| IRS Approves Phoenix Contract
by Eric S. Petersen and Eric J. Torkelson
The proposed service agreement with Earth Tech for the Phoenix Lake Pleasant Water Treatment Project will be the City’s first long-term agreement for the private management of municipal utility assets. Over $200 million in tax-exempt water revenue bonds are expected to be issued to finance the development and construction activities under the service agreement. The scale of the project, and the expected variability in the scope of water treatment services over the 20-year contract term, suggested the advisability of seeking an IRS private letter ruling (PLR) as to potential “private business use” issues arising under the service agreement.
On April 17, 2003, after a four-month review period, the IRS ruled favorably on the service agreement, allowing the City to proceed with its planned tax-exempt financing. While the Internal Revenue Code provides that such rulings may not be relied upon as precedent, the Phoenix PLR can serve as general guidance in considering similar arrangements. The PLR, which was handled by the tax attorneys in Hawkins, Delafield & Wood’s Washington D.C. office, was the first ruling issued by the IRS pertaining to a proposed compensation arrangement under a water or wastewater contract since the issuance of Revenue Procedure 97-13.
Earth Tech’s design-build-operate responsibilities are incorporated in a single service agreement. Tyco International Ltd. is the parent guarantor. There is a “development period” for design and permitting work, a “construction period” for design completion, construction, commissioning, interim operations and acceptance work, and an “operation period” for operation, maintenance, repair, replacement and management services. The operation period under the unified agreement is considered to be the “management contract” for IRS purposes in determining private business use (design, permitting and construction work performed by private companies is irrelevant to this determination).
Operating performance guarantees are established during the operation period for water treatment (including enhanced standards for more than 15 parameters), water delivery and availability, production efficiency and hydraulic transients. Substantial liquidated damages were included for non-compliance with the performance guarantees. The project will be owned by the City. Earth Tech will have no leasehold or other real estate interest in the project, nor any financing responsibility. No water sales by Earth Tech to third parties are permitted.
Rev. Proc. 97-13 establishes “safe harbor” conditions under which management contracts will not be considered to create private business use under Section 141(b) of the Internal Revenue Code (and thus obviate the need for private activity bond “volume cap” allocations to secure bond tax-exemption). Among these is a requirement that, for management contracts with terms up to 10-years (or 20-years for certain “public utility property”), at least 80% of the compensation for services in each annual period during the term of the contract be based on a periodic fixed fee. Under such requirement, variable fees can constitute up to 20% of the total annual compensation. Rev. Proc. 97-13 provides that reimbursement of the service provider for actual and direct expenses paid by it to unrelated parties is not by itself treated as compensation subject to the 80-20 rule.
The primary challenge in structuring the service fee in the Phoenix project to comply with Rev. Proc. 97-13 was the fact that water demand in the developing Lake Pleasant service areas was expected to grow from 40 mgd to 80 mgd over the course of the 15-year operation period. Selecting one annual water production level, and paying one related fixed fee, would have been antithetical to the City’s interests. For example, paying a fixed fee for 80 mgd for the entire term when only 40 mgd was needed in the early years, would have resulted in unnecessary overpayments for service. Conversely, a fixed fee based on 40 mgd would have resulted in excessive variable payments in the out-years that may be constrained by the 20% limitation. A 60 mgd fixed fee would have had elements of both the 40 and 80 mgd overpayment scenarios.
Accordingly, the City structured the service fee to include three fixed fee “resets” corresponding to three different water production levels at 40, 55 and 70 mgd. There is a separate fixed fee payable for each reset level, which fees were competitively established through the procurement process. The service agreement obligates the City to select one of the three reset levels and related fixed fees on an annual basis. If actual demand exceeds the selected reset level, a competitively established unit-price for the additional water applies. The “reset” structure is intended to conform to the general principle of a fixed fee for a fixed workscope on a pre-negotiated basis. Hawkins, Delafield & Wood, the City’s procurement and contract counsel, previously used the fixed fee “reset” structure in the service contract for the Springfield Water and Sewer Commission’s wastewater treatment system privatization in 2000 as a means of addressing the under-utilization of the Commission’s wastewater treatment plant.
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