The IRS released Revenue Procedure 2014-12 on December 30. It is available here. It addresses the structuring of historic tax credit transactions (i.e., transactions involving rehabilitation tax credits provided for in section 47 of the Internal Revenue Code (the “Code”)). It is similar in scope to Revenue Procedure 2007-65, 1 which addresses the structuring of production tax credit partnership transactions involving wind farms.
Revenue Procedure 2014-12 provides a safe harbor for only a partnership’s allocation of tax credits. It does not address any other issues (e.g., economic substance or tax ownership). Thus, the actual safe harbor is rather narrow. Nonetheless, the conventional wisdom is that, if a transaction satisfies a published safe harbor, the IRS may be unlikely to attack it on audit with respect to issues beyond the scope of the safe harbor.
The revenue procedure was requested by the historic tax credit community following the Third Circuit’s opinion in favor of the government in Historic Boardwalk Hall, LLC v. Commissioner, 2 which chilled the market for historic tax credit transactions. Here is a blog post discussing that case and the Supreme Court’s denial of certiorari. Following the Third Circuit’s decision, members of Congress wrote the Treasury requesting the revenue procedure in the hope that it would provide tax equity investors with comfort to resume investing in historic tax credit transactions.3
The revenue procedure blesses two structures: (i) a “flip” partnership and (ii) an “inverted” lease. The revenue procedure refers to the flip partnership as a “Developer Partnership” and an inverted lease as a “Master Tenant Partnership.”
The government spent months debating the inverted lease structure, and some tax practitioners may be surprised to see it included in the safe harbor. It appears an argument could be made that the historic tax credit community, by insisting on an inverted lease safe harbor, forced the IRS and the Treasury to include vague, or in some instances, difficult standards, particularly regarding pretax economics and call options.
“Developer Partnership” Safe Harbor
The mathematical standards articulated for the Developer Partnership are very similar to those in Revenue Procedure 2007-65. Here is the diagram for the Developer Partnership. It looks much like the wind partnership provided for in Revenue Procedure 2007-65.
The tax equity investor can be allocated up to 99 percent of the tax items, but, after achieving its flip rate (i.e., internal rate of return), must have an interest equal to at least five percent of its greatest allocation of any material partnership item (as opposed to items of income and gain as provide for in the wind revenue procedure). Further, the tax equity investor must contribute 20 percent of its equity investment prior to the building being placed in service. Finally, the tax equity investor’s investment can be only 25 percent contingent or pay go (i.e., the obligation to make 75 percent of the equity investment must be fixed).
However, Revenue Procedure 2014-12 appears to arguably provide for a more onerous requirement with respect to the tax equity investor’s right to cash distributions than does the wind revenue procedure. Specifically, the first example in the wind revenue procedure provides that the tax equity investor in the initial period of the transaction can be entitled to zero cash distributions. No comparable comfort is provided in Revenue Procedure 2014-12.
Further, Revenue Procedure 2014-12 includes the following cryptic and potentially troubling reference to the tax equity investor’s pretax economics: 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.”4
The concern about the tax equity investor’s pretax economics is heightened by the first example in Revenue Procedure 2014-12: The tax equity investor “has a right to receive a pro rata share of all distributions commensurate with [its] share of the Partnership profits. [Its] percentage interest has a reasonably anticipated value commensurate with [its] overall percentage interest . . . , separate [from the tax attributes].” [Emphasis added.] Thus, if the tax equity investor is to be allocated 99 percent of the investment tax credit and other tax attributes for the first five years, in order to maximize the historic tax credit and avoid recapture, it appears it also is to receive 99 percent of the cash distributions during those five years.
It would have been helpful if the example had explained how the anticipated value of the equity investment is determined, apparently without regard to tax benefits, and had included guidelines for testing whether that value is “commensurate” with the investor’s overall percentage interest in the partnership. Do the IRS and the Treasury naively expect the tax equity investor’s equity contribution to be determined without regard to the historic tax credits? It is hard to fathom such an expectation because it could potentially nullify much of the utility of the safe harbor; however, how else is the “commensurate value” requirement to be applied? In addition, the revenue procedure uses “overall percentage interest in the partnership” as if it is a term of art; however, neither a definition nor a cross-reference is provided to assist taxpayers in divining the meaning of the phrase. Further clarification of these points would be helpful.
“Master Tenant” (Inverted Lease) Safe Harbor
In the inverted lease as described in the revenue procedure, a lessor has two partners: a developer and the master tenant partnership. The lessor then enters into a head lease of the building with the master tenant partnership (which is also a partner in the lessor), and the lessor elects for the master tenant partnership to claim the investment tax credit. The master tenant has two partners: a principal (also known as a sponsor) and the tax equity investor. The master tenant then subleases the building to the ultimate user. Here is a diagram of the inverted lease structure.
In the inverted lease, the mathematical standards referred to above and the vague language about the pretax economics are applied at the master tenant level (i.e., the entity in which the tax equity investor is a partner). After that, the safe harbor provides little in terms of objective guidelines.
The revenue procedure provides that the tax equity investor may have no direct ownership in the lessor, but may have an indirect interest through being a partner in the master tenant, which is a partner in the lessor. However, no guideline is provided as to how much of an indirect interest the tax equity investor may have in the lessor. This is a fundamental question in inverted lease transactions, and tax practitioners are left guessing.
The revenue procedure sensibly provides that the term of the head lease must be longer than the term of the sublease. This is sensible because it provides the master tenant with real exposure to the asset to justify it being viewed as having a leasehold for tax purposes. However, the revenue procedure does not state how much longer the head lease term must be than the sublease term. Is one day enough, or should it be some percentage longer than the sublease term?
Section 4.06 of Revenue Procedure 2014-12 also takes a novel approach to put/call rights. The tax equity investor may have the benefit of a right to “put” its interest to the sponsor, provided that the put price is not in excess of the fair market value of the tax equity investor’s interest as determined at the time of the exercise of the put. In contrast, Revenue Procedure 2007-65 prohibits the tax equity investor from having any put right.
Section 4.06(1) of Revenue Procedure 2014-12 prohibits all call options. This is more conservative than even the initial iteration of Revenue Procedure 2007-65, which permitted call options only at the then determined fair market value. The IRS, two years after issuing Revenue Procedure 2007-65, succumbed to industry requests and revised it to permit a sponsor call right at a fixed price “the parties reasonably believe, based on all facts and circumstances at the time price is determined, will not be less than the fair market value.”5 We will see if similar requests are made with respect to Revenue Procedure 2014-12.
Section 4.06(3) of Revenue Procedure 2014-12 also adds an odd gloss to the determination of fair market value of the tax equity investor’s interest by requiring that it “may take into account only those contracts or other arrangements creating rights or obligations that are entered into in the ordinary course of the Partnership’s business and that are negotiated at arm’s length with parties not related to the Partnership or” the tax equity investor. In an inverted lease, this would appear to prohibit consideration of the head lease, due to its related-party nature, when determining the fair market value of the tax equity investor’s interest. However, since the head lease is central to the tax equity investor’s economics, it would appear impossible to value the tax equity investor’s interest without taking it into account. If the goal of this fair market value language is to prohibit put options in inverted leases, the IRS could have more readily effectuated that goal by merely stating that.
Tax Indemnity Protections
Revenue Procedure 2007-65 provides that no “person may guarantee or otherwise insure the [tax equity investor] the right to any allocation” of production tax credits. Revenue Procedure 2014-12 goes far beyond this prohibition:
(a) No person involved in any part of the [historic tax credit transaction] may directly or indirectly guarantee or otherwise ensure the [tax equity investor’s] ability to claim [historic tax credits], the cash equivalent of the credits, or the repayment of any portion of the [tax equity investor’s] contribution due to the inability to claim the [historic tax credits] in the event the Service challenges all or a portion of the transactional structure of the Partnership. . .
(b) No person involved in any part of the [historic tax credit transaction] may pay the [tax equity investor’s] costs or indemnify the [tax equity investor] for [its] costs if the Service challenges [its] claim of [the historic tax] credits.6
The tax equity investor may be protected by guarantees that the other parties to the transaction (i) will take the steps necessary to claim the historic tax credit and (ii) will not cause the historic tax credit to be recaptured.7
It seems a bit excessive in paragraph (b) to provide that the tax equity investor must bear its own legal costs in defending an IRS audit, particularly as there is no exception for audits triggered by an act or omission that is covered by a permissible guarantee.
The tax equity investor may be protected by “completion guarantees, operating deficit guarantees, environmental indemnities and financial covenants.” However, neither these protections nor the limited guarantees about the historic tax credits may be funded. That is, the tax equity investor must be exposed to the financial wherewithal of the guarantor. Further, although financial covenants are permissible, the guarantor may not agree to maintain a minimum net worth.8
Letters of credit are a customary means to ensure payment of commercial obligations. The revenue procedure is silent as to whether a letter of credit is permissible. This is despite the fact that section 470(d)(1)(A) of the Code, which also addresses funded obligations, permits a letter of credit so long as it is not collateralized by a deposit.
A permissible type of financial protection is a reserve “in an amount less than or equal to the Partnership’s reasonably projected operating expenses for a twelve-month period.”9
Implications for Renewable Energy Investment Tax Credit Transactions
The revenue procedure provides that it applies to only historic tax credits. Nonetheless, historic tax credits are an “investment tax credit”; thus, the question arises as to what the revenue procedure means for structuring solar projects or wind projects (or other production-tax-credit-eligible projects) that elect the investment tax credit in lieu of the production tax credit.
On the positive side, the revenue procedure could be interpreted to imply endorsement for inverted leases in all investment tax credit transactions; the inverted lease is a powerful tax structuring tool that, in some circumstances, delivers the most attractive after-tax economics. However, if one takes that view, would one also have to adopt the revenue procedure’s pretax economic parameters and prohibitions on call options in renewable energy investment tax credit transactions? That may not be a trade that renewable energy tax credit investors are willing to make.
When the IRS issued Notice 2013-29 addressing the 2013 start-of-construction requirement for wind farms to qualify for production tax credits, glitches were identified that were promptly addressed.10 One can only hope that the IRS and the Treasury are similarly proactive in clarifying Revenue Procedure 2014-12’s pretax economics standard and other ambiguities described above.
1 2007-45 I.R.B. 967.
2 694 F.3d 425 (3d Cir. 2012), cert. denied, U.S. No. 12-901 (May 28, 2013).
3 See, e.g., Letter from Rep. Niki Tsongas (D-MA) to Jack Lew, Secretary of the Treas. (Apr. 26, 2013) (available at TNT DOC 2013-11090).
4 § 4.02(b); see Amy Elliot, IRS Provides Rehab Tax Credit Following Historic Boardwalk, 2014 TNT 1-2 (Jan. 2, 2014).
5 Ann. 2009-69, 2009-40 I.R.B. 475 (revising Rev. Proc. 2007-65, 2007-45 I.R.B. 967).
6 § 4.05(2).
7 § 4.05(1)(a)(ii)
8 § 4.05(1)(b), (c)
9 § 4.05(1)(c)
10 See, e.g., Notice 2013-60.