US TAX The 63-20 Not-for-Profit Contrivance

US TAX

The 63-20 Not-for-Profit contrivance

The United States has one of the world’s most anti-capitalist tax codes in its treatment of simple for-profit business versus supposedly not-for-profit (NFP) charitable and governmental businesses. Most toll facilities are capital-intensive businesses with interest on debt looming very large in their total expenses, since relative to many other businesses, their operations and maintenance are small. According to Karen Hedlund of the law firm Nossaman Gunther Knox & Elliott the US tax code is a nearly insuperable obstacle to the privatization of major state turnpike and other toll authorities in the US, and a major handicap in launching new investor-based projects. She says the tax code gives the state sector an approx 200 basis point advantage over investors when borrowing longterm in the capital markets.

So for example a tax-exempt can borrow at 5% whereas for the same project or business unit investors would have to pay 7%. If a toll facility carrying an average 50,000 vehicles per day is financed by investors buying say $200m of taxable bonds it will be paying $14m/yr in debt interest which amounts to 77c/toll, whereas a NFP will be paying $10m/yr or 55c/toll. The 22c/toll tax handicap probably isn’t the key to it. If the toll road is only expected to start with 30k vehs/day and to rise to 70k vehs/day by the end of the loan period, the opening year interest cost/toll will be $1.28/toll if financed in the taxable bond market compared to 91c/toll financed tax-exempt. That early handicap of say 37c/toll in the US tax code is enough to get developers scrambling around to find some way to contrive not-for-profit status.

Overseas we have the US State Department and various aid agencies preaching the virtues of privatization and reliance on market mechanisms to the rest of the world, while at home we suffer the world’s most socialistic tax code! The Chinese, still communist in their political system, do more to encourage investors to build toll roads that the US IRS. Perhaps one shouldn’t ever expect coherence, consistency let alone commonsense from the hucksters who legislate the US tax codes. But there is a Senate proposal which is a timid first step toward putting investors on a similar footing to not-for-profits, the grandiosely titled Highway Infrastructure Privatization Act known as HIPA (‘hyper’) which would establish a pilot program of 15 tax-exempt debt highway projects selected by — not the investors, we couldn’t trust them in the ‘ole US of A could we? — but the US Sec of Transp, and then only after consultation with the Treasury Sec, the 20 yr state transp plan etc etc. And the money cannot be used to take over an existing asset only for the construction of a new one. Whether this feeble HIPA bill makes it into law remains to be seen but it represents at least a glimmer of recognition of the anti-investor bias of the current tax regime.

Tax tail wags corporate dog: Meanwhile the tail of the tax code wags the corporate dog. Tax provisions almost dictate either the state or local government ownership of toll roads or private participation via a contrivance known as 63-20, an entity which can only be formed with the help of a select bunch of lawyers who devote their lives to mastering the esoterica of constantly evolving IRS case law. The way a toll road authority is structured, who appoints whom, and what their responsibilities and powers are, is dictated not by what is needed to serve the interests of those risking their money in funding the road, or what best serves the local community, or motorists, but what the IRS and tax courts demand. Traditionally 63-20 status has been used at local government behest to borrow for public schools, a courthouse, new town or municipal hospital. But local government is often “borrowed out” — unable or unwilling to take on more debt itself. So increasingly local governments want these things funded at arms length so that they have no responsibility if the projects goes sour and the debt cannot be serviced. So they have steadily stretched the envelop of tax law so that de facto independent agencies supposedly acting on their behalf, but for whom they have no fianncial responsibility, can gain IRS acceptance to issue tax exempt debt.

So the tax lawyers stage a little charade each time a 63-20 is floated. In order to gain IRS acceptance of the tax exempt status of its debt, the local government must approve the charter of the 63-20 corporation and the issue of its debt and have title to its assets after its bonds are paid off. But then it can effectively disown the outfit and usually proceeds to do so lest it be held responsible for any bad debts it generates. This need to put the 63-20 at arms length means that the local government cannot have the power to appoint or remove board members or get involved in operations, even though the project may have been sponsored by local government.

63-20s are increasingly sponsored by developers as a way to borrow cheaply and toll roads in Greenville SC, Phoenix AZ, Richmond VA and elsewhere are taking this form. Since the 63-20 cannot have any equity or generate any profit, the developers cannot get a return for their work in any longterm yields. The corporate form forces them to get their “profit” in the form of development “fees” charged for consulting services in setting up the project.

Hedlund: Karen Hedlund one of the country’s leading 63-20 lawyers said in a paper to a recent “Public Private Ventures in Transp Conference” held by the road builders association in Wash DC that the 63-20 form is “troubling” because of its artfully contrived lack of responsibility.

“The responsible government agency must first recognize that although the 63-20 corporation is issuing debt on its ‘behalf’ the non-profit entity may not be under its direct control. Once the government unit approves the corporationa nd its debt it generally has no formal role in determining how the corporation carries out the project. Indeed it may not even have the power to remove and reappoint board members. And its inability to replace board members means that this entity is not really politically responsible. Furthermore and perhaps even more troubling, it lacks any independent fianncial commitment to the project since it is a nonprofit corporationa nd cannot earn an equity return on any investment. What it constitutes is a group of (hopefully - ed) public-spirited citizens with a sincere interest in the success of the project, but not directly anserable to any elected official, and with no financial stake of their own in the project. How then can this entity be relied upon to act in the longterm interest of the private parties, including the developer/sponsor, contractors and bondholders) as well as the government unit?”

Here the specialist lawyers try to construct an elaborate set of agreements and contractual arrangements between the different parties to cover all possible eventualities and to get them to behave as if this were a less contrived and inherently awkward corporate form. (Contact Karen Hedlund 213 612 7800 kjh@ngke.com)