On December 30, 2013, the IRS issued Revenue Procedure 2014-12, which provides much needed guidance for taxpayers looking to participate in federal historic rehabilitation tax credit (HTC) transactions. This highly anticipated Revenue Procedure establishes a safe harbor for structuring HTC deals in response to confusion and uncertainty in the HTC industry following the decision by the U.S. Court of Appeals for the Third Circuit in Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012).
Under Section 47 of the Internal Revenue Code of 1986, as amended (the "Code"), a taxpayer is eligible for an HTC of up to 20 percent of the "qualified rehabilitation expenditures" (QREs) incurred in connection with a qualifying rehabilitation project. The availability of the HTC has enabled many developers to complete rehabilitation projects that otherwise would not have gone forward by allowing them to attract investors that could utilize the HTC. In a typical direct HTC structure, the HTC investor makes an equity contribution(s) of capital into the project partnership in exchange for a significant membership interest therein. Such investor then would be allocated a substantial portion of the HTCs generated by QREs associated with the project's rehabilitation. Both investors and developers typically negotiated for some risk protection, as well as ways to eventually "exit" the deal
After many years of HTC transactions being structured along the lines of these investor/ developer partnerships, HTC deals virtually came to a halt after August of 2012 when the Third Circuit released its Historic Boardwalk Hall decision. In reversing the Tax Court's taxpayer-favorable decision, the Third Circuit held that the investor member in the HTC partnership at issue was not a bona fide partner for federal income tax purposes because it had "no meaningful stake" in the success or failure of the partnership. Thus, it could not be allocated the HTCs generated by the historic tax credit partnership. The case was troubling for the HTC community for many reasons, including that, in typical HTC deals, investors generally are given some protection against downside risk and have some limitation on their upside potential. In light of the Third Circuit's holding in Historic Boardwalk Hall, the HTC industry was left asking how much downside risk or upside potential is needed to demonstrate this required "meaningful stake." With no clear standard from the court or the Internal Revenue Service (IRS), many developers and investors have been unwilling to move forward with HTC deals until specific guidance is provided.
THE SAFE HARBOR (REV. PROC. 2014-12)
After more than sixteen months of uncertainty for the HTC community, the IRS has finally issued that sought-after guidance in the form of Revenue Procedure 2014-12. Rev. Proc. 2014-12 does not establish substantive law, but rather establishes a safe harbor for HTC deal structures. If an HTC structure stays within the parameters of the safe harbor, the IRS has stated that it will not challenge an allocation of validly claimed HTCs to an HTC Investor by a Partnership if such allocation is made on or after December 30, 2013.
For purposes of Rev. Proc. 2014-12, the term "Partnership" refers to a partnership that validly claims the Section 47 rehabilitation credit. A Partnership can be structured as either a Developer Partnership or a Master Tenant Partnership. A Developer Partnership is a Partnership that owns and restores a qualified rehabilitation building or a certified historic structure (a "Building"). A Master Tenant Partnership is a Partnership that leases a Building from a Developer Partnership and for which an election is made pursuant to Treasury Regulation Section 1.48-4(a)(1) to treat the Master Tenant Partnership as having acquired the Building solely for purposes of the Section 47 rehabilitation credit.
The key requirements of the safe harbor are summarized as follows:
- Minimum Partnership Interest (Developer/ Sponsor) -- The Principal must have a minimum 1 percent interest in each material item of Partnership income, gain, loss, deduction, and credit for the duration of the Partnership's existence.
- Minimum Partnership Interest (HTC Investor) -- The HTC Investor will need to maintain an interest in each material item of Partnership income, gain, loss, deduction, and credit at all times equal to at least 5 percent of its percentage interest in each such item for the taxable year in which its share of that item was the largest.
- Thus, partnership "flip" structures are authorized by the safe harbor, but HTC transaction participants need to be aware of the limitations.
- For example, an HTC Investor with an initial 99 percent interest in all Partnership items will need to maintain at least a 4.95 percent interest in all Partnership items following a "flip" in Partnership percentages at some future date (such as after the expiration of the five-year compliance period).
- Minimum Unconditional Contribution (HTC Investor) -- On or before the date the Building is placed into service, the HTC Investor must make a minimum unconditional contribution to the Partnership equal to at least 20 percent of the total capital contributions it expects to make under the agreements relating to the Partnership as of the date the Building is placed in service.
- The HTC Investor must maintain this minimum unconditional investment for as long as it owns a partnership interest in the Partnership.
- The HTC Investor must not be protected from loss with respect to this minimum investment through any arrangement, directly or indirectly, by any person involved with the rehabilitation, except for the limited guarantees detailed below.
- Contingent Consideration - At least 75 percent of the HTC Investor's total expected capital contribution must be fixed in amount at the time the rehabilitated building is placed into service and the HTC Investor must "reasonably expect" to be able to meet its funding obligations as they arise.
- "Bona Fide Equity Investment" -- The HTC Investor's Partnership interest must constitute a bona fide equity investment with a "reasonably anticipated value commensurate with" the HTC Investor's overall percentage interest in the Partnership, separate from any federal, state and local tax deductions, credits, or other tax attributes.
- Such value must be contingent on the Partnership's net income, gain, and loss and such value cannot be substantially fixed.
- The HTC Investor must share in the profits of the Partnership in a manner that is not limited to the receipt of a preferred return. Similarly, the HTC Investor cannot be "substantially" protected from Partnership losses.
- Value Reduction Arrangements -- Fees (including developer, management, and incentive fees), lease terms, or other arrangements that would not be considered "reasonable" in non-HTC real estate development deals may not be used to reduce the value of the HTC Investor's interest in the Partnership.
- In addition, the value of the HTC Investor's Partnership interest may not be reduced by disproportionate rights to distributions or by issuances of interests in the Partnership (or rights to acquire interests in the Partnership) for less than fair market value consideration.
- Loans -- Neither the Partnership nor the Principal can loan funds to the HTC Investor for it to use to purchase its interest in the Partnership.
- Purchase Rights -- Neither the Partnership nor the Principal can have a call option or other contractual right or agreement to purchase or redeem with respect to the HTC Investor's interest in the Partnership at a future date.
- Sale Rights -- The HTC Investor can have a put or other contractual right or agreement to require any person involved in any part of the rehabilitation transaction to purchase (or liquidate) the HTC Investor's interest in the Partnership at a future date as long as the price is not greater than such interest's fair market value at the time such right is exercised.
- The revised version of Rev. Proc. 2014-12 issued on January 8, 2014 clarifies that a determination of fair market value of the HTC Investor's interest may take into account only those contracts or arrangements creating rights or obligations that are at arm's length and do not constitute impermissible value reduction arrangements.
- Abandonment of Interest -- The HTC Investor cannot acquire its interest in the Partnership with the intent of "abandoning" it. If, at any time, the HTC Investor actually abandons its interest in the Partnership, it will be presumed such Investor acquired the interest with an intent to abandon unless facts and circumstances clearly show otherwise.
- Permissible Guarantees -- The following guarantees to the HTC Investor are specifically permitted as long as they are unfunded: (i) performance of acts necessary to claim the HTC; (ii) avoidance of acts that would either prohibit the claiming of the HTC or that would cause a recapture of the HTC; (iii) completion guarantees; (iv) operating deficit guarantees; (v) environmental indemnities; and (vi) financial covenants.
- For purposes of this requirement, "unfunded" means: (i) no money or property can be set aside to fund such guarantee; and (ii) neither the guarantor, nor any person under the control of the guarantor, can agree to maintain a minimum net worth in connection with such guarantee.
- A reasonable reserve in an amount approximating the Partnership's operating expenses for a twelve (12) month period will not be considered an amount set aside to fund a guarantee.
- Impermissible Guarantees -- The following guarantees to the HTC Investor are specificallynot permitted: (i) ability of the HTC Investor to claim the HTC; (ii) cash equivalent of the HTCs; (iii) repayment of the HTC Investor's capital contribution in the event of an IRS challenge; (iv) Partnership distributions; (v) purchase price for partnership interest (with the exception of fair market value put right); and (vi) payment of the HTC Investor's costs in the event of an IRS challenge.
- Compliance with 704(b) Regulations -- Allocations under the Partnership agreement must satisfy the requirements of Section 704(b) and the regulations thereunder. The allocation of the HTCs must be made in accordance with Treasury Regulation Section 1.704-1(b)(4)(ii).
- "Master Lease" Structure -- In the event the HTC deal is structured using the "lease pass-through" model, the following additional guidelines must be followed: The Master Tenant cannot terminate the Master Lease for as long as the HTC Investor remains a partner in the Master Tenant. All subleases from the Master Tenant must have a shorter duration than the Master Lease. A sublease from the Master Tenant back to the Master Landlord or Principal will not be permitted unless the sublease is mandated by a third party unrelated to the Principal.
- Additionally, if an HTC Investor receives an allocation of Section 47 rehabilitation credits from a Master Tenant Partnership, the HTC Investor cannot also invest in the Developer Partnership other than through an indirect interest in the Developer Partnership held through the Master Tenant Partnership.
- The above prohibition does not apply to a separately negotiated, distinct economic arrangement (e.g., a separate arm's length investment into the Developer Partnership to share in allocations of federal new markets tax credits or low-income housing credits).
- The revised version of Rev. Proc. 2014-12 issued on January 8, 2014 clarifies that in a "lease pass-through" structure, solely for purposes of determining whether a Partnership satisfies the requirements of Section 704(b) and the regulations thereunder, the Partnership's allocation to its partners of the income inclusion required by Section 50(d)(5) shall not be taken into account.
It should be noted that all references within the above guidelines to Partnership, Principal, or HTC Investor also include any "related" persons within the meaning of Sections 267(b) or 707(b)(1) of the Code.
The guidance in the Revenue Procedure does not apply to any other federal or state tax credit transactions, and is not determinative of whether an investor is a "partner" in an arrangement or transaction outside of its limited scope -- namely with respect to allocations of Section 47 HTCs. Further, other requirements necessary for Partnerships to claim the HTC are also specifically mentioned as being outside the scope of Rev. Proc. 2014-12, such as whether the tax-exempt property rules of Section 168 of the Code are met, whether an expenditure qualifies as a QRE, and whether a Partnership has the requisite benefits and burdens of ownership of a Building for purposes of claiming the HTC.
Rev. Proc. 2014-12 provides much needed guidance for developers, investors, and other industry participants looking to structure an HTC transaction or an interest in an HTC deal in the wake ofHistoric Boardwalk Hall. BakerHostetler attorneys have been helping clients determine how best to integrate the guidelines into HTC deal structures that meet the business, tax, and financing goals of all parties involved. We have significant experience helping clients with the planning, structuring, and implementation of HTC transactions, and we would be pleased to discuss with you and help evaluate the opportunities in light of Rev. Proc. 2014-12 and other applicable authorities.