New Guidelines for Private Management Contracts

In a move that should help facilitate public-private partnerships ("P3s"), the Internal Revenue Service has issued new 'safe harbor' guidelines for private management contracts involving bond-financed municipal assets. Revenue Procedure 2016-44, issued August 22, 2016, greatly expands on the safe harbor provisions originally outlined in Revenue Procedure 97-13, under which certain private management contracts would not result in private business use of projects that were financed with the proceeds of tax-exempt governmental or qualified 501(c)(3) bonds.

Revenue Procedure 97-13, which many considered to be too restrictive as P3s have grown in popularity, outlined various compensation formulas based on the length of the term of a service agreement. Under Revenue Procedure 97-13, the compensation of a provider of management or other services had to be reasonable and could not, in any event, be based in any part on a share of net profits. Several compensation structures were permissible under Revenue Procedure 97-13, which allowed for progressively longer contract terms that corresponded with progressively larger percentages of fixed fee arrangements. Under Revenue Procedure 97-13, a private management contract of up to 10 years would require at least 80 percent of the manager's annual compensation to be based on a fixed fee. Fifteen-year contracts would require at least 95 percent of the annual compensation be based on a fixed fee.

These provisions were implemented to help municipalities and other public entities entering into P3 and other infrastructure transactions to avoid jeopardizing the tax-exempt status of bonds if a tax-exempt financed project would involve private management. Given the duration of most P3 transactions, however, many in the industry felt these safe harbor provisions were inadequate.

Revenue Procedure 2016-44 addresses some of the industry's concerns. While this new procedure still requires compensation for management services to be "reasonable" and not based on a share of net profits, it does allow for a longer contract term of the lesser of 30 years or 80 percent of the weighted average reasonably expected economic life of the managed property. It also aims for a "more flexible and less formulaic approach toward variable compensation for longer-term management contracts," allowing for "any type of fixed or variable compensation that is reasonable compensation for services rendered under the contract." In addition, the revised safe harbors are effective for any management contract that is entered into on or after August 22, 2016, and an issuer may apply the revised safe harbors to any management contract that was entered into before August 22, 2016.

While Revenue Procedure 2016-44 eliminates restrictions regarding contract length and fixed compensation, it does impose other restrictions. For example, the new safe harbor provisions require that a service provider cannot bear the burden of any net losses from the operation of a managed property. In addition, a qualified user, such as a municipality, must bear the risk of loss due to damage or destruction of a managed property, and the qualified user must demonstrate a significant degree of control over the use of a managed property.

Notwithstanding these requirements, with the elimination of restrictive term limits and fixed compensation requirements, Revenue Procedure 2016-44 should enhance the ability of municipalities and other public entities to enter into P3 transactions. That said, any interpretive guidance issued by the IRS going forward should be monitored.

If you would like to learn more, please contact PLDW Principal Teno A. West and Senior Counsel William A. Lawrence at (914) 898-2400 or email twest@pldw.com or wlawrence@pldw.com. We welcome your comments, questions and suggestions.

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