Healthcare management contract update

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. 

Eight Safe Harbor Conditions under Rev. Proc. 2016-44

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.

1. 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 such restrictions, 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?
   
   
2. 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.⁷  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.  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.
   
   
3. 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.  As an example of application of this safe harbor, a compensation arrangement that provides for reductions by stated dollar amounts for failure to cause the operation of the managed property to satisfy targeted expense limitations 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
   
   
4. 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.⁸  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 financed property to ensure that the term of any newly entered into management contract meets the requirement of the safe harbor.
   
   
5. 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 property⁹ 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.  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 is a prime example of how the new framework, while seemingly more flexible than the Original Safe Harbors, may in some ways prove more restrictive for healthcare organizations.
   
   
6. 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. 
   
   
7. 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 Rev. Proc. 2016-44 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.
   
   
8. 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.

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.¹⁰

Please contact our team members below to learn more about how Rev. Proc 2016-44 affects healthcare organizations.