WASHINGTON — The American Bar Association’s taxation section has sent a letter to the Internal Revenue Service and the Treasury Department urging them to update their rules and guidance on management contracts, which are important in determining that certain governmental and 501(c)(3) bonds remain tax-exempt and are not private-activity bonds.
The group made the request in a 19-page letter sent to the two agencies last week, after several years of deliberation on the issue. It comes one week after the National Association of Bond Lawyers sent a similar letter to the IRS and Treasury.
The ABA group said it made recommendations that would permit broader spectrum of agreements. Some of the IRS’ rules and guidance on management contracts were issued nearly three decades ago. Both the ABA taxation section and NABL are seeing some of the same areas of confusion arise and believe they should be updated to reflect current business practices.
“We just wanted to make sure that the recommendations given were doable and didn’t ask for a complete overhaul of the whole process and structure,” said Christie Lombard Martin, vice chair of the taxation section’s committee on tax-exempt financing and co-author of the letter. “We are just trying to work with the rules that have been there for years and make them more flexible.”
The ABA group made a total of 10 recommendations for how the two agencies could update their rules and regulations. “We’re hopeful that this [letter] will lead to some positive changes,” Lombard Martin said.
If the IRS finds that a management contract results in too much private use of a bond-financed facility, it could rule that the bonds are private-activity bonds that are taxable since they do not meet the private use test. Bonds are PABs if more than 10% of the proceeds are used by private parties or more than 10% of the payments for debt service are made by private entities. PABs are not tax-exempt unless they fall within certain “qualified” categories.
One of the ABA group’s top concerns is that the contract terms and termination provisions should be clarified. Current guidelines say that in order for management contracts not to result in private business use, they must satisfy certain compensation requirements and be in the form of one of six arrangements. In addition, “the service provider must not have any role or relationship with the qualified user that substantially limits the qualified user’s ability to exercise its right.”
The ABA group suggests removing any need for a termination right without a penalty. It also requests defining the “contract term” so that it means a period from the effective date of the contract to its stated end date.
For example, a five-year contract that can be terminated at the end of three years at the option of the qualified user is effectively a three-year contract, the ABA group said. There should be no difference between a three-year contract with an option to extend for two years and a five-year contract with an option to terminate at the end of three years, the group said.
Another concern is that the current guidance provides safe harbors for contracts with two-year and three-year terms but has different criteria for each in order to comply with tax law. If a contract meets the criteria under the safe harbors then it would it be considered to give rise to private use.
“Confusion has arisen among practitioners regarding the different requirements of these safe harbors,” the ABA group wrote. It proposed that the IRS combine them into a single three-year safe harbor that would be applicable in all cases where the long-term safe harbor provisions would not apply.
“There is so much complexity in the short-term safe harbors right now that it isn’t adding anything to the analysis,” Lombard Martin said. “You can get to the same place by adding a simpler safe harbor.”
The group also asks the IRS to recognize that management contracts include both incidental, non-incidental services and that when multiple services are included in one contract, they be analyzed under the safe harbors separately where the payment terms and the termination provisions are clearly severable.
The ABA also asked that the guidelines be clarified for incidental services not considered management contracts that give rise to private business use, such as food service in a cafeteria, to include a wider range of services.
