On August 22, 2016, the Internal Revenue Service (“IRS”) issued Rev. Proc. 2016-44 which provides new safe harbor conditions under which management contracts with private entities, entered into or materially modified after August 22, 2016, do not result in impermissible private business use of tax-exempt bond financed property. The new safe harbor is of interest to any issuer of tax exempt bonds, such as governmental entities and 501(c)(3) organizations (collectively “qualified users,), service providers to any such issuer and lenders and other parties involved in tax exempt public financing transactions. The new safe harbor takes a “more flexible and less formulaic approach” than the prior safe harbors established in Rev. Proc. 97-13, Rev. Proc. 2001-39 and Notice 2014-67.
One of the most notable changes under the new Rev. Proc. 2016-44 safe harbor is that the allowable term of a management contract is significantly expanded from a term of as short as one, three, or five years under the prior safe harbors to a term that can be as long as 30 years. Another important change under the new safe harbor is that management contracts are specifically permitted to include compensation in the form of reimbursement of expenses.
In order to satisfy the new safe harbor, a management contract must meet each of the following characteristics:
- Compensation must be reasonable for the services rendered;
- Service provider must not be compensated based on a share of net profits from the managed property (i.e., no part of the compensation takes into account, or is contingent upon (a) the managed property’s net profits, or (b) both the managed property’s revenues and expenses);
- The service provider must not bear the burden of any share of net losses from the managed property (i.e., the service provider’s compensation and obligation to pay expenses do not take into account (a) the managed property’s net losses, or (b) both the managed property’s revenue and expenses);
- The term of the contract must be no longer than the lesser of (a) 30 years, or (b) 80 percent of the weighted average reasonably expected economic life of the managed property (a material modification to the contract will result in a retesting of the term);
- The qualified user must maintain a significant degree of control over the use of the managed property. For example, the management contract should specifically provide that the qualified user must, at a minimum, approve the annual budget, capital expenditures and any disposition of the managed property by the service provider, the rate charged for use of the managed property, and the general nature and type of use of the managed property;
- The qualified user must bear the risk of loss for damage or destruction of the managed property (third party insurance does not cause a failure of this requirement);
- 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 (i.e., no depreciation, amortization, investment tax credit, or rent deduction); and
- The service provider must not be in a role or relationship with the qualified user that substantially limits the qualified user’s ability to exercise its rights under the management agreement. There will not be a prohibited relationship if: (a) no more than 20 percent of the voting power of the qualified user’s governing body is vested in the directors, officers, shareholders, partners, members and employees of the service provider; (b) the governing body of the qualified user does not include the service provider’s CEO or chairperson of the service provider’s governing body (or equivalent positions); and (c) the CEO of the service provider is not the CEO of the qualified user or any of the qualified user’s related parties.