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
Managing Director, IMG Capital LLC
4733 Bethesda Ave., Suite 600
Bethesda, MD 20814
301-907-2900; Fax: 301-907-2906