Utility management agreement does not create private business use of bond-financed systems

Plain-English summary

A governmental authority asked whether an amended agreement for operating and maintaining electric transmission and distribution systems would create private business use of tax-exempt bond-financed property. The agreement paid a manager a fixed fee, performance-based incentive compensation, and reimbursement of pass-through expenditures. The IRS concluded that the agreement did not create private business use because the compensation was not based on the systems' gross revenues or net profits, the reimbursements generally reflected actual costs, and the agreement's term and governance safeguards fit the relevant guidance. The ruling matters because private business use can affect whether interest on state or local bonds remains tax exempt under IRC § 103.

Ruling snapshot

• Question: Does the amended utility management agreement result in private business use of bond-financed systems under IRC § 141(b)?
• Outcome: Approved
• Key authorities: IRC §§ 103, 141; Treas. Reg. §§ 1.141-3, 1.150-1; Rev. Proc. 97-13

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201412011 Third Party Communication: None
Release Date: 3/21/2014 Date of Communication: Not Applicable
Index Number: 141.00-00, 141.07-00
Person To Contact:
--------------------- -----------------, ID No. --------------
------------------------ Telephone Number:
--------------------------------------- ----------------------
---------------------------------- Refer Reply To:
---------------------------------------------- CC:FIP:B05
PLR-147299-13
Date:
December 23, 2013

LEGEND:

Act = ----------------------------

Authority = ---------------------------------------------

Amended Agreement = ---------------------------------------------------------------

Board = ---------------------------------------------------------------

Department = ---------------------------------------------------------------

Electric Company = ---------------------------------------------------------------

Existing Agreement = ---------------------------------------------------------------

Manager = -------------------------------------

Operator = ---------------------------------------------------------------

Service Area = ---------------------------------------------------------------
---------------------------------------------------------------------------------------------------
---------------------------------------------------------

State = ------------------------------
PLR-147299-13 2

Storm Event = ------------------------

Adjustment Factor = ---------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

Bonds = ---------------------------------------------------------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

a = ----------------

b = ----------------

c = --------------

d = --------------

x = -----

y = ----

z = -----

Dear ------------------:

   This responds to Authority’s request for a ruling that the Amended Agreement

described below will not result in private business use of the Bonds under § 141(b) of
the Internal Revenue Code (the “Code”).

Facts and Representations

   You make the following representations. Authority owns all of the stock of

Electric Company, a governmental person. Electric Company owns and controls an
PLR-147299-13 3

electric transmission system and an electric distribution system (collectively referred to
herein as the “T&D Systems”), and has the right to provide retail electric service to
customers in the Service Area. Proceeds of the Bonds were used to finance the T&D
Systems.

   Electric Company and Manager entered into the Existing Agreement in

December of Year 1. Pursuant to the Existing Agreement, effective January 1 of Year
2, Manager is required to operate and maintain the T&D Systems in accordance with
policies established by Authority and Electric Company. To this end, Manager formed
Operator as a wholly-owned subsidiary to provide substantially all of the management
and operations services required under the Existing Agreement. In Year 1, Authority
sought a letter ruling relating to the consequences, under Code Section 141(b), of the
Existing Agreement in relation to interest on then-outstanding Bonds of Authority. A
favorable ruling letter was subsequently issued.

    Authority and Manager now propose to enter into the Amended Agreement in

order to implement the requirements of the Act and to modify certain provisions of the
Existing Agreement to improve service and reliability of the T&D Systems at rates set at
the lowest level consistent with sound fiscal operating practices. The Act was enacted
in response to operational difficulties encountered by the Electric Company and its
current service provider in restoring service on the T&D Systems as a result of damage
inflicted by the Storm Event and to a range of criticisms relating to, among other
matters, storm preparedness, limited accountability, disconnected management,
planning and operational policies and a lack of oversight and transparency in the
ratemaking process. The Act imposes additional regulatory oversight and requirements
on Electric Company and mandates additional duties for any service provider operating
the T&D Systems.

   The Act also establishes a separate office in Department responsible for

reviewing and making recommendations regarding the operations and terms and
conditions of service of, and rates and budgets established by, Authority and/or its
service provider.

     The Amended Agreement has a term that does not exceed 12 years. The

Amended Agreement provides that in the event that Manager achieves the level of
performance with respect to criteria set forth in the Amended Agreement during the
initial term, the parties will negotiate in good faith an extension of the term of the
Amended Agreement to 20 years from the original service commencement date on
terms and conditions substantially similar to those set forth in the Amended Agreement.
The Amended Agreement may be immediately terminated prior to the end of the term
by either party due to specified events of default.

 None of the voting power of the governing body of Electric Company is vested in

Manager and its directors, officers, shareholders, and employees. There are no
PLR-147299-13 4

overlapping board members between Manager and either Authority or Electric
Company. Authority represents that it is not a related party, as defined in § 1.150-1(b)
of the Income Tax Regulations, to either Manager or Operator.

    The Act requires that a service provider prepare and maintain an emergency

response plan to assure the reasonably prompt restoration of service in the case of an
emergency event. Implementation of the Act further necessitates the transfer of
significant operational duties and enables Manager to independently set a wide range of
operational policies. Under the Amended Agreement, Electric Company will no longer
have a contractual right to approve subcontractors (subject to certain limitations) and a
joint operating committee will no longer exist. Manager must nonetheless operate the
T&D Systems in a manner consistent with prudent utility practice and other “Contract
Standards”. Also, it cannot transmit or distribute electric energy using the T&D Systems
other than power and energy obtained by, on behalf of, or with the approval of Electric
Company, nor can it use the T&D Systems to serve any person other than Electric
Company and its customers in the Service Area.

   Manager will receive the following (collectively referred to herein as the “Services

Fee”) under the Amended Agreement: the Fixed Direct Fee; the Incentive
Compensation Component; and the Reimbursement of Pass-through Expenditures.

   Fixed Direct Fee. Each contract year, Manager will be paid a stated amount (the

“Fixed Direct Fee”) in 12 equal monthly installments. The Fixed Direct Fee, expressed
in Year 1 dollars, is $a annually, subject to a one time increase after Year 3 to $b
annually thereafter. In each contract year, the Fixed Direct Fee will be adjusted by the
Adjustment Factor, which is based on the Consumer Price Index, except that if the
Adjustment Factor is negative, the Fixed Direct Fee will be the same as in the previous
contract year.

    Annual Incentive Compensation Component. In any contract year, Manager also

will be eligible to receive a payment referred to as the “Incentive Compensation
Component”, which will be based on neither gross revenues nor net profits of the T&D
Systems. This amount will be paid from an incentive compensation pool established by
Electric Company. The Electric Company will credit to the compensation pool an
incentive compensation, expressed in Year 1 dollars, of $c, an amount that will increase
to $d beginning with the Year 3 contract year. The Incentive Compensation Component
may be earned by Manager based on favorable performance measured against certain
performance goals outlined in the Amended Agreement. The Incentive Compensation
Component earned by Manager for any year will be adjusted downward if the Manager
fails to achieve stated minimums described in the Amended Agreement.

   The performance goals consist of four categories: cost management

performance, customer satisfaction performance, technical and regulatory performance,
and financial performance. In general, Manager attains these goals by (1) close
PLR-147299-13 5

adherence to the capital and operating budgets approved for each contract year; (2)
achieving high levels of end-use customer satisfaction; (3) providing safe, reliable power
supply in a way that complies with regulation; and (4) meeting Electric Company’s
financial needs. These performance goals, and their assigned weightings, are largely
the same as under the Existing Agreement, although some of the earlier “Performance
Metrics”, defined below, have been consolidated. The Performance Metrics will be
adjusted to account for the impact of a new outage management system which, if
implemented by Manager, can be expected to improve outage identification capabilities.

   The performance categories are subdivided into actual performance metrics (the

“Performance Metrics”). The cost management performance category, which has the
greatest potential effect on the Incentive Compensation Component, contains two
Performance Metrics, one for the approved operating budget and the other for the
approved capital budget. These Performance Metrics are satisfied if operating costs
and capital costs in any contract year do not exceed x% of the separately approved
budget levels for that year. If, in any year, Manager does not achieve the expected
performance level for both of the cost management Performance Metrics, Manager will
not be eligible to receive any incentive compensation for that year. If Manager does not
achieve the expected performance level for the same cost management Performance
Metric for two consecutive years, Manager will not be eligible to receive any incentive
compensation for the second year. If, in any contract year, Manager achieves the
expected performance level for only one of the cost management Performance Metrics,
Manager will be eligible for a maximum of y% of the Incentive Compensation
Component for that year.

  For any contract year, Manager’s level of performance in each performance

category will be measured based on actual results achieved for that year. The
performance categories other than the cost management performance category are
weighted according to relative importance based on the assignment of points referred to
as “base points”. The weighted percentages determine the share of the incentive
compensation pool that may be allocated to a performance category.

    Commencing with the third contract year, the annual incentive compensation for

a performance category for any contract year will be reduced by (i) y% if Manager has
failed to achieve a stated minimum performance level for the same Performance Metric
in that performance category in the then-current contract year and any one of the two
preceding contract years, or (ii) z% if Manager has failed to achieve the minimum
performance level for two or more of the same Performance Metrics in that performance
category in the then-current contract year and any one of the two preceding contract
years.

  Also commencing with the third contract year, a failure of satisfactory

performance by Manager with respect to certain Performance Metrics relating to
customer satisfaction and service interruptions in the then-current contract year and any
PLR-147299-13 6

one of the two preceding contract years will result in (a) forfeiture of z% of the Incentive
Compensation Component for that contract year, and (b) payment to Electric Company
of a penalty equal to a certain percentage of the Fixed Direct Fee for that year.

    Reimbursement of Pass-through Expenditures. The Amended Agreement

identifies and includes a number of Pass-through Expenditures. The term “Pass-
through Expenditures” is generally defined to mean those expenditures incurred by
Operator in the course of providing operations services, including capital improvements.
Specifically included are wages, salaries, benefits, and other labor costs of the general
workforce (chiefly management, professional, and union personnel employed by
Operator); costs incurred by Operator for all materials, supplies, vehicles, purchased
services; subcontractor costs, costs and fees incurred or payable with respect to leases,
permits, and similar instruments; costs incurred in connection with various potential
claims; certain costs related to storm events and non-storm emergencies; various taxes;
costs of compliance with Department and other regulatory requirements to which
Manager or Authority is subject, including as provided in the Act; initial and ongoing
costs necessary to achieve efficiency savings for the benefit of Service Area customers;
certain demonstrated transition costs; costs incurred in connection with an advisory
committee formed under the Amended Agreement to provide advice on clean and
renewable energy programs and to arrange periodic public meetings for the purpose of
developing and providing input and recommendations to Manager on demand reduction
goals, renewable program goals established under various State initiatives by
Department for utilities and similar matters; costs incurred in connection with branding
and customer and public communications; long range planning costs; and demonstrated
transition costs incurred to achieve efficiency savings and costs of providing operations
services related thereto on an ongoing basis. Pass-through Expenditures do not include
amounts paid by Manager to or for individuals who are part of senior management and
who are employed by Manager.

     Manager will be reimbursed by Electric Company for the Pass-through

Expenditures at its cost of service without mark-up, multiplier, or other adjustment.
However, the costs to Manager, if any, of transactions with affiliates under which an
affiliate agrees to provide an operations service as a shared service will be at
Manager’s total costs (defined as all costs of the affiliate providing the relevant service
calculated using (i) a fully allocated cost methodology in compliance with the relevant
rules, regulations or orders of the Board, or (ii) such other cost allocation methodology
as may be required by other applicable regulatory requirements in lieu of the foregoing)
incurred in connection with such transaction (including reasonable and demonstrated
costs incurred which are necessary to integrate Operator with such affiliate), but will not
include in any event a profit or mark-up component for the affiliate. Transactions with
an affiliate under which the affiliate agrees to provide a service relating to the T&D
Systems not included in the immediately preceding sentence, which must be approved
by Electric Company, may include profit or mark-up paid or payable to the affiliate.
PLR-147299-13 7

     The Amended Agreement covers additional categories of costs and capital

investments which will or may be paid to or through Manager or made by or for
Manager and calls attention to ancillary agreements under which payments will be
made to an affiliate of Manager. The additional categories of costs involve major storm
and non-storm emergency expenditures in circumstances beyond the reasonable
control of Manager. The permitted capital investments would involve investments in
such things as energy efficiency, demand response, renewable energy, energy storage,
distributed generation, and electric vehicle charging stations, and can be made only if
authorized by Electric Company in its sole discretion. The ancillary agreements, each
among Authority, Electric Company and an affiliate of Manager, provide for fuel
management and power supply management services. Such costs, investments and
agreements all involve circumstances or activities in respect of which Manager (or an
affiliate) will take on responsibilities or assume a role engendered by uncontrollable
events or otherwise far removed from the regular, day-to-day operation and
management of the T&D Systems and related services. Based on all the facts and
circumstances, we conclude that they need not be taken into account in our evaluation
of the Amended Agreement for purposes of Code Section 141(b).

Law and Analysis

   Section 103(a) provides that gross income does not include interest on any state

or local bond. Section 103(b)(1) provides that this exclusion does not apply to any
private activity bond unless, among other requirements, it is a qualified bond (within the
meaning of § 141). Section 141(a) provides that a bond is a private activity bond if the
bond satisfies the private business use test and the private security or payment test of
§ 141(b).

    Under §§ 141(b)(1) and 141(b)(6)(A), the private business use test is met if more

than 10 percent of the proceeds are used, directly or indirectly, in a trade or business
carried on by any person other than a governmental unit. Under § 141(b)(6)(B), any
activity carried on by a person other than a natural person is treated as a trade or
business.

   Section 1.141-3(b)(1) provides that both actual and beneficial use by a

nongovernmental person may be treated as private business use. In most cases, the
private business use test is met only if a nongovernmental person has special legal
entitlements to use the financed property under an arrangement with the issuer. In
general, a nongovernmental person is treated as a private business user of proceeds
and financed property as a result of ownership; actual or beneficial use of property as
pursuant to a lease, or a management or incentive payment contract; or certain other
arrangements such as a take or pay or other output-type contract.

   Section 1.141-3(b)(4)(i) provides that a management contract with respect to

financed property may result in private business use of that property based on all of the
PLR-147299-13 8

facts and circumstances. A management contract with respect to financed property
generally results in private business use of that property if the contract provides for
compensation for services rendered with compensation based, in whole or in part, on a
share of net profits from the operation of the facility.

   Section 1.141-3(b)(4)(ii) defines a management contract as a management,

service, or incentive payment contract between a governmental person and a service
provider under which the service provider provides services involving all, a portion of, or
any function of, a facility. Under § 1.141-3(b)(4)(iii)(C), a contract to provide for the
operation of a facility or system of facilities that consists predominantly of public utility
property, if the only compensation is the reimbursement of actual and direct expenses
of the service provider and reasonable administrative overhead expenses of the service
provider, is generally not treated as a management contract that gives rise to private
business use. Similarly, § 1.141-3(b)(4)(iii)(D) provides that a contract to provide for
services generally does not give rise to private business use if the only compensation is
the reimbursement of the service provider for actual and direct expenses paid by the
service provider to unrelated third parties.

    Revenue Procedure 97-13, 1997-1 C.B. 632, as modified by Revenue Procedure

2001-39, 2001-2 C.B. 38 (“Rev. Proc. 97-13”), sets forth operating guidelines for
contracts to manage bond-financed facilities which, if satisfied, allow management
services to be provided under the contract without causing the facilities to be treated as
used in a private business use under § 141(b). Rev. Proc. 97-13 requires that
management contracts conform to guidelines relating to (1) compensation
arrangements, (2) contract term, and (3) any circumstances substantially limiting the
qualified user’s ability to exercise its rights. Section 5.02(1) of Rev. Proc. 97-13
provides that reimbursement of the service provider for actual and direct expenses paid
by the service provider to unrelated third parties is not by itself treated as compensation.

     Section 5.02(1) of Rev. Proc. 97-13 also provides in part that the contract must

provide for reasonable compensation for services rendered with no compensation
based, in whole or in part, on a share of net profits from the operation of the managed
facility. For this purpose, § 5.02(3) of Rev. Proc. 97-13 provides that a productivity
reward equal to a stated dollar amount based on increases or decreases in gross
revenues (or adjusted gross revenues), or reductions in total expenses (but not both
increases in gross revenues (or adjusted gross revenues) and reductions in total
expenses) in any annual period during the term of the contract generally does not cause
the compensation to be based on a share of net profits.

   Section 5.03 of Rev. Proc. 97-13 sets forth permissible compensation

arrangements. Section 5.03(2) provides an arrangement under which at least 80
percent of the services for each annual period during the term of the contract must be
based on a periodic fixed fee. The arrangement provided in § 5.03(2) also contains a
term limit under which the term of the contract, including all renewal arrangements,
PLR-147299-13 9

must not exceed the lesser of 80 percent of the reasonably expected useful life of the
financed property and 10 years. Section 5.03(3) of Rev. Proc. 97-13 provides that if all
of the financed property subject to the contract is a facility consisting of predominantly
public utility property (as defined in § 168(i)(10)), then 20 years is substituted for 10
years in applying § 5.03(2).

   Section 3.05 of Rev. Proc. 97-13 defines a periodic fixed fee to mean a stated

dollar amount for services rendered for a specified period of time. The stated dollar
amount may automatically increase according to a specified, objective, external
standard that is not linked to the output or efficiency of a facility. For example, the
Consumer Price Index and similar external indices that track increases in prices in an
area or increases in revenues or costs in an industry are external standards.

    Section 5.04(1) of Rev. Proc. 97-13 provides that the service provider must not

have any role or relationship with the qualified user that, in effect, substantially limits the
qualified user’s ability to exercise its rights, including cancellation rights, under the
contract, based on all of the facts and circumstances. Section 5.04(2) provides this
requirement is satisfied if (a) Not more than 20 percent of the voting power of the
governing body of the qualified user in the aggregate is vested in the service provider
and its directors, officers, shareholders, and employees; (b) Overlapping board
members do not include the chief executive officers of the service providers or its
governing body or the qualified user or its governing body; and (c) The qualified user
and the service provider under the contract are not related parties, as defined in
§ 1.150-1(b).

   The Amended Agreement must meet all requirements of section 5 of Rev. Proc.

97-13 for that contract to be deemed under that revenue procedure not to result in
private business use of the T&D Systems by Manager. If any requirement is not met,
then pursuant to § 1.141-3(b)(4)(i), whether the Amended Agreement results in private
business use depends on all of the facts and circumstances. In determining whether
the facts and circumstances indicate private business use, the principles set forth in
Rev. Proc. 97-13 are useful reference points.

    Whether Manager’s compensation meets the requirements of Rev. Proc. 97-13

first requires an analysis of the amounts paid to Manager under the Amended
Agreement, which are: (1) the Fixed Direct Fee; (2) the Incentive Compensation
Component; and (3) Reimbursement of Pass-through Expenditures.

   The Fixed Direct Fee does not meet the requirements of section 5.03(2) of Rev.

Proc. 97-13, since it is not a periodic fixed fee. It is subject to reductions because of
poor performance. These reductions are not specified, objective, and external within
the meaning of section 3.05 of Rev. Proc. 97-13. Nevertheless, based on all of the facts
and circumstances, we conclude that the Fixed Direct Fee does not cause the Amended
Agreement to result in private business use of the T&D Systems for purposes of § 141.
PLR-147299-13 10

A reduction based on poor performance will not be based on a change of net profits. In
addition, the Fixed Direct Fee, after a reduction, will remain a stated amount for the
particular annual period.

   Based on all of the facts and circumstances, we also conclude that the Incentive

Compensation Component of the Services Fee does not cause the Amended
Agreement to result in private business use of the T&D Systems. Although the various
performance categories that make up the Performance Metrics provide incentives to
reduce expenses, none of the performance categories are based on gross revenues or
net profits of the T&D Systems.

    Manager also will be reimbursed by Electric Company for the Pass-through

Expenditures. The reimbursements for Pass-through Expenditures, with the exception
of the charges from its affiliates, are reimbursements for actual and direct expenses
without markup, multiplier, or other adjustment or profit. The charges from affiliates
relating to shared services may include costs using a fully allocated cost methodology in
compliance with applicable regulatory requirements. The allocated costs under such a
methodology will not, however, be based on, or include a share of the T&D Systems’
net profits. The charges in respect of affiliate transactions not involving shared services
will also not be based on, or include a share of the T&D Systems’ net profits. In
addition, the latter transactions must be approved by Electric Company. We conclude
that under the facts and circumstances, the reimbursements for Pass-through
Expenditures do not cause the Amended Agreement to result in private business use.

    Finally, neither the length of the Amended Agreement nor any relationship

between Manager and Authority or Electric Company will result in private business use
of the T&D Systems. The term of the Amended Agreement will not exceed the 20-year
term allowable under § 5.03(3) of Rev. Proc. 97-13. Pursuant to § 5.04(2), Manager will
have no role or relationship with Authority or Electric Company that will substantially
limit Electric Company’s ability to exercise its rights under the Amended Agreement.

Conclusion

 Based on the facts and circumstances represented, we conclude that the

Amended Agreement does not result in private business use of the Bonds within the
meaning of § 141(b).

    Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any transaction or item discussed or referenced in
this letter.

  This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)

provides that it may not be used or cited as precedent.
PLR-147299-13 11

   In accordance with a Power of Attorney on file with this office, a copy of this letter

is being sent to the authorized representative of Authority.

  The ruling contained in this letter is based upon information and representations

submitted by Authority and accompanied by a penalty of perjury statement executed by
an appropriate party. While this office has not verified any of the materials submitted in
support of the request for a ruling, it is subject to verification upon examination.

                               Sincerely,


                               Associate Chief Counsel
                               (Financial Institutions and Products)

                                                  /S/

                               By:     ________________________
                                       Timothy L. Jones
                                       Senior Counsel
                                       Branch 5

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