The Use of Tax-Exempt Bonds to Finance Hotels: The Qualified Management Agreement
July 17, 2001
Harold Bucholtz - Washington
Michael "Mike" Ruane- Washington
Prior to the 1986 tax law changes, it was not uncommon to finance the
development and construction of a hotel through the issuance of tax-exempt
bonds; the hotel was part of a larger public project, such as an airport or a
convention center. For the decade following 1986, however, hotels were rarely
financed with tax-exempt bonds.
In recent years, there has been a renewed use of tax-exempt bonds to finance
the development and construction of hotels. As was the case before the 1986 tax
law changes, tax-exempt financing is again being used for hotel development
where the hotel comprises a part of a larger, public use project such as a
convention or conference center, or perhaps a sports arena. Another common
example is a hotel located at an airport or at some other public transportation
facility. The hotel facility may be proposed as a part of such a project on the
basis that the overall project requires lodging and related facilities to
support and enhance the remaining facilities.
Often, the hotel will be a prominent feature of the project, requiring that
the hotel be operated and branded by a first-class, full-service hotel operator.
This often means that the hotel will be operated by one of the major hotel
companies.
The Fundamentals of Tax-Exempt Financing: A Very Brief Summary
To understand how hotels are again being financed on a tax-exempt basis, it
is necessary to understand some of the basic rules that apply to all types of
tax-exempt bonds. First, the issuer of a tax-exempt bond always will be a state
or local government or an agency of a state or local government, such as a
downtown development authority or airport authority. Interest on all
governmental bonds is not tax-exempt, however.
The tax rules divide governmental bonds into two categories - private -
activity bonds and public-purpose bonds. Two mechanical tests are applied to
distinguish between private - activity bonds and public-purpose bonds. The first
test - called the "private business use test" - focuses on how the
financed project is used and by whom; that is, whether the project is to be used
by the public at large - such as streets and roads - or primarily by a few
private parties - such as a factory project owned by a private manufacturer.
The second test - called the "private security or payment test" -
focuses on the source of funds expected to be used to repay the bonds; that is,
whether the security for the bonds is public funds, such as tax revenues, or
private funds, such as loan repayments made by a private party - for example,
the party that borrowed the bond proceeds to develop or purchase the facility.
If both the "private business use test" and the "private
security or payment test" are met, the bonds are private activity bonds and
therefore the interest paid in respect of those bonds may not be tax exempt.
Stated differently, for the purposes of the subject analysis, if the
"private business use test" is not met, the bonds will not be private
activity bonds. As to hotels, the outcome of this analysis is critical because
hotels cannot be financed with private activity bonds.
For purposes of the "private business use test," a bond-financed
project is treated as being used by a business if the business (1) owns the
project, (2) leases the project, or (3) has some other type of arrangement with
the owner of the bond-financed project that entitles it to special legal
entitlements to use the project. One of the most common examples of the third
type of business use is the use of a bond-financed project by a private
management company pursuant to a management contract with the governmental owner
of the project.
Management Contract vs. Lease
It is clear from the IRS regulations and guidelines implementing the
"private business use test," however, that only some types of
management contracts will result in that test being met. Those regulations and
guidelines are a combination of some very general concepts and some extremely
specific "safe harbor" rules.
The IRS has reserved the right to look at all of the facts and circumstances
pertaining to a management contract arrangement to determine whether the
arrangement creates "private business use." Further, the IRS has made
it clear that it will look beyond how the parties to a management contract have
labeled their arrangement. If the IRS believes that the terms of the contract
make the arrangement look more like a lease than a management contract, it will
recharacterize the manager as a lessee and apply the "private business use
test" on that basis.
As a result, a hotel operator's proposed form of management agreement will be
scrutinized carefully by the bond counsel for the governmental issuer of the
bonds to make certain that the bond-financed project will remain within the
"possession and control" of the owner, i.e., the public or
governmental entity. Before the bonds can be issued, the bond counsel will be
required to render an opinion that all tax law requirements will be satisfied in
order that the interest on the bonds is tax exempt. Therefore, the bond counsel
will generally take responsibility for assuring that the terms of the proposed
management agreement will satisfy those tax law requirements.
It has been our experience that bond counsel have carefully focused on the
power of the operator to set room rates and other levels of compensation for the
use of hotel facilities. The power to set rates, together with the right to
establish operating budgets, may afford a level of control to the operator that
could result in the management agreement being recharacterized as some other
type of use arrangement.
Such "control" concerns may be addressed by the express language of
the agreement that serves to confirm the parties' intention that the operator is
a "manager" of the facility only, and that the facility is operated in
all events for the account of the owner. In addition, standards of operation may
be expressly adopted, such as providing that the operator establish
"market" room rates that reflect the particular market segment
applicable to the hotel. At another level, the owner may seek certain review or
approval rights in respect of the annual budget or business plan.
Qualified Management Contract
Once reaching a reasonable level of comfort that the proposed agreement will
be treated as a management contract for tax law purposes, the next several steps
will be aimed at assuring that the terms of the agreement fall within certain
"safe harbors" that the IRS has provided in its published guidelines -
that is, that the agreement is a so-called "Qualified Management
Contract" or "QMC." Satisfying these requirements often can be a
difficult undertaking, particularly for a hotel operator that is unfamiliar with
tax-exempt financing requirements and accustomed to conducting business in its
usual and customary manner. The operator's customary business relationship with
the hotel owner is typically memorialized in the operator's own form of
management or operating agreement - a form that is unlikely to satisfy the
standards for a Qualified Management Contract.
Under the IRS guidelines for QMCs, the contract may have a term (including
all renewal rights) that does not exceed the lesser of (1) 80% of the reasonably
expected useful life of the facility and (2) fifteen years, so long as 95% of
the operator's compensation is based on a "periodic fixed fee."
Because a newly constructed hotel's expected useful life would exceed 20 years,
a management contract for the operation of a newly constructed hotel would
qualify for a 15 year term, so long as the management fees payable to the
operator satisfied the "periodic fixed fee" requirement.
Periodic Fixed Fee
The term "periodic fixed fee" generally means a fee that is a
fixed-dollar amount payable for services rendered during a specified period of
time. The stated dollar amount may increase at periodic intervals (e.g.,
annually) so long as such increase is based upon a specified, objective,
external standard that is not linked to the output or efficiency of the
facility. This means that a fixed-dollar amount that is subject to increase
annually based on an objective, recognized index, such as the CPI, should
satisfy the "periodic fixed-fee" standard.
Incentive Fee
The operating agreement may provide for an "incentive award" or
bonus payable to the operator upon the satisfaction of certain prescribed
standards. The award or bonus must itself be a fixed amount or percentage
increase in compensation and may be based, for example, on increases in hotel
revenues or decreases in hotel expenses, but may not be based on both increases
in revenues and decreases in expenses. By focusing on either the revenue side or
expense side of the hotel's operations, but not both, the incentive award would
not be based on a share in net operating profits. The IRS guidelines absolutely
prohibit any compensation arrangement in which the operator receives
compensation based upon a share of the hotel's net profits.
The management fee will not, however, fail to qualify as a periodic fixed fee
if it provides for a one-time incentive award during the term of the contract
payable upon the achievement of a specified gross revenue or expense target (but
not both).
Expense Reimbursement
Under the typical hotel management agreement, the operator is entitled to be
"reimbursed" for expenditures incurred in operating the hotel.
Generally, sums received by the operator to reimburse it for actual expenses
paid to unrelated parties for the provision of "incidental services"
to the hotel are not considered "compensation" to the operator. Thus,
most, if not all, of the typical service agreements customarily entered into by
the operator on behalf of the hotel, and the payment of the service providers,
will not disqualify the operating agreement as a QMC. The operator's
compensation will still qualify as a "periodic fixed fee" even if the
operator is reimbursed for payments made, for example, to an unrelated trash
removal company, window washing firm, or elevator repair company Special
concerns may arise, however, where the service provider is an affiliate of the
operator.
Services Provided by Affiliates
An area that may prove particularly troublesome involves the provision of
services and goods by affiliates of the operator. Many operators procure at
least some of the services and goods necessary for the hotel's operation from
affiliates. In determining the operator's compensation, and whether its
compensation satisfies the periodic- fixed-fee standard, any compensation earned
by an affiliate of the operator in connection with the hotel's operation must be
taken into account as part of the operator's overall compensation. In other
words, for purposes of the QMC guidelines, an operator and its affiliates will
be tested as if they are a single service provider. As a result, if an affiliate
of the operator earns a profit from the provision of services to the hotel, that
"profit" may serve to prevent the management agreement from satisfying
the fixed-periodic-fee requirement, thus disqualifying the agreement as a QMC.
The same result also may occur if the payment to the affiliate includes, in
addition to the actual and direct costs incurred by the affiliate to provide the
services to the hotel, an amount intended to cover all or part of the
affiliate's general overhead.
Hotel Employees Salaries and Benefits
Generally, the employees of the hotel operator should be treated as unrelated
parties to the operator. This assumes that none of the employees holds a
substantial equity interest in the operator. Because the employees of the
operator are unrelated parties, the salaries, fringe benefits and other
compensation paid to the operator's employees should be reimbursable to the
operator under the management agreement without adversely affecting the
agreement's status as a QMC.
On occasion, however, bond counsel will question the pass through of certain
employee expenses. For example, some bond counsel will readily accept as
qualifying the reimbursement of the salaries and benefits of on-site employees,
but will challenge the reimbursement of the salary and benefits of employees who
provide services to the hotel from offsite. Thus, according to this view, the
reimbursement of the compensation paid to front desk personnel, bellmen and
kitchen staff is acceptable for satisfying the standards of a QMC, but the
reimbursement of personnel providing billing or data processing services from a
central location is not.
Other bond counsel argue that the reimbursement of salaries and benefits paid
to management personnel would disqualify a management agreement from being a QMC.
Under this interpretation, the management agreement could not allow for the
reimbursement of the compensation paid to an on-site hotel manager whose sole
responsibility is the efficient operation of the hotel.
In addressing these and similar concerns over the reimbursement of employee
expenses the analysis generally involves issues about whether (1) the salary
expenses in question might be characterized as overhead rather than actual and
direct cost of operating the hotel, and/or (2) the management personnel in
question in fact will be treated as unrelated parties to the operator. In either
case, the resolution is best reached on a case-by-case analysis taking into
account industry norms and the actual practices and overall operations of the
manager.
Discretion and Authority of the Manager
In a typical hotel management contract, the manager has considerable
discretion to enter into contracts for services, supplies and equipment for the
hotel, and to grant licenses and other concessions for the operation of certain
amenities within the hotel, such as restaurants and gift shops. Although these
rights and discretion do not, in themselves, disqualify the management contract
from being a QMC, the operator's power to exercise such discretion over the use
and operation of the facility does raise the possibility that the operator may
enter into contracts, set rates and allow such uses as would violate, or permit
others to violate, the private-use rules. For example, the operator of a hotel
located at an airport might, at least theoretically, reserve an entire floor of
the hotel for the exclusive use of an airline serving the airport or a
corporation having its headquarters near the airport.
One approach to balancing the operator's need for broad discretion in the
day-to-day operation of the hotel, against the potential of disqualifying the
bonds from tax-exempt status as a result of some inadvertent act of the
operator, is to establish within the management agreement a process for the
review of service and procurement agreements, licenses or other concessions. The
purpose of the process would be to protect against inadvertent disqualification.
Such a review mechanism might involve contracts for services, supplies and
equipment; leases, licenses and concessions; and special rights to amend or
terminate.
Contracts for Services, Supplies and Equipment
Contracts that exceed a specified dollar amount and/or term may be subject to
the review of owner and/or owner's bond counsel to assure that the agreement
does not create private-business-use" concerns. To satisfy the operator's
concern with potential delay and uncertainty, the review mechanism may provide
for a short review period and a "deemed approval" if no response is
forthcoming within the prescribed period.
Leases, Licenses and Concessions
A similar review process may be established for leases, licenses or
concessions. For example, proposed leases, licenses or concessions exceeding a
specified dollar value and/or term could be made subject to review with a fixed
period provided for a response, failing which the proposed instrument would be
deemed approved.
Special Rights to Amend or Terminate
The owner may seek extraordinary rights to cause the operating agreement to
be modified in order to conform the agreement to the requirements of the law
governing tax-exempt bonds, or to prohibit activities of the operator that,
although permitted under the terms of the operating agreement, jeopardize the
tax-exempt status of the bonds. The need for such modifications to the
management agreement might arise, for example, where applicable law changes, or
where the offending activities were not anticipated by bond counsel in its
initial review and approval of the operating agreement.
In return for granting such extraordinary modification rights, the operator
may require a right of termination in the event such a required modification
adversely affects its operation of the hotel. A related issue arises regarding
whether the operator is entitled to compensation in the form of damages or a
termination fee in the event it must exercise its termination right upon such a
"forced" modification of the agreement. The answer to this issue may
be dictated by the circumstances that prompted the required modification, and
related termination, in the first place.
For example, if the modification is required as a result of an unanticipated
change in law, this circumstance might suggest a relatively small breakage or
unwind fee. On the other hand, if the modification is the result of
circumstances that were, or should have been, anticipated by the owner or its
bond counsel, then the cost of termination might be set relatively high;
sufficient, at least, to compensate the operator for its loss of bargain and
extra expense.
Conclusion
In the right circumstances, the use of tax-exempt bonds to finance the
development of hotel facilities may be a very attractive alternative to
conventional financing. Indeed, in certain circumstances, tax-exempt bonds may
be the only viable source of such financing. Owners and operators who wish to
participate in the development and operation of bond-financed properties will
face many challenges in structuring each deal in a manner that balances the
competing needs of the parties with the complex requirements associated with
such financing. But with patience, perseverance and the guidance of
knowledgeable and experienced professionals, it can be an achievable and
rewarding undertaking.