New IRS Rules Allow Long-Term Management Agreements for Public Facilities Without Losing Favorable Tax-Exempt Financing


January 20, 1997

 

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State and local governments generally are allowed to issue bonds to finance publicly-owned infrastructure projects, with the interest on those bonds being exempt from federal income tax.  As a result, the interest rate on such bonds is lower than for other taxable kinds of financing.  However, in certain situations the bonds may be deemed to be "private activity bonds" and become subject to a number of restrictions and special rules that affect their availability and whether the interest on the bonds will be tax-exempt. 

The principal way in which a bond becomes a private activity bond, in the infrastructure arena, is for there to be "private business use" of the facility which was financed.  This will occur, for example, when the facility is owned by or leased to a private party.  The government agency generally can enter into a management agreement with a private party for the management of the facility, without causing the bonds to become private activity bonds. 

However, the IRS traditionally has imposed restrictions on the terms and conditions of these management agreements in order to ensure that they do not have an effect similar to the ownership or lease of the facilities by the private manager.  The most significant restriction has been a five year limitation on the term of such agreements.  These restrictions have limited the utility of management agreements as a means of implementing cost-saving privatization measures for public facilities.
 

The New Rules

The new rules provide that a management agreement "may" give rise to private business use of the financed property, based on all of the facts and circumstances.  In particular, the regulations state that such private business use "generally" results if the compensation under the agreement is based, in whole or in part, on a share of the net profits of the facility.  Rev. Proc.  97-13 confirms that the following generally are not considered to result in compensation based on net profits: (i) payments based on a percentage of gross revenues or gross expenses (but not both); (ii) capitation fees such as periodic fixed amounts paid for each customer; (iii) per-unit fees, such as fees based on a unit of service performed; and (iv) "productivity awards" equal to a stated dollar amount based on increases or decreases in gross revenues, or reductions in total expenses (but not both). 

The most important change is in the allowable term of the agreement.  If the manager's compensation is reasonable and not based on net profits, and the manager is not related to the government agency, the management agreement generally will not affect tax exempt bonds used to finance a facility if the term of the agreement is limited as follows, with respect to the kind of compensation indicated.  Revenue Procedure 97-13 has a glitch in the reference to public utility property which we understand the IRS intends to fix in subsequent guidance.  Once fixed, the special rule allowing 20-year terms should apply to most kinds of government-owned utility systems.
 

Compensation Method	Maximum Term of Agreement
At least 95% of the annual compensation is a periodic fixed fee.	Lesser of (i) 80% of the useful life of the facility, or (ii) 15 years (20 years in the case of public utility property once the IRS fixes Rev. Pro 97-13).
At least 80% of the annual compensation periodic fixed rate.	Lesser of (i) 80% of the useful life of the facility, or (ii) 10 years (20 years in the case of public utility property once the IRS fixes Rev. Proc 97-13).
Either (i) at least 50% of the annual compensation is a periodic fixed fee, or (ii) entirely a capitation fee or combination of capitation and a periodic fixed fee.	5 years, with the government agency being allowed to terminate the agreement on reasonable notice, without penalty or cause, at the end of 3 years.
Either (i) entirely a per-unit fee, or (ii) entirely a per-unit fee and a periodic fixed fee.	3 years, with the government agency being allowed to terminate the agreement on reasonable notice, without penalty or cause, at the end of 2 years.
Either (i) a percentage of fees charged, or (ii) a combination of a per-unit fee and a percentage of revenues or expense fee, but only if the service provider primarily provides services to third parties (such as in a radiology clinic), or the contract applies to a startup period when it is difficult to estimate the annual amount of gross revenues and expenses.	2 years, with the government agency being allowed to terminate the agreement on reasonable notice, without penalty or cause, at the end of the first year.

Effective Dates

The new regulations generally are effective for bonds issued after May 16, 1997, and the revenue procedure is effective for management agreements entered into, materially modified or extended after that date.  However, agencies may elect to apply the rules to bond issues and management agreements entered into before that date.  As a result, the new rules will apply in structuring management agreements for both new and existing tax-exempt bond financed projects in a manner which avoids the limitations of the private activity bond rules.
 

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For more information about the issues covered in this report, please contact Paul Berning in our San Francisco office at 415-848-4996 or at paulberning@howrey.com or contact your Howrey attorney. For more information about Howrey's Construction Practice Group, click here.

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