From the Journal of Taxation and Regulation of Financial Institutions, November/December 2014

Transcription

1 From the Journal of Taxation and Regulation of Financial Institutions, November/December 2014 Historic Tax Credits IRS issues safe harbor for tax-credit investors By Peter J. Berrie, Partner, Faegre Baker Daniels In August 2012, the seminal Historic Boardwalk Hall decision created turmoil in the historic tax credit industry. Subsequent IRS activity in the wake of this decision severely curtailed the use of the federal historic tax credits. Reacting to the need for guidance, on December 30, 2013, the IRS issued a safe harbor as to when it would not challenge the partnership status of a historic-tax-credit investor. Section 47 of the Internal Revenue Code provides a powerful tool for the preservation of this country s historic buildings often referred to as historic tax credits, but technically called the rehabilitation credit. 1 Basically Section 47 provides a one-time credit against federal income tax based on a fixed percentage of rehabilitation (renovation) costs for qualified structures. For reasons explained below, it is usually necessary for the entity performing the rehab to bring in an investor partner to monetize the tax credits. Before September 2012, a relatively commonplace partnership structure and pool of investors had existed to monetize these credits efficiently. But on August 27, 2012, the IRS won its appeal challenging whether the tax-credit investor in the Historic Boardwalk Hall case was a true partner in the entity that owned the building, which in turn controlled whether the investor would receive any of the tax credits. This IRS victory and subsequent IRS actions severely curtailed the ability (or willingness) of developers and investors to proceed with historic tax credit developments. Many traditional taxcredit investors refused to close any new transactions unless and until the IRS provided further guidance as to when a partnership structure would be respected. In early 2013, the IRS announced that it would produce guidance. After about 10 months, the IRS issued Revenue Procedure on December 30, 2013, which provided a safe harbor regarding the partnership status of historictax-credit investors. Despite some inherent limitations of the safe harbor, after several months of digesting the safe harbor and revising applicable transaction documents, many traditional investors began closing deals again. This article will briefly describe the relevant requirements of the Code as relates to the monetization of the tax credits. It will then summarize the Historic Boardwalk Hall case and its effect on the historic-tax-credit industry. And finally it will set forth the safe harbor requirements and how they are working in practice. 1 Unless otherwise noted, all Section references are to the Internal Revenue Code of 1986, as amended, which shall be referred to as the Code. 1

2 REHABILITATION CREDIT As stated above, the rehabilitation credit is a one-time credit based on a fixed percentage of certain rehabilitation costs for qualified buildings. The fixed percentage is 10% of qualified rehabilitation expenditures for qualified buildings that were first placed in service before 1936, unless the applicable building is a certified historic structure. 2 The fixed percentage increases to 20% of qualified rehab expenditures for certified historic structures (which do not need to have been originally placed in service before 1936). 3 The detailed requirements to be a qualified rehabilitated building are beyond the scope of this article. This tax credit is available only to a taxpayer with an appropriate ownership interest at the time the rehab project is placed in service. 4 Generally, this would be the owner of the building (or a qualifying tenant in some circumstances) at the time the project is placed in service. This credit can be claimed for the year in which the project was placed in service, but to the extent unused in full, it also may be carried back one year, and carried forward for 20 years. 5 But despite this 22-year window, many building owners do not have enough income-tax liability to use all of the available tax credits, which problem is compounded by the passive activity rules, the AMT rules and other factors. Accordingly, developers and other owners of eligible historic buildings have had to monetize the tax credits as described below. Monetizing the Credit Because most building owners cannot take full advantage of the tax credits generated by a qualified rehabilitation, they must find a way to monetize the credits, i.e. convert the credits into funds that can be used to either pay for the rehab expenditures directly, repay a construction loan, or reimburse the building owner for the expenditures. Incorrectly, people often refer to this as selling the tax credits for cash that is channeled into the development. But the credits cannot be sold; as described above, they can only be used by the entity that owns the building at the time the project is placed in service. 6 Accordingly, the developer/building owner must create a pass-through entity such as a limited partnership or limited liability company to be the building owner. Using a limited partnership as an example, the developer (or a related entity created for this purpose) will be the general partner and the tax-credit investor will be the limited partner. Typically, the limited partner will have a 99% (or greater) 7 interest in the owner entity and receive a commensurate allocation of the tax 2 As defined in IRC Section 47(c)(3). 3 IRC Section 47(a). 4 The term placed in service is not well defined in the Code. For purposes of depreciation, Treas. Reg. Section 1.167(a)-11(e)(1)(i) states that a building will ordinarily be placed in service on the date such construction, reconstruction, or erection is substantially complete and the building is in a condition or state of readiness and availability. 5 IRC Section 39(a)(1). 6 Actually, in limited circumstances a tenant of a building may receive the tax credits for qualified rehab expenditures made by the tenant. In addition, the Code allows a building owner to pass through the credits to a tenant provided certain requirements are met. IRC Section 50(d)(5) (incorporating former Section 48(d) as in effect before the enactment of the Revenue Reconciliation Act of 1990). 7 At least before the safe harbor was issued the investor often obtained a 99.99%, but that is very unlikely now as explained below. 2

3 credits. The purchase price for the tax credits is actually the limited partner s capital contribution for its ownership interest in the pass-through entity. The developer can either monetize the tax credits directly to an investor or to a syndicator, who acts as a broker between the developer and ultimate investor or investors. In the example above, the tax-credit investor obtains a 99% interest in the building-owner entity, so that it can obtain 99% of the federal tax credits generated (or, more often, a 99% interest in a master tenant of the building with a long-term lease pursuant to a structure that passes-through the credits to the master tenant under Section 50(d)(5)). The amount of the investor s capital contributions to acquire this 99% interest is generally based on the amount of tax credits actually received by the investor. The investor would also receive other tax benefits or burdens as a 99% partner, as well as cash distributions as a partner, all of which would also affect the amount the investor would agree to pay. And while the tax credits are a one-time credit, the cash flows and other tax attributes of being a partner would continue to accrue for as long as the investor remains a partner. Exit Strategy Of course, the developer or owner of the project views the admission of the investor into the ownership structure as a way to monetize the credits not as a way to monetize the credits and convey 99% of all economic benefits of owning the building. Happily, the investor also is looking for its economic return primarily through the receipt of the tax credits, as well as some minimal level of cash flow distributions. Typically, before the HBH decision, investors would enter into put/call option agreements with the developer or project sponsor. These agreements would give the investor the right to compel the counterparty (usually the developer or affiliate of the developer) to buy out the investor s 99% ownership interest in the entity for a fixed price (which was often either a nominal sum such as $1,000 or an amount equal to a percentage of the investor s overall capital contributions, such as 5%, 10% or 15%). 8 It is important to note that the investor cannot promise, contractually or otherwise, that it will exercise its put option, otherwise it would jeopardize its status as a true partner. But the general expectation is that the investor will transfer its partnership interest to the developer or project sponsor sometime shortly after the expiration of the recapture period, typically through exercise of the put option. If the investor did not exercise its put right, then the counterparty would have a call option, i.e. the right to buy out the investor for a price equal to the fair market value of the investor s interest. But neither the put nor call option would be exercisable within the five years immediately following the placed-in-service date, because a transfer of ownership during those five years would cause a complete or partial recapture of the tax credits. 9 8 Because there generally is an expectation that the put will be exercised, the amount of the put price directly affects how much the investor would be willing to provide as its capital contribution. 9 IRC Section 50(a). 3

4 HISTORIC BOARDWALK HALL Too often people in the tax-credit industry talk about selling tax credits as a shorthand way of describing the monetization described above. In Historic Boardwalk Hall, this carelessness helped contribute to the ruling that the tax-credit investor was not a true partner in the entity that owned the building. 10 As a result, none of the approximate $22 million of tax credits accrued to the tax-credit investor. By siding with the IRS, the Third Circuit Court of Appeals sent a clear message that the credits could not be sold, but rather they could only flow to the true partners of the building owner. The case was decided on partnership analysis, and it immediately affected how historic credit deals were thereafter structured. Practitioners were not surprised that a partnership analysis was applied it has always been understood that the investors needed to be actual partners but the application of the analysis, coupled with the extreme facts in Historic Boardwalk Hall, caused many to question how investments had been traditionally structured. The basic message in Historic Boardwalk Hall was that to be a partner, an investor had to have a meaningful stake in the success or failure of an entity. While the facts of Historic Boardwalk Hall were uniquely bad, there were enough similarities to the way typical tax-credit investments were structured to cause most traditional investors to restructure their requirements for all historic projects that had not yet been placed in service. HBH Factual Background Historic Boardwalk Hall involved the renovation of the convention center (known as East Hall or the Historic Boardwalk Hall) in Atlantic City where the Miss America pageant was held for many years. The Hall was owned by the New Jersey Sports and Exposition Authority (the Authority ) pursuant to a 35-year lease. A few months before starting the rehabilitation, the Authority received a proposal for the sale of the credits expected to be generated by the rehab. Even worse, the consultant making the proposal stated that the best way to view the equity generated by a sale of the historic tax credits is to think of it as an $11 million interestonly loan that has no term and may not require any principal repayment. (emphasis added) The consultant s proposal involved the Authority subleasing the Hall to a new entity for a term long enough that the sublease would be deemed a sale of the facility to the new entity for tax purposes. The new entity would be a pass-through limited liability company comprised of the Authority as the general partner, and a tax-credit investor as the 99.99% limited partner. This was a relatively common structure. 11 The proposal referred to purchasers of historic tax credits and generally indicated that there would be little risk and little cash-flow return for the purchasers. Before the investment was made, the project had already been fully funded in other words, the rehabilitation could be 10 Historic Boardwalk Hall, LLC v. Commissioner of Internal Revenue, (3 rd Circuit App. Ct. 2012). 11 The Authority could not use the credits itself because as an agency of the State of New Jersey it was exempt from federal income taxation and would have no use for any tax credits. And in any event, pursuant to tax-exempt use property rules, any building owned solely by tax-exempt entities is not eligible to receive federal tax credits. IRC Section 50(b)(4). See also Section 47(c)(2)(B)(v) and Section 168(h) relating to disqualified leases to tax-exempt entities. 4

5 completed without the tax-credit equity. Pitney Bowes, Inc. was selected as the investor and it committed to pay approximately $18 million in capital contributions, with only $650,000 to be paid at the time of the investor s admission to the company. The balance was not paid until after the project was completed. 12 Because of the structure and various guaranties, Pitney Bowes as investor assumed practically no downside risk. In addition to the fact that the vast majority of capital contributions were not paid until after the historic credits were assured, Pitney Bowes was protected against downside risk by a completion guaranty, tax credit guaranty, operating deficit guaranty, and environmental guaranty. The guarantor was the Authority, an entity with deep pockets and commitments from another governmental entity to reimburse project costs. The 3% preferred return to Pitney Bowes (further discussed below) was backed by a guaranteed investment contract (often referred to as a GIC). Pitney Bowes also had the right to compel the Authority to purchase its interest for a price equal to all of the projected tax credits and expected cash distributions (i.e. the 3% preferred return) if the Authority defaulted. In an attempt to show a profit motive to satisfy the economic-substance test, Pitney Bowes was to receive a priority return of cash flow equal to 3% of its capital contributions. But this also caused problems for the court because this preferred return was guaranteed by the GIC, and thus further showed the investor had little downside risk. But just as importantly, the Authority s right to buy-out the investor, and the actual operating results of the Hall demonstrated that Pitney Bowes never had a realistic opportunity to realize any economic gain beyond the receipt of the tax credits and the 3% priority return. The court noted that despite the smoke and mirrors of the financial projections, the parties behind-the-scenes statements reveal that they never anticipated that the fair market value of Pitney Bowes interest would exceed Pitney Bowes accrued but unpaid Preferred Return. Based on the lack of upside potential and lack of downside risk, the court concluded that Pitney Bowes was not a partner for tax purposes. Accordingly, the tax credits could not flow through to Pitney Bowes. But the case was somewhat ambiguous as to whether both an upside potential and downside risk had to be present to be considered a partner, or rather if just one or the other would be sufficient. In addition, the case left some wondering whether an investor receiving the same types of guaranties from a less credit-worthy guarantor (and not backed by a GIC) would also be perceived as not having downside risk. In the immediate aftermath of Historic Boardwalk Hall, many tax credit transactions were delayed for at least 6-8 weeks as investors and their attorneys decided how to re-structure their projects to withstand IRS and judicial scrutiny. The following are a few of the approaches used in the first 4-6 months following the HBH decision: 1. The investor would commit to make its investment substantially before the rehabilitation was placed in service; 12 Even at the time of the initial contribution of $650,000, it is likely that Phase 3 of the renovation was already complete with about 12 months left to complete all of the renovation. 5

6 2. At the time of admission to the partnership, the investor would invest a substantial amount of cash (previously the initial capital contribution was often as low as $1,000); 3. Guaranties in favor of the investor were revised so that not all downside risk was eliminated; for example some recapture guaranties would leave the investor suffering a 10% loss; and 4. Cash-flow distribution provisions were revised so that the investor would have some meaningful possibility of upside return (beyond the usual 3% preferred return). Subsequent IRS Action Problems only became worse when in March, 2013, the IRS issued guidance that mirrored much of the reasoning in the 3rd Circuit s Historic Boardwalk Hall case. 13 Then, on May 28, 2013, the U.S. Supreme Court denied certiorari to Historic Boardwalk Hall, LLC. While neither action was a surprise, they made it clear that the historic tax credit industry needed to develop ways to address the structuring issues raised by the 3rd Circuit and the IRS. Around this same time, i.e. Spring 2013, the IRS began large-scale audits of some of the major investors historic-tax-credit portfolios. Based on these IRS actions, most large-scale tax-credit investors refused to close any additional historic tax credit investments unless and until the IRS issued guidance as to when it would respect the parties intention to create partnership interests. SAFE HARBOR REV. PROC In response to repeated requests from industry participants and in recognition of the nationwide decrease in the use of historic tax credits, the IRS issued Revenue Procedure on December 30, 2013, setting forth its much anticipated safe harbor for investments in historic tax credit projects. The safe harbor indicates that it is intended to provide more predictability after the uncertainty created by the IRS s victory in Historic Boardwalk Hall. While the revenue procedure may provide some predictability, there exists uncertainty that investors have resolved through third-party reports as further explained below. Ultimately, the safe harbor has achieved its goal and most investors are actively closing the backlog of transactions that had accumulated during the hiatus. This revenue procedure is effective for federal historic tax credits allocated after December 30, 2013, i.e. effective for projects placed in service after December 30, (In addition, any projects placed in service before December 31, 2013 that just happened to meet all the requirements of the safe harbor would also get its benefit.) Because this revenue procedure is a safe harbor only, it does not mean that partnership allocations that do not comply with its requirements are necessarily improper. But because of the general uncertainty created by Historic Boardwalk Hall, there is strong motivation for investors and developer/sponsors to comply with this revenue procedure. 13 Chief Counsel Memorandum No F. 6

7 If a partnership meets the standards of this new safe harbor, the IRS will not challenge the investor s status as a partner. The main standards are briefly set forth below, as well as a few concerns and questions. Partnership Interest Percentages Investor s Minimum Interest. The tax-credit investor s share of income, gain, loss, deductions and tax credits at all times while it is a partner cannot be less than 5% of its highest allocation percentage for any taxable year. For example, if the investor initially is allocated 99% of income and tax credits, then its share cannot be reduced after the 5-year credit recapture period to less than 5% of 99% (which would be 4.95%). This requirement contemplates that the investor s ownership percentage could flip at some point in time. In practice, after the safe harbor most transactions now incorporate a provision that the investor s ownership interest will flip to a lower percentage after the 5- year recapture period but often to a percentage higher than 5% (but much lower than 99%). This structure, while used previously in connection with wind-energy partnerships that monetize certain renewable energy tax credits, had not often been used with historic tax credits before the safe harbor. 14 But the flip minimizes the economic risk to the developer/sponsor if the investor does not exercise its put option or otherwise exit the partnership at the end of the 5-year recapture period. Principal s Minimum Interest. The principal/sponsor must have at least a 1% interest in each material item of income, gain, loss, deductions and tax credits at all times during the existence of the partnership. Before the issuance of the safe harbor, investors would most often receive a 99.99% interest in the entity receiving the tax credits (with the general partner/sponsor receiving the remaining.01% interest). To be within the safe harbor, no investor can have an interest greater than 99%. These first two standards are similar to those for wind-energy partnerships set forth in Revenue Procedure , which contemplates that the tax-credit investor will be allocated up to 99% of tax benefits, but after achieving a certain internal rate of return its interest may flip to 5%. Compliance with these requirements should not be difficult. Investor s Investment Requirements Minimum Contribution. Before the building is placed in service, the investor must contribute at least 20% of the investor s total expected capital contributions... as of the date the Building is placed in service. Because the calculation of the total expected capital contributions is not made until the building is placed in service, this standard cannot be met with certainty until the date the building is placed in service, which makes this requirement logistically difficult (although in practice, many investors are taking a more practical approach). Deals may be structured with contributions 14 The investment tax credits for certain renewable energy projects function much like the historic tax credits. A safe harbor applicable only to wind-energy investment tax credits was issued in 2007, and as mentioned below this safe harbor had some similar features to the historic-tax-credit safe harbor. See Rev. Proc

8 slightly in excess of the projected 20% to create some buffer. This requirement is somewhat interesting because while it eliminates the previous practice of investors making an initial capital contribution of $1,000, the fact that it is only required before the building is placed in service means that the initial capital contribution could be made very late in the rehab process. Waiting until the rehab is almost substantially complete takes away some of the uncertainty investors face, and is certainly less conservative than investors had been following the Historic Boardwalk Hall decision. Fixed Contribution. At least 75% of the investor s total expected capital contributions (determined as of the placed-in-service date presumably) must be fixed in amount before the date the building is placed in service. This limits the parties ability to have adjusters to the investors capital contributions. Typically the member control agreement or limited partnership agreement required the investor to provide a certain amount of capital contributions, but that such amount would be adjusted later depending on the actual amount of federal tax credits generated. This adjustment is now limited to 25% to remain within the safe harbor. Bona Fide Equity Investment. The investor s partnership interest must constitute a bona fide equity investment with a reasonably anticipated value commensurate with the Investor s overall percentage interest in the Partnership, separate from any federal, state and local tax deductions, allowances, credits and other tax attributes to be allocated. (emphasis added). This is the most problematic aspect of the safe harbor. There is little guidance in the safe harbor as to what is meant by reasonably anticipated value commensurate with the Investor s overall percentage interest or even what is meant by overall percentage interest. But if the value of the tax benefits cannot be considered in determining the investment value, it is unclear how there could be commensurate value without giving the investor substantially all (i.e. 99% in most deals) of the economic benefits from the transaction, at least for the first five years (and then giving the investor 5% of all economic value after the flip). The first example in Revenue Procedure supports this interpretation by implying that the investor must receive cash distributions on a pro rata basis commensurate with its share of profits. Subsequent conversations with the IRS confirm this interpretation. IRS personnel have also indicated that projects that do not cash flow (for example, community theaters that are expected to always have operating deficits) will not run afoul of this provision even though the investor s interest would presumably have a fair market value way below its capital contribution, so long as the organizational documents provide that the economic benefits be split in proportion to the investor s percentage interest. Interestingly, that interpretation makes deals without any projected cash flow easier from a practical standpoint, because deals with expected substantial cash flow, especially if speculative, are harder to price due to the uncertainty of the amount of cash that the investor will receive in addition to the tax credits. Market Terms. The value of the investor s interest cannot be reduced through fees (including developer, management, and incentive fees), lease terms or other arrangements that are unreasonable compared to a real estate development project that does not qualify for historic tax credits. Similarly, the investor cannot receive distributions disproportionate to its interest. 8

9 This provision is a necessary corollary to the bona fide investment requirement above. In effect, the safe harbor is trying to prevent the parties from shunting cash flow from the project away from the investor, who is now supposed to receive a percentage of the economic benefits commensurate with its ownership percentage. Without this provision, developers could increase management fees, developer fees, master-lease rents or other provisions to minimize the cash flow payable to the investor. But the existence and/or level of these types of fees and rents in non-tax-credit deals varies widely, and in any case is often highly subjective. This presents a problem for investors wanting certainty that they remain within the requirements of the safe harbor. Investors have dealt with this conundrum by engaging knowledgeable consultants to provide third-party reports opining as to whether a specific project s deal terms meet this requirement. Guarantees and Indemnities Permissible Guarantees. The investor may receive guarantees from the principal/sponsor as to any act or omission that would prevent the partnership from qualifying for the credit. In addition, the principal/sponsor can provide completion guarantees, operating deficit guarantees, environmental indemnities and guarantees of financial covenants. Guarantees Must be Unfunded. These permissible guarantees cannot be "funded," meaning the sponsor cannot set aside money or property to ensure payment on the guarantees. In addition, the guarantor may not agree to maintain a minimum net worth. The one exception to the requirement that guarantees must be unfunded is that operating reserves in an amount no more than 12 months of reasonably projected partnership operating expenses will not constitute an amount set aside to fund the guarantee. Impermissible Guarantees. No person may guarantee the investor s ability to claim the credits, the cash equivalent of the credits, or the repayment of any portion of the investor s capital contributions due to the inability to claim the credits if the IRS challenges all or a portion of the transactional structure of the partnership. The requirement to disallow funded guarantees presumably is meant to show that the investor has downside risk, and thus supports the finding that it is a partner. Exit Provisions (Puts and Calls) No Call Options. Neither the principal/sponsor nor the partnership can have a call option to repurchase the investor's interest. Investor Put Options. But the investor can have a "put" to force the principal/sponsor to repurchase its interest, as long as the put price is not above fair market value when the put is exercised. No Abandonment. The investor may not abandon its interest in the partnership at any time if it does, it will be presumed to have originally acquired its interest with the intent to abandon it (unless the facts and circumstances clearly establish that it did not). 9

10 Although it is not clear what is meant by abandonment, some initially feared that exercising a put for a nominal amount (e.g. $1000 as has been common) could be deemed to be abandonment. But subsequent conversations with the IRS confirmed that the sale of the investor s interest for as low as $1 is not abandonment. (An investor abandoning its ownership interest i.e. surrendering it for no compensation would result in tax results more advantageous to the investor than if the same investor sold its interest for compensation.) Master Lease Pass-Through Structure General. If the building owner passes the tax credits through to a master tenant, each of the requirements described above are applied at the master tenant level. Investment in Building Owner. If the investor is receiving the credits as a partner in the master tenant, the investor cannot also invest in the building owner, except through an indirect interest in the building owner through the master tenant. This last point recognizes a common practice in master lease structures the master tenant often uses all or most of the equity investment from the investor to make a similar equity investment in the building owner. So while it may be beneficial that the IRS does not prohibit the master tenant from acquiring an interest in the building owner, there are no guidelines regarding any limitations or requirements of that investment by the master tenant in the building owner. Subleases Back to Building Owner or Principal. A sublease of the building from the master tenant back to the building owner or to the principal of either the building owner or the master tenant will be deemed unreasonable unless it is mandated by an unrelated third party. Sublease Term Must be Shorter than Master Lease. Any sublease of the building will be deemed unreasonable unless it is for a term shorter than the master lease. This last requirement makes sense, but it is unclear if a sublease term one day shorter than the master lease would also be unreasonable. CONCLUSION The historic tax credit industry waited eagerly (and, justifiably, anxiously) for this IRS guidance, and the safe harbor gives investors and developers greater certainty as to how to structure historic tax credit investments. Despite a few shortcomings as described above, Rev. Proc has provided a meaningful safe harbor that has allowed project sponsors and tax credit investors to close new tax-credit investments. 10