Informal conversations with the drafters of Revenue Procedure 2012-14 (the “Revenue Procedure”) have clarified the safe harbor’s pretax economics requirements. The Revenue Procedure is available here.
The Value Requirement
The Revenue Procedure includes the requirement that the tax equity investor’s “interest must [have] a reasonably anticipated value commensurate with the [tax equity investor’s] overall percentage interest in the Partnership, separate from any federal, state and local tax deductions, allowances, credits and other tax attributes to be allocated” (the “Value Requirement”).1
As discussed in the blog post below, there may be uncertainty as to the meaning of the Value Requirement.2 Informal conversations with the drafters of the Revenue Procedure have provided some insight into how to apply the Value Requirement.3
First, the Revenue Procedure does not stipulate any minimum requirements for the tax equity investor’s equity contribution. The only requirements included in the Revenue Procedure with respect to this equity contribution are that the tax equity investor must contribute at least 20 percent of its investment prior to the building being placed in service and that the amount of the equity contribution cannot be more than 25 percent contingent. The Revenue Procedure also does not include any express relational requirement between the size of the equity contribution (or the tax equity investor’s purchase price if it acquires its interest from another party) and the associated tax benefits. Rather, the Value Requirement looks at the value of the tax equity’s “overall percentage interest in the Partnership,” without regard to tax benefits, as compared to the “reasonably anticipated value” of that interest.
Second, the phrase “reasonably anticipated value” implies that the issue is value at a point in time after the funding of the transaction, further indicating that the Value Requirement does not go to the size or value of the tax equity’s initial equity contribution. How one determines whether the tax equity’s interest in the partnership is commensurate with the anticipated value of that interest remains unclear. This is partly due to the fact that the Revenue Procedure provides no guidance on the meaning of the phrase “overall percentage interest in the Partnership.” The informal conversations provided only a slight insight into this issue. It was indicated that the phrase is intended to be descriptive, rather than a term of art that has an ascertainable meaning under the tax laws. The drafters apparently did not base it on a concept from any prior precedent, and it does not necessarily refer to the initial allocation of income and loss (i.e., tax attributes).
Informally it was indicated that the Value Requirement was intended to be a backstop to the requirement in section 4.02(2)(c) that the tax equity investor’s “Partnership interest may not be reduced through fees …, lease terms, or other arrangements that are unreasonable as compared to fees, lease terms or other arrangements for a real estate development that does not qualify for” historic tax credits. Thus, the Value Requirement is effectively an admonition to not execute transactions with artificial features.
The first example of the Revenue Procedure provides that one way to meet the Value Requirement is to structure a transaction in which the income allocations and the cash distributions percentages are the same. The informal conversation suggested that the Revenue Procedure intended to provide more flexibility than that. The following appears to be a potential means to ensure the legitimacy of a transaction in which (i) the allocation of income and loss and (ii) the sharing of cash distributions are at times in different percentages:4
- Ensure that anytime the tax equity investor is entitled to cause a sale of its interest that the sale right provides for an amount at least equal to its capital account balance (as the capital account will reflect its right to income that has been accrued but not yet matched by a cash distribution).
- Ensure that the overall transaction does not include any artificial features (e.g., non-arm’s length fees) the effect of which is to reduce the tax equity investor’s share of the pretax economics.
These two requirements are, obviously, in addition to the general requirements for partnership allocations to be deemed to have “economic effect” under the subchapter K regulations: maintain capital accounts, avoid impermissibly negative capital account balances and liquidate in accordance with positive capital account balances.5
Master Tenant Partnership Structuring Issues
When asked about the lack of specific guidance in regards to the master tenant partnership (i.e., an inverted lease) transaction with respect to (i) how much of an indirect interest the tax equity investor may have in the head lessor and (ii) by how much must the term of the head lease exceed the term of the sublease, the drafters informally noted that the Revenue Procedure addresses only partnership allocations. These questions appear to raise true lease issues governed by true lease precedent (e.g., Revenue Procedure 2001-28,6 and the associated case law and rulings). Unfortunately, there is scant precedent on head lease/sublease arrangements, other than the negative lease-in/lease-out ruling and cases.7 As the ruling holds and every case ultimately held against the defeased lease-in/lease-out transactions, it is difficult to divine much from them that is of use in structuring a transaction such as the master tenant partnership that the IRS has purported to bless.
In the informal conversation, it sounded as if it may have been suggested to the drafters, while they were preparing the Revenue Procedure, that in master tenant partnership transactions involving historic tax credits that the tax equity investor typically has a ten percent indirect interest in the head lessor. Ten percent is far less than what has been commonly used in this structure.8 It remains to be seen where transactions will settle on this point after the Revenue Procedure. It could be an interesting topic of discussion when government lawyers participate in panels at tax conferences addressing the Revenue Procedure.
With respect to the question of how much the term of the head lease must exceed the term of the sublease, the drafters generally alluded to in the requirement in the Revenue Procedure that the “anticipated value is contingent upon the Partnership’s net income, gain, and loss, and is not substantially fixed.”9 If the head lease and sublease are each net leases with equal terms, then the tax equity investor’s return is likely to be “substantially fixed”.
These informal clarifications are certainly welcome; however, the processes of rendering tax opinions and determining the necessity for financial statement reserves for uncertain positions under FIN 4810 would benefit from further formal guidance.
1 § 4.02(2)(b).
2 See Amy Elliot, IRS Provides Rehab Tax Credit Following Historic Boardwalk, 2014 TNT 1-2 (Jan. 2, 2014) (“All of these concepts that are in section 4.02(2)(b) in … may give the IRS a lot of wiggle room down the road. [T]he concepts may hard to administer because they are not defined.” (quoting Timothy Jacobs of Hunton & Williams)); Diane Freda, IRS Safe Harbor on Historic Rehabilitation Tax Credit Misses Mark, Practitioner Says, BNA Daily Tax Rep. G-2 (Jan. 3, 2014).
4 See, e.g., Ex. 1 of § 5.01 of Rev. Proc. 2007-65 for such a factual scenario.
5 See Treas. Reg. § 1.704-1(b)(2)(ii).
6 2001-1 C.B. 1156.
7 See Rev. Rul., 2002-69, 2002-2 C.B. 670 (superseding Rev. Rul. 99-14, 1999-1 C.B. 853 (which was the IRS’s first attempt at a negative lease-in/lease-out ruling)); see, e.g., BB&T v. United States, 523 F.3d 461 (4th Cir. 2008) and Consol. Edison Co. of N.Y., Inc. v. United States, 703 F.3d 1367 (Fed. Cir. 2013), reversing 90 Fed. Cl. 228 (2009).
8 See, e.g., http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/Energy_us_er/us_er_Strctrng MdlngInvestTaxPrspc_AE_Prsntn_2011.pdf (page 14) (49 percent indirect interest) and http://www.novoco.com/energy/resource_files/reports/sbt_finalpreso_102609.pdf (page 116) (up to a 49 percent indirect interest). Both of these presentations address energy tax credit transactions, while the Revenue Procedure on its face is limited to historic tax credits.
9 § 4.02(2)(b).
10 Now codified as ASC 740-10.