United States: Overview Of Tax-Exempt Financing For NonProfit Hospitals

Introduction

Scope. This memorandum provides a brief explanation and overview of tax-exempt financing for nonprofit hospitals and other healthcare organizations under Georgia law and the Internal Revenue Code of 1986. A variety of governmental debt obligations may qualify for tax exemption (e.g., bonds, notes, revenue anticipation certificates, bank loans, installment sales and leases), and these are sometimes referred to interchangeably as "bonds," "debt," or "obligations." A summary is presented of the state law requirements for issuance of debt by public hospital authorities. Rules governing the exemption from federal income taxation of interest paid on such obligations also are outlined. Debts issued for both governmental hospitals that have "reorganized" to be operated by a 501(c)(3) organization, and 501(c)(3) hospitals not affiliated with a Hospital Authority, are subject to additional federal requirements outlined below under the heading "Additional Requirements for 501(c)(3) Financing."

All Tax-Exempt Financing Must Be Through a Hospital Authority. 501(c)(3) organizations cannot themselves issue tax-exempt obligations (except in the very limited circumstance of a 63-20 corporation.) Instead, a tax-exempt obligation must be issued by a Hospital Authority and the proceeds made available by the Hospital Authority (by loan or otherwise) to the 501(c)(3) organization.

State Law of Debt Issuance

Hospital Authority Loans. Georgia Hospital Authorities have power to obtain secured or unsecured loans on their general credit, without the issuance of revenue anticipation certificates. However, such loans will not be tax-exempt unless the federal requirements outlined below are satisfied.

Revenue Anticipation Certificates. Hospital Authorities can issue revenue anticipation certificates for projects described in the Hospital Authorities Law. Projects can be, but need not be, mortgaged in support of the revenue anticipation certificates. Revenue anticipation certificates can only be utilized when the revenues pledged will be sufficient to pay the debt. However, a number of like or unlike revenue sources can be aggregated together to support an unprofitable project.

Leasing and Installment Purchases. Hospital Authorities may enter into long-term contracts, including leases and installment purchase contracts. Such a contract may allocate a portion of payments to interest, so that a lender may earn tax-exempt interest by leasing property, or selling it through installments. Alternatively, some other organization can serve as lessor, and a lender can lend funds to that organization or purchase the lease or fractional interests therein ("Certificates of Participation").

County 7-Mill Support. As authorized by the Hospital Authorities Law, Counties can enter into intergovernmental contracts with their Hospital Authorities and pledge up to 7 mills of ad valorem tax in support of Hospital Authority debt.

Validation. Revenue anticipation certificates, but not loans, installment purchases and leases, must be validated through a Superior Court proceeding prior to their issuance. The validation procedure takes approximately three weeks, and establishes that the certificates and their security are valid and incontestable.

Federal Requirements for Tax Exemption

Information Reporting. An information report on Form 8038-G must be filed with the Internal Revenue Service not later than the 15th day of the second calendar month after the close of the calendar quarter in which any tax-exempt governmental obligations are closed. Form 8038-GC can be utilized to consolidate borrowings aggregating less than $100,000, and must be filed annually by the February 15th following the calendar year of the borrowings. Form 8038-G requires such information as the issuer name, address and tax identification number; the name, date, CUSIP number and purpose of the issue; the maturity date, interest rate, issue price, stated redemption price at maturity, average weighted maturity, yield and net interest cost of the issue; and a description of the uses of the proceeds of the issues. If the obligation qualifies as a 501(c)(3) obligation, Form 8038 must be used.

Costs Financeable. Capital expenditures for a hospital's governmental or 501(c)(3) purposes are financeable. Costs expended before the financing may be financed only if the Hospital Authority or 501(c)(3) organization previously made a "declaration of official intent" to finance such costs. Working capital is financeable only in very limited circumstances.

Registration Requirement. With limited exceptions, tax-exempt obligations must be in registered form. Provision must be made for the registration of the recipient of the tax-exempt interest on a register maintained by or on behalf of the issuer, and assignments must be registered.

Federal Guaranty Prohibition. Governmental obligations are not entitled to tax exemption if the payment of principal or interest is directly or indirectly guaranteed in whole or in part by the United States or any of its agencies or instrumentalities. Obligations will be treated as guaranteed by the federal government if 5% or more of the proceeds are used to make loans guaranteed by the federal government or to invest in federally insured deposits or accounts. Exceptions are made to permit proceeds to be invested in United States Treasury obligations and to permit investments of bona fide debt service funds, reasonably required reserve funds, and funds to hold proceeds prior to their initial use.

Arbitrage Restrictions. Obligations are not entitled to tax exemption if they are deemed "arbitrage bonds." Arbitrage rules are exceedingly complex, and only a brief sketch is provided below. Obligations are arbitrage bonds if more than 5% or $100,000 of the proceeds are reasonably expected to be used, or to replace funds used, directly or indirectly to acquire higher yielding investments. This concept of "investments" is broad, including virtually any contract or property to which a rate of return can be ascribed. Although debt proceeds can be invested in other tax-exempt governmental bonds, they cannot be invested in higher yielding private activity bonds subject to alternative minimum tax. Exceptions are made for investment of proceeds during certain temporary periods, including the temporary investment of monies in a bona fide debt service fund and in a fund for proceeds awaiting use. The temporary period for investment of proceeds pending use for the acquisition or construction of property is three years. Amounts in a reasonably required reserve or replacement fund are not subject to investment yield restrictions, provided that the reserve or replacement fund cannot generally exceed 10% of the proceeds of the issue.

Arbitrage Rebate. Even though obligations may comply with the arbitrage rules referred to above, arbitrage earnings in excess of the yield on the obligations must be rebated periodically to the federal government. The rebate rules also are exceedingly complex, and require that periodic computations and filings be made. However, there are limited "construction," "18-month" and "6 month" exemptions from the rebate requirement.

Construction Exemption. The construction exemption applies to financings where at least 75% of the "net proceeds" of the obligations are to be used for construction, reconstruction or rehabilitation. The rebate requirement does not apply if the net proceeds are expended in accordance with the following minimum requirements: 10% within six months; 45% within one year; 75% within 18 months; and 100% within two years (except that the two year period may be extended to three years if the requirement would have been met within two years but for a reasonable retainage not exceeding 5% required to ensure compliance with a terms of a construction contract). "Net proceeds" includes the proceeds of the obligations (except for amounts placed in a reasonably required reserve fund) plus investment proceeds earned before the close of the period. If, however, the Hospital Authority elects on the closing date, net proceeds excludes interest earnings on any reasonably required reserve fund, but interest earnings on such fund will be subject to the rebate requirement from the closing date, rather than from the end of the two-year expenditure period. If an Hospital Authority elects on or before the closing date to pay a penalty in lieu of payment of the rebate amount, the rebate requirement is deemed to be satisfied if the Hospital Authority pays a penalty with respect to the close of each six-month period after the closing date equal to 1.5% of the amount of the net proceeds of the obligations, which as of the close of such period, are not spent as required.

18-Month Exemption. An exemption from the rebate requirement applies if all gross proceeds (except for proceeds placed in a reasonably required reserve fund) are expended in accordance with the following schedule: At least 15% within 6 months; at least 60% within 12 months; and 100% within 18 months (with an exception for reasonable retainage spent within 30 months).

Six Month Exemption. An exemption from the rebate requirement applies if all gross proceeds (except for proceeds placed in a reasonably required reserve fund) are expended within six months.

Limitation of Exemptions. Compliance with the construction exemption, the 18-month exemption or the 6-month exemption does not relieve the Hospital Authority from rebating arbitrage from investment of a reasonably required reserve fund or, for issues other than governmental fixed rate bonds with a maturity in excess of 5 years, arbitrage on a bona fide debt service fund in excess of $100,000 per year.

"Bank-Qualified Obligations". Generally, financial institutions holding a tax-exempt obligations are not entitled to a deduction for related carrying costs. The institution's carrying cost is considered that portion of the cost of the obligation determined by the ratio of the institution's borrowed funds to its equity. Consequently, banks and other financial institutions find it unattractive to hold many tax-exempt obligations. However, a Hospital Authority that reasonably anticipates issuing not more than $10,000,000 of governmental obligations during any calendar year may designate its governmental and 501(c)(3) obligations as "qualified tax-exempt obligations." Such obligations are subject to only a 20% disallowance of the allocable carrying cost, and are attractive for banks to hold. For the purpose of determining compliance with the $10,000,000 limitation, obligations of the Hospital Authority and any subordinate entities must be aggregated, together with obligations of all superior entities issued on behalf of the Hospital Authority. Note that bank-qualified obligations issued by a Hospital Authority may count against the ability of the related County to issue bank-qualified obligations.

Refundings. Tax-exempt governmental and 501(c)(3) obligations may be refinanced or "refunded" by the issuance of tax-exempt refunding obligations. An unlimited number of "current" refundings may occur, in which the prior obligations are retired within 90 days of the issuance of the refunding obligations. However, governmental obligations originally issued after December 31, 1985 may be "advance" refunded (refunding occurs more than 90 days before the original obligations will be retired) only once, and the originally issued obligations must be retired on their first call date. Because bonds are commonly issued as non-callable for a fixed period, the only refinancing possible frequently is an advance refunding. Special arbitrage rules apply to refundings. When obligations are refunded, the liens and covenants securing them normally are "defeased," and the property or revenues can be pledged to the refunding obligations.

Private Activity Bond Tests. In order for governmental Hospital Authority obligations to be and remain tax-exempt they must not constitute "private activity bonds". However, if the private activity is by 501(c)(3) organizations, the obligations can qualify for tax-exemption if the additional requirements for 501(c)(3) financing are satisfied (see the section "Additional Requirements For 501(c)(3) Financing," below). Private activity bonds are obligations that meet the private business test or the private loan financing test. Particular analysis of the private activity test will be required when a user of the facility to be financed has entered or will enter into a management contract, lease, or other long-term contract.

  • Private Business Test. Obligations meet the private business test if more than 10% of the proceeds are to be used directly or indirectly in a private business use, and if more than 10% of the proceeds are directly or indirectly secured by or to be derived from property put to a private business use (or payments with respect to such property). Private business use generally means use by private persons or entities other than as members of the general public. For example, if more than 10% of a facility is to be used by a nongovernmental entity (e.g., a hospital managed by a for-profit or nonprofit management company, or hospital space leased for the conduct of private medical practices), and payments derived from such use will be available to pay the bonds, the otherwise governmental bonds issued for the facility would become private activity bonds. However, certain management contracts and other use arrangements are exempted if they meet I.R.S. guidelines. Any private business issues should be analyzed by Bond Counsel in the light of the new, detailed regulations.
  • Management Contract Safe Harbors. Part or all of facilities to be financed by a Hospital Authority are sometimes managed or operated by for-profit companies. "Safe harbor" guidelines can be used to assure that such arrangements do not impair the tax exemption of obligations issued for such facilities. Briefly, the guidelines require that the manager's or operator's compensation be determined by a periodic fixed fee, a capitation fee (an amount per person, regardless of services rendered), a per-unit-of-services fee, or a percentage of gross revenues or expenses, but in no case by a percentage of net revenues or profits. The permitted length of a contract (including all binding renewal options) is limited depending on the type of compensation; the more fixed compensation, the longer a contract may extend. If compensation is based on at least 95% fixed fees, contracts may be for a term up to 15-years; if at least 80% fixed fees, 10-years; if 50% fixed fees or 100% capitation fees (or a combination), 5-years (if the contract is cancellable by the Hospital Authority within 3 years); if per-unit fees, 3-years (if the contract is cancellable by the Hospital Authority within 2 years). A special rule applies to new facilities during a start-up period or to facilities primarily providing services to third parties: compensation can be based entirely on a percentage of fees charged, or a combination of per-unit-of-services fees and a fixed fee (or during the start-up period, a percentage of gross revenues, adjusted gross revenues or expenses), if the contract has a term of 2-years or less (cancellable by the Hospital Authority within 1 year).
  • Private Loan Test. The private loan financing test is met if the lesser of 5% of debt proceeds or $5,000,000 is used directly or indirectly to make or finance loans to persons other than governmental units. An indirect loan may be found, for example, if borrowings are used to finance facilities to be used by less than all of the general public and paid for by user fees.

Additional Requirements for 501(c)(3) Financing

Entities Subject to Additional Requirements. Obligations issued by a Hospital Authority that has "reorganized" to be operated by a 501(c)(3) organization, and obligations issued for a nonprofit hospital operating as a 501(c)(3) organization and not directly affiliated with a Hospital Authority, may qualify for tax-exemption, but only if requirements are satisfied in addition to the requirements set forth above under the heading "Federal Requirements for Tax-Exemption." Principally, these requirements are the use of proceeds test, the TEFRA hearing and approval procedure, and the 2% limitation on the financing of costs of issuance.

Use of Proceeds Test. In order for financing for a 501(c)(3) organization to qualify for tax exemption, no more than 5% of the proceeds of the financing may be directly or indirectly put to "business use," if payments of more than 5% of the financing is directly or indirectly secured by or to be derived from property put to "business use" (or payments with respect to such property). "Business use" means use by the 501(c)(3) organization that would be treated as "unrelated taxable business income" or use by others in any nongovernmental trade or business. For the purposes of this test, the "Private Activity Tests" described above in this Memorandum are applied, although treating the 501(c)(3) organization as if it were a governmental unit and substituting 5% of proceeds "for 10% of proceeds."

TEFRA Hearing and Approval. Before any tax-exempt obligation in the 501(c)(3) category can be issued, a "TEFRA" public hearing must be conducted in accordance with IRS requirements, and thereafter a "TEFRA" approval must be given by the appropriate elected representative or representatives. Usually the Board of County Commissioners is the appropriate approving body, although additional approvals may be required. This requirement applies regardless of whether the obligations are denominated as bonds, certificates, loans, leases or installment sales.

Length of Financing. The maturity of a 501(c)(3) financing is limited by Federal law to 120% of the average reasonably expected economic life of the Project. Average economic life must be weighed by taking into account the respective costs of the components of the Project. Economic life is to be determined as of the later of the date a debt is issued or the date facilities are placed into service. Midpoint lives under the old ADR system for personal property and guideline lives under Revenue Procedure 62-21 for buildings may be treated as safe harbors for determining economic lives. Land generally is not to be taken into account in determining the average.

Costs of Issuance Limitation. For 501(c)(3) category of obligations, no more than 2% of the borrowed funds can be used to pay costs associated with the issuance or closing. If costs exceed that amount, they must be paid from other funds.

Summary

This memorandum provides an overview of tax-exempt financing for nonprofit hospitals and other healthcare organizations from both a Georgia law and federal tax prospective. Both Hospital Authorities and 501(c)(3) organizations (when the debt is issued on their behalf by a Hospital Authority) can use tax-exempt financing. The special rules for 501(c)(3) hospitals and "reorganized" Hospital Authorities also are described above. This brief treatment can do no more than touch upon some of the more salient issues. Many details and complicating factors have been omitted, and additional information is available from the writer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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