By CHRISTIE L. MARTIN and MAXWELL D. SOLET
The IRS on August 22, 2016 released long-anticipated Revenue Procedure 2016-44 (Rev. Proc. 2016-44), which substantially increases flexibility in, and provides a less formulaic approach to, the ability of a tax-exempt bond issuer or 501(c)(3) conduit borrower to contract with private parties without jeopardizing the tax-exemption of bonds that financed the facilities at which the applicable services are provided. Under the revised guidance, the term of the contract can be up to 30 years, but not in excess of 80% of the weighted average reasonably expected economic life of the managed property, and there are no restrictions on the percentage of compensation that can be variable, so long as none of the compensation constitutes a share of net profits.
The Internal Revenue Code restricts private use of facilities financed by certain categories of tax-exempt bonds, including governmental bonds and bonds issued for the benefit of hospitals, colleges and other organizations that are tax exempt under Section 501(c)(3) of the Internal Revenue Code. A manager of a facility is generally treated as a user of the facility. Rev. Proc. 2016-44 addresses so-called “management contracts” which are defined as “management, service, or incentive payment contracts between qualified users and service providers under which the service provider provides services for a managed property” and provides a revised management contract safe harbor under which a private management contract does not result in impermissible private business use of projects financed with tax-exempt bonds. This revised safe harbor generally permits almost any type of fixed or variable rate compensation for services rendered under a contract provided that the compensation is reasonable for services rendered during the term of the contract. It removes the previous requirements for prescribed percentages of fixed compensation for contracts with different terms. The revised safe harbors add certain new principles-based constraints (governmental control, governmental risk of loss, and no inconsistent tax positions by private service providers). As with the previous safe harbors, there is a prohibition against sharing of net profits.
The new safe harbor components are as follows:
- Compensation for services rendered during the term of the contract must be reasonable.
- The contract must not provide the service provider with any share of the net profits from operation of the managed facility. The guidance states that compensation to the service provider will not be treated as providing a share of net profits if no “element” of the compensation takes into account or is contingent upon, either the managed property’s net profits or both the managed property’s revenues and expenses for any fiscal period. For this purpose, “elements” of the compensation include eligibility for, the amount of, and the timing of the payment of the compensation. Incentive compensation will not be treated as providing a share of net profits if the eligibility for the incentive compensation is determined by standards that measure quality of services, performance or productivity.
- The service provider must not bear the burden of any share of net losses from operation of the managed property.
- The term of the contract cannot be greater than the lesser of 30 years or 80% of the weighted average reasonably expected economic life of the managed property.
- The bond issuer or conduit borrower (each a “qualified user”) must exercise a significant degree of control over the use of the managed property. The guidance states that this control requirement is met if the contract requires the qualified user to approve the annual budget of the managed property, capital expenditures with respect to the managed property, each disposition of property that is part of the managed property, rates charged for the use of the managed property, and the general nature and type of use of the managed property (for example, the type of services).
- The qualified user must bear the risk of loss upon damage or destruction of the managed property.
- The service provider must agree that it is not entitled to and will not take any tax position that is inconsistent with being a service provider to the qualified user with respect to the managed property (e.g. agree not to take depreciation or amortization, tax credit or deduction for rent).
- There can be no circumstances that would substantially limit the qualified user’s ability to exercise its rights under the contract based on all of the facts and circumstances. A safe harbor is provided for governance overlap between the contracting parties, under which governance overlap is permitted if (i) no more than 20 percent of the voting power of the governing body of the qualified user is vested in the directors, officers, shareholders, partners, members, and employees of the service provider or a related party thereof, (ii) the governing body of the qualified user does not include the chief executive officer of the service provider or the chairperson (or equivalent executive) of the service provider’s governing body, and (iii) the chief executive officer of the service provider is not the chief executive officer of the qualified user or any of the qualified user’s related parties.
The overall impact of Rev. Proc. 2016-44 would seem to be an increase in the ability of bond issuers and tax-exempt users of bond-financed facilities to use for-profit contractors at bond-financed facilities. However, practitioners have already noted that the increased flexibility comes with less certainty and more facts and circumstances analysis with respect to many aspects of the safe harbor. One area in which flexibility may be diminished is in the conditions under which payments may be subordinated or deferred, as the guidance indicates that timing of payment may not be conditioned on tests involving both the managed property’s revenues and expenses for any fiscal period.
The revised safe harbors are effective for any management contract that is entered into on or after August 22, 2016, and an issuer may apply these safe harbors to any management contract that was entered into before August 22, 2016. In addition, an issuer may apply the safe harbors in Rev. Proc. 97-13, as modified by Rev. Proc. 2001-39 and amplified by Notice 2014-67, to a management contract that is entered into before February 18, 2017 and that is not materially modified or extended on or after February 18, 2017 (other than pursuant to a renewal option as defined in Treasury Regulations §1.141-1(b)).