29 August 2016 IRS revises safe harbor procedures relating to private business use of tax-exempt bond financed property In Revenue Procedure 2016-44, the IRS has set forth new safe harbor procedures (the New Safe Harbor) under which a management contract does not result in private business use of property financed with governmental tax-exempt bonds under Section 141(b) or cause the modified private business use test under Section 145(a)(2)(B) to be met for property financed with qualified 501(c)(3) bonds. 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) generally 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. Under Treas. Reg. Section 1.141-3(b)(4)(i), a management contract with respect to financed property may result in private business use of that property, based on all of the facts and circumstances. Section 141(e) provides a "qualified bond," includes in part, qualified 501(c)(3) bonds meeting certain requirements. Section 145(a) defines a "qualified 501(c)(3) bond" as any private activity bond issued as part of an issue if: (1) all property, which is to be provided by the net proceeds of the issue, is to be owned by a 501(c)(3) organization or a governmental unit; and (2) such bond would not be a private activity bond if — (A) 501(c)(3) organizations were treated as governmental units with respect to their activities that do not constitute unrelated trades or businesses, determined by applying Section 513(a), and (B) Section 141(b)(1) and (2) were applied by substituting "5%" for "10%" each place it appears and by substituting "net proceeds" for "proceeds" each place it appears. Revenue Procedure 97-13, as amended 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). The previous IRS guidance also applies to determinations of whether a management contract causes the test provided in Section 145(a)(2)(B) to be met for qualified 501(c)(3) bonds. The requirements for a management contract to not be treated as resulting in private business use were originally set forth in Section 5 of Revenue Procedure 97-13. Specifically, Section 5.02(1) provides that the management contract 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 certain types of compensation that are not considered to be based on a share of net profits. Section 5.02(3) clarifies that certain productivity rewards will generally not cause management contract compensation to be based on a share of net profits. Finally, Section 5.03 sets forth six permissible arrangements (Section 5.03(1)-(6)) that satisfy the requirements of Section 5 of the revenue procedure and therefore not cause a management contract to result in private business use. In Notice 2014-67, the IRS issued interim guidance on whether governmental entities or 501(c)(3) organizations will be considered to have private business use of their tax-exempt bond financed facilities due to their participation in accountable care organizations in connection with the Affordable Care Act, as well as guidance on management contracts that will not result in private business use. Effectively, Notice 2014-67 consolidated the multiple safe-harbors from Revenue Procedure 97-13 into one, which required no more than a five-year term (with no early termination requirement) and retained the requirements of (1) reasonable compensation, not based on net profits, and (2) no circumstances which would substantially limit the qualified user's (e.g., the exempt borrower's) ability to exercise its rights under the contracts. See Tax Alert 2014-1919. Revenue Procedure 2016-44 modifies and supersedes the previous guidance on management contracts and private business use contained in Revenue Procedures 97-13 and 2001-39 and Section 3.02 of Notice 2014-67 (all other sections of Notice 2014-67 remain in effect). The New Safe Harbor retains the previous constraints on (1) net profits arrangements and (2) the relationship between the parties entering into management contracts (as described in previous IRS guidance) — but aims to apply a more "principles-based approach." Management contracts that meet all of the applicable conditions specified in the New Safe Harbor will not result in private business use under Section 141(b) or Section 145(a)(2)(B). These requirements include: 1. General financial requirements. In general, the compensation paid to the "service provider" (i.e., the person providing services under the management contract) under the contract must be reasonable. In addition, the contract must neither provide the service provider a share of net profits from the operation of the managed property, nor impose on the service provider the burden of bearing any share of net losses from the operation of the property. 2. Term of the contract and revisions. The term of the contract, including renewal options, must be no greater than the lesser of 30 years or 80% of the weighted average reasonably expected economic life of the managed property. 3. Control over use of the managed property. The "qualified user" of the managed property (i.e., generally, the applicable governmental person or 501(c)(3) organization) must exercise a significant degree of control over the use of the managed property (e.g., by exercising approval over the managed property's annual budget, capital expenditures, dispositions of property, rates charged for use, etc.) 4. Risk of loss of the managed property. The qualified user must bear the risk of loss upon damage or destruction of the managed property. 5. No inconsistent tax position. The service provider must agree that it is not entitled to and will not take any tax position that is inconsistent with being a service provider to the qualified user with respect to the managed property. 6. No circumstances substantially limiting exercise of rights. In general, the service provider must not have any role or relationship with the qualified user that, in effect, substantially limits the qualified user's ability to exercise its rights under the contract, based on all the facts and circumstances. In addition, Section 5.08 of Revenue Procedure 2016-44 reiterates the principle from Revenue Procedure 97-13 that a service provider's use of a project that is functionally related and subordinate to performance of its services under a management contract that meets the requirements listed above does not result in private business use. Similarly, as was the case under Revenue Procedure 97-13, a management contract that constitutes an "eligible expense reimbursement arrangement" does not result in private business use. An eligible expense reimbursement arrangement is generally defined in Revenue Procedure 2016-44 as a management contract where the only compensation provided to the service provider consists of reimbursements of actual and direct expenses paid by the service provider to unrelated parties and reasonable related administrative overhead expenses of the service provider. The New Safe Harbor applies to management contracts that are entered into on or after August 22, 2016. Issuers may also apply the New Safe Harbor to management contracts entered into before August 22, 2016. In addition, issuers may apply the safe harbors in Revenue Procedure 97-13, as modified by Revenue Procedure 2001-39 and amplified by Notice 2014-67, to a management contract that is entered into before February 18, 2017, and that is not materially modified or extended on or after February 18, 2017 (other than pursuant to a renewal option as defined in Treas. Reg. Section 1.141-1(b)). Through Revenue Procedure 2016-44, the IRS has provided a significantly more favorable framework for the issuers of governmental tax-exempt bonds and qualified 501(c)(3) bonds seeking to comply with the private business use tests outlined in Sections 141(b) and 145(a)(2)(B). In sum, Revenue Procedure 2016-44 provides an easier pathway to enter into management contracts in connection with tax-exempt bond financed property. The language of Revenue Procedure 2016-44 makes clear that management contract arrangements will not be treated as giving rise to private business use if they provide for reasonable fixed or variable compensation that is not tied to net profits for the services provided under the contract, provided qualified users that are parties to the contract are primarily in control of the tax-exempt bond financed projects. Governmental persons and 501(c)(3) organizations that are (or are seeking to become) parties to management contracts in connection with tax-exempt bond financed property should take the principles of Revenue Procedure 2016-44 into account when reviewing existing, or structuring future, management contracts. A revenue procedure is an official statement of a procedure published by the IRS that affects the rights or duties of taxpayers or other members of the public under the Internal Revenue Code, Treasury Regulations, and related statutes and treaties. — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg
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