Tax Free Bond Financed Facilities
Carnegie Mellon University (the “University”) is an exempt organization described in section 501(c)(3) of the Internal Revenue Code of 1986 (the “Code”). Because of its status under the Code, the University may benefit from issuing tax-exempt bonds, meaning that the holders of the bonds are not taxed on the interest paid to them by the University. There are very specific rules concerning the exempt organization’s use of tax-exempt bond financed facilities, and if the University were to violate the rules, then the interest on the bonds would become taxable. All of the University’s bond documents require the University to compensate the bond holders for the additional tax due on the interest if the bonds become taxable. Because tax-exempt bonds were so significant in the financing used by the University to build, acquire and renovate property, such a penalty amount would be substantial and would amount to many millions of dollars. Further, the University would have difficulty issuing tax-exempt bonds in the future because its credibility in the marketplace would have been damaged. Thus, it is imperative that the University operate in accord with the rules with respect to the use of bond financed property.
The rules with respect to using bond financed property for sponsored research are set forth in Rev. Proc. 2007-47. Because the amount of tax-exempt bonds has been so significant, essentially all research space at the University was financed with outstanding tax-exempt bonds in some manner. Thus, the rules in the Rev. Proc. should be applied to all sponsored research undertaken by the University.
As an initial matter, only “basic research”, as defined in the Rev. Proc., may be undertaken in tax-exempt financed facilities. Basic research is defined as any original investigation for the advancement of scientific knowledge not having a specific commercial objective. This would generally permit research through the prototype stage to be undertaken in bond financed facilities. On the other hand, product testing of any type would not be permitted in bond financed facilities. The reason for this requirement is that basic research is deemed to be related to the University’s tax-exempt purpose while research having a specific commercial objective is not. This requirement applies whether there is one sponsor or a cooperative research project.
The Rev. Proc. then sets forth two standards with respect to operating guidelines for sponsored research agreements depending on whether the research is sponsored by a corporation or is pursuant to a cooperative research agreement.
Corporate sponsored research is permitted in bond financed facilities as long as the sponsor is required to pay “a competitive price” for the license or any other use of the resulting technology. The price must be determined at the time the license or other resulting technology is available for use. While the sponsor may have exclusive use of the technology, the price paid by the sponsor for the rights at the time of the license or other use must be no less than the price that would have been paid by any non-sponsoring party for the same rights. There can be no credit toward the licensing fee for any amounts paid by the sponsor to sponsor the research.
Given that the license fee must be based on fair market value at the time of licensing, it would be highly likely to violate Rev. Proc. 2007-47 if the University were to allocate some portion of the sponsor’s payment to a pre-paid license. On the other hand, the University may determine to undertake the research for a lesser amount knowing that there would be a payment by the sponsor for the license when the research is complete. There should be no direct correlation between the amount requested of the sponsor initially and the license fee. At most, the agreement for the sponsored research should state that the sponsor would pay fair market value for any license at the time of licensing. Further, the Internal Revenue Service has ruled in Ltr. Rul. 199914045, January 8, 1999, that an exempt organization could offer a non-exclusive, royalty-free license to a corporate sponsor as long as it was willing to offer a license on the same terms to any non-sponsoring party. If either of these two accommodations is not possible, then the sponsor must pay for the research and then pay fair market for the license at the time of licensing. What this means, in practical terms, is that the University is not able to offer non-exclusive royalty free licenses to sponsors in the initial sponsored research contract.
Cooperative Research Agreements.
Research pursuant to a joint industry-governmental cooperative research arrangement, as defined in the Rev. Proc., is permitted in bond financed facilities. There are four conditions to qualify as a joint industry-governmental cooperative research arrangement:
- There must be multiple, unrelated sponsors who agree to fund governmentally performed basic research
- The research to be performed and the manner in which it is to be performed must be determined by the University
- Title to any patent or other product incidentally resulting from the basic research must be exclusively with the University
- The sponsors must receive no more than a nonexclusive, royalty-free license to use the product of any of the research
As long as the four requirements are met, the research does not adversely affect the outstanding bonds.
Finally, the Rev. Proc. does provide a de minimus exception for small amounts (collectively) but it is extremely complicated to apply, and generally not workable for our purposes. We are, however, exploring with outside tax counsel the ability to stretch these limits as much as possible.
While colleges and universities have lobbied the Internal Revenue Service to reconsider its position with respect to sponsored research in bond financed facilities, they have not, as yet, been successful. Consequently, if the University does not receive fair market royalties from the sponsors of sponsored research, it risks having its tax exempt bonds become taxable, with all of the concomitant consequences.
Federal Tax Issues Related to Tax-Exempt Financing of University Sponsored Research Facilities
Universities qualified as 501(c)(3) organizations, prior to 1997, could use "qualified 501(c)(3) bonds" to fund projects, including sponsored research facilities, so long as the research performed in the facilities did not constitute an "unrelated trade or business."
In February 1997, the IRS implemented new private activity bond regulations that applied to "qualified 501(c)(3) bonds." (Rev. Proc. 2007-47)
Regulations restrict the type of facilities which may be financed on a tax-exempt basis based on whether the activities conducted there amount to a "private business use" of the facility.
Higher hurdle: "private business use" is different from activities constituting an "unrelated trade or business" use.
If the private business use test is "met," then the issued bond will no longer qualify as tax-exempt. Note: 5% of the proceeds of the issue can be used for private business use.
Under "private use," the Service provided a narrow "safe harbor" for two types of sponsored research contracts:
- Corporate research projects where the corporate sponsor pays a competitive price for any license or other use of the resulting technology, determined at the time the research is complete and ready for exploitation
- Multi-party cooperative research whereby unrelated sponsors agree to fund basic research
Corporate Sponsored Research
- Will not result in private business use if license or use of technology is permitted on the same terms as would be required to permit such use by any unrelated non-sponsoring organization
- Requires university to sell any license to sponsor for fair market value (university may agree in advance to only offer the technology to sponsoring organization, provided the amount of the fee reflects the fair market value of the research licenses at time of sale)
- To whether sponsored costs may be deducted from the sale of the technology to the sponsoring organization
- As to how to determine what constitutes a "competitive price" for the salable technology
Cooperative Research Agreements
- Multiple sponsors must agree to fund research performed by the university
- The research and manner in which it is to be performed must be selected by the university
- Sponsoring organizations may be entitled to no more than a nonexclusive, royalty-free license of use the product or technology of the research
- Rev. Proc. 2007-47 is silent as what costs a university may charge a non-sponsoring organization seeking to use the new product or technology
Federally Sponsored Cooperative Research Agreements
- Should not result in private business use