On December 30, 2013, the Internal Revenue Service (the “IRS”) issued Revenue Procedure 2014- 12 providing a safe harbor (the “HTC Safe Harbor”) under which the IRS will not challenge allocations by a partnership to its partners of validly claimed historic rehabilitation tax credits (the “Historic Credits”) under Section 47 of the Internal Revenue Code (the “Code”). The IRS issued minor revisions to the HTC Safe Harbor on January 8, 2014.
The Historic Credit is an investment credit that may be claimed in respect of certain types of qualifying capital improvements to certain historic structures in the year those improvements are placed in service for federal income tax purposes.
The HTC Safe Harbor was issued by the IRS primarily in response to the decision in Historic Boardwalk Hall, LLC. v. Commissioner, 694 F.3d 425 (3d Cir. 2012), cert. denied, U.S., No. 12-901 (May 28, 2013), which had created significant uncertainty in the historic rehabilitation industry. The crux of Historic Boardwalk was the finding by the court that the taxpayer, which had invested for the relevant Historic Credits, had no “meaningful” upside or downside risk in its investment, accordingly had not made a “bona fide” equity investment, and thus was denied the ability to claim the Historic Credits.
The HTC Safe Harbor provides that the IRS will not challenge the allocation of the Historic Credit by the Developer Partnership or the Master Tenant, as applicable, to the Investor if the transaction meets the safe harbor (which is similar to the conclusion provided in the Wind Credit Safe Harbor). The HTC Safe Harbor does not address whether the relevant partnership is eligible to claim the Historic Credits, or whether the Developer Partnership is the owner of the relevant improvements for tax purposes, which is not surprising because the criteria within the HTC Safe Harbor do not address either of those questions.
However, the HTC Safe Harbor requires that the partnership allocations of the relevant Developer Partnership or Master Tenant satisfy the requirements of Code Section 704(b) and that the Historic Credit must be allocated in accordance with the relevant rules provided for the allocation of the Historic Credit (and other similar investment credits) under the Treasury Regulations. It may be noted that, if the Developer Partnership or Master Tenant satisfies the requirements of the Code and underlying Treasury Regulations for the allocation of the Historic Credit to its partners, the IRS could not successfully challenge that allocation. Accordingly, in that case, the HTC Safe Harbor would be redundant, at least for its stated conclusion, i.e., that the IRS will not challenge the allocation of the Historic Credit by the Developer Partnership or the Master Tenant, as applicable.
In that light, this requirement highlights what is perhaps the real import of the HTC Safe Harbor, i.e., that the Investor will be respected as having made a “bona fide” equity investment, and thus will not be denied the ability to claim the Historic Credits. Accordingly, what the HTC Safe Harbor really provides is safety against the IRS challenging that the Investor’s interest in the Developer Partnership and/or Master Tenant is not that of a “bona fide” equity partner (as opposed to a lender), and perhaps also in the context of the inverted lease that the Master Tenant is a separate partnership from the Developer Partnership. The apparent implication of being a “bona fide” equity partner is also that the Investor’s investment has economic substance for purposes of Code Section 7701(o). Thus, an Investor that is allocated the Historic Credit in a manner that complies with Code Section 704(b) and the underlying Treasury Regulations may claim that distributive share of Historic Credit as a bona fide equity partner.
The nature of the HTC Safe Harbor essentially follows that of the safe harbor previously issued by the IRS for partnership allocations of production tax credits generated by wind projects under Section 45 of the Code in Revenue Procedure 2007-65 (the “Wind Credit Safe Harbor”). Thus, as the Wind Credit Safe Harbor applies to the commonly used “partnership flip” structure for the Code Section 45 tax credit for wind, the HTC Safe Harbor applies in respect of two partnership structures commonly used for an investment in the Historic Credit by a taxpayer (the “Investor”).
Under the first “partnership flip” structure, the Investor invests as a partner in a tax partnership (“Developer Partnership”) that owns and restores the improvements upon which the Historic Credit is claimed. The other project sponsor or “cash equity” partners of the Developer Partnership (who are authorized to act for the partnership) are the “Principals”. The Historic Credit is disproportionately allocated (similar to the Wind Credit Safe Harbor, not more than 99%) to the Investor as part of an allocation of not more than 99% of the income and loss of the Partnership, under the partnership tax accounting rules for “special allocations”. At some point (in a provided example, at the end of the Historic Credit recapture period (five years)), the Investor’s percentage share of allocated income and loss may be reduced (similar to the Wind Credit Safe harbor, to not less than 4.95%).
Under the second “inverted lease” structure, the Investor invests alongside the Principals as a partner in a tax partnership (the “Master Tenant”) that acts as the lessee of the improvements upon which the Historic Credit is claimed from the Developer Partnership. The Developer Partnership elects to pass through Historic Credit to the Master Tenant. As implemented in the market, the Investor generally has a very high percentage share (e.g., 99%) of the Master Tenant and indirectly through its interest in the Master Tenant less than a majority (e.g., 49%) percentage share of the Developer Partnership.
The scope of the HTC Safe Harbor is narrowly limited to the Historic Credit, and specifically may not apply to any other federal or state tax credits or any transaction that does not fully comply with the criteria of the HTC Safe Harbor (in the same manner as the Wind Credit Safe Harbor is limited in scope to transactions involving the production tax credit for wind energy facilities that strictly comply with the criteria of the Wind Credit Safe Harbor). Moreover, the HTC Safe Harbor is perhaps more explicit than the Wind Credit Safe Harbor by providing that it does not intend for any of the criteria “to be an indication either of [its] views of the significance of that criterion with respect to any other federal or state tax credit transactions”.
However, the necessity for “meaningful upside and downside” generally applies for the requisite status as an equity investor across a broad category of business tax credits. Further, the statutory structure and rules for the Historic Credit are very close to those for the investment credit in respect of renewable energy facilities under Code Section 48 (e.g., nature of credit based upon investment, relevant recapture rules, and applicable partnership allocation rules). Accordingly, the Developer Partnership structure and the Master Tenant structure described in the HTC Safe Harbor are also used for transactions involving the investment credit in respect of renewable energy facilities under Code Section 48.
Based upon the foregoing similarities, it is not clear why the IRS chose not to include the investment credit in respect of renewable energy facilities under Code Section 48 within the scope of the HTC Safe Harbor. In any event, despite the stated limitation on its scope, because of these similarities, the HTC Safe Harbor is at least instructive in respect of the IRS’s view of what may be required for claiming the investment credit under Code Section 48 for such renewable energy facilities in a Developer Partnership transaction and/or Master Tenant transaction.
The HTC Safe Harbor criteria generally fall into the following categories relevant to the Investor having “meaningful” upside potential and downside risk: (a) permissible timing of the Investor’s investment, as a way of protecting the downside to the Investor, (b) permissible and impermissible guarantees in respect of protecting the downside risks of the Investor’s investment, (c) permissible and impermissible mechanics for the Investor to exit its investment that do not limit its downside or upside, and (d) the requisite nature of the interest of the Investor to provide sufficient equity upside to the Investor from its investment.
Timing of Investment
With respect to the permissible timing of the Investor’s investment, 20% of the Investor’s total expected contributions to the Developer Partnership or Master Tenant claiming the Historic Credits (the “Partnership”) must be contributed by the Investor to the Partnership before the date the relevant improvements are placed in service. Further, 75% of the Investor’s total expected contributions to the Partnership must be fixed in amount on the date the relevant improvements are placed in service. Neither the Partnership nor the Principal is permitted to lend the Investor funds, or provide a guarantee on behalf of the Investor, to facilitate the Investor’s acquisition of its Interest in the Partnership. These requirements are substantially similar to those found in the Wind Credit Safe Harbor when modified to allow for the timing of the tax credit flowing on the placed in service date.
Guarantees and Indemnities
The HTC Safe Harbor provides great detail as to the scope and nature of guarantees and indemnities that may be provided to the Investor.
Risks that may not be indemnified by a Principal (including parties related to the Principal) consist of the Investor’s ability to claim Historic Credits, the repayment of any portion of the Investor’s contributions due to an inability to claim the Historic Credits based upon a IRS challenge of any portion of the transactional structure and any distributions, or consideration for its interest in, the Developer Partnership or the Master Tenant (except for the permitted options discussed below). However, even these risks may be covered by guarantees and/or insurance provided by unrelated parties.
Risks that may be indemnified by a Principal (including parties related to the Principal) consist of completion guarantees, environmental indemnities, financial covenants, the performance of any act necessary to claim the Historic Credits, and the avoidance of acts or omissions that would cause the Partnership to fail to qualify for, or cause recapture of, the Historic Credits. The Principals may also cover operating deficits, but only up to twelve months of expected operating expenses.
However, even a permitted listed guarantee above would become an impermissible guarantee if it is “funded” in that money or property is set aside to pay the guarantee or if a minimum net worth requirement is provided in connection with the guarantee. The only exception is that reserves sufficient to cover twelve months of the Partnership’s operating expenses may be set aside without causing a guarantee to be treated as funded.
This limitation on the ability to require security for guarantees of commercial risks presents an uncharacteristic lapse on the part of the IRS in understanding what non-tax risks are ordinarily covered in the course of a typical commercial transaction versus what types of risks are required to be undertaken under the Code to qualify for the relevant tax credit.
The focus on these guarantees is not surprising in that the court in Historic Boardwalk examined whether the taxpayer faced any meaningful downside risk of any type in the construction and the operation of the project. In that examination, the court noted that the relevant sponsor/principal provided a construction completion guarantee, environmental indemnity, operating deficit guarantee, tax credit recapture indemnity and tax structure indemnity, and that such sponsor/principal, as a State entity, had sufficient credit to support those guarantees and indemnities.
As noted above, the HTC Safe Harbor permits completion guarantees, environmental indemnities, a (limited) operating deficit guarantee and a tax credit recapture indemnity to be provided by the Principals, but not a tax structure indemnity.
Under federal income tax law, the Investor should be expected to bear certain risks to be respected as equity. The HTC Safe Harbor concludes that the Investor generally must bear the “structural tax risk”. It may be argued that the IRS was generous in the scope of protection it allows against tax credit recapture, allowing for a guarantee from the Principals against Historic Credit recapture for any act or omission, whether or not within the control of a Principal, because such recapture events overlap with operational issues and thus allow the Investor to be protected to some extent against the equity risk of operations.
However, the HTC Safe Harbor then adds the requirement that any such permitted indemnity or guarantee not be “funded”, i.e., it may not be secured, including indirectly through a net worth covenant. In Historic Boardwalk, the indemnities and guarantees were in fact unsecured, but the court focused on the relative strength of the guarantee/indemnitor, a subdivision of the State of New Jersey, rather than any presence or absence of security. Moreover, that examination of the relative financial strength of the guarantor/indemnitor should be read in the context the court’s search for any possible meaningful risks indicative of being a bona fide partner, and not that some minimum level of credit risk be required under that guaranty/indemnity.
The HTC Safe Harbor apparently recognizes this reading of Historic Boardwalk by allowing for standard commercial indemnities that are found in equity investments outside of a tax-based transaction, i.e., the construction completion guarantee, environmental indemnity, and limited operating deficit guarantee, even though such risks are included in the list of potential meaningful risks to the taxpayer. However, whatever benefit is provided in that recognition is generally eliminated by the imposition of that prohibition against security. This prohibition, not required by Historic Boardwalk, dramatically reduces any utility of the HTC Safe Harbor.
At least for these more standard commercial risks, to allow for the guarantee or indemnity of that risk, but then require that such guarantee or indemnity be unsecured, makes very little economic or commercial sense. Under this restriction, a guarantee from a Principal with a high credit quality is permitted, but the use by a Principal, with a lower credit quality, of the pledge of its assets to achieve the same level of commercial risk to the Investor, is not permitted. Moreover, even in case of a Principal having very substantial assets and a very high credit rating, an unsecured guarantee by a Principal, with the requirements of standing in line as an unsecured creditor, is generally given little to no value as a commercial matter. Accordingly, the allowance by the HTC Safe Harbor of such a “naked” guarantee is of limited practical use. In the past the IRS has recognized that these types of business judgments, such as the credit decision to require or not require security for a permitted guarantee, are not relevant to the substance of the transaction for federal income tax purposes.
With respect to the mechanics for the Investor to exit its investment, the HTC Safe Harbor does not permit the Principals or the Partnership to have a call option to purchase the Investor’s interest in the Partnership (even at then determined fair market value), but does allow the Investor to have a put option to sell its interest in the Partnership at not more than the then determined fair market value. This put option payment may be guaranteed, so long as the guarantee is not “funded”. Moreover, the Investor is also prohibited from acquiring its interest with “an intent to abandon it”, and if the interest is abandoned, such intent will be presumed unless the Investor can clearly establish otherwise.
In contrast, the Wind Credit Safe Harbor prohibits a put option on the Investor’s interest, but permits a call option exercisable five years (or later) after the wind project has been placed in service either at a price not less than then determined fair market value or a fixed price determined at the closing of the transaction that is not less than the expected then determined fair market value.
This reversal in the HTC Safe Harbor from what is allowed in the Wind Credit Safe Harbor is puzzling. The IRS has now publicly established that what is permissible in the context of a flip partnership for a wind energy facility eligible for Code Section 45 production tax credits is impermissible for a flip partnership for a partnership eligible for Historic Credits, and vice versa, without providing any rationale for the difference.
Under a typical federal income tax analysis, a fixed price put option to a Principal would not be allowed to the Investor on the basis that, under the relevant authorities, the unilateral ability to be repaid its investment from (the Principal’s) assets outside those of the partnership made the Investor’s investment appear to be too much like debt (by providing too much downside protection). (See Hewlett-Packard Co. v. Commissioner, T.C. Memo 2012-135.) On the other hand, a Principal call option gave the Investor no such downside protection and did not limit the equity upside so long as it was exercisable at fair market value (or the expected fair market value).
It is the case that recent case law in the context of “LILO/SILO” lease transactions have focused on whether a lessee call option was too certain to be exercised to respect the lease as a “true lease” for federal income tax purposes. However, the IRS’ safe harbor guidelines for lease transactions specifically permit then fair market value lessee call options and prohibit lessee put options of the type permitted under the HTC Safe Harbor (in the same manner as the Wind Credit Safe Harbor). Accordingly, any additional scrutiny applied to permitted call options does not explain the relaxation of scrutiny in the case of already prohibited put options.
Perhaps an implied (and optimistic) rationale for this difference is that the HTC Safe Harbor sets a taxpayer- favorable limit beyond that permitted in the Wind Credit Safe Harbor by permitting Investor put options, but only in the context of there also being no Principal call options.
Similarly, it appears that in the inverted lease structure, the HTC Safe Harbor generally prohibits the Investor’s investment from being truncated in that any sublease of the relevant improvements by the Master Tenant may not have a term that is not shorter than term of the lease to the Master Tenant, and the lease that may be terminated by the Master Tenant while the Investor is still a partner.
Nature of Investor’s Interest
With respect to the requisite nature of the interest of the Investor to provide sufficient equity upside, the HTC Safe Harbor requires that (a) the reasonably expected value of the Investor’s interest must be proportionate to the Investor’s overall percentage interest in the Partnership, separate from the tax attributes (including the Historic Credits) expected to be allocated to the Investor, (b) the value of the Investor’s interest must also vary based on the Partnership’s net income, gain, and loss, cannot be substantially fixed in amount, and cannot be ubstantially protected from losses from the Partnership’s items, and (c) the Investor’s interest must participate in the profits from the Partnership, and may not be limited solely to a preferred return that is merely a payment for capital. Further, the value of the Investor’s interest may not be reduced by disproportionate distributions or by issuances of interests in the Partnership for less than fair market value. Finally, any fees, lease terms, and other arrangements designed to reduce the value of the Investor’s interest are not permitted if they are commercially unreasonable, i.e., more than those generally found in real estate projects that do not qualify for Historic Credits.
The foregoing restrictions, although critical to complying with the HTC Safe Harbor, have material ambiguities, in particular for guidance that is intended to provide taxpayers a safe harbor. Further, if read literally in some respects, these requirements would represent a substantial change from current market practice, and/or would be directly contrary to what is permitted under the Wind Credit Safe Harbor.
Perhaps the most confusing or concerning is the requirement that the reasonably expected value of the Investor’s interest be “proportionate” to the Investor’s “overall” percentage interest in the Developer Partnership, separate from the tax attributes (including the Historic Credits) expected to be allocated to the Investor. In general, an Investor’s expected return is substantially based upon tax attributes and, as described in the Wind Credit Safe Harbor, “some participation in operating cash flow”. Accordingly, if the value of the tax attributes is taken away from that expected return, then the only way for the reasonably expected value of the Investor’s interest to be proportionate to the Investor’s “overall” percentage interest in the Developer Partnership is for the “overall” percentage interest in the Developer Partnership to be determined as that based upon that relatively low share of pre-tax cash flows, rather the very large allocation (e.g., 99%) of taxable loss and taxable income during the pre-flip credit period (or some other measure).
With respect to the requirement that the value of the Investor’s interest vary based on the Partnership’s net income, gain, and loss, cannot be substantially fixed in amount, and may not be limited solely to a preferred return that is merely a payment for capital, it appears that the typical combination of Investor’s post-recapture period percentage share of allocated income and loss being not less than 4.95% (similar to the Wind Credit Safe harbor) and the requirement that the relevant Developer Partnership or Master Tenant liquidate in accordance with positive capital accounts, suffices for that purpose. However, the use of such a post- recapture period variable allocation of income and loss, along with a fixed cash distribution amount that does not follow that variable share, may violate this provision. In any event, the foregoing language is less than a model of clarity in this respect.
The requirement under the HTC Safe Harbor that the Investor cannot be substantially protected from losses from the Partnership’s items would appear to be already covered by the requirements noted above regarding guarantees, as well as the requirement that the value of the Investor’s interest vary based on the Partnership’s net income, gain, and loss, cannot be substantially fixed in amount, and may not be limited solely to a preferred return that is merely a payment for capital.
With respect to the requirement that the value of the Investor’s interest participate in the “profits” from the Partnership, the example provided in the HTC Safe Harbor is instructive. In that example, the Investor is allocated 99% of “profits and losses, as determined for federal income tax purposes”. With respect to distributions, the Investor “has a right to receive a pro rata share of all distributions commensurate with the Investor’s share of the Partnership’s profits”. (Emphasis added.) The HTC Safe Harbor notes that the allocation of the Historic Credit (and other similar investment tax credits) is based upon the ratio in which the partners divide the general profits of the partnership, and that such “general profits” consist of the taxable income of the partnership described in Code Section 702(a)(8) for the year the relevant property is placed in service, regardless of whether the amount under Code Section 702(a)(8) is taxable income or taxable loss during such year. Moreover, to avoid recapture of that allocated credit, the interest of the partner in such Code Section 702(a)(8) income or loss may not be reduced by more than a third during the five-year period beginning with that placed in service date. The example would appear to recognize the distinction between “profits” as Code Section 702(a)(8) taxable income and “losses” as Code Section 702(a)(8) taxable losses, and would appear to require only that the Investor be distributed 99% of available cash equal to any allocation of such taxable income, and not for years for which there are such taxable losses. However, again, the foregoing language is less than a model of clarity in this respect.
The prohibition within the HTC Safe Harbor against disproportionate distributions in favor of the Principals represents a substantial change from current market practice and is directly contrary to what is permitted under the Wind Credit Safe Harbor (which allows for priority distributions to the sponsor to return it initial capital). It is not clear what the rationale is for this difference. The Code Section 45 tax credit is allocated based upon the allocation of income or loss attributable to sale of electricity for each year that such credits are available. The Historic Credit (and other similar investment tax credits) are allocated based upon the ratio in which the partners divide taxable income or loss under Code Section 702(a)(8) for the year the relevant property is placed in service. The allocation of both such production income or loss and Code Section 702(a)(8) income or loss is generally subject to the rules of Code Section 704(b) in order to be respected. Those rules do not necessarily prohibit disproportionate distributions.
For the inverted lease structure, a sublease of the relevant improvements by the Master Tenant to the Developer Partnership or a Principal is prohibited, unless mandated by a third party. Moreover, the HTC Safe Harbor requires that the lease terms (and other fees paid to Principals) be reasonable compared to such terms for a lease of a project that does not qualify for the Historic Credit. Thus, it appears that the HTC Safe Harbor generally requires that the Investor, through the Master Tenant, bear the risk and reward of being an operating lessee for some period of the lease, and does not allow the Investor to avoid such risk by entering into a sublease, unless such sublease is to a third party.