WASHINGTON -- Internal Revenue Service audits and ambiguities in the federal tax code continue to hamstring Indian tribal governments' efforts to finance capital needs, a panel of tribal attorneys and academics told a Senate subcommittee yesterday.

The vagueness of the term "essential government function," coupled with a lack of clarity on Congress' intent with regard to tribes' access to tax-exempt financing, has driven tribal issuers and bond counsel from pursuing infrastructure and economic development projects paid for with governmental or private-activity bonds, they said.

A legislative "fix," by way of congressional action, is the best way to correct problems in the sector, panelists told Sen. Gordon Smith, R-Ore., chairman of the Senate Finance Committee's subcommittee on long-term growth and debt reduction. Smith said he convened the hearing, entitled "Encouraging Economic Self-Determination in Indian Country," to take stock of tribes' perspectives and needs.

Under current tax code rules tribes are treated as states for purposes of tax-exempt bond issuance only if the bonds they sell are used in the exercise of an "essential government function," a much-debated requirement that tribes say has been interpreted too strictly by the IRS.

Conduit financings, in which tribes lend bond proceeds to other entities, require the same purpose, the IRS has said. State and local issuers are not subject to the same "essential government function" requirement when issuing tax-exempt bonds.

Even though tribal bond audits comprise a small portion of the IRS' caseload, the enforcement environment has been highly contentious, centering mainly on whether tribes can use municipal bonds to build golf courses, hotels, casinos, and other facilities.

Raymond C. Etcitty, chief legislative counsel for the Navajo Nation in Window Rock, Ariz., noted that tribes want to achieve economic development "the old-fashioned way," using muni bonds to finance infrastructure as state and local governments do, but that statutory language limits their access to capital markets.

The IRS' audits of deals done to finance golf courses and hotels exacerbate the situation, making the problem "the tax law as it is written and interpreted by the [Internal Revenue Service,]" he said.

Lenor A. Scheffler of Best & Flanagan LLP in Minneapolis said there is a perception in Indian country that the IRS has paid an "inordinate amount of attention" to the tribal finance sector in the recent times given the relatively small number of deals - usually about a half-dozen - done annually.

Scheffler is a member of the subgroup of the IRS' Advisory Committee on Tax-Exempt and Government Entities that reviewed existing regulations and guidance for tribes last year. That group determined that those enforcement efforts were a major factor in tribes staying away from tax-exempt bonding, she said.

Nearly 40% of all tribal deals, and 100% of the conduit tribal deals, done in recent years have been challenged by the IRS, according to Gavin Clarkson, assistant professor at the University of Michigan's School of Law.

Indian tribes have about $50 billion of unmet capital needs each year, a "direct result of tribes' inability to access capital markets," he said. Even when they do move forward with deals the market's "natural and appropriate" reaction is to charge more interest because of uncertainty surrounding the bonds' tax status, he added.

"The IRS is taking the most extreme interpretation of the statute, and tribes are being punished," Clarkson said.

Wayne A. Shammel, general counsel for the Cow Creek Band of Umpqua Tribe of Indians in Roseburg, Ore., pointed to what he called a "large institutional bias" built into the tax code over decades.

"We're paying 20% more for money" because tax code rules appear to disregard tribes' ability to separate their governmental and commercial activities, he argued.

The Treasury Department and the IRS Office of Chief Counsel could issue additional guidance to clarify certain issues, but a legislative initiative by members of Congress would be more effective, the panelists said.

Scott Schickli, a partner with Orrick Herrington & Sutcliffe LLP in Portland, Ore., said Congress could at least assist tribes by clarifying its intent for their treatment - whether they should be subject to the same set of rules as state and local governments, or a set of rules with additional requirements.

Smith seemed to be receptive to the panelists' concerns and recommendations, telling them it "sounded like Congress didn't write [the law] clearly enough and that Treasury is sitting on it."

"We'll fix it," he said, but did not elaborate.

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