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IRS Approves Phoenix Contract

by Eric S. Petersen and Eric J. Torkelson

The proposed service agreement with Earth Tech for the Phoenix Lake Pleasant Water Treatment Project will be the City’s first long-term agreement for the private management of municipal utility assets.  Over $200 million in tax-exempt water revenue bonds are expected to be issued to finance the development and construction activities under the service agreement.  The scale of the project, and the expected variability in the scope of water treatment services over the 20-year contract term, suggested the advisability of seeking an IRS private letter ruling (PLR) as to potential “private business use” issues arising under the service agreement.

On April 17, 2003, after a four-month review period, the IRS ruled favorably on the service agreement, allowing the City to proceed with its planned tax-exempt financing.   While the Internal Revenue Code provides that such rulings may not be relied upon as precedent, the Phoenix PLR can serve as general guidance in considering similar arrangements.  The PLR, which was handled by the tax attorneys in Hawkins, Delafield & Wood’s Washington D.C. office, was the first ruling issued by the IRS pertaining to a proposed compensation arrangement under a water or wastewater contract since the issuance of Revenue Procedure 97-13.

Earth Tech’s design-build-operate responsibilities are incorporated in a single service agreement.  Tyco International Ltd. is the parent guarantor.  There is a “development period” for design and permitting work, a “construction period” for design completion, construction, commissioning, interim operations and acceptance work, and an “operation period” for operation, maintenance, repair, replacement and management services.  The operation period under the unified agreement is considered to be the “management contract” for IRS purposes in determining private business use (design, permitting and construction work performed by private companies is irrelevant to this determination).  Operating performance guarantees are established during the operation period for water treatment (including enhanced standards for more than 15 parameters), water delivery and availability, production efficiency and hydraulic transients.  Substantial liquidated damages were included for non-compliance with the performance guarantees.  The project will be owned by the City.  Earth Tech will have no leasehold or other real estate interest in the project, nor any financing responsibility.  No water sales by Earth Tech to third parties are permitted.

Rev. Proc. 97-13 establishes “safe harbor” conditions under which management contracts will not be considered to create private business use under Section 141(b) of the Internal Revenue Code (and thus obviate the need for private activity bond “volume cap” allocations to secure bond tax-exemption).  Among these is a requirement that, for management contracts with terms up to 10-years (or 20-years for certain “public utility property”), at least 80% of the compensation for services in each annual period during the term of the contract be based on a periodic fixed fee.  Under such requirement, variable fees can constitute up to 20% of the total annual compensation.  Rev. Proc. 97-13 provides that reimbursement of the service provider for actual and direct expenses paid by it to unrelated parties is not by itself treated as compensation subject to the 80-20 rule. 

The primary challenge in structuring the service fee in the Phoenix project to comply with Rev. Proc. 97-13 was the fact that water demand in the developing Lake Pleasant service areas was expected to grow from 40 mgd to 80 mgd over the course of the 15-year operation period.  Selecting one annual water production level, and paying one related fixed fee, would have been antithetical to the City’s interests.  For example, paying a fixed fee for 80 mgd for the entire term when only 40 mgd was needed in the early years, would have resulted in unnecessary overpayments for service.  Conversely, a fixed fee based on 40 mgd would have resulted in excessive variable payments in the out-years that may be constrained by the 20% limitation.   A 60 mgd fixed fee would have had elements of both the 40 and 80 mgd overpayment scenarios. 

Accordingly, the City structured the service fee to include three fixed fee “resets” corresponding to three different water production levels at 40, 55 and 70 mgd.   There is a separate fixed fee payable for each reset level, which fees were competitively established through the procurement process.   The service agreement obligates the City to select one of the three reset levels and related fixed fees on an annual basis.  If actual demand exceeds the selected reset level, a competitively established unit-price for the additional water applies.  The “reset” structure is intended to conform to the general principle of a fixed fee for a fixed workscope on a pre-negotiated basis.  Hawkins, Delafield & Wood, the City’s procurement and contract counsel, previously used the fixed fee “reset” structure in the service contract for the Springfield Water and Sewer Commission’s wastewater treatment system privatization in 2000 as a means of addressing the under-utilization of the Commission’s wastewater treatment plant.

As to variable compensation, the service agreement calls for variable payments to the contractor, in addition to those for water demanded above the selected annual reset level, for electricity usage savings and extra chlorine used for supplemental water treatment.   In recognition of the possibility that annual variable payments might exceed the 20% limitation in some years, the service agreement contains a “carry forward” provision.  If any annual variable payment excess not paid in a prior year can be paid in a future year without violating the 80-20 fixed/variable compensation rule for that year, the variable payment excess which was carried forward can be paid in such future year.  This provision protects the contractor in part from the arbitrary denial of compensation for work performed that would otherwise result from a year-by-year application of the 80/20 rule.

The PLR concluded that the service agreement would not cause the bonds to be issued for the project to meet the private business use test under Section 141(b)(1) of the Internal Revenue Code based on all of the facts and circumstances.  The IRS reasoned that the fixed fees would constitute at least 80% of the compensation paid to the contractor in each annual period, and that neither the fixed fees nor the variable payments would be based on a sharing of the net profits from the operation of the project.  The PLR further confirmed that the reimbursable costs and any payments with respect to capital modifications that are in the nature of capital expenditures for the project were not management compensation under the service agreement.  Neither the three fixed fee “resets” nor the carry forward of excess variable payments elements of the service agreement caused the IRS any concern as to the private business use question, nor indeed as to compliance with Rev. Proc. 97-13.

In concluding that the service agreement did not meet the Rev. Proc. 97-13 safe harbor conditions, the primary concern seemed to be with regard to compensation for occasional out-of-scope work.  The service agreement provides that when uncontrollable circumstances (such as changes in law and uninsured casualties), emergencies and similar circumstances occur, the contractor will receive additional compensation for performing any additional work with respect thereto.  The IRS expressed concern that such events, and the related compensation, could undercut the required “periodic fixed fee” nature of the contractor’s total annual compensation and accordingly, denied safe-harbor treatment for the service agreement.  Nonetheless, the PLR permits the City to proceed with tax-exempt financing for the project on the basis of an overall facts and circumstances analysis. 

In general, the PLR validates the absence of private business use in a long-term management contract of this nature.  It is an unavoidable reality that long-term management contracts will involve additional work to be performed by a service provider, not known in establishing the original fixed fee, as changes in circumstances arise over the term of the contract.  The impact of accounting for such occasional additional work was also a significant factor in PLR 9823008 (February 27, 1998), in which the IRS declined to give safe harbor treatment to a management contract relating to an electric transmission and distribution system but nonetheless similarly concluded that such contract did not involve private business use.  In light of the Phoenix PLR, the IRS appears to be comfortable in affirming long-term water and wastewater management contracts as not involving private business use if they adhere to the basic fixed fee/variable fee strictures of Rev. Proc. 97-13 and do not involve private project ownership, leasing or financing or compensation arrangements based on a sharing of net profits from the operation of the facilities.