Certainty at Last: Safe Harbor Guidance Issued for Historic Tax Credit Transactions
By Jerome A. Breed
9 min read
On January 8, 2014, the U.S. Treasury and IRS issued a revised Revenue Procedure 2014-12 (“Guidance”) establishing a “safe harbor” for federal historic tax credit (HTC) investments made within a single tier or through a master tenant structure. This responded to the decision in Historic Boardwalk Hall, LLC v. Commissioner[1], in which the U.S. Circuit Court of Appeals for the Third Circuit held that the purported investor was not a partner in the partnership that owned the rehabilitated project because it possessed neither a meaningful upside potential nor a meaningful downside risk. The HBH decision created uncertainty that produced a substantial dislocation in the equity market.
The new guidance does not establish substantive tax law. Rather it creates a “safe harbor” for structuring HTC transactions. Compliance with the terms of the guidance provides certainty that the HTC generated by a project will be treated as allocated to the investor and that the investor will be respected by the IRS as a partner in the allocating partnership for federal tax law purposes.
The guidance does not address other types of federal or state credits or transactions combining federal historic tax credits with federal low-income housing or new markets tax credits.
Structuring historic tax credit transactions to comply with the guidance will necessitate significant changes in underwriting and review practices, but we are optimistic that the guidance successfully establishes a structure that will permit both developers and investors to achieve their goals in these deals.
Cash Distributions, Flips
The guidance makes clear that there is no minimum amount of cash that must be distributed by the partnership to the investor. As a result, “community benefit” projects (e.g., museums, community theaters) that do not generate substantial cash returns can satisfy the upside return requirement of the guidance even if the aggregate cash generated by the investment will not exceed the amount of the investor’s capital contribution.
The investor must receive a reasonably anticipated value, exclusive of tax benefits, commensurate with its percentage interest in the partnership. IRS and Treasury have informally indicated in a public conference that the investor does not need to receive an interest in current cash flow from operations of the project equal to its percentage interest in the partnership and that a portion of the reasonably anticipated value may be derived from its interest in the residual value of the project. The economic value of the investor’s interest may not be reduced through fees, lease terms, or other arrangements that are “unreasonable” compared to the terms found in real estate development projects that do not qualify for the HTC. Specifically, subleases of the project to an entity affiliated with the developer or the partnership are a type of agreement that will be deemed to be “unreasonable” if not mandated by a third party. Similarly, subleases are deemed “unreasonable” if their term is not shorter than that of the master lease.
The guidance authorizes “flips” in the partnership interests of the developer and the investor after the end of the five-year tax credit recapture period. The developer’s interest at all times must be at least 1% and the investor’s interest at least 5%. To the extent that current cash is deferred, the post-flip percentage held by the investor should be increased over the 5% minimum.
Example 1 in the guidance shows a flip in the developer/investor interests, respectively, of 1%/99% at the beginning of the transaction to 95%/5% later.
Preferred returns to investors are permitted. However, the reasonably expected value of the investor’s interest must be contingent upon the success or failure of the activities of the partnership and the investor must have a reasonable possibility of receiving meaningful cash in excess of any preferential return.
Allowable Risk Protections, Put Options
The guidance provides for meaningful downside risk in part by requiring that at least 20% of the investor’s total expected capital contribution be contributed before the project is placed in service and maintained for as long as the investor owns an interest in the partnership. Moreover, at least 75% of the investor’s expected capital contribution must be fixed before placement in service. This provision effectively limits timing and delivery tax credit adjusters to 25% of the expected investor capital contribution. The contribution of the “fixed” portion of the investor’s investment may be subject to the satisfaction of contingencies such as placement in service or stabilization of the project or the receipt of a Part 3 approval from the National Park Service.
To further ensure that the investor bears some risk of loss, the guidance prohibits funded guaranties and a clearly defined range of “impermissible” guaranties. The definition of “funded” guaranties curiously includes any guaranty for which the guarantor agrees to maintain a minimum net worth. Impermissible guaranties include any guaranty of partnership distributions or other economic return, and any guaranty of tax structural risk or other disallowance or recapture events not due to an act or omission of the developer.
No person involved in the rehabilitation transaction may pay the investor’s costs or indemnify the investor for expenses incurred in connection with an IRS challenge of the HTCs. The guidance confirms that the investor may require a guaranty with respect to damages it has incurred as a result of the developer’s actions or inactions, including a breach of a representation, warrant, or covenant that involves actions or omissions of the developer. While the guidance does not specifically address casualty losses that result in recapture, IRS and Treasury have indicated that the risk of casualty loss must be borne by the investor. There is no prohibition against an investor procuring third-party insurance covering risk associated with “impermissible” guaranties, including loss of credit due to a casualty. Except for “impermissible” guaranties, unfunded guaranties may cover 100% of environmental liabilities and the amount of the HTC or the capital contributed to the partnership with respect to the HTC due to the developer’s failure to complete the project. The investor may also be protected by an operating deficit reserve equal to no more than 12 months of project operating expenses and an operating deficit guaranty, which may be unlimited.
A developer may not hold an option to acquire the investor’s partnership interest. However, the investor may hold an option to put its partnership interest to the developer for an amount not exceeding its fair market value. While a put of the investor’s interest at a nominal price below fair market value is permissible, an investor may not abandon its interest. Investors doing so will be deemed to have acquired the interest with the intention of abandoning it, unless the facts clearly establish that the interest is worthless.
Conservative Approaches Expected
Because the guidance shifts 100% of the tax structure risk to the investor, we expect that investors will impose rigorous standards to ensure compliance with the guidance, to try to minimize or eliminate this risk. Investors will likely underwrite the guarantors more stringently at the outset of the transaction, including requiring principals rather than entities to provide the guaranties (since the guidance bars ongoing financial covenants). During the period between HBH and the new guidance, some investors in historic transactions used capped recapture guaranties as a way to establish risk of loss, but such caps are no longer necessary after the issuance of the guidance. Since the guidance does not require such a cap on guaranties (apart from effective cap on timing and basis adjusters), it is unlikely that investors will continue using such an approach going forward.
When structuring new transactions, developers will also need to consider the increased scrutiny on fees, lease terms, and any other arrangements that reduce cash flow to the investor, to assure that the investor receives a reasonably anticipated value commensurate with its percentage interest in the partnership, separate from any tax benefits, that is not substantially fixed in amount.
While the standards set forth in the guidance provide considerable clarity to the industry, questions remain for taxpayers and practitioners. The guidance is not precise in defining “unreasonable” fees, lease terms, and other arrangements. Thus, compliance with the safe harbor will depend upon a comparative analysis of the terms of similar non-HTC real estate development projects. For most industry participants, this requirement will necessitate an additional layer of underwriting and review that will not lend itself to “bright-line” interpretations. Investors may consider obtaining a third party “fairness” opinion with respect to fees, rent payments and “other arrangements” paid to affiliates of the developer to establish the reasonableness of such payments. Even with this material issue remaining, we believe that, taxpayers, using the standards established in the guidance, will be able to create deal structures for new historic transactions that will be acceptable to both the IRS and to the parties participating in transactions.
Effective Date
The guidance is effective for projects that are placed in service on or after December 30, 2013. Transactions closed but not yet placed in service may be amended to be consistent with the terms of the guidance. Taxpayers should consider conforming such transactions to the safe harbor requirements. Transactions placed in service prior to December 30, 2013 that meet the requirements of the guidance will not be challenged by the IRS. However, such transactions are unlikely given the specifics of the guidance.
Jerry Breed is a partner and Corenia Riley Burlingame is an associate in the Washington, D.C. office of Bryan Cave LLP. Both work on transactions utilizing historic, new markets, and low-income housing tax credits. Breed, who is also a member of the Editorial Advisory Board of Tax Credit Advisor, may be contacted at 202-508-6036, Jerome.Breed@bryancave.com. Burlingame may be contacted at 202-508-6057, Corenia.Burlingame@bryancave.com.
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1 694 F.3d 425 (3d Cir. 2012), cert. denied, US No. 12-90, May 28, 2013
[1] 694 F.3d 425 (3d Cir. 2012), cert. denied, US No. 12-90, May 28, 2013
