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Tribes denied equal access to popular development tool

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WASHINGTON -- When local governments want to make their economy grow, they
often build things with a cheap form of financing called the tax-exempt
bond. Across the country these bonds, also called municipals, have helped
raise sports stadiums, convention centers and industrial parks: even golf
courses. They are a popular economic tool for states, cities, regional
taxing districts -- just about every form of government in the country,
except Indian tribes.

In spite of a formal federal policy encouraging tribal economic
development, this tool is being denied to Indian country by an ambiguous
act of Congress and a current campaign by the Internal Revenue Service.
Some tax lawyers now say the IRS has embarked on a wrong-headed crusade
that even its internal counsel thinks might not hold up in court.

IRS audits have already forced the Seminole Tribe of Florida to retire
nearly half a billion dollars of tax-exempt bonds issued through a local
development agency. (The Seminoles paid off the bonds through a new taxable
issue of $730 million, but the issue was so well-received by Wall Street
that the tribe might actually have lowered its average interest cost.) The
Cabazon Tribe of Cahuilla Indians is also under the taxman's fire. The IRS
has challenged the tax exemption on an issue of $145.5 million the tribe
used to build a hotel and convention center. But the director of its resort
authority told a local paper that the IRS had not forced a Seminole-style
refinancing.

According to press reports, another 10 or so tribal audits are under way.

These audits are evenly divided between two types of bond. The first and
more traditional are tribal issues on behalf of tribally owned businesses.
The second are called "conduit bonds"; like the Seminoles, the tribe
arranges with a neighboring tax-exempt agency to issue bonds on its behalf.

The IRS campaign prompted The Wall Street Journal to write "At Indian
casinos, odds grow longer for some tribes." The story greatly exaggerated
the impact of the dispute, since very few tribes so far have turned to
tax-exempt bonds. But the IRS has put a chill on tribal plans to finance
even traditional government projects like water and sewer lines. It argues
that these public works would benefit not only tribal members but patrons
of its casino. The dispute denies Indian country access to a low-cost form
of raising money that has given some tribes the extra resources to add a
day care center or an elders clinic to their original building plans.

The idea of issuing any sort of bond at all is still very new to the
tribes, Deron Marquez, chairman of the San Manuel Band of Mission Indians,
told a Native financial conference in early 2005. Before the advent of
gaming, he said, the only source of funding for most tribes was the federal
government through grant programs "that were designed to fail." The cash
flow from casinos awakened Wall Street's interest. Marquez said that when
he first became chairman, his office was flooded with brochures from
financial companies he'd never heard of.

The tribes have learned quickly, however. The first big casino financings
were private placements at high interest rates. Tribes were initially
reluctant to issue bonds for the open market, since they would be subject
to stringent public financial reporting regulated by the Securities and
Exchange Commission. But some tribes have crossed that line, lured by lower
interest costs.

The casino bonds have been taxable, however. The tax-exempt market offers
even lower interest rates. "Municipal bonds" are based on the principle
that sovereign governments cannot be taxed by other sovereigns. So
investors who earn interest on bonds issued by a state or locality don't
have to pay taxes on that income to the federal government. Because the
investor gets to keep all of the interest payment instead of forking over
30 percent to the IRS, he can be attracted to buy a tax-exempt issue at a
lower interest rate. This financial market is the cheapest of all for
issuers, and tribes have been trying to get a toehold in it.

But the IRS is jealously guarding the door. It argues that tax exemptions
cost the federal government money (although the constitutional principle is
that the federal government doesn't have a right to the money in the first
place.) Thirty years ago, it fought local governments over bonds for
economic development projects, trying to limit the tax exemption to
"essential government functions." Local governments won that fight, and
tax-exempt bonds for convention centers and the like are commonplace.

The tribes are facing a stiffer struggle. Congress, for whatever reason,
saddled Indian country with a set of restrictions that don't apply to other
governments. In the 1982 Indian Tribal Governmental Tax Status Act, it
permitted tribes to issue bonds only for facilities serving an "essential
governmental function." It amended the act in 1987, but only added to the
confusion.

Kathleen M. Nilles, a tax lawyer with the Indian Tribal Governments
practice of Gardner, Carton & Douglas, wrote in American Indian Report
magazine that "neither the statute nor any IRS regulation defines what
constitutes an "essential governmental function." The best guidance from
Congress was simply to say "activities 'customarily performed by State and
local governments with general taxing powers.'"

In the nearly two decades since the last version of the act, IRS
policy-makers have not bothered to come up with a better set of guidelines.
When the IRS audit staff began to target tribal bond issues in late 2002,
the then-head of the bond division, Mark Scott, said the examiners would
see if the bonds met the "essential governmental function" test, but they
would also try to define it. As Nilles wrote at the time, tribal attorneys
were worried that "the IRS would be attempting simultaneously to enforce
and to make the applicable rules."

The worry was not misplaced. Leading attorneys are now charging that the
IRS has been abusing its power. Although some decline to be quoted by name,
for fear of jeopardizing their tribal clients' negotiations with the IRS,
they point "with shock" to statements by the current head of the IRS
compliance initiative. In the Nov. 3 Bond Buyer, the trade publication for
the bond market, Charles Anderson, field manager for the audit team,
repeated cliches popularized by anti-Indian and anti-casino activists.

He explained his "rule of thumb" for distinguishing commercial from
governmental functions in the case that started the campaign, a challenge
to a bond issue for a tribal golf course. "If there are more golf holes
than tribal members it is probably commercial and intended solely for
tourists," he said. "If no tribal members work there and they all collect a
dividend, it is probably commercial.

"I don't think Congress ever intended several dozen people getting
six-figure checks due to a resort financed by tax-exempt bonds."

But Anderson's position was severely undercut by a recently obtained
internal memo from a counsel in the IRS Tax-Exempt Division. The memo was
released in response to a Freedom of Information Act inquiry by Dorset &
Whitney, the law firm that originally represented the unnamed tribe which
issued the golf course bonds. It contained a section that the IRS had
previously withheld, in which the assistant chief counsel warned against
litigating the case.

He noted that more than 2,600 state and local governments owned golf
courses. He concluded that "it is probable that a court, faced with this
fairly common activity of state and local governments, and taking into
account the interpretative standard accorded Tribal governments, would
conclude that the Golf Course meets the statutory standard for an essential
governmental function."

The memo also noted that the distinction between commercial and
governmental function does not even appear in the statute: the test is the
"customary" practice.

Release of the memo sparked an outbreak of criticism of the IRS audits,
along with hopes that the issue was finally grabbing the attention of
senior IRS and Treasury officials. The question remained: What could be
done? Remarkably, none of the audits have yet gone to court, or even to the
higher levels of the IRS appeals process. Lawyers say it's a difficult case
to bring, because the owners of the bonds are the ones directly affected,
not the tribe.

Tribes have sought a change in the law to bring about a true level playing
field. A provision to give them full equality made its way into versions of
the last tax reform bill, but was deleted at the last minute. And some
tribal lawyers say this remedy shouldn't be necessary, if the IRS would
comply with the language of the existing statutes.

"The IRS should apply the rule of law, not a rule of thumb," said one.

It remains to be seen whether the new spotlight on this previously arcane
issue will bring results, but it remains a prime example of bureaucratic
sabotage of the federal policy to encourage tribal economic development.