New Rules for Privatization

The U.S. Internal Revenue Service (IRS) has issued important new rules affecting tax-exempt bonds - rules that will accelerate the trend toward privatization of public facilities.

The new rules - final regulations and a revenue procedure - make it possible to arrange private management of a public facility financed by tax-exempt bonds under a long-term contract (up to 20 years) without losing the benefit of the tax-exempt financing. In addition, they generally give a government agency more flexibility in selling or leasing a bond-financed facility to a private party without causing the bonds to become taxable retroactively, if the bonds are redeemed or other remedial action is taken.

Previous Restrictions

State and local governments are generally allowed to finance publicly-owned infrastructure projects by issuing bonds whose interest payments are exempt from federal income tax. As a result, the interest rate on such bonds is lower than for other, taxable kinds of financing. However, in certain situations the bonds may be deemed to be "private activity bonds," which are subject to a number of restrictions and rules that limit their use.

The principal way in which a bond becomes a private activity bond in the infrastructure arena is when there is a "private business use" of a facility that was financed by those bonds. The private-business-use test is met if more than 10 percent of the proceeds of the issue is used in a trade or business carried on by a nongovernmental entity. This private use may result from ownership or leasing of the facility, a management or incentive payment contract, or various other arrangements, including a take-or-pay contract.

The prior IRS guidelines allowed a governmental agency to enter into an agreement with a private party for the management of a facility without causing the bonds to be deemed private activity bonds. However, these guidelines generally restricted the terms and conditions of the management agreement to ensure that it did not have an effect similar to selling or leasing the facility to the private manager.

The most significant restriction was a five-year limit on the term of the agreement, with the right of the governmental entity to cancel the agreement at the end of the third year. These restrictions have limited the use of management agreements as a means of implementing cost-saving privatization measures for public facilities.

In addition, the prior IRS rules relating to a "change in the use of proceeds" also limited the ability of governmental entities to completely privatize projects through the sale or lease of the facilities. If there was such a change in ownership or use, the bonds became taxable unless certain safe-harbor conditions were met, including a requirement that the bond proceeds had been used for a qualified use for at least five years.

The New Rules

The new regulations provide that a management contract involving a publicly financed property may result in private business use of the property in certain circumstances. In particular, the regulations state that private use generally results if the compensation under the management contract is based, in whole or part, on a share of net profits from the operation of the facility.

Revenue Procedure 97-13 stipulates that the following are generally not considered to result in compensation based on net profits:

• payments based on a percentage of gross revenues or gross expenses (but not both);
• capitation fees, such as periodic fixed amounts paid for each customer;
• per-unit fees, such as fees based on a unit of service performed; and
• "productivity awards" equal to a stated dollar amount, based on increases or decreases in gross revenues, or reductions in total expenses (but not both).

The most important change in the new rules is to allow longer-term agreements. If the manager's compensation is reasonable and not based on net profits, and if the manager is not related to the governmental agency, entering into a management contract will not result in private business use if the term of the contract (including all renewal terms) is limited to a period ranging from two years to 15 years (or 20 years in the case of public utility property).

The permitted terms are generally a function of the method of compensation paid to the manager, with longer terms requiring that a high percentage of the compensation be based on a periodic fixed fee.

Revenue Procedure 97-13 has a technical error in the rule relating to public utility property which the IRS is reportedly planning to correct. Once corrected, this rule allowing 20-year terms should apply to most kinds of government-owned utility systems. The maximum term of the management contract permitted by the revenue procedure, based on the method of compensation indicated, is summarized in the chart (below).

Despite the changes, tax exempt bonds may still become private activity bonds if the use of the proceeds of the issue changes from a qualified use to a private business use. This could occur, for example, if a facility owned by a governmental entity were sold to a private user or became subject to a management contract that does not qualify for the safe-harbor exception to the private-business-use rules. Even in that case, the bonds would not lose their tax-exempt status if the issuer took one of several permissible "remedial actions" specified in the regulations.

The most important permissible remedial action would be to redeem all of the bonds within 90 days of the change in use or establish a defeasance escrow within that 90-day period, in order to redeem the bonds on their earliest call date. To qualify for this test, the first call date of the bonds cannot be more than ten and a half years after the issue date.

The other principal remedial action applies to a cash sale of the facility. In that case, the bonds would not lose their tax exemption if the proceeds of the sale are spent for another governmental purpose, such as acquiring a facility that is not subject to private business use.

These remedial actions will prevent a loss of the bonds' tax-exempt status only if certain additional conditions are met. For example, the issuer must reasonably have expected on the issue date that there would be no private business use during the term of the bonds. In addition, the term of the bonds must not be longer than 120 percent of expected economic life of the facility, and any new user would have to pay fair market value for the use of the facility.

The regulations have dropped the requirement in the prior rules that remedial action could only be taken if the proceeds were used for a qualified use for at least five years. Thus the new rules will apply to facilities regardless of how long they have existed.

New Rules Apply Immediately

The new regulations are generally effective for bonds issued after May 16, 1997, and Revenue Procedure 97-13 is also effective for management contracts entered into, significantly modified or extended after that date. However, agencies may elect to apply the rules to bond issues and management contracts entered into before that date.

As a result, the new rules will apply in structuring management agreements for both new and existing tax-exempt, bond-financed projects. Thus, if a government agency wishes to sell or lease an existing facility rather than have it managed by a private operator under a management contract, the new rules will give it further flexibility in avoiding a retroactive loss of the tax exemption on the bonds.

Ultimately, each of these rules should permit increasing private use of facilities without losing the benefit of low-cost, tax-exempt financing.
(chart)

Calculating Terms for Management Contracts: