On December 30, 2013, the IRS issued Revenue Procedure 2014-12, setting forth its much-anticipated safe harbor for investments in historic tax credit projects. The move is in response to industry backlash and congressional pressure for the IRS to issue clarification and guidance in the wake of its victory in Historic Boardwalk Hall, LLC, New Jersey Sports and Exposition Authority, Tax Matters Partner v. Commissioner of Internal Revenue, a decision that dramatically curtailed the ability to use federal historic tax credits and introduced uncertainty as to when the IRS would respect partnership allocations of the tax credits.
While the guidelines set forth in Revenue Procedure 2014-12 are somewhat helpful, uncertainties remain. Without additional clarification it may be difficult to structure transactions that are simultaneously acceptable to investors and developers and certain to satisfy the safe harbor. Over the next few weeks industry participants will be evaluating the meaning of some of the requirements and whether they will be mandatory in future historic tax credit transactions.
In Historic Boardwalk Hall, the tax-credit investor lost all tax credits because it was found not to be a true partner. In the wake of this case, investors and developers were left with little guidance regarding when the IRS would respect the parties' intention of creating a partnership. After the IRS commenced audits of past tax-credit transactions, many investors decided to forego investing in new deals until the IRS issued guidance. This, together with requests from Congressional members, prompted the IRS to create a safe harbor for investors and developers to rely on.
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, 2013. (In addition, any projects placed in service before December 31, 2013 that meet all the requirements of the safe harbor will 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 will be strong motivation for investors and developer/sponsors to find a way to comply with this revenue procedure. 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 summarized below, along with our commentary on some key issues or concerns:
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%, or 4.95%.
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.
These first two standards are similar to those for wind-energy partnerships set forth in Revenue Procedure 2007-65, 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 "flips" 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. Deals may be structured with contributions slightly in excess of the projected 20% to create some buffer.
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.
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 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 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 2014-12 supports this interpretation by implying that the investor must receive cash distributions on a pro rata basis commensurate with its share of profits.
"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.
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 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." However, this requirement fails to acknowledge the vast spectrum of guarantor creditworthiness (and the potential hardship this could create for nonprofit or community projects that do not have strong – or any –guarantors).
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).
Although it is not clear what is meant by abandonment, exercising a put for a nominal amount could be deemed to be abandonment. It is unclear whether a gift would constitute abandonment. Finally, it is not clear what happens if abandonment occurs after the expiration of the statute-of-limitations period for the credit. The implication is that the investor is not allowed to ever abandon its interest.
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 an investor in the master tenant, it 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 an 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.
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: Additional Guidance is Needed
Although the historic tax credit industry has anxiously awaited this IRS guidance, this safe harbor may have little benefit until investors and developers have greater certainty as to how to comply with its requirements—and how such compliance will affect investor pricing. Affected practitioners and working groups have already set up calls, meetings and conferences to discuss this safe harbor. Hopefully progress can be made in the next month or two to turn this into a meaningful safe harbor that can work for project sponsors and tax credit investors.