The Internal Revenue Service, in Revenue Procedure 2016-44, has loosened the restrictions on safe harbors for management contracts entered into by governmental issuers of tax-exempt bonds in connection with facilities financed by such bonds. The revenue procedure, which will be published in the Internal Revenue Bulletin on September 6, 2016, is a welcome development for issuers considering a management contract, especially in connection with a public-private partnership, although restrictions still remain.

Rev. Proc. 2016-44 follows on several prior official publications from the IRS on the topic of management contracts, and significantly, dispenses with the rigid, formulaic rules set forth in the prior official guidance, instead applying a “principles-based approach” that is focused on the following factors: (1) issuer control over projects, (2) issuer bearing of risk of loss, (3) the economic lives of managed projects, and (4) consistency of tax positions taken by the service provider.

In addition, the management contract must continue to satisfy compensation requirements that have long been a hallmark of official IRS guidance on this topic; and the service provider also must not have a role or relationship with the issuer that limits the issuer’s ability to exercise its rights under the management contract.

A management contract that satisfies each of these safe harbor requirements is deemed to not create “private business use” of the tax-exempt bond-financed property. However, the mere failure of a contract to qualify for the safe harbor does not automatically lead to a finding that private business use has occurred. Rather, the contract must be further tested under the general private business use rules in the Code and regulations to determine whether private business use has occurred – and if so, whether that private business use will result in the tax-exempt bonds that financed the property being declared taxable private activity bonds.

Under Rev. Proc 2016-44 a management contract must provide that the issuer retain a “significant degree of control over the use of the managed property.” The IRS explains that this requirement is met if the contract requires that the issuer approve the annual budget, capital expenditures, dispositions of property, rates charged, and the types of services provided.

The management contract must also provide that the issuer bear the risk of loss if the managed property is damaged or destroyed. The issuer can, however, obtain insurance against such loss, and impose penalties on the service provider if the provider failed to meet the standards set forth in the contract, resulting in the loss.

The “economic lives” requirement is perhaps the most noteworthy aspect of Rev. Proc. 2016-44. This requirement is met if the contact has a term (including all renewal options) no greater than the lesser of (1) 30 years, or (2) 80% of the economic life of the managed property. Prior IRS guidance only outlined safe harbors for contracts of up to 15 years. The ability to enter into contracts of up to 30 years and still qualify for a safe harbor will be especially attractive in public-private partnerships, which generally have much longer terms than other management contracts.

The management contract also may not permit the service provider to take a tax position that is inconsistent with its role as a service provider. This restriction appears intended to prevent the service provider from realizing tax benefits generally reserved to property owners, such as depreciation.

In addition to these general principles set forth in Rev. Proc. 2016-44, the restrictions on compensation seen in prior guidance remain. Most importantly, these contracts still may not permit compensation based on net profits – or shift responsibility for net losses to the service provider. Compensation may include incentive payments for meeting service goals (although such goals cannot be tied to net profits or net losses). Of course, fixed fee compensation based on services provided remains permissible.

Finally, the service provider must not have a role or relationship with the issuer that limits the issuer’s ability to exercise its rights under the management contract, based on all of the facts and circumstances. This rule substantially limits circumstances in which the service provider and issuer may have common ownership or control.

The rules announced in Rev. Proc. 2016-44 apply equally to governmental issuers of tax-exempt bonds and qualified 501(c)(3) organizations that have availed themselves of tax-exempt bonds to finance their facilities. The new rules announced in the revenue procedure apply to any management contract entered into on or after August 22, 2016; issuers may elect to apply the new rules to any contract entered into prior to that date. If an issuer still wishes to apply the safe harbor rules in prior guidance, it may do so for any contract entered into before February 18, 2017.

Issuers and 501(c)(3) organizations that are considering a management contract should consult counsel to determine the tax implications of the contract before signing it.