Association of State Correctional Administrators

Alternatives
for Financing
Prison Facilities

213 Court Street

•

Middletown, CT 06457

•

(860) 704-6410

Alternatives for Financing
Prison Facilities

Prepared by
Brown & Wood LLP

1999

TABLE OF CONTENTS
EXECUTIVE SUMMARY ......................................................................................................... iii
I.

GENERAL INTRODUCTION............................................................................................ 1

II. PUBLIC FINANCE VEHICLES FOR PRISON CONSTRUCTION ............................. 1
A. GENERAL OBLIGATION BONDS..........................................................................................................................2
1.
General Description ...................................................................................................................2
2.
Prison Financing with General Obligation Bonds .....................................................................2
B. REVENUE BONDS...............................................................................................................................................2
1.
General Description ...................................................................................................................2
2.
Prison Financing with Revenue Bonds......................................................................................4
C. CERTIFICATES OF PARTICIPATION .....................................................................................................................5
1.
General Description ...................................................................................................................5
2.
Prison Financing with Certificates of Participation...................................................................7
3.
County and Municipal Financing of Prison Facilities ...............................................................8

III. FEDERAL TAX CONSIDERATIONS............................................................................. 10
IV. PUBLIC/PRIVATE COMBINATIONS ........................................................................... 11
A.
B.
C.
D.
E.
F.
G.

V.

PUBLIC OWNERSHIP, CONSTRUCTION, AND OPERATION .................................................................................11
PUBLIC OWNERSHIP, PRIVATE DESIGN-BUILD ................................................................................................12
PUBLIC OWNERSHIP AND CONSTRUCTION, PRIVATE OPERATION ...................................................................13
PUBLIC OWNERSHIP, PRIVATE CONSTRUCTION AND OPERATION ...................................................................15
PRIVATE FINANCING AND CONSTRUCTION: THE USE OF REITS.....................................................................15
PRIVATE FINANCING, CONSTRUCTION AND OPERATION (A/K/A BUILD-OWN-OPERATE)................................17
THE BIRTH OF SPECULATIVE PRISONS.............................................................................................................18

A MATRIX SUMMARY.................................................................................................... 21

APPENDICES:
Appendix A
Appendix B

Federal Tax Considerations
Parameters For Management Contracts Under Revenue
Procedure 97-13

i

EXECUTIVE SUMMARY
This paper considers the various alternatives currently available to finance, develop and
operate new prison facilities.1
Due to the enormous growth in demands for limited state budget dollars, state officials
and their advisors have needed to develop a number of alternative methods of financing and
developing prison facilities in ways that will satisfy conflicting demands. This paper discusses
the financing alternatives, assuming tax exempt financing where possible, and other methods of
financing when necessary or preferable. As part of this analysis we consider the privatization
alternatives now available from private companies.
The issuance of general obligation bonds has been the traditional methodology for
financing prison facilities, but over time there has been increasing use of revenue bonds and
certificates of participation, known as COPs. In the latter two, the debt is not secured by the
general obligation of the state or municipality issuing the debt, but by a pledge of the streams of
revenues that are generated by use of the facility. In a corrections context the revenue streams
are payments made for housing inmates in the facility (per diem or fixed payment amounts), or
for the exclusive use of the facility. A revenue bond or COP transaction might be structured to
also include certain tax revenues or user fees as pledged revenues. Revenue Bonds and COPs
will generally not be included within the state or local government's overall debt limit.
A revenue bond for a prison facility might be issued through a state authority, which is
responsible for the financing of capital projects. The authority then leases the project to an
operating arm of the state (i.e., the department of corrections) and has debt service on the bonds
paid from a stream of appropriated payments coming from the state for the housing of inmates.
One drawback to this kind of financing is that the state's obligation to make payments to house
its inmates would be subject to an annual appropriation, so it is not equivalent to a full faith and
credit obligation to pay debt service on outstanding debt of the state. As a result, interest rates on
revenue bonds tend to be slightly higher than those on general obligation bonds. The annual
appropriation from the state to pay the operating and debt service costs of such facilities can be
supported by a variety of other revenue sources, such as a prison construction trust fund, fees
collected by the state for automobile inspections or other purposes, or even revenue derived from
inmate labor in industrial or agricultural programs.

1

Martin E. Gold was assisted in the writing of this paper by Henry S. Klaiman, Mark O. Norell and Albert M.
Rodriguez. Martin E. Gold is a partner with the law firm of Brown & Wood LLP and specializes in the areas of
project finance, real estate and public-private partnerships including the privatization of prisons. He is also an
adjunct associate professor at Columbia University. Henry S. Klaiman is a partner with the law firm of Brown
& Wood LLP and specializes in tax law with an emphasis on tax exempt financings. Mark O. Norell is an
associate with the law firm of Brown & Wood LLP and specializes in tax law with an emphasis on tax exempt
financings. Albert M. Rodriguez was with Brown & Wood LLP and now is a Vice President with Merrill
Lynch Pierce Fenner & Smith Incorporated specializing in tax exempt financings.

iii

Certificates of participation are an alternative to revenue bond financing, but with the
same purposes and a similar structure. With a COP, the state typically leases property that it
owns to a third party called a "financing agent". The financing agent is usually a governmental
corporation or authority or not-for-profit corporation, created specifically to develop projects for
the state. The financing agent then subleases the property back to the state under a sublease, and
the state makes lease rental payments. The financing agent assigns its interest in the sublease to
an entity that acts as trustee for the purchasers of the COPs. Each purchaser of an interest in
these certificates of debt gets a proportionate interest in the assigned revenues from the sublease,
which is why they are called "Certificates of Participation."
In recent years, a number of states have facilitated the development of prison facilities
through arrangements with counties or other local government entities. For example, a not-forprofit corporation, organized by the local county, can issue tax-exempt bonds to finance the
construction of a new prison. The state, in turn, would agree with the county or the not-for-profit
issuing the bonds to provide a certain number of inmates to the facility and make per diem
payments on their behalf. The revenues received on behalf of these inmates would be pledged to
the payment of debt service for the bondholders. Where a private prison developer is involved,
the credit risk can be improved for the potential bond purchasers by having a private operating
company guarantee payments in the event there are not enough inmates provided to adequately
cover debt service or if revenues are not otherwise adequate to cover expenses. The stronger the
state's obligation to place inmates in the facility to be financed and to pay for them, the less the
need for credit enhancement. The local county can also assist, for example, by pledging a supply
of inmates to the financing as a supplement or back-up to the state's supply.
In order to take advantage of tax-exempt financing, which has a lower cost than other
means of financing, it is necessary to understand and comply with the numerous regulations
issued under the Internal Revenue Code. If done properly, one can combine the off balance sheet
formats of project revenue bonds or COPs together with tax exempt financing. This will allow
tax exempt financing to be utilized with a private company acting as the developer/operator or
just as operator. The federal tax rules are described briefly in Section III of this paper and are
discussed more fully in Appendix A.
Section IV of the paper describes, in a spectrum format, the different degrees to which a
project can be fully public (at one end of the spectrum) or almost entirely private (at the other
end of the spectrum). The first model, also the traditional model, has public ownership,
construction and operation is the first example. The second model moves slightly into the
private realm by retaining public ownership but private design and construction. In the first
model, construction by a private construction company is common, but private design would not
be. A combination of private design and construction most likely would be undertaken by one of
the many prison private companies now in existence. Each model constitutes a separate option
for public officials to consider. The third model is public ownership and construction, and
private operation. The fourth model has public ownership still, combined with private
construction and operation.

iv

An alternative to traditional state prison financing on the opposite end of the spectrum is
private financing, private construction and private operation. Initiated less than twenty years ago
as a highly experimental and controversial alternative to public prison operation, private prisons
for both adults and juveniles, are now firmly established in many states. The Corrections
Corporation of America and Wackenhut Corrections Corporation are the two biggest adult
private prison operators. Private involvement in prison construction and operation covers a
broad range. Many prisons are designed and built by private contractors, with funding through
traditional general obligation bonds. Prisons may be built and owned by the state, but operated
privately. Or they may be designed, constructed and operated privately, using private, taxable
bond financing, usually after a state or county has made a commitment to supply a certain
number of prisoners and pay the cost of their incarceration on a per diem basis.
In recent years prison privatization has undergone a major transformation. Today the
major private prison operators are public companies. Some operate with or have folded
themselves into Real Estate Investment Trusts, or REITS, which are special real estate
corporations that are exempt from corporate income taxes as long as they comply with strict
rules. Because these private financial structures sometimes offer short- and long-term financial
advantages over traditional public ownership and operation of state prison facilities, some states
have sold prison facilities to private companies and then leased them back, or sold the facilities
and have the private prison companies also operate them.
The advantages and disadvantages of public vs. private construction and ownership can
be complicated. The pros and cons of allowing all or part of a corrections operations system to
become private are more easily understood. With privatization, the corrections system gains the
flexibility and efficiency of an organization not beholden to a state bureaucracy and its extensive
and sometimes counterproductive civil service rules. Private operators eager to show good faith
and retain their contracts may react with greater responsiveness to directives for change and
improvement from a department of corrections than their public counterparts who fear no
consequences from their inaction. On the other hand, profit-making organizations are often be
tempted to cut costs in order to maximize earnings—in construction, furnishing and providing
security for a new facility, in hiring competent staff, and in providing care, protection and
services to the prison population. More broadly, private prison staff may have a diminished
sense of responsibility to protect the public interest in its broader sense.
The success of the private prison industry and its desire to expand and increase profits
has yielded a new type of institution: the speculative prison. Since prison facilities are an
attractive source of jobs, especially in communities that have a poor job base, some counties and
cities have facilitated the development of prison facilities for economic reasons through revenue
bonds issued locally, or through the private prison companies and their REITS. In the typical
case, a not-for-profit corporation, organized by the county, issues tax exempt bonds to finance
the construction of a new prison. In the best case scenario, the state agrees with the county or the
not-for-profit organization issuing the bonds to provide a certain number of inmates to the
facility and makes per diem payments for the cost of their incarceration. The revenues received
on behalf of these inmates are pledged to the payment of debt service for the bondholders.
Where a private prison developer or operator is involved, the credit risk can be improved for the
v

potential bond purchasers by having a private operating company use some of its guaranteeing
capacity to assure that payments will be made by the company in the event there are not enough
inmates provided each year by the state to adequately cover debt service. The stronger the state's
obligation to place and pay for inmates in the facility to be financed, the less the need for credit
enhancement—and the less speculative the enterprise.
The risk of failure, and thereby the financing cost, increases substantially for institutions
that are built without adequate guarantees that they can fill their beds, or, with a design on
staffing that does not meet state standards. In such cases the sponsors of the speculative prisons
may seek prisoners from other states. If there are no contracts with any commitments to supply
inmates, and inadequate guarantees from, or capacity on the part of the private operating
company to obtain inmates from other jurisdictions or cover the risk, the project may not be
financeable, or if financed, be a candidate for economic disaster.

vi

I.

GENERAL INTRODUCTION

The evolution of financing and operating prison facilities in many ways is representative
of the evolution of public facilities in general. Both the original and the present base model use
tax exempt general obligation bonds and public sector operation. To solve the problem of the
expanding need for a larger variety of facilities and infrastructure and for competing use of
public funds and stiff legal and political and economic constraints on state budgets, creative
energies have been applied to the crafting of various new structures, as alternatives to tax exempt
general obligation debt.
These new financing formats seek to preserve the benefits of tax exempt financing
wherever possible, while drawing upon alternative revenue sources for the payment of debt
service. For many other public and quasi-public facilities, the source of revenues is from the
project itself, i.e. those who pay to use the facility (e.g., buy tickets or space, pay tolls, advertise,
etc.). For prison facilities, however, governments, not inmates are the source of revenue.
Nonetheless, financings are being done outside of constitutional and statutory constraints through
the use of authorities and not-for-profit corporations that are arms of the state or work in close
conjunction with state and local agencies. Upon the termination of the vast majority of these
financings, the government will become the owner of the facility.
In addition, the private sector is also offering alternatives to the public sector for nearly
everything, including design, construction, financing, and operation. And public officials can
choose which of the various forms of partnerships with the private sector it prefers, from none to
full privatization. Most of these private sector partnerships can be combined with general
obligation financing, or with revenue bond or certificate of participation financing, in structures
that seek to satisfy the state’s various purposes, and include tax exempt financing.

II.

PUBLIC FINANCE VEHICLES FOR PRISON CONSTRUCTION

This section includes a general description of some of the methods used by states and
municipalities (sometimes referred to as “governmental entities”) to provide tax exempt longterm financing of capital projects, with brief discussions as to how some state and local
governments have used different formats to finance construction or renovation of prison
facilities. It should be noted that the information provided in this section is not generated by
federal law, but by state law, so applicability will depend on the particular state in question. The
legal framework of each state would require a more specific review than we can provide in this
general paper. The power of a state to issue debt, or to make a conditional promise to pay an ongoing obligation, must be authorized and is governed by the state’s constitution and statutes.
Some of the financing methods described in this section may not be authorized, or may be
prohibited, in some states by state law or courts decisions, or may not be clearly authorized, or
may require the enactment of authorizing legislation.

1

A.

General Obligation Bonds
1.

General Description

Historically, the most common method used by governments to provide long-term
financing of capital projects has been through the issuance of general obligation bonds (“G.O.
bonds”). In calendar 1997, approximately one-third of all publicly issued debt was general
obligation debt. General obligation bonds are normally backed by a pledge of the “full faith and
credit” of the issuer. This pledge generally represents an obligation of the issuer to levy and
collect taxes on all taxable property, without limitation on the rate or amount of such taxes, for
the payment of principal and interest on the bonds. The constitutional or statutory provisions
authorizing general obligation debt may provide for the use of specific taxes or other receipts to
pay the debt. Generally, such provisions do not limit the sources of payment and all other
resources of the state or municipality must be utilized for such payment if the identified taxes or
receipts are insufficient. Accordingly, the pledge of the full faith and credit of a state or
municipality is considered in the debt markets to be among the most secure investments and thus
results in low interest costs for the projects financed.
The ability of some states to rely on general obligation bonds, however, may be
restrained by constitutional or statutory provisions which limit the purposes for which general
obligation debt may be issued, and the aggregate amount of general obligation debt that may be
incurred. In addition, many state constitutions require voter approval pursuant to a referendum
prior to the issuance of general obligation debt. Because of such restrictions many governmental
entities rely very heavily upon the issuance of revenue bonds or certificates of participation,
(“COPs”) which are not included in the calculation of a government’s debt limit, to finance their
capital programs.
2.

Prison Financing with General Obligation Bonds

Approximately one-third of the states fund their prison construction programs exclusively
with general obligation debt. Approximately one-sixth of the states use a mixture of general
obligation debt and revenue bonds or COPs. Some states have authorized the use of both
revenue bonds and COPs.
B.

Revenue Bonds
1.

General Description

Most, if not all, states authorize, directly or through lease arrangements, the issuance of
revenue bonds for capital purposes. In calendar year 1997, revenue bonds accounted for at least
50% of all publicly issued debt. State governments do not usually issue revenue debt on their
own account but through a state corporation, authority or other entity which is authorized by
statute and established for that purpose. Revenue bonds are most commonly characterized as
“limited obligations” or “special obligations” of the issuer because the payment of the bonds is
secured solely by a pledge of a particular stream of revenues and not by a general taxing power
of the state. Consequently, such debt does not count towards a state’s debt limit. In general,
2

revenue bonds are considered a more risky investment than general obligation bonds and result
in higher interest costs than G.O. bonds.
Revenue bonds are issued under a variety of structures with a variety of sources of
payment. Typically, the pledged revenue source is (a) the operating income of the financed
project, (b) lease payments from the lease of the financed project, (c) loan repayments from the
loan of the bond proceeds or (d) a special state tax or revenue, or the general funds of the state.
In most cases, a revenue bond transaction will approximate one of the following:
(a)
a state authority, such as a housing authority, issues bonds, loans the bond
proceeds to a project developer pursuant to the terms of a loan agreement and a mortgage, and
pays the debt service on the bonds from payments received from the project developer
(sometimes referred to as a “conduit financing”);
(b)
a state authority, such as a bridge or port authority, issues bonds, constructs and
operates a project and pays the debt service on the bonds from its operating revenues and/or a
specific tax or other revenue appropriated by the state;
(c)
a state authority responsible for the financing of state capital projects, such as a
building authority, issues bonds to finance a project, leases (or subleases) the project to the
operating arm of the state (e.g., the department of corrections) and pays the debt service on the
bonds from the rentals paid by the state;
(d)
a state authority issues bonds to finance a state capital project and the state agrees
to appropriate money from its general funds or other specified revenues to the authority in
amounts sufficient to pay the debt service on the bonds; or
(e)

a state directly issues revenue bonds backed by some special state tax or revenue.

Under the law of most states, bonds issued as described in cases (a) through (d) are not
considered a state debt for purposes of the state’s debt limitations. The trade-off for avoiding a
state’s debt limitations is that the risk of non-appropriation by the state results in higher interest
costs for revenue bonds. In case (e) the state’s obligation is usually limited to the extent the
special taxes or revenues are collected and the bonds are usually authorized by, but not
considered a general debt, under the state’s constitution.1 In example (a) and where the bonds
are backed solely by the operating revenues of the project, the state is under no contractual
obligation to provide funds to pay debt service on the bonds. In cases (b), (c) and (d) the state’s
1

For example, the State of New Mexico funds its prison facilities (and some of its other capital projects) with a
special severance tax levied on the energy and transportation industries in the state. These severance tax bonds
are authorized by the state constitution. The bonds are payable only from the taxes actually collected although
the state has pledged in related trust indentures to make a good faith effort to get the legislature to raise the rate
of the tax, and therefore the collectibles, sufficient to pay debt service on the bonds in the event the debt
service coverage ratio of the taxes to the debt service falls below 1.0.

3

payment obligation is almost always made subject to the legislature appropriating the required
tax revenues or payments and the actual availability of such revenues or payments once
appropriated.2 And, where the bonds are supported by specific tax revenues or other special
revenues, the state legislature may be under no obligation to continue directing such revenues to
the authority or to even continue the tax at all.
It should also be remembered that state authorities do not have an unlimited capacity to
issue debt. The authorizing statute of many state authorities limit the total amount of bonds the
authority may issue. In addition, the trust indenture securing an authority’s bonds will normally
include a debt service coverage covenant which prohibits the issuance of additional debt unless
the authority can maintain a certain debt service coverage ratio, i.e., produce revenues which
exceed the operating and debt service expenses of the authority by a certain factor on an ongoing
basis.
It should also be noted that new revenue bond programs are often the subject of litigation
regarding whether the bonds result in a state debt under the state’s constitution. In some states,
almost every new program results in litigation brought by an outside party claiming the program
violates the state’s constitutional debt and referendum limitations in one way or another.
2.

Prison Financing with Revenue Bonds

At least one quarter of all states currently use lease revenue bond financing for prison
construction. Revenue bonds issued for a prison facility are usually issued by a state building
authority or similar authority which uses the bond proceeds to reimburse the state for the costs of
constructing or rehabilitating a project. As part of the transaction, the state3 generally leases or
conveys title to a project, in need of construction, rehabilitation or expansion, to the authority.
The authority then leases (or subleases) the property back to the state for a term equal to the life
of the bonds and the state promises to pay the lease rentals (which are assigned by the authority
to the trustee) from its general fund or other specified revenues in amounts sufficient to pay the
debt service on the bonds (plus any other incidental expenses such as trustee fees or letter of
credit fees), subject to the appropriation and availability of such funds.4 If the authority holds
title to the property, the authority may give a mortgage to the trustee as further security for the
bonds. Title (or possession in the case of a lease-sublease structure) to the project usually reverts
back to the state at the point all lease rentals are paid (and, consequently, all the bonds) either at
2

It is a common perception in the debt markets that most states would not allow a state authority responsible for
a key governmental function to default on its debt.

3

The reference to the “state” here means the executive branch of the state, in most cases, acting through its
department of corrections.

4

The statute authorizing the State Public Works Board of California (which is the primary issuer of prison
facility bonds in California) provides for an automatic appropriation for the lease payments (payable to the
Board) if the legislature has failed to do so, and if the state director of finance certifies to the state controller
that sufficient funds are available in the state treasury for such purposes.

4

the end of the lease term or upon the exercise of a lease prepayment option. A prepayment of all
rentals would also lead to a reversion, if the amount is adequate to defease the bonds.5
Under the State of New York’s revenue bond program, for example, the State generally
sells the existing prison facility (or the facility to be built) to the Empire State Development
Corporation (“ESDC”) (formally called the New York State Urban Development Corporation
(“UDC”)), in exchange for the proceeds of the bonds and then uses the bond proceeds to
renovate the existing facility, construct additions to it, or to build a new facility. New York has
recently decided, however, to discontinue the practice of selling its prisons outright and instead
will use a lease-sublease structure, and back ESDC prison bonds with a promise to pay debt
service on the bonds pursuant to a service contract (sometimes referred to as a financing
agreement).
The ultimate source of payment of prison revenue bonds issued by a state authority is
normally the general funds of the state, but some states tap a dedicated source of revenues. The
State of Arkansas, for example, has a prison construction trust fund managed by the state
treasurer for the payment of certain prison bonds issued by the Arkansas Development Finance
Authority. In one of the Authority’s bond programs, the primary source of the state’s lease
payments is income from the agricultural operations of the state’s department of corrections,
which is deposited by the state into a special subaccount of the prison construction trust fund.6
Arkansas has pledged the net receipts of automobile safety inspection fees for deposit into the
prison trust fund to secure prison bonds.7
C.

Certificates of Participation
1.

General Description

The most recent development in long-term financing of state capital projects is the use of
certificates of participation (“COPs”). While the national market for COPs is less developed than
the markets for general obligation and revenue bonds, in states such as California, where the
restrictions on general obligation debt are quite severe, a strong market has developed for such

5

Some agreements may provide for purchase options, as opposed to lease payment or prepayment options, at or
before the end of the lease term. These purchase option provisions are, in financial terms, usually very nearly
identical to lease payment and prepayment provisions. In either case the transaction ends with title to the
prison facility going to the state.

6

For a description of this bond program, see the Official Statement of the Arkansas Development Finance
Authority, dated December 12, 1996, regarding its $38,895,000 Correction Facilities Revenue Bonds, Series
1996.

7

For a description of this bond program, see the Official Statement of the Arkansas Development Finance
Authority, dated February 20, 1997, regarding its $20,710,000 Correction Facilities Refunding Bonds, Series
1997.

5

obligations. However, the sale of COPs backed by a pledge of appropriations generally requires
higher interest coupons than general obligation bonds or even revenue bonds.
As with revenue bonds, COPs are issued under a variety of structures which are very
similar to revenue bond structures. A financing utilizing certificates of participation will
normally involve a lease-sublease, lease-purchase, installment purchase or loan structure as
described below. As with revenue bonds, the governmental entity’s obligation to make the
payments under the applicable sublease, lease-purchase, installment purchase or loan agreement
will almost always be subject to the appropriation and availability of funds and thus avoids
applicable debt obligation limitations.
Lease-Sublease Financing
A lease-sublease COPs financing is generally composed of the following simultaneous
events:
(a)
the state leases property it owns (where it needs to build or renovate a new
facility) to a third party (referred to as the “financing agent”) for a nominal fee. Generally, the
financing agent is a government corporation or authority or a not-for-profit corporation created
specifically for the purpose of developing projects for the state and in many cases functions as a
shell corporation or a trustee bank;
(b)
the financing agent subleases the property back to the state pursuant to a sublease
agreement which requires the state to make certain rental payments;
(c)
the financing agent assigns its interest in the sublease agreement, including all
rights to the sublease payments required under the sublease agreement, to the trustee for the
COPs (the “certificates trustee”);
(d)
the certificates trustee, pursuant to a trust indenture, sells to investors “certificates
of participation” which provides a proportionate interest in the sublease agreement including the
lease rentals;
(e)
the certificates trustee holds, and at the times provided for under the trust
indenture, disburses the proceeds of the COPs to the state, as sublessee, for the costs of the
construction, renovation or expansion of the project; and
(f)
under the sublease, the state is required to pay lease rentals in amounts sufficient
for the certificates trustee to make the required payments to the investors. Upon payment of all
the lease rentals, the financing agent’s leasehold interest ends and the state retakes possession of
the property from the financing agent.

6

Lease-Purchase Financing
The structure of a lease-purchase financing (usually involving the construction of a new
project) is substantially similar to a COPs lease-sublease transaction except for the following:
(i) the financing agent, which will always be a governmental entity, takes title to
the financed project; and
(ii)
pursuant to lease-purchase agreement, the financing agent leases the
project back to the state which has the option to purchase the project prior to the end of the lease
term by paying the amount required to pay off all outstanding certificates. Generally, if the state
pays all lease rentals to the end of the lease term, title to the property transfers back to the state.
Installment Purchase Financing
The structure of a COPs installment purchase transaction is substantially similar to a
lease-purchase transaction except for the following:
(i)
The financing agent, which is always a governmental entity, sells the project to
the state pursuant to an installment purchase agreement. Title to the financed project resides
with the state; and
(ii)
the financing agent will get a mortgage, deed of trust or other security interest
with respect to the financed property until the last payment is made by the state under a purchase
agreement, whether by prepayment or at the end of the agreement. The financing agent assigns
the mortgage, along with the installment payments, to the certificates trustee.
Loan Financing Model
A COPs loan financing (sometimes referred to as an “installment financing”) simply
involves a loan of the proceeds of the sale of the certificates of participation to the state for the
cost of constructing or rehabilitating the financed project and is substantially identical to an
installment purchase financing except that the financing agent may be a commercial financial
institution or a governmental entity.
2.

Prison Financing with Certificates of Participation

At least seven states currently use COPs financing for prison construction. These states
have financed prison facilities with lease-sublease, lease-purchase and loan structures as
described above.8 COPs generally have more appropriation risk, while revenue bonds depend
8

For an example of a lease-sublease transaction, see the Official Statement of the State of Rhode Island and
Providence Plantations, dated January 24, 1997, regarding its $24,000,000 Lease Participation Certificates
(Howard Center Improvements - 1997 Series). For an example of a lease-purchase transaction, see the
Preliminary Official Statement of the State of Illinois, dated April 26, 1996, regarding its Certificates of

7

more on project revenues or specified taxes without the need for appropriations. Research
conducted by the Criminal Justice Institute indicates that more states are seriously considering or
plan to increase the role of COPs financing in their prison construction programs because they
have similar advantages to revenue bond structures and afford significant flexibility.
3.

County and Municipal Financing of Prison Facilities

While a state authority normally issues revenue bonds for state prison construction, in
recent years, several states have secured the use of prison facilities through leasing or other
arrangements with county or other local authorities. These transactions are generally more
complicated but serve several purposes. First, if the debt capacity of the state or of the state
authority is a problem, such limited capacity is preserved. Second, depending on how the
financing is structured, the state may have little or no financial risk. Recent prison financings in
Virginia and Tennessee, one with a town backed by state payments and one with a county
backed by a private company, provide examples of these types of transactions.
In the financing for the town of Big Stone Gap, the Commonwealth of Virginia (the
“Commonwealth”) and the Commonwealth’s Department of Corrections (“VDOC”) entered into
certain agreements with Big Stone Gap and the Big Stone, Virginia Redevelopment and Housing
Authority (the “Authority”) to provide for the development and lease to VDOC of a 1,200-bed
maximum security facility. The Authority was authorized by the Commonwealth’s local housing
authorities act but is controlled by the Town.
The Authority and VDOC entered into a development agreement in which the Authority
agreed to cause the facility to be constructed to VDOC’s specifications. The financing
agreement requires the Authority to issue bonds to provide funds for the cost of constructing and
equipping the facility, and the cost of completing the project is the Authority’s responsibility.9
The project is being constructed by Wallens Ridge Development Corporation (“WRDC”).
WRDC is a Virginia non-profit corporation organized by the Authority to assist it in its
activities. The financing agreement also required the Authority to issue bonds to provide funds
for the cost of constructing and equipping the facility. 10 Pursuant to a license from the Authority,

...(continued)
Participation (Bureau of the Budget), Series 1996A. For an example of a loan transaction, see the Official
Statement of the State of Oregon Department of Administrative Services, dated April 17, 1997, regarding its
Certificates of Participation, 1997 Series A.
9

Although the Authority is technically responsible for any cost overruns, the Commonwealth would probably
provide or arrange financing for the completion cost since the related lease agreement requires lease payments
by the Commonwealth whether or not the facility is completed.

10

For a description of the bonds and the Big Stone Gap transaction, see the Official Statement of the Big Stone
Gap, Virginia Redevelopment and Housing Authority, dated October 24, 1995, regarding its $77,500,000
Commonwealth of Virginia Correctional Facility Lease Revenue Bonds (Wallens Ridge Development Project),
Series 1995.

8

WRDC has been granted the rights to occupy and, as agent for the Authority, lease the facility to
VDOC.
Under the lease agreements between VDOC and WRDC and the Commonwealth and
WRDC, respectively, VDOC will occupy and operate the facility and the Commonwealth is
obligated to make rental payments equivalent to debt service on the bonds, whether or not the
facility is completed. The Commonwealth’s payment obligation is, however, subject to the
appropriation of funds by the Virginia General Assembly. This puts the state’s backing behind
the bonds (indirectly and subject to appropriation) while responsibility for the “debt” belongs to
the “local” Authority. The interest on the bonds is tax exempt. Pursuant to the terms of the trust
indenture, the income stream of the facility was assigned, and a mortgage on the facility was
granted, to the trustee. In the event the Commonwealth defaults on its payment obligations, the
trustee’s remedies are limited to foreclosure on the facility. Upon payment of the bonds, title to
the facility will vest with the Commonwealth.
A variation on the above approach can be found in the 1997 Hardeman County financing
in Tennessee. Hardeman County Correctional Facilities Corporation (“HCCFC”), a not-for-profit
corporation organized by Hardeman County, Tennessee, issued two series of tax exempt bonds
to finance the construction of a 1700-bed facility for the purpose of housing Tennessee, out-ofstate, and federal inmates. Pursuant to a construction and management agreement between
HCCFC and the Corrections Corporation of America (“CCA”), CCA constructed and operates
the facility. HCCFC leased the facility to Hardeman County. Hardeman County agreed, pursuant
to an incarceration agreement with the State of Tennessee, to make available housing for
Tennessee inmates at the facility for per diem payments. The incarceration agreement also
provides the State the option to purchase the facility at a price less than the outstanding principal
and interest on the bonds. Neither the incarceration agreement nor the lease with Hardeman
County required the State of Tennessee or Hardeman County to house inmates at the facility.
Nor were there any contracts to house federal or out-of-state inmates. While the gross revenues
of the facility are pledged to payment of the bonds, the main security for the transaction resides
in a credit support agreement (the Debt Service Deficits Agreement) between HCCFC and CCA.
Pursuant to that agreement, CCA has agreed to pay HCCFC any deficit to the extent moneys on
hand are insufficient to pay debt service on the bonds when due and payable, and to pay any
difference between the purchase price paid by the State of Tennessee upon exercise of its option
to purchase the facility and the outstanding principal and interest on the bonds. Neither the State
of Tennessee nor Hardeman County are under any obligation to pay the debt service on the
bonds.11 A financing very similar to the Hardeman County financing involving CCA was

11

For a description of the Hardeman County transaction, see the Official Statement of the Hardeman County
Correctional Facilities Corporation, dated April 21, 1997, regarding its $15,675,000 Correctional Facility
Revenue Bonds, Series 1997. For additional discussion of this financing see infra Section IV G “Economic
Development and Speculative Bonds.”

9

conducted by the Cushing Municipal Authority (“CMA”), a local authority of the City of
Cushing, Oklahoma.12
Counties in the State of New Mexico have planned similar transactions involving the
Wackenhut Corrections Corporation. In the New Mexico transactions, however, the state has
made a firm commitment to provide inmates for the facilities and it is expected that counties will
also use the facilities. These transactions have been postponed by litigation challenging, among
other things, the constitutionality of the State’s commitment to provide and pay for prisoners
housed at the facilities.13 A proposed financing in Huerfano, Colorado failed to attract the
necessary tax exempt bond purchasers because the State’s commitment to sending inmates was
extremely limited and the privatization was open to potential legal challenge as well.14 CCA
ultimately financed the facility from its own resources.
III.

FEDERAL TAX CONSIDERATIONS

Federal tax statutes and regulations (the “Regulations”) issued by the Internal Revenue
Service (the "IRS") impose a variety of constraints on the use and investment of proceeds of tax
exempt bonds and on the facilities financed with such bonds. A larger discussion of applicable
rules is set forth in Appendix A attached hereto.
One of the key issues for prison financings with tax exempt bonds is that of "private
business use." With certain limited exceptions, private business use is not permitted. Generally,
a private business use is the use of a facility by a privately owned entity. The policy reason for
limiting private business use is that tax exempt financing is viewed as a subsidy and that while
the subsidy is appropriate for governmental entities, there should be limits placed on providing
subsidies to private entities.
However, recognizing that certain services inevitably need to be provided by the private
sector, the IRS has set forth rules that provide certain safe-harbors with respect to management
and service contracts, which if satisfied, will not result in private business use. The operating
agreement's payment formula is key. To qualify for a safe-harbor, compensation must be
reasonable, and no part of the compensation can be based on a share of "net profits" obtained
from the operation of the prison. The more the compensation is based overall on "Periodic Fixed
Fees", the longer the term of the agreement to operate the facility may be. A "Periodic Fix Fee"
is a stated dollar amount for services rendered for a specified time period. 15 In contrast a "Per
12

For a description of this transaction, see the Official Statement of the Cushing Municipal Authority, dated
October 23, 1996, regarding its $36,070,000 Correctional Facility Revenue Bonds, Series 1996.

13

For a description of these proposed transactions, see the Preliminary Official Statement of Lea County, New
Mexico, dated August 29, 1997, regarding its $59,980,000 Jail Project Revenue Bonds, Series A, and the
Preliminary Official Statement of Guadelupe County, New Mexico, dated August 29, 1997, regarding its
$31,500,000 Jail Project Revenue Bonds, Series A.

14

See, infra Section IV G for further discussion of the financing of the Huerfano County facility.

15

Such term is more fully discussed in Appendix A.

10

Unit Fee" is a fixed dollar amount per unit of service. 16 A per diem fee (dollars per inmate per
day) is a Per Unit Fee and does not generally qualify as a Periodic Fixed Fee (see Appendix A
for more details). If more than 95% of total compensation will be paid in the form of a Periodic
Fixed Fee, then it may be possible for the term for a prison facility agreement to be as long as 15
years. If the Periodic Fixed Fee constitutes between 80% and 95% of total compensation, then it
may be possible for the term to be 10 years. If it is only 50% of the total compensation, then the
maximum term can be 5 years as long as the governmental entity has the right to cancel at the
end of the third year. If the Periodic Fixed Fee is below 50% and is combined with a per diem
payment for the remaining portion of compensation, then the maximum term for the operating
agreement can be only three years, provided a right on the part of the government to cancel exists
at the end of the second year. This last formula would apply also if all compensation is based on
per diem fees. The following table summarizes these safe-harbor provisions derived from the
Code and regulations.
Compensation

Maximum Term

Cancellation Requirement

95% Periodic Fixed Fee

Lesser of 80% of Useful Life or 15
years

N/A

80% Periodic Fixed Fee

Lesser of 80% of Useful Life or 10
years

N/A

50% Periodic Fixed Fee

5 Years

3 Years

Per Unit Fee or Combo With Periodic
Fixed Fee

3 Years

2 Years

Percentage of Revenue/Expense or
Combo With Per Unit Fee

2 Years

1 Year

Of course there are a number of caveats and wrinkles to these tax rules. Many of these
are discussed in Appendix A.
IV.

PUBLIC/PRIVATE COMBINATIONS
A.

Public Ownership, Construction, and Operation

The traditional method of financing facilities has been the issuance of general obligation
bonds for the total cost. The public sector owns the facility, the facility is constructed pursuant to
public works construction requirements (which may be by bidding to a private company) and the
department of corrections operates the facility.
The total cost, (i.e., true cost) of operating prison facilities by the public sector is not
generally tracked because the costs are often allocated to the budgets of several agencies besides
the department of corrections. For example, litigation would be handled by the law department
or attorney general’s office; building maintenance and restorations would be handled by a
16

Such term is more fully discussed in Appendix A.

11

department of general services; medical costs might be the responsibility of the health
department or a separate program; and transportation might be the responsibility of yet another
agency. This of course is also true for other public facilities such as schools and police facilities.
B.

Public Ownership, Private Design-Build

In order to get the benefits of private sector expertise in designing modern correction
facilities the government can hire a private prison design team, which can provide state-of-the-art
designs for each particular security level. The right design can improve the ability to provide
both appropriate security and services, require fewer correctional officers, and reduce operating
costs.
Studies indicate that no matter how it is financed, construction by private companies
generally is faster and cheaper than public works construction. The typical public works
construction period averages around two and a half years and the average for private company
construction appears to take only one and a half years to two years.17 Private companies will
sometimes guaranty the construction period and price, and pay damages if they are late. CCA
agreed to pay $5,000/day if it was late in its Puerto Rican prison development agreements. (The
credit rating of the guarantor can be important to realizing the full benefit of such guaranties.)
The net result, according to reports, can produce significant savings in construction costs.
Bonuses for early completion may provide further incentive for quick completion.
Also, when a single team is hired to both design and build (or renovate) a facility, there
can be more than a combining of efficiencies. A design-build team can be hired on a competitive
basis. The proposals will often produce valuable ideas and feedback to officials and should also
yield a superior price. Design-build construction should create a single seamless entity that is
responsible for the project from design commencement through the various stages of
construction, the completion of the work, and the warranty period. If there is a problem, or a
flaw, the government will not be caught between parties claiming the other is primarily
responsible. (This can be an even greater problem in renovation projects than it is in new
construction.) The likelihood of completing the work on time and on budget should also
increase.
Design-build requires the company to complete drawings after being selected. In the
traditional format the government must complete all drawings before it bids the work to private
contractors. Private prison companies can suggest designs that will be innovative, and reflect
17

Charles H. Logan, Private Prisons: Pros & Cons 215-18 (Douglas C. McDonald, ed. 1990). The quicker speed
is one of the sources of savings. Unrestricted procurement procedures and minimal approvals is another. See
Samuel J. Brakel, Privatization and Corrections, POLICY INSIGHT, (Reason Foundation), Jan. 1989, at 7; Eric J.
Savitz, Pros and Cons: The Jury Is Still Out on Private Prisons, BARRONS, Nov. 6, 1993, at 13. Costs per cell
or bed are higher as the security level increases. CCA estimates that its average savings are about 30%. See
T.C. Bradford & Co., Corrections Corporation of America—Company Report (July 15, 1989). Charles
Thomas estimates that the capital cost of private facilities is generally 15 to 25% lower.

12

their multijurisdictional experience. These designs should also facilitate more efficient
operations (at lower cost) if the same private company is going to operate the facility.18
Design-build, however, may not provide as many checks and balances as is the case when
the architect is independent of the contractor and has its own contract with the government. The
government, therefore, should always have some design expertise to review the plans and the
construction work in design-build projects. It is also possible that state authorization for designbuild public procurement does not exist.19
Private prison companies, using the design-build approach, can, according to a number of
estimates, reduce construction costs by 15 to 30 percent.20 In addition, the financing can be done
with tax exempt G.O. Bonds.
C.

Public Ownership and Construction, Private Operation

To get both the advantage of public sector tax exempt financing and the lowest available
interest rate, officials may combine G.O. bond financing and public construction programs with
private operation. Or a completed prison, even with outstanding tax exempt financing, may be
turned over to a private company for operation. Provided that the service agreement is a
“qualified management contract” the interest on the bonds will remain tax exempt. (See
Appendix A.)
There is a substantial amount of literature comparing public and private sector operation
of corrections facilities. Today, virtually every type of facility can be managed by some private
provider of services. This includes maximum security facilities and specialized youth offender
facilities.
Private operation has been reported in a number of studies as providing savings,
especially when total costs are compared. Without going into detail, efficiencies can be derived,
at least in theory, from private operation through the following:
1.
Maximum use of state-of-the-art design and technological systems which can
permit operation with fewer or less expensive personnel.
2.
Freedom from civil service hiring requirements yields significant flexibility. This
flexibility includes salary levels crafted to specific needs, tighter fringe benefits (such as
pensions, medical insurance packages, or annual leave) and use of economic incentives to obtain
18

See Martin E. Gold, The Privatization of Prisons, 28 THE URBAN LAWYER 359, at 382 (1996).

19

Also, in some states the architect must be a locally licensed. So a private company that uses an out-of-state
architect may also have to hire a local one.

20

Industry annual reports; Alex Singal and Raymond Reed, "An Overview of the Private Corrections Industry,"
Legg Mason Equity Research, 1997, p.16. Charles W. Thomas, "Private Adult Correctional Facility Census,
1994," University of Florida, Gainesville, 1994, p.2.

13

maximum performance. There is greater flexibility to move officers and specialists within the
facility for different shifts, during emergencies and for efficiency generally.
3.

Part-time workers are more easily employed and expensive overtime is avoided.

4.

There are fewer administrative personnel so there is less overhead.

5.

Supplies, such as medicine, food and linens, can be purchased in bulk at a better

price.
6.
There is a single entity responsibility for all liability risk and costs; this leads to
greater overall cost efficiency and cost-saving preventative programs. For example, to avoid
incidents that will incur litigation expenses and liability, and possibly affect insurance costs and
the company’s reputation, most private operators will spend substantial amounts on training,
grievance procedures, and internal operations, such as lawyers who can warn the operator of
potential problems early on and protect against law suits.
Does private operation actually produce cost savings? There have been numerous studies
of companies' operating costs. An analysis of these is beyond the scope of this paper. In one
review of 14 studies, 12 showed a savings from private operation of from 5 to 28 percent. The
other two showed no difference.21 On the other hand, the General Accounting Office (GAO)
examined five studies by others and summarized its findings by saying:
"We could not conclude from these studies that privatization of
correctional facilities will not save money. However, these studies
do not offer substantial evidence that savings have occurred."22
The GAO Report and its conclusion, however, has been criticized on an number of grounds.23
At this time, there is less of a consensus that there would be savings from private operations,
than from private design and construction.
For full operating agreements, longer term agreements can now be negotiated using tax
exempt financing. The higher the proportion of the compensation that is on a fixed basis, the
longer the allowable term. The alternatives are summarized in Appendix A.

21

Adrian T. Moore, Private Prisons: Quality Corrections at a Lower Cost, R EASON PUBLIC POLICY INSTITUTE,
April 1998, at 10-12.

22

U.S. General Accounting Office (GAO), "Private and Public Prisons: Studies Comparing Operational Costs
and/or
Quality
of
Service,"
at
3,
Washington,
D.C.,
August
1996,
at
www.gao.gov/AindexFY96/abstracts/gg96158.htm.

23

See Adrian T. Moore, Private Prisons: Quality Corrections at a Lower Cost, REASON PUBLIC POLICY
INSTITUTE, April 1987, at 10-12.

14

A longer term allows the operator to recoup more return on its expenditures but many
private operators with public financing are content with short or moderate term contracts because
they may wish not to continue, or to renegotiate. If the relationship is working well, the built-in
mutual option to renew can suffice.24 When the facility is paid for by the public sector, the
limited investment made by the private operator will not require a very long term for recoupment
or amortization.
D.

Public Ownership, Private Construction and Operation

Some states, counties and municipalities have chosen to turn construction and operation
of their facilities over to private companies while maintaining public ownership. This allows
privatization as well as government financing through tax exempt bonds. Allowing the private
sector to have a major role in design and construction allows the design aspects to be fully
integrated with the company’s operating philosophy and staffing plan. In theory at least, it should
yield some benefit in lower operating costs for the public sector.
The operating company will use its own construction forces, or hire a company to handle
construction under its direction. State statutory authority to enter into such a combination of roles
with a single company, as in other scenarios considered here, would have to be assessed. Usually
this is achieved through a request for proposals for the combination of roles. That way
construction costs and operating costs can both be assessed, and analyzed together for their total
(present value or life-cycle) cost.
The build-operate combination should also help in the transition from the construction
phase to the full operating phase. The company can create its start-up team and commence the
hiring and training of staff as timing and the level of the facility’s completion dictate. The
operator may need a period during which staff act as if the facility is populated with inmates
before actual intake begins. All equipment can be tested by the people who installed it and the
people who must now operate it. A single company responsible for ramp-up and transition
should mean a single point of responsibility and less conflict or finger pointing. This should be
true whether the single entity is the public sector or the private sector.
E.

Private Financing and Construction: The Use of REITS

Entities such as a real estate investment trust (REIT) will do design/build/finance
projects. A REIT is a corporation that holds and manages real property in compliance with
federal tax rules that allow it to distribute income to its shareholders without paying corporate
level income taxes. Seventy five percent of gross income must come from real property or
mortgages, and ninety-five percent of gross income must come from the same two categories or
securities, and 95% of all income must be distributed to stockholders each year. REITS
generally can not actively operate properties, but performing certain limited management duties

24

See Appendix A for a discussion of renewal options.

15

is acceptable (such as taking on landlord type responsibilities as the owner of leased property).
They therefore typically act through leases and independent contracting.
The capital markets—the world of public trading in debt instruments and stocks that Wall
Street is known for—generally evaluate REITS within the real estate category along with other
real estate holding companies.25 REITS in turn have broad corporate access to the capital
markets. REITS can issue shares to investors reflecting the value of their real estate assets (and
income therefrom) and make the equity they raise available to finance a public sector project.
Their shares of stock can be purchased by any entities worldwide, such as mutual funds, and they
can raise more capital equity by issuing more shares. REITS also can borrow from capital
market institutions. Their financings do not have the advantage of tax exempt financings, but
they can obtain competitive capital market interest rates. The interest rate is generally lower than
what can be obtained by a corrections company (whose ability to borrow is limited, because they
are evaluated as prison operating companies), although it will be some basis points higher than
tax exempt interest rates. A REIT is judged by investors by the rental income it gets, the
certainty of continuing receipts, and the residual value of the underlying property.
The two largest for-profit prison companies each recently created REITS. CCA created
CCA Prison Realty Trust (PRT) as its REIT in 1997, and Wackenhut created Correctional
Properties Trust (CPT) with an initial public offering (a first offering of stock to the public) in
April 1998. The equity and debt raised by these REITS can be combined by the REITS into a
single blended taxable rate that can be made attractive to the local government. While REIT
financing is not facility specific (“one off” is the expression used in the capital markets), the debt
payment obligations of the public sector can still be crafted to fit the government’s preferences.
The government can select the maturity date and repurchase options. Generally fixed rates will
be offered. Responsibility for maintenance and property taxes are negotiable.26
Following its initial public offering in 1997, CCA's Prison Realty Trust purchased 13
correctional facilities from CCA, having 11,500 beds and an aggregate value of over $500
million. It reported in November 1999 that it owned, or was in the process of developing, 51
facilities, 40 of which are in operations.27 Prison Realty Trust had a credit facility (available loan
capacity) of $1 billion in mid-1999.28

25

That may not have been the case, however, with CCA's Prison Realty Trust. Purchasers of that REIT's stock
were mostly growth oriented investment funds (rather than real estate oriented investors) and there has been a
60 percent overlap of owners between CCA and its REIT. The New York Times, April 21, 1998, at D5.

26

Memorandum from Prison Realty Trust, received March 5, 1998, and a telephone discussion with J. Michael
Quinlan, CEO of PRT, on March 5, 1998.

27

Prison Realty Trust, News Release, November 10, 1999.

28

It also had to borrow $100 million at a high 12% rate after its stock price dropped substantially. Prison Realty
Trust, News Release August 11, 1999 and S.G. Cowen, Perspectives: Prison Realty Corp., June 28, 1999.

16

Wackenhut's CPT purchased and owned 8 facilities as of May 1998, all of which were
leased back to Wackenhut Corrections. By November 1999, CPT owned two more facilities for
a total of 10.29 CPT has a $100 million credit facility. CPT plans to enter into leases with
governmental agencies and other operating companies in the future.30 (Wackenhut Corrections
has its own credit facility of $250 million.)31
A REIT might be particularly useful where renovations are sought using private resources
and the government wishes to continue to operate the facility. This can be done through a sale
and lease back. The sale of publicly financed properties, such as schools, hospitals or prisons, is
permissible, but the rules applicable to sales to private entities normally require the tax exempt
debt to be retired before the transfer. The sale price would generally be based on the current
market value. A lease back to the government would then allow the government to operate the
facility. In the lease the government would pay principal and interest, on money borrowed by
the REIT, as rental. At the end of the term, or upon a prepayment of outstanding principal or the
exercise of a purchase option, title to the facility would revert back to the public sector. New
facilities can be financed using this mechanism or old ones sold for cash, renovated and leased
back for government operation.
Notwithstanding CCA's expectations for its REIT, however, general market hostility to
REITS in 1999 and CCA's operating and intercorporate problems caused company stock to
plummet. At the end of 1999, CCA decided to convert its corporate structure back to that of a
single tax-paying company and announced that it would sell over $300 million in equity interests
as part of the restructuring32. Sale and lease backs presumably, can still be done with recombined entity.
F.

Private Financing, Construction and Operation (a/k/a Build-Own-Operate)

Some of the private operating companies have undertaken to build, own and operate
facilities using equity and taxable debt raised by the operating company. CCA has owned at
least 18 facilities financed this way. Some of these have been purchases of an existing property,
which are renovated by the company and leased back to the government for debt service
payments. In the District of Columbia, CCA paid over $50,000,000 for the Correctional
Treatment Facility and will be repaid (and earn a profit) under its lease back to the District.
29

Interview with Charles Jones, CEO of CPT, November 23, 1999.

30

Correctional Properties Trust, News Release, May 12, 1998. CPT also plans to acquire facilities from other
private prison operators and from governmental entities, but so far has not. Interview with Charles Jones, CEO
of CPT, November 23, 1999. Prospectus for Correctional Properties Trust, dated April 22, 1998, regarding the
issuance of 6,200,000 common shares.

31

Interview with Patrick Cannan, Director, Corporate Relations, Wachenhut Corrections. November 23, 1999.

32

The New York Times, December 28, 1999, at C6, and The Wall Street Journal, December 27, 1999, at A4.
CCA and PRT also came under criticism for the fees PRT paid to CCA and the various interrelationships
between the two companies. Both Doctor R. Crants, chairman and CEO of PRT, and his son Robert Crants III,
president of PRT, will step down.

17

Generally, renovations are handled the same way as new facilities, but construction costs are
more difficult to fix in renovations, and renovated old facilities with poorer layouts are more
difficult to use and more expensive to operate.
A REIT has the capacity to finance and do design and construction work but not to
operate a facility. Construction or renovation work might be done by its own employees or the
company might turn to a local construction company. If private operation of the facility is part
of the plan, an operating company will have to be brought in. Prison Realty Trust has had an
exclusive option to do all the projects that CCA would otherwise own or finance, and brought
CCA into the picture when an operating company was required on a PRT project. There are a
good number of projects where CCA’s PRT purchased the facility from CCA and then leased it
back for operations.33 Correctional Properties Trust uses Wackenhut, and other private
operators, or the government, as an operator.34
During 1999, CCA utilized three companies for operations: one for management of
government owned adult prison facilities, one for other facilities owned by governments, and one
for facilities owned by CCA or PRT.35 This corporate structure was intended to improve CCA's
ability to develop or purchase facilities which would be operated by the public sector but allow
governments to privatize the asset (freeing money for other uses) and avoid political or labor
opposition to private management.36 How CCA will satisfy these goals after it restructures yet
again in 2000, is yet to be seen.
G.

The Birth of Speculative Prisons

Since the construction of a prison can produce several hundred construction jobs, and
operation of a corrections facility can produce 200 to 500 permanent jobs, communities that are
eager for job growth and a flow of public dollars sometimes push for the development of prison
facilities in their own community. The economic effect of such a facility, through the payment
of salaries, and the growth of ancillary businesses cannot be predicted exactly, but it is likely to
have a positive effect on the housing market and retail establishments in the area. In addition,
rent payments under a site lease or payments in lieu of taxes may be used by the local
government for other economic development or infrastructure improvement purposes.
33

Telephone discussion with J. Michael Quinlan, CEO of PRT, on March 5, 1998. As of November 1999 CCA
had contracts for 83 facilities of which 70 facilities with a design capacity of 55,000 beds were in operation.

34

Telephone discussion with Patrick Hogan, CFO of CPT, July 17, 1998.

35

Prison Realty Trust, News Release May 5, 1999. One of the three, called "OPCO" is primarily owned by
management, key employees and wardens, with 32% ownership by outside investors. It manages 30 prisons
leased from the REIT plus 10 others. The other two, Prison Management Services and Adult and Juvenile and
Jail Facilities Services have contracts for 30 facilities none of which are owned by Prison Realty Trust. S.G.
Cowen, Perspectives: Prison Realty Corp., June 28, 1999.

36

The New York Times, April 21, 1998, at D5, and Legg Mason Wood Walker, Inc., CCA Prison Realty
Trust/Corrections Corp. of America Merger Analysis, May 26, 1998; and telephone call with J. Michael
Quinlan, CEO of PRT, on July 14, 1998.

18

The impetus for such a facility may come from local officials, a developer, construction
companies and trade groups, private prison operating companies or their shareholders, or from
any combination of these. The financing is likely to be done through a local economic or
industrial development agency which will issue project revenue bonds or act as a financing agent
for COPs.
The issuance can be tax exempt if ownership is public and the tax requirements discussed
previously are satisfied. The issuer may, in the alternative, be a not-for-profit corporation that is
an instrumentality of the local county. Its sole asset may be the revenue generated by the project.
There would be no full faith and credit pledges from the state or the county or municipality.
Even the issuer may have no obligation. The payment of debt service will be dependant on the
revenues generated from the per diem payments made for the incarceration of inmates. The
ability to issue the bonds may therefore depend upon the level of the state commitment to send
inmates to the facility. This commitment may vary from substantial and long term, to minimal,
or subject to periodic full review, on down to no commitment at all. A large portion of
commitments are also subject to annual appropriations. Lenders are accustomed to annual
appropriation risk and know how to evaluate it. Subjecting a facility to a periodic "policy"
evaluation is a more serious credit risk for lenders.
If the project is subject to annual policy review, the local department of corrections (the
host state may be the intended major supplier but not the sole supplier) will be in a position to reevaluate the use of this facility in comparison with other available correction facilities that then
exist or are being built. If the bonds for a proposed project are being considered by institutional
lenders or the capital markets, the potential lenders will study the projections, looking most
carefully at gross revenues, costs, and the risks that are involved. The analysis will be based on
the agreements, the parties, and projected cash flows, and other things.
The risks include the quality of the design of the facility, and the variety/type of inmates
the facility is designed and staffed to accommodate. There needs to be a match between
projected demand and the capacity of the facility to satisfy it. The larger the variety of possible
inmates the prison can take in terms of age, gender and custody level, the greater the flexibility
to find inmates if the need arises. The geographic location of the facility (which can affect
recruiting, salaries, other costs and political support) and the selected operator are also important.
If the operator is a reputable company and the operating agreement is reasonable, and for a
substantial period of years, this will help market the bonds. The level of the operator’s financial
commitment (which may include an equity investment or other financing help) and the ability of
the sponsor or operator to secure additional inmates from other states, will also affect the
marketability of the bonds. Since the commitment from the main provider of inmates (usually
the host state) will be crucial, these will be evaluated closely. The facility will be evaluated by
private lenders as being in potential competition with other facilities during the term of the
financing.
The weaker the cash flow projections, and the greater the risks, the more the facility will
be perceived as truly speculative in nature, and the more there will be a need for some form of
credit enhancement such as guarantees, bond insurance or letters of credit backing the bonds.
19

Credit enhancement is most apt to come from a key sponsor of the project like the operating
company and/or the developer.
In the Hardeman Tennessee Correctional Facilities Corporation financing, for example,
neither the State of Tennessee (which signed an agreement allowing it to send prisoners) nor the
County was obligated to provide a minimum number of inmates to the facility. If the trustee
were forced to foreclose, the bondholders would have a facility that was not likely to be useful
for anything besides a prison. But CCA signed a Debt Service Deficits Agreement obligating
CCA to cover shortfalls in amounts required to pay principal and interest on the bonds. If there
is a mandatory redemption of the bonds, CCA is only obligated to pay principal and interest on
the originally scheduled payment dates and is not obligated to advance funds to cover any
premium that may be due (in e.g., a determination that interest paid on the bonds is taxable). The
State of Tennessee was also granted an option to purchase the prison at prices that would be less
than outstanding debt. If the option is exercised, the Debt Service Deficits Agreement calls upon
CCA to pay the difference between the State’s purchase price and the bonds outstanding (all of
which must be redeemed upon exercise of the option by the State). If there is a foreclosure, CCA
is not liable for any deficiency that may remain unless the acceleration is the result of a default
by CCA under the Debt Service Deficits Agreement or a bond document. The interest on the
bonds was tax exempt. In some projects (e.g., Huerfano, Colorado) the proposed institutional
lenders, which were generally mutual funds, found the project to be too risky even for their high
yield tax exempt portfolios. So in some, such as Huerfano, the company, in this case CCA, went
ahead using its own taxable debt and equity to finance and develop the project.
Some facilities which have been financed (either on a taxable or tax exempt basis) were
even more speculative than Hardeman County or its cousins. The N-Group for example built
nine prisons in Texas, six of which failed. They were financed without any contracts in place to
supply prisoners. These were totally speculative prisons. Some of the N-Group prisons in Texas
did not even meet state standards, so they could not be supplied with Texas inmates even if
Texas had wanted to use these facilities. Ultimately, the N-Group company failed, the bonds
defaulted and investors sued.37 In speculative financings that fail (as was the case with the NGroup) the developers are apt to be sued by the bond purchasers . Fortunately such financings
have been a small minority among correctional facility project financings, and there appear to be
fewer today, now that the market has become more knowledgeable and mature.
If the risk is too high today, the facility will not be financed on a project finance (nonrecourse basis) at all. The sponsor or operating company may have to finance it itself, using
company credit, or bring in a REIT. Most host states today will not provide long-term
commitments to send inmates to a speculative prison. But the political pressure to provide
inmates to a struggling local community will be noticeable and perhaps compelling. One town in
Oklahoma, in poor economic shape, built a speculative prison in 1996 with CCA's help. The
state which was in need of additional cell space, proceeded to send inmates. Over the next two
37

See Martin E. Gold, The Privatization of Prisons, 28 THE URBAN LAWYER 359, footnote 50, at 374 (1996)

20

years, five more spec prisons were built in various Oklahoma communities, causing the state to
pull its prisoners out of facilities in other states in order to fill these facilities.38 The private
sector, acting without state commitments or encouragement, moved the state from one that only
two plus years earlier had a substantial shortage of cells, to one with excess capacity.
With so many prisoners moving to rented cells across state borders or to speculative
prisons in their home state, inmates are starting to look more and more like commodities. And to
the private sector, building an economic development or speculative facility, that to an important
extent is what they are: commodities having a stream of revenue attached.
V.

A MATRIX SUMMARY

The following matrix sets forth the financing and development methods availability for
the various combinations of public/private ownership projects. Across the top of the matrix are
the types of debt issuances, running from most public (G.O. bonds) to most private. The column
down the left contains the spectrum of construction and operation models also running from the
most public to the most private. A check mark indicates that the combination can be done.
Where there is a note the combination can be done (or occur) as stated in the note.
Summary of
Financing and Development Methods Available
Type of
Development/Operations
and Debt
A. Public Ownership,
Construction and
Operation
B. Public Ownership,
Private Design-Build
C. Public Ownership and
Construction, Private
Operation

D. Public Ownership,
Private Construction and
Operation

Tax Exempt
G.O. Bonds

Tax Exempt
Revenue Bonds or
COPS

,

,

,

,
Must have positive
expectation that there
will be no "bad"
contracts or other "bad"
use
Must have positive
expectation that there
will be no "bad"
contracts or other "bad"
use

,

,

E. Private Financing and
Construction
F. Private Financing,
38

Government Issued
Taxable Bonds

If fail to satisfy Tax
Rules for Management
Contracts

If fail to satisfy Tax
Rules for Management
Contracts

If state law allows
If state law allows

See Christopher Swope, The Inmate Bazaar, GOVERNING, October 1998, at 18-21.

21

Private Company
Taxable Debt

Either by Operating
Company or REIT
By Operating Company

Construction and
Operation
G. Economic Development
and Speculative Projects
(Public Ownership)

or REIT plus Operating
Company
Must have positive
expectation that there
will be no "bad"
contracts or other "bad"
use

H. Economic Development
and Speculative Projects
(Private Ownership)

If state law allows

If state law allows
,

2

APPENDICES

Appendix A
FEDERAL TAX CONSIDERATIONS

A.

Introduction

Federal tax statutes1 and regulations (the “Regulations”) issued thereunder by the Internal
Revenue Service (the “IRS”) of the United States Treasury Department (the “Treasury”) impose
a variety of constraints on the use and investment of proceeds of tax exempt bonds and on the
facilities financed with such bonds.
This section provides the reader with a general understanding of certain of the
fundamental concepts of the Code and Regulations concerning the tax exempt financing of
prison facilities, but cannot comprehensively address all tax exempt financing issues.2 Tax
exempt financing can be used not only with general obligation bonds, but also with revenue
bonds and COPs. It may therefore be used with private company operators, if structured
properly.
The topic addressed in this Appendix is private business issues, which is further
subdivided into use issues, payment issues, and security issues.3
B.

Private Business Issues

Normally, governmentally owned and operated prison facilities can be financed with tax
exempt bonds. However, tax exempt bonds cannot be used to finance prison facilities in two
important circumstances. First, tax exempt bonds generally cannot be used to finance prison
1

The subject federal statutes are contained in the Internal Revenue Code of 1986, as amended, and may be
referred herein as the “Code.”

2

One issue beyond the scope of this paper is the requirement that as of the issue date, the issuer have certain
“expectations” regarding how the prison facilities are to be used during the stated term of the bonds.
Another such issue is that of a "federal guarantee." The Code provides that the payment of principal or interest
on tax exempt bonds may not be guaranteed in whole or in part by the United States or any agency or
instrumentality thereof. All arrangements for the use of prison facilities by the federal government must be
carefully reviewed to determine whether, under federal income tax principals, such arrangements give rise to a
legal or economic federal guarantee for the payment of principal or interest on tax exempt bonds. Similarly,
arrangements regarding the use of prison facilities by state and local governments under circumstances where
the payment of principal or interest on tax exempt bonds is derived from the federal government must be
carefully reviewed for federal guarantee concerns.

3

An additional tax issue is that of “reimbursement.” Under limited circumstances, the proceeds of tax exempt
bonds can be used to reimburse a borrower for costs incurred prior to the issuance of such bonds Generally,
reimbursement is permitted only if and to the extent “official intent” is declared (and documented) prior to the
expenditure to be reimbursed. Consequently, issuers planning to reimburse themselves for the costs of prison
facilities paid prior to the issuance of the bonds, are best served by adopting official intent declarations prior to
the time of making such expenditures. A detailed discussion of reimbursement is beyond the scope of this
paper.

A-1

facilities if (1) a person or organization other than a state or local governmental unit (hereinafter
referred to as a “Private Entity”) is using the facility in a trade or business (such use is referred to
hereinafter as “Private Business Use”)4 and (2) the payment of debt service on the subject bonds
is directly or indirectly derived from payments in respect of property used for a Private Business
Use (such payments are referred to hereinafter as “Private Payments”).
Second, tax exempt bonds cannot be used to finance prison facilities if (1) there is
Private Business Use, and (2) the payment of debt service on the subject bonds is secured by
either any property used for a Private Business Use or by payments in respect of property used
for a Private Business Use (such security is referred to hereinafter as “Private Security”).5 If the
financing fails to satisfy the requirements, then the bonds will be fully taxable.
This can be summarized as follows:
IF

(1) PRIVATE
BUSINESS
USE

PLUS

(2)(a)
PRIVATE
PAYMENTS
OR
(2)(b)
PRIVATE
SECURITY

THEN

TAX EXEMPT
FINANCING
UNAVAILABLE

Of course there are a number of caveats and wrinkles to these tax rules. It is
recommended that qualified tax counsel be consulted as early as possible in the financing
process.
1.

Private Business Use

Private Business Use is the use of facilities financed with the proceeds of tax exempt
bonds by a Private Entity for use in its trade or business. Determining whether a Private
Business Use may exist is critical since the presence of a Private Business Use is a prerequisite
to the existence of both Private Payments or Private Security and to the possible failure to use tax
exempt financing.
Private Business Use may result from either actual or beneficial use by a Private Entity of
the facility. Generally, Private Business Use arises only if a Private Entity has “special legal
entitlements” to use the tax exempt financed property. Also, if a prison facility is used by the
4

The federal government (including its agencies and instrumentalities) is treated as a Private Entity.
Consequently, absent the satisfaction of a "90 day exception," use of tax exempt bond financed facilities by the
federal government will result in Private Business Use.

5

Under certain circumstances, the statutes and regulations allow for up to ten percent (10%) of Private Business
Use and allow for up to ten percent (10%) of the debt service on an issue of tax exempt bonds to be paid with
and secured by Private Payments and Private Security without jeopardizing the tax exempt status of the subject
bonds. The 10 percent threshold drops to five percent (5%) in certain circumstances.

A-2

federal government and payments from the federal government secure the debt service on the
subject bonds, use by the federal government is Private Business Use because the federal
government is deemed to be a "Private Entity" and the application of such payments to “secure”
debt service gives rise to Private Security. The result is taxable bonds.6 These concepts will now
be discussed in more detail.
a.

Ownership and Leases

The ownership by a Private Entity of the bond financed property results in Private
Business Use. The lease of bond financed property to a Private Entity also results in Private
Business Use.7
b.

Management/Service Contracts

The actual or beneficial use of a facility pursuant to a management or service contract
under which a private company provides services for a facility will generally give rise to Private
Business Use. But, the IRS has provided certain “safe-harbors” with respect to management or
service contracts, which if satisfied, will not result in Private Business Use. Contracts for
services that are solely incidental to the operation of prison facilities (such as janitorial and office
equipment repair) will not give rise to Private Business Use. Additionally, use during
construction by a developer is not Private Business Use if the issuer and developer proceed with
all reasonable speed to develop the property and transfer it to the governmental entity after
completion of construction.
For a contract to satisfy one of the safe-harbors, it must provide for reasonable
compensation and no part of the compensation can be based on a share of net profits from the
operation of the facility.8 The following two forms of compensation are not considered to be a
share of net profits: (1) a percentage of gross revenues (or adjusted gross revenues) or a
percentage of the expenses of a facility9 or (2) a per unit fee (hereinafter a “Per Unit Fee,"10).

6

In addition to providing rules regarding Private Business Use, Private Payments, and Private Security, the
Code and Regulations also contain provisions regarding the investment of proceeds of tax exempt bonds until
such proceeds are spent, as well as other money that is used to pay debt service on or is security for the bonds.
Generally, these provisions contain rules regarding the yield that may be earned on tax exempt bond proceeds
before they are spent, specific investments that may be purchased with tax exempt bond proceeds, how quickly
tax exempt bond proceeds must be spent, and those circumstances under which positive arbitrage earned must
be remitted to the federal government.

7

For this purpose, any arrangement that is properly characterized as a lease for federal income tax purposes is
treated as a lease.

8

Reimbursement of the service provider for expenses it pays to unrelated parties is generally not treated as
compensation.

9

However, the use of both percentage of gross revenue and a percentage of expenses at the same time will be
considered a share of net profits.

10

A Per Unit Fee is generally defined as a stated dollar amount based on a unit of service, such as a per diem fee.

A-3

In addition, to keep interest tax exempt under a safe-harbor, the compensation and term
provisions must satisfy one of the following arrangements:11
(1)
At least 95 percent of the compensation for each annual period is based on
a “Periodic Fixed Fee” (defined as a stated dollar amount for services rendered for a
specified period of time)12, and the term of the contract, including all renewal options,13
must not exceed the lesser of (1) 80 percent of the reasonably expected useful life of the
financed property and (2) 15 years.
(2)
At least 80 percent of the compensation for each annual period is based on
a Periodic Fixed Fee, and the term of the contract, including all renewal options, must not
exceed the lesser of (1) 80 percent of the reasonably expected useful life of the financed
property and (2) 10 years.
(3)
At least 50 percent of the compensation for each annual period is based on
a Periodic Fixed Fee, the term of the contract, including all renewal options, does not
exceed five (5) years, and the contract must be terminable by the governmental entity on
reasonable notice, without penalty14 or cause, at the end of the third year of the contract
term.
(4)
All compensation is based on a Per Unit Fee or a combination of a Per
Unit Fee and a Periodic Fixed Fee, the term of the contract, including all renewal options,
must not exceed three (3) years, and the contract must be terminable by the governmental
entity on reasonable notice, without penalty or cause, at the end of the second year of the
contract term.
(5)
All compensation is based on a percentage of fees charged or a
combination of a Per Unit Fee and a percentage of revenue or expenses, the term of the
contract, including all renewal options, must not exceed two (2) years, and the contract
must be terminable by the governmental entity on reasonable notice, without penalty or
cause, at the end of the first year of the contract term.

11

An additional requirement is that the service provider must not have any role or relationship with the owner or
governmental unit that, in effect, substantially limits the ability of the owner or governmental unit (based on all
facts and circumstances) to exercise its rights, including cancellation rights, under the contract.

12

A fee that is a "Periodic Fixed Fee" per year may automatically increase according to a specified objective
external standard such as an index, or another acceptable formula under the rules.

13

For purposes of all five safe-harbor exceptions, a renewal option is defined as a provision under which the
service provider has a legally enforceable right to renew the contract. A provision under which a contract is
automatically renewed for specified periods absent cancellation by either party is not a renewal option.

14

For purposes of the safe-harbor exceptions, penalties for terminating a contract include a limitation on the
owner’s right to compete with the service provider; a requirement that the owner purchase more than minor
amounts of equipment, goods, or services from the service provider; and a requirement that the owner pay a
penalty for canceling the contract.

A-4

The table set forth in Appendix B summarizes these safe-harbors. If a safe-harbor is
satisfied there is no reason to apply the other safe-harbors. The general concept of the safeharbors is that the greater the Private Entity’s compensation is based on fixed amounts, the
longer the permissible term.
Per diem fees, by themselves, constitute “per unit” fees, not fixed fees or stated dollar
amounts. Fixed fees or stated dollar amounts means the aggregate total must be fixed (subject to
acceptable adjustments).15 If there is a guaranty from the state, for example, that 80% of all cells
will be paid for regardless of use, the contract can qualify for the 80% Periodic Fixed Fee and
have a 10 year term. The fixed daily compensation would be calculated using the following
formula: Fixed Fee = (number of inmates) x (per diem amount per inmate) x 80%. If the
calculation period is a year, the preceding would then be multiplied by 365.
It should be noted that an arrangement that is referred to as a "management" or "service"
or "operations" contract may nevertheless be treated as a "lease" because a proper
characterization under tax rules depends upon a detailed analysis of facts and circumstances. A
lease will give rise to Private Business Use.
Renewal options that require mutual agreement of the parties to continue are not included
in a base period, i.e., are not part of the “term”. Automatic extensions unless either party
exercises its right to terminate do not become part of the contract term either. If the operator
alone has the right to renew, however, the periods covered by those options are counted as part
of the term. No right of the government to terminate is required in 10 and 15 year contracts that
otherwise qualify. A right to terminate without cause a qualifying 5 year contract is required
after the third year, and such termination must be without penalty.
Prison operating agreements are commonly funded on a per diem basis, with escalations
and some pass-through payments for disbursements. Escalators based on an index or a
combination of indices are acceptable for adjusting the periodic fixed fee or the per diem fee.
They may also grow by fixed dollar amounts or fixed percentages. The portion of the
compensation that is not a fixed fee, however, must still fall into another acceptable fee payment
category. These include per-unit fees (per diems), and percentages of gross revenue categories.
No portion of the compensation may ever be based on net profits. The latter might arise in
prison operations, possibly, if the prison accepts prisoners from other entities or the operator is
paid on a per diem, per prisoner basis, and adjusts payments required from the state to reflect
reduced operating costs. Bonuses for efficiencies, or cost savings, may be acceptable. Each
such arrangement would require review by counsel.
If the formula uses 100 percent per diem payments and pass-throughs, then even the fiveyear term (with a right of termination after three years) cannot be used, but a contract with a
three-year term with a two-year cancellation provision (a “3/2” term) can be used, and would be
the longest base term available. A “5/3” contract is only available if at least 50% of the fee is
fixed. But these short terms should not necessarily be viewed as a serious barrier: if the business
15

A per diem fee is not “capitation fee” as used here.

A-5

relationship works, the parties will probably renew the agreement. And mutual renewal terms
can be added without limit.16 If, however, there is a minimum payment commitment due the
operator (e.g. on the assumption that the facility will be utilized to a minimum percentage level),
and if that minimum fee is contractually required to equal 80% or 95% of the total annual
compensation (pass-throughs being ignored), then it may be possible for the contract to be
written for a term with 10 or 15 years and no early termination would be required.
c.

Special Economic Benefits – The Catchall

Private Business Use may also arise solely on the basis of a “special economic benefit” to
a Private Entity, even if such entity has no special legal entitlement to the physical use of the
financed property. A priority right such as a right of first refusal for space (cells) (e.g., by the
federal government) or to purchase a facility would be a Private Business Use. In determining if
the circumstances give rise to a special economic benefit, all facts and circumstances are
considered.
2.(a)

Private Payments

As stated above, Private Payments are payments of debt service on tax exempt bonds
which are directly or indirectly derived from any facilities which are used in a Private Business
Use. The most common form of a Private Payment is payments of rent by a private corporation
for the use of property financed with tax exempt bonds.
But the source of revenue that is typically used to satisfy the debt service requirements of
bonds that finance prison facilities is, directly or indirectly, tax revenues of governmental
entities, since such governmental entities will be obtaining the benefits of the financing by virtue
of their prisoners being housed in the subject facilities.17 Normally, the use of general tax
revenues (or any particular taxes not related to the specific property) as the source of debt service
payments on bonds will not give rise to Private Payments; however, tax revenues combined with
the existence of a Private Business Use may result in Private Payments. For example, under the
tax rules, Private Payments will arise if the payment “is with respect to property used in a Private
Business Use.” Consequently, if a prison facility is treated as “used” by a Private Entity (e.g.,
because a safe-harbor under the management contract rules was not used) payments with respect
to such Private Business Use, such as payments to the operator for prisoners from other
jurisdictions for more than 10 per cent of the facility's space, are apt to be Private Payments18. If
such payments, however, are made to the host government and the operator only receives

16

They probably need to satisfy the same tax rules as the initial term, but that is not certain.

17

It is noted that revenues from the federal government may also give rise to “federal guarantee issues” discussed
more fully in a footnote above.

18

Under §141(b) of the Internal Revenue Code, up to ten percent of total use may be for Private Business Use
and ten percent of total revenues may be Private Payments without causing the bonds to be taxable. For this
purpose a cumulative test may be available to help keep the issue from turning taxable. This may be helpful in
facilities, for example, where federal prisoners are housed.

A-6

additional amounts therefor under its qualified management contract with the host government,
the payments are unlikely to be Private Payments.19
2.(b)

Private Security

"Security" exists if the property serves as security for debt service on the bonds (e.g.,
under a mortgage or deed of trust or other security instrument producing a lien or pledge).
Security also exists if the revenues from the facility are pledged or otherwise available for
payment of debt service. If there is also Private Business Use, this security will be "Private
Security" and the bonds will be taxable. For example, if a mortgage secures debt service on
bonds issued to finance a prison facility used by the federal government or operated by a Private
Entity pursuant to an arrangement that does not satisfy one of the IRS safe-harbors, there will be
Private Security. Hence, if you have a Private Business Use because a safe-harbor was not used,
and you have a mortgage to secure payments, the bonds will not be exempt.
Since the vast majority of financings involve either a mortgage or a pledge of the revenue
stream, tax exemption can generally only be obtained by avoiding Private Business Use in the
first place. That is best achieved by direct government operation of the prison or employment of
a private company using a qualified management contract.

19

It is not clear whether it would be acceptable to have several states enter into contracts relating to a single
facility which all attempt to be qualified management contracts because an operator is supposed to be operating
a facility on behalf of a single government which owns the facility. Bond counsel may be reluctant to give an
opinion that more than one qualified management contract can exist at a time with respect to a single facility
owned by one governmental entity.

A-7