On August 22, 2016, the Internal Revenue Service (the “IRS”) released Revenue Procedure 2016-44 (“Rev. Proc. 2016-44”),1 which modifies and supersedes existing management contract guidance under Revenue Procedures 97-13 and 2001-39 and section 3.02 of Notice 2014-67.2 Rev. Proc. 2016-44 provides new safe harbor conditions for management contracts, and provides for a new “eligible expense reimbursement arrangement,” that, if satisfied, will not result in private business use under sections 141 and 145 of the Internal Revenue Code of 1986 (the “Code”).
Rev. Proc. 2016-44 may allow tax-exempt bonds to be issued by a state or political subdivision (a “governmental person”) in so-called “public-private partnership” transactions (“P3s”) to finance governmental facilities subject to long-term contracts whereby such governmental person contracts with a nongovernmental person to design, build, finance, operate and maintain the facilities to be used by governmental persons. As noted below, Rev. Proc. 2016-44 continues to provide that a qualifying management contract not transfer any direct or indirect ownership interest in the facilities to a nongovernmental person. This requirement may be a limiting factor in the context of certain P3 structures.
Under section 103(a) of the Code, interest on bonds of a governmental person generally is excluded from the gross income of the bondholder for regular federal income tax purposes. However, such exclusion is denied under sections 141 and 145 of the Code in the case of bonds that are “private activity bonds” but not “qualified bonds.”3 A private activity bond is a bond of an issue that satisfies both a “private business use” and also a “private security or payment” test. Generally, the private business use test is satisfied if more than a limited amount of the proceeds of the issue are to be “used” by a nongovernmental person in any activity of an entity, or any activity of an individual that is in a trade or business (a “private business use”); and, the private security or payment test is satisfied if either the obligation of the issuer to pay debt service is secured to a substantial extent by property subject to private business use (a “private security”) or the issuer is to receive substantial payments (whether or not made by a nongovernmental user) with respect to a private business use of the proceeds of the issue. In either case, a use of property financed with proceeds of the issue is treated as a use of the proceeds.4 Thus, in determining whether an issue comprises private activity bonds, it is important to identify any private business use of the proceeds of that issue.
A nongovernmental person may enjoy a “use” relationship to bond-financed property if it has special legal entitlements with respect to the bond-financed property such as a direct or indirect (e.g., through a joint venture or partnership) ownership interest; or has a leasehold interest in that property (determined under general federal income tax principles); or will receive a special economic benefit from the property (e.g., by reason of owning nongovernmental property specially benefitted by the proximity of the financed property). In addition, however, a nongovernmental person may enjoy such a “use” relationship to bond-financed property if that nongovernmental person provides services to the governmental owner with respect to any function of the financed property pursuant to a “management contract.”5
Over the previous 34 years,6 the IRS has recognized that not all service arrangements between governmental owner and nongovernmental provider should result in a denial to the governmental owner of the benefits of tax-exempt bond financing. Governmental units and 501(c)(3) organizations frequently enter into arrangements with nongovernmental persons to provide management or other services, with respect to all or a portion of a bond-financed property, that do not create in the service provider sufficient indicia of ownership, possession, or indirect benefit to warrant such denial.
In recent years, issuers have relied on the safe harbor conditions established under Revenue Procedures 97-13 and 2001-39 and Notice 2014-67 (collectively, the “Original Safe Harbors”) satisfaction of which would assure that a management contract would not be treated as establishing in private business use under sections 141 and 145 of the Code. The Original Safe Harbors, however, have been quite narrow, resulting in elaborate efforts to conform the normal commercial practices of the nongovernmental service provider to noncommercial constraints regarding compensation, reimbursement of expenses and, importantly, the term of the service arrangement. Such constraints, for example, have prevented other than the shortest of P3 arrangements, essentially precluding the typical design-build-finance-operate-maintain method of procurement of governmental facilities, all in an effort by the IRS to assure that the nongovernmental service provider derive no benefit as a consequence of the governmental tax-exempt bond financing of the managed facilities.
Rev. Proc. 2016-44
Under Rev. Proc. 2016-44, the traditional structure of the IRS guidance providing management contract templates that, with careful compliance, afforded safe harbor protection from private business use characterization is abandoned in favor of a broad and generally more inclusive set of principles. The Rev. Proc. 2016-44 safe harbor relief generally includes long- or short-term contracts providing for any type of fixed or variable compensation that is determined to be reasonable for services rendered under management contracts. As under the Original Safe Harbors and applicable regulations, Rev. Proc. 2016-44 does not permit net profits arrangements. Rev. Proc. 2016-44 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. In short, Rev. Proc. 2016-44 adopts criteria closely aligned to the criteria that would be applied in a traditional tax ownership analysis.
Rev. Proc. 2016-44 generally applies to any management contract that is entered into on or after August 22, 2016, provided that an issuer may continue to rely upon the Original Safe Harbors in evaluating any agreement entered into prior to February 18, 2017, that is not materially modified or extended after that date (other than pursuant to a renewal option). In addition, an issuer may apply the new Rev. Proc. 2016-44 safe harbor conditions to any management contract that was entered into before August 22, 2016.
Eight safe harbor conditions
A management contract satisfying all of the conditions below does not result in private business use under sections 141 or 145 of the Code:7
- Compensation must be reasonable for services rendered during the term of the contract. For this purpose, compensation includes payments to reimburse actual and direct expenses paid by the service provider and related administrative overhead expenses of the service provider.8
- 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 purposes of this safe harbor, 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.9 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.
- 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 of the burden of bearing a share of net losses if (i) the amount of compensation to and of unreimbursed expenses to be paid by the vendor 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. As an example of application of this safe harbor, a compensation arrangement for that provides for reductions for failure to cause the operation of the managed property to satisfy targeted expenses limitations under the safe harbor will not (in and of itself) be treated as imposing the burden of a share of net losses from operation of the managed property on the service provider
- Term of contract (including all renewal options) must not exceed the lesser of 30 years or 80% of the weighted 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 mid-point life under the asset depreciation range system in effect in 1984 may be applied.10
- 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. For example, this safe harbor may be met through approval of an annual budget that includes the operating budget, a capital expenditure budget (by functional purpose and specified maximum amounts), an authorization of dispositions of property and a 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.
- 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 in contract. The latter also is key to facilitating the typical P3 DBFOM transaction, under which the nongovernmental service provider is contractually obligated to “hand-back” the facility in a condition that satisfies specific minimum standards at the end of the arrangement.
- 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 person. 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 Rev. Proc. 2016-44 safe harbor. In the context of P3 transactions, this may have the effect of discouraging service provider investment into non-severable improvements of the managed property, even in those cases in which there is no resulting adjustment to compensation or other financial obligation of the qualified user to the service provider.
- 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. Among other things, the safe harbor permits: (i) up to 20% of the voting power of the qualified user to be vested in directors, officers, shareholders, partners, members, or employees of the service provider (or of any related person to the service provider); (ii) the chief executive officer (or person with similar management responsibilities) (the “CEO”) or the chairperson of the service provider’s governing board to be a member of the governing board of the qualified user; and (iii) the CEO of the service provider (or of any related person to the service provider) to be the CEO of the qualified user or any related person to the qualified user.
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 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.
1 2016-36 I.R.B. 1.
2 All other sections of Notice 2014-67, 2014-46 I.R.B. 822, remain in effect with respect to contracts entered into prior to February 18, 2016 and not materially modified thereafter. Revenue Procedure 97-13, 1997-1 C.B. 632, as originally issued, specifies various permitted terms of contracts that depend on 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, only made a minor amendment to Revenue Procedure 97-13. Notice 2014-67 expanded the Revenue Procedure 97-13 safe harbors 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.
3 “Qualified bonds” are listed in section 141(e) of the Code and include “exempt facility bonds” issued under section 142 of the Code and “qualified 501(c)(3) bonds” issued under section 145 of the Code.
4 Section 145(a) of the Code provides generally that a “qualified 501(c)(3) bond” means any private activity bond issued as part of an issue if all property that is to be provided by the net proceeds of the issue is to be owned by a 501(c)(3) organization or a governmental unit, and if there is to be only insubstantial private business use of the property by any nongovernmental person (other than by a 501(c)(3) organization in an activity that, as to its exempt purposes, is not an unrelated trade or business under section 513(a) of the Code).
5 Treas. Regs. § 1.141-3(b)(4)(i). This concept of “use” of property is a deviation from general federal income tax provisions in the converse situation, in which such certain federal income tax benefits, including investment credits and accelerated depreciation, are denied to a nongovernmental owner by reason of a governmental entity’s “use” of nongovernmental property. Under those provisions, “use” is limited to situations of governmental ownership or possession of the nongovernmental property, and does not include situations where the governmental involvement is through the provision or receipt of services involving the nongovernmental property. For that reason, Code provisions such as section 7701(e) and legal authority under Code provisions such as sections 49 or 168(i) are of limited value in identifying where a service arrangement should give rise to private business use of a governmental facility.
6 See, e.g., Rev. Procs. 82-14, 82-15, 92-17, etc.
7 For purposes of Rev. Proc. 2016-44, 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.” In the case of a contract that covers both pre-operating services (e.g., construction management) and operating services, only that portion of the contract covering the latter is the “management contract”. 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 government person or, for projects financed with qualified 501(c)(3) bonds, any governmental person or 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.
8 For purposes of Rev. Proc. 2016-44, the term “service provider” means any person other than a qualified user that provides services to, or for the benefit of, a qualified user under a management contract. A “qualified user” means, for projects financed with government bonds, any government person or, for projects financed with qualified 501(c)(3) bonds, any governmental person or 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.
9 For purposes of Rev. Proc. 2016-44, the term “unrelated party” means a person other than a related party (as defined in Treas. Regs. § 1.150-1(b)) or a service provider’s employee. Thus, for example, an arrangement under which the amount of reimbursement of a vendor for its employee expenses (or those of a related party) is contingent on both the revenues and expenses of operation of the managed property would fail this second condition.
10 See, Rev. Proc. 83-35, 1983-1 CB 745. For buildings, the asset guideline lives under Rev. Proc. 62-21 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 governmental owner of the property.