Landmark Letter Ruling may allow private use of tax-free debt

By Susanna Duff Barnett
The Internal Revenue Service has ruled that a management contract between a city water authority and a private entity does not constitute private   business use even though it does not meet the precise tax-exempt standards outlined by the agency.

The IRS based its ruling on the specific circumstances of the management contract tax attorney Linda D'Onofrio of Winstead Sechrest & Minick PC in New York yesterday said it is something that could have implications for other issuers.

"This could apply to any management contract for any type of service because it is a general thing - the service is willing to look at all facts and circumstances even if you don't fall squarely within the ruling," D'Onofrio said.

The April 17 private-letter ruling released yesterday examined a contract between a nonprofit corporation created to help a city acquire and finance real estate and equipment, including a proposed new water treatment plant and sewage facilities, to see if the agreement violated the private business use test. Under the tax code, bonds can retain their tax-exempt status if they meet one, but not both, of the two prongs of the private-activity test. A municipal bond issue is considered taxable if more than 10% of its proceeds are used for private purposes and if more than 10% of the debt service is paid from private sources.

The IRS based its determination in this case on a revenue procedure released in 1997 that describes the conditions under which a management contract would not be considered a private business use. Revenue procedures outline the steps an issuer must take to finance a facility with tax-exempt bonds.

The city wanted to hire a management company to operate the facilities for 15 years with the option of an additional five years and stated that the city and the manager's board of directors would not overlap.

Those provisions would meet the conditions outlined in Revenue Procedure  97-13, but the issuer requested guidance for its definition of a fixed compensation fee outlined in the contract. That procedure states that in such management contracts, 80% of the total compensation must be a fixed fee over 10 years or a 95% fixed fee over 15 years.

In its definition of a fixed fee, the issuer included a provision that allowed for the manager to renegotiate for more money if an extraordinary event should occur - such as a change in the law, a natural disaster, or a labor dispute.

The IRS determined that the management contract did not meet the fixed fee requirements outlined in the revenue procedure. However, it concluded that the facts in the case allowed for the issuer to finance the facilities with tax-exempt bonds without violating the private-activity bond test.

"These payments are not based on services to be provided by the manager rather than revenue from the facilities," the letter said. "Furthermore, payments of the fixed component will constitute at least 80% of the total compensation to the manager for each annual period during the management period of the contract. Thus, these payments are not based on a share of net profits of the facilities."

Although private letter rulings cannot be used as precedent for other deals, they can offer guidance to issuers in similar circumstances. The flexibility the IRS showed in this ruling could be helpful for other cities, said Edwin Oswald, a tax attorney with Orrick Herrington & Sutcliffe here.

"It's increasingly difficult, as cities and private entities become more sophisticated in forging contracts, to at times fit inside the 97-13 revenue procedure guidelines," Oswald said. "The IRS has shown flexibility in analyzing management contracts that literally fall outside the boundary of the revenue procedure but nevertheless do not and should not gives rise to private business use."  
  Sasha N. Page
  Vice President, Infrastructure Management Group, Inc.
  Managing Director, IMG Capital LLC
  4733 Bethesda Ave.,   Suite 600
  Bethesda, MD  20814
  301-907-2900; Fax: 301-907-2906
  spage@IMGgroup.com; www.IMGgroup.com