In January 2013, the Federal Circuit Court of Appeals handed down a decision in Consolidated Edison Co., Inc. of New York v. United States (“ConEd”) which could potentially affect the use of put options in tax credit transactions.1 The court in ConEd applied the standard set forth in its earlier decision in Wells Fargo & Co. v. United States2 that there was a reasonable likelihood that the purchase option in the Lease-in/Lease-out (“LILO”) transaction would be exercised and, thus, would be treated as having been exercised at closing.3 The reasonable likelihood standard set forth in Wells Fargo and ConEd is a departure from the standard applied by the Tax Court in Penn-Dixie Steel Corp. v. Commissioner, which considered whether the parties to the transaction were economically compelled to exercise the put option.4 If a put contained in a typical new markets tax credit or historic tax credit transaction were deemed exercised, the investor in such a transaction would not be treated as the owner of its interest, and the tax credits would be lost.
Consolidated Edison Company of New York (“ConEd”) leased a cogeneration plant located in the Netherlands from N.V. Electriceitsbedrijf Zuid-Holland (“EZH”) for a term of 43.2 years and subleased the plant back to EZH for 20.1 years. 5 The rent under the head lease was fully funded at closing, and consisted of approximately $40 million in equity and an approximately $80 million nonrecourse loan (the “HBU Loan”). 6 EZH deposited the loan proceeds into a debt defeasance account, retained $6.7 million as an “accommodation fee,” purchased a $1.4 million letter of credit, and deposited the remaining equity in an equity defeasance account to secure its obligations under the sublease. 7 The rent payments under the sublease and corresponding debt service on the HBU Loan were funded by releases from the debt defeasance account, reflected solely by book entries, with no funds changing hands after closing.8 EZH was responsible for all costs of maintenance and operations of the plant.9 At the end of the term of the sublease, EZH had the option to acquire ConEd’s leasehold interest in the plant, at a price equal to the amount remaining in the debt defeasance account and the equity defeasance account.10 If EZH did not exercise its option, ConEd could choose to require EZH to renew the sublease or ConEd could take over operations of the plant, neither of which were attractive alternatives.11 The IRS disallowed ConEd’s deductions attributable to rent paid to EZH and the interest on the HBU Loan.12 ConEd paid the deficiency and filed a refund claim with the IRS and, when denied, appealed to the Court of Federal Claims.13 The Claims Court ruled in favor of ConEd and the IRS appealed. On appeal, the Federal Circuit Court of Appeals reversed, holding that the Claims Court erred in refusing to apply the substance over form doctrine.14 The court agreed with the IRS’ argument that, “if the Sublease Purchase Option were reasonably expected to be exercised, the transaction would be recharacterized as one without any meaningful substance.”15 Thus, ConEd had no ownership interest in the plant and the HBU Loan was not genuine indebtedness.
The Federal Circuit Court of Appeals could have attacked the LILO transaction in ConEd as a sham without applying the new, lower standard in determining whether an option should be treated as exercised as set forth in Wells Fargo. The court’s analysis in the ConEd decision supports the proposition that EZH was economically compelled to exercise the option at the end of the term of the sublease, and the Federal Circuit arguably had sufficient basis to reverse the Claims Court’s decision applying the standard set forth in Penn-Dixie. The court notes that statements made by ConEd executives prior to the closing date reveal their expectation that EZH would exercise the option, which was supported by the fact that the plant was a newly constructed, key asset for EZH, and EZH had analyzed the transaction on the assumption that the plant would be purchased.16 ConEd’s internal analysis of the transaction assumed no economic benefit from the period following the initial term of the sublease.17 Although the purchase price under the option was likely to be greater than the fair market value of the plant at the time of exercise, the proceeds used to fund the option price were set aside at closing, and required no expenditure of funds beyond those already set aside for the payment of the purchase price by EZH.18 The supporting documentation prepared by Deloitte prior to closing was intended to show that there was no “economic compulsion” to exercise the option, but the court dismissed this argument, perhaps in part because, under examination, Deloitte admitted that it had produced approximately 100 appraisal reports for LILO transactions, and never found that there was “economic compulsion” to exercise a purchase option.19
Investors in historic and new markets tax credit transactions often have the option to put their interest while developers or project owners hold an option to purchase the assets at fair market value. While the tax credit put option is the reverse of the option in ConEd, most investors have routinely exercised the put at the end of the compliance period (although there is no legal obligation to do so). The court’s decision in ConEd could arguably be applied to tax credit transactions that use a put option to unwind the transaction. As in the ConEd transaction, the purchase price with respect to the put option in tax credit transactions is frequently fixed prior to the initial closing. On these facts, the IRS could argue, as it argued in Wells Fargo and ConEd, that a prudent investor would reasonably expect that the put option would be exercised. If such an argument were successful, the investor would not be treated as the owner of its interest and would not be eligible to claim the historic or new markets tax credits arising from its investment.
Although there are similarities between LILO options and the put option used in tax credit transactions, there are also important differences. In tax credit transactions, taxpayers are availing themselves of tax benefits intended by Congress for certain types of activities or investments. 20 Tax credit transactions are structured in such a way to provide real economic risk and potential return to the investor during the life of the transaction. For example, historic tax credit transactions require cash-on-cash returns to the investor during the term of the investment. Unlike the ConEd transaction, where sublease rent payments and debt service payments were made solely through book entries, in tax credit transactions cash changes hands throughout the life of the deal through rent and debt service payments which causes a meaningful change in the economic positions of the parties.
An argument could also be made that the policy behind the enactment of tax credits should result in more favorable treatment under tax principles of general applicability compared to LILO transactions. In the description prepared by the staff of the Joint Committee on Taxation of the codification of the economic substance doctrine, Footnote 344 clarifies that the Economic Substance Doctrine should not apply to disallow tax benefits in transactions, such as federal tax credit investments, “if the realization of the tax benefits…is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate.”21 Further, the Ninth Circuit in Sacks v. Commissioner, a case involving an alternative energy investment, ondicated that a taxpayer is entitled to tax benefits produced by its investment, even though the investment was unlikely to generate a profit without regard to tax benefits, citing the legislative intent to subsidize alternative energy investments.22 The recent decisions by the Fourth Circuit in Virginia Historic Tax Credit v. Commissioner and the Third Circuit in Historic Boardwalk Hall, LLC v. Commissioner, however, indicate that tax credit transactions should be structured in such a way that respects the applicability of general tax principles.23 The Fourth Circuit specifically acknowledged the legislative intent of the Virginia historic tax credit program, but drew a distinction between attacking the program as a whole and applying tax law of general applicability.24 The Third Circuit echoed that sentiment in the final paragraphs of the Historic Boardwalk Hall decision, noting that “we reach our conclusion mindful of Congress’s goal of encouraging rehabilitation of historic buildings,” but concluding that it was appropriate to examine the substance over the form of the transaction and concluding that Pitney Bowes was not a bona fide partner because it did not have a meaningful stake in the success or failure of the transaction.25
Although the applicability of the principles of the ConEd decision to tax credit transactions is uncertain, particularly because Wells Fargo, on which the court relied, involved a similar LILO transaction, prudent taxpayers should take action to protect against an IRS challenge applying the ConEd standard. Where put options are used, care should be taken by practitioners and parties to the transaction in the description of the put option in transaction documentation, correspondence, and internal memoranda. The exercise of the put should always be described as a potential method of unwinding the transaction, but not the expected or only way that the transaction will be unwound, with full consideration of the alternative methods available. Any economic analyses prepared in connection with the transaction should consider both the consequences of the exercise of the put, as well as the result if the put is not exercised. Additionally, the sponsor’s obligation to pay the put price should not be secured (by funded reserves, guarantees or otherwise). Because the investor’s exercise of the put is not a legally enforceable obligation, the sponsor arguably gains no benefit by its existence in any given transaction, and would have the same rights as if an unwind structure using only a call option at fair market value with respect to the investor’s interest was used. The analysis in Revenue Procedure 2007-65 setting forth a safe harbor for the structuring of partnerships claiming wind energy production tax credits may be instructive. Among other factors, the IRS indicated that no party could have a right to purchase the wind farm, or an interest in the company owning the wind farm, at a price less than the fair market value of such property as determined at the time of exercise. 26 Some major investors in the new markets tax credit space close transactions without puts. These transactions often use a mechanism where the debt is accelerated at the end of the compliance period at a discounted price to unwind the investment. While some historic rehabilitation investors are eliminating puts from their investment structure, there is not a consensus in the industry as to the use of puts.
The application of the reasonable likelihood standard of ConEd to tax credit transactions is not a certainty, but the Historic Boardwalk Hall and Virginia Historic decisions caution against treating tax credit transactions as exempt from the application of general tax principles. Accordingly, taxpayers and their advisors should consider whether the application of the “reasonable likelihood” standard to new markets and historic tax credit transactions with put options could cause such transactions to lose their intended tax benefits.