A Management Contract

A Management Contract

September 01, 2012

A management contract for a private company to operate the portion of the electricity grid belonging to a municipal utility will not cause loss of the tax exemption on debt the utility used to finance the equipment, the IRS said.

Municipalities can issue tax-exempt bonds to finance schools, roads, hospitals and other public facilities. The bonds allow borrowing at a reduced interest rate because the bondholders do not have to pay federal income taxes on the interest. However, a municipality must be careful not to allow more than 10% “private business use” of property financed with the bonds or the tax exemption may be lost.

It is potentially private business use to hire a private company to operate the grid. The IRS issued guidelines in 1997 for municipalities to follow in drafting management contracts with private parties. A contract involving public utility property cannot run longer than 20 years or, if shorter, 80% of the expected useful life of the equipment. At least 80% of the services in each contract year must be compensated on a fixed-fee basis. No part of the fee can be tied to operating profits. A contract that merely passes through actual and direct costs of the contractor and reasonable administrative overhead is not a problem. The manager cannot have a relationship with the municipality that substantially limits the municipality’s ability to exercise its contract rights.

The IRS approved a proposed arrangement to manage a municipal electricity grid that departed from these guidelines in a private ruling that the agency made public in July. The ruling is Private Letter Ruling 201228029.

The contract had a term of 10 years. The municipal utility agreed to pay the grid manager periodic fixed payments, plus incentive payments that were tied to four performance metrics, plus reimburse the manager for its actual costs.

The contract raised issues because the “fixed” fee was not really fixed. It was subject to downward adjustment to the extent the manager failed to provide credit support or performed poorly. The manager could receive additional incentive payments tied to performance metrics. It could pass through charges from affiliates with a mark up at a rate of return approved by the Federal Energy Regulatory Commission.

The IRS said none of these features is a problem because none of them is tied to operating profits.

Keith Martin