New IRS Rules Enable Longer Term Privatization Management Contracts

One form of privatization of municipal-owned water and wastewater systems is "contractual" privatization. This is privatization of an operation or function of a water or wastewater system, without acquiring the assets, pursuant to an ongoing contract.

Although these arrangements may take a variety of forms, perhaps the more typical is a management agreement under which a privatizer will manage and operate all or a portion of a utility system owned by a local government.

Where a municipality has issued tax-exempt bonds for construction of its water or wastewater system, contract privatization has been significantly limited by certain Internal Revenue Service rules. If these rules are not followed, the bonds could be deemed "private activity" bonds and, consequently, could lose their tax-exempt status.

Under these rules, to be a qualified management contract which would avoid such consequences, the arrangement would have to meet several criteria, including that the term of the contract must not exceed flve years and the contract must be cancelable by the city after three years without cause or penalty. In addition, at least 50 percent of the fee paid the manager must be a fixed periodic fee, and no portion of the fee paid the manager can be based upon a percentage of net income from operations.

These rules have had a limiting effect on privatization management contracts where municipal bonds have been outstanding regarding the system being managed. For example, a privatizer may successfully manage a system for five years, and then lose the project when the contract is re-bid.

The IRS now has liberalized its rules by creating a "safe harbor" for public utility privatization management contracts. New Revenue Procedure 97-13 allows management contracts up to 20 years if at least 80 percent of the compensation is based on a periodic fixed fee. If the fixed fee portion is 50 percent to 80 percent, the term must not exceed five years, with the three year cancellation provision.

In addition, where the fee is at least 80 percent fixed, the new rule permits a one-time incentive award during the term of the contract, under which compensation automatically increases when a gross revenue target or expense target is attained, if that award is equal to a single, stated dollar amount. Under no circumstances may compensation be based on a share of net profits from operations of the system. The balance of a management fee which is not fixed must be based on volume, gross revenues or something other than net income.

The IRS defines a periodic fixed fee as a stated dollar amount for a specified period of time. For example, a stated dollar amount per month is a periodic fixed fee. The stated dollar amount may automatically increase per a specified, objective external standard, such as the CPI. However, it cannot be linked to the output or efficiency of the system.

These new rules enabling longer term management contracts should broaden interest in this form of privatization.

Dan Kucera is a partner with the Chicago law firm of Chapman and Cutler, specializing in public utilities, water and wastewater and environmental law. Tel: (312) 845-3757; Fax: (312) 701-2361; email: wimbush@chapman.com.