On January 17, 2017, the IRS released Revenue Procedure 2017-131 (“Revenue Procedure 2017-13”), which provides guidance with respect to management contracts2 related to property financed with certain types of tax-advantaged debt, including tax-exempt bonds.3 Revenue Procedure 2017-13 modifies, amplifies, and supersedes the recently issued Revenue Procedure 2016-44,4 which had modified and superseded prior guidance contained in Revenue Procedures 97-13 and 2001-395 and section 3.02 of Notice 2014-676. The end result is that there will be one safe harbor found in Revenue Procedure 2017-13, with all prior management contract safe harbor guidance having been superseded.
Revenue Procedure 2017-13 provides new safe harbor conditions for management contracts which, if satisfied, will assure that the contract does not create private business use under sections 141 and 145 of the Internal Revenue Code of 1986 (the “Code”).7 Having more than a de minimis amount of private business use may disqualify bonds from being tax-exempt. This alert discusses Revenue Procedure 2017-13 specifically in the context of healthcare financings.
Certain types of tax-exempt bonds (including qualified 501(c)(3) bonds, which are issued for many nonprofit healthcare systems) are subject to a limitation on the amount of private business use of financed facilities. Private business use may result from certain types of management contracts relating to bond‑financed facilities. Until now, issuers of tax-exempt bonds and conduit borrowers such as healthcare systems have relied on the safe harbor conditions in Revenue Procedures 97-13 and 2001-39 and, more recently, Notice 2014-67 (collectively, the “Original Safe Harbors”) to ensure that management contracts entered into with respect to financed property do not result in private business use. Revenue Procedure 97-13, however, was somewhat constraining, resulting in significant efforts to conform the normal commercial practices of the nongovernmental service provider to noncommercial constraints regarding compensation, reimbursement of nongovernmental expenses and term of the service arrangement.
Healthcare organizations have typically utilized relatively short-term contracts, particularly with respect to contracts with physicians and medical practices. Such short duration has typically allowed for maximum flexibility in compensation under Revenue Procedure 97-13. Even with the shortest term contracts there were difficulties meeting the requirements of Revenue Procedure 97-13. For example, requirements under Revenue Procedure 97-13 to include fee schedules for per-unit fee contracts presented commercial difficulties with physician group contracts, which were often structured as separate billing arrangements without specific fees enumerated in the contract. Notice 2014-67 removed some of Revenue Procedure 97-13’s constraints by allowing contracts with any combination of compensation with a term of up to five years so long as there was no sharing of the net profits of the bond-financed facility. Five years, however, was thought not to be long enough by governmental issuers that desired long-term arrangements with respect to long-lived infrastructure projects. In response, the IRS issued Revenue Procedure 2016-44 and, in January, Revenue Procedure 2017-13, which, as described below, provide for a longer maximum contract term, but with certain additional requirements.
Under the new framework set forth in Revenue Procedure 2017-13, all management contracts, no matter the term, must satisfy a uniform set of requirements in order to qualify for the safe harbor. This new framework provides much needed relief for activities that need very long-term management contracts such as the construction and operation of toll roads. However, there are now additional conditions that must be taken into account, and some of these new requirements, discussed in more detail below, will require changes to the traditional forms of management contracts used by healthcare organizations.
The new management contract safe harbor provided under Revenue Procedure 2017-13 generally allows for fixed or variable compensation that is determined to be reasonable for services rendered under the contracts. As under the Original Safe Harbors and applicable regulations, the sharing of net profits from operation of the bond-financed facility is still not permitted, but now with a renewed focus on prohibiting the sharing of net losses as well. Revenue Procedure 2017-13 applies a principles-based approach focusing on (i) the extent of governmental control over the financed property; (ii) the extent to which the service provider does (or does not) bear risk of loss with respect to the financed property; (iii) the term of the arrangement in comparison to the economic life of the financed property; and (iv) consistency of tax positions taken by the service provider.
Revenue Procedure 2017-13 generally applies to any management contract that is entered into on or after August 22, 2016. However, an issuer may continue to rely upon the Original Safe Harbors in evaluating any agreement entered into prior to August 18, 2017, that is not materially modified or extended on or after that date (other than pursuant to a renewal option under which a party to the contract has a legally enforceable right to renew the contract). Conversely, an issuer, if it wanted to, is permitted to apply the new Revenue Procedure 2017-13 safe harbor conditions to any management contract that was entered into before August 22, 2016. As noted above, given that many management contracts with healthcare service providers are short-term in nature and were structured to qualify for favorable treatment under the Original Safe Harbors (and may not currently be structured to satisfy the additional requirements of the new safe harbor), it may be advantageous to keep these contracts grandfathered and not elect to have the new guidance apply to them. All contracts, however, should be reviewed on a case-by-case basis before making such a blanket determination. Any contracts entered into, materially modified or extended (other than pursuant to a legally enforceable renewal right) on or after August 18, 2017, must satisfy the requirements of Revenue Procedure 2017-13 in order to qualify for the new safe harbor; as such, healthcare systems should review and update any management contract templates to conform to the new safe harbor.8
Eight safe harbor conditions under revenue procedure 2017-13
Under Revenue Procedure 2017-13, a management contract must satisfy certain conditions in order to qualify for the safe harbor and ensure that such contract does not result in private business use under sections 141 or 145 of the Code.9 Below is a discussion of the eight conditions along with commentary specific to healthcare-related contracts.
- Compensation must be reasonable for services rendered during the term of the contract. Reasonable compensation has always been required under the Original Safe Harbors. However, compensation for such purposes is now defined to include payments to reimburse actual and direct expenses paid by the service provider and related administrative overhead expenses of the service provider. Nonprofit healthcare systems that are exempt from taxation under Section 501(c)(3) of the Code are generally already subject to a requirement that compensation be reasonable, as unreasonable compensation may result in impermissible private inurement or private benefit. This requirement raises the concern as to what type of evidence will need to be established to support a finding of reasonableness with respect to physician and practice group contracts. For example, in determining fees for specific physician services, should such fees be based on schedules provided by unrelated third parties and any increases in such fees be tied to a specified, objective, external standard such as the Consumer Price Index? Revenue Procedure 2017-13 provides helpful guidance when explaining the control requirement, discussed below, by noting that such requirement may be satisfied “by requiring the service provider to charge rates that are reasonable and customary as specifically determined by, or negotiated with, an independent third party (such as a medical insurance company).”
- Contract must not provide the service provider a share of the net profits from the operation of the managed property. As a safe harbor, a compensation arrangement will not be treated as a sharing of net profits if no element of the compensation for services takes into account or is contingent upon either the managed property’s net profits or both the managed property’s revenues and expenses for any fiscal period. For such purposes, the “elements” of compensation are: (i) eligibility for compensation; (ii) amount of compensation; and (iii) timing of compensation. Solely for the purpose of evaluating whether the amount of compensation (element (ii)) “takes into account, or is contingent upon, either the managed property's net profits or both the managed property's revenues and expenses for any fiscal period,” any reimbursement of actual and direct expenses paid by the service provider to “unrelated parties” is disregarded as compensation. As an example of application of this safe harbor, a compensation arrangement that provides for incentive bonuses for reaching targeted quality, performance or productivity goals in the service provider’s operation of the managed property will not (in and of itself) be treated as providing the service provider a share of the net profits from the operation of the managed property. Certain types of management fees are not considered to be net profits arrangements. These arrangements include capitation fees, periodic fixed fees, per-unit fees,11 and incentive fees based on certain performance metrics. Finally, Revenue Procedure 2017-13 clarifies that the deferral of compensation due to insufficient cash flow from the operation of the managed property will not cause the compensation to be treated as contingent upon net profits or net losses if it is payable annually, there are reasonable consequences for late payment (such as interest charges or late payment fees) and the contract includes a requirement that the qualified user will pay the deferred compensation within five years of the original due date of the payment. It is important to remember that although the new safe harbor allows for more flexibility with respect to terms of contracts and variable compensation, an arrangement (such as a patient food services contract or a physician contract) with compensation based both on revenues and expenses of the financed facility may result in private business use. Note also that contracts that provide for compensation based on a share of gross revenues, which were generally protected under the Original Safe Harbors, are not automatically protected under the new safe harbor. Thus, it is important that such arrangements be closely reviewed to ensure they do not give rise to private business use, particularly if coupled with the reimbursement of the service provider’s employee expenses. Additionally, it may be useful to examine closely the nature of the expenses the service provider is obligated to pay. For example, the payment by the service provider of its own “internal” costs – e.g., supplies, service provider personnel costs, telephone and its own IT – may not be thought of as giving rise to a sharing of net profits, even when coupled with compensation to the service provider in whole or in part based on gross revenues. On the other hand, to the extent the service provider is obligated to bear any “plant-related” expenses – e.g., maintenance, HVAC, the cost of insuring the property – the risk of charactering the arrangement as a sharing of profits relating to the operation of the property may increase.
- Contract must not, in substance, impose upon the service provider the burden of bearing any share of net losses from the operation of the managed property. As in the case of net profits, above, as a safe harbor, an arrangement will not be treated as shifting the burden of bearing a share of net losses if (i) the amount of compensation and unreimbursed expenses of the service provider does not take into account either the net losses of the managed property or both the revenues and expenses of the managed property for any fiscal year, and (ii) the timing of payment of compensation is not contingent upon the net losses of the managed property. Similar to the net profits prohibition above, the reimbursement of third-party costs is generally ignored, and management fees that are based on capitation fees, periodic fixed fees, and per-unit fees are not considered to be net loss arrangements. Further, as discussed above, the deferral of compensation due to insufficient cash flow will not cause the compensation to be treated as contingent on net losses if the compensation is payable annually, there are reasonable consequences for late payment (such as interest charges or late payment fees), and the contract includes a requirement that the qualified user will pay the deferred compensation within five years of the original due date of the payment.
- Term of contract (including all legally enforceable renewal options) must not exceed the lesser of 30 years or 80% of the weighted average reasonably expected economic life of property. For this purpose, “economic life” is determined in the same manner as under section 147(b) of the Code. Under existing law, as a safe harbor with respect to the economic life of acquired or improved property, its midpoint life under the asset depreciation range system in effect in 1984 may be applied. For purposes of measuring the weighted average reasonably expected economic life of property, land will be disregarded unless 25 percent or more of the net proceeds of the issue that finances the managed property is used to finance land, in which case the land is treated as having an economic life of 30 years. As noted above, although this expansion of time periods is of great benefit to certain industries, it may have limited effect on healthcare-related management contracts, which for commercial reasons are generally of much shorter duration. However, the short-term nature of such contracts suggests more frequent testing dates for satisfying this requirement. Care should be taken toward the end of the economic life of the managed property to ensure that the term of any new or renewed management contract meets the requirement of the safe harbor. Contracts entered into when little economic life remains on the managed property may not qualify for the safe harbor.
- Qualified user must exercise a significant degree of control over managed property. This requirement will be met if the contract requires that the qualified user approve the annual budget of the managed property, capital expenditures with respect to the managed property, each disposition of property that is part of the managed property, rates charged for the use of the managed property and the general nature and type of use of the managed property. Revenue Procedure 2017-13 clarifies that a qualified user may satisfy the approval of rates requirement by approving a reasonable general description of the method used to set the rates or by requiring that the service provider charge rates that are reasonable and customary as specifically determined by, or negotiated with, an independent third party (such as a medical insurance company). For example, this condition may be met through approval of an annual budget that includes the operating budget, approval of a capital expenditure budget (by functional purpose and specified maximum amounts), an authorization of dispositions of property, and approval of the methodology for the setting of rates (or requiring that rates be reasonable and customary as specifically determined by an independent third party) for the use of the managed property. This is a new requirement that did not exist under the Original Safe Harbors. Management contracts that are entered into, extended or materially modified after the effective date should be closely examined to ensure compliance with this requirement. For example, under separate billing arrangements with physicians and under patient food services contracts, healthcare organizations often cede control over rates charged for the use of managed property to the service provider. Under the new safe harbor, either the healthcare organization must expressly approve such rates or the methodology for setting such rates, or the contract must include a requirement that the service provider charge customary and reasonable rates as specifically determined by an independent third party. This requirement may create a trap for the unwary.
- Qualified user must bear the risk of loss upon damage or destruction of the property. This requirement may be satisfied notwithstanding that the qualified user insures the property through a third party or, under the contract, imposes upon the service provider a penalty for failure to operate managed property in accordance with standards set forth in the contract.
- Service provider must agree that it is not entitled to and will not take any tax position inconsistent with being a service provider to the qualified user. The contract must include an express written undertaking by the service provider not to take depreciation or amortization, investment tax credits, or deduction for any payment as “rent” with respect to the managed property. While as a practical matter a service provider under a management contract satisfying the Original Safe Harbors likely would not have been able to take a return position that it had an adequate ownership interest to support credits, depreciation or rental deductions, an express contractual covenant is one of the conditions to the Revenue Procedure 2017-13 safe harbor. Many healthcare management contracts likely do not currently contain such explicit language. In order to continue qualifying for the safe harbor, such language will need to be added to these contracts at the time they are otherwise extended or materially modified. This requirement is another potential trap for the unwary.
- Service provider must not have any role or relationship with the qualified user that would restrict the exercise by the qualified user of its rights under the contract. As a safe harbor, this condition will not be violated if: (i) no more than 20% of the voting power of the qualified user is vested in directors, officers, shareholders, partners, members, or employees of the service provider (or of any person related to the service provider); (ii) neither the service provider’s chief executive officer (or person with similar management responsibilities) (the “CEO”) nor the chairperson of the service provider’s governing board is a member of the governing board of the qualified user; and (iii) the CEO of the service provider (or of any person related to the service provider) is not also the CEO of the qualified user or any person related to the qualified user. As under Revenue Procedure 97-13, this requirement may prove difficult to meet in certain situations in which the service provider is a joint venture involving the exempt health care provider, such as a hospital/physician joint venture. However, if the qualified user has a controlling majority interest in the service provider, one may be able to conclude, consistent with prior private letter rulings issued by the IRS, that, although this “safe harbor” within the overall safe harbor is not itself satisfied, the service provider does not have a role or relationship with the qualified user that would restrict the exercise by the qualified user of the rights the qualified user has under the contract. This provision was much more relevant under the Original Safe Harbors because it was important for the qualified user to be able to terminate the contract, without cause or penalty, at a certain point in time during the term of a contract.
Furthermore, a service provider’s use of a project that is functionally related and subordinate to its performance under a management contract meeting all of the conditions above does not result in private business use.
Eligible expense reimbursement arrangement
If a management contract is an “eligible expense reimbursement arrangement,” such management contract does not result in private business use under Sections 141 and 145 of the Code. An “eligible expense reimbursement arrangement” is a management contract under which the compensation consists only 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.13 This type of arrangement may have limited applicability in the healthcare context.
To whom should I speak about Revenue Procedure 2017-13 as it affects healthcare organizations?
1 2017-6 I.R.B. 787.
2 Management contracts generally include service contracts and incentive payment contracts. Management contracts that are properly treated as leases for federal income tax purposes are not subject to this guidance.
3 Tax-advantaged debt includes, in addition to tax-exempt bonds, outstanding build America bonds and other governmental tax credit bonds. For purposes of this alert, for ease of reference, we will use the term “tax-exempt bonds,” but the principles set forth would apply equally to other tax-advantaged debt.
4 2016-36 I.R.B. 1. Our prior alert on Revenue Procedure 2016-44 may be found here. Revenue Procedure 2017-13 made four significant modifications to Revenue Procedure 2016-44, related to approval of certain types of compensation, the timing of payment of compensation, the treatment of land, and methods of approving rates. These modifications are encompassed in the discussion of the new safe harbor that follows.
5 Revenue Procedure 97-13, 1997-1 C.B. 632, as originally issued, specified various permitted terms of contracts that depend on the nature of the compensation, including the extent to which the compensation is a periodic fixed fee. The greater the percentage of fixed compensation, the longer the permitted term of the management contract. Revenue Procedure 2001-39, 2001-2 C.B. 38, made only a minor amendment to Revenue Procedure 97-13 allowing for automatic increases in set fees according to specified, objective, external standards.
6 Section 3.02 of Notice 2014-67, 2014-46 I.R.B. 822, expanded the Revenue Procedure 97-13 safe harbor to address certain developments involving accountable care organizations after the enactment of the Patient Protection and Affordable Care Act, Pub. L. 111-148, 124 Stat. 119, and also to allow a broader range of variable compensation arrangements for shorter-term management contracts of up to five years. The remainder of Notice 2014-67, which sets forth circumstances under which participation in the Medicare Shared Savings Program through an accountable care organization will not in itself result in private business use of the healthcare organization’s tax-exempt bond-financed facilities, is not modified or superseded by Revenue Procedure 2017-13 and remains in effect.
7 Revenue Procedure 2017-13 also creates a category of contracts called eligible expense reimbursement arrangements. If the conditions for this category are satisfied, the arrangement will not give rise to private business use.
8 In addition, it appears that contracts renewed on or after August 18, 2017 pursuant to an "evergreen" renewal provision would not be grandfathered and, thus, issuers could no longer apply the Original Safe Harbors upon the post-August 18 evergreen renewal. Accordingly, contracts with evergreen renewal provisions should be reviewed in anticipation of the August 18 “applicability date” and, depending on the circumstances, may need to be amended or supplemented to comply with the new safe harbor under Revenue Procedure 2017-13.
9 For purposes of Revenue Procedure 2017-13, a “management contract” means a management, service or incentive payment contract between a qualified user and a service provider under which the service provider provides services for a “managed property.” A “service provider” means any person (other than another qualified user) that provides services to, or for the benefit of, a qualified user under a management contract. The term “qualified user” means, for projects financed with governmental bonds, any governmental person and, for projects financed with qualified 501(c)(3) bonds, any governmental person and any 501(c)(3) organization with respect to its activities that do not constitute an unrelated trade or business, determined by applying section 513(a) of the Code.
10 For purposes of Revenue Procedure 2017-13, the term “unrelated party” means a person other than a related party (as defined in Treas. Reg. § 1.150-1(b)) or a service provider’s employee. This represents a major change from the IRS’s previous position evidenced in a private letter ruling that had treated a service provider’s employees as unrelated parties for such purposes. Thus, for example, an arrangement which includes reimbursement of a service provider’s onsite employee expenses (a common provision in many management contracts, including patient food service contracts) must now be reviewed to determine whether such arrangement provides for compensation based on both the revenues and expenses of operation of the managed property.
11 Revenue Procedure 2017-13 provides that separate billing arrangements between physicians and hospitals are treated as per-unit fee arrangements.
12 See Revenue Procedure 83-35, 1983-1 CB 745. For buildings, the asset guideline lives under Revenue Procedure 62-21, 1962-2 CB 418, may be used. As an alternative, economic life may be established under section 147(b) through the expert opinion of a licensed engineer or other professional, and usually is based upon industry experience with the particular type of property and familiarity with the maintenance practices of the owner of the property.
13 Under the Original Safe Harbors, contracts that provided only for reimbursement of actual and direct expenses paid by the service provider to unrelated parties did not result in private business use, but contracts (other than those related to public utility property) that provided for reimbursement of administrative overhead expenses were subject to the general rules of the Original Safe Harbors and could result in private business use.