Tax-exempt bonds and the private business use dilemma

Transcription

1 Tax-exempt bonds and the private business use dilemma Presenters Chad Franks Tax Principal KPMG LLP Edward N. Lee Audit Partner KPMG LLP

2 Agenda 1 Post-issuance compliance Overview of basic rules and common examples 2 IRS update Historical and current IRS activity 3 Leading practices for monitoring private business use 4 Other bond compliance matters 2

3 Notice The content presented in this presentation is for discussion purposes only and is not intended to be written advice concerning one or more Federal tax matters within the scope of the requirements of section 10.37(a)(2) of Treasury Department Circular 230. To the extent that you decide to act, or not to act, based on any information contained in this presentation you acknowledge that the information was prepared based on facts, representations, assumptions, and other information you provided to us, the completeness and accuracy of which we have relied on you to determine. In addition, the information contained herein is based on tax authorities that are subject to change, retroactively and/or prospectively, and any such changes could affect the observations made or any conclusions reached that are contained herein. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The advice or other information in this document was prepared for the sole benefit of KPMG s client and may not be relied upon by any other person or organization. KPMG accepts no responsibility or liability in respect of this document to any person or organization other than KPMG s client. 3

4 Post-issuance compliance Overview of basic rules and common examples

5 General rule General rule: IRC Section 103 provides that gross income does not include interest on any State or local bond issued by a state or local governmental entity Unless: Private activity bond (impermissible use by third parties) Arbitrage bond (intended higher yield investments when issued) Bond is not registered as tax-exempt 5

6 Private activity tests Private business use test - No more than 10% (5% for 501(c)(3) borrowers) of net bond proceeds are used for any private business use (PBU). Private security or payment test - No more than 10% (5% for 501(c)(3) borrowers) of principal and/or interest may be secured directly or indirectly by property used in a private business use or payments from such use. - No more than 10% (5% for 501(c)(3) borrowers) of principal and/or interest may be paid directly or indirectly by property or payments derived from private business use activities. Private loan test - No more than the lesser of $5 million or 5% of proceeds may be loaned to other than state and local governmental entities. 6

7 Private Business Use (PBU) Who are private business users? Private business users - Federal government and its agencies (i.e., FEMA) - Any third-party conducting a trade or business (i.e., contractors, for-profit subsidiaries, some joint ventures, etc.) - Use by an unrelated Section 501(c)(3) entity unless for purposes substantially similar to the exempt purposes of the conduit borrower - Partnerships/JVs with for-profit parties 7

8 How is PBU calculated/measured The 10% (governmental user) or 5% (501(c)(3) user) is measured based on the average PBU over the life of the bonds The 10% (or 5%) is calculated based on net proceeds Net proceeds = total proceeds less reasonably required reserve Bond-financed cost of issuance treated as PBU Cost of issuance subject to limit of 2% of total proceeds 8

9 Sample calculation of PBU limit Sample calculation of PBU limit (Assumes 501 (c)(3)) Total proceeds $1,500,000 Less reasonably required service $500,000 Total net proceeds: $1,000,000 PBU limit: $50,000 (1M*5%) Less bond-financed cost of issuance (per se PBU) $20,000 Effective PBU limit (3%): $30,000 Remember: Can fail PBU in one year, but over the life of the bonds may be within limit. Need to determine average PBU over life. 9

10 Private Business Use (PBU) risk analysis Common PBU generators High risk of PBU Research-testing (drug trials) Activities resulting in unrelated business income (UBI) (per se PBU) Leases* to third-parties except: - State and local government entities - Section 501(c)(3) entities carrying out substantially similar exempt purpose * Includes disguised leases and leases without a formal lease arrangement Medium risk of PBU Corporate/industry sponsored research Management/service contracts* (i.e., dining/retail services, pharmacy, physician services) Naming rights * Includes basically any contract where a third-party is permitted to utilize bond-financed facilities to carry out its activities Low risk of PBU Incidental uses (not to exceed 2.5% (i.e., kiosks/atms/vending) Contracts for copying machines, janitorial, security, maintenance, equipment repair, billing, HR/admin functions, warehousing, etc. (facts and circumstances analysis). 10

11 Potential PBU examples Sports facility Large University s (LU s) Baseball Stadium was financed entirely with tax-exempt bonds. The stadium is used primarily for LU sporting events, however, LU has a multi-year seasonal contract with Learn to Win, Inc. a 501(c)(3) to operate summer day camps using the facilities (no personal property or services are rented and all camp revenues are not UBTI). Does the Learn to Win s use of the facility result in impermissible private use? If so, what permissible methods of measuring the PBU % can be used? The stadium s outfield walls and scoreboard have available space for corporate sponsorships and advertisements. 75% of the available advertising space is comprised of mere acknowledgements of corporate sponsors (e.g., logos, slogans, etc.) and 25% is made up of advertisements, which LU has no control over the content of and contain qualitative statements about companies, products and services. Does the rental of advertising result in impermissible private use? If so, what permissible methods of measuring the PBU % can be used? 11

12 Potential PBU examples (continued) Laboratory/research facility State U, a state-owned/operated university, financed an expansion and improvements to its Science Building s laboratory wing with tax-exempt bond financing. The laboratory facilities and equipment are used primarily by State U s students and professors as part of State U s degree programs. However, State U does conduct research for both governmental research and nongovernmental sponsored research with a commercial objective in the laboratory. The nongovernmental sponsors will own title to any patents resulting from the research performed. Do either or both the government and non-government sponsored research result in impermissible private use? If so, what permissible methods of measuring the PBU % can be used? State U is considering leasing a section of its laboratory facilities to a 3rd party entity, Lab Lease, LLC to conduct research. Lab Lease will conduct the same mix of governmental and non-governmental research with the same patent ownership arrangements. Do all or some of Lab Leases leased space result in impermissible private use? If so, what permissible methods of measuring PBU % can be used? 12

13 Potential PBU examples (continued) Food service/student union building Small College financed its Student Union Building (SUB), which is a multipurpose building also containing a cafeteria, administrative offices and vending/atm machines areas with tax-exempt bonds. The Cafeteria within the SUB is broken into 2 sections: the 1st section comprising of 75% of the cafeteria space is operated by FoodMark under a 2-year management contract through which FoodMark receives revenue under a fee per swipe arrangement, the 2nd section comprising of the remaining 25% is leased to Leasor, LLC and is used for the operation of a famous TacoWorld franchise restaurant. Do either or both of these food service arrangements represent impermissible private use? If so, what permissible methods of measuring the PBU % can be used? The SUB has several vending machines and ATMs located sporadically throughout the common areas of the building. These machines take up approximately 1% of the total bond financed space. Do either or both of these machines represent impermissible private use? If so, what permissible methods of measuring the PBU % can be used? 13

14 Potential PBU examples (continued) Lease/parking example Yell Lawschool is a 501(c)(3) organization that used the proceeds of tax-exempt bonds to finance the acquisition, construction, and equipping of a new conference center. A portion of the conference center is leased to a local Section 501(c)(3) museum that operates in the space. The museum generates unrelated business income from operation of a bookstore in the space. Additionally, some of the proceeds were used for the cost of issuance of the bonds. Do either or both of these arrangements represent impermissible private use? If so, what permissible methods of measuring the PBU % can be used? Proceeds of the bonds were used for construction of a parking deck on the University campus. 75% of the spaces are reserved for University employees, faculty, families, and visitors. The remaining spaces are reserved for employees of an adjacent theme park, paid for directly under the terms of a multi-year lease. Do either of these parking arrangements represent potential impermissible private use? If so, what permissible methods of measuring the PBU % can be used? 14

15 IRS update Historical and current IRS activity

16 PBU History of IRS enforcement Separate IRS division devoted to tax-exempt bonds and governmental entities was created Annual compliance check questionnaires hundreds sent to taxpayers Increase in education outreach generally Issuance of New Regulations Present s Prior to early 1990s: IRS audits of tax-exempt bonds were extremely rare and early IRS focus was on arbitrage rebate and date of issuance issues Over $45 million in settlements related to bond audits Implementation of Schedule K requiring increased reporting Issuance of best practices for postissuance compliance procedures FY Priority Plan (Focus on Bonds)/Issuance of New Guidance/Re-launch of Soft-check letters. 16

17 IRS enforcement Why this should be important to you? Defending tax-exempt status of bonds in an IRS audit is expensive and time consuming - Better to be prepared on the front-end IRS Schedule K reporting requirements - Schedule K includes additional, more elaborate questions, complicating the form even further and the risks of IRS examination based on responses Risk management - Potential impact to reputation - Potential impacts to credit ratings and ability to borrow in the bond market Avoid financial settlement to protect bondholders Better decision making regarding use of bond financed property 17

18 Leading practices for monitoring private business use

19 What is required to monitor PBU Annually 1 Identify all bond-financed assets and tie out to specific bond issues 2 Identify all uses of bond-financed assets (i.e., leases, management/service contracts, research agreements) by bond issue 3 Determine compliance with Safe Harbors or application of exceptions for any third-party use 4 Develop monitoring questionnaires or other tools to assess changes in uses of bond-financed assets over time 5 Determine a reasonable methodology for calculating the amount of PBU associated with any bad arrangements and consider revising agreements where possible to bring them into compliance. (i.e., square footage/revenue approach) 6 Establish any allocation of proceeds and qualified equity to the projects 7 Document findings and take appropriate remedial actions 19

20 Common issues encountered in tracking PBU Simultaneous use General rule All of the space is PBU If on same or similar basis, can allocate based on the proportionate benefit received by the various users (qualified versus nonqualified). Two common approaches: - Square footage approach (discrete or allocation) - Revenue approach Use occurring at different times Ratio of use by PBU as compared to all actual uses Vacant or dark periods are disregarded Common areas Use methodology that reflects proportional benefit Allocations of qualified equity Apply final regulations partnership/qualified equity/mixed-use 20

21 Post issuance compliance monitoring Monitoring process at a glance Assessing risk of PBU Reviewing contracts and arrangements for PBU Calculating PBU post-assessment Re-assessing strength of policies and procedures Who are the responsible parties? Finance Treasury Legal Facilities Operations Procurement Other Stakeholders Identify bond-financed assets and facilities Monitoring questionnaires to responsible individuals Assess changes in: - Physical nature of bond-financed facilities - The Use of bond-financed facilities Lease agreements PBU unless: Exceptions met Lease is to State or Local government Lease is to 501(c)(3) with similar exempt purpose ID new formal and informal arrangements Unrelated business income (UBI) Management service contracts Safe Harbor Rev Proc Safe Harbor Rev Proc Research agreements Safe Harbor Rev Proc Terminated contracts 10% (gov t user) or 5% (private user) is measured based on the average PBU over the life of the bonds. The 10% (or 5%) is calculated based on Net Proceeds. Net Proceeds = Total Proceeds less reasonably required reserve. Bond-financed Cost of Issuance treated as PBU. Cost of Issuance subject to limit of 2% of total proceeds. Determine methodology for calculating PBU for bad arrangements (sq. foot vs. revenue) Identify Existing Policies Description of required training programs Frequency of compliance monitoring Nature of compliance activities Remedial actions Document findings Documentation retention Participation in VCAP Are policies geared towards assessing tax compliance matters? Do policies meet minimum reporting requirements? Schedule K-1 reporting Forms 8038 and 8038-T 21

22 Step one Identify the appropriate stakeholders who hold the information with respect to PBU. This typically includes: Facilities management or individual with knowledge of facilities and ability to monitor facility use. - Facilities operations - Procurement Treasury or department with ability to monitor investment of proceeds and use of funds. - Finance - Treasury - Accounting Legal or individual with knowledge of contracts relating to use of bond financed facilities. Recommend a committee rather than a single individual. 22

23 Step two Determine if any new bonds have been issued or outstanding bonds retired or refunded. If so, perform the following additional steps: Determine any new facilities, parking lots, and other assets that may require issuance of monitoring questionnaire or removal from list of assets needing a questionnaire. Follow the additional steps that follow with respect to each new bond issue as outlined on the following slides. 23

24 Step three Inventory all facilities, parking lots, and equipment (as applicable) and issue PBU monitoring questionnaires to appropriate stakeholders. Note: Before sending, Questionnaires should be updated with all current UBI activity information and a listing of all contracts deemed to give rise to private business use in a prior year. For each bond-financed asset, questionnaires Request Information Regarding: - Third party uses of bond financed assets - Unrelated business income (UBI) activities occurring in or with respect to bond financed assets - Request copies of any leases, management (service) contracts, sponsored research agreements and any other details regarding informal use arrangements. Ref no. Name of agreement Date of agreement/ term of agreement Type of agreement (e.g., Lease) Name of third party user Relationship of third party user to organization Room number/ identify space used Total square footage of space used

25 Step four Review questionnaire responses and take the following actions: Follow-up on any open items or responses not received or responses needing clarification. Review any new leases and determine whether there is a private business user and remove any terminated leases from private use calculation. Review any management/service contracts for compliance with safe harbor revenue procedure and If noncompliant or terminated, update tool/analysis accordingly. Review any research agreements for compliance with safe harbor Revenue Procedure If noncompliant or terminated, update tool/analysis accordingly. Identify any noted informal use arrangement (e.g., non memorialized in contract) and update tool accordingly. Note any new UBI activities or activities identified with respect to the asset being queried. Tour facilities to confirm information. 25

26 Lease reviews Steps 1. Only review those leases where bond-financed facilities are utilized by parties that are not the Section 501(c)(3) conduit borrower (e.g., the hospital or university). 2. Determine if any of the leases are with permitted parties: A. State or local governmental entity B. Section 501(c)(3) entity (related activities only) C. Certain Joint Ventures (e.g., exempt partners) 3. Leases with the following parties generally should be treated as private business use: A. Federal government and its agencies B. For-profit affiliates and joint ventures C. Unrelated for-profit organizations and third parties 26

27 Lease reviews (continued) Steps 4. If leases are identified as being with private users, determine whether any other exceptions apply: A. General Public Use (<200 Days) B. Short-Term Use I. <100-day exception would qualify for public use but for inability to lease to the public (e.g., prison) II. <50-day exception C. Temporary use by developer D. Granting of admitting privileges E. Incidental use exception 27

28 Management/service contract reviews and safe harbors General Compensation paid to the service provider under the contract must be reasonable. Contract neither provides the service provider a share of net profits from the operation of the managed property nor imposes on the service provider the burden of any share of net losses from the property s operation Term of the contract and revisions The term of the contract, including renewal options, must be no greater than the lesser of 30 years or 80% of the expected economic life of the managed property. Control over use of the managed property The qualified user of the managed property must exercise a significant degree of control over the use of the managed property (e.g., by exercising approval over the managed property s annual budget, capital expenditures, dispositions of property, rates charged for its use, etc.). Risk of loss of the managed property The qualified user must bear the risk of loss upon damage or destruction of the managed property. No inconsistent tax position. The service provider must agree that it is not entitled to and will not take any tax position that is inconsistent with being a service provider to the qualified user with respect to the managed property (i.e., service provider does not take deduction for rents, or amortization/depreciation deduction related to property). No circumstances substantially limiting exercise of rights 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 under the contract, based on all the facts and circumstances. 28

29 Management/service contract reviews and safe harbors Compensation C arrangement 1 At least 95% based on periodic fixed fee Maximum term of the contract (including all renewal options) The lesser of (1) 95% of the reasonably expected useful life of the financed facilities and (2) 15 years Termination provision Incentive award Other Reference None Incentive award ok if one-time incentive award during the term of the contract under which compensation automatically increases when a gross revenue or expense target (but not both) is reached if that award is equal to a single, stated dollar amount. None Rev. Proc , Section 5.03(1) Analysis Focuses on (1) type of compensation, (2) the permitted length of the contract including renewal options, and (3) required termination provisions where applicable. Complete following chart for each contract: Contract no. Name of contract Insert name of contract Parties Insert name of parties Description of services Compensation method Termination Facility location Safe harbor analysis Provide explanation why or why not safe harbor is met. Refer to tab safe harbor analysis guide. Productivity reward If there is a productivity award, describe below and provide contract section. CANNOT be based on net profits. OK if the reward is equal to a stated dollar amount based on increases or decreases in gross revenues, or reductions in total expenses in any annual period during the term of the contract. OK if reward is based on quality of services provided or based solely on level of performance achieved. Provide description of services from third party to qualified user (and applicable contract section) Describe compensation method (and applicable contract section) can be one or combination of following: Percentage of gross revenues Capitation fee Per-unit fee CANNOT be percentage of net profits; this is PBU and no safe harbor available Describe termination provision (and applicable contract section) Provide name of facility where services are being provided 29

30 Sponsored research agreement reviews safe harbor The purpose of this revenue procedure is to set forth conditions under which a research agreement does not result in private business use Analysis Focuses on (1) purpose of the research (scientific), (2) identity of the sponsor, and (3) the intellectual property rights transmitted. Step 1: Complete analysis below QU = Qualified User. Part I: Safe harbor eligibility Complete as Yes or No 1. Is the research performed basic research? Basic research means any original investigation for the advancement of scientific knowledge not having a specific commercial objective. For example, product testing supporting the trade or business of a specific nongovernmental person is not treated as basic research. If yes, move to next question If no, stop analysis Safe Harbor not available 30

31 Sponsored research agreement reviews safe harbor (continued) Step 2: Complete findings template below Category/question Tax Classification of Sponsor Purpose of Research Type of Research (Scientific, Clinical Testing or Other) Description of Intellectual Property Rights Accruing to Sponsor or Third Parties Name of Building Utilized for Research Activities PBU Conclusion Recommendations/Notes Response/findings 31

32 Unrelated business income/informal use arrangements/commercial naming rights Steps 1. Review latest filed Forms 990-Ts for any new unrelated business taxable income for the year. These should be included in PBU monitoring questionnaires. 2. For any unrelated business income tax activities, update PBU Tracker/analysis to reflect appropriate private business use following instructions. 3. For any unrelated business income tax activities that are no longer occurring or which may no longer occur in bondfinanced facilities/assets, update the PBU Tracker/analysis to reflect no private business use following the instructions provided with the tool. 4. Tour all facilities and document any informal use arrangements not memorialized in contract and look for commercial naming rights. 32

33 Other items If a bond issuance exceeds the applicable 5% or 10% limit, consider appropriate remedial actions including use of VCAP Program. Consider applicability of Private Security or Payment Tests for any bonds with excessive limits Separately consider whether any bond proceeds have been loaned in excess of the 5% or 10% limit 33

34 Other bond compliance matters Annual certifications, debt covenant compliance

35 Annual certifications Other types of certifications that may be required CEO Certification CFO Certification Debt Covenant Compliance Report (external auditor) What process has your institution put in place to support these certifications? 35

36 Leading practices Consider the following leading practices: Create a summary of debt covenants and other matters that are required to be certified Review summary with bond counsel to ensure the summary is complete and all certifications have been identified Document how you will determine compliance with each covenant or requirement Create a set of work papers to support the certification process that is reviewed by someone other than the preparer Obtain representations from department heads as to compliance, where applicable Do not assume that you are in compliance! Verify and Validate 36

37 Common findings Common findings or obstacles: Management was not aware of certification requirement or covenant Covenant or definitions are not clearly defined in the resolution or agreement, requiring management to make significant interpretations and/or seek guidance Definitions include terms that are no longer considered GAAP or information is no longer readily available Resolutions require a higher level of external certification (i.e., opinion on compliance) than what is reasonably possible and/or expected External certification required by resolution or agreement on non-financial matters that would not be in compliance with applicable professional standards CEO/CFO certifications are not supported by evidence of appropriate due diligence 37

38 Questions?

39 Contact information Chad D. Franks Tax Principal Development and Exempt Organizations Tax Practice T: E: Edward N. Lee Partner Audit Higher Education, Research and Other Not-for-Profit Practice T: E: 39

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