On August 22, 2016, the US Internal Revenue Service (“IRS”) published Revenue Procedure 2016-44, which modifies and supersedes the prior management contract safe harbor guidance. This is the third recent IRS effort to transform older tax-exempt bond guidance that does not fit well into evolving tax-exempt financing structures, particularly in the context of public-private partnerships (“P3s”). In October 2014, the IRS issued Notice 2014-67, which included enhanced flexibility for short-term management contracts, and in November 2015, the US Department of the Treasury and the IRS released final regulations which included mixed-use allocation and partnership structure rules. In this new revenue procedure, the IRS has revised the management contract safe harbors to allow for longer term contracts than those previously covered.
Section 103 of the Internal Revenue Code of 1986 (the “Code”) provides an exclusion from gross income for interest on any State or local bond as long as the bonds, the bond-financed property and use of bond proceeds meet certain criteria. Very generally, one requirement relates to a restriction on “private business use” such that more than 10 percent of the bond-financed property may not be used in a nongovernmental trade or business. This “private business use” is present if the nongovernmental person has special legal entitlements to use the bond-financed property, including pursuant to a lease, management contract or incentive payment contract. The regulations provide generally that whether a management contract consists of private business use is based on all of the facts and circumstances, and a management contract generally results in private business use if the contract provides for compensation for services rendered with compensation based, in whole or in part, on a share of net profits from the operations of the property or if the nongovernmental person is treated as the lessee or owner of the property for federal income tax purposes.
In 1997, the IRS developed in Revenue Procedure 97-13 various “safe harbors” to provide tax-exempt bond issuers with bright lines to avoid private business use caused by a nongovernmental person’s (“service provider”) use pursuant to a management or service contract. The safe harbors focused on the contract term and the extent to which the compensation was a fixed amount. As amplified by Notice 2014-67, a contract that does not exceed five years can include compensation based on a percentage of gross revenues or expenses (but not both), stated amount, periodic fixed fee, a capitation fee, a per-unit fee or a combination of the preceding. For long-term contracts, Revenue Procedure 97-13 provided that a contract term can generally be the lesser of 80 percent of the reasonably expected useful life of the bond-financed property and 15 years if compensation consists of a 95 percent fixed amount (with an allowance for certain inflation adjustments and a predetermined one-time incentive award), and a contract term can generally be the lesser of 80 percent of the reasonably expected useful life of the bond-financed property and 10 years if compensation consists of an 80 percent fixed amount (with an allowance for certain inflation adjustments and a predetermined one-time incentive award). The service provider’s use of the bond-financed property pursuant to a management contract meeting these terms and conditions (along with other requirements) is not treated as constituting private business use.
The New Management Contract Safe Harbor
This safe harbor applies to any management contract with a term no greater than the lesser of 80 percent of the weighted average reasonably expected economic life of the bond-financed property and 30 years. Satisfaction of the safe harbor requires the presence of four general items relating to ensuring the governmental entity’s rights with respect to the bond-financed property and compliance with a specified compensation framework. The IRS calls this safe harbor a “more principles-based” and “less formulaic” approach in blessing a type of management contract to not run afoul of the statutory and regulatory private business use concern.
Bond Issuer Rights. Generally, the four general items that must be present with respect to the management contract and bond-financed property are:
- The governmental entity (or other qualified bond issuer) is required to approve with respect to the managed bond-financed property (i) the annual budget, (ii) capital expenditures, (iii) any disposition of property, (iv) use of property rates and charges and (v) the general nature and type of use of the property.
- The governmental entity (or other qualified bond issuer) must bear the risk of loss upon damage or destruction of the bond-financed property.
- The service provider must agree that it will not take any tax position inconsistent with being a service provider and not the owner of the bond-financed property (e.g., no depreciation deduction or investment tax credit).
- The service provider cannot have a role or relationship with the governmental entity (or other qualified bond issuer) in a manner that substantially limits the governmental entity (or other qualified bond issuer) from exercising its rights under the contract (this can be met under a safe harbor primarily relating to overlap between the parties’ governing bodies and chief officers).
Compensation Arrangement. Payments to the service provider must be reasonable compensation and cannot provide the service provider a share of the bond-financed property’s net profits nor penalize the service provider based on the bond-financed property’s net losses. Compensation will not be treated as providing a share of net profits if (i) neither the eligibility for, (ii) nor the amount of, (iii) nor the timing of payment of compensation takes into account, or is contingent upon, either (a) the bond-financed property’s net profits or (b) both the bond-financed property’s revenues and expenses for any fiscal period (ignoring for this purpose any payments that are reimbursement of actual and direct expenses paid by the service provider to unrelated parties). Further, incentive compensation will also not be treated as providing a share of net profits as long as the amount and timing of the compensation are consistent with the general rule above, and the eligibility for such compensation is determined by the service provider’s performance in meeting one or more standards that measure quality of services, performance or productivity. Finally, compensation will not be treated as requiring the service provider to bear a share of net losses if (i) the timing of payment is not contingent on net losses and (ii) the amount of payment of compensation and the amount of any expenses to be paid by the service provider (and not reimbursed) do not take into account either (a) the bond-financed property’s net losses or (b) both the bond-financed property’s revenues and expenses for any fiscal period.
Revenue Procedure 2016-44 also includes an additional safe harbor relating to certain expense reimbursement arrangements.
Bond issuers can apply these safe harbors to contracts entered into before August 22, 2016, and the safe harbors apply to any management contract entered into on or after August 22, 2016. The safe harbors of Revenue Procedure 2016-44 supersede the management contract safe harbors under Revenue Procedure 97-13 (as modified by Revenue Procedure 2001-39 and amplified by Notice 2014-67) except that the older safe harbors can still be applied to a management contract that is entered into before February 18, 2017.
This new framework will generally impact all management contract arrangements going forward and may introduce the necessity for certain new features and considerations. Various details of this new safe harbor appear to have open interpretative issues and may in certain cases be more restrictive than the older safe harbors. However, ultimately we expect the new safe harbor to expand the ability of participants to use tax-exempt bonds for municipal and governmental financing projects that contemplate private operators.