                     105 T.C. No. 19



                 UNITED STATES TAX COURT



       HARBOR BANCORP & SUBSIDIARIES, Petitioner
    v. COMMISSIONER OF INTERNAL REVENUE, Respondent

      EDWARD J. KEITH AND ELENA KEITH, Petitioners
    v. COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket Nos.   24112-92, 5857-93.       Filed October 16, 1995.



     The Housing Authority of Riverside County,
California, issued revenue bonds to finance the
construction of multifamily housing for families of low
and moderate incomes. Ps purchased some of these bonds
and, believing that the bonds were tax exempt, did not
include the interest received thereon in income. Sec.
103(a), I.R.C., generally provides a tax exemption for
interest earned on bonds issued by State and local
governments. This exemption does not apply to
"arbitrage bonds". Sec. 103(c), I.R.C. Under sec.
148(f), I.R.C., a bond is treated as an "arbitrage
bond" if (1) the bond proceeds are used to purchase
investments that are not acquired to carry out the
governmental purpose of the bond issue; (2) the
investment of the bond proceeds produces an excess
amount of earnings described in sec. 148(f)(2), I.R.C.;
and (3) the bond issuer fails to pay such excess amount
to the United States. The Commissioner determined that
the bonds should be treated as arbitrage bonds pursuant
                                - 2 -

     to sec. 148(f), I.R.C., and that, as a result, the
     interest on the bonds was not excludable from Ps'
     income.

          Held: The Commissioner's determination is upheld.
     The bonds are to be treated as arbitrage bonds pursuant
     to sec. 148(f), I.R.C. The interest on the bonds is
     not excludable from Ps' taxable income under sec.
     103(a), I.R.C.


     Anita C. Esslinger, Mary Gassmann Reichert, Brenda J.

Talent, Juan D. Keller, Michael F. Coles, and Linda M.

Martinez (specially recognized), for petitioner in docket No.

24112-92.

     Mary Gassmann Reichert, Juan D. Keller, Michael F. Coles,

and Linda M. Martinez (specially recognized), for petitioners in

docket No. 5857-93.

     Clifton B. Cates III, Lillian D. Brigman, Debra Lynn Reale,

and Jon Kent, for respondent.



     RUWE, Judge:*    Respondent determined the following

deficiencies in petitioners' Federal income taxes:


                 Harbor Bancorp & Subsidiaries
                      docket No. 24112-92

                        Year     Deficiency

                        1988       $6,587
                        1989        6,588
                        1990        6,588



     *
      This case was reassigned to Judge Robert P. Ruwe by order
of the Chief Judge.
                                - 3 -

                  Edward J. and Elena Keith
                      docket No. 5857-93

                        Year     Deficiency

                       1989      $14,709
                       1990       18,521
                       1991       14,840


     These consolidated cases are test cases that involve the

Commissioner's attempt to tax interest received on two

multifamily housing revenue bonds (the Bonds) issued by the

Housing Authority of the County of Riverside, California (the

Housing Authority).   The ultimate issue for decision is whether

interest on the Bonds is excludable from gross income under

section 103(a).   This, in turn, will depend on the applicability

of section 148(f).    References to section 103 are to that section

of the Internal Revenue Code of 1954,1 as amended, and references

to section 148 are to that section of the Internal Revenue Code

of 1986.2

     Some of the facts have been stipulated and are found

accordingly.   The stipulations of fact and attached exhibits are


     1
      We apply sec. 103 of the 1954 Code as in effect for Feb.
20, 1986, instead of the 1986 Code, because (1) sec. 1301 of the
Tax Reform Act of 1986 (TRA), Pub. L. 99-514, 100 Stat. 2085,
2602, which amended sec. 103, became effective for bonds issued
after Aug. 15, 1986, TRA sec. 1311(a), 100 Stat. 2659, and (2)
the bonds we deal with were issued before that date.
     2
      We apply sec. 148(f) of the 1986 Code, because (1) TRA sec.
1314(d)(1), 100 Stat. 2664, provides that sec. 103 of the 1954
Code shall be treated as including the requirements of sec.
148(f) of the 1986 Code for bonds issued after Dec. 31, 1985, and
(2) we conclude, infra, that the bonds we deal with were issued
after that date.
                               - 4 -

incorporated herein by this reference.   The trial judge made the

following findings of fact, which we adopt.


                         FINDINGS OF FACT


     At the time its petition was filed, the principal office of

petitioner Harbor Bancorp & Subsidiaries was Long Beach,

California.   Petitioners Edward J. and Elena Keith resided in

Pebble Beach, California, when they filed their joint petition.

     Riverside County is a political subdivision of the State of

California, governed by an elected board of supervisors.     Within

the Riverside County government exists the Housing Authority.

The Housing Authority is empowered to issue revenue bonds, the

proceeds of which are lent to private developers to construct

housing projects.   The Riverside County Housing Authority

Advisory Commission (Advisory Commission) was created to review

proposed multifamily housing bond issuances.

     By the mid-1980's, there was a large demand for low- and

moderate-income housing in Riverside County.   In the fall of

1985, an established commercial and residential development

company named SBE Development, Inc. (SBE), approached officials

of Riverside County seeking "conduit financing"3 to fund


     3
      Conduit financing is distinguishable from "governmental
financing" in which the bond proceeds would be used directly by
the governmental unit in order to construct public facilities,
such as roads, bridges, and schools. Here, the Bond proceeds
were not going to be used directly by the issuing governmental
unit (the Housing Authority), but rather by a private developer,
                                                   (continued...)
                               - 5 -

construction of two multifamily housing projects in Riverside

County.   SBE was a California corporation founded in the early

1970's by Craig K. Etchegoyen, who was its chief executive

officer and president.   One of these projects was the Whitewater

Garden Apartments (Whitewater), a proposed 460-unit multifamily

rental project to be located in Cathedral City, California.    Its

anticipated cost was slightly more than $17 million.   The other

was the Ironwood Apartments (Ironwood), a proposed 312-unit

project located in Moreno Valley, California.   Its anticipated

cost was slightly more than $12 million.   Twenty percent of the

apartment units to be constructed in each of these projects were

to be set aside to provide housing for low-to-moderate-income

families.

     SBE submitted detailed information concerning the

feasibility of the projects to Riverside County officials.    Upon

receipt of the development information, the Housing Authority and

related county agencies conducted an extensive review of the

proposals to determine the need, feasibility, cost effectiveness,

accessibility, and desirability of these projects.    The Housing

Authority approved the projects and thereafter engaged the law

firm of Camfield & Christopher to act as bond counsel.

     James W. Newman, Jr., was a partner in the Houston office of

the law firm of Stubbeman, McRae, Sealy, Laughlin & Browder



(...continued)
a partnership in which SBE was the general partner.
                                 - 6 -

(Stubbeman).   Mr. Newman (and thereafter Stubbeman) acted as

special tax counsel and underwriter's counsel on the Whitewater

and Ironwood bond issues.   Mr. Newman prepared the Bond documents

used in the Whitewater and Ironwood deals.      It is customary for

bond counsel to draft, disseminate, and revise all documents

needed to bring about the issuance of a tax-exempt bond.      In this

case, however, Stubbeman assumed that responsibility inasmuch as

it was preparing several sets of similar documents for a number

of other bond transactions to be issued at the same time as the

Whitewater and Ironwood bonds.

     The plan that was developed contemplated that two firms--

Donaldson, Lufkin & Jenrette Securities (DLJ) and Drexel,

Burnham, Lambert, Inc. (Drexel)--would be the underwriters on the

Whitewater and Ironwood bond issues.      Ira McCown, an investment

banker at DLJ, was deeply involved in bringing the Whitewater and

Ironwood bonds to market.   The Interfirst Bank of Houston would

be trustee for the bondholders.    The financing plan further

contemplated that the Housing Authority would issue the Bonds and

then lend the Bond proceeds to a developer, in exchange for a

developer note.   The Housing Authority would then assign the

developer note to the Trustee bank.      The developer would make

payments on its note to the Trustee bank.      The developer would

use the Bond proceeds, which were to be in a "developer loan

fund", to construct the projects.
                                - 7 -

     With respect to each project, SBE operated as a general

partner of a partnership formed to act as the developer.     The

developer of the Whitewater Project was the Whitewater Limited

Partnership (Whitewater, Ltd.), and the developer of the Ironwood

Project was Ironwood Apartments, Ltd. (Ironwood, Ltd.).


Credit Enhancement


     As security for the loan, each developer was to obtain an

irrevocable letter of credit, in exchange for a second

developer's note, called a "reimbursement note", secured by a

mortgage on the property to be developed.    The provider of the

letter of credit would then discount the developer's note to

another entity--the "mortgage purchaser"--in exchange for cash

that the letter of credit provider would use to acquire, from a

solid financial institution, a "guaranteed investment contract"

(GIC).   The GIC would be pledged to secure payment of interest

and principal, under the letter of credit, to the bondholders.

In effect, each developer would issue a second note in order to

obtain a guaranteed means of repayment on its first note.

     For the Ironwood project, the letter of credit provider was

to be Mercantile Capital Finance Corp. No. 30 (MCFC No. 30) and

for the Whitewater project, Mercantile Capital Finance Corp. No.

47 (MCFC No. 47).    The sole shareholder of each of these

corporations was James J. Keefe.    The mortgage purchaser for both

projects was Unified Capital Corp. (Unified).    This entity was
                               - 8 -

owned by Mr. Keefe, Steven Tetrick, and Steve Jarchow.   Mr.

Tetrick was Unified's chief executive officer.


Notice of Hearing


     In November and December of 1985, the Housing Authority

published notices of a hearing on the Ironwood bond issue in the

Press Enterprise, a newspaper of general circulation in Riverside

County.   Subsequently, on December 17, 1985, the Housing

Authority authorized the issuance of the Ironwood bonds in the

amount of $13 million.

     Apparently because of staff oversight, there was no

newspaper publication concerning hearings held on December 3,

1985, on the Whitewater bonds by both the Advisory Commission and

the Housing Authority.   However, both the Housing Authority and

the Advisory Commission followed notification procedures for such

hearings under a California statute known as the Brown Act.    As

required by the Brown Act, the Advisory Commission posted notices

containing the agenda of its December 3, 1985, meeting regarding

the proposed issuance of the Whitewater bonds at least 72 hours

prior to the date thereof.   The notice containing the agenda was

posted at Riverside County's eight public housing projects and at

the Indio and Riverside County Housing Authority offices.    Listed

in the notice as "New Business" was "Recommend approval of

Resolution Number 85-052 - Bond Financing - Whitewater Garden

Apartments Multi-Family Housing Revenue Bond ($17,200,000)."
                                - 9 -

     Also as required under the Brown Act, the Housing Authority

gave notice by distributing several hundred copies of its agenda

throughout Riverside County at least 72 hours in advance of its

hearings.    The copies were distributed to all personnel in the

office of the clerk of the board of supervisors, members of the

board of supervisors, local news media (including the Press

Enterprise), the county courthouse (for public posting in the

clerk's office), all county offices, and a list of developers and

attorneys.    The notices stated that at the December 3, 1985,

meeting of the board of supervisors and Housing Authority,

consideration would be given to "Resolution 85-709 approving the

issuance of bonds by the Housing Authority of the County of

Riverside for the SBE Development Corp. Project ($17,200,000)."

A notice for a special meeting of the Housing Authority on

December 10, 1985, announced that the Housing Authority would

give consideration to "Resolution 85-052 approving the Whitewater

Garden Apartments Multi-family issuance of tax-exempt revenue

bonds and approving documentation for issuance of revenue bonds."

     Early in December 1985, the board of supervisors of

Riverside County authorized the issuance of the Whitewater bonds

in the amount of $17,200,000 and, a week later, transferred its

rights and duties with respect to such issuance to the Housing

Authority.
                                - 10 -

Preclosing Activities


     Prior to closing on the Whitewater and Ironwood bond issues,

officials of the Housing Authority, Riverside County's counsel,

the trustee's officers and its counsel, and bond counsel all

engaged in reviewing drafts of the Bond documents.

     On December 17, 1985, William A. Rosenberger, executive

director of the Housing Authority, executed a "Non-Arbitrage

Certificate" for the Whitewater and Ironwood bonds.      Therein, he

represented that the Housing Authority, as issuer of the Bonds,

reasonably expected that the Bond proceeds would be used for the

construction of multifamily housing.      He further represented

that, except for a permissible temporary period, the Bonds would

not be invested in higher yielding taxable securities in an

attempt to gain arbitrage profits.       Bond counsel checked with the

county government and were informed that notices of hearings on

the Bonds had been published.

     The parties to the Bond issuances then attended a preclosing

at the Stubbeman office in Houston in mid-December 1985.      Mr.

Christopher, as the Housing Authority's bond counsel, represented

Riverside County.   Also present at the preclosing were Mr. Newman

and two other lawyers from the Stubbeman firm, Mr. McCown from

DLJ, and representatives from Unified.      The purpose of the

preclosing was to obtain signatures and otherwise put the

documents into form for the final closing.      The Stubbeman firm
                              - 11 -

held the documents so executed in escrow pending the final

closing.


Changes in the Program


     Because of a pending change in the tax law setting forth

restrictive new arbitrage rebate rules on bonds issued after

December 31, 1985, there was considerable pressure for local

governments to issue multifamily housing bonds on or before

December 31, 1985.   As the anticipated December 31, 1985, closing

date approached, principals of DLJ informed Mr. McCown that the

firm was financially unable to underwrite the large number of

tax-exempt bonds that were scheduled for closing on December 31,

1985.   Mr. McCown scrambled to find another underwriter.   (Drexel

had lessened its involvement in underwriting these types of

securities by this time and was not a viable alternative.)

     Mr. McCown was on good terms with Arthur Abba Goldberg, vice

president of the investment firm of Matthews & Wright, Inc., a

Wall Street underwriter.   Mr. Goldberg told Mr. McCown that his

firm would underwrite the Bond transactions.   Mr. McCown then

informed Mr. Newman that the Matthews & Wright firm would do the

underwriting.   Mr. Newman had dealt with Matthews & Wright in the

past and agreed to the substitution of underwriters.

     Prior to being sold to the public, the Bonds needed to be

rated by a recognized rating agency, such as Standard & Poor's

Corp.   Because the rating agencies needed a period of time to
                              - 12 -

rate the Bonds, the Bonds were to be "temporarily warehoused"--

that is, the Bonds were to be sold and held prior to their

ultimate sale to the investing public.   Two days before closing,

a representative from Matthews & Wright informed Mr. Newman that

an entity known as the Commercial Bank of the Americas, Ltd.,

located on the island of Saipan in the Northern Marianas, would

purchase the Bonds from Matthews & Wright and hold them for

temporary "warehousing".   Mr. Newman subsequently discovered that

the Commercial Bank of the Americas no longer had a banking

charter and was operating simply as a corporation.

     On December 30, 1985, Mr. Newman instructed Richard B.

Hemingway, an associate in the Stubbeman firm, to take the

Whitewater, Ironwood, and 16 other bond certificates to New York.

Karen J. Cole, a representative of Interfirst Bank, was also in

New York on other business on December 31, 1985.   Although she

had little prior involvement in the Bonds' issuance, she was

asked to go to the offices of Matthews & Wright to attend the

closing.

     Mr. Goldberg headed a federal credit union named New

American Federal Credit Union, located in Jersey City, New Jersey

(the credit union).   On December 31, 1985, Mr. Goldberg

instructed Joel S. Schwartz, the general manager of the credit

union, to come to Matthews & Wright and to bring "starter kit"
                               - 13 -

books of the credit union's share drafts4 with him.    Mr. Goldberg

informed Mr. Schwartz that he (Mr. Schwartz) would be signing

documents as a representative of the Commercial Bank of the

Americas.

     On December 31, 1985, using credit union starter kits,

personnel at the offices of Matthews & Wright prepared the

endorsements and typed out the faces of 24 share drafts.    These

included a share draft payable to Interfirst as trustee in the

amount of $17,613,020.83 for Whitewater, and another in the

amount of $13,083,958.33 for Ironwood.   On that day, share drafts

totaling approximately $750 million were drawn by Matthews &

Wright on a nonexistent account at the credit union.

     At the closing, Mr. Hemingway showed the documents relating

to the issuance of the Bonds to Ms. Cole and then delivered them

to Mr. Goldberg.    Following directions from her home office, Ms.

Cole received the Whitewater and Ironwood share drafts.    She

endorsed these share drafts "without recourse" to the Commercial

Bank of the Americas to purchase two investment agreements from

that institution.   As of December 31, 1985, the Commercial Bank

of the Americas had no apparent assets in excess of $5,011 in an

account with the Bank of Guam.

     Mr. Schwartz, on behalf of the Commercial Bank of the

Americas, then endorsed these share drafts back to Matthews &



     4
      These "share drafts" were the functional equivalent of a
check drawn on the credit union.
                               - 14 -

Wright.   He did so as an accommodation to Mr. Goldberg, who told

him that it was a legitimate transaction.   An employee of

Matthews & Wright then restrictively endorsed these share drafts

for deposit to the account of Matthews & Wright.   These share

drafts did not enter any banking channels; instead, Mr. Schwartz

took them home over New Year's Eve and later kept them in a file

at the credit union.

     Also, on December 31, 1985, in Houston, Interfirst's

officer, H. Bradbury Foster, exchanged cross-receipts with Mr.

McCown, who was now representing Matthews & Wright's interests.

Interfirst recorded evidence of the share drafts and of their

exchange for the investment agreements on its corporate trust

books for December 31, 1985.

     Officers of Interfirst were familiar with Matthews & Wright

as being a Wall Street underwriter of tax-exempt municipal bonds.

Just before the closing, they were informed that the Bonds would

be held and warehoused by the Commercial Bank of the Americas in

exchange for its investment agreements.   Mr. Foster found the

Commercial Bank of the Americas listed in an international

banking directory.   The information in the directory matched the

information concerning the bank he had received from Mr. Newman.

Mr. Foster also contacted Interfirst's international department,

which verified his information.   Interfirst's head office then

referred him to the bank's New York international office.    That

office also verified the information he had received.   When
                              - 15 -

Interfirst received the share drafts, it had no reason to believe

that they could be dishonored.

     Because the Stubbeman firm was responsible for a number of

closings in New York, and because it was issuing the tax opinion

in those issues, it was decided that the Stubbeman firm, rather

than Mr. Christopher's firm (the actual bond counsel) would be

present.   Mr. Christopher had no reason to mistrust the Stubbeman

firm.

     On or about December 31, 1985, Mr. Newman telephoned Mr.

Christopher to tell him that the Bonds had been sold.     Mr. Newman

did not, however, immediately inform bond counsel or county

authorities of the change in underwriters.   Mr. Newman did not

convey to bond counsel the fact that a substitution of

underwriters had occurred until after the beginning of 1986.

Thus, Mr. Christopher first learned on February 10, 1986, from a

Drexel employee that Matthews & Wright--and not DLJ--was

warehousing the Bonds.   Mr. Christopher was upset with the news.

He telephoned Mercantile Capital Corp., leaving a message as to

his displeasure at not being informed of the change in

underwriters.   Two days later he further learned that Drexel was

out of the deal.   On the same day, he was advised by Mr. Newman

that because the Bond documents were still in escrow, they could

be amended without following formal amendment procedures.

     Had Mr. Christopher been aware of the developments

surrounding the issuance of the Bonds, he would not have
                               - 16 -

authorized the use of his opinion.      He would have recommended

that the Housing Authority not proceed with the issuance.

     Neither Mr. Rosenberger nor anyone else in the Housing

Authority knew of the switch in underwriters until February 1986,

when Mr. Rosenberger was advised of the change by bond counsel.

Mr. Rosenberger believed that the closing on the issuance of the

Bonds occurred on December 31, 1985.      As chief of the Riverside

County Housing Authority, Mr. Rosenberger relied upon county

counsel and bond counsel to advise him with respect to the

documents and to discuss any terms that might cause a potential

problem.

     County counsel had not been made aware of these problems.

Mr. Anthony Wetherbee served as deputy county counsel and was

primarily responsible for reviewing bond issuances of Riverside

County during 1984 and 1985.   He typically consulted with bond

counsel concerning documentation for a given bond issue.      Mr.

Wetherbee participated in about 30 or 40 bond closings for

Riverside County.   With respect to the Ironwood and Whitewater

issuances, he observed that they differed from other financing in

several ways.   For example, most of the documents were being

prepared by the underwriter's counsel, the Stubbeman firm, and

not by bond counsel.   The closing was to take place out of State,

but that was not unusual because the primary attorneys (the

Stubbeman firm) were in Texas.   Another distinguishing factor was

that the Bonds were to be "warehoused"--kept by the underwriters
                                - 17 -

until they were rated by a rating agency and made available to

the investing public.    Mr. Wetherbee was aware of a sense of

urgency in issuing the Bonds before the end of 1985 because of a

pending change in the tax laws.    These differences, however, did

not operate as a "flag" to indicate that anything was improper

with the issuance.    Had Mr. Wetherbee been informed of the

details concerning the alleged closing and the subsequent

remarketing of the Bonds, he would not have recommended that the

Housing Authority proceed, and, in his opinion, the Housing

Authority would not in fact have proceeded with the financing.

     After December 31, 1985, as a result of the change in the

underwriter, bond counsel urged the Housing Authority to pass a

resolution ratifying assignment of the underwriting agreement to

Matthews & Wright.    The Housing Authority did so.


Events of February 20, 1986


     A number of carefully orchestrated events occurred on

February 20, 1986, most of them taking place by wire transfers.

First, Matthews & Wright borrowed $58,475,287.37 from Security

Pacific National Bank (Security Pacific) pursuant to an existing

credit arrangement.     The money was then wire transferred to Chase

Manhattan Bank for the account of the New American Federal Credit

Union, and for further credit to the Commercial Bank of the

Americas in order to purchase, inter alia, the Bonds.    Matthews &

Wright pledged the Bonds, among other things, as collateral for
                               - 18 -

the loan.   (Matthews & Wright repaid this loan later in 1986

using funds received from the sale of the Bonds to the investing

public.)    The money from Security Pacific, less an amount paid to

redeem a relatively small amount of the Ironwood bonds,

ultimately went to the Heritage National Bank of Austin, Texas

(Heritage).   Heritage deposited $17,778,146.53 of these funds

into the "developer loan fund" account of Whitewater, Ltd.    Of

this amount, $1,425,000 was used to purchase land for the

Whitewater project.

     Whitewater, Ltd., had agreed to provide credit enhancement

for the Whitewater bonds by obtaining a letter of credit.    To

arrange for this letter of credit, Whitewater, Ltd., entered into

an agreement with MCFC No. 47 and gave MCFC No. 47 a

reimbursement note, secured by a First Deed of Trust on the

Whitewater project.   On the same day, pursuant to a "deposit

agreement", Whitewater, Ltd., transferred the $17,778,146.53 from

its developer loan fund at Heritage to Unified's account at

Heritage.   This transaction was made pursuant to an understanding

that Unified would disburse the Bond proceeds, as needed, for

construction.   This deposit agreement was not revealed to the

Housing Authority or its counsel.   Using the bond proceeds from

Whitewater's developer loan fund, Unified then purchased

Whitewater, Ltd.'s reimbursement note, secured by the First Deed

of Trust, from MCFC No. 47 for $16,110,817.98.   MCFC No. 47 used

this $16,110,817.98 to purchase a "Settlement Annuity Contract"
                                - 19 -

from Crown Life Insurance Co.    (This was the Whitewater

Guaranteed Investment Contract, or Whitewater GIC.)     Thus, the

source of the funds from which the Whitewater bonds would be paid

was now Crown Life Insurance Co.

     Similar transactions also took place on February 20, 1986,

with the $12,190,843.34 proceeds of the Ironwood bonds.     These

proceeds were deposited in an Ironwood, Ltd., account at

Heritage.   Ironwood, Ltd., gave a reimbursement note, secured by

a similar mortgage on the Ironwood property, to MCFC No. 30 in

exchange for a letter of credit securing payment of the Ironwood

bonds.   But again, without the knowledge of the Housing

Authority, Ironwood, Ltd., deposited the $12,190,843.34 proceeds

with Unified.   Using these proceeds, Unified purchased the

Ironwood reimbursement note from MCFC No. 30 for $11,047.408.05.

MCFC No. 30 used this latter amount to purchase a "Settlement

Annuity Contract" from Crown Life Insurance Co.    (This was the

Ironwood Guaranteed Investment Contract, or Ironwood GIC.)

     Although most of the Bond proceeds went into the GIC's,

substantial sums were used to pay fees, including fees to

Stubbeman, Unified, and MCFC Nos. 30 and 47.    The Housing

Authority, however, only received reimbursement of administrative

fees of $16,250 in connection with the issuance of the Ironwood

bonds, and $21,375 with respect to the Whitewater bonds.

     Once the money went into the GIC's, it was there

irrevocably. Although the proceeds available to buy the GIC's
                                - 20 -

were diminished by numerous fee payments, because the GIC's paid

interest at higher rates than the Bonds, the remaining proceeds

were sufficient to guarantee payment of both principal and

interest to the holders of the Bonds.    In fact, the payments

yielded by the Whitewater and Ironwood GIC's exactly equaled the

debt service requirements needed to pay the bondholders.

     Pursuant to "Collateral Security Agreements", MCFC Nos. 47

and 30 pledged the Whitewater and Ironwood GIC's as security and

as sources of payment to the trustee, so that the trustee might

make scheduled payments to the Whitewater and Ironwood

bondholders.


Events After February 20, 1986


     Standard & Poor's rating service noted that payment of

principal and interest for the Bonds was secured by guaranteed

investment contracts issued by a solid insurance company.    This

security was sufficient for Standard & Poor's to issue a Triple-A

rating for the Bonds.   Nevertheless, the effect of the diversion

of Bond proceeds from the developer loan fund to the purchase of

the GIC's was that no moneys were available to be expended on

construction of the projects.    Mr. Etchegoyen of SBE, the general

partner of the Whitewater and Ironwood developers, sought funds

from the deposit agreements with Unified so that he might

undertake construction of the projects, but Unified refused.

When he sought to determine why he could not get the funds, Mr.
                              - 21 -

Tetrick, the president of Unified, provided him with excuses,

saying that Mr. Tetrick would have to check with Mr. Keefe, who

headed the MCFC entities.

     In the absence of funds, the Whitewater project was not

constructed.   In an assignment dated August 4, 1987, Unified

assigned its rights under the Ironwood reimbursement note to Far

West Savings and Loan Association, which replaced Unified as the

construction lender.   SBE issued a new note to Far West Savings,

secured by a deed and an assignment of rents.   The deed

identified the Ironwood bonds at issue and stated, in pertinent

part:


     the proceeds of the Bonds * * * are to be loaned to
     Trustor for the purpose of providing construction and
     permanent financing for the acquisition of that certain
     real property situate[d] in the County of Riverside
     * * *


     The Ironwood project, currently operating under the name

Cross Creek Village, was completed in March 1989 with funds

borrowed from Far West Savings and Loan Association.   The

resulting capital construction costs allocated to the Ironwood

project were more than 90 percent of the face amount of the

Ironwood bonds.   When they were occupied, 20 percent of the

apartments were occupied by persons of low or moderate income.

SBE suffered severe financial reverses as a result of defaulting

on these projects, and Mr. Etchegoyen eventually lost his company

to his creditors.
                              - 22 -

     In 1988, Mr. Newman pleaded guilty to criminal charges in

connection with the issuance of other purported tax-exempt bonds

that supposedly closed on December 31, 1985.   Mr. McCown resigned

from DLJ and, in 1990, pleaded guilty to aiding and abetting the

filing of false tax returns in connection with the Matthews &

Wright tax-exempt bond transactions.   Mr. Goldberg was indicted,

with others, in connection with certain bond transactions in the

Territory of Guam and negotiated a plea arrangement.


Petitioners' Bond Purchases


     On July 25, 1986, Harbor Bancorp acquired Whitewater bonds

with a face amount of $250,000.   In the same month, the Keiths

acquired Ironwood bonds with a $400,000 face amount and

Whitewater bonds with a face amount of $300,000.   Harbor Bancorp

received $19,375 of interest on the Whitewater bonds in each of

the years 1988, 1989, and 1990.   The Keiths received $54,250 of

interest on the Whitewater and Ironwood bonds in each of the

years 1989, 1990, and 1991.   Neither Harbor Bancorp nor the

Keiths included the interest received on the Bonds in the gross

income that they reported on their Federal income tax returns for

the years in issue.

     On February 20, 1991, the Commissioner notified the Housing

Authority that the interest paid on the Bonds would be treated as

taxable income to the bondholders unless the Housing Authority

paid, to the United States, the amount required by section
                              - 23 -

148(f), which the Commissioner determined to be $2,250,475 with

respect to the Whitewater bonds, and $1,543,199 with respect to

the Ironwood bonds.5   The Housing Authority refused to make such

payments.


                              OPINION


     Section 103(a) generally excludes interest earned on State

and local government bonds from taxable income.    This exclusion,

however, does not apply to "arbitrage bonds".   Sec. 103(c)(1).6

Section 103(c)(2) defines an arbitrage bond generally as a bond

the proceeds of which are "reasonably expected" to be used to

acquire higher yielding investments.    Section 148(f)(1) provides

that if the requirements of section 148(f)(2) are not met, State

and local government bonds will be "treated as" arbitrage bonds.

Respondent's primary argument is based on section 148(f).

Accordingly, we will first consider whether the Bonds should be

treated as arbitrage bonds under section 148(f).




     5
      On June 20, 1991, the Housing Authority filed an action in
the U.S. District Court in Los Angeles, California, seeking a
preliminary injunction enjoining the Internal Revenue Service
from declaring the interest on the Bonds taxable. On June 20,
1991, Judge Marshall of the District Court granted a preliminary
injunction. On July 23, 1992, she dissolved the injunction,
ruling that the court lacked jurisdiction. No decision on the
merits was entered.
     6
      Sec. 103(c)(1) provides that "any arbitrage bond shall be
treated as an obligation not described in subsection (a)(1) or
(2)."
                              - 24 -

     Section 148(f) was enacted by the Tax Reform Act of 1986,

and it is applicable to bonds issued after December 31, 1985.

Tax Reform Act of 1986, Pub. L. 99-514, sec. 1314(d), 100 Stat.

2664.7   Thus, our initial determination must be whether the Bonds

were issued on December 31, 1985, as petitioners contend, or on

February 20, 1986, as respondent contends.   This is a mixed

question of fact and law, and we adopt the following analysis and

findings of the trial judge regarding the date on which the Bonds

were issued.

     "Date of issue" is defined in section 1.103-13(b)(6), Income

Tax Regs., as


     the date on which there is a physical delivery of the
     evidences of indebtedness in exchange for the amount of
     the issue price. For example, obligations are issued
     when the issuer physically exchanges the obligations
     for the underwriter's (or other purchaser's) check.[8]


     7
      TRA sec. 1314(d), 100 Stat. 2664, provides:


     Except as otherwise provided in this subsection, in the
     case of a bond issued after December 31, 1985, section
     103 of the 1954 Code shall be treated as including the
     requirements of section 148(f) of the 1986 Code in
     order for section 103(a) of the 1954 Code to apply.
     8
      Respondent insists that the proper definition of "issue
date" for the Bonds involved here is that contained in sec.
1.150-1(c)(2), 57 Fed. Reg. 21032 (May 10, 1994), which provides:


          (2) Date of Issue. The date of issue of a bond
     is the first day on which there is physical delivery of
     the written evidence of the bond in exchange for the
     purchase price. Such day shall not be earlier than the
     first day on which interest begins to accrue on the
                                                   (continued...)
                              - 25 -


     Courts have never regarded "the simple expedient of drawing

up papers" as controlling for tax purposes when the objective

realities are to the contrary.    Commissioner v. Tower, 327 U.S.

280, 291 (1946).   Here, the hastily drawn up papers used at the

putative closings on December 31, 1985, utterly fail to reflect

objective reality.   The alleged payment for the Bonds took the

form of share drafts from starter kits, drawn on nonexistent

accounts at a Jersey City credit union.   The agent of the trustee

promptly endorsed these items, without recourse to the trustee,

to the order of an undercapitalized institution located in Saipan

that had recently lost its banking license.   In exchange, the

trustee took the Saipan institution's investment agreements.     If,

on December 31, 1985,--the alleged "date of issue"--the trustee

had sought either to cash the share drafts or to collect upon its

investment agreements, it would have been unsuccessful.   Neither

the share drafts nor the investment agreements had any substance

behind them.   These items fell embarrassingly short of

representing actual payment for the Bonds within the meaning of

the Commissioner's regulations.   Accordingly, the date of issue

of the Bonds was not December 31, 1985, but rather February 20,

1986, when actual funds were transferred from Security Pacific


(...continued)
     bond for federal income tax purposes.


Suffice it to say our determination as to the date of issue would
be the same under either version.
                                - 26 -

Bank to Chase Manhattan Bank and subsequently to Heritage, to the

credit of the developer partnerships and then to Unified.

Because the Bonds were issued after December 31, 1985, section

148(f) applies.

     Section 148(f)(1) provides that a bond shall be treated as

an arbitrage bond unless the amount described in section

148(f)(2) is paid to the United States.   Such amount is equal to

the sum of:


          (A) the excess of--

               (i) the amount earned on all nonpurpose
          investments (other than investments
          attributable to an excess described in this
          subparagraph), over

               (ii) the amount which would have been
          earned if such nonpurpose investments were
          invested at a rate equal to the yield on the
          issue, plus

          (B) any income attributable to the excess
     described in subparagraph (A),


Sec. 148(f)(2).   Payments required by section 148(f)(2) are

generally required to be made at 5-year intervals.    Each required

installment must be in an amount that ensures that 90 percent of

the amount described in section 148(f)(2) has been paid, and full

payment must be made with the last installment.   Sec. 148(f)(3).9


     9
      Sec. 148(f)(3) provides in part:


     Except to the extent provided by the Secretary, the
     amount which is required to be paid to the United
                                                   (continued...)
                               - 27 -

Failure to pay the required amount results in the bond's being

treated as an arbitrage bond, which results in the loss of tax-

exempt status.

     The parties have stipulated that no payments required by

section 148(f) were made to the United States.   Therefore, if (1)

the Whitewater and Ironwood GIC's constitute nonpurpose

investments of the proceeds of the Bonds, and (2) these

investments earned a higher rate of return than the yield rate on

the Bonds, then the Bonds must be treated as arbitrage bonds

pursuant to section 148(f).

     A "nonpurpose investment" is defined as any investment

property that is acquired with the gross proceeds of a bond issue

and is not acquired to carry out the governmental purpose of the

issue.   Sec. 148(f)(6)(A).   "Gross proceeds" include any amounts

actually or constructively received from the sale of the bonds as

well as any amounts received from investing the original proceeds


(...continued)
     States by the issuer shall be paid in installments
     which are made at least once every 5 years. Each
     installment shall be in an amount which ensures that 90
     percent of the amount described in paragraph (2) with
     respect to the issue at the time payment of such
     installment is required will have been paid to the
     United States. The last installment shall be made no
     later than 60 days after the day on which the last bond
     of the issue is redeemed and shall be in an amount
     sufficient to pay the remaining balance of the amount
     described in paragraph (2) with respect to such issue.


There is no dispute that the Housing Authority of Riverside
County has not made such a payment within the time prescribed by
sec. 148(f)(3).
                              - 28 -

of the bond issue.   Sec. 148(f)(6)(B); sec. 1.148-8(d)(1)-(5),

Income Tax Regs.

     The Whitewater and Ironwood GIC's were acquired with the

gross proceeds of the Whitewater and Ironwood bond issues,

respectively.   These proceeds were first placed in developer loan

fund accounts and then transferred to Unified.   Unified then

transferred most of these proceeds to the MCFC entities, which,

in turn, used them to purchase the GIC's.   Following the flow of

funds on February 20, 1986, it is clear that $16,110,817.98 of

Whitewater bond proceeds and $11,047,408.05 of Ironwood bond

proceeds were expended to acquire the GIC's.   The governmental

purpose for the issuance of the Whitewater and Ironwood bonds was

the construction of low- and moderate-income multifamily housing

projects.   The GIC's were not acquired to carry out this

governmental purpose.   Accordingly, the GIC's constituted

nonpurpose investments within the meaning of section

148(f)(6)(A).

     Petitioners argue that the GIC's do not constitute

nonpurpose investments, because neither the Housing Authority nor

the developer made an "investment decision".   Petitioners ask

this Court to construe the meaning of "nonpurpose investment" to

exclude any unauthorized investment.10   However, the statute does


     10
      Petitioners also argue that the Treasury's regulation
defining "nonpurpose investment" is invalid, because the
definition therein is broader than the definition in the statute.
We fail to see a significant difference in the definitions. Sec.
                                                   (continued...)
                                 - 29 -

not provide such an exclusion.       Section 148(f)(6)(A) defines a

nonpurpose investment broadly to include any investment property

that is acquired with the gross proceeds of an issue, and is not

acquired to carry out the governmental purpose of the issue.11

While the Housing Authority did not directly purchase the GIC's



(...continued)
148(f)(6)(A) defines "nonpurpose investment" as any investment
property that is acquired with the gross proceeds of an issue and
is not acquired to carry out the governmental purpose of the
issue. Sec. 1.148-8(e)(9), Income Tax Regs., defines "nonpurpose
investment" as any investment that is not a purpose investment.
"Purpose investment" is defined as any investment that is
allocated to the gross proceeds of an issue and that is acquired
to carry out the governmental purpose of the issue. Sec. 1.148-
8(e)(10), Income Tax Regs. In any event, we have relied upon the
statutory definition for purposes of our holding.
     11
          Sec. 148(f)(6) provides:


     (6) Definitions.--For purposes of this subsection and
     subsections (c) and (d)--

          (A) Nonpurpose Investment.--The term "nonpurpose
     investment" means any investment property which--

                  (i) is acquired with the gross proceeds
             of an issue, and

                  (ii) is not acquired in order to carry
             out the governmental purpose of the issue.

          (B) Gross proceeds.--Except as otherwise provided
     by the Secretary, the gross proceeds of an issue
include--

                  (i) amounts received (including
             repayments of principal) as a result of
             investing the original proceeds of the issue,
             and

                  (ii) amounts to be used to pay debt
             service on the issue.
                                 - 30 -

and, presumably, did not intend that the Bond proceeds be used to

purchase the GIC's, the GIC's were in fact purchased with the

proceeds of the Bonds and committed to provide funds for the

repayment of principal and interest on the Bonds rather than for

the governmental purpose of constructing multifamily housing.

Thus, the GIC's fall within the statutory definition of

nonpurpose investments.

     Next, we must determine whether there was an amount earned

on the nonpurpose investments that exceeded the amount that would

have been earned if the nonpurpose investments had been invested

at a rate equal to the yield on the Bond issues (hereinafter

sometimes referred to as the excess amount).     Sec. 148(f)(2).12

An amount earned within the meaning of section 148(f)(2) is an

amount actually or constructively received by the bond issuer

from the nonpurpose investment.     See secs. 1.148-2(b)(2)(i),

1.148-8(d)(5), Income Tax Regs.13     Here, the amounts earned on


     12
      Sec. 148(f)(4) contains special rules for applying par.
(2). Petitioners make no claim that these special rules require
any modification to the computation of the excess amount defined
in sec. 148(f)(2), and we find nothing in par. (4) that would
modify the literal application of par. (2) to the facts in this
case.
     13
          Sec. 1.148-2(b)(2)(i), Income Tax Regs., provides:


     The term "receipt" means, with respect to an investment
     allocated to an issue, any amount actually or
     constructively received with respect to the investment.
     Except as provided in § 1.148-4(c)(3), receipts are not
     reduced by selling commissions, administrative
     expenses, or similar expenses. * * *
                                                    (continued...)
                              - 31 -

the GIC's were constructively received by the Housing Authority

because the proceeds of the GIC's were used to pay the debt

service on the Bonds that the Housing Authority had issued.14

     Logic indicates that the amount earned on the nonpurpose

investments (the GIC's) was substantially in excess of the amount

which would have been earned if the amounts invested in the GIC's

had been invested at a rate equal to the yield on the Bond

issues.   The amount available to buy the GIC's--the Bond

proceeds--had been diminished by substantial fee payments and by

the purchase of land.   Nevertheless, the payments yielded by the

Whitewater and Ironwood GIC's exactly equaled the debt service

payments specified in the Bond documents.   Because an amount that

was substantially less than the Bond proceeds was invested in the

GIC's, and because the GIC's nevertheless generated enough

revenue to pay the Bonds' debt service requirements, it follows

that the GIC's paid interest at higher rates than the yield on

the Bonds.   It further follows that amounts earned on the



(...continued)

     Sec. 1.148-8(d)(5), Income Tax Regs., provides:


     The term "investment proceeds" means, with respect to
     an issue, any amounts actually or constructively
     received from investing original proceeds of the issue.
     14
      Satisfaction of a debtor's obligation by means of a third
party's payment to the creditor is the equivalent of receipt by
the debtor. Old Colony Trust Co. v. Commissioner, 279 U.S. 716,
729 (1929); Amos v. Commissioner, 47 T.C. 65, 70 (1966); see
Bintliff v. United States, 462 F.2d 403, 408 (5th Cir. 1972).
                              - 32 -

investment of a given sum at the rate of the higher yielding

GIC's would substantially exceed amounts earned upon investment

of that same sum at the yield rate of the Bonds.

     The regulations calculate the excess amount to be paid to

the United States as the future value of all nonpurpose receipts

over the future value of all nonpurpose payments.    Sec. 1.148-

2(a)(1) and (2), Income Tax Regs.   "Receipts" are defined to

include any amount actually or constructively received with

respect to the investment (but not reduced by administrative or

similar expenses).   Sec. 1.148-2(b)(2)(i), Income Tax Regs.15

"Payments" are defined to include the amount of gross proceeds of

the bond issue to which the investment is allocated (not

including administrative or similar expenses), whether or not the

investment was directly purchased with such gross proceeds.      Sec.

1.148-2(b)(3)(i) and (ii), Income Tax Regs.

     The parties have stipulated the schedule of payments for and

receipts pursuant to the Whitewater GIC as follows:


      Date                   Payment                  Receipt

     2/20/86              $16,110,817.98
     5/27/86                                        $678,125
    11/26/86                                         678,125
     5/27/87                                         678,125
    11/25/87                                         678,125
     5/27/88                                         678,125
    11/25/88                                         678,125


     15
      For an investment held at the end of a computation period,
the term "receipt" includes the fair market value of the
investment at the end of that period. Sec. 1.148-2(b)(2)(iii),
Income Tax Regs.
                             - 33 -

     5/26/89                                       678,125
    11/24/89                                       678,125
     5/25/90                                       678,125
    11/26/90                                       678,125
     5/24/91                                       678,125
    11/26/91                                       678,125
     5/27/92                                       678,125
    11/25/92                                       678,125
     5/27/93                                       678,125
    11/26/93                                    18,178,125


Similarly, the schedule of payments for and receipts pursuant to

the Ironwood GIC has been stipulated by the parties as follows:

      Date                  Payment                Receipt

     2/20/86             $11,047,408.05
     5/27/86                                      $465,000
    11/26/86                                       465,000
     5/27/87                                       465,000
    11/25/87                                       465,000
     5/27/88                                       465,000
    11/25/88                                       465,000
     5/26/89                                       465,000
    11/24/89                                       465,000
     5/25/90                                       465,000
    11/26/90                                       465,000
     5/24/91                                       465,000
    11/26/91                                       465,000
     5/27/92                                       465,000
    11/25/92                                       465,000
     5/27/93                                       465,000
    11/26/93                                    12,465,000


     Utilizing the procedures outlined in sections 1.148-2 and

1.148-8, Income Tax Regs.,16 respondent has undertaken to show

how much the amount earned on the GIC's exceeded the amount which

would have been earned if the GIC's had been invested at a rate



     16
      Sec. 148(i) provides that "The Secretary shall prescribe
such regulations as may be necessary or appropriate to carry out
the purposes of this section."
                                        - 34 -

equal to the yield on the Bond issues.                These calculations

indicate that the yield of the Whitewater GIC was 9.5520 percent,

and the yield of the Whitewater bonds was 7.3750 percent.                   As of

February 20, 1991, the first computation date, respondent's

calculations indicate that the future value of the earnings on

the Whitewater GIC exceeded the amounts that would have been

earned if the GIC were invested at the yield rate of the

Whitewater bonds by $2,079,204.05.17              Equivalent calculations for

the Ironwood bonds show that the yield on the Ironwood GIC was

again 9.5520 percent while the yield on the Ironwood bonds was

7.6652 percent, generating an excess of $1,242,876.71 as of the




     17
          Respondent computed this excess as follows:


                                                                  Days
                 Payment           Receipt      Future Value     To Comp.

  2/20/86    (16,110,817.98)                   (23,140,973.48)    1800
  5/27/86                         678,125.00       955,210.32     1703
 11/26/86                         678,125.00       921,424.96     1524
  5/27/87                         678,125.00       888,477.02     1343
 11/25/87                         678,125.00       857,224.42     1165
  5/27/88                         678,125.00       826.405.87      983
 11/25/88                         678,125.00       797,336.65      805
  5/26/89                         678,125.00       768,825.81      624
 11/24/89                         678,125.00       741,782.00      446
  5/25/90                         678,125.00       715,257.66      265
 11/26/90                         678,125.00       689,681.77       84
  2/20/91                      17,061,551.08    17,061,551.08        0
  2/20/91         (3,000.00)            0.00        (3,000.00)       0
  5/27/92                               0.00             0.00     -457
  1/25/92                               0.00             0.00     -635
  5/27/93                               0.00             0.00     -817
 11/26/93                               0.00             0.00     -996

             (16,113,817.98)   23,842,801.08     2,079,204.05


Respondent used the same procedure in calculating the excess amount for the
Ironwood bonds.
                              - 35 -

first computation date according to respondent.   In their briefs,

petitioners did not attempt to refute respondent's calculations.

     We are convinced that the amounts earned on the GIC's

substantially exceeded the amounts which would have been earned

if the GIC's had paid a rate equal to the yield of the Bonds.

Petitioners do not seriously contend otherwise.   We need not, and

do not, decide the exact amount of that excess.   In order to hold

that the Bonds should be treated as arbitrage bonds within the

meaning of section 148(f), it is sufficient to find, as we do,

that the amount earned on the nonpurpose investments (the GIC's)

substantially exceeded the amount that would have been earned if

the nonpurpose investment had been invested at a rate equal to

the yield on the Bond issues, and that the Bond issuer failed to

pay the amount of that excess to the United States at the

required time.

     Petitioners argue that a literal reading of section 148(f)

should not apply to the Bonds at issue, because the statute was

intended only to recapture the economic benefit received by the

issuer.   Petitioners cite Washington v. Commissioner, 692 F.2d

128 (D.C. Cir. 1982), affg. 77 T.C. 656 (1981), for the

proposition that a bond issuer must realize an economic benefit

in order to trigger the arbitrage provisions.   In State of

Washington, this Court concluded that the general arbitrage

provisions of section 103(c) were intended to apply only where

the issuer of the bond realized an economic benefit.   As a
                              - 36 -

result, we held that the costs of issuing the bonds, including

underwriting costs, should be taken into account in determining

the existence of arbitrage.   The Court of Appeals for the

District of Columbia Circuit affirmed.

     In 1986, when Congress enacted section 148, it specifically

reversed Washington v. Commissioner, supra.


          The bill provides that, under all arbitrage
     restrictions applicable to tax-exempt bonds, the yield
     on an issue is determined based on the issue price,
     taking into account the Code rules on original issue
     discount and discounts on debt instruments issued for
     property (secs. 1273 and 1274). This amendment
     reverses the holding in the case State of Washington v.
     Commissioner, supra. [S. Rept. 99-313, at 845 (1986),
     1986-3 C.B. (Vol. 3) 1, 845.]


The Committee explained the reason for this change as follows:


          The committee believes it is important for issuers
     of tax-exempt bonds to pay the costs associated with
     their borrowing. The bill provides that the costs of
     issuance, including attorneys' fees and underwriters'
     commissions, must be paid by the issuers or
     beneficiaries of the bonds, rather than recovered
     through arbitrage profits at the Federal Government's
     expense. The committee believes that this restriction
     will result in a more efficient use of tax-exempt
     financing, as borrowers will more closely monitor the
     costs of their borrowing. However, the committee
     intends to monitor the effect of these provisions to
     determine whether further restrictions on costs such as
     attorneys' fees and underwriters' commissions are
     needed. [S. Rept. 99-313, supra at 828, 1986-3 C.B.
     (Vol. 3) at 828.]


From this, it is clear that when Congress enacted section 148, it

did not want to permit the investment of tax-exempt bond proceeds

in higher yielding investments, the income from which would be
                               - 37 -

used to recover costs associated with the bond issue.    In the

instant case, that is exactly what happened.    When all the smoke

had cleared, the underwriters, bankers, and attorneys had

received substantial amounts from the Bonds' proceeds, and the

repayment of those Bonds had been secured by the purchase of the

GIC's.    The relatively small amount left was insufficient to

accomplish the governmental purpose of the bonds.

     Petitioners next argue that section 148(f) should not apply

when the governmental issuer of the bonds did not intend that the

bond proceeds be invested in higher yielding, nonpurpose

obligations.    However, the literal provisions of section

148(f)(1) and (2) make no reference to the issuer's intent.

Rather, the language of section 148(f)(2) is computational in

nature and unambiguous.18




     18
      There is no need to resort to legislative history, unless
the statutory language is ambiguous. In Hubbard v. United
States, 514 U.S.    ,    ,    , 115 S. Ct. 1754, 1759, 1761
(1995), the Supreme Court recently stated:

     In the ordinary case, absent any "indication that doing
     so would frustrate Congress's clear intention or yield
     patent absurdity, our obligation is to apply the
     statute as Congress wrote it." BFP v. Resolution Trust
     Corp., 511 U.S.     (1994) (SOUTER, J., dissenting).

                            * * * * * * *

     Courts should not rely on inconclusive statutory
     history as a basis for refusing to give effect to the
     plain language of an Act of Congress, particularly when
     the Legislature has specifically defined the
     controverted term. * * *
                              - 38 -

     The statutory context of section 148(f) also supports a

literal application of its terms.   The general definition of an

"arbitrage bond" is contained in section 103(c)(2).   An

"arbitrage bond", within the meaning of that section, is one that

the issuer "reasonably expected" to produce arbitrage.     If an

issuer "reasonably expected" to earn arbitrage with bond

proceeds, the bonds are not tax exempt.   Section 148(f) is an

additional arbitrage restriction.   It was intended to restrict

arbitrage even further than the historic reasonable expectation

test.   In its explanation of the new section 148(f) provisions,

the Senate Finance Committee report states:


          The bill generally extends to all tax-exempt bonds
     (including refunding issues) additional arbitrage
     restrictions similar to those presently applicable to
     most IDBs and to qualified mortgage bonds. These
     restrictions, requiring the rebate of certain arbitrage
     profits and limiting investment of bond proceeds in
     nonpurpose obligations, are in addition to the general
     arbitrage restrictions for all tax-exempt bonds. [S.
     Rept. 99-313, supra at 845, 1986-3 C.B. (Vol. 3) at
     845; emphasis added.]


See also H. Rept. 99-426 (1985), 1986-3 C.B. (Vol. 2) 1, 555.

There is no indication in the statute or legislative history that

Congress wanted to limit section 148(f) to situations where the

issuer intended, or reasonably expected, to earn arbitrage.

     Were we to superimpose an intent requirement onto section

148(f), that section would become redundant.   Section 103(c)

already defined arbitrage bonds as those whose proceeds the

issuer reasonably expected, at the time of issue, would be used
                               - 39 -

to produce arbitrage.   For bonds issued after August 15, 1986,

the general definition of an arbitrage bond appears in section

148(a).   Section 148(a) expanded the definition to include not

only bonds that the issuer reasonably expected, at the time of

issuance, would produce arbitrage, but also bonds whose proceeds

were at any time "intentionally" used by the issuer to acquire

higher yielding investments.    Arbitrage bonds within the

definition of section 103(c) and section 148(a) are not tax

exempt, and there are no statutory provisions allowing the issuer

to attain or regain tax exempt status by paying the amount of

arbitrage earnings to the Federal Government.    In contrast, a

bond's treatment as an arbitrage bond under section 148(f)

depends first upon whether a payment to the United States is

required by section 148(f).    This cannot be ascertained until

after the date the State or local government bonds are issued and

after the nonpurpose investment is made.    The first computation

date for making this determination is normally 5 years after the

original bond issue.    Furthermore, section 148(f)(1) and (2) does

not treat a bond as an arbitrage bond merely because of the

existence of excess earnings within the meaning of section

148(f)(2).   Rather, it is the existence of such excess (based on

a mathematical calculation) plus the failure of the issuer to pay

the excess amount to the Federal Government that triggers

arbitrage bond treatment and the resulting loss of tax-exempt

status.
                              - 40 -

     The regulations under section 148(f) are consistent with the

statute and legislative history in that they are mechanical in

nature and require no reference to the issuer's intent or

expectations.   The section 148(f)(2) amount is defined as the

excess of the future value of all nonpurpose receipts over the

future value of all nonpurpose payments.    Sec. 1.148-2(a), Income

Tax Regs.   "Receipts" are defined broadly to include any amount

actually or constructively received with respect to the

investment as well as the fair market value of the investment at

the end of a computation period.   Sec. 1.148-2(b)(2)(i), (iii),

Income Tax Regs.   "Payments" are also defined broadly and include

the amount of gross proceeds of the issue to which the investment

is allocated, whether or not the investment was directly

purchased with such gross proceeds.    Sec. 1.148-2(b)(3)(i) and

(ii), Income Tax Regs.   If the receipts exceed the payments,

there is an amount that must be paid to the United States in

order to avoid treatment as an arbitrage bond.

     It is clear that the investments in the GIC's earned a

higher rate of return than the yield on the Bonds.    This produced

an excess amount within the meaning of section 148(f)(2).     It is

also clear that some of the excess was used for purposes that

Congress did not want to subsidize through Federal tax

exemptions.   Congress provided that the exempt status of such

bonds could be maintained only if the issuer paid the excess

amount as defined in section 148(f)(2) to the United States.
                                - 41 -

Here, the issuer has thus far refused to pay that amount.

Accordingly, we hold that the Whitewater and the Ironwood bonds

are to be treated as arbitrage bonds pursuant to section 148(f)

and that the interest earned thereon is includable in

petitioners' income.19

     Because we have determined that the Bonds are to be treated

as arbitrage bonds under section 148(f), we must address some of

the other arguments advanced by petitioners.    Petitioners contend

that respondent lacks the authority to tax the bondholders, and

that her sole remedy is to disqualify the issuer from certifying

the nonarbitrage status of its tax-exempt bonds in the future

under section 1.103-13(a)(2)(iv), Income Tax Regs.    The

regulation cited by petitioners neither states nor implies such a

proposition.    Petitioners have cited no authority to show why the

decertification remedy is inconsistent with the Commissioner's

concurrent duty to collect income taxes on interest from bonds

that are not exempt from tax under section 103.    See secs. 6212,

7601.     It is not uncommon for the Commissioner to have a variety

of ways to carry out her duties.    See, e.g., Pesch v.

Commissioner, 78 T.C. 100, 117-118 (1982).


     19
      The parties addressed the following additional issues on
brief: (1) Whether the Bonds are arbitrage bonds within the
meaning of sec. 103(c)(2); (2) whether the Bonds are taxable
industrial development bonds within the meaning of sec. 103(b);
and (3) with respect to one of the involved bond issues, whether
the public approval requirement set forth in sec. 103(k) was
satisfied. However, because we hold that the Bonds are to be
treated as arbitrage bonds under sec. 148(f), we need not decide
these issues.
                             - 42 -

     Petitioners also argue that respondent has impermissibly

discriminated against them by taxing them on the Bond proceeds

while, in other cases, respondent has settled with the issuers.20

This argument is wide of the mark.    It is the responsibility of

this Court to apply the law to the facts before it and to

determine the tax liability of petitioners before it.    The

Commissioner's treatment of other taxpayers has generally been

considered irrelevant in making that determination.     Jaggard v.

Commissioner, 76 T.C. 222, 226 (1981) (citing Teichgraeber v.

Commissioner, 64 T.C. 453, 456 (1975)).    To establish illegal

discrimination by the Commissioner, petitioners must show more

than the fact that they have been treated less favorably than

other similarly situated taxpayers.   Petitioners must also show

that such allegedly discriminatory treatment is based upon

impermissible considerations such as race, religion, or the

desire to prevent the exercise of constitutional rights.       Penn-

Field Indus., Inc. v. Commissioner, 74 T.C. 720, 723 (1980).

     Petitioners have not shown, in the first instance, that

other similarly situated taxpayers received better treatment.      In

addition, petitioners have not demonstrated that respondent has

used impermissible criteria in determining the deficiencies in



     20
      Any "settlements" with bond issuers may well have included
the issuers' payment of an amount pursuant to sec. 148(f)(2).
The Housing Authority of Riverside County has made no such
payment.
                               - 43 -

issue.    Petitioners may be, as they allege, the first bondholders

to be taxed upon interest received from purportedly tax-exempt

bonds that fail to meet the requirements for tax exemption.

However, that does not mean that they have been targets of

impermissible discrimination.21

     Finally, we realize that under our holding, it is the

bondholders, rather than the bond issuer, that bear the immediate

brunt of the issuer's failure to pay the amount required by

section 148(f)(2).   However, the statutory exemption from Federal

tax for interest on State and local government bonds is

conditioned on the requirement that the bond issuer pay the

amount required by section 148(f)(2), and exclusions from taxable

income are to be narrowly construed.    Commissioner v. Schleier,


     21
      Petitioners rely on International Business Machines Corp.
v. United States, 170 Ct. Cl. 357, 343 F.2d 914 (1965), to
support their claim of discrimination. In that case, one of
IBM's competitors had obtained a ruling from the Commissioner
that certain equipment was exempt from an excise tax. IBM sought
a similar ruling for similar equipment, which the Commissioner
finally denied 2 years later. At the time of the denial, the
Commissioner prospectively revoked the favorable ruling that
IBM's competitor had received, but the competitor had already
enjoyed several years of favorable tax treatment. The Court of
Claims found that this course of conduct constituted "manifest
and unjustifiable discrimination", and its effect "was to favor
the other competitor so sharply that fairness called upon the
Commissioner, if he could under Section 7805(b), to establish a
greater measure of equality." 343 F.2d at 923.

     We find that the present case is distinguishable from IBM.
The present case does not involve a determination by the
Commissioner, which has the effect of penalizing petitioners and
favoring similarly situated taxpayers so as to give them a
significant competitive or financial advantage.
                               - 44 -

515 U.S. ___, ___, 115 S. Ct. 2159, 2163 (1995).    The simple fact

is that the statutory requirements for exempting the interest

earned on the Bonds have not been met.   As with other debtor-

creditor relationships, the risk that the issuer of bonds will

not live up to the responsibilities undertaken when it

represented the quality of its obligations must be born by the

bond purchasers.

     One might also sympathize with the situation of the Housing

Authority of Riverside County.   However, it seems clear that, as

between it and the Federal Government, the Housing Authority

should bear responsibility for what happened.   The Housing

Authority issued the Bonds and selected those who were

responsible for implementing their issuance and applying the

proceeds.    Congress clearly wanted bond issuers to be responsible

for meeting the requirements for tax exemption.    The Housing

Authority certified that the Bonds would qualify for tax

exemption.   Like any other local government bond issuer, the

Housing Authority was responsible for paying any amount required

by section 148(f)(2), regardless of whether it intended to

generate the excess described in section 148(f)(2).    It has thus

far chosen not to do so.   Unfortunately for its bondholders, the
                              - 45 -

statutorily required result of this choice is that the interest

on the Bonds is not exempt from Federal taxation.



                                   Decisions will be entered

                              for respondent.


     Reviewed by the Court.


     HAMBLEN, CHABOT, GERBER, WRIGHT, PARR, WELLS, WHALEN,
COLVIN, BEGHE, CHIECHI, LARO, FOLEY, and VASQUEZ, JJ., agree with
this majority opinion.

     SWIFT, J., concurs in the result only.
                                - 46 -

     HALPERN, J., concurring:    I agree with the majority's

opinion except in one respect, the majority's reliance on tracing

the bond proceeds into the GIC's.    I am not convinced that the

statute (sec. 148(f)) contemplates tracing, and I would rely on a

different rationale, viz, that the issuer (the Housing Authority)

itself invested in the GIC's.

     The key to the majority's analysis concerning section 148(f)

is in the following paragraph:

          The Whitewater and Ironwood GIC's were acquired
     with the gross proceeds of the Whitewater and Ironwood
     bond issues, respectively. These proceeds were first
     placed in developer loan fund accounts and then
     transferred to Unified. Unified then transferred most
     of these proceeds to the MCFC entities, which, in turn,
     used them to purchase the GIC's. Following the flow of
     funds on February 20, 1986, it is clear that
     $16,110,817.98 of Whitewater bond proceeds and
     $11,047,408.05 of Ironwood bond proceeds were expended
     to acquire the GIC's. The governmental purpose for the
     issuance of the Whitewater and Ironwood bonds was the
     construction of low- and moderate-income multifamily
     housing projects. The GIC's were not acquired to carry
     out this governmental purpose. Accordingly, the GIC's
     constituted nonpurpose investments within the meaning
     of section 148(f)(6)(A). [Majority op. p. 28.]

     Petitioners attempt to rebut the majority's conclusion about

the GIC's by (1) conceding that, yes, the bond proceeds are

traceable into the GIC's, but (2) arguing that the GIC's were an

unauthorized investment.   In effect, petitioners' argument is

that, whatever in fact happened to the bond proceeds, the Housing

Authority did not do it:   Some other guys (thieves!) did it.      Id.

p. 28.   The majority makes plain that, to the majority, it does
                               - 47 -

not matter who invested the bond proceeds in the GIC's, so long

as someone (anyone) invested the bond proceeds in the GIC's:

     While the Housing Authority did not directly purchase
     the GIC's and, presumably, did not intend that the Bond
     proceeds be used to purchase the GIC's, the GIC's were
     in fact purchased with the proceeds of the Bonds and
     committed to provide funds for the repayment of
     principal and interest on the Bonds rather than for the
     governmental purpose of constructing multifamily
     housing. Thus, the GIC's fall within the statutory
     definition of nonpurpose investments. [Id. at 29-30.]

     Section 148(f)(6)(A) defines the term "nonpurpose

investment".    The operative provision, however, is section

148(f)(2)(A), which provides that the rebatable excess of an

arbitrage bond is determined by starting with "the amount earned

on all nonpurpose investments".      An important question, of

course, is:    investment by whom?    The majority's analysis

implicitly leads to the conclusion that, if A lends bond proceeds

to B, who lends them to C, who makes an investment of the bond

proceeds that, in A's hands, would be a nonpurpose investment,

the bonds issued by A can be arbitrage bonds under section

148(f).   A's balance sheet, however, shows only B's obligation,

and the only investment made by A is in a loan to B.      The

majority's analysis, in effect, attributes C's use of the bond

proceeds to A.    Generally, unless there is some special

arrangement between the parties to a loan, we would not attribute

the actions of the borrower to the lender.      If A lends money to

B, who, without any instruction from A, buys drugs with the

money, we do not attribute the drugs to A.      A pertinent
                                - 48 -

regulation is section 1.103-13(f)(1), Income Tax Regs.,22 which

provides:

     In general. A State or local governmental unit shall
     allocate the cost of its acquired obligations to the
     unspent proceeds of each issue of governmental
     obligations issued by such unit. * * * [Emphasis
     added.]

The majority fails to state who it thinks is making the

nonpurpose investments in the GIC's.     If it is any person other

than the Housing Authority, then the majority fails adequately to

emphasize and justify its tracing rationale.

     I would not attempt to justify a tracing rationale.    I think

that, on the facts of this case, we can find that the Housing

Authority made nonpurpose investments.    I would do so as follows.

     The financing plan was that the Housing Authority would lend

the bond proceeds to the developers and, in consideration

thereof, receive the developer notes and the benefit of the

letters of credit.   The letters of credit were to be secured by

the GIC's.   Indeed, the expectation was that the letters of

credit would be the exclusive source of repayment to the Housing

Authority (and on the Bonds).    The first paragraph of the first

page of the Secondary Offering Statement of the Ironwood Bond

issue states in part:




     22
          The parties agree that sec. 1.103-13(f), Income Tax
Regs. (1979), is the appropriate regulation governing the
allocation of investments to bond proceeds in the case of the
bonds in issue.
                              - 49 -

     The Bonds are secured by, and are paid solely from, a
     direct pay Letter of Credit issued by Mercantile
     Capital Finance Corporation No. 30 (the "Credit
     Institution") to secure and provide the source of
     repayment of the principal of, and interest on, a loan
     to be made to the Developer to finance the Development
     (as hereinafter defined) with respect to which the
     Bonds are issued. The sole source of payment of the
     Letter of Credit is a guaranteed investment contract
     . . . described herein, the payments on which are to be
     made to the First National Bank of Commerce, New
     Orleans, Louisiana, as collateral agent (the Collateral
     Agent").

The Secondary Offering Statement for the Whitewater bonds is

identical except that Mercantile Capital Finance Corporation

(MCFC) No. 47 is substituted for MCFC No. 30.     The letters of

credit (secured by the guaranteed investment contracts) were,

thus, in substance, if not in form, investment property held by

the Housing Authority.   I say that for the following reasons:

The letters of credit were to be the source of funds to discharge

the Housing Authority's nominal obligation to repay the bonds.

The developer notes were of no economic consequence to the

Housing Authority (or to the bondholders).     Neither the Housing

Authority nor the bondholders necessarily cared whether the

developer notes were paid.   Indeed, it is difficult to see how,

if the deal had gone as planned, the developers could have paid

off both the developer notes and the reimbursement notes (issued

to pay for the letters of credit).     Based on that rationale, I

would say that the letters of credit were acquired by the Housing

Authority and were not acquired in order to carry out the

governmental purpose of the issue.     Accordingly, the letters of
                             - 50 -

credit constitute nonpurpose investments within the meaning of

section 148(f)(6)(A).

     My analysis does not turn on the diversion of the bond

proceeds from the contemplated purposes of the bond issues.

Thus, it should answer the criticism of Judge Jacobs as to the

reasonable expectations of the Housing Authority officials on

February 20, 1986, the date on which the majority finds (and

Judge Jacobs agrees) the bonds were issued.   As of that date,

apparently, the "black [boxes]" referred to by Judge Jacobs

(Jacobs, J., dissenting op. note 4) had been designed, as

integral parts of the bond financings, and were known to (or

should have been known to) the Housing Authority.
                              - 51 -

     BEGHE, J., concurring:   I agree with and have joined the

majority opinion that the bonds in question were taxable

arbitrage bonds within the meaning of section 148(f):   the bond

proceeds were used to purchase investments that were not acquired

to carry out the governmental purpose; those investments produced

excess earnings under section 148(f)(2); and the issuer has

failed to rebate the amount of the excess earnings to the United

States.   In enacting section 148(f) of the 1986 Code, Congress

repudiated the holding of Washington v. Commissioner, 77 T.C. 656

(1981), affd. 692 F.2d 128 (D.C. Cir. 1982), and thereby made

clear that "amounts earned" on nonpurpose investments are not

limited to amounts that directly inure to the issuer:   they also

include excess earnings that enable more than a de minimis part

of the bond proceeds to be diverted to pay underwriters, bond and

tax counsel, and other service providers.   See S. Rept. 99-313,

at 828, 845 (1985), 1986-3 C.B. (Vol. 3) 1, 828, 845.   As a

result, the interest on the bonds ostensibly issued by the

Riverside Housing Authority was not excludable from the income of

the bondholders under section 103.

     I write separately to focus on three additional grounds, the

first two of which were also advanced by respondent, for holding

taxable the bonds in this case (and the bonds in other pending

cases).
                                - 52 -

                                  I.

       I believe that the bonds in question were arbitrage bonds on

the date of issuance under section 103(d), as enacted by the Tax

Reform Act of 1969, Pub. L. 91-172, sec. 601(a), 83 Stat. 487,

656.    Contrary to Judge Jacobs, dissenting op. p. 65, I believe

that the Riverside Housing Authority failed to show, as of the

date of issuance in February 1986, that it did not reasonably

expect that the proceeds would be invested in higher yield

obligations.

       On the subject of reasonable expectations, petitioners are

off base in arguing that, if our decision goes against them, the

standard of care required of state and local issuers will have

been retroactively made higher than it was or should have been at

the time the deals were done.    I agree with respondent that the

issuer's standard of care set forth in section 1.148-1(b), Income

Tax Regs. (the 1993 reg.), is basically no different from what

was required under the regulation in effect in 1985-86, section

1.103-13(a)(2), Income Tax Regs. (the 1979 reg.).   Even if there

may now be a higher level of consciousness among state and local

bond issuers and their counsel about the levels of due diligence

required, reasonableness is an objective and normative standard.

By any such standard, the Riverside Housing Authority and its

counsel were egregiously and inexcusably lax in failing to
                             - 53 -

monitor the Whitewater and Ironwood transactions and in allowing

the messes to happen.1

                               II.

     In addition to being arbitrage bonds, the bonds were also

taxable industrial development bonds under section 103(b)(1) of

the 1954 Code.

     Petitioners have conceded that the Whitewater and Ironwood

bonds were industrial development bonds within the meaning of

     1
          What I have in mind here was said by Judge Learned Hand
in the landmark tort case in which he made it clear that a
normative standard of care and reasonableness--that courts are
authorized to determine and impose--trumps the customary
practices of a particular industry:

          Is it then a final answer that the business had
     not yet generally adopted receiving sets? There are,
no doubt, cases where courts seem to make the general practice of
the calling the standard of proper diligence; we have indeed
given some currency to the notion ourselves. Indeed in most
cases reasonable prudence is in fact common prudence; but
strictly it is never its measure; a whole calling may have unduly
lagged in the adoption of new and available devices. It never
may set its own tests, however persuasive be its usages. Courts
must in the end say what is required; there are precautions so
imperative that even their universal disregard will not excuse
their omission. But here there was no custom at all as to
receiving sets; some had them, some did not; the most that can be
argued is that they had not yet become general. Certainly in
such a case we need not pause; when some have thought a device
necessary, at least we may say that they were right, and the
others too slack. The statute does not bear on this situation at
all. It prescribes not a receiving, but a transmitting set, and
for a very different purpose; to call for help, not to get news.
We hold the tugs therefore because had they been properly
equipped, they would have got the Arlington reports. The injury
was a direct consequence of this unseaworthiness. [The T.J.
Hooper v. Northern Barge Corp., 60 F.2d 737, 739 (2d Cir. 1932);
citations omitted.]
                              - 54 -

section 103(b)(2) of the 1954 Code, on the ground that the

proceeds of both issues were "to be used directly . . . in any

trade or business carried on by any person who is not an exempt

person."   The only dispute on this issue is whether the bonds

qualified under section 103(b)(4)(A), which provides that an

industrial development bond will not be taxable under section

103(b)(1) if it is part of an issue "substantially all of the

proceeds of which are to be used to provide" (emphasis added)

various exempt facilities.   The question is the meaning of the

phrase "are to be used".

     Both the Whitewater and the Ironwood issues were industrial

development bonds under section 103(b)(2) because the proceeds

were to be lent to private, for-profit developers for the purpose

of constructing apartment projects to be used in a private trade

or business, and repayment of the bonds was to be secured,

directly or indirectly, by the apartment projects and the income

they produced.   Although the documents provided that the

Whitewater bonds and the Ironwood bonds were to fund the

construction of residential rental properties that would meet the

20 percent low-income set-aside requirements of section

103(b)(4)(A)(ii),2 what is in dispute is whether substantially




     2
      Respondent concedes that the Ironwood project met the low-
income set-aside requirements of sec. 103(b)(4)(A)(ii).
                               - 55 -

all the proceeds of the Whitewater and Ironwood bonds were to be

used for residential rental property.

     While the phrase in section 103(b)(4) is "are to be used,"

the statutory sentence does not stop there but sets forth low-

income residence requirements that must be met "at all times

during the qualified project period".   Thus, compliance requires

examination of actual events occurring after the issue date.    It

would be illogical to suggest that expectations controlled until

the units were occupied, and that thereafter actual events would

control.   Such a reading would put a party that never tried to

build the residential rental project in a better position than a

party who built the project but inadvertently failed to satisfy

the low-income requirements.   Under section 1.103-8(b)(6)(ii) and

(iii), Income Tax Regs. (the 1979 reg.), issuers are permitted a

reasonable period of time to correct noncompliance.

     Section 1.103-8(b)(6)(i) and (9), Income Tax Regs. (the 1979

reg.), makes clear that satisfaction of the residential rental

property exception of section 103(b)(4)(A) requires more than

just a good faith hope or assumption that the proceeds of a bond

issue will be properly applied.   Section 1.103-8(b)(6)(i), Income

Tax Regs. (the 1979 reg.), provides that a post-issuance

nonconforming change will vitiate the exemption--retroactive to

the original issue date--unless corrected within a reasonable

time.   Examples (4) and (5) of section 1.103-8(b)(9), Income Tax

Regs. (the 1979 reg.), illustrate this rule.
                               - 56 -

     In example (5), 5 years after constructing a qualified

residential rental project, Corporation P, the developer and

owner, converted 80 percent of the units into nonqualifying

condominium units and repaid the loan to State X, the bond

issuer, which in turn redeemed the bonds.   The example concludes

that the bonds were not used to provide residential rental

housing within the meaning of section 103(b)(4)(A).

     In example (4), there is a similar disqualifying event, the

failure of the issuer, County Z, to enforce the 20 percent

requirement.   As a result, the bonds are classified as nonexempt

industrial development bonds, retroactive to the date of

issuance.3

     Petitioners would construe examples (4) and (5) as

inapplicable because the disqualifying actions by the issuers or

developers are "volitional".   I believe that the examples do

apply to the case at hand because in each of them--as in the case

at hand--the governmental issuer fails to enforce the statutory




     3
      See also sec. 1.103-8(a)(1), Income Tax Regs. (the 1979
reg.). ("Substantially all of the proceeds of an issue of
governmental obligations are used to provide an exempt facility
if 90% or more of such proceeds are so used."); H. Conf. Rept.
99-841, at II-697 (1986), 1986-3 C.B. (Vol. 4) 1, 697 ("The
conference agreement further provides that at least 95 percent of
the net proceeds of each issue must be used for the exempt
facility for which the bonds are issued"); Woods v. Homes &
Structures, Inc., 489 F. Supp. 1270, 1292 (D. Kan. 1980)
("Although section 103, speaks in prospective terms * * * we tend
to agree with plaintiffs that the actual distribution of the
proceeds will control.").
                               - 57 -

requirements that are violated by the developer-owner of the

project.

     The Whitewater project was never built; no units were ever

built for rental to low- and moderate-income tenants or to anyone

else.    Indeed, the Whitewater project could never have been built

with bond proceeds because, on February 20, 1986, $16,110,817.98

(91 percent) of the $17,778,146.53 of the Whitewater bond

proceeds was invested in a GIC that had the same maturity as the

bonds.

     The appropriate test is whether the issuer reasonably

expects, at the time the bonds are issued, that substantially all

of the bond proceeds will be devoted to the exempt facility and

the issuer thereafter takes steps to ensure that the bond

proceeds are used in a manner consistent with those expectations.

In addition, in conduit financing transactions such as Whitewater

and Ironwood, the expectations and subsequent conduct of the

conduit borrowers, the Whitewater and Ironwood partnerships, must

also be considered.   Industrial development bond financing by

definition contemplates significant involvement by

nongovernmental parties.   Interest on industrial development

bonds is exempt from taxation only if the exempt facility rules

are met.    Because the exempt facility rules require proceeds to

be spent in a specified manner and because a conduit borrower is

a necessary party to an exempt facility financing, testing

compliance with the exempt facility rules in the use at hand
                               - 58 -

requires consideration of the actions of the conduit borrowers,

the Whitewater and Ironwood partnerships.

     Construing section 103(b)(4) to require subsequent conduct

in furtherance of the original reasonable expectations is

consistent with the statutory language and furthers the statutory

purpose.   Section 103(b)(4) contains set-aside requirements that

must be met throughout the "qualified project period" (a period

that begins on the first day in which 10 percent of the project

units are occupied).    If those set-aside requirements are not

met, the interest on the bonds is taxable from the date of

issuance, irrespective of the reasonableness of the issuer's

expectations at the inception of the deal.    Sec. 103(b)(4)(A),

(12)(B).   Thus, the phrase "are to be used" looks to how the bond

proceeds are actually used, not just to how the proceeds were

expected to be used at the time the bonds were issued.

     This conclusion is supported by the contrasting language of

subsections (c) and (b) of section 103.    Section 103(c) defines

an "arbitrage bond" as a bond "the proceeds of which are

reasonably expected to be used" (emphasis added) for higher

yielding investments.    Compare the clear command of section

103(c) to look only at expectations with the language of section

103(b), which provides how substantially all of the "proceeds of

* * * [the bond issue] are to be used."     (Emphasis added.)   This

difference in focus strongly suggests that Congress intended two
                                - 59 -

different tests to apply and that the test in section 103(b) was

intended to be more than a pure expectations test.

     This suggested reading of this statutory provision also

prevents bizarre and inappropriate results.   If only expectations

on the date of issue are relevant, then an issuer who initially

planned to have residential rental property built, but never took

steps to assure that the housing project was constructed, would

be better off under the statute than an issuer who actually

caused the housing to be constructed but then inadvertently

failed to satisfy the set-aside requirements.   Such an anomalous

result would be the product of petitioners' interpretation of the

statute.   Thus, substantially all of the Whitewater bond proceeds

were not "to be used" for residential rental property within the

meaning of section 103(b)(4).

     While respondent concedes that the Ironwood project was

built and provided housing for low- and moderate-income tenants,

the Ironwood bonds are nevertheless not entitled to tax-exempt

status under section 103(b)(4).    Just like the Whitewater bonds,

substantially all of the bond proceeds ($11,047,408.05 of the

$12,190,843.34 or 91 percent of the proceeds) went directly into

a higher yielding GIC that had the same maturity as the bonds.

Because the bond proceeds were tied up in the GIC, another source

of funds had to be found to pay for the project.   That source

turned out to be Far West Savings and Loan, which made a

conventional secured construction loan of $10,300,000 to Ironwood
                               - 60 -

Apartments Ltd. evidenced by a disbursement agreement, promissory

note, deed of trust, and other related loan documents.

     Except for the relatively modest amount spent to purchase

the Ironwood land, the Ironwood project was financed by a

conventional mortgage loan from a conventional savings and loan,

not with bond proceeds.   Given the structure of the deal, it

could not have been otherwise.    The lion's share of the Ironwood

bond proceeds had already been invested in the Ironwood GIC.

From February 20, 1986, until December 1, 1993, when the GIC paid

off and the bonds were redeemed, that is where they stayed.

     The Riverside Housing Authority could not have reasonably

expected that substantially all of the proceeds of the Whitewater

and Ironwood bonds would be used to construct the projects.     This

is because the bond financing documents deprived it, the Trustee,

and the conduit borrowers (the developers) of control over the

bond proceeds and allowed the bond proceeds to be diverted.

Without any agreement, the Riverside Housing Authority, the

Trustee, and the conduit borrowers had no assurance that the bond

proceeds would be used, as required by the bond indentures, to

finance the multifamily housing projects.

     Petitioners have argued that the Riverside Housing Authority

was duped, indeed that the bond proceeds were stolen, and Judge

Jacobs seems to agree.    It was not, however, reasonable for the

Riverside Housing Authority to sponsor a financing structure that

permitted it, the Trustee, and the developer to lose control of
                              - 61 -

the bond proceeds.   Like section 103(c), section 103(b) should

not be read to encourage issuers both to be ignorant of the facts

prospectively and to remain ignorant and do nothing after the

fact.

     Because the Whitewater and Ironwood bonds were not exempt

industrial development bonds under section 103(b)(4), by virtue

of section 103(b)(1), they were not tax-exempt bonds under

section 103(a).

     Petitioners and Judge Jacobs, dissenting op. note 2, argue

that the diversion of the bond proceeds amounted to "involuntary

noncompliance" under section 1.103-8(b)(6)(iii), Income Tax Regs.

(the 1979 reg.).   Their argument seems to be based on the

assumption or assertion that nothing could be done after the fact

by the Riverside Housing Authority because the bond proceeds had

flowed irrevocably to Crown Life Insurance Co., which had issued

the GIC's.   Judge Jacobs states that "the Bond proceeds were

improperly locked into GIC's", dissenting op. note 2.    However, I

don't understand why the Riverside Housing Authority could not

have brought a successful action to revoke the GIC's and recover

the proceeds for use as originally intended.    If the funds had

been unlawfully diverted, didn't Crown Life Insurance Co. have

notice, actual or constructive, of this fact?    The answer to

these questions may be that the Riverside Housing Authority

decided, once things started to go badly for the developer, that

it would be better to leave the bond holders with the continuing
                              - 62 -

better assurance that they would receive interest and principal

payments, as originally scheduled, through the security of the

GIC's.   Even if such had been the case, the security so created

must be at the price of the loss of the tax exemption for the

interest on the bonds.

                               III.

     Although I accept the stipulations of the parties and the

findings of the trier of fact, as adopted by the majority in the

case at hand, I'm impelled to raise a question that may be

germane to other pending cases.    If the failures in other cases

of the purported government issuers to supervise the receipt and

disposition of bond proceeds were as egregious as they were in

the case at hand, the question that may arise in such other cases

is whether the bonds were ever issued or validly issued by the

local governments or authorities.

     In the case at hand, it might well have been concluded that

the Riverside Housing Authority was so out of the loop that,

under step transaction principles, the bond holders were the

recipients of nothing more than the obligations of Crown Life

Insurance Co. or of undivided interests in the GIC's--taxable

obligations of a private issuer--that were purchased with the

bond proceeds for their benefit.    The Housing Authority was so

lax in failing to see to it that the proceeds were used for the

intended purpose as to raise the question whether the Housing

Authority actually had any such purpose, thereby calling into
                              - 63 -

question the validity of its purported issuance of bonds.    As the

Court of Appeals for the District of Columbia Circuit said in

Washington v. Commissioner, 692 F.2d at 137:

           Still, states and municipalities should be
     chary in their issuance of tax-free bonds and their
     subsequent reinvestment of the proceeds. It is a
     fundamental principle of state and municipal bond law
     that the issuing body must have a legitimate,
     independent purpose to sell debt instruments in order
     to raise moneys. L. Jones, THE LAW OF BONDS AND BOND
     SECURITIES §12 (1950). If no such purpose exists, the
     issuance would be violative of local law, and should
     not qualify for the tax exemption that Section 103
     provides for validly issued municipal and state bonds.
     * * *

     The steps in the analysis would be along the following

lines:

     1. The bonds were sold to the public as the Housing

Authority's revenue bonds, based on representations that the

proceeds would be used to finance construction of the housing

projects.

     2.   Because the obligations on the bonds were nonrecourse to

the Housing Authority, the primary sources of payment of the bond

obligations were to be the housing projects and the income

streams that the projects were expected to generate.

     3.   Contrary to the conception underlying a properly

structured "black box" scheme,4 the proceeds of the bond

offerings were irrevocably diverted from the projects on the day

     4
      I have my doubts about the efficaciousness of the   "black
box" scheme, but, under the facts of the purported bond   issues of
the Riverside Housing Authority, that question need not   detain us
in other cases in which the bond proceeds were diverted   in
similar fashion.
                               - 64 -

of issuance and what was substituted for the projects as security

for the obligations to the investors were shell corporations'

letters of credit secured by the GIC's.

     4.   What this means is that the so-called originator of the

conduit financings, the Housing Authority, was eliminated from

(or never even got into) the loop.      The Housing Authority as such

did not issue its own bonds.   All that the so-called bonds

purportedly issued by the Housing Authority evidenced were the

interests of the bond holders in the GIC's, which were

obligations of a taxable entity, the Crown Life Insurance Co.     As

a result, the bonds were taxable obligations from their

inception.

     All the woofing about reasonable expectations, monitoring

actual usage, the arbitrage rebate rules, and the status of the

bonds as industrial development bonds may well be subsequent

questions that one need never get to under a proper tax analysis.

     CHABOT, J., agrees with this concurring opinion.
                                       - 65 -

       JACOBS, J., dissenting:         The majority opinion is premised on

the notion that section 148(f) is unambiguous, thus preventing us

from looking beyond the words of the statute.               In my opinion, the

majority's         mechanical    interpretation   of   section   148(f),    when

applied to the unusual facts of this case,1 leads to a result that

does not comport with the rationale behind the promulgation of the

arbitrage provisions.           See Birdwell v. Skeen, 983 F.2d 1332, 1337

(5th       Cir.    1993);   Wilshire   Westwood   Associates      v.    Atlantic

Richfield Corp., 881 F.2d 801, 804 (9th Cir. 1989).               Accordingly,

I believe that we should resort to the legislative history for aid

in applying section 148(f) to the facts of this case.             By doing so,

I conclude, as petitioners do, that Congress did not intend to make

the issuers of tax-exempt bonds (here, the Housing Authority of

Riverside County, California) the insurers for wrongful actions of

those who misuse the bond proceeds to earn arbitrage profits for

themselves. Accordingly, I would hold that the Bonds issued by the

Housing Authority are not arbitrage bonds.                I would further hold

that       the    Bonds   are   nontaxable   industrial   development    bonds.2

       1
          Statutory text should not be read in an atmosphere of
sterility, but rather in the context of the specific facts and
circumstances of each case. See 2A Singer, Sutherland Statutory
Construction, sec. 45.12, at 61 (5th ed. 1992). "The use of
literalism suggests that a judge puts on blinders, so to speak,
obscuring from view everything but the text of the statute whose
effect on the matter at issue is in question." Id. sec. 46.02,
at 92.
       2
          Admittedly, the Bonds were industrial development bonds
under sec. 103(b)(2). However, the Bonds come within the
exception provided by sec. 103(b)(4)(A). That section provides
that the interest on the obligations is not taxable as long as
                                                   (continued...)
                                    - 66 -

Ultimately,   I   would   hold    that   the   interest   on   the   Bonds   is

excludable from gross income under section 103(a).

     Section 103(a) provides that a taxpayer's gross income does

not include interest earned on the obligations of a State or a

political subdivision of a State.              This exemption has been a

feature of the Internal Revenue Code ever since the Federal income

tax was adopted in 1913.         S. Rept. 91-552, at 219 (1969), 1969-3

C.B. 423, 562.    The purpose of this exemption is to assist State

and local governments by allowing them to issue marketable bonds at

interest rates below those of corporate and Federal securities.

See, e.g., State of Washington            v. Commissioner, 77 T.C. 656

(1981), affd. 692 F.2d 128 (D.C. Cir. 1982); 113 Cong. Rec. 31,611

(daily ed. Nov. 8, 1967) (statement of Senator Ribicoff).




     2
      (...continued)
substantially all of the proceeds are to be used to construct
residential rental property where 20 percent or more of the units
in each project are to be occupied by individuals of low or
moderate income. Such obligations are referred to in the body of
this dissent as nontaxable industrial development bonds.
          Pursuant to sec. 1.103-8(b)(6)(iii), Income Tax Regs.,
the "substantially all" requirements of sec. 103(b)(4) do not
apply to a project in the event of "involuntary noncompliance",
provided the obligation used to provide financing for the project
is retired within a reasonable period. In my opinion, the Bonds
satisfied the "substantially all" requirements of sec. 1.103-
8(b)(6)(iii), Income Tax Regs., because the Whitewater and
Ironwood projects were not constructed due to "involuntary
noncompliance" on the part of the Housing Authority of Riverside
County. Further, because the Bond proceeds were improperly
locked into GIC's, the term of the GIC's determined when the
Bonds could be retired.
          Morever, with respect to the Whitewater bonds, I would
hold that their issuance satisfied the reasonable public notice
requirements of sec. 103(k)(2)(B)(i).
                              - 67 -

     Having been the trial judge,3 I had the opportunity to observe

William Rosenberger (executive director of the Housing Authority

and the person charged with responsibility for the issuance of the

Bonds) testify.   I am convinced that he, as well as the other

Housing Authority officials, reasonably expected that the Bond

proceeds would be used for the construction of housing for low-to-

moderate-income families and that the GIC's would be held by the

MCFC companies as unrelated guarantors of the bond payments.   I am

further convinced that at no relevant time did he or other Housing

Authority officials have any reason to suspect that Unified and the

MCFC companies would divert the Bond proceeds from the construction

of housing to the purchase of GIC's, which in turn would be used to

pay the debt service on the Bonds.4

     3
          The majority opinion has adopted my findings of fact.
See majority op. p. 4.
     4
          In basic bond financing, bond proceeds are disbursed
directly to the developer in exchange for the developer's note,
which is secured by a lien on the underlying project (including
the anticipated revenue stream). In many instances, a credit
enhancement instrument, such as a letter of credit, is obtained.
The bond issue in this case involved a form of "black box"
structure. Theoretically, in such a structure, the bond proceeds
are disbursed to the developer pursuant to an unsecured loan
agreement with the issuer. The developer then invests the bond
proceeds with a financial institution. Simultaneously, the
developer procures a letter of credit to secure repayment of the
bonds from another institution (the L/C provider) in exchange for
a mortgage on the project. The L/C provider simultaneously sells
the project mortgage to the financial institution where the bond
proceeds are invested. Finally, and also simultaneously with the
other transactions, the L/C provider purchases a GIC from an
insurance carrier and hypothecates it to secure the interest and
principal payments on the bonds. Thus, in theory, the black box
structure makes bond proceeds available to a developer for
construction on a credit enhanced and rated basis.
                                                   (continued...)
                                        - 68 -

       The Housing Authority did not benefit from the misuse of the

Bond       proceeds.   The   majority,      however,    would   attribute    the

shenanigans of the wrongdoers to the Housing Authority; I would

not.

       The    development    of   the    arbitrage     provisions   shows   that

Congress sought to prevent States and their subdivisions from

misusing their tax-exempt privileges by issuing low-yielding bonds

and thereafter investing the bond proceeds into higher-yielding

instruments.       There is no indication that Congress would require

States or local governments to rebate amounts that they never

authorized or received.

       In 1969, when Congress enacted the section 103 provisions

removing arbitrage bonds from tax-exempt status, the Senate Finance

Committee explained that it did so to ensure that the Federal

Government does not become "an unintended source of revenue for

State and local governments". S. Rept. 91-522, supra at 219, 1969-

3 C.B. at 562.         Concerns later developed, however, that unwary

purchasers of tax-exempt bonds might be taxed upon the interest

       4
      (...continued)
          In this case, the black box structure was corrupted by
the use of Unified, a shell entity, instead of a bona fide
financial institution that was supposed to be both the depository
of the bond proceeds and the buyer (from separate funds) of the
project mortgage from the L/C provider. Because Unified had no
substantial capital of its own, it used the Bond proceeds to buy
the project mortgage; and via this route, the Bond proceeds were
invested in the GIC's. Unified improperly used the Bond proceeds
to purchase the GIC's, causing the Commissioner to assert that
the Bonds are to be treated as arbitrage bonds pursuant to the
provisions of sec. 148(f). Hence, the central failure in this
case was the improper use of the Bond proceeds by Unified to
purchase the GIC's.
                               - 69 -

received if the issuer subsequently used the proceeds for arbitrage

revenue.    At a congressional hearing in 1978, Assistant Secretary

Lubick was asked whether the Commissioner could change his mind

about the nonarbitrage status of a bond after it was issued.    Mr.

Lubick replied: "That is a determination which is made as of the

issuance date.     The fact that the [issuer] goes on and does

something different from what it proposed originally does not

change the status of the bond.      This determination is made ab

initio."    Revenue Act of 1978: Hearings on H.R. 13511 before the

Senate Comm. on Finance, 95th Cong., 2d Sess. 958-959 (1978).

     In 1984, Congress reviewed the various remaining provisions

that permitted States to collect arbitrage and noted: "Present

rules permit issuers to retain any arbitrage earned under these

rules".    H. Conf. Rept. 98-861, at 1205 (1984), 1984-3 C.B. (Vol.

2) 1, 459 (emphasis supplied).   Congress therefore made the rebate

provisions applicable to certain industrial development bonds and

to certain student loan bonds. Sec. 103(c)(6), as added by Deficit

Reduction Act of 1984, Pub. L. 98-369, sec. 624(a), 98 Stat. 922.

     In the Tax Reform Act of 1986, Congress decided to extend the

rebate requirements to additional classes of tax-exempt bonds,

including those issued to provide multifamily residential housing.5

See Tax Reform Act of 1986 (TRA), Pub. L. 99-514, sec. 1314(d), 100

Stat. 2664.     With this change came new rules relating to the


     5
          I agree with the majority's conclusion that the date of
issuance of the Bonds was not Dec. 31, 1985, but rather Feb. 20,
1986.
                                     - 70 -

computation of the rebate.         The amount to be rebated is determined

by first finding the amount earned on "nonpurpose investments".

These earnings then are compared to the amount that would be

yielded at the bond issue's rate of interest.               For such purposes,

the Commissioner's regulations, in general, require an allocation

of the higher-earning nonpurpose "acquired obligations" to bond

proceeds    under    an    accounting       pooling       convention.            These

regulations,   however,     continue       to   reflect    that   the    "acquired

obligations" to be scrutinized are those acquired by the State or

local government that issues the bonds.                   Thus, section 1.103-

13(f)(1), Income Tax Regs., provides:

     In general.    A State or local government unit shall
     allocate the cost of its acquired obligations to the
     unspent   proceeds  of   each   issue  of   governmental
     obligations issued by such unit. * * * [Emphasis added.]

     Congress added another important provision in the Tax Reform

Act of 1986 when it provided that a bond will be considered an

arbitrage    bond   if,    after    the     bond   is     issued,    the     issuer

intentionally uses the proceeds to earn arbitrage. Sec. 148(a), as

added by TRA sec. 1301(b), 100 Stat. 2641; see H. Conf. Rept. 98-

841, at II-746 (1986), 1986-3 C.B. (Vol. 4), 1, 746.                By its terms,

section    148(a)   will   remove    the    tax-exempt      status      of   a   bond

retroactively, but only when the issuer intentionally contravenes

the provisions against arbitrage. This new provision thus provides

an exception to the assurances earlier provided by Assistant

Secretary Lubick that the tax-exempt status of a bond would be

determined as of the date of issue.
                                    - 71 -

     The legislative history of the arbitrage and rebate provisions

shows a consistent congressional intent that State and local

governments (the issuers) not profit from arbitrage.               It is plain

that, in requiring rebates of excess earnings on "nonpurpose

investments",     Congress    contemplated      investments      made   by    the

issuers, not unauthorized investments of bond proceeds diverted to

improper uses by others.         As petitioners state in their brief:

"Nothing * * * suggests that money once stolen is subject to the

yield restriction rules".

     When Congress enacted section 148(f), it did not intend to

require the rebate of arbitrage created by the unauthorized acts of

persons other than the issuer and not received by the issuer.                Such

amounts are not amounts earned on nonpurpose investments within the

meaning    of   that   provision.     My     conclusion    is    reinforced   by

Congress' contemporaneous inclusion of section 148(a) in the Tax

Reform Act of 1986.          As a result of the enactment of section

148(a), Congress expanded the definition of arbitrage bonds to

include those that involved the issuer's intentional acquisition of

post-issuance arbitrage earnings.          Congress       thus    put the tax

exemption for interest earned on bonds at risk where a State or its

subdivision intentionally used the bond proceeds to earn arbitrage

profits.    In such a circumstance, a violation of section 148(a)

cannot be cured.       However, by enacting section 148(f), Congress

permitted the use of the rebate provisions to preserve the bonds'

exempt status in situations where the issuer unintentionally made
                               - 72 -

a post-issuance, nonpurpose investment that yielded earnings in

excess of the bond earnings.

     Section 148(f) by its terms applies only to amounts earned on

nonpurpose investments.   Nothing in section 148(f) indicates that

it should apply to an issuer that did not make any nonpurpose

investment.
