To welcome in the new year, the Internal Revenue Service (the “IRS”) issued Rev. Proc. 2014-12, 2014-3 I.R.B. 415, to provide administrative guidance to the federal historic tax credit industry in the aftermath of the Third Circuit’s decision in Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012), cert. denied, 133 S.Ct. 2734 (2013). Rev. Proc. 2014-12 includes a safe harbor (the “Safe Harbor”) pursuant to which the IRS will not challenge the allocation of rehabilitation tax credits (“Historic Credits”) under Section 47 of the Internal Revenue Code of 1986, as amended (the “Code”), among partners in a partnership. Overall, the guidance is a good faith and useful attempt by the IRS to set reasonable Safe Harbor parameters while addressing its concerns with the deal structure in the Historic Boardwalkcase. Unfortunately, it does also include some puzzling elements.
I. Background – The Historic Boardwalk Case
In the Historic Boardwalk case, the Third Circuit addressed whether an equity investor in a partnership which completed the rehabilitation of a historic building in a manner which qualified for Historic Credits should be regarded as a partner in the partnership for federal income tax purposes. In this case, the New Jersey Sports and Exposition Authority (the “NJSEA”) was the lessee and operator of a historic structure which required substantial renovation. To complete the rehabilitation, NJSEA created Historic Boardwalk Hall, LLC (“HBH”), in which it served as the managing member. A subsidiary of Pitney Bowes (“PB”) was admitted to HBH as the investor member. The building was subleased by NJSEA to HBH for a term of 87 years.
Under the terms of the operating agreement for HBH, PB had a 99.9% interest in HBH’s profits, losses, Historic Credits and cash flow, and was entitled to an annual priority return equal to 3% of its capital contributions. Only a small portion of PB’s capital was contributed prior to placement in service, with the balance dependent upon, and calculated with reference to, the amount of Historic Credits actually allocated to PB. NJSEA provided PB with a construction completion guaranty, an unlimited operating deficit guaranty, a guaranty against environmental liability and a guaranty of PB’s projected federal income tax benefits (including indemnification against any loss of such benefits following an audit by the IRS). In certain circumstances, NJSEA had the right to purchase PB’s interest in HBH for an amount equal to the present value of unrealized federal income tax benefits and cash flow projected to be realized by PB during the 5-year Historic Credit recapture period. Following the recapture period, NJSEA had the right to acquire PB’s interest in HBH for a formula price equal to the greater of (i) the fair market value of its interest or (ii) PB’s unpaid priority return. PB also had the right to put its interest in HBH to NJSEA for the same formula price. NJSEA’s obligation to pay the purchase price under the foregoing options was secured by a Guaranteed Investment Contract (“GIC”) equal to the anticipated cumulative priority return.
At the trial court level, the Tax Court held that PB was a bona fide partner in HBH. The Third Circuit reversed, finding that PB had no meaningful interest in either the success or failure of HBH’s activities. The court determined that there was no meaningful potential for economic upside from PB’s investment, finding that the financial projections had been manipulated to create the impression of a pre-tax economic motive for PB’s investment by using unsupported and overly optimistic assumptions. Thus, it concluded that the only possible economic benefit to PB, apart from federal income tax benefits, was its 3% priority return, the payment of which was guaranteed by NJSEA through the put and call options, and which was fully secured by the GIC. The court further noted that PB bore no risk that it would not receive the anticipated Historic Credit (or its cash equivalent), and had contributed little capital until the rehabilitation was completed and the amount of Historic Credits had been determined. The court was also swayed by the fact that (i) NJSEA provided construction completion, cost overrun and operating deficit guaranties, (ii) the sources of financing available to HBH were sufficient to fund the rehabilitation without PB’s capital, with the original budget being revised to add a development fee payable to NJSEA and most of PB’s capital being used to pay it.
Although the Historic Boardwalk case had some very bad facts for the taxpayer, the overall structure and scope of investor protections were not far afield from those in typical Historic Credit transactions being done at the time. Due to the turmoil the Historic Boardwalk decision caused in the industry and the adverse impact on the willingness of investors to invest in Historic Credit properties, the IRS announced it would issue guidance providing a safe harbor for Historic Credit investments. Rev. Proc. 2014-12 is that promised guidance.
II. The Rev. Proc. 2014-12 Historic Credit Safe Harbor
Rev. Proc. 2014-12 makes clear that the Safe Harbor is not intended to provide substantive legal rules, such that (in theory, at least) no inference is intended with respect to a transaction that does not satisfy the Safe Harbor requirements. The Rev. Proc. also states that the determination of whether an expenditure is a qualified rehabilitation expenditure, or whether a partnership is the owner of a building for purposes of claiming the Historic Credit, are outside the scope of the guidance. Nevertheless, following the uncertainty engendered by the Historic Boardwalk decision, it is useful to have an indication of the IRS’s position on the issues addressed. While a number of the elements in the Safe Harbor have precedent in previous guidance released by the IRS in other areas, certain aspects of the Safe Harbor do seem somewhat surprising, and only time will tell how the industry ultimately reacts to them.
The key provisions of the Safe Harbor are described below. As becomes clear, the Safe Harbor departs from the manner in which Historic Credit transactions have typically been structured in a number of respects, with some departures seemingly benefiting investors and others benefiting developers. Stated simply, the Safe Harbor requires investors to sacrifice certain customary protections while requiring developers to cede pre-tax economics to investors.
The discussion adopts the nomenclature of the Safe Harbor, which defines the manager of the partnership in question (the “Partnership”) as the “Principal”, the equity investor as the “Investor”, and the partnership that owns the building and performs the rehabilitation as the “Developer Partnership.” If the deal is structured as a lease pass-through, the master lease is referred to as the “Head Lease” and the lessee as the “Master Tenant Partnership”.