In Revenue Procedure 2017-13, the IRS has updated the safe harbor procedures 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.

Revenue Procedure 2017-13 modifies, amplifies and supersedes Revenue Procedure 2016-44, updating the safe harbor procedures therein. This Alert describes changes from the previous guidance.

Previous guidance on management contracts and private business use

In August 2016, the IRS issued Revenue Procedure 2016-44, which set forth new safe harbor procedures relating to management contracts and private business. Revenue Procedure 2016-44 modified and superseded the previous guidance on management contracts and private business use contained in Revenue Procedures 97-13 and 2001-39 and Section 3.02 of Notice 2014-67.

In Revenue Procedure 2016-44, the IRS stated that it aimed to apply a more "principles-based approach" than in the previous guidance, while retaining the existing constraints on: (1) net profits arrangements; and (2) the relationship between the parties entering into management contracts (as described in previous IRS guidance).

For a discussion of the new safe harbor procedures set forth in Revenue Procedure 2016-44, as well as additional background on relevant law and previous guidance, see Tax Alert 2016-1469.

Updated safe harbor

Revenue Procedure 2017-13 makes some updates to the new safe harbor procedures that were included in Revenue Procedure 2016-44. The updates address four areas: (1) types of compensation, (2) the timing of payment of compensation, (3) the treatment of land, and (4) methods of approving rates. Management contracts that meet all of the applicable conditions specified in the new safe harbor, as updated in Revenue Procedure 2017-13, will not result in private business use under Section 141(b) or Section 145(a)(2)(B).

Types of compensation

Revenue Procedure 2016-44 set forth general financial requirements for management compensation arrangements to be eligible for the safe harbor. In general, the compensation paid to the service provider 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.

The safe harbor guidance prior to Revenue Procedure 2016-44 expressly treated certain types of compensation — including capitation fees, periodic fixed fees, and "per-unit fees" — as not providing a share of net profits. The absence of similar language in Revenue Procedure 2016-44 raised questions about whether the same treatment continues to apply. Similarly, questions have arisen since the publication of Revenue Procedure 2016-44 about whether a service provider's payment of expenses of the operation of the managed property without reimbursement from the "qualified user" affects the treatment of these types of compensation.

To address the questions that have arisen and provide continuity with the previous safe harbors, Revenue Procedure 2017-13 specifies that compensation for services will not be treated as providing a share of net profits if the compensation is: (1) based solely on a capitation fee, a periodic fixed fee or a per-unit fee; (2) incentive compensation, as described in the Revenue Procedure; or (3) a combination of these types of compensation. This treatment applies regardless of whether the service provider pays expenses with respect to the operation of the managed property without reimbursement by the qualified user.

Timing of payment of compensation

Revenue Procedure 2017-13 also clarifies a statement in Revenue Procedure 2016-44 regarding the timing of payment of compensation. Specifically, Revenue Procedure 2016-44 stated that the timing of payment of compensation cannot be contingent upon net profits or net losses from the operation of the managed property. Revenue Procedure 2017-13 clarifies that deferred compensation will not be treated as contingent on net profits or net losses if the contract requires that: (1) the compensation is payable at least annually, (2) reasonable consequences apply for late payment (such as interest charges or late payment fees), and (3) the qualified user will pay the deferred compensation within five years of the original due date of the payment.

Treatment of land

Revenue Procedure 2016-44 specified that 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. For this purpose, Revenue Procedure 2016-44 stated that economic life is determined in the same manner as under Section 147(b), but without regard to Section 147(b)(3)(B)(ii). Under Section 147(b)(3)(B)(ii), land is generally not taken into account, but it is taken into taken into account if 25% or more of the net proceeds of any issue is to be used to finance the acquisition of land (in which case, the land is treated as having an economic life of 30 years).

Revenue Procedure 2017-33 states that economic life is determined in the same manner as under Section 147(b) as of the beginning of the term of the contract. Thus, it removes the provision included in Revenue Procedure 2006-44 that added: "but without regard to Section 147(b)(3)(B)(ii)." Accordingly, land will be taken into account under Revenue Procedure 2017-33 under the conditions specified in Section 147(b)(3)(B)(ii).

Methods of approving rates

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.)

Under Revenue Procedure 2016-44, a qualified user may show approval of rates charged for use of the managed property by either expressly approving such rates (or the methodology for setting such rates) or by including in the contract a requirement that the service provider charge rates that are reasonable and customary as specifically determined by an independent third party.

To address concerns about circumstances in which it is not feasible to approve each specific rate charged (e.g., physician services at a charitable hospital), Revenue Procedure 2017-13 clarifies that a qualified user may satisfy the approval of rates requirement by: (1) approving a reasonable general description of the method used to set the rates; or (2) requiring that the service provider charge rates that are reasonable and customary as specifically determined by, or negotiated with, an independent third party.

Applicability dates

Revenue Procedure 2017-13 applies to any management contract that is entered on or after January 17, 2017. In addition, issuers may apply Revenue Procedure 2017-13 to any management contract entered before January 17, 2017.

Issuers may also 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 August 18, 2017, and that is not materially modified or extended on or after August 18, 2017 (other than under a renewal option as defined in Reg. Section 1.141-1(b)).

Implications

Revenue Procedure 2017-13 provides welcome clarification for uncertainties from Revenue Procedure 2016-44, which was recently issued in August 2016. For 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), Revenue Procedure 2017-13 effectively only adds to the language of Revenue Procedure 2016-44, which offered a substantial shift in how organizations calculate private business use regarding management contracts in connection with tax-exempt bond financed property.

The clarification comes in four key areas: (1) compensation arrangements structured under the older safe harbors (capitation fees, fixed fees, and per unit fees and certain incentive compensation) will not be treated as a net-profit arrangement; (2) certain deferred compensation if paid within five years will qualify under the new safe harbor; (3) when considering the term of the management contract under the new safe harbor, economic life for land is determined in the same manner as under Section 147(b); and (4) when determining the user's level of control over the managed property, the user has favorable options if it is not feasible for the user to approve each specific charge rate.

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.

Please contact your Ernst & Young tax professional with any questions.

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