On August 27, 2012, the Court of Appeals for the Third Circuit entered its opinion on a historic tax credit case, holding against the taxpayer claiming the tax credits. The case involved a common structure for investment tax credit transactions and could have a significant impact on transactions financed through incentive tax credit programs.
The case, Historic Boardwalk Hall, LLC v. Commissioner, involved the historic rehabilitation of an exhibition facility in New Jersey. Under this particular structure, Historic Boardwalk Hall, LLC (LLC) was formed to complete the renovations and earn the related historic tax credits. The LLC incurred approximately $104 million in qualified rehabilitation expenditures resulting in federal historic rehabilitation tax credits (HTCs). The LLC had two members -- New Jersey Sports and Exposition Authority (NJSEA), the governmental organization overseeing the renovation of the facility, and Pitney Bowes. Pitney Bowes was admitted as a member of the LLC in exchange for an equity contribution of approximately $18.2 million. Under the terms of the LLC’s operating agreement, Pitney Bowes was allocated 99.9 percent of the federal historic tax credits resulting from the rehabilitation of the facility. The operating agreement also provided for a 3 percent priority return on Pitney Bowes’ invested capital and contained certain put and call rights that facilitated Pitney Bowes’ exit from the investment structure after the HTC recapture period expired. An affiliate of NJSEA provided contractual protection to Pitney Bowes, including recapture and completion guarantees, that are typical for HTC transactions.
The IRS denied Pitney Bowes’ claim for historic tax credits and asserted that the structure violated the prohibition of transfers of HTCs. Pitney Bowes filed a petition in the U.S. Tax Court, which held that the transaction should be respected and the taxpayer was entitled to the claimed credits.
Upon appeal to the Third Circuit, the IRS argued that the transaction should be disregarded because it lacked economic substance and that Pitney Bowes’ interest in the LLC should be disregarded since it had no true economic risk. The Court analyzed the economic arrangement in detail and determined that Pitney Bowes did not have any material economic risk with respect to its investment in the LLC. The Court noted that Pitney Bowes did not have to make a payment on the installment contribution until it was certain that it would receive an allocation of HTCs and that the guarantees made certain that, if the HTCs were disallowed, Pitney Bowes would be made whole. Further, the Court determined that Pitney Bowes had no meaningful upside potential on its interest in the LLC. Although Pitney Bowes ostensibly had a 99.9 percent interest in residual cash, the Court found that the distribution waterfall, financial projections, and call right held by NJSEA rendered that residual right illusory. Therefore, the Court held the LLC should be disregarded for tax purposes and the investment by Pitney Bowes treated as an impermissible transfer of HTCs.
The structure in the case was common for an HTC transaction. Historic tax credit investors often have limited exposure to the underlying development, and the Court’s holding may eliminate a tax credit purchaser’s ability to invest only in the tax credits. Although the Court noted that capping upside benefit or limiting downside risk is permissible, it did not indicate what was sufficient to create enough economic risk and benefit to be respected as a partner in a pass through entity. But in the Court’s eyes, something more than Pitney Bowes’ limited exposure is required. Simply having an entity engaged in transactions that have economic substance is insufficient -- the members of the entity must also have a legitimate, profit-motivated reason, other than the receipt of tax credits, to invest in the partnership.
The decision could be a significant blow for the HTC industry and other tax credit structures, such as renewable energy tax credits transactions. Further, state tax credit programs that mirror many of the terms of the federal HTC program or similar incentive tax credit programs could be affected by the decision.