Public Finance Advisory: IRS Releases Clarifying Management Contracts Rules

by Sherman & Howard L.L.C.
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Sherman & Howard L.L.C.

For the third time in as many years, the Internal Revenue Service (the “IRS”) has issued guidance for determining whether a management contract will result in private business use for property financed with governmental or qualified 501(c)(3) tax-exempt bonds. Revenue Procedure 2017-13, released on January 17, 2017, modifies, amplifies and supersedes the management contract safe harbor provisions set forth in Revenue Procedure 2016-44 (see Sherman & Howard’s client advisory dated August 30, 2016) to address certain questions raised by the National Association of Bond Lawyers concerning certain “old school” types of compensation, the timing of payment of compensation, the treatment of the economic life of land and the methods of approving rates applicable to management contracts. This client advisory should be read in conjunction with our August 30, 2016 client advisory.

General Background

In August of 2016, the IRS released Revenue Procedure 2016-14 to provide a “more flexible and less formulaic approach” for issuers and 501(c)(3) borrowers entering into long-term management contracts for the management and operation of facilities financed with the proceeds of tax-exempt bonds. The guidance set forth in Revenue Procedure 2016-44 drastically changed the longstanding guidance set forth in Revenue Procedures 97-13. Revenue Procedure 2017-13 generally restates the entirety of Revenue Procedure 2016-44, but includes the following specific revisions and clarifications to the safe harbor provisions of the Revenue Procedure 2016-44.

  1. Types of Compensation
    • Rev. Proc. 2016-44 Safe Harbor Provision: The contract must neither provide to the service provider a share of net profits nor impose on the service provider the burden of bearing any share of the net loss from the operation or management of the financed facility.
    • Rev. Proc. 2017-13 Clarification: The new Rev. Proc. clarifies that certain types of compensation that have traditionally been blessed under Rev. Proc. 97-13 and its progeny – capitation fees, periodic fixed fees, per unit fees and some forms of incentive fees (all of which had been permitted under Rev. Proc. 97-13) do not provide a share of net losses and, accordingly, qualify for safe harbor treatment.
  2. Timing of Compensation
    • Rev. Proc. 2016-44 Safe Harbor Provision: The timing of compensation cannot be contingent on net profits or net losses arising from the operation of the managed property.
    • Rev. Proc. 2017-13 Clarification: Rev. Proc. 2017-13 clarifies that compensation subject to an annual payment requirement and reasonable consequences for late payment (such as reasonable interest or late charges) will not be treated as contingent upon net profits or net losses insofar as the contract includes the requirement that the qualified user will pay the deferred compensation within five years of the original due date of the payment.
  3. Treatment of Land
    • Rev. Proc. 2016-44 Safe Harbor Provision: Rev. Proc. 2016-44 additionally provided the term of the management contract, including the renewal thereof, cannot be greater than the lesser of 30 years or 80% of the weighted average reasonably expected economic life of the managed property. Additionally, Rev. Proc. 2016-44 provided that the economic life of property is determined under Section 147(b) of the Internal Revenue Code, without regard to Section 147(b)(3) (B)(ii), which provides that if 25% or more of the net proceeds of any issue is to be used to finance the land, such land will be taken into account and shall be treated as having an economic life of 30 years.
    • Rev. Proc. 2017-13 Clarification: Rev. Proc. 2017-13 clarifies that economic life is determined in the same manner as under Section 147(b) as of the beginning of the management contract term. Therefore, land is treated as having an economic life of 30 years if 25% or more of the net proceeds of the issue which financed the managed property is used for the purchase of land.
  4. Methods of Approving Rates
    • Rev. Proc. 2016-44 Safe Harbor Provision: Rev. Proc. 2016-44 provided that the qualified user must exercise a significant degree of control over the managed property. If the contract provided that the qualified user must approve, among other things, rates charged for the use of the managed property, this requirement was considered met.
    • Rev. Proc. 2017-13 Clarification: Rev. Proc. 2017-13 clarifies that a qualified user may satisfy the approval of rates requirement by approving a reasonable general description of the method used to set the rates or requiring that the service provider charge rates that are reasonable and customary as specifically determined by, or negotiated with, an independent third party.

Effective Date

Revenue Procedure 2017-13 applies to any management contract that is entered into on or after January 17, 2017, and may be applied to any management contract that was entered before such date. In addition, issuers may apply the safe harbor provisions of Revenue Procedure 97-13, as modified by Revenue Procedure 2001-39 and amplified by Notice 2014-67, to a management contract entered into on or before August 18, 2017 which is not thereafter materially altered.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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