Bonded to Privatization

Maintaining municipal services at an acceptable cost is the ultimate challenge facing all communities attempting to control tax levels.

For tiny Pleasant Ridge, an Oakland County bedroom community with an area of one-half square mile and a population of 2,700 (fewer people than on an aircraft carrier), this challenge is especially daunting, given the city’s limited tax base.

Although garbage pick-up services had been contracted out to a private company over fifteen years ago, other Department of Public Works (DPW) services continued to be supplied directly by the city. But due to budget constraints, the Department was continually shrinking, making it ever more difficult to purchase and maintain the equipment needed to provide services such as leaf pick up, snow removal on city sidewalks, and street sweeping.

The Internal Revenue Service (IRS) issued new private activity bond regulations on January 10, 1997. The rules may change the way government does business with business.

Prior to the new regulations, opportunities were limited for local governments to partner with private, for-profit companies to manage facilities built with tax-exempt bonds. The implicit reasoning behind impeding such partnerships was that businesses should not profit by managing facilities financed with tax-free debt. The problem with such a regulation was that it reduces the opportunity of state and local governments to contract with private-sector specialists for additional expertise and savings.

Under the old rules, tax-exempt bonds would be taxable if more than 10% of a government operation (a sewage treatment plant, for example) was used by private sources. The "10% rule" often made many public-private partnerships cost-prohibitive. Municipalities rightfully feared losing their tax-exempt debt status on large projects, and businesses feared losing money on contracts limited by law to a maximum of five years, which was another stipulation of the previous rules.

Under the old rules, tax-exempt bonds would be taxable if more than 10% of a government operation (a sewage treatment plant, for example) was used by private sources.

The five-year cap on contractual arrangements often prevented municipalities from creating healthy, long-term relationships with businesses for expensive infrastructure construction and repair. If contracts were allowed for longer periods—say, 20 years instead of five—private investors could invest large sums of money up front and be more assured of a fair return on their investment.

The city of Alpena in northeastern lower Michigan has contracted with Earth Tech (formerly WW Operations Services) in short stints and has saved the city more than $1 million since 1988 while improving water service and winning two national awards from the Environmental Protection Agency (EPA). Imagine the opportunities that may develop given the additional flexibility of a 20-year contract.

The new IRS rules allow for the following without loss of tax exempt status:

  • management agreements to run as long as 20 years or 80% of the facility’s life;

  • outsourcing of maintenance (such as janitorial work or equipment repair); and

  • the outright sale of government assets.

The final point above falls under what the new IRS rules call "change in use." Under change-in-use rules, the government that issued the tax-exempt debt to build, repair, and operate a public facility must have had no intention of changing the ownership or management of the facility when the bonds were issued. In addition, if the facility is sold, it must be sold at fair-market value. These rules, coupled with any one of the following three, are necessary to retain tax-exempt status during the sale of a government asset:

  • Outstanding bonds must be redeemed within 90 days of the sale of the facility. If the bonds cannot be redeemed, the issuer must create a "defeasance escrow" with funds that are sufficient to retire the principle and interest on outstanding bonds at their earliest due date. (A defeasance escrow is a legal and financial mechanism whereby a third party holds money to a transaction that is used for purposes stipulated in an agreement. )

  • If the sale results in a net cash profit for the issuing government, the income must be spent on a government-related purpose within two years of the sale.

  • The sale must result in the use of the facility for a purpose that would qualify it, for 501(c)3 bonds (bonds that are issued to finance nonprofit projects sponsored by organizations like the United Way) or tax-exempt private activity bonds.

A word of warning is warranted with regard to water and wastewater contracts. There appears to be an inter-departmental skirmish going on between the IRS and the EPA. The EPA is refusing to accept the IRS definition of what constitutes a lease versus an operating arrangement.

This has stalled private management agreements in municipalities across America and led The U.S. Conference of Mayors to express its concern over EPA involvement in local public-private partnerships.

The new rules make it easier for government and business to build stronger relationships that benefit everyone—governments, job providers, and taxpayers alike. Interdepartmental squabbles aside, the improvement in IRS regulations will provide business and government the flexibility to arrange mutually beneficial, voluntary arrangements with fewer federal restrictions and less waste of scarce public funds.