Revenue Procedure 2016-44 replaces the long-standing safe harbors in Revenue Procedure 97-13 for analyzing private business use under management contracts with a more flexible safe harbor, but requires specific provisions in the management contract and introduces several new concepts into the analysis.
Many facilities owned by a governmental entity or an organization described in section 501(c)(3) of the Internal Revenue Code of 1986, as amended (each a “qualified user”), are financed through tax-exempt bonds. There are significant restrictions on the amount of “private business use” (i.e., generally use by a for profit entity) that can be made of such tax-exempt bond financed facilities. Management contracts that a qualified user may enter into with a service provider for a facility financed by tax-exempt bonds (a “managed property”) can give rise to such private business use. Internal Revenue Service (IRS) Revenue Procedure 97-13 (together with certain updates and related guidance) has been the long-standing guidance from the IRS for management contracts that do not create private business use. It sets forth safe harbors specifying maximum contract lengths, cancellation provisions and types of compensation permitted under each length contract; generally, the longer the term of a contract, the less variable compensation permitted, and compensation taking into account both revenues and expenses of the managed property is also generally not permitted.
In contrast, Revenue Procedure 2016-44 takes a more flexible approach, looking at the overall relationship under a management contract between the qualified user and the service provider. Classification of contracts by length and compensation as fixed or variable is eliminated, and the maximum contract length is extended to up to 30 years. Revenue Procedure 2016‑44 adds a requirement for certain specific agreements by the service provider to be in the management contract. Also, certain elements of Revenue Procedure 2016-44, such as the requirement that compensation be reasonable, are new, not specifically defined, and subject to further interpretation.
In particular, Revenue Procedure 2016-44 requires that:
Compensation Must Be Reasonable. Payments to the service provider under the contract must be reasonable compensation for services rendered during its term, including payments to reimburse actual and direct expenses paid by the service provider and its related administrative overhead expenses.
Service Provider Must Not Share in Net Profits. The service provider must not have a share of net profits from the managed property. Compensation to the service provider does not provide a share of net profits if no element of the compensation (eligibility for, amount of, and timing of payment) takes into account, or is contingent upon, either the managed property’s net profits or both its revenues and expenses for any fiscal period. Reimbursements of actual and direct expenses paid by the service provider to unrelated parties are disregarded.
Service Provider Must Not Bear Risk of Net Losses. The service provider must not bear the risk of net losses from the managed property. Compensation to the service provider does not provide a share of net losses if (i) it and the amount of any unreimbursed expenses paid by the service provider, separately and collectively, do not take into account either the managed property’s net losses or both its revenues and expenses for any fiscal period and (ii) timing of payment is not contingent upon the managed property’s net losses.
Maximum Term. The term of the contract, including all renewal options, is no greater than the lesser of 30 years or 80 percent of the weighted average reasonably expected economic life of the managed property.
Control by Qualified User. The qualified user must exercise a significant degree of control over the use of the managed property. This may be met by requiring the qualified user to approve, with respect to the managed property, its annual budget, capital expenditures, disposition of property, rates charged, and its general nature and type of use. Control of rates may be established by requiring that they are reasonable and customary (as specifically determined by an independent third party).
Qualified User has Risk of Loss of Managed Property. The qualified user must bear the risk of loss upon damage or destruction of the managed property.
No Inconsistent Tax Position. The service provider must agree that it is not entitled to and will not to take any tax position that is inconsistent with its role as a service provider for the managed property (such as claiming depreciation or amortization, investment tax credit or deduction for rent payments with respect to the managed property).
No Limitation on Exercise of Rights. The qualified user’s ability to exercise its rights under the contract, based on all the facts and circumstances, must not be limited by any role or relationship of the service provider with the qualified user. A service provider will not be treated as having such a role or relationship if: (i) the governing body of the qualified user (a) in the aggregate has no more than 20 percent of its voting power in the directors, officers, shareholders, partners, members, and employees of the service provider and (b) does not include the service provider’s chief executive officer or the chairperson (or equivalent executive) of the service provider’s governing body; and (ii) the service provider’s chief executive officer is not the chief executive officer of the qualified user (or any related party).
In addition to management contracts meeting the above provisions, under Revenue Procedure 2016-44, a management contract does not give rise to private business use if it only provides for reimbursements of actual and direct expenses paid by the service provider to unrelated parties and reasonable related administrative overhead expenses of the service provider.
Revenue Procedure 2016-44 applies to any management contract that is entered into on or after August 22, 2016, and may be applied to any management contract entered into before then. To provide for a transition for existing contracts, the safe harbors in Revenue Procedure 97-13 (and related guidance) may be applied to a management contract that is entered into before August 18, 20171 that is not materially modified or extended on or after such date (other than pursuant to a renewal option). If a management contract subject to Revenue Procedure 2016-44 is materially modified with respect to any matters relevant to Revenue Procedure 2016-44, it is retested as a new contract as of the date of the material modification.
