IRS Releases New Management Contract Safe Harbor Guidance for Tax-Exempt Bond Financed FacilitiesAugust 23, 2016
On August 22, 2016, the Internal Revenue Service released Revenue Procedure 2016-44 (“RP 2016-44”), which lays out a new and significantly liberalized safe harbor model for management contracts affecting facilities that are financed with tax-exempt bonds. RP 2016-44 establishes a broad, principles-based approach to management contracts that is likely to afford State and local government bond issuers, as well as qualified 501(c)(3) bond borrowers (collectively, “Qualified Users”), substantial flexibility to craft arrangements with third parties for the management and operation of assets financed with tax-exempt bonds, without giving rise to “private business use” of those assets.
The most notable feature of RP 2016-44 is that it offers safe harbor treatment to management contracts as long as 30 years (subject to the useful life limitation described below), as long as the compensation paid to the service provider under the terms of the contract is reasonable and does not have a net profits component. This is a dramatic contrast to the longstanding management contract safe harbor provisions of Revenue Procedure 97-13, which are much more restrictive, requiring significantly shorter contract terms, and are more exacting with respect to the specific types of compensation that can be paid to service providers. Overall, RP 2016-44 appears to be designed to facilitate and encourage investment in long-lived infrastructure, including in certain kinds of so-called public-private partnerships (or “P3s”), while providing enhanced flexibility to Qualified Users for all types of tax-exempt bond-financed assets.
The new safe harbor guidance supersedes Revenue Procedure 97-13 and is generally applicable to management contracts for bond financed property that are entered into or materially modified on or after August 22, 2016; Qualified Users may also apply the RP 2016-44 safe harbor to management contracts entered into prior to August 22, 2016. Additionally, Qualified Users may apply the older, more formulaic safe harbor provisions of Revenue Procedure 97-13 to management contracts entered into prior to (and not materially modified or extended on or after) August 18, 2017.
The following is a brief summary of the main elements of the new guidance in RP 2016-44, each of which must be satisfied in order to secure safe harbor treatment:
1. Financial Requirements
Under RP 2016-44, the compensation paid to a service provider under a management contract (including payments to reimburse expenses paid by the service provider or to cover the service provider’s administrative overhead) must be reasonable for the services rendered during the term of the contract.
Further, compensation paid to the service provider must not take into account, or be contingent on, either the net profits of the managed property or both the revenues and expenses of the managed property for any fiscal period. By contrast, incentive compensation will not be treated as net profits-based if eligibility for the incentive compensation is determined by the service provider’s performance in meeting standards that measure quality of service, performance or productivity, without regard to net profits performance.
Finally, the management contract must not impose on the service provider the burden of sharing net losses from the operation of the managed property. This requirement will be satisfied if (i) the determination of the service provider’s compensation and the amount of any expenses to be paid by the service provider (and not reimbursed) do not take into account the managed property’s net losses or a combination of revenues and losses for the property during any fiscal period and (ii) the timing of payment of compensation to the service provider is not contingent on the managed property’s net losses. RP 2016-44 notes, by way of example, that a service provider whose compensation is reduced by a stated dollar amount for failure to keep the managed property’s expenses below a specified target will not be treated as bearing a share of net losses.
2. Contract Term
The term of the management contract (including all renewal terms pursuant to options exercisable unilaterally by either the Qualified User or the service provider) cannot exceed the lesser of 30 years or 80% of the expected useful life of the managed property.
3. Control of Managed Property
The Qualified User must exercise a significant degree of control over the use of the managed property. Such control will be evidenced if the management contract requires the qualified user to approve (i) annual budgets for the managed property, (ii) capital expenditures on the managed property, (iii) dispositions of assets associated with the managed property, (iv) the rates charged for use of the managed property and (v) the general nature and types of use of the managed property.
4. Damage or Destruction of Managed Property
The qualified user must bear the risk of loss upon damage or destruction of the managed property, for example as a result of a casualty such as flood or fire. However, a qualified user may impose a penalty on the service provider for failures to operate the managed property under the terms of the management contract. A qualified user also may insure against the risk of loss of the managed property through an insurer.
5. Tax Accounting
The service provider must agree that it is not entitled to and will not take any tax position that is inconsistent with its status as service provider to the qualified user with respect to the managed property. Specifically, the service provider must agree that it will not take any depreciation or amortization, investment tax credit or deduction for any payment as rent with respect to the managed property. These requirements appear to be designed to ensure that the service provider does not have significant tax law attributes of ownership of or tenancy under a leasehold in the managed property.
6. No Substantial Limitation of Qualified User’s Rights
In general, the service provider must not have any role or relationship with the qualified user that has the effect of substantially limiting the qualified user’s ability to exercise its rights under the management contract. This condition will be met if (1) not more than 20% of the aggregate voting power of the governing body of the qualified user is vested in the directors, officers, shareholders, partners, members and employees of the service provider, (ii) the governing body of the qualified user does not include the chief executive office or the chairperson (or equivalent executive) of the service provider and (iii) the chief executive officer of the service provider is not the chief executive officer of the qualified user or of any related party to the qualified user.
The preceding is a brief summary of RP 2016-44. Please contact Antonio Martini at (617) 378-4136 or any other member of Hinckley Allen’s public finance practice group if you would like more information about the management contract rules or on the limitation of “private business use” of assets financed with tax-exempt bonds, or if you have any other tax-exempt bond compliance matter you would like to discuss.