2013-Issue 28—On August 27, 2012, in Historic Boardwalk Hall LLC v. Comm'r, 694 F.3d 425 (2012), the United States Court of Appeals for the Third Circuit sided with the IRS and denied historic rehabilitation credits for a state authority's purported partnership with a credit investor, Pitney Bowes Inc., to redevelop the Atlantic City, N.J., Historic Boardwalk Hall. On May 28, 2013, the U.S. Supreme Court declined to hear the taxpayer's appeal of the Third Circuit's decision. Thus, the Supreme Court effectively left the market for historic tax credit transactions in a state of significant uncertainty.

The IRS has stated publicly that "The [historic] credit is not under attack here. It is the prohibitive sale of tax credits, not the tax credit provision itself, that the IRS has challenged." Without debating the merits of the Historic Boardwalk opinion itself, investors in historic tax credits, and other incentive tax credits, are rightly concerned about the manner in which the IRS chose to challenge the validity of the historic tax credit investor's status as a partner in that case.

A key issue in Historic Boardwalk is the theory that a traditional credit investor must have significant economic upside and/or downside, as ultimately determined by the IRS, to be respected as a partner. This theory provides the IRS with the discretion to apply a similar line of reasoning to all types of credit transactions. While the IRS has indicated that it plans to provide safe harbor guidance on a fast-track basis, it appears likely that the structure of a qualifying transaction will involve a significant increase in the amount of risk assumed by a credit investor. One could argue that the IRS's position may ultimately be a healthy turn of events for the overall market by increasing the number of small real estate or other developers who choose to sponsor credit-based transactions such as alternative energy, low-income housing and new market tax credit programs as a means to enter the market. Previously, many smaller real estate developers found the amount of the required guarantees in typical credit-based transactions to be a significant, if not prohibitive, barrier to entry into this market.

While the specific structure of each type of credit vehicle is unique, they typically share a few key characteristics. Traditionally, most incentive tax credit transactions are structured as a partnership investment or tiers of investment partnerships, to which a government entity makes an allocation of credits to be allocated among the partners, provided the partnership meets the requirements of the program. The requirements include the restrictions on the type of activity in which the partnership may engage and a specified time period for which the activity must qualify.

The investors in typical structures are often a bank, which makes a relatively small equity investment and lends much of the development funds to the entity, the sponsor of the project, which is often a developer that typically invests relatively little capital, and a party or parties known as the credit investor, which makes a significant contribution of cash equity to the project.

Generally, the partnership agreements are designed in a manner such that the credit investor is allocated almost all of the tax credits in exchange for a contribution of cash to the partnership in an amount that represents a significant discount from the notional dollar amount of the allocable credits. In exchange for the allocation of the credits, the investors typically expect very little economic return beyond the value of the credits. In fact, in many circumstances, including that of the credit investor in Historic Boardwalk, the sponsor has an option to purchase the equity of the credit investor for a relatively nominal amount at the end of the deal, therefore effectively limiting the upside potential to the value of the credits. However, given the insignificant chance for upside and the fact that a number of the credit investment programs have significant recapture provisions, the credit investors have frequently required the sponsors to guarantee up to 100 percent of their equity position in the event that the partnership failed to deliver the credits for any reason. As a result, to participate as a sponsor of an incentive credit deal, a developer is often required to have either deep pockets itself or access to a deep pocket investor.

It is the combination of the greatly reduced downside risk and limited upside potential that ostensibly created the concern on the part of the government in the Historic Boardwalk case. The IRS believed that such a narrow collar amounted to a purchase and sale of the tax credits, which at least some parts of the IRS believed was an unintended result of the rehabilitation program. Questions remain as to whether other types of credits were intended by Congress to be transferred from the outset and are therefore outside of the reach of the Historic Boardwalk decision. It is clear that other tax credit programs involve different elements of risk with respect to the recapture of the credits and the time over which the credits are earned and allocated, something that may provide additional credible arguments that the credit investors in those deals significantly share in the entrepreneurial risks and rewards required to be respected as a partner. However, it seems reasonable to assume that many taxpayers will not be comfortable with that type of technical distinction to satisfy themselves that the Historic Boardwalk line of reasoning does not apply to other types of credit transactions.

In light of the limited upside in many incentive tax credit deals, Historic Boardwalk may place pressure on the ability of credit investors to demand guarantees to protect against their downside risk. As a result, the days of a complete guarantee against downside risk of the credit investor are changing. What remains to be seen is the extent to which the guarantees are reduced.

Alvarez & Marsal Taxand Says:
The market for incentive credit partnerships should be alive and well, particularly since the IRS has indicated that it does not view the Historic Boardwalk decision as a mandate to examine and recast all credit transactions. The shift of risk from the sponsor to the credit investor may have a short-term impact, and possibly a long-term impact, on the pricing of credits, but we expect the market to respond to the changes efficiently, and the forthcoming safe harbor guidance will hopefully ease the friction. Further, we believe the safe harbors may resemble other viable regimes such as the wind energy safe harbor, which has proven successful.

On the brighter side, ultimately, this may be a benefit to the market, since sponsors with shallower pockets may be able to enter the game because they may not be expected to make substantial financial guarantees to the credit investors, not only in the event that they engage in disqualifying activities but also in the event a deal underperforms economically. While this is a change to the status quo, and the pricing of the bank debt involved in the structure and the level of capital required from the sponsors may increase to offset the limited guarantees, it is quite possible that this distribution of risk is what the IRS believed was appropriate all along.

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