UNITED STATES TAX COURT



         CITY OF COLUMBUS, OHIO, Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 3301-95B.                      Filed May 14, 1996.



     P, a home rule municipal corporation and political
subdivision of the State of Ohio, seeks a declaratory
judgment that interest on bonds it proposes to issue
will be exempt from taxation under sec. 103(a), I.R.C.
In 1967, in exchange for the assumption of P's accrued
unfunded pension obligation by a fund established for
that purpose by the State of Ohio, P incurred a long-
term obligation to the State Fund. In 1994, P made a
lump-sum payment equal to 65 percent of the remaining
principal in satisfaction of the long-term obligation.
Taking into account the 35-percent discount, the yield
to P in making the prepayment, as compared to the
payments it otherwise would have made, is 7.57484
percent. P proposes to issue long-term obligations,
with an interest rate of 6 percent, to fund the
prepayment to the State Fund. Pending our decision
herein, P has issued short-term obligations to fund the
prepayment. Held, P entered into the prepayment
transaction with a principal purpose being to profit
     from the discount offered by the State Fund. Held,
     further, to reflect the economic substance of the
     transaction, R may characterize the prepayment as the
     acquisition of property. Sec. 1.148-10(e), Income Tax
     Regs. Held, further, the prepayment constitutes
     investment-type property, sec. 148(b)(2), I.R.C., with
     a materially higher yield than the proposed bonds.
     Thus, interest on the proposed bonds will not be
     excludable from gross income under sec. 103(a), I.R.C.



     David L. Miller, Jerry O. Allen, and David A. Rogers, for

petitioner.

     Rebecca L. Caldwell-Harrigal, Joel E. Helke, and Richard L.

Carlisle, for respondent.



                                OPINION


     TANNENWALD, Judge:     This is an action for a declaratory

judgment pursuant to section 7478 and Rule 211.1    On June 3,

1994, petitioner submitted a ruling request to respondent seeking

a determination that interest on certain proposed bonds will be

excludable from gross income under section 103(a).    After

administrative review, on December 5, 1994, respondent ruled that

interest on the proposed bonds will not be excludable under

section 103(a) on the grounds that the bonds would be arbitrage

and/or hedge bonds within the meaning of sections 148 and 149(g),

respectively.   All of the jurisdictional requirements for a

declaratory judgment action have been satisfied.    Rule 210(c).


 All statutory references are to the Internal Revenue Code, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
Petitioner bears the burden of proof.   Rule 217(c)(2)(A).   Our

decision is based upon the stipulated administrative record,

which is incorporated herein by this reference, and additional

evidence received pursuant to an Order of this Court.   Rule

217(a).2

     Petitioner is the City of Columbus, Ohio (City).   On

December 20, 1993, the City Council of Columbus adopted an

ordinance authorizing the issuance of bonds in a principal amount

not to exceed $28 million.   In its ruling request, petitioner

anticipated the actual amount of the proposed bonds would be

$27,300,000.   Having retired $600,000 in principal amount of its

1994 bond anticipation notes (see infra p. 8), petitioner now

anticipates the actual amount of the proposed bonds will be

$26,700,000.

     Petitioner is a home rule municipal corporation and

political subdivision of the State of Ohio (State).   Before 1967,

the City maintained two pension funds for its police officers and

firefighters (collectively referred to hereinafter as the City

Fund).

     In 1965, a State law was enacted creating the Police and

Firemen's Disability and Pension Fund (the State Fund), a


  Respondent objects to what she describes as petitioner's
attempt to admit additional material into evidence, by way of
Appendices A and B to petitioner's opening brief. Appendix A
contains an amortization of the City Obligation based on an
exhibit in the stipulated record and is thus not new evidence.
Appendix B, however, is an amortization schedule of the proposed
bonds and is new evidence as to which we sustain respondent's
objection.
                                - 4 -



statewide pension fund for police officers and firefighters.    The

State Fund was created to replace unfunded plans of the City and

other municipalities with a fully funded pension plan.    The State

Fund assumed and guaranteed the pre-1967 pension liabilities of

Ohio municipalities, including the City (the State Fund

Obligation).   In addition, the State law provided that pension

liabilities for police officers and firefighters accruing on and

after January 1, 1967, would be supported by current employer and

employee contributions.

     Pursuant to the State law, the value of the transferred

liabilities and assets of each municipality was determined by The

Wyatt Company (Wyatt), an actuarial company employed by the State

to make the calculations.    Wyatt computed the present value of

each municipality's accrued unfunded pension liability, using a

discount factor of 4.25 percent, compounded annually (the

mathematical equivalent of 4.21 percent compounded semiannually),

and certain actuarial assumptions based on mortality tables.

Wyatt determined the present value of the accrued unfunded

liabilities of the City Fund that were transferred to the State

Fund, to be $44,638,971.    Of that amount, $1,929,702 was

satisfied by assets of the City Fund, and the City was credited

with $21,470 of accrued interest, resulting in a net accrued

liability of $42,687,799.
                                 - 5 -



     On January 1, 1967, as required by the law creating the

State Fund, the liabilities and assets of the City Fund were

transferred to the State Fund.

     The State law required each municipality to pay to the State

Fund, either immediately or over time with interest, an amount

equal to its accrued unfunded pension liability, i.e., the

difference between the transferred liabilities and assets.    If a

municipality opted to pay that amount over time, the State law,

as originally enacted, required it to pay interest at 4 percent

per annum on the unpaid balance.    Subsequent to an amendment to

the State law in 1968, the interest rate charged by the State

Fund has been 4.25 percent per annum.

     Petitioner chose to pay the present value of its accrued

unfunded pension liability over time (the City Obligation).      It

has never been obligated to make up for any shortfalls or

deviations from the actuarial calculation of its accrued unfunded

pension liability.

     The deferred payment option in the original State law

required any amount unpaid as of January 1, 1968, to be paid over

20 years in equal principal installments, i.e., at least 5

percent of the amount unpaid as of January 1, 1968, each year),

together with interest at 4 percent.     Principal and interest on

the obligation were payable semiannually on dates to be

determined by the trustees of the State Fund.    By State law,
                                - 6 -



effective November 25, 1969, the unpaid City Obligation, as of

January 1, 1969, was to be paid 2 percent in 1969, 2 percent in

1970, 3 percent in 1971, 4 percent in 1972, and 5 percent per

annum beginning in 1973 and each year thereafter for 62 years.

This repayment schedule incorporated the payment of interest at a

rate of 4.25 percent, compounded semiannually.   The City made

payments pursuant to the above schedule through 1993.

     Under the State Fund pension system, both municipal

corporations and their employees who are police officers and

firefighters contribute a percentage of current wages to the

State Fund.   The State Fund pays pensions in defined amounts to

retired police officers, firefighters, and surviving spouses and

dependents.   It treats all participating municipal corporations

and their police officers and firefighters equally based on

current contributions.   No consideration is given as to whether a

particular municipal corporation paid the principal amount of its

accrued unfunded pension liability in full or agreed to pay such

liability over time.    Amounts in the State Fund are invested for

the equal benefit of all police officers and firefighters

throughout the State.    The actuary for the State Fund has assumed

a rate of return on investments of the State Fund of 8.25

percent, compounded annually.

     Approximately 304 municipalities transferred their assets

and accrued liabilities as of January 1, 1967, to the State Fund.
                                 - 7 -



     In 1993, section 742.30(C) was added to the Ohio Revised

Code which provided:

          (C) The board of trustees of the police and
     firemen's disability and pension fund may enter into an
     agreement with a municipal corporation for a single
     payment by the municipal corporation of the employer's
     accrued liability. The agreement may provide for a
     reduction in the amount of the accrued liability based
     on the value to the fund of receiving a single payment.
     A municipal corporation that has made payment in
     accordance with such an agreement shall have no further
     obligation to make payments under this section. [Ohio
     Rev. Code Ann. sec. 742.30(C) (Anderson Supp. 1995).]


     Pursuant to this provision, the State Fund allowed single,

lump-sum payments, beginning October 20, 1993.    The State Fund

adopted 65 percent of the outstanding principal balance as the

discounted amount it would accept for such a payment.

     From October 20, 1993, to December 14, 1995, 36

municipalities, including the City, made a lump-sum payment, in

exchange for release of the full amount of their outstanding

liability to the State Fund.

     On November 3, 1993, the City entered into a prepayment

agreement with the State Fund.    On November 15, 1993, the

outstanding principal balance of the City Obligation was

$41,435,720, which amount was still to be paid periodically until

2035.   Under the agreement, the City agreed to pay a lump sum of

$26,933,218, following which it would have no further obligation

to the State Fund.   The City was obligated to make the lump-sum
                               - 8 -



payment within 90 days of November 3, 1993, and was required to

pay interest at a rate of 4.25 percent per annum from

November 15, 1993, until the payment was made.   The City made the

payment of $27,304,720 to the State Fund on January 31, 1994,

including interest of $371,502.

     If the 35-percent discount is taken into account, the yield

to petitioner for prepaying the City Obligation, as compared to

the payments it otherwise would have made, is 7.57484 percent.

     It was commercially reasonable for the City to finance the

lump-sum payment by issuing obligations carrying a taxable

interest rate.   However, petitioner initially contemplated

issuing tax-exempt bonds.   After discussions with respondent, and

before issuing long-term bonds, petitioner decided to obtain a

private letter ruling from respondent on whether interest on the

bonds would be excludable from gross income under section 103.

     On January 31, 1994, the City issued $27,300,000 in 1-year

bond anticipation notes (BAN's), due January 31, 1995.   The BAN's

sold for $27,334,125 and were general obligations of the City.

On January 31, 1994, the City transferred $27,304,720 of the BAN

proceeds to the State Fund in satisfaction of the lump-sum

payment agreement.

     Upon the maturity of the 1994 BAN's, petitioner, having

repaid $600,000 of the 1994 BAN's, refinanced the remaining

$26,700,000 with an issue of BAN's in that amount, maturing
                               - 9 -



January 30, 1996 (the 1995 BAN's).     All 1995 BAN proceeds were

expended on January 31, 1995, to discharge the 1994 BAN's.

     Petitioner intends to continue to refinance the 1995 BAN's

with short-term BAN's until there is a final court determination

in this matter.3

     Petitioner proposes to issue the proposed bonds either on a

tax-exempt or taxable basis, depending on the final determination

in this proceeding, and immediately utilize all proceeds of the

bonds to discharge the then-outstanding BAN's and pay related

expenses on the issue of the proposed bonds.     Petitioner

represents that the proposed bonds will be long-term obligations

but did not, in its ruling request or otherwise (until its

original brief, see supra note 2), set forth any terms of payment

of principal.   For purposes of its ruling request, petitioner

represented that the proposed bonds would be long-term

obligations, with a term of 25 years or less, and that the yield

should be assumed to be 6 percent compounded semiannually.

     Section 103(a) generally excludes interest on State and

local government bonds from taxable income.     The exclusion is


  The BAN's have been issued on the basis that the interest
thereon was not excludable under sec. 103(a). Petitioner has,
however, sought to preserve the possible tax-exempt status of
such interest by filing Internal Revenue Service Form 8038-G in
respect of the 1994 and 1995 BAN's and Internal Revenue Service
Form 8038-T, along with an arbitrage rebate payment in respect of
the 1994 BAN's based on the differential between the 4.25-percent
interest rate on the City obligation and the yield on such BAN's.
                                - 10 -



inapplicable to any arbitrage bond within the meaning of section

148.    Sec. 103(b).

       An arbitrage bond is defined in section 148(a) as follows:

            (a) Arbitrage Bond Defined.--For purposes of
       section 103, the term "arbitrage bond" means any bond
       issued as part of an issue any portion of the proceeds
       of which are reasonably expected (at the time of
       issuance of the bond) to be used directly or
       indirectly--

            (1) to acquire higher yielding investments * * *

       For purposes of this subsection, a bond shall be
       treated as an arbitrage bond if the issuer
       intentionally uses any portion of the proceeds of the
       issue of which such bond is a part in a manner
       described in paragraph (1) * * *.

       A higher yielding investment is "any investment property

which produces a yield over the term of the issue which is

materially higher than the yield on the issue."    Sec. 148(b)(1).

       Section 148(b)(2) provides in pertinent part:

            (2) Investment property.--The term "investment
       property" means--

                 (A) any security (within the meaning of
            section 165(g)(2)(A) or (B)),

                 (B)   any obligation,

                 (C)   any annuity contract,

                 (D)   any investment-type property * * *

       The legislative purpose in enacting these provisions is

reflected in the following statement in the report of the House
                                - 11 -



Ways and Means Committee at the time section 148 was enacted in

1986:

          The bill also provides additional restrictions on
     the types of obligations in which bond proceeds may be
     invested without regard to yield restrictions. Under
     the bill, the arbitrage restrictions are expanded to
     apply to the acquisition of any property held for
     investment other than another bond exempt from tax
     under the Code. Thus, investment in any taxable
     security as well as any deferred payment contract
     (e.g., an annuity) or other property held for
     investment is precluded if the yield on the property is
     materially higher than the yield on the bonds. This
     restriction applies regardless of the purpose of the
     investment (e.g., whether the investment is acquired as
     an acquired purpose obligation, an acquired nonpurpose
     obligation, or an acquired program obligation). Under
     this rule, for example, the purchase of an annuity
     contract to fund a pension plan of a qualified
     governmental unit would be subject to the same
     arbitrage restrictions as would direct funding of that
     plan with bond proceeds. The purchase of bond
     insurance is not considered to be the purchase of an
     annuity contract. Similarly, investment of bond
     proceeds in any other type of deferred payment
     investment-type contract to fund an obligation of the
     issuer or bond beneficiary would be subject to these
     yield restrictions. The restriction would not apply,
     however, to real or tangible personal property acquired
     with bond proceeds for reasons other than investment
     (e.g., courthouse facilities financed with bond
     proceeds). [H. Rept. 99-426 (1985), 1986-3 C.B. (Vol.
     2) 1, 552; fn. ref. omitted; emphasis added.]

Almost the same statement appears in the report of the Senate

Finance Committee.     S. Rept. 99-313 (1985), 1986-3 C.B. (Vol. 3)

1, 845; see also H. Conf. Rept. 99-841 (1986), 1986-3 C.B. (Vol.

4) 1, 747.

        Investment-type property is defined in section 1.148-1(b),

Income Tax Regs., in pertinent part, as follows:
                              - 12 -



          Investment-type property includes any property,
     other than property described in section 148(b)(2)(A),
     (B), (C), * * * that is held principally as a passive
     vehicle for the production of income. Except as
     otherwise provided, a prepayment for property or
     services is investment-type property if a principal
     purpose for prepaying is to receive an investment
     return from the time the prepayment is made until the
     time payment otherwise would be made. A prepayment is
     not investment-type property if--

               (1) The prepayment is made for a substantial
          business purpose other than investment return and
          the issuer has no commercially reasonable
          alternative to the prepayment, or

               (2) Prepayments on substantially the same
          terms are made by a substantial percentage of
          persons who are similarly situated to the issuer
          but who are not beneficiaries of tax-exempt
          financing.

     The parties have presented us with a welter of arguments

many of which are devoted to a semantical analysis of the

foregoing statutory provision and of other provisions of the

regulations under sections 148 and 150 dealing with the extent to

which the regulations in respect of the refunding of prior issues

apply to the proposed bond issue and the BAN's.   In particular,

petitioner argues that the proposed bonds constitute a refunding

issue of the BAN's and through them of the City Obligation and

that the specific tracing methods of the regulations4 preempt any

prepayment analysis.   Respondent agrees that the proposed bonds

are a refunding issue of the BAN's, so that we may treat the



  See secs. 1.148-9, 1.150-1(d)(1), (5), Income Tax Regs.
                              - 13 -



proposed bonds as if the funds raised therefrom were utilized

directly in 1994.   As to petitioner's characterization of the

City Obligation, petitioner fails to accord adequate recognition

to the broad authority given to the Secretary to issue

regulations implementing section 148.   Thus, section 148(i)

provides:

          (i) Regulations.--The Secretary shall prescribe
     such regulations as may be necessary or appropriate to
     carry out the purposes of this section.

     The breadth of this authority to issue "legislative"

regulations, see Coca-Cola Co. & Subs. v. Commissioner, 

, 18-19 (1996), is clearly revealed by the following statement

in the report of the House Ways and Means Committee at the time

of the enactment of the Technical and Miscellaneous Revenue Act

of 1988, Pub. L. 100-647, sec. 1013(a)(34)(A), 102 Stat. 3342,

3544:

          The bill further deletes and re-inserts the term
     "necessary" in the specific regulatory authority
     granted the Treasury Department under the arbitrage
     restrictions. This amendment is intended to clarify
     that Treasury's regulatory authority is to be
     interpreted broadly, rather than in a literal,
     dictionary manner * * *. That regulatory authority is
     intended to permit Treasury to eliminate any devices
     designed to promote issuance of bonds either partially
     or wholly as investment conduits in violation of the
     provisions adopted by Congress to control such
     activities and to limit the issuance of tax-exempt
     bonds to amounts actually required to fund the
     activities for which their use specifically has been
     approved by Congress. Further, that regulatory
     authority is intended to permit Treasury to adopt rules
     (including allocation, accounting, and replacement
                               - 14 -



     rules) necessary or appropriate to accomplish the
     purpose of the arbitrage restrictions, which is to
     eliminate significant arbitrage incentives to issue
     more bonds, to issue bonds earlier, or to leave bonds
     outstanding longer. [H. Rept. 100-795 at 327-328
     (1988).]

     In accordance with the authority, section 1.148-10(e),

Income Tax Regs., provides:

          (e) Authority of the Commissioner to clearly
     reflect the economic substance of a transaction. If an
     issuer enters into a transaction for a principal
     purpose of obtaining a material financial advantage
     based on the difference between tax-exempt and taxable
     interest rates in a manner that is inconsistent with
     the purposes of section 148, the Commissioner may
     exercise her discretion to depart from the rules of
     § 1.148-1 through § 1.148-11 as necessary to clearly
     reflect the economic substance of the transaction. For
     this purpose, the Commissioner may recompute yield on
     an issue or on investments, reallocate payments and
     receipts on investments, recompute the rebate amount on
     an issue, or otherwise adjust any item whatsoever
     bearing upon the investments and expenditures of gross
     proceeds of an issue.

     Petitioner makes much of the fact that it is prepared to

issue the proposed bonds on the basis of the interest thereon

being taxable, i.e., not exempt under section 103(a).   Such being

the case, petitioner argues that the prepayment did not have "a

principal purpose * * * to receive an investment return" within

the meaning of section 1.148-1(b) or 1.148-10(e), Income Tax

Regs.   Consequently, petitioner asserts that the question of

"yield" becomes irrelevant in determining whether the proposed

bonds are arbitrage bonds.    We disagree.
                              - 15 -



     There is no question that petitioner's purpose in prepaying

the City Obligation was to profit from the discount offered by

the State Fund.5   The fact that it would profit from the discount

if the interest on the proposed bonds were taxable does not

negate the fact that such profit would be greater if such

interest was exempt from tax under section 103(a).   Nor does the

fact that the issuance of taxable bonds would also be

advantageous turn the purpose of the proposed issue on a

nontaxable basis from a principal to a subsidiary purpose.    Such

a view would emasculate the arbitrage restrictions of section 148

whenever a financial advantage of a bond issue could be obtained

whether the interest on the bonds was taxable or nontaxable.    In

this connection, we think it significant that the regulation

speaks in terms of "a" and not "the" principal purpose.     Santa Fe

Pacific v. Central States Pension Fund, 

, 727 (7th

Cir. 1994).



  In its application for the ruling, petitioner stated:

     [O]ne of the principal governmental purposes for
     issuing the BANs, and for issuing the Proposed Bonds
     * * * was to achieve an economic benefit represented by
     a present value debt service savings with respect to
     the City Obligation. That debt service savings was
     made possible in part because of the ability of the
     City to pay off the City Obligation at the amount
     provided for in the Payoff Agreement, i.e. 65% of the
     principal balance of the City's employer's accrued
     liability, plus accrued interest through January 31,
     1994 at 4.25%.
                              - 16 -



     Two key requirements for the application of the arbitrage

provisions of section 148 are that there must be an acquisition

of investment property, which produces a materially higher yield.

Sec. 148(a) and (b), supra p. 10.    We turn first to the question

of whether the prepayment was used to acquire investment

property.   Petitioner argues initially that, at no time, was

there any acquisition of investment property because, in 1967,

there was simply an exchange of liabilities, i.e., the obligation

of the City Fund for the obligation of the State Fund.    This

position is utterly without merit.     The obligation of the State

Fund was clearly property in the hands of the City and was a

specific type of property that Congress had in mind, i.e., the

equivalent of a funding of the pension obligation of the City.

See supra p. 11.

     Petitioner goes on to argue that, at the time of the

prepayment in 1994, the City was doing nothing more than

discharging the City Obligation and that one does not acquire

property when it acquires its own indebtedness.    Leaving aside

the question whether the acquisition of one's own indebtedness

constitutes the acquisition of "property", we think petitioner

overstates the proposition in the context of the situation

herein.   The City Obligation represented the payment for the

obligation of the State Fund in 1967, and we think that nexus

remained extant at the time of the 1994 prepayment.    In short,
                                - 17 -



the source to which the prepayment applied was the acquisition of

the obligation of the State Fund and controls the character of

the transaction.   Cf. Woodward v. Commissioner, 

(1970) (articulating the "origin of the claim" test).    Thus, we

conclude that the prepayment was for property and consequently we

turn to the question whether it was "investment property".      On

this point, the parties have locked horns on whether the

prepayment falls within the ambit of "investment-type property"

within the meaning of section 1.148-1(b), Income Tax Regs., supra

p. 12.

     Petitioner argues that the prepayment is not investment-type

property because it satisfies the latter of the two exceptions in

the regulations, namely a prepayment is not investment-type

property if prepayments on substantially the same terms are made

by a substantial percentage of persons who are similarly situated

but who are not beneficiaries of tax-exempt financing.    The

regulation does not define a substantial percentage.

     As of October 20, 1993, when the State Fund offered the

discount for prepayment, there were 224 municipalities with

obligations to the State Fund.    As of December 14, 1995, 36

municipalities had prepaid at the 35-percent discount.    It is

represented that none of the 35 municipalities, excluding

petitioner, utilized the benefit of tax-exempt financing with

respect to their prepayments.    In sum, 36 of 224 municipalities,
                              - 18 -



or 16.07 percent, made a prepayment on substantially similar

terms.

     Petitioner cites various instances where the term

"substantial" refers to percentages of 5 to 15 percent, including

section 1.103-11(b), Income Tax Regs. (5 percent); section 1.148-

2(e)(2)(B), Income Tax Regs. (5 percent); section 6662(d)(1) (10

percent); and section 147(c)(2)(E) (15 percent).   Elsewhere, the

term refers to percentages as high as 25 percent, section

42(d)(2)(D)(i)(III); section 6229(c)(2), and 33 percent, section

382(l)(4)(B)(i).

     Clearly, the term "substantial" can cover a wide range of

values.6   Where Congress meant only to allow customary

prepayments, we do not find that 16.07 percent is a substantial

percentage.   Thus, the prepayment herein does not satisfy the

exception, and the prepayment of the City Obligation with the

proceeds of the BAN's constitutes the acquisition of investment-

type property.   Moreover, we are not convinced that Congress

intended that the exception should apply where, as is the case

herein, the only offerees of the prepayment opportunity were

entities who were beneficiaries of tax-exempt financing rather

than to a class of offerees that included some of these

beneficiaries.   If this were the standard for the application of


  See Nabisco Brands, Inc. v. Commissioner, T.C. Memo. 1995-127
at n.22.
                              - 19 -



the exception, the number of persons who took advantage of the

prepayment terms would appear to be irrelevant.

     Having decided that petitioner is not entitled to the

benefits of the exception in section 1.148-1(b), Income Tax

Regs.,7 we are left with the issue whether the prepayment

produced a materially higher yield than the proposed bonds.     Sec.

148(b)(1).

     Respondent argues that, by virtue of the discount

arrangement with the State Fund, the City should be treated as

sharing in the investment yield of that fund, the rate of yield

being 8.25 percent.   Petitioner argues that the City and the

State Fund are separate entities and that such "sharing" implies

a partnership or combined entity which has no legal

justification.   We agree with petitioner on this point.    There is

no doubt that the high rate of yield anticipated by the State

Fund was the foundation of the discount arrangement and no doubt

entered into the determination of the amount of the discount

which the State Fund decided to offer.   But it does not follow

that this circumstance justifies the conclusion that the City had

an ongoing share in the investment yield of the State Fund.     Our


  No inference should be drawn that we would have ruled in favor
of petitioner if the exception did apply. Under such
circumstances, we would still have to decide whether respondent
should still prevail because of the broad discretionary authority
conferred upon her by sec. 1.148-10(e), Income Tax Regs., supra
p. 14.
                             - 20 -



rejection of respondent's yield argument does not, however, end

our inquiry.

     Petitioner concedes that, if the discount is taken into

account, the yield is 7.57484 percent, which is more than

sufficient to constitute a materially higher yield than the 6

percent yield on the proposed bonds.8   Petitioner contends,

however, that the discount should not be taken into account and

that the proper yield for purposes of comparison is the 4.25-

percent interest rate on the City Obligation.   We disagree.   If

the discount is not taken into account, one is faced with a most

peculiar situation, namely, a borrowing at 6-percent interest to

pay off an obligation bearing 4.25-percent interest.   It is only

because of the discount that the prepayment and the financing

thereof at a 6-percent interest rate make any sense.   Indeed,

that is the clear foundation of the transactions and the

substantive justification for the prepayment.

     In sum, we hold that, however one views the transactions

involved herein, a principal purpose of the City was to replace

the City Obligation with a payment for an investment in the State



     A materially higher yield, with exceptions not applicable
herein, is a yield one-eighth of 1 percentage point greater than
that of the issue in question. Sec. 1.148-2(d)(2), Income Tax
Regs.; Staff of the Joint Comm. on Taxation, General Explanation
of the Tax Reform Act of 1986, at 1201-1202 (J. Comm. Print
1987).
                               - 21 -



Fund's obligation to finance the City's original unfunded pension

obligations in a manner which produces the equivalent of a

7.57484-percent return, i.e., yield, on such investment.    Under

the circumstances herein, irrespective of the technicalities of

the arbitrage regulations under section 148, respondent was

entitled to make the adjustment of the yield calculation to take

the 35-percent discount into account and to reject petitioner's

application for ruling under section 1.148-10(e), Income Tax

Regs., on the ground that the economic substance of the

transaction clearly revealed a materially higher yield within the

meaning of section 148(a) and (b) and the regulations thereunder.

Consequently, the interest on the proposed bonds will not be

exempt under section 103(a).

     In view of the foregoing, we find it unnecessary to consider

the other arguments of the parties.

                                      Decision will be entered

                               for respondent.