WASHINGTON - The Treasury Department and Internal Revenue Service should create guidance to facilitate the development of public-private partnerships, the tax-exempt financing committee of the American Bar Association's taxation section recommended.
The group made its recommendations in comments sent to Treasury and IRS officials on Friday.
The recommendations are designed to create rules that would prevent P3 arrangements from giving rise to private business use and that would also be consistent with current law, said Carol Lew, a shareholder at Stradling Yocca Carlson & Rauth in Newport Beach, Calif. who had principal responsibility for preparing the comments. The suggestions "provide more workable safe harbors in light of existing structures out there," she said.
Under federal tax law, no more than 10% of the proceeds of tax-exempt governmental bonds can be used for private business use and no more than 10% of the debt service can be paid for, or secured by, private parties or the bonds become private-activity bonds. PABs are only tax-exempt if they are used to finance projects that fall within certain specified categories. For 501(c)(3) nonprofit bonds to be tax-exempt, the thresholds for the private business use and private payments tests are lowered to 5%. Service contracts can give rise to private business use "based on all the facts and circumstances," and private business use includes contracts that base compensation on a share of the net profits.
During the time since the private business use law and rules were created, arrangements relating to providing and operating public infrastructure have changed, and the demand for infrastructure improvements has exceeded the amount of public funding available to finance projects. State and local governments and nonprofits are entering into P3 arrangements under which private companies "can be involved in the design, construction, operation and maintenance in a manner that achieves the best, and in the appropriate circumstance, most cost-effective result," the committee wrote. The federal government is trying to encourage the use of P3s.
In one of the most common types of P3, the government or nonprofit compensates the private partner through "availability payments." The government or nonprofit commits to make predetermined periodic payments to the private partner if the construction has been completed according to required specifications and the project is available for use at agreed upon service levels. The operating portion of the arrangement is often 20 to 50 years.
In order for P3s to be implemented successfully when projects are financed with tax-exempt governmental or 501(c)(3) bonds, the current rules governing contractual arrangements between the governmental or nonprofit owners of projects and the for-profit contractors need to be "clarified and amplified" to allow longer-term arrangements, the committee wrote. While tax-exempt PABs bonds could be used for some types of P3 transportation facilities, these financings tend to be more expensive, time consuming and complicated, according to the committee.
Under an existing safe harbor, service contracts don't create private business use if the term of a contract with a private operator is the lesser of 10 years or 80% of the economic life of the project in connection with arrangements that are at least 80% based on fixed fees. Under another safe harbor, contracts could be the lessor of 15 years or 80% of the economic life of the project in connection with arrangements that are at least 95% based on fixed fees. For certain public utility property, contracts can be up to 20 years or 80% of the economic life of the project without giving rise to private business use.
Existing safe harbors permit compensation based on stated amounts, periodic fixed fees, capitation fees, per-unit fees and a percentage of either gross revenues or expenses but not both. However, these types of fees may not reflect the payment methods of certain types of P3s.
The committee recommends that Treasury and the IRS create a new safe harbor, which at a minimum would state that contracts wouldn't give rise to private business use if they were the lesser of 30 years or 80% of the useful life of the facility, with a flexible compensation structure. These guidelines would help governments and nonprofits "in providing potentially higher quality capital improvements at a lower cost," the committee wrote.
Longer-term arrangements whose compensation is not based on net profits should not give rise to private business use "given the economic substance of some P3 models … with governmental (or 501(c)(3) organization) ownership and control over the applicable facilities," the committee said. In these models, the contractor is neither a lessee nor a proprietor of the bond-financed facility. Instead, it's an agent of the government or nonprofit, even if the term of the contract is longer than 15 years.
Also, P3 arrangements should not result in private business use "provided the compensation methodology is reasonable, reflects current market practices for P3 models, and does not result in a net profits arrangement," the committee wrote. "The key for determining whether an operational arrangement constitutes private business use should be whether the operator has the benefits and burdens of ownership of the tax-exempt bond financed portion of the facility, including bearing the cost of capital and serving as a proprietor over such business - as opposed to merely being paid a fee for services provided to the [government or nonprofit] user," it wrote.
The committee also recommended that Treasury and the IRS create a second new safe harbor that would permit governmental or 501(c)(3) bonds to finance some of a P3 facility that is also being funded with private equity.
"Because of the variety of P3 models presently contemplated and encouraged by the federal government, we believe that changing the safe harbors for service contracts, without [going further], will likely not address many arrangements that nonetheless should not be viewed as giving rise to private business use," the committee wrote. For example, there are some P3s where the private party who agrees to build and operate the facility also provides private financing for some of the construction cost and is paid a return on its investment from a percentage share of residual receipts.
The committee pointed out that the IRS has been willing in the past "to address situations where private involvement is a necessary or important factor in fulfilling a governmental entity's purposes and where the private participant is not otherwise receiving the benefits of tax-exempt financing."
Last year, the IRS created a safe harbor under which a governmental or nonprofit bond-financed hospital participating in certain accountable care organizations would not have private use as long as several conditions are met. ACOs are arrangements between hospitals and other health care organizations to manage and coordinate care for Medicare patients.
Like ACOs, P3s are intended to facilitate quality service at the lowest practicable cost. "Consequently, we believe that a safe harbor, comparable to that provided for ACOs, is appropriate for P3 models where there is no transfer of the benefits of tax-exempt financing to a private person, even if a joint venture is created," the committee wrote.
The committee recommended that an arrangement should not give rise to private business use if four criteria are met. The first is that the arrangement is determined in advance, in writing, with market rate terms. The second is that the contractor be compensated at an amount no greater than fair market value, regardless of whether tax-exempt financing is used. The third is that the arrangement does not shift losses to the governmental or nonprofit user in excess of its pro rata interest in the facility. And the fourth is that the government or nonprofit's share of benefits derived from the P3 transaction is at least proportional to its contribution.
