The IRS has released new management contract safe harbors that profoundly change the prior rules under Rev. Proc. 97-13. The new revenue procedure, Rev. Proc. 2016-44, which was released August 22 by the IRS, appears on first glance to have brought many favorable changes to the safe harbor rules. Unlike the prior guidance under Rev. Proc. 97-13, Rev. Proc. 2001-39, and Notice 2014-67, the new safe harbor under Rev. Proc. 2016-44 applies more principles-based tests rather than mechanical tests based on the length of the contract.
The new safe harbor takes effect immediately, but during an initial transition period running until February 18, 2017, issuers and borrowers can apply either the prior safe harbors or the new safe harbor. More specifically, the new safe harbor of Rev. Proc. 2016-44 applies to management contracts entered into on or after August 22, 2016. In addition, issuers may elect to apply the new safe harbor to management contracts entered into earlier. The prior safe harbors may continue to be applied to any contract entered into before February 18, 2017, that is not materially amended or modified on or after February 18, 2017, except pursuant to certain renewal options.
The safe harbor provided by Rev. Proc. 2016-44 is generally available to management contracts that satisfy the following six requirements:
- General financial requirements. A contract (i) must provide only for “reasonable compensation” (ii), must not give the service provider “a share of net profits,” and (iii) must not impose the burden of sharing any of the net losses on the service provider. 5.02.
- Term of the contract. The contract term, including renewal options, must not be longer than the lesser of 30 years or 80% of the weighted average reasonably expected economic life of the “managed property” (the portion of the project to which the services relate). If contract terms relevant to the safe harbor analysis are “materially modified,” the contract must be retested as a new contract. § 5.03.
- Control over the managed property. The “qualified user” (depending on the project, this is either a governmental person or a 501(c)(3) organization) must exercise a “significant degree of control” over the managed property. § 5.04.
- Risk of loss of the managed property. The qualified user must bear the risk of loss upon damage or destruction of the property. § 5.05.
- Consistent tax positions. The service provider must agree “not [to] take any tax position that is inconsistent with being a service provider,” e.g., by claiming depreciation with respect to (and presumably, ownership of) the managed property, or by claiming a deduction for a payment as rent (and presumably classifying itself as a lessee of some or all of the managed property). § 5.06.
- No circumstances substantially limiting the qualified user’s ability to exercise its rights. The service provider must not have any role or relationship with the qualified user that acts to substantially limit the qualified user’s ability to exercise its rights under the contract. This safe harbor requirement may be satisfied by its own mini-safe harbor that requires showing: (i) that certain individuals affiliated with the service provider (e.g., directors and officers) do not control 20% or more of the vote of the qualified user’s governing body, (ii) the qualified user’s governing body doesn’t include the service provider’s chief executive officer (“CEO”) or its chairperson (or the equivalents), and (iii) the CEO of the service provider is not the CEO of the qualified user (or CEO of any entity related to the qualified user). § 5.07.
Management contracts also do not result in private business use if they are an “eligible expense reimbursement arrangement.” § 5.01. An “eligible expense reimbursement arrangement” means “a management contract under which the only compensation consists of reimbursements of actual and direct expenses paid by the service provider to unrelated parties and reasonable related administrative overhead expenses of the service provider.” § 4.01.
Also, use by a service provider that is “functionally related and subordinate to” a management contract that meets the safe harbor requirements does not result in private business use. The functionally related/subordinate use rule is clarified by an example: Storage areas to store equipment used to perform activities required under a management contract that complies with Rev. Proc. 2016-44 does not result in private business use (and presumably would mean that such space would not be treated as leased to the service provider).
A few key points to note:
- The new safe harbor may require certain special provisions that might not otherwise appear in a management contract and might not have been required under 97-13. Where does the service provider have to memorialize its agreement not to take inconsistent tax positions? The logical place is in the text of the management contract itself. Likewise, the qualified user must document its control over the managed property through budgetary control and rate-setting powers – these also may require special contract provisions.
- Under the new safe harbor, we no longer have to examine the termination provisions of a management contract.
- We also no longer have to categorize compensation into various buckets (per unit fee, periodic fixed fee, etc.).
- The greatly expanded permitted term opens the door to tax-exempt financing for a whole new world of P3 projects with long-term concession contracts
The summary above does not include all of the specifics. The summary also does not include the full definitions of various terms in Rev. Proc. 2016-44 (most of which are in Section 4 of Rev. Proc. 2016-44).