When facilities are financed with tax-exempt debt, the borrower is subject to an array of restrictions and compliance requirements. At the core are the requirements that the proceeds be used to further tax-exempt purposes and that the financed facilities comply with use restrictions. (There are also restrictions on arbitrage and obligations to rebate excess investment earnings on bond proceeds.)
A basic requirement is that the owner of the facilities must be an entity exempt under Section 501(c)(3) of the Internal Revenue Code (or a governmental entity). Generally, for 501(c)(3) debt to qualify as tax-exempt debt, one of two conditions must be met: Either private business use must be less than 5 percent of the proceeds, or debt service payments secured by property or attributable to revenues from property that is used or intended for private business use must not exceed 5 percent of total debt service payments.
For purposes of these rules, private business use includes:
- Payment of costs of issuance
- Use of the property in an unrelated trade or business
- Use of the property by non-exempt parties or the federal government
Even certain types of management and service agreements with respect to financed property can create private use (although there are safe harbors under which parties can structure management and services compensation to avoid private use characterization). For large financings, the amount of bonds attributable to private use may not exceed $15 million, even if that is less than 5 percent of the total amount of the bonds. Substantial adverse consequences (including loss of tax exemption for bond interest) can follow violation of the requirements.
A party choosing tax-exempt financing, then, must pay close attention to use of the financed property over time and monitor the changing characteristics of a facility. When outpatient or mixed-use space is envisioned, such as with respect to an ambulatory care facility, the practical effect may be limited flexibility as the use of space changes through the years. The IRS has an active oversight and audit program for tax-exempt financing, and there have been recent cases where borrowers have been surprised that the changing character of facilities over time has resulted in bond financing violations and the attendant undesirable consequences. Parties faced with mitigating the effect of the limitations associated with tax-exempt financing sometimes impose severe restrictions on themselves and further limit the flexibility of the financed facilities (e.g., no “for-profit” tenants).
Daniel K. Zismer, PhD, is Wegmiller Professor in Health Administration and director, Masters of Health Administration and Executive Studies Program, Division of Health Policy and Management, School of Public Health, University of Minnesota, Minneapolis.
James Fox is a director and senior CFO consultant, Warbird Consulting Partners, LLC, Minneapolis.
Paul Torgerson, JD, is a partner, Dorsey & Whitney, LLP, Minneapolis.
For more information, see Daniel Zismer, James Fox and Paul Torgerson's "Financing Strategic Healthcare Facilities: The Growing Attraction of Alternative Capital", hfm, May 2013