Investor-owned hospital companies may find it more expensive to buy not-for-profit hospitals that have issued tax-exempt bonds in the past five years.
That's the implication of an Internal Revenue Service private-letter ruling issued last month.
The ruling was requested by a not-for-profit hospital that is being sold to an investor-owned chain in a deal that involved defeasing, or replacing the collateral of, the hospital's tax-exempt bonds.
Howard Levenson, healthcare tax partner in the Washington office of Ernst & Young, said the ruling made a $1 million difference in the hospital's sale price. The letter will be made public in September, 90 days after it was issued.
Because the hospital, whose name was not disclosed, issued tax-exempt bonds within the past five years, it was not protected by a "safe harbor" ruling issued by the IRS in 1993 concerning the sale of tax-exempt hospitals.
With the flurry of merger-and-acquisition activity by not-for-profit hospi- Finance
tals, many are requesting private-letter rulings from the IRS when their bond issues are less than 5 years old, Levenson said.
"It's very difficult, if not impossible, to get bond counsel to render any kind of opinion because they don't know what's acceptable," he added.
Generally, hospitals thought they were safe if they paid what's considered a "reasonable premium" over market value to defease the tax-exempt bonds. However, the private-letter ruling his client received puts "a new twist" on the safe harbor for selling tax-exempt bonds, he said.
Generally, when a tax-paying company buys a tax-exempt hospital, it must defease the bonds, meaning that it must replace the collateral of the hospital with other collateral. Typically, the other collateral is risk-free, triple-A rated bonds. Then, at the first available call date, the bonds are bought back from investors.
But in many cases the hospital's bonds aren't as highly rated as the ones with which they're replaced. That means the premium paid may not be as high as the value of the replacement bonds.
However, the IRS told the hospital in the ruling that it's not enough to offer more for the bonds than the current market value. In such cases, by paying more to the bondholders, the tax-exempt charity winds up getting less of the sale proceeds. The IRS said the buyer must pay a premium above what the bonds would be worth if they were triple-A securities.
That made a big difference to the hospital in the recent case. "It takes $1 million out of the charitable organization and transfers it to private individuals or investors holding the bonds," Levenson said, noting that the sale proceeds were being funneled into a charitable foundation.
However, he acknowledged this could be a point of negotiation between a hospital board and investor-owned chain. Instead of subtracting the amount from the foundation, the chain could be asked to increase the overall purchase price, he said.