Rev. Proc. 2016-44 Provides a Path for Long-Term Management Contracts with a Few New Challenges

Editor’s Note: Rev. Proc. 2016-44, discussed in this article, has now been superseded by Rev. Proc. 2017-13. An article explaining the guidance changes in the new revenue procedure will appear in the next issue of ABA Tax Times.

State and local governments have been able to issue bonds that bear interest that is exempt from federal income tax.  Those bonds, however, must meet certain conditions. If there is “private business use,” then a series of rules specific to “private activity bonds” must be taken into account in order to secure tax-exempt interest for those bonds.  Management contracts provide an instance where arrangements with service providers can result in “private business use.”  This article discusses the recent guidance in this area and highlights a number of new issues and potential pitfalls that practitioners will need to take into account when analyzing management contracts.

On August 22, 2016, the IRS released Rev. Proc. 2016-44, modified on September 2, 2016, which modifies and supersedes existing management contract guidance under Rev. Proc. 97-13, Rev. Proc. 2001-39, and section 3.02 of Notice 2014-67 (collectively, the Original Safe Harbors).¹   Rev. Proc. 2016-44 provides new safe harbor conditions for management contracts and creates a new “eligible expense reimbursement arrangement” that, if satisfied, will not result in private business use under Code sections 141 and 145.  Generally, most practitioners have treated a contract for the management of, or services provided at, bond-financed property that does not fit within the Original Safe Harbors as giving rise to private business use of the bonds for tax purposes, with the understanding that more than a de minimis amount of private business use may disqualify interest on the bonds from tax exemption.  Practitioners should be aware, however, that a number of IRS private letter rulings have concluded that various management contracts under various fact patterns that fall outside of the Original Safe Harbors nonetheless do not rise to private business use under the general facts and circumstances test of the applicable regulations.²   Although these private letter rulings cannot be relied on as precedent, they provide an indication of the IRS’s views on this matter.

With Rev. Proc. 2016-44, the IRS replaced the longstanding safe harbor formulas for management contracts under Rev. Proc. 97-13 with a universal or “one-size-fits-all” safe harbor for all management contracts and brought under the purview of the revenue procedure many of the considerations that existed previously in the facts and circumstances test of the regulations.  As a result, while many agreements that fail to qualify under the new safe harbor could also fail the facts and circumstances test, the margins of qualification under the fact and circumstances test have narrowed significantly.

Background

Under section 103(a), interest on governmental bonds generally is excluded from the gross income of the bondholder for federal income tax purposes.  However, such exclusion is denied under sections 141 and 145 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 an individual that acts 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.⁵   A nongovernmental person may enjoy 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.”⁶

Over the previous 34 years,⁷ the IRS has recognized that not all service arrangements between a governmental owner or a 501(c)(3) organization and a 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 requirements established under the Original Safe Harbors, satisfaction of which would assure that a management contract would not be treated as establishing private business use.  The Original Safe Harbors, however, have been quite narrow and overly formulaic, 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 anything but the shortest of Public-Private Partnership (P3) arrangements, essentially precluding the typical long-term design-build-finance-operate-maintain (DBFOM) method of procurement of governmental facilities.

Rev. Proc. 2016-44

Rev. Proc. 2016-44 abandons the traditional structure of a menu of management contract templates that afford safe harbor protection from private business use characterization in favor of a broader 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.  Instead of rigid parameters, it 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 profit or 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 or lease analysis.

Rev. Proc. 2016-44 generally applies to any management contract that is entered into on or after August 22, 2016. An issuer may continue to rely upon the Original Safe Harbors in evaluating any agreement entered into prior to August 18, 2017, so long as it is not materially modified or extended after that date.  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:⁸

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 and the regulatory fact and circumstances test.  For this purpose, compensation now includes payments to reimburse actual and direct expenses paid by the service provider and related administrative overhead expenses of the service provider.⁹   Under the Original Safe Harbors, this change would be problematic given the strict percentage limitations on non-fixed fee arrangements.  As discussed further below, the focus is now on the overall amount of compensation, so the concern is not whether a percentage limitation has been breached but whether the compensation as a whole results in a proprietary or net-profits type of arrangement.
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 (within the general safe harbor), a compensation arrangement may be treated as not sharing 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 its expenses for any fiscal period.  The “elements” of compensation to be considered are (i) the eligibility for compensation, (ii) the amount of compensation and (iii) the timing of compensation.  Solely for the purpose of evaluating whether the amount of compensation inappropriately considers net profits or revenues and expenses, any reimbursement of actual and direct expenses paid by the service provider to “unrelated parties” is disregarded as compensation.¹⁰   As an example, 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.
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.  A safe harbor ensures that an arrangement will not be treated as shifting 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, a compensation arrangement 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 a share of net operational losses 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 the property.  For this purpose, “economic life” is determined in the same manner as under section 147(b).  A safe harbor under existing law provides that determinations for acquired or improved property may use the property’s midpoint life under the asset depreciation range system in effect in 1984.¹¹
5. Qualified user must exercise a significant degree of control over the 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 property¹² and the general nature and type of use of the managed property.  This is a new requirement not present under the Original Safe Harbors; accordingly, any contract that is entered into, extended or otherwise materially modified should be reviewed to ensure compliance.
6. Qualified user must bear the risk of loss from 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 contracted standards.  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.
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 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.  This express written commitment is a new requirement not present under the Original Safe Harbors.  While as a practical matter a service provider under a management contract satisfying the Original Safe Harbors likely would not have been able to claim such return positions, an express contractual covenant is required under 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.  Many short-term contracts, on the other hand, probably do not contain the required language, which will need to be added if the contracts are 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.  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.

Certain of these criteria are similar to ones contained in past guidance. Under section 1.141-3 of the regulations, control over managed property and risk of loss are two of the criteria explicitly mentioned in the private business use regulations as factors that distinguish management contracts from lease agreements.  Stated differently, a management contract that conveys too much control or the risk of loss to the service provider is not eligible to meet the facts and circumstances test because it is not a management contract.  Furthermore, the ability to substantially limit a qualified user’s ability to exercise its rights is a form of control: failing that requirement could arguably cause the agreement to be considered a lease.  Although not drafted with tax-exempt bonds in mind, section 7701(e) provides certain relevant criteria to distinguish a lease from a management contract, including whether the service provider has a significant economic interest in the property.  In a 2015 letter to the IRS discussing the impact of section 141 on public/private arrangements, the Tax Section interpreted section 7701(e) and relevant case law as standing for the proposition that a “contract should be treated as a lease (as contrasted with a mere service contract), based upon . . . the operator’s ability to share in both the combined revenues and expenses of the applicable enterprise.”¹³

Eligible Expense Reimbursement Arrangement

If a management contract is an “eligible expense reimbursement arrangement,” it does not result in private business use under sections 141 and 145.  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.¹⁴

Questions Raised for Practitioners

At first blush, Rev. Proc. 2016-44 would seem to facilitate long-term variable compensation-based arrangements by for-profit contractors of bond-financed facilities.  The most notable feature of Rev. Proc. 2016-44 is that it offers safe harbor treatment to management contracts with terms as long as 30 years, provided that the compensation paid to the service provider under the terms of the contract does not have the indicia of a lease or ownership arrangement—i.e., it is reasonable and does not have a net profits component.  This represents a dramatic expansion of the safe harbor provisions of Rev. Proc. 97-13. Rev. Proc. 2016-44 thus appears conducive to investment in long-lived infrastructure, including in certain kinds of P3 projects, while providing enhanced flexibility to qualified users for all types of bond-financed projects.

Many practitioners have noted, however, that increased flexibility comes at the expense of less certainty and heightened facts and circumstances analysis.  This is necessarily the case given that the new guidance has replaced the Original Safe Harbors based on numeric parameters with a principles-based approach.  Originally, the IRS issued revenue procedures outlining the conditions to be met in order to issue an advance ruling that there was no private use with respect to certain bond-financed facilities.¹⁵   These revenue procedures focused on reasonableness of compensation and avoidance of net profit shares.  They had very short terms of no more than five years with a unilateral cancellation right held by the qualified user after two years.  The 1986 tax reforms provided a statutory directive regarding the general treatment of management contracts as not having trade or business use under similar parameters.¹⁶   Rev. Proc. 93-19 expanded the types of allowable compensation while still maintaining the touchstones of reasonable compensation and no net profits (and a term not to exceed five years).  Rev. Proc. 97-13 further liberalized the types of compensation and lengths of term with respect to management contracts, maintaining the reasonableness and ‘no net profits’ requirements. 

While each piece of new guidance liberalized rules, all of the guidance has been based on the same principles of reasonable compensation and no net profits.  The analysis seeks to distinguish those arrangements in which the service provider is merely managing the property from those in which it has some kind of proprietary, partnership or leasehold-type interest.  Rev. Proc. 2016-44 makes the principles-based analysis explicit.  While removing the restrictive bright-line requirements, it still requires a careful determination of whether the contemplated arrangement vests the service provider with the risks and rewards associated with a proprietary or leasehold-type interest.

Because the new guidance expands rather than restricts the type of compensation arrangements for management contracts, the arrangements specifically allowed under Rev. Proc. 97-13 (e.g., those based on capitation fees, per-unit fees and the like) should still be available.  Some practitioners have suggested that the IRS issue supplemental guidance explicitly stating that these prior acceptable arrangements remain valid.

Although contemplated arrangements will no longer be required to meet a specific percentage of fixed compensation, they will still need to be tested to see whether the arrangement provides a proprietary interest in the facility through the sharing of net profits or net losses or creation of a leasehold arrangement.  For example, although a 30-year management contract based entirely on a percentage of gross revenues is not explicitly disallowed by the new guidance, that arrangement might not satisfy the principles since a longer time period introduces more uncertainty and hence greater risk with respect to that uncertainty—both hallmarks of an equity interest rather than an interest as a mere service provider.  Further, consider a long-term contract in which the service provider is responsible not only for the expenses associated with the provided services but also for the facility’s insurance, taxes and utilities.  These components cause the arrangement to take on the color of a lease as opposed to a management contract (not to mention one with a net loss/net profit component). 

As the above examples illustrate, the longer the contract and the more ownership indicia there are, the more practitioners should be concerned that risk may be transferred to the service provider in a manner more in keeping with an owner, partner or lessee.  Some practitioners have expressed concerns regarding contracts that provide for a percentage of gross revenues but subordinate part of the fee to other service-provider expenses, including debt service.  In such cases, a practitioner may consider requesting revenue projections to establish that there will be sufficient revenues to pay the full management fee.  Of course, the longer the contract, the harder it will be to provide reliable projections—indeed, the IRS has considered projections beyond five years problematic.¹⁷   Perhaps this concern can be alleviated by strong contractual provisions requiring that the deferred management fee be an absolute obligation of the qualified user that must be paid after a certain relatively short period of time.  Again, the touchstone is whether the service provider is morphing into an owner/partner/lessee who is bearing the benefits and burdens of net profits and net losses.

Although this principles-based approach may provide more flexibility in crafting the terms of management contracts, there still may be areas where earlier guidance’s flexibility now falls outside of the new safe harbor guidance and necessitates a facts and circumstances analysis.  For example, there may be less flexibility in the conditions under which payments may be subordinated or deferred.  The new guidance indicates that timing of payment may not be conditioned on tests involving the managed property’s revenues and expenses for any fiscal period.  Another area of uncertainty is the application of the weighted average reasonably expected economic life of the managed property.  For example, if an issuer or tax-exempt conduit borrower entered into a 30-year contract for a 40-year property and the entity enters into a new management contract (or materially modifies the existing management contract) at the end of year 15, must it retest the remaining economic life of the managed property?  Rev. Proc. 2016-44 states that “[t]he life is determined . . . as of the beginning of the term of the contract.”  For practical application, would the new or materially modified management contract have term-length flexibility if the engineers estimate at the end of year 15 that the building has an additional 37.5 years of useful life?  Is such an estimate necessary if the safe harbor for depreciation purposes is used? Conversely, would the term length be restricted if the engineers estimate that the building will not last more than an additional 10 years, and, if so, does this mean that the entity would be unable to have a management contract during the last 20% of the project’s useful life or would the determination be 80% of the remaining economic life?  Many practitioners believe that retesting would run counter to the other rules relating to the evaluation and estimation of the useful life of a project.  However, others have pointed out that even if one cannot retest for this safe harbor, that simply means one is back to facts and circumstances; accordingly, if the new contract under the newly re-tested useful life is less than 80% of that new life, one may become comfortable with having satisfied the principles of Rev. Proc. 2016-44.

Further, section 4.03 of Rev. Proc. 2016-44 refers to “managed property” as opposed to “financed property.”  This phrasing was apparently adopted to make clear that one is not to be concerned with all the projects financed with a bond issue but only that particular part of the financed property subject to a management contract. 

Other practitioners have suggested an ambiguity in the term “unrelated parties” (discussed above).  Rev. Proc. 2016-44 states that “Unrelated parties means persons other than a related party (as defined in Section 1.150-1(b)) or a service provider’s employee.”  This could be interpreted to mean that an unrelated party would be (i) persons other than a related party (as defined in section 1.150-1(b)) or (ii) a service provider’s employee.  It could also be interpreted to mean that an unrelated party would be persons other than (i) a related party (as defined in Section 1.150-1(b)) or (ii) a service provider’s employee.  Each interpretation is reasonable, yet the outcome of the first interpretation would be markedly different than the outcome of the latter.  Practitioners have wondered why a salaried employee would be treated as something other than a pass-through expense.

Additionally, section 5.02(3)(a)(ii) of Rev. Proc. 2016-44, which prohibits the manager from bearing the losses of the operation of the facility, states that “[t]he timing of the payment of compensation is not contingent upon the managed property’s net losses.”  Practitioners are left wondering whether deferred management fees would therefore be disallowed.

Finally, practitioners have also questioned the “control over the use” requirement in section 5.04 of Rev. Proc. 2016-44, which states that the “qualified user must exercise a significant degree of control over the use of the managed property.”  At first, this requirement appears easily met, but further analysis shows it could be a problem for many common types of contracts.  The exempt person needs to either “approve the rates” or the rates charged by the manager are “reasonable and customary as specifically determined by an independent third party.”  For the typical toll roads or utility systems financings, this requirement is straightforward and should be easily satisfied.  There is some uncertainty, however, as to how this would apply to healthcare systems financings where the facilities frequently are used by specialists such as radiologists, pathologists, or pharmacists.  Further, when reviewed in the context of a hotel financing where rates change with frequency based upon a variety of ever-changing factors (i.e., business use vs. personal use, duration of the stay, size and status of the hotel), there is a concern over whether major hotel management companies would be willing to agree to have room rates determined by the local hotel owner or by an independent third party.  Indeed, such pricing algorithms tend to be proprietary and an owner would typically not be given access to an independent third party.  There is a similar concern over food services at a university.  For example, in the case of a dining hall where the service provider wishes to have control over the university’s meal plan pricing, most practitioners would likely treat this as a rate for the use of the property.¹⁸

Looking Ahead

While many practitioners may have preferred to see Rev. Proc. 2016-44 encapsulate the Rev. Proc. 97-13 safe harbor with an increase to a 30-year permitted contract term and including the Notice 2014-67 modifications, the release of Rev. Proc. 2016-44 has provided increased flexibility in many areas, perhaps decreased certainty in others, and certainly additional questions.  With some slight adjustments to the terms and provisions of existing management contracts (particularly with respect to disavowing an inconsistent tax position and indicating a significant degree of control over the managed property) and with the coupling of the facts and circumstances and the ability to define the “project” at a tailored level, Rev. Proc. 2016-44 should be a workable and beneficial change to the evaluation of what constitutes a qualified management contract. ■