11.0 Tax Exempt Financing

When facilities are financed through the issuance of tax-exempt bonds, as with many A&M System facilities, continued treatment of the bonds as tax-exempt depends on proper use of the facilities. For bonds to be qualified as tax-exempt, 90% of the proceeds must be used for exempt purposes of state educational institutions. In other words, not more than 10% of the tax-exempt bond proceeds can be subject to “private business use.” It also currently appears that where a facility is built partially from funds other than tax-exempt bonds, a favorable ruling may be possible in some cases where there is “private business use” exceeding 10%. Please forward the necessary information to the System Office of Budgets and Accounting if the need arises to make such a determination.

“Private business use” in regard to tax-exempt financing is defined as use of tax-exempt bond proceeds or bond-financed facilities in the trade or business of a non-governmental unit, including tax-exempt charitable organizations and the Federal government. The use does not have to result in unrelated business income to be considered private business use. Examples of private use include contracts for facility management, bookstore operations, providing of food services, and with private organizations such as sports and entertainment groups, seminar groups, and even alumni associations. Students, faculty, staff, and the general public may use these facilities on a non-exclusive basis without constituting private business use.

Where there is more than 10% private business use, the IRS has established “safe harbors” to avoid the loss of tax-exempt status for the bonds. IRS Revenue Procedure 93-19 explains how a contract must be structured to avoid having the proceeds of the bonds treated as used for a private activity use. Revenue Procedure 93-19 is effective for contracts entered into after March 15, 1993.

The two primary elements of IRS Revenue Procedure 93-19 are compensation arrangements and the term of the contract, including renewal options. No part of the compensation can be based on net profits (although reimbursement of actual and direct expenses is not considered compensation). The permitted compensation arrangements and corresponding contract term limits are as follows:

  1. 50% periodic fixed fee — up to 50% of the compensation may be based on any reasonable method (other than net profits) as long as at least 50% is based on a periodic fixed fee. Periodic fixed fee contracts may be no longer than 5 years, including renewal options, with the exempt organization able to cancel with or without cause after 3 years.
  2. Capitation fee — all of the compensation is based on a capitation fee, or a combination of capitation fee and periodic fixed fees. Capitation fee contracts have the same term limits as periodic fixed fee contracts.
  3. Percentage of fees charged — all of the compensation is based on a percentage of the fees charged for services, or a combination of percentage of fees and periodic fixed fees. Percentage of fees charged contracts are limited to 2 years with a 1 year cancellation provision. These types of arrangements are permitted in start-up situations only.
  4. Per-unit fees — all of the compensation is based on a per-unit fee, or a combination of per-unit fees and periodic fixed fees. Per-unit fees contracts are limited to 3 years with a 2 year cancellation provision.

In each case, the cancellation provision must provide that the institution has the ability to cancel without penalty or cause, although reasonable notice requirements may be permitted.

The A&M System’s bond counsel has provided the following information on leases and research agreements.

Leases also could pose a problem because such arrangements grant a possessory interest in the bond-financed facility which results in the lessee receiving a right to use the facility which is superior to the members of the general public. Certain short-term leases may be disregarded. Specifically, if there is an existing lease with a nongovernmental person, at the time of acquisitions, and the remaining lease term does not exceed one year, the tenant may be considered a holdover tenant and such use disregarded for purposes of private business use. Otherwise, leaseholds give rise to private business use.

A cooperative research agreement with a private sponsor whereby the private sponsor uses bond-financed facilities also may cause a private business use problem. Nevertheless, such use of a bond-financed facility by a nongovernmental person is to be disregarded for purpose of private business use if the arrangement is in one of the following forms. First, the arrangement may be disregarded if the sponsoring party is required to pay a competitive price for any license or other use of the resulting technology, and such price must be determined at the time the technology is available. Second, an arrangement may also qualify if a four-part requirement is met: (1) multiple, unrelated industry sponsors must agree to fund institution-performed basic research; (2) the institution must determine the research to be performed and the manner in which is it performed; (3) the institution must have exclusive title to any patent or other product incidentally resulting from the basic research; (4) sponsors must be limited to no more than a nonexclusive, royalty-free license to use the product of any such research.

Another tax-exempt financing issue is the effect on the tax-exempt status of bonds when there is a change in use of the bond financed facilities. Disqualified private use may not exist on the date of issuance, and change in use may endanger the tax-exempt status of the bonds. If a change in use situation is encountered, please contact the System Office of Budgets and Accounting for consultation with Bond Counsel.

With the new construction and changes at many campuses in the A&M System, it may be necessary to review the use of tax-exempt bond-financed facilities and the contracts associated with private use of these facilities.