New safe harbor guidelines released by the IRS on August 22, 2016 (Rev. Proc. 2016-44) are likely to have a significant impact on a variety of management and service contracts entered into by tax-exempt hospitals financed with tax-exempt bonds. The new safe harbor guidance provides significant additional flexibility (e.g., longer term contracts). As compared to existing safe harbors, however, the new guidelines limit the use of some financial terms and prohibit the tax-exempt hospital from ceding full operational control to the contracting service provider. The new guidelines continue to leave open key questions for the operation of accountable care organizations (“ACOs”) and clinically integrated networks (“CINs”) involving bond-financed facilities.

Overview of Private Use Considerations

Many governmental and private tax-exempt hospitals rely on tax-exempt bonds to help finance capital projects and acquisitions. Most hospital executives are well aware that access to the tax-exempt bond market comes with a few strings attached, including restrictions on how bond-financed property is used. If that property is used in any private trade or business (“private use”), beyond a de minimis amount, the exclusion for interest paid on the bonds could be lost, triggering defaults under the bond documents. By designing management and service contracts to fall within the IRS’s safe harbor guidelines, a tax-exempt hospital can protect against the risk that the contract will trigger these adverse consequences for the bonds.

Use in a private trade or business includes use or operation of the bond-financed facility, or a department or service line in the facility, by a private party under a management or service contract or an incentive payment contract (e.g., for physician services). There is also private use of a bond-financed facility where ownership interests are given to private parties, or private parties lease or receive other possessory or preferred rights to use the bond-financed property. Private use does not include use by the general public, granting medical staff privileges, or use by a “qualified user” (which includes use by governmental units and use by a section 501(c)(3) organization and its agents and employees other than use in an unrelated trade or business). Private use must generally be limited to a percentage of the bond proceeds over the life of the bonds, including costs of issuance. Bond documents also may restrict use of the percentage “bucket” (10 percent for governmental bonds and 5 percent for qualified 501(c)(3) bonds) for anything other than costs of issuance.

For 35 years, the IRS has provided an evolving set of safe harbors for management and service contracts that prevent the contracts from resulting in private use. The last major overhaul of the safe harbors occurred in 1997 (Rev. Proc. 97-13). Multiple safe harbors were offered, each of which included specific requirements related to the compensation, term, and termination provisions of a covered contract, and avoided board and officer overlap that could limit the qualified user’s exercise of its rights under the contract. Those guidelines were modified in 2001 to allow for automatic increases in compensation tied to objective, external standards (Rev. Proc. 2001-39). They were further modified in 2014 to allow for certain productivity awards based on quality metrics such as achieving Medicare Shared Savings Program (“MSSP”) quality performance standards or data reporting requirements and to extend the maximum permitted term of certain contracts to five years (Notice 2014-67). In all, there were seven different safe harbors, each with a combination of unique and overlapping criteria. In general terms, the higher the percentage of compensation under the contract that consisted of a fixed fee, the longer the permitted term could be.

New Safe Harbor Criteria

Rev. Proc. 2016-44 replaces the seven distinct safe harbors and their detailed patchwork of criteria with a single safe harbor encompassing eight criteria that must be satisfied. Half of the requirements are either substantially the same as or more flexible than the options available under prior safe harbors, and half of the criteria are new. As with the prior safe harbors, the new guidelines protect only management and service contracts and functionally related uses (e.g., storage of equipment), not leases or other agreements that could result in private use.

Reasonable Compensation. As was the case under the prior safe harbors, all compensation must be reasonable. The new safe harbor expressly includes reimbursement of expenses and overhead charges as part of a service provider’s compensation for this purpose.

Permitted Compensation Methodologies. Also, as was true under the old safe harbors, the contract cannot award the service provider a share of the net profits from the operations of the property. Compensation will not be treated as a sharing of net profits if no element of the compensation arrangement either “takes into account” (a phrase that has been interpreted broadly by other government agencies) “or is contingent upon” the net profits of the property or both revenues and expenses of the property for the same period. The “elements” of compensation include eligibility to receive a payment as well as the amount and timing of the payment. Accordingly, a qualified user cannot deny, delay, or vary the amount of compensation (either the aggregate amount or rate) based on net profits or a combination of revenues and expenses of the property for the same period. In applying these standards, any reimbursement of expenses paid by the service provider to unrelated parties is disregarded (and if such reimbursement is the only compensation, the contract does not result in private use). For this purpose, “unrelated parties” would include any person or entity other than entities in the same corporate group and the service provider’s employees.

Within those broad parameters, the new safe harbor would permit any type of fixed or variable compensation that is reasonable in amount for the services actually provided, including the periodic fixed fee, capitation, and per unit of service fees that were acceptable in prior safe harbors. The new safe harbor also would appear to allow for compensation based on a percentage of gross or adjusted gross revenues or a percentage of expenses (but not both revenues and expenses) as long as it meets the other criteria for the safe harbor, including a prohibition on shifting liability for losses to the service provider. The new safe harbor also continues the ability for qualified users to pay incentives based on metrics that measure quality, performance, or productivity as long as the amount and timing of compensation do not take into account and is not contingent upon the net profits or a combination of revenues and expenses of the property.

Net Operating Losses. The first new criterion is that the contract cannot have the substantive effect of shifting liability to the service provider for any portion of net losses from the operation of the property. To meet this criterion, the compensation and reimbursement for expenses cannot take into account either the net losses or both the revenues and expenses of the property, nor can the timing of payments be contingent upon the net losses from the property. Accordingly, compensation such as an annual incentive payment could not be conditioned upon the managed department or facility generating a surplus of revenues over expenses. Compensation, however, can be reduced by specific stated dollar amounts (not a percentage) for failure to meet one or more specific expense targets.

Term and Termination. Under the new safe harbor, the term of the contract may be no more than the lesser of 30 years or 80 percent of the weighted average reasonably expected economic life of the property, determined as of the beginning of the term of the contract. This criterion will require working closely with hospital finance staff to check the term against the current economic life of the property, which itself can be a complicated calculation involving different classes of assets. The maximum term also must be retested as if it were a new contract as of the date of any material modification related to any of the eight criteria of the safe harbor. Note, however, that there are no longer any required early termination provisions for contracts—rather, they would be optional based on the agreement of the parties. Nevertheless, business considerations may make it prudent to reevaluate the terms periodically with an opportunity to terminate a contract that is no longer in the qualified user’s best interest or that may stand in the way of a larger transaction. Moreover, an extended “no cut” contract may raise questions of reasonableness for other tax purposes (e.g., excess benefit/inurement, or the control test for certain joint ventures) and non-tax statutes.

Control of the Property. The second criterion that is new in comparison to the previous safe harbors is a requirement that the qualified user exercise a significant degree of control over the property that is being used by the service provider. The control requirement may be satisfied by retaining the right to approve at least the following items with respect to the property: (i) annual budgets; (ii) capital expenditures; (iii) disposition of property; (iv) rates charged; and (v) the general nature and type of use of the property (e.g., type of services provided). Expense approvals may be by category with maximum amounts through an approved budget. Rates may be approved either specifically, by methodology, or by requiring rates to be “reasonable and customary as specifically determined by an independent third party.”

Retained Risk of Loss. Another new criterion in the safe harbor is that, as between the qualified user and the service provider, the qualified user must bear the risk of damage or destruction of the property (e.g., loss caused by unforeseeable circumstances beyond the parties’ control). That risk, however, may be insured. The example of loss as being beyond the parties’ control and the ability to provide for insurance also suggest that indemnification for loss resulting from the service provider’s own actions should be acceptable; however, the safe harbor does not expressly address indemnification.

Consistent Tax Positions. The fourth new criteria is that the service provider must agree not to take any tax position that is inconsistent with being a service provider for the property. For example, the service provider must not take a deduction for depreciation or amortization, claim an investment tax credit, or deduct any payment with respect to the property as rent. This criterion is consistent with the scope of the new safe harbor which, as with the prior safe harbors, does not protect any arrangement that would be characterized as a lease for federal tax purposes. The safe harbor, however, does expressly provide that a service provider’s use that is functionally related and subordinate to performance of its duties under a contract that otherwise meets the requirements of the safe harbor does not result in private use, such as use of storage areas to store equipment used to perform activities required under the contract.

Independence of Parties. As in the prior safe harbors, the service provider cannot have any role or relationship with the qualified user that would have the effect of substantially limiting the qualified user’s ability to exercise its rights under the contract. Although this is a facts and circumstances test, there is a safe harbor within the safe harbor that provides a bright line test for maintaining the required independence: (i) no more than 20 percent of the qualified user’s board seats (by voting power) can be held by the service provider or its directors, officers, shareholders, partners, members, or employees; (ii) overlapping board members cannot include the service provider’s CEO or chairperson (or equivalent executives); and (iii) the parties cannot have the same CEO. The two changes of significance from the independence standard in the prior safe harbors are that the limitations apply not only to the service provider but also to related parties of the service provider, such as for-profit subsidiaries, and it no longer limits the representation of a qualified user on the board of the service provider.

Effective Date and Transition Period

There are three options for when to apply the new safe harbor. The default setting is that the new safe harbor applies to contracts entered into on or after August 22, 2016. Issuers also have the option to apply the new safe harbor to any contract entered into before August 22, 2016. An issuer also may apply the prior safe harbors to contracts entered into before August 18, 2017, provided that the contract is not materially modified or extended on or after August 18, 2017 (other than pursuant to an enforceable option that satisfied the old safe harbors).

The effective date, however, may be less flexible than it seems for two reasons. First, existing bond documents may have locked in compliance with a particular set of safe harbors requiring either an amendment of that provision or an opinion of bond counsel to vary from those prior safe harbors even after they have been superseded by new IRS guidance. Second, only “issuers” have the ability to choose one of the optional effective dates. Hospitals and other qualified users that are nongovernmental section 501(c)(3) organizations do not have the authority to issue bonds. Rather, they are “conduit borrowers” of the proceeds of bonds issued by a federal, state, or municipal corporation or political subdivision or instrumentality with the authority to issue bonds. Any conduit borrower looking to apply the new safe harbor to older contracts or defer application until post-August 18, 2017 renewals may want to approach the relevant issuers to see if an accommodation can be made.

Opportunities, Next Steps, and Open Questions

All qualified users should revise their contract templates for management and other services (including hospital-based physician services) to add provisions that will satisfy the four new criteria (see “Net Operating Losses,” “Control of the Property,” “Retained Risk of Loss,” and “Consistent Tax Positions,” above). If the new safe harbor is to be applied retroactively, existing contracts should be amended for those same criteria. Qualified users also may wish to change other terms in the contract template and/or existing contracts (where permitted), such as the compensation methodology, term, and termination rights to take advantage of the new flexibility that is available.

Hospitals now will have significant added flexibility in several arrangements that have become common in the health care industry in recent years. For example, co-management arrangements frequently have had limited terms (often no more than three years) to fit within the prior safe harbors. It also should be possible to add an expense or cost savings component either as an incentive or as a penalty, assuming the compensation arrangement complies with the Stark Law and other applicable laws and regulations. Under the prior safe harbors, percentage of expense arrangements were limited to the start-up period of a facility.

The new safe harbor is also more friendly to ACOs and CINs. Although Rev. Proc. 2016-44 does not answer the question of whether the operations of a typical ACO or CIN result in private use, by going beyond strictly quality-based incentives and stated dollar amount awards, the new safe harbor should be adaptable to arrangements where incentives are calculated based on the savings generated as long as that is not a proxy for net profits or the excess of revenue over expenses of the bond-financed property. Note, however, that the new safe harbor would not appear to allow hospitals in a two-sided risk model ACO or CIN to require participants to share in those losses (if the operations of the ACO or CIN do constitute private use and the participants are service providers for the bond-financed property).

Finally, the new safe harbor also may be useful for whole hospital deals by raising the possibility of a longer term management agreement, as long as the other party does not have a direct or indirect profits interest in the facility.