US: Death penalty sanctions: A rare last resort for egregious civil misconduct
This update discusses elements considered by courts when imposing death penalty sanctions.
On August 22, 2016, the Internal Revenue Service (the "IRS") released Revenue Procedure 2016-44,1 further modified on September 2, 2016 ("Rev. Proc. 2016-44"), which provides guidance with respect to management contracts2 related to property financed with certain types of tax-exempt debt. Rev. Proc. 2016-44 modifies and supersedes prior guidance contained in Revenue Procedures 97-13 and 2001-393 and section 3.02 of Notice 2014-674. Rev. Proc. 2016-44 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").5 Having more than a de minimis amount of private business use may disqualify bonds from being tax-exempt. Our general alert regarding Rev. Proc. 2016-44 along with a background discussion may be found here. This alert discusses Rev. Proc. 2016-44 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 established under 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 set 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 Rev. Proc. 2016-44, which, as described below, provides for a longer maximum contract term, but with certain additional requirements.
Under the new framework set forth in Rev. Proc. 2016-44, 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, may require changes to the traditional forms of management contracts used by healthcare organizations.
The new management contract safe harbor provided under Rev. Proc. 2016-44 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 is still not permitted. 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.
Rev. Proc. 2016-44 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 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). 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. 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) after August 18, 2017 must satisfy the requirements of Rev. Proc. 2016-44 in order to qualify for the safe harbor; as such, healthcare systems should review and update any management contract templates to conform to the new safe harbor.
Under Rev. Proc. 2016-44, 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.6 Below is a discussion of the eight conditions along with commentary specific to healthcare-related contracts.
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.
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.10
1 2016-36 I.R.B. 1.
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 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.
4 Section 3.02 of Notice 2014-67, 2014-46 I.R.B. 822, 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. 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 Rev. Proc. 2016-44 and remains in effect.
5 The new revenue procedure 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.
6 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." 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.
7 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 service provider 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.
8 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 owner of the property. Additional guidance will be required to fully interpret this requirement, e.g., the proper treatment of financed land.
9 Rev. Proc. 2016-44 provides that a qualified user may show approval of capital expenditures for a managed property by approving an annual budget for capital expenditures described by functional purpose and specific maximum amounts, and that it may show approval of dispositions of property in a similar manner. Rev. Proc. 2016-44 further provides that a qualified user may show approval of rates charged for the use of the managed property either by expressly approving such rates or the methodology for setting such rates, or by including in the contract a requirement that the service provider charge rates that are reasonable and customary as specifically determined by an independent third party.
10 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.
This update discusses elements considered by courts when imposing death penalty sanctions.
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