In comments at the ABA Forum – IRS/Treasury meetings, Paul Handleman, chief of the passthroughs and special industries branch of the IRS Chief Counsel’s office, raised the question as to whether Revenue Ruling 2003-60 is applicable to sponsor leverage loans. Revenue Ruling 2003-60 holds that a leverage loan may be includible in the amounts of a “Qualified Equity Investment” for purposes of the New Markets Tax Credit. The ruling references the leverage lender as a “bank”, presumably not related to the QALICB or the sponsor of the QALICB.
Since the issuance of Revenue Ruling 2003-60, the industry has considered the scope of the ruling to include all lenders regardless of their relationship with the QALICB. Standard rules of classifying debt and equity as well as standard methods of determining whether transactions should be recharacterized under step-transaction, sham transaction or economic substance, however, remain applicable. Footnote 344 to the HERA provides an exception for NMTC transactions that are “clearly consistent with the Congressional purpose” in enacting the NMTC. If and when a transaction is closed that is not “clearly consistent” with the purposes of the NMTC statute, the IRS may determine that circular cashflows and non-economic relationship should be disregarded.
The mere fact that a leverage lender is related to a QALICB is not “inconsistent” with the purpose of the NMTC. Inconsistency must be based on a more substantive issue. The purpose of the NMTC is to bring new capital either to a non-profit activity or to a business located in an area that is underserved by capital. Where NMTC proceeds are removed from the activity or business and not reinvested through a leverage loan, the result would be inconsistent with the NMTC statute. Likewise, the QALICB should be an entity (or a portion of the business) which is distinct from the leverage lender. Where a QALICB is a single purpose entity that leases all of its property to a related party that happens to be the leverage lender, the only source of income to the QALICB is the income produced by the leverage lender. This is the primary fact pattern that has been questioned by the IRS.
There are a number of transactions that have been closed under structures that resemble this fact pattern. If the IRS chooses to raise questions about the NMTC consequences regarding this structure, CDFI or the IRS should issue prospective guidance to notify the NMTC community that such transaction structures may not receive favorable treatment.