Some Lawyers Have Questions About New Management Contract Safe Harbors

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WASHINGTON – While the Internal Revenue Service's revenue procedure on management contracts received widespread praise from many bond and tax lawyers who felt it would help facilitate bond financing in public-private partnerships, several attorneys also had questions or concerns about it.

Rev. Proc. 2016-44, released by the IRS on Monday, contains safe harbors for long-term management contracts of up to 30 years from the previous 15-year limit and also removes the formulaic fixed fee requirements for manager compensation.

The new safe harbor under which a management contract does not result in private business use allows for the contracts to be more accessibly used in funding bond-financed infrastructure projects and public-private partnerships as well as for more incentive-based compensation.

Dave Caprera, an attorney with Kutak Rock in Denver, said the revenue procedure is "simpler, [and] easier to understand and apply" than the prior one. He felt the previous formulaic approach involving fixed fees under Rev. Proc. 97-13 released in 2013 was ineffective in addressing compensation and term length. The new safe harbors allow longer-term contracts for long-lived projects and short-term contracts for short-lived assets as long as the compensation is reasonable and not tied to profits or losses.

"The deal guys in my office are partying in the hallway," he said.

Still, Caprera wanted to know if the term or economic life of a contract is retested when a contract is modified or a new contract is entered into.

The new revenue procedure adopts the existing tax law that treats a term which exceeds 80% of the reasonably expected economic life of a facility as being the equivalent of ownership.

"So, I have a 40-year property and I entered into a 30-year contract," Caprera said hypothetically. "But the contract is terminated at the end of 15 years. I want a new contract. Can it be 30 years? 20 years, something else? What if the property is in bad repair and is only going to last 10 more years?"

Section 5.03 of the new revenue procedure under "Term of the Contract and Revisions" states that, "[a] contract that is materially modified with respect to any matters relevant to this section 5 is retested under this section 5 as a new contract as of the date of the material modification."

The new revenue procedure amends Rev. Proc. 97-13, which provided safe harbors under which a contract of up to 10 years would require at least 80% of the manager's annual compensation to be based on a fixed fee. Fifteen-year contracts under Rev. Proc. 97-13 required at least 95% of annual compensation to be based on a fixed fee.

The new guidance will supersede the safe harbors under Rev. Proc. 97-13, which Michael Bailey, a partner with Foley and Lardner in Chicago, said will "raise many questions regarding whether certain contracts that were within the Rec. Proc. 97-13 safe harbors will continue to be within the new safe harbors."

The new rules generally require state or local governments to control rates, but many contracts under the existing safe harbors do not have that requirement, Bailey said. A major example of this is the separate billing arrangements that are often used in hospital management contracts.

Section 7 of the revenue procedure states that the new safe harbors apply to any "management contract that is entered into or after Aug. 22, 2016 and an issuer may apply these safe harbors to any management contract that was entered into before Aug. 22, 2016."

But it adds that issuers also have the option of applying the safe harbors in Rev. Proc. 97-13 "to a management contract that is entered into before Feb. 18, 2017 and that is not materially modified or extended on or after [that date]."

"For contracts entered into after that date, there could be problems," Bailey said.

While the new guidance is more liberal than Rec. Proc. 97-13 in some cases, such as long-term management contracts for public infrastructure projects, it is "not necessarily true in many other cases," Bailey said.

He called this a "major issue" that he said will likely need to be addressed in comments submitted to the IRS and the Treasury Department.

Scott Lilienthal, a partner at Hogan Lovells in Washington, said on Wednesday that the new rules are helpful in allowing longer terms and greater flexibility for variable compensation, but had a similar analysis as Bailey.

"The revenue procedure also introduces some new conditions, such as requiring a certain amount of control over the managed facility by the qualified user, and it may take some time to see whether those new conditions may be problematic when applied to specific types of agreements," Lilienthal said.

The new revenue procedure includes several requirements that must be met under a safe harbor in order for a management contract to avoid resulting in private business use. Similar to 97-13, payments cannot be based on a share of net profits.

But the procedure also includes three new requirements to ensure there is no private ownership or lease of a project. A state or local government "must exercise a significant degree of control of the use of the managed property" and "must bear the risk of loss upon damage or destruction of the managed property." In addition, the private party "must agree that it is not entitled to, and will not take any tax position that is consistent with the state or local government with respect to the managed property. The private party must not take any depreciation or amortization, investment tax credit, or deduction for any rent payment for the property.

Christie Martin and Maxwell Solet, attorneys with Mintz Levin in Boston, said that Rev. Proc. 2016-44 "substantially increases flexibility" for an issuer to work with private parties without jeopardizing the tax-exempt status of bonds.

In a post published on the firm's website Wednesday, Martin and Solet wrote, "The overall impact of Rev. Proc. 2016-44 would seem to be an increase in the ability of bond issuers and tax-exempt users of bond-financed facilities to use for-profit contractors at bond-financed facilities. However, practitioners have already noted that the increased flexibility comes with less certainty and more facts and circumstances analysis with respect to many aspects of the safe harbor."

"One area in which flexibility may be diminished is in the conditions under which payments may be subordinated or deferred, as the guidance indicates that timing of payment may not be conditioned on tests involving both the managed property's revenues and expenses for any fiscal period," they added.

Several other bond attorneys also told The Bond Buyer on Monday that it is clear the IRS and Treasury listened to industry concerns in constructing the new rules, which they said will foster more public-private partnerships.

Many market participants felt the prior rules were too restrictive regarding their ability to use tax-exempt bonds to help finance P3s, where private parties join with state or local governments to develop infrastructure projects under long-term management contracts.

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