2014-Issue 1—On January 13, 2014, the Internal Revenue Service will publish Revenue Procedure 2014-12 in Internal Revenue Bulletin 2014-3. Oh, and by the way, Happy New Year to you too. In the Revenue Procedure, the Internal Revenue Service sets forth a safe harbor for partners to share rehabilitation credits generated by a partnership under IRC Section 47.
Historic Boardwalk Hall v. Commissioner
In Historic Boardwalk Hall (649 F. 3d 425, 3rd Cir. 2012, cert. denied, U.S. No. 12-901, May 28, 2013), an investor had provided capital (tax equity) to a partnership that generated rehabilitation credits under IRC Section 47. The investor had provided the tax equity to help finance the rehabilitation and take the tax credits that were generated, using them in the most economically beneficial way possible. The investor had a preferred return that was guaranteed with a funded account and a special allocation of the IRC Section 47 credits and other tax benefits. During or after the “pay-off” period (presumed to be five years), the investor could be redeemed from the partnership for the greater of either the present value of the accrued but unpaid tax benefits or the fair market value. The Commissioner argued that the investor was not a partner, as the investor really had no meaningful participation in the entrepreneurial risk of the partnership’s venture since the investor’s return was fixed and exposure to downside risk was limited. In addition, the investor’s return was essentially guaranteed and partially funded. The Third Circuit agreed and found that the investor was not a partner, and the credits were reallocated to the other partners in accordance with their interests in the partnership profits.
Safe Harbor Relief
The safe harbor relief is simple but not all-encompassing as would be expected. It will provide protection from the Internal Revenue Service attacking the existence of a partnership and the investor as a partner in the partnership. It will also provide protection for allocations of rehabilitation credits under the substantial economic effect rules. It does not provide protection from determining if the activity qualifies for the credit under IRC Section 47 or the amount of the credit. It only provides for protection against the arguments that a bona fide partnership doesn’t exist or the investor is not a partner and that the allocation of the credits doesn’t have substantial economic effect. Essentially, the Internal Revenue Service is giving guidance to avoid issues like those in Historic Boardwalk Hall, as much as possible.
This ruling is similar in effect to Revenue Procedure 2007-65 establishing a safe harbor for investors and developers/operators of wind farms. Revenue Procedure 2007-65 blessed the allocation of production tax credits (credits for energy generated from renewable sources) in a wind farm to an investor as pay-back for the tax equity investment. Although by its terms this Revenue Procedure only applies to wind farms, tax practitioners have extended its application to the sharing of production tax credits generated from other sources of renewable energy. In 2009 (Announcement 2009-69), the Internal Revenue Service noted it would change its level of review from “closely scrutinize” to “subject to examination” for partnerships claiming production tax credits. Thus the IRS has even agreed to a lesser level of review for partnership structures that fail the generous safe harbor rules.
In any event, there is similar guidance in the tax world in partnership flip structures that permit certain disproportionate allocations of partnership income items and therefore the sharing of production tax credits that are similar to the rehabilitation credits in early years of the partnership, provided the allocations reverse or “flip” in later years. The Service’s approach to auditing structures that share the tax credits shows it is more lenient in its litigation position. Publishing safe harbor guidance for sharing rehabilitation credits similar to that for production tax credits should provide a more stable source of funds for restoration projects. Investors usually desire some form of certainty for their capital.
Safe Harbor Rules Generally
Generally, the safe harbor rules require the investor partner to maintain a minimum of a five percent interest in all partnership items while being a partner. The safe harbor requires the investor to have an equity interest versus a fixed or debt-like interest in the partnership. That makes sense. The safe harbor also has minimum requirements on the investor’s ultimate capital contribution amounts. The safe harbor also limits the guarantees that can be provided to the investors. The guarantees that are allowed include performance guarantees related to activities necessary to claim the IRC Section 47 credit, environmental guarantees, completion guarantees, financial covenants, etc., but prohibit guarantees that essentially monetize the investor’s return or guarantee a cash equivalent if the IRC Section 47 credits fail for some reason. Remember, the investor must have an equity interest in the partnership venture and not be treated under the tax laws as a creditor. The guarantees allowed fall more along the lines of commercial guarantees associated with the underlying activity versus the financial guarantees and arrangements that protect the investor’s capital and bargained-for return.
Alvarez & Marsal Taxand Says:
The partnership flip structure is not uncommon, but also not free of pitfalls. We’ve worked under the safe harbor rules for sharing production tax credits. The guidance the Internal Revenue Service has given for sharing the rehabilitation credits is good to have, but must be followed carefully — same as with the renewable energy credits. Usually, the protections the investor desires run close to the prohibited protections or the items that tend to move the investor closer to the creditor side of the creditor versus equity owner ruler. Careful planning upfront allows all parties to model their expected returns and make their investment decisions based on their models. Adherence to the guidelines of Rev. Proc. 2014-12 will ensure that the modeled benefits will flow as desired. Given the inability to guarantee the cash equivalent amount of the credits to the investor, the arrangement begins to look economically more like a preferred equity investment than an effective sale of the credits. This could have an impact on the pricing for the tax equity.
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