Earlier this summer, we blogged about recent developments and proposals in Washington designed to encourage P3s, including indications from the IRS that it would publish further guidance on management contracts with respect to tax-exempt bond-financed governmental facilities. In August, the IRS delivered on this promise with guidance that expands private developers’ ability to enter into certain types of long-term facility management agreements — including those involving P3s — on projects that are financed with tax-exempt bonds, without jeopardizing the bonds’ tax-exempt status.
State and municipal agencies finance many infrastructure projects by issuing tax-exempt bonds, but these types of bonds generally cannot be used to develop facilities that will be subject to private use. Clearly, the ownership and leasing of property constitutes private use but private management of bond-financed property could also fall under this category. Specifically, the federal tax regulations stipulate that a management contract that provides for compensation to a private service provider or manager based on a share of net profits from a facility’s operations constitutes private use.
To further clarify this issue, the IRS provided guidance, Rev. Proc. 97-13, which established the original safe harbors for contract terms that would not result in private use. For example, the original safe harbors permit management contracts of up to 15 years if at least 95 percent of the compensation consists of a periodic fixed fee and contracts of two to five years if the highest percentage of compensation consists of variable fees, based on the type of fee.
A couple of years ago, the IRS expanded these safe harbors in Notice 2014-67, which allows for a broader range of variable compensation arrangements covering shorter-term management contracts with terms up to five years. Such variable compensation may include a percentage of gross revenues or expenses of a facility, but not both revenues and expenses.
In August, the IRS issued Rev. Proc. 2016-44, which, the agency explains, “builds upon the amplifications in Notice 2014-67 by taking a more flexible and less formulaic approach toward variable compensation for longer-term management contracts of up to 30 years.” Under Rev. Proc. 2016-44, a management contract will not result in private use if the following conditions are met:
- The payments to the service provider are reasonable, the contract does not provide the service provider with a share of net profits from the managed property and the service provider does not bear the burden of net losses from the managed property;
- The term of the contract does not exceed 30 years or 80 percent of the economic life of the managed property, whichever is less;
- The governmental entity continues to exercise a significant degree of control over the managed property’s use;
- The governmental entity continues to bear the risk of loss with respect to the managed property;
- The service provider agrees that it is not entitled to and will not take any tax position that is inconsistent with being a service provider (e.g., will not take depreciation or amortization or an investment credit with respect to the managed property); and
- The service provider does not have any role or relationship with the governmental entity that would substantially limit the governmental entity’s ability to exercise its rights under the contract.
These new rules are similar in some ways to the safe harbor for leases and management contracts with respect to projects financed with tax-exempt private activity bonds that must be governmentally owned. Examples of such facilities include airports and mass transit systems. Under that safe harbor, the lease or management contract term may not exceed 80 percent of the economic life of the project and the private service provider or manager must not claim depreciation or an investment credit with respect to the project.
The new guidance does raise a few questions, such as how a tax-exempt bond issuer should demonstrate that it maintains sufficient control over the managed property. However, the longer 30-year term and more flexible compensation arrangements Rev. Proc. 2016-44 permits should help to facilitate more P3s, especially with respect to larger, tax-exempt bond-financed infrastructure projects.Michael J. Bradshaw, Jr.