The formation of integrated delivery networks, a key to healthcare reform, is likely to be inhibited by rising capital costs caused by restrictions on tax-exempt financing.
Healthcare finance experts say that without changes in the federal tax code, not-for-profit healthcare organizations will spend more on attorneys' fees to structure networks to avoid limits on tax exemption, and more providers will be forced to finance projects with taxable sources of capital.
If the rules for tax-exemption are tightened or hospitals' charitable status is repealed altogether, financing costs could skyrocket. The interest rates on a 30-year taxable bond issue are about two percentage points more than on a comparable tax-exempt deal.
No one knows whether any networks have been prevented from forming because of tax-law quirks, but finance experts worry that they could be.
According to the National Council of Health Facilities Finance Authorities, one New York hospital may be passed over by others looking to merge. The hospital, which the council didn't identify, has been rejected once by a potential merger partner that refused to assume the burden of a covenant on the hospital's financing.
Since then, the hospital has advance refunded its debt to reduce its interest expense. But because of a tax-law limit on refundings, it won't be able to eliminate the debt that discouraged the consolidation, making it "an unattractive merger candidate," the council said.
To comply with tax laws, hospitals must endure needless hassles, finance experts said.
Consider the $130 million medical complex that Fallon Healthcare System is building in Worcester, Mass. The complex, which includes a new 350-bed hospital and medical office buildings, will be funded with both taxable and tax-exempt debt. The tax code doesn't allow hospitals to fund medical office buildings with tax-exempt money.
The financing will be complex and cumbersome, but Fallon executives knew that from the project's inception, according to Alan M. Stoll, executive vice president of the Fallon Foundation. "That's the reality."
Code needs updating.Manymunicipal healthcare experts believe it's yesterday's reality. They believe the Internal Revenue Code is out of sync with tax-exempt hospitals' emerging capital needs and should be updated to conform with the incentives of healthcare reform. They want any reform plan Congress passes to address the issue.
An IRS spokesman said it's inappropriate to comment on what hospitals perceive as undue restrictions in the tax code because only Congress can decide to change the law.
Difficulty navigating through the maze of tax-law limits won't stop hospitals from selling tax-exempt bonds, observers said. Last year, the nation's healthcare providers sold 735 tax-exempt healthcare issues worth $28.4 billion, said Securities Data Corp., a Newark, N.J.-based financial services firm. Just 50 taxable deals worth $899.3 million were sold by healthcare providers last year, Securities Data said.
"I don't see the tax law significantly impacting hospital access to tax-exempt capital," said Joan Marron, first vice president in the municipal investment banking division of PaineWebber. About 80% of the time, changes in tax law diminish access to the market, but "creative minds work around this," she said.
But even those who don't believe the laws need to be amended expect hospitals to spend more to navigate around the current rules.
"It's a real potential problem and I don't think people are looking at the whole picture," said Wendy Herr, group executive of policy services at the Healthcare Financial Management Association, Baltimore.
Neither the HFMA nor the American Hospital Association has focused on updating the tax law to help hospitals raise capital. The groups' lobbying efforts are aimed at preserving a broad measure of charity care for not-for-profit hospitals to retain their tax-exempt status.
Testifying before the House Ways and Means Select Revenue Measures subcommittee last month, Stephen Claiborn, a managing director in the Houston office of Lehman Brothers, pointed out several areas in which the federal tax code collides with tax-exempt hospitals' capital needs.
Many tax provisions that affect hospital borrowing were designed to prevent abuses by tax-exempt providers.
For example, through the Tax Reform Act of 1986, Congress enacted a cap on the amount of money that non-hospital organizations may borrow. The cap was meant to prevent well-endowed organizations such as universities from reaping profits by investing lower-rate tax-exempt funds in higher-yielding securities. But with healthcare reform, many non-hospital settings will be integral parts of regional health networks.
Mr. Claiborn said the federal tax law limits the ability of hospital networks to finance outpatient facilities, such as emergency-care clinics and community-care centers. The tax code also contains limits that make it needlessly difficult and more costly for small hospitals to sell their bonds, he said.
Proposed changes in the so-called "community benefit standards," which spell out the rules for hospitals' exemption from federal taxes, could reduce the value of outstanding bonds and increase the perceived risk of future bond issues, he said.
Mr. Claiborn spoke on behalf of the Public Securities Association, an international trade association that represents municipal securities dealers. The PSA and other municipal healthcare finance organizations are seeking changes that would make it easier and less costly for hospitals to form integrated delivery networks.
"If the objective (of healthcare reform) is to encourage consolidation, then these issues probably ought to be dealt with in some kind of reform legislation," said Christopher Conley, a senior vice president at Lehman Brothers in New York.
No one has proposed separate legislation, and current healthcare reform proposals don't address the issue.
In the national healthcare reform debate, hospitals' capital needs aren't as important as whether or not there will be an employer mandate, said Daniel M. Fox, president of the Milbank Memorial Fund, the nation's oldest endowed philanthropic foundation in healthcare. "But it's up there in the next rank," he said.
Milbank has developed a policy paper on the capital issue in the hope of influencing key decisionmakers.
New capital priorities.In past years,hospitals sold tax-exempt bonds mostly to pay for "bricks-and-mortar" projects. But as the industry restructures, its capital needs are shifting.
"We don't need these Gothic castles that have been called hospitals," said Donn Szaro, director of Ernst & Young's Miami-based healthcare practice. What's needed are patient-friendly systems that provide a comprehensive array of services, he said. "That's where the capital needs will come in."
For example, hospitals and healthcare systems that merge with other providers will need to sell bonds to consolidate existing debt. New money will be used to renovate or replace aging facilities and acquire or build community clinics, private practices and other hospitals. Also, more providers will invest in new computer systems to link all the facilities in their network.
In the future, bond issues may become smaller, but hospitals will need to sell bonds more frequently, finance experts said.
But Steven Renn, a first vice president at AMBAC Indemnity Corp., a New York-based bond insurer, said he doesn't see healthcare and hospital bond issues declining. From 1992 to 1993, the average healthcare bond issue rose to $28.9 million from $24.6 million, and the average hospital bond issue increased to $36.2 million from $29.2 million.
The trouble comes when hospitals' capital needs clash with tax law, experts said.
The federal tax code requires only that tax-exempt hospitals open their emergency departments to anyone seeking care, regardless of a patient's ability to pay. The IRS has ruled that a tax-exempt hospital also must have a community-based governing board and a medical staff that's open to any physician who seeks privileges there.
Most hospital finance officers say they believe that not-for-profit hospitals will continue to have access to tax-exempt capital. But the criteria for qualifying as a tax-exempt healthcare provider may get tougher, they add.
While Mr. Clinton's plan provides a broad standard for measuring a hospital's community benefit, some policymakers want to tighten the rules.
In 1991, bills introduced by Reps. Brian Donnelly (D-Mass.) and Edward Roybal (D-Calif.) would have linked hospitals' tax-exempt status to specific levels of charity care and community service. Neither bill survived, and no new legislation has been introduced. Both sponsors are no longer in Congress.
However, a bill introduced last November by Rep. Fortney "Pete" Stark (D-Calif.), chairman of the House Ways and Means health subcommittee, would give the IRS the authority to assess excise taxes against tax-exempt providers that abuse their tax status. Mr. Stark's bill is still in committee.
If tougher criteria are approved, it could be more difficult for hospitals to sell their bonds, said Roy A. Pentilla, executive director of the Michigan Hospital Finance Authority.
Costly talk.Eliminating hospitals'tax exemptions would be so disruptive that few people have seriously considered how hospitals would react."It's far too early in the healthcare debate to even talk about that," Mr. Conley said.
But the fact that hospitals' future tax-exempt status remains in question could frighten bond buyers, making it more difficult and costly for hospitals to sell their bonds now and in years to come, said Micah S. Green, executive vice president and head of the Washington office of the Public Securities Association.
Another potential roadblock is the $150 million cap on the amount of tax-exempt money not-for-profit healthcare facilities may borrow. The law, implemented in 1986, exempts hospitals from the cap. But other types of not-for-profit facilities that hospitals might own, such as clinics, home health agencies and health maintenance organizations, are barred from exceeding the limit.
While the president's reform plan encourages alternatives to hospital care, the $150 million cap is stultifying, industry experts said. They said the cap may impede hospital-based healthcare systems from forming integrated networks of care.
For example, if two hospitals plan to merge and each has $80 million in non-hospital bonds outstanding, they would violate the cap, Mr. Pentilla said. "They'll have to stop and see what they can do to get around it," such as to pay off some of the debt before the merger, he said. Hospitals will have to spend more in legal fees to look for potential violations and address them, he said.
The limit also affects non-hospital providers that want to raise capital. The New York State Association of Retarded Persons, the nation's largest provider of not-for-profit community-based mental health services, has reached the limit and can't issue more bonds for new community facilities. Meanwhile, the association is attempting to comply with a court-ordered mandate to de-institutionalize state mental health patients.
According to the National Council of Health Facilities Finance Authorities, at least 12 healthcare institutions in five states have reached the cap. Another four providers are close to the cap, with $120 million to $150 million in bonds outstanding. The council only identified two institutions by name, including the New York mental health provider and a not-for-profit organization in Idaho.
Current tax law also sets a limit of one advance refunding for hospital bonds. The limit applies to refundings of bonds issued after 1986.
In an advance funding, an escrow account is established with proceeds from a tax-exempt bond sale. The account is used to make debt-service payments until the old bonds can be redeemed. Advance refundings enable hospitals to refinance long-term debt at lower rates before the first call date on the bonds.
The one-time limit has prevented some hospitals from further reducing outstanding debt costs. The limit also may restrain hospitals that want to merge, finance experts said.
Eventually, the advance refunding limit will increase hospitals' underlying debt, said Ronald R. Long, senior vice president of finance at St. Mary's Health Network in Reno, Nev.
Refunding maneuver.St. Mary's wasprevented from refunding $45 million in outstanding bonds last year because it refunded the bonds in 1988. The interest rate on the original debt was 7.75%. To take advantage of lower interest rates, the hospital system skirted the advance refunding restriction.
First, St. Mary's identified $25 million in new construction projects and issued an equivalent amount of new debt. Then, it took another $25 million out of its cash reserves and placed the money in escrow to advance-refund its old bonds. The $25 million withdrawal from cash reserves was offset by the new debt. The maneuver enabled St. Mary's to reduce a portion of its higher-rate debt.
Hospitals with outstanding tax-exempt bonds face another potential barrier. Federal tax law bars them from making any significant change in the use of their facilities for five years. They're permanently prevented from leasing out any significant amount of space, said Edward M. Murphy, executive director of the Massachusetts Health and Educational Facilities Authority.
The restriction prevents hospitals from downsizing and redeploying their assets, Mr. Murphy said. What healthcare providers need now is more flexibility, "and the tax code affirmatively stands in the way of doing that," he said.
Furthermore, a prohibition on the use of tax-exempt bond proceeds will inhibit affiliations needed to implement healthcare reform, he said. Under the federal tax code, no proprietary entity may benefit from the use of tax-exempt assets, and no earnings of a tax-exempt charity can "inure" to the benefit of private individuals.
A not-for-profit hospital that decides to acquire a taxable, physician-owned hospital will have to prove to the IRS that it paid fair-market value, said Laura Kalick, director of Coopers & Lybrand's not-for-profit healthcare practice.
Because of limits on the use of tax-exempt financing in joint ventures with for-profit entities, more hospitals will turn to taxable financing sources, experts said. Taxable bonds, bank loans, receivables securitization, and mortgages and sale-leaseback arrangements with real estate investment trusts are among some options.
Even if the hospital pays the fair market price, the "IRS still likes to see the (tax-exempt) hospital in (financial) control," Ms. Kalick said.
In one closely watched case, the IRS ruled that a new tax-exempt organization formed by the for-profit physician-owned Friendly Hills HealthCare Network in La Habra, Calif., could have no more than 20% physician representation on the board of the not-for-profit corporation (Feb. 15, 1993, p. 2).
Getting physicians to surrender majority control is "probably one of the biggest roadblocks to integration," Ms. Kalick said.
Unless Congress decides to ease tax law restrictions, tax-exempt money will be a little harder to come by. "If you want to get the financing," Ms. Kalick said, "you'll have to dot your i's and cross your t's (and) comply with all the IRS rules."