July 17, 2001

The Use of Tax-Exempt Bonds to Finance Hotels: The Qualified Management Agreement

Holland & Knight Newsletter
Harold Bucholtz

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.

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