WASHINGTON – The National Association of Bond Lawyers is urging tax regulators to liberalize existing safe harbors for longer term management and service contracts and to consider rule changes to facilitate the use of tax-exempt bonds in public-private partnerships financing infrastructure projects.
The group made its requests in a letter and accompanying 33-page document detailing the changes and the need for them that was sent to two Treasury Department officials – John Cross, associate tax legislative counsel, and Kent Hiteshew, director of the office of state and local finance. The letter was also sent to Jim Polfer, chief of Branch 5 in the financial institutions and products division of the Internal Revenue Service's office of chief counsel.
NABL's action comes after the American Bar Association's tax-exempt financing committee recommended Treasury and IRS create guidance to facilitate the development of P3s. Those recommendations were broader and didn't focus solely on management contracts.
The NABL lawyers' main concern is that the current safe harbors for longer term management contracts require a high percentage of the manager's compensation be a fixed fee to avoid private use that would make bonds taxable. The lawyers want the percentages in the current safe harbors lowered. They also are suggesting Treasury and the IRS consider taking an alternative approach in creating a new safe harbor that would focus on the issuer's control over such things as rates and property, rather than on the manager's type of compensation.
"We submit these recommendations particularly in light of recent increased emphasis on improving efficiency of state and local government enterprises, and on fostering '"public-private partnerships,' said the letter signed by NABL president Ken Artin.
The letter noted President Obama's recent initiatives to foster the development of P3s to finance infrastructure projects. It cited a memorandum the president released in July 1914 called "Expanding Public-Private Collaboration of Infrastructure Development and Financing," which said: "The federal government can play an important role in supporting, promoting and expanding opportunities for public and private partners to work together."
It also cited a Treasury Department white paper entitled "Expanding our Nation's Infrastructure through Innovative Financing" that was released in September 2014. That paper noted that many P3s employ management or service contracts between state or local governments and private sector service providers.
The NABL added that, "We respectfully submit that the safe harbors for longer-term management and other service contracts are unnecessarily inflexible to accommodate many arrangements that are entirely consistent with relevant federal tax policies, and in many respects are based on an outdated conceptual framework that merits reconsideration."
The NABL paper, worked on by a group of lawyers and primarily drafted by Mike Bailey, a partner at Foley & Lardner in Chicago, says safe harbors for management contracts precede the Tax Reform Act of 1986. The act directed Treasury to create a liberalized safe harbor, under which a management contract would not create private use and result in taxable bonds if: the contract was five years of less in length; the governmental owner of the project could cancel the contract after three years; the manager under the contract was not compensated with a share of net profits, and: at least 50% of the annual compensation of the manager was based on a fixed fee.
The earlier safe harbors and the one described by Congress in the tax reform act focused on the term of the contract and the type of compensation, but also made clear that Treasury should not be constrained from adopting other, more flexible rules.
Under federal tax law, governmental tax-exempt bonds can become taxable PABs if the projects they finance generally have more than 10% private use and more than 10% of the debt service is payable from, or secured, by a private party. The thresholds drop to 5% for 501(c)(3) tax-exempt bonds. PABs that don't finance projects in certain categories are taxable.
The tax reform act led Rev. Proc. 97-13, which set up safe harbors for longer term management contracts. For a contract up to 10 years, at least 80% of the manager's annual compensation had to be based on a fixed fee. For one of 15 years, at least 95% of the annual compensation had to be based on a fixed fee.
The IRS issued Notice 2014-67 in October 2014 that covered management contracts that included most types of fixed or variable rate compensation for contracts of five years or less. But it did not permit compensation based on a share of net profits. NABL applauded the increased flexibility but said the guidance was still too narrow to accommodate the broad range of management contracts that exist.
In October of this year, the Treasury and IRS released final allocation and accounting rules that would help issuers use tax-exempt bonds to finance "mixed use" projects that have some private involvement.
In its paper, NABL proposes that Treasury and the IRS make the compensation provisions of the safe harbor for longer term management contracts more lenient. For a contract of 10 years or less, only 50% of the manager's compensation should be based on a fixed fee, NABL said. The percentage should be 75% for contracts or fifteen years or less.
NABL also suggested the agencies reconsider their focus solely on compensation and instead create another new safe harbor based on control relationships, and more specifically on whether the issuer would retain controls to ensure the project is used for public purposes and that the benefits of tax-exempt financings is not passed to private parties.
"We did not want to be limited by the construct of fixed fees," said Bailey. "Treasury has broad authority to determine what's private use" based on the language in the Tax Reform Act of 1986, he said.
NABL said the new safe harbor could be viewed in the context of the anti-abuse provisions in existing regulations. Those provisions generally state that the IRS commissioner can take any action to reflect the substance of a transaction "[i]f an issuer enters into a transaction or series of transactions with respect to one or more issues with a principal purpose of transferring to nongovernmental persons (other than members of the general public) significant benefits of tax-exempt financing in a manner that is inconsistent with the purposes of Section 141," the section of the federal tax code that covers PABs.
