On August 22, 2016, the Internal Revenue Service released Revenue Procedure 2016-44, generally expanding the IRS safe harbor under which governmental and 501(c)(3) owners of tax-exempt bond financed facilities may enter into management or other service contracts with for-profit service providers without jeopardizing the tax-exempt status of the bonds.
Background. One of the conditions for tax-exemption for interest on state or local bonds is that they are not "private activity bonds" (other than certain specified types of "qualified private activity bonds"). The determination of whether a state or local bond issue consists of private activity bonds is generally based on whether the proceeds of the bonds are used in a private trade or business and whether the security for or payments on the bonds are derived from property used in a private trade or business.
Since 1997, IRS Revenue Procedure 97-13 (modified by Revenue Procedure 2001-39 and amplified by Notice 2014-67) has provided a safe harbor under which management and other service contracts meeting certain conditions would not be treated as resulting in private business use of bond financed facilities despite the fact that the service provider is a for-profit entity. These conditions included a prohibition on net profits arrangements, restrictions on the relationship between the parties, and limitations on the length of the contract term and on the types of compensation.
New safe harbor. The new safe harbor under Revenue Procedure 2016-44 generally retains the prohibition on net profits arrangements and restrictions on the relationship between the parties from the 1997 safe harbor, as well as retaining the general requirement that the compensation be reasonable for the services provided, but significantly expands both the length of the permitted term and the allowable types of compensation. The new safe harbor generally limits the term of contracts to no greater than the lesser of 30 years or 80 percent of the weighted average reasonably expected economic life of the facilities (as compared to the 1997 safe harbor, which in many cases imposed a term limit of 5 years for contracts providing for significant levels of variable compensation), and the new safe harbor broadly permits all forms of variable compensation other than net profits arrangements
. Other conditions added under the new safe harbor are:
- the contract may not impose upon the service provider the burden of bearing any share of net losses from the operation of the facilities;
- the governmental or 501(c)(3) party to the contract must maintain a significant degree of control over the use of the facilities;
- the governmental or 501(c)(3) party must bear the risk of loss upon damage or destruction of the facilities; and
- the service provider must agree not to take any inconsistent tax positions (e.g., no depreciation or amortization, investment tax credit, etc.).
The significant control requirement is met if the contract requires the governmental or 501(c)(3) party to approve the annual budget of the facility, capital expenditures with respect to the facility, dispositions of property that are part of the facility, rates charged for use of the facility, and the general nature and type of use of the facility.
Impact of new safe harbor. The new safe harbor will make it much easier to structure long-term management and service contracts for bond financed assets with long economic lives. This may prove to be particularly helpful in utilizing public-private partnership structures for tax-exempt bond financed facilities. The significant control requirement under the new safe harbor, however, will place new limitations on the operational discretion that may be granted to a for-profit service provider.
Effective date. The new safe harbor applies to any management or service contract entered into on or after August 22, 2016, and may electively be applied to any contract entered into before that date. Issuers may continue to apply the 1997 safe harbor to any contract entered into before February 18, 2017 and that is not materially modified or extended on or after that date.