into various bond deals to ensure that tax revenue was indeed used for tax-exempt purposes. Maybe with everything going on there, they’ve decided to look into things,” said Amy Doppelt, managing director at Fitch Ratings, a credit rating firm.
“That obviously is a big deal to investors because suddenly you thought you had a tax-exempt investment and you based your interest rate on that, and then you don’t,” she added.
Mayor Jerry Sanders released the IRS request Wednesday and said the city will be providing the agency with all relevant information. He said a copy of the request had been filed Tuesday with the Nationally Recognized Municipal Securities Information Repositories, an SEC-sanctioned clearinghouse for financial disclosure information.
A spokesman for the IRS declined to comment on the inquiry. Sanders said he didn’t know the details of the probe, but wanted to make the information he had public. Many speculated that the scrutiny of the SEC and Justice Department had prompted the IRS’ interest.
“The IRS was very quiet,” he said. “…We’re simply producing the documents that they ask for.”
A bond could be ruled not to be tax-exempt if it were determined that proceeds had gone to a private development or another cause that didn’t serve the broad public purpose, Doppelt said.
IRS agents first only petitioned information surrounding the 2003 bond issuance. However, city officials later informed them that the 2003 bonds were issued in order to refinance the 1993 bonds for the trolley extension. The refinancing allowed the city to finance the bonds at 3.88-percent interest, compared to the original 5.33-percent interest.
Lakshmi Kommi, financing services manager at the city, said the bond issuance was a standard restructuring and didn’t know why the IRS had targeted it.
Sanders, who took office in December, is scheduled to travel to San Francisco on Thursday to meet with officials from the three major credit rating firms in an effort to pitch his financial recovery plan and hear the firms’ concerns. All three firms either slashed or suspended San Diego’s credit rating following the discovery of omissions and errors in the city’s financial statements to investors and the public.
Questions surrounding the veracity of the city’s financial reporting have caused the delay of audits for the city’s 2003, 2004 and 2005 financial statements. The situation has left the city essentially suspended from Wall Street markets and without access to cash for basic projects, such as the construction of fire stations and water system upgrades.
The audits are on hold pending the completion of an investigation into alleged illegal acts by the city officials. The investigation itself has also been delayed by questions of independence, budget overruns and technical glitches.
Sanders will be joined in San Francisco by a number of his staff members, bond counsel and a representative of the City Attorney’s Office.
“We’re not asking for anything,” Sanders said. “We’re just reestablishing a relationship and telling them there’s new people in position that are going to work very hard.”
The SEC and Justice Department began investigating city finances and politics in February 2004. The IRS regulates tax code, whereas the SEC would be searching for civil securities fraud and the Justice Department criminal securities fraud and political corruption.
Please contact Andrew Donohue at