The Impact of Recent IRS Revisions for Management Contracts
on Long-Term Public/Private Partnerships

by: Douglas Herbst
Vice President of Corporate Development
Earth Tech
On January 16, 1997, the Internal Revenue Service (IRS) removed a long-standing obstacle to public/private partnerships. These new regulations now make it easier for municipalities to enter into long-term contracts for the private operation, maintenance and management (OM&M) of their water and wastewater treatment systems.

Prior IRS regulations limited contract terms to five years. However, the IRS has now provided “safe harbor guidelines” for municipalities to follow in order to allow them to enter into long-term public/private partnerships.

EXTENDING CONTRACT TERMS
Prior to the new changes, OM&M contracts were not only limited to five-year terms, but were required to be terminable by the public sector partner without penalty or cause at the end of the third year. This structure made it difficult for private providers to think in the long term and make investments to reduce costs, automate or initiate capital improvements because, in effect, they only had a three-year contract.

Contracts were also subject to certain compensation arrangements. New arrangements for compensation are now permitted, three of which are most applicable to the water and wastewater industry. Compensation for these IRS-permitted contracts must be reasonable and not based in any part on a share of net profits (sharing in both revenue savings and expense reductions).

The three arrangements involve differing levels of periodic fixed fee (PFF) types of compensation. A PFF is defined as a stated dollar amount for services rendered over a specified period of time. As a general principle, the more the compensation is based on a fixed fee, the longer the contract term allowed. Such a fee is permitted to be increased automatically according to a specified objective, external standard that is not linked to the performance of the facilities.

The first option is a holdover from previous regulations, permitting at least a 50 percent PFF with a term up to five years and termination rights without cause or penalty at the end of the third year. The second fixed fee option specifies at least an 80 percent PFF. The maximum term must not exceed the lesser of 80 percent of the expected useful life or 10 years. The third arrangement outlines a 95 percent PFF. The maximum term must not exceed the lesser of 80 percent of the expected useful life or 15 years. Under 10- and 15-year contracts, there are no IRS regulatory required termination rights, and penalty provisions may exist if the contract is terminated.

The IRS also allows for special arrangements involving designated public utility property. If facilities are public utility property, the permissible contract term is 20 years, provided an 80 percent PFF can be met and subject to the 80 percent useful life constraint. Water and wastewater treatment systems are designated as public utility property. However, a “glitch” arose when it was realized that the IRS Code elsewhere defines public utility property as state-regulated utilities with rates set on a rate-of-return basis. The IRS did not intend this narrowing effect and is expected to issue a conforming modification.

Note the significance of the “up to” terminology in defining maximum contract terms. Partners may sign a 4-, 7- or 11-year contract or break down the maximum term into a preliminary contract with successive renewals. Any combination is acceptable as long as the total is less than or equal to the maximum term selected.

It is important to remember that even though IRS regulations now permit 10-, 15- and 20-year contracts, some state laws forbid extended agreements. Each municipality should be sure to check its state law to see if it places limits on contract terms.

Compensation in addition to the PFF is referred to as variable compensation. It may take many forms such as:
“Incentivized” costs:

Sharing in cost reductions (i.e., through operational changes or capital improvements)

Sharing in increased revenues (i.e., through a meter replacement program)

Compensation adjustments (i.e., taking into account flow and loading variations)

Unit fees (i.e., dollars per ton for biosolids management)

Any compensation which reimburses the private provider for costs paid to third parties (i.e., pass-through costs) does not have to be included in the PFF calculation. When including finance obligations in a contract, if a debt reflects internal financing by the service provider, compensation is considered a PFF. On the other hand, if financing is obtained from a third party, the debt service is viewed as a pass-through cost.

EXPANDING CONTRACT SCOPES

By impacting contract terms and compensation options, the new IRS regulations also increase the potential benefits achievable by the public sector partner. Such benefits may include: