WASHINGTON -- The Yakama Indian Nation has received a proposed adverse determination letter from the Internal Revenue Service on $9.3 million of conduit bonds used to finance a sawmill, and is now deciding whether to settle or appeal the agency's finding that the bonds are taxable.

The letter, which the Washington tribe disclosed in a material event notice yesterday, comes just one day after a tribal advocate told members of Congress that the agency's stance is overly strict, citing enforcement data now under dispute by IRS officials who claim their audits of tribal bonds were overestimated and misrepresented.

In the notice, filed with the nationally recognized municipal securities information repositories, the Yakama tribe said it received the proposed adverse determination letter from the IRS last Wednesday. The IRS concluded that interest on the Series 1997 revenue bonds is taxable because the bonds were non-qualified private-activity bonds, having financed a sawmill with an impermissible amount of private use.

Indian tribes are permitted to issue tax-exempt governmental bonds directly or through conduit issuers if their proceeds are used to finance "essential government functions." Several private-activity "tests" apply to the use of bond proceeds, as they do for state and local government bonds.

In the Yakama case, the IRS is asserting that Yakama Forest Products, a corporation owned by the tribe, "permitted a private corporation, Vanport Manufacturing, to use the assets financed by the bonds in a manner not permitted by" the tax code, making the bonds non-qualified private-activity debt.

Ater Wynne LLP was bond counsel on the 1997 deal, Seafirst Bank was underwriter, and First Trust NA was trustee. The tribe redeemed $1.2 million of the bonds last month, according to an April 26 bond call notice filed with the NRMSIRs.

Troy Thompson of Orrick Herrington & Sutcliffe LLP in San Francisco, the tribe's tax controversy representative, said yesterday that there has been some confusion about the use of the facility.

"Yakama Forest Products owns and runs the sawmill, and gets logs from Vanport," he said. "It is that relationship between Vanport and Yakama Forest Products that [IRS officials are] focusing their attention on."

He declined to discuss the entities' relationship in further detail, and IRS tax-exempt bond field operations manager Charles Anderson said he could not comment on the case.

The material event notice stated that the tribe is analyzing whether to appeal the proposed adverse determination, which becomes final 30 days from the date of issuance, or to negotiate a closing agreement with the IRS, under which it would likely have to pay a fee to keep the bonds tax-exempt.

The Yakama case is atypical because most of the IRS' tribal bond audits center on issues of commerciality related to casinos, hotels, and other facilities, not private use of bond-financed facilities.

Such audits were a hot topic at a Tuesday hearing of the Senate Finance Committee's subcommittee on long-term growth and debt reduction, where Gavin Clarkson, an assistant professor at the University of Michigan, said "almost 40% of the direct-issue tax-exempt bonds issued by tribes in the last three years have been challenged by the IRS, and 100% of the conduit bonds issued" have been audited, compared to about 1.25% of the nearly 15,000 tax-exempt bonds issued every year that face scrutiny.

Clifford Gannett, acting director of the tax-exempt bond office, took issue with the 40% figure yesterday, arguing that it was "wholly inaccurate" and that the percentage of direct tribal deals that have been audited is quite a bit lower.

He was reluctant to provide comparable statistical information, noting that the IRS has "some trouble because of how small the universe [of tribal deals] is; we really cannot talk about it without being concerned about privacy issues."

But public statements by other officials have indicated that the IRS has a dozen audits of tribal bonds open, six of them regarding direct deals done for tribal projects and six related to conduit financings. Sources suggest that of the approximately 90 tribal issuers that have sold bonds since 2002, many have done more than one deal, creating a pool of several hundred deals. A dozen out of several hundred would translate to an audit rate of between 2% and 6%.

Clarkson's 40% figure came from dividing the six known audits of direct tribal deals by 15, the number of such deals publicly reported on Thomson Financial since 2002. Gannett said - and Clarkson acknowledged - that the actual pool of tribal deals is larger, especially since non-reported private placement deals dominate the market.

Clarkson said in a brief interview yesterday that his statistics were based on "the available data" and that he was happy to revise them based on additional information. He said IRS officials have been "very reasonable and equally interested in identifying any potential bias" in the tax-exempt bond enforcement program.

Even if the audit rate is closer to 10%, "that is still an order of magnitude higher than the audit rate for non-tribal bonds," he said. "This is not about scoring points; this is actually about finding the truth."

Gannett noted that damage might have been done because tax policy is shaped by what lawmakers take away from hearings.

"I'm very, very troubled," he said. "My principal interest has been to get an accurate reflection of what we're doing, in [the] context of our entire exam program and the entire bond market, and unfortunately that was misrepresented."

The IRS' Anderson indicated yesterday that the agency is not trying to cast a wide net over tribal transactions, noting that almost all of the 12 audits open now relate to casino or "destination resort" deals.

"This is about casino financing, not tribal financing," he said. "Any statements otherwise are misleading.

"Our focus has been very narrow since we are especially concerned that a relatively small number of law firms are trolling for business by offering unqualified opinions on casino-related financing," Anderson continued.

In an unrelated matter, the South Florida Sun-Sentinel reported yesterday that the Seminole Tribe of Florida filed a circuit court suit this week alleging that Baltimore developer David S. Cordish, whose company developed the tribe's two Hard Rock Hotel and Casino complexes, has improperly received millions of dollars in fees from the deals.

The IRS issued a preliminary adverse determination of taxability in 2004 for the municipal bonds used to finance those complexes.

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