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10/15/2002 |
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Patrick K. O'Hare A version of this article appeared in Healthcare Financial Management, The Grantsmanship Center Magazine, and The CPA Journal. The IRS issued two documents earlier this summer that will be of interest to hospitals with outstanding tax-exempt bonds. Both provide additional guidance and flexibility as to the permissible terms of certain management service agreements entered with for profit entities which involve bond financed facilities. Private Letter Ruling 200123057, released on June 8, 2001, will be of interest to exempt hospitals with outstanding bond issues participating in joint ventures with their medical staff physicians or other for profit entities that provide management services to the hospital. In essence, that Letter Ruling reiterated that the safe harbor requirements for management agreements set forth in Rev. Proc. 97-13, 1997-1 C.B. 632, are just that, and deviations from the safe harbors can occur without jeopardizing the exemption for interest on the bonds. On June 20, 2001, the IRS released Rev. Proc. 2001-39 (published in the Internal Revenue Bulletin on July 9), further amending 97-13. The Letter Ruling Rev. Proc. 97-13 defines certain characteristics of management services agreements that are deemed to be permissible and which do not create “private business use” in the circumstance where a non-exempt entity provides management services to an exempt entity involving bond financed property. Under applicable IRS requirements, too much “private business use” of facilities financed with exempt bonds will destroy the exemption on the bonds, making interest on the bonds taxable, thereby potentially causing a default on the bonds and acceleration of their principal. Key principles of 97-13 include requirements governing the contract term and compensation methodologies that service agreements should incorporate. Another key provision of 97-13, and the one at issue in the Letter Ruling, is the required governance relationship between the exempt entity (referred to as the “qualified user”) and the management entity (referred to as the “service provider”). As a general rule, the service provider “must not have any role or relationship with the qualified user that … substantially limits the qualified user’s ability to exercise it rights … under the contract.” Rev. Proc. 97-13, Section 5.04(1). The logic of this is that if the service provider has control over the qualified user, the service agreement could be used primarily to benefit the service provider as opposed to the exempt facility. Rev. Proc. 97-13 then provides various governance safe harbors, which, if met, will satisfy this lack of control test. These include a requirement that (i) not more that 20% of the board members of the exempt institution are board members, officers, shareholders or employees of the service provider; (ii) the CEO of both the hospital and service provider not sit on each others’ boards, and (iii) the parties not be “related parties” within the meaning of various Treasury Regulations which define certain control relationships. Applied to hospital-physician joint ventures that provide management services to hospitals with outstanding bond issues, these requirements are often applied to disqualify the hospital CEO from the board of the joint venture, limit board overlap, and minimize control by the hospital over the venture. The Letter Ruling (which although not precedential provides valuable insight into the IRS position) serves as a reminder that the governance safe harbors are just guidelines, and that depending on the facts of the arrangement, deviations from the safe harbors may be possible to accommodate the business needs of the parties. Significantly, the subsidiary in the Letter Ruling did not comply with these governance safe harbors, both with respect to the role of the CEO and the parties’ relationship as “related parties” due to the hospital’s control over the subsidiary. Despite that, the IRS ruled that because the subsidiary entity could not influence the hospital’s rights under the contract there at issue, no threat to the bonds’ exemption existed. This ruling is consistent with an earlier ruling (see PLR 9823008) that held that despite the fact that a service contract contained compensation provisions outside of those recommended by Rev. Proc. 97-13, the contract at issue did not convert the arrangement into private business use. As a result, and depending on the particular facts involved, exempt providers may have additional flexibility to structure service agreements with subsidiaries and joint ventures entities outside the narrow confines of 97-13. Rev. Proc. 2001-39 “Per unit fees” — as now amended — are primarily relevant under Rev. Proc 97-13 in two instances. These include the case where (i) if the fee to be paid to the service provider is a per unit fee (or a combination of per unit fee and a fixed fee), the contract can extend for three years (subject to the right of the hospital to terminate at end of year two) and (ii) if the fee to be paid to the service provider is based on a combination of a per unit fee and percentage of revenue or expense, the contract can extend for two years (subject to the right of the hospital to terminate at the end of year one). In both of these instances, the additional flexibility now allowed per unit fees will provide hospitals additional flexibility in structuring management service agreements with service providers involving bond-financed facilities. Rev. Proc. 2001-39 will apply both to contracts entered after July 9, 2001 (its publication date) as well as to existing contracts. |
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Ober, Kaler, Grimes & Shriver Maryland
Washington, D.C. Virginia
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