03 June 2016 Bond issuer's contract with hotel manager will not result in private business use In PLR 201622003, the IRS has ruled that a management contract between a bond issuer and an unrelated manager of the bond-financed hotel will not result in private business use, despite the contract including a fee contingent, in part, on a variation of net profits and a term that exceeds five years. Issuer plans to use the proceeds of Bonds to finance a hotel. Issuer has a contract with Manager, an unrelated party, to manage the hotel for more than five years. In compensation, Manager will receive a base fee equal to a percentage of the hotel's gross revenues. Manager will also receive an incentive fee equal to an additional percentage of the hotel's gross revenues in any year in which the hotel meets both a "RevPAR Test" (comparing the hotel's per-room revenue to comparable hotels) and a "Margin Test" (comparing the hotel's adjusted revenue margin to a fixed percentage). Under Section 103(a), gross income does not include interest on any state or local bond. Section 103(b)(1) provides, however, that Section 103(a) will not apply to any private activity bond that is not a "qualified bond" under Section 141. Section 141(a) defines "private activity bond" as any bond issued as part of an issue that: (1) meets the private business use test of Section 141(b)(1) and the private security or payment test of Section 141(b)(2); or (2) meets the private loan financing test of Section 141(c). Under Section 141(b)(1), an issue generally meets the private business use test if more than 10% of the proceeds of the issue are to be used for any private business use. Section 141(b)(6) defines "private business use" for purposes of Section 141(b), as use (directly or indirectly) in a trade or business carried on by any person other than a governmental unit. Revenue Procedure 97-13, as modified by Revenue Procedure 2001-39 and amplified by Notice 2014-67, provides conditions under which a management contract does not result in private business use under Section 141(b). If a management contract fails to meet such conditions, the determination of whether the contract will result in private business use will depend on all the facts and circumstances surrounding the subject arrangement. Section 5 of Revenue Procedure 97-13 sets forth requirements for a management contract to not be treated as resulting in private business use. Specifically, Section 5.02(1) requires the management contract to provide for reasonable compensation for services rendered, with no compensation based, in whole or in part, on a share of net profits from the operation of the facility. Section 5.02(2) specifies the certain types of compensation that are not considered to be based on a share of net profits. Under Section 5.02(2), compensation is generally not considered to be based on a share of net profits if it is based on: (a) a percentage of gross revenue (or adjusted gross revenues) of a facility or a percentage of expenses from a facility, but not both, (b) a capitation fee, or (c) a per unit fee. Section 5.02(3) clarifies that certain productivity rewards will generally not cause the compensation to be based on a share of net profits. Section 5.03 of Revenue Procedure 97-13 sets forth seven permissible arrangements (Section 5.03(1)-(7)) that satisfy the requirements of Section 5 of the revenue procedure. In one of the permissible arrangements, found in Section 5.03(7) (added by Notice 2014-67), all of the compensation for services: (1) is based on a stated amount, periodic fixed fee, a capitation fee, a per-unit fee or a combination of the preceding, and (2) may include a percentage of gross revenues, adjusted gross revenues or expenses of the facility, but not both revenues and expenses. In addition, under the arrangement in Section 5.03(7), the term of the contract cannot exceed five years, including renewal options, but also does not need to be terminable by the qualified user prior to the end of the term. The IRS determined that the management contract between Issuer and Manager does not meet the requirements of Section 5 of Revenue Procedure 97-13. Accordingly, whether such contract will result in private business use of the hotel depends on all the facts and circumstances. Nonetheless, the IRS stated that the factors in Section 5 of Revenue Procedure 97-13 continue to serve as a guide for such a determination. The IRS noted that Manager's base fee is based on a percentage of gross revenue of the hotel, which — unlike a fee based on net profit — generally does not result in private business use. The IRS noted that the Manager's incentive fee is also set as a percentage of revenue; however, the incentive fee is contingent, in part, on the Margin Test, which is a variant of net profits. The IRS concluded that, while triggered in part by a variant of net profits, the incentive fee does not rise and fall relative to the hotel's net profits. Moreover, its application is further contingent on the RevPAR test, which is not related to net profits and is based entirely on revenues. Based on these facts and circumstances, the IRS determined that the incentive fee is not based on a share of net profits for purposes of the application of the private business use test. The IRS further stated that, with the exception of having a term of greater than five years, the management contract closely resembles the permissible arrangement described in Section 5.03(7) of Revenue Procedure 97-13. The IRS added that it considers such longer term reasonable under the facts and circumstances. Generally, to avoid private business use in these type of management contracts, the terms of the contract need to fall within one of the seven permissible arrangements described in Revenue Procedure 97-13 as amplified by Notice 2014-67. In PLR 201622003, the IRS analyzes the management contract in question under the applicable section of Revenue Procedure 97-13, which permits compensation in management contracts to be based on stated amounts or certain fees and may include a percentage of gross revenue provided that the term does not exceed five years. Because the management contract in question exceeded five years, it did not meet the applicable requirements of the revenue procedure. Yet under the facts and circumstances test of Treas. Reg. Section 1.141-3(b)(4)(i), the IRS determined that the management contract did not result in private business use. Using Revenue Procedure 97-13 as a reference, the IRS concluded that because the management contract at issue so closely resembled the arrangement described in Section 5.03(7), it would not result in private business use. The IRS noted that the only feature of the management contract that deviated from the permissible management contract described in Section 5.03(7) of Revenue Procedure 97-13 was its term, which exceeded five years. PLR 201622003 illustrates that municipal bond issuers that provide hotel financing may have a management contract with both a base fee and incentive fee that does not squarely meet the conditions of Revenue Procedure 97-13 but may still be found, under a facts and circumstances analysis, not to give rise to private business use, provided that such fees are not based on a percentage of net profits. — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.
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