United States: IRS Revenue Procedure 2017-13 Safe Harbor Requirements For Services Contracts

Last Updated: March 31 2017
Article by Charles C. Cardall

IRS Revenue Procedure 2017-13 (the "Revenue Procedure") sets forth, and significantly liberalizes, the requirements for determining whether a contract (a "Services Contract") with a service provider or manager (a "Service Provider") can cause the Service Provider to be treated as a private business user of a facility financed with tax-exempt bonds (a "Project").  This guidance provides a safe harbor relating to government purpose and 501(c)(3) bonds.  Satisfying the requirements means the Services Contract will not cause private business use ("Private Use"). 

SAFE HARBOR REQUIREMENTS

Reasonable Fee:  The fee paid to the Service Provider must be reasonable.  Fees determined through a competitive process or fees within a normal range for such services will be reasonable.

No Net Profits:  Compensation to the Service Provider cannot be based, even in part, on the net profits of the Project.  This includes directly sharing net profits, as well as designing incentives that are based on a combination of gross revenues and expenses.  Incentive compensation based on performance metrics like quality of services or productivity is not necessarily treated as a net profits incentive.  In practice, payments under most Services Contracts are split between (i) reimbursement for actual Service Provider costs, subject to the approval of annual budgets by the Project owner, and (ii) a separate management fee.  The cost reimbursement payments generally are ignored in determining if there is a net profits interest.  The IRS strongly prefers this split payment approach, as opposed to an "all-in" compensation structure in which the Service Provider is paid a comprehensive fee and is entirely responsible for paying all operating costs out of that fee.  Such all-in contracts raise net profits concerns and may also conflict with the Control and Risk of Loss requirements described below.  Finally, even in the context of all-in contracts, certain types of management fees defined in the Revenue Procedure (one or more of a capitation fee, a periodic fixed fee, a per-unit fee, or a fee based on certain performance metrics) are not considered to be net profits arrangements.  Although subordinated management fees can raise net profits concerns, this feature is discussed in Net Losses, immediately below.

No Net Losses:  Very similar to the net profits prohibition, compensation to the Service Provider cannot be based, even in part, on the net losses of the Project.  The most common example of a net losses problem is if the fee paid to the Service Provider is subordinate to the payment of debt service and if the fee would never be paid if there are insufficient funds at the time the fee is due.  Subject primarily to some timing limitations, a solution can be for any unpaid fees to accrue with interest.  A Service Provider whose compensation is reduced by a stated dollar amount for failure to keep the managed property's expenses below a specified target will not be treated as bearing a share of net losses as a result of this reduction.  Like the net profits prohibition, all-in contracts raise significant concerns, the reimbursement of costs generally is ignored, and management fees that are capitation fees, periodic fixed fees, and per-unit fees are not considered to be net losses arrangements, even in all-in Services Contracts.

Term Limitation:  The term of the Services Contract may not be longer than 30 years, or 80% of the remaining useful life of the Project if shorter.  The useful life of a newly constructed Project that consists primarily of building construction or improvements should support a 30-year Services Contract.

Control:  The Project owner must exercise control over the Project.  This control requirement is met if the Project owner approves (i) the annual operating budget, (ii) any capital expenditures, (iii) the disposition of property, (iv) the rates charged for the use of the Project, and (v) the general nature and type of use of the Project.  For Services Contracts with cost reimbursement plus a management fee, these control requirements should be satisfied under typical practices.

Risk of Loss:  The Service Provider cannot be responsible for replacing the Project if there is a catastrophic loss.  The Service Provider can, however, be responsible for obtaining adequate insurance, so long as the cost of the insurance is a cost reimbursement item. 

Service Provider Tax Position:  The Services Contract must state that the Service Provider will not claim any depreciation or amortization deduction, investment tax credit, or deduction for any payment as rent with respect to the Project.

Limitation on Rights:  Finally, the Service Provider must not have a role or relationship with the Project owner, such as the CEO of the Service Provider being in a similar position with the Project owner, that as a practical matter would limit the Project owner's rights to take action under the Services Contract.

PROFESSIONAL SERVICES CONTRACTS

The requirements described above apply in a specialized manner when the contract relates to services provided solely by individuals or groups of professionals, for example physician contracts.  The control requirements relating to budgeting, capital expenditures and disposition are not meaningful in that context.  Control over rates charged can be meaningful, but the Revenue Procedure allows for the rates in this context to simply be "reasonable and customary as specifically determined by, or negotiated with, an independent third party (such as a medical insurance company)."  Similarly, it is difficult for these contracts to be anything other than all-in contracts, because the primary expense is simply the compensation to the professional. 

EXCLUDED INCIDENTAL SERVICES

An important point that often is ignored is that contracts for ancillary or incidental services are not considered to be Services Contracts and therefore do not cause the Service Provider to be a private business user even if the term of the contract is longer than 30 years.

Incidental Services.  Contracts for services that are solely incidental to the primary governmental function of the financed facility are not considered to be Services Contracts.  Excluded incidental services include routine, hard asset services, such as repair and maintenance, that do not give the Service Provider control over the business represented by the Project (such as setting prices) or compensate the Service Provider directly based on the economic performance of the Project.  For example, a 40-year, all-in contract to maintain and repair a Project will not result in Private Use, if the compensation to the Service Provider is not based on Project net profits and the Service Provider is not economically responsible for replacing components of the Project.  Similarly, an asset manager retained by the Project owner purely to oversee the Service Provider is an excluded incidental contract.

Cost Reimbursement Contracts.  Even if the contract is not for incidental services, if the only compensation payable to the Service Provider is the reimbursement of the Service Provider for actual and direct expenses paid by the Service Provider to unrelated parties, the contract is not considered to be a Services Contract.  If the Project consists predominantly of electric generating facilities, electric transmission facilities or other public utility property, the contract also is not considered to be a Services Contract if the only compensation is (i) the reimbursement of actual and direct expenses of the Service Provider, and (ii) reasonable administrative overhead expenses of the Service Provider.

CONCLUSION

The Revenue Procedure replaces prior guidance, most notably Revenue Procedure 97-13, and provides a new approach.  The old formulaic approach to balancing the contract term and the fixed portion of the compensation is entirely replaced.  The main takeaways from the discussion above are (i) except in the context of certain contracts for professional services (e.g., physician contracts), Services Contracts generally should be structured so that the payments to the Service Provider are split between reimbursement for actual Service Provider costs, subject to an annual budgeting process, and a separate management fee that can include incentives and (ii) most of the tax analysis, even for very long term contracts, will focus on the net profits/losses limitation.  Also, when contemplating a repair and maintenance services arrangement for a Project, the first question should be whether the contract is solely for excluded incidental services.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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