Safe Harbor for Rehabilitation Tax Credits

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By Madeline Chiampou Tully, Esq., Gale Chan, Esq.,
John Lutz, Esq., Martha Pugh, Esq., Philip Tingle, Esq., and K.
Christy Vouri, Esq.
 

McDermott Will & Emery, New York, NY, Washington, D.C., and
Miami, FL

On December 30, 2013, the Internal Revenue Service (IRS) issued
Rev. Proc. 2014-12, which provides the requirements where the IRS
will not challenge a partnership's allocations of §47
rehabilitation tax credits to its partners (Safe Harbor) for all
allocations made by a partnership on or after December 30, 2013 (or
made prior to December 30, 2013 for those existing partnerships
already satisfying the Safe Harbor). The Safe Harbor is a response
to the U.S. Court of Appeals for the Third Circuit decision in
Historic Boardwalk Hall, LLC v. Commissioner 694 F.3d
425 (3d Cir. 2012) (Historic Boardwalk). As discussed
below, in Historic Boardwalk, the Third Circuit
disallowed a partnership's allocation of rehabilitation tax credits
because the purported partner did not have a meaningful stake in
the economic realities of the partnership.  In light of this
decision, investors in rehabilitation tax credit eligible projects
and other tax credit eligible projects have asked the U.S.
Department of the Treasury and the IRS for clarifying guidance; the
IRS responded with the Safe Harbor discussed below.

While the Safe Harbor expressly applies only to partnerships
allocating the rehabilitation tax credit, it may provide some
guidance and points to consider in the context of other federal tax
credits, such as the investment tax credit, low-income tax housing
credit, and new market tax credit. While the Safe Harbor is a
response to Historic Boardwalk, it addresses general
partnership tax credit allocation issues not unique to the
rehabilitation tax credit.

Background  

Section 47 provides a rehabilitation tax credit for a portion of
the expenditures made in rehabilitating a qualified building. The
rehabilitation credit for any taxable year is the sum of 10% of the
qualified rehabilitation expenditures with respect to any qualified
rehabilitated building other than a certified historic structure
and 20% of the qualified rehabilitation expenditures with respect
to any certified historic structure. Regs. §1.46-3(f)(2)(i)
generally requires that a partner's share of the rehabilitation
credit be determined by the ratio by which the partners divide the
general profits of the partnership. In many transactions,
third-party investors help fund the rehabilitation of historic
buildings, in part, to receive a share of the rehabilitation
credit. In Historic Boardwalk, the Third Circuit denied
the rehabilitation credit to one such investor when the investor
was deemed not to have sufficient economic risk or upside in the
rehabilitation project to be a partner for federal income tax
purposes. There, the New Jersey Sports and Exposition Authority
(NJSEA), a state instrumentality, was rehabilitating a convention
center and had originally obtained funding for the rehabilitation
through grants from government agencies and the issuance of
government bonds. After construction had begun, NJSEA was
approached about partnering with an investor in order for the
investor to take advantage of the rehabilitation credit. NJSEA
agreed and formed a partnership with the investor pursuant to which
the investor would be allocated rehabilitation credits.

Under the partnership agreement between NJSEA and the investor,
the investor was allocated 99.9% of all partnership items,
including the rehabilitation credit. In addition, the NJSEA and the
investor entered into a put/call arrangement, which generally
assured that the investor would get its expected return and no more
or no less. The parties also entered into a series of guarantees
that guaranteed the value of the rehabilitation credits, provided
for the funding of operating deficits and excess construction costs
and generally protected the investor from downside risk. The Third
Circuit found that the parties did not actually intend to conduct
business together because the investor "did not have any meaningful
downside risk or any meaningful upside potential" in the
partnership.  Thus, the investor was not a bona fide partner
in the partnership and was, therefore, not entitled to an
allocation of rehabilitation credits.

As a result of the holding in Historic Boardwalk, the
rehabilitation credit community and others requested guidance on
rehabilitation tax credit allocations from the IRS, which led to
Rev. Proc. 2014-12.

In addition to this Safe Harbor, the IRS previously released
Rev. Proc. 2007-65, which established a safe harbor for wind
partnerships allocating the production tax credit pursuant to §45
(Wind Safe Harbor). In the summary of the Safe Harbor below, we
compare the requirements of the Wind Safe Harbor to those of the
rehabilitation credit Safe Harbor, recognizing that the applicable
revenue procedures are intended to apply to different tax credits.
The Wind Safe Harbor and Safe Harbor are, nevertheless, relevant to
each other, as each addresses partnership credit allocation issues
generally.

Rev. Proc. 2014-12  

Through the Safe Harbor established by Rev. Proc. 2014-12, the
Treasury and the IRS intend "to provide partnerships and partners
with more predictability regarding the allocation of §47
rehabilitation credits to partners of partnerships that
rehabilitate certified historic structures and other qualified
rehabilitated buildings." The Safe Harbor makes clear that it
applies only to rehabilitation credits and not to other federal tax
credits or state credits. It also provides that it does not
indicate the IRS's views as to whether a partnership has the
requisite benefits and burdens of ownership of the relevant
building or whether an expenditure is a qualified rehabilitation
expenditure for purposes of the credit. Recently, the IRS made
additional changes to the revenue procedure to clarify that it does
not address how partnerships are required to allocate the income
inclusion required by §50(d)(5). The IRS also states in the revenue
procedure that it will not provide private letter rulings to
individual taxpayers regarding the allocation of rehabilitation
credits.

The Safe Harbor addresses two types of rehabilitation credit
transaction structures-the first is the "Developer Partnership"
that owns and restores the applicable building, and the second is a
"Master Tenant Partnership" that leases the building from the
Developer Partnership (Head Lease) and is entitled to the
rehabilitation credit pursuant to an election available under the
Code to treat the lessee as having acquired the building for
purposes of the credit. The Safe Harbor provides that, if an
investor receives an allocation of rehabilitation credits from a
Master Tenant Partnership, the investor cannot also invest in the
Developer Partnership other than through an indirect interest in
the Developer Partnership held through the Master Tenant
Partnership. This prohibition does not apply to an investment
pursuant to a separately negotiated, distinct economic arrangement,
such as an investment into the Developer Partnership to share in
allocation of federal new market tax credits or low-income housing
tax credits.

The following is a summary of the requirements that must be met
with respect to the Developer Partnership and Master Tenant
Partnership structures in order to qualify for the Safe Harbor:

Minimum Partnership Interests of Principal and
Investor
 

Under the Safe Harbor, the managing partner (referred to in the
Safe Harbor as the Principal) must have, at all times during the
period it owns an interest in the partnership, at least a 1%
interest in each material item of partnership income, gain, loss,
deduction and credit throughout the existence of the
partnership.  The investor partner (Investor) must have an
interest equal to at least a 5% interest in each material item of
the partnership for the taxable year in which the Investor's
percentage share of that item is the largest.

The Wind Safe Harbor under Rev. Proc. 2007-65 contains virtually
identical ownership interest requirements. These requirements are,
therefore, not surprising to those who invest in renewable energy
projects eligible for production tax credits or to renewable energy
investors generally.

Investor's Bona Fide Equity Investment Requirement  

The Safe Harbor requires that the Investor's partnership
interest be a "bona fide equity investment with a reasonably
anticipated value commensurate with the Investor's overall
percentage interest in the [p]artnership, separate from any
federal, state and local tax deductions, allowances, credits, and
other tax attributes to be allocated by the [p]artnership to the
Investor." The Investor also cannot be "substantially protected
from losses from the [p]artnership's activities." The Safe Harbor
specifies that an Investor's interest is a bona fide equity
investment only if the reasonably anticipated value of its interest
is contingent upon the partnership's net income, gain and loss and
is not substantially fixed in amount. Moreover, the Investor "must
participate in the profits from the partnership's activities in a
manner that is not limited to a preferred return that is in the
nature of a payment for capital."

This requirement and the requirement immediately below are
perhaps the most significant of the Safe Harbor because they are
less objective, bright-line tests than the other
requirements.  Rev. Proc. 2007-65 does not contain these bona
fide investment requirements. 

Arrangements to Reduce the Value of the Investor's
Partnership Interest
 

The value of the Investor's interest cannot be reduced through
fees, lease terms or other arrangements that are unreasonable as
compared to other such arrangements for a real estate development
project that does not qualify for the rehabilitation credit. 
In addition, the Investor's interest may not be reduced by
"disproportionate rights to distributions or by issuances of
interests in the [p]artnership (or rights to acquire interests in
the [p]artnership) for less than fair market value
consideration."

The Wind Safe Harbor does not contain this requirement, and its
reach is uncertain. One unanswered question, for example, is
whether the requirement relating to disproportionate rights to
distributions is requiring that an Investor's percentage of
partnership items must match its percentage of cash distributions.
We understand that requiring this matching was not the intent of
this provision, and that the intent was to insure that the
partnership does not use these arrangements to significantly reduce
the value of the Investor's residual interest. However, it is clear
that having cash distribution percentages that match profit and
loss allocation percentages would fall squarely within this part of
the Safe Harbor, and it is not yet as clear what other arrangements
also would be acceptable.

The Safe Harbor also addresses Master Tenant Partnerships with
respect to this requirement. Subleases of the building back to the
Developer Partnership or the Principal are deemed unreasonable
unless the sublease is mandated by an unrelated third party. If a
building is subleased to any person by the Master Tenant
Partnership, such sublease is deemed unreasonable unless the
duration of the sublease is shorter than the duration of the Head
Lease. However, the Safe Harbor does not indicate how much longer
the term of the Head Lease must be than the sublease to satisfy
this requirement. Would one day suffice? In addition, the Safe
Harbor provides that the Master Tenant Partnership may not
terminate its lease of the building from the Developer Partnership
during the period in which the Investor remains a partner in the
Master Tenant Partnership.

Investor's Minimum Unconditional Contribution and Contingent
Consideration Requirements
 

Before the date the rehabilitated building is placed in service,
the Investor must contribute at least 20% of the Investor's total
expected capital contribution (Minimum Contribution), and at least
75% of the Investor's total amount of expected capital
contributions must be fixed. The Investor must maintain the Minimum
Contribution throughout the Investor's ownership of its partnership
interest and the Investor cannot be protected from loss, except
pursuant to a "permissible guarantee" (discussed below). The
determination of whether the Investor has met the Minimum
Contribution requirement disregards investments made in the form of
promissory notes or other obligations of the Investor.

The Minimum Contribution requirement is required to be met
before the applicable project is placed in service. The Wind Safe
Harbor contains a similar Minimum Contribution requirement but
specifically provides that the Minimum Contribution must be made on
or before either the date the wind farm is placed in service or the
date the Investor acquires its interest in the applicable project
company, whichever is later. The Wind Safe Harbor also clarifies
that the Investor's Minimum Contribution is permitted to be reduced
by distributions of cash flow from the project company's operation
of the wind farm.

Guarantees and Loans  

The Safe Harbor provides that the following "unfunded"
guarantees may be provided to the Investor: guarantees for the
performance of any acts necessary to claim the rehabilitation
credit, guarantees for the avoidance or omission of any act that
would cause the partnership to fail to qualify for such credits or
that would result in recapture of such credits and any guarantees
that are not "impermissible guarantees" described below. Such
permissible guarantees include, for example, completion guarantees,
operating deficit guarantees, environmental indemnities and
financial covenants. The Safe Harbor provides that guarantees are
"unfunded" if no money or property is set aside to all or any
portion of the guarantee and if neither the guarantor nor its
affiliates agrees to maintain a minimum net worth in conjunction
with the guarantee. However, requiring reserves in an amount less
than or equal to the partnership's reasonably projected operating
expenses for a 12-month period will not constitute an amount set
aside to fund a guarantee.

Impermissible guarantees are defined by the Safe Harbor as a
direct or indirect guarantee of the Investor's ability to claim the
rehabilitations credits, the cash equivalent of the credits or the
repayment of any portion of the Investor's contribution due to
inability to claim the rehabilitation credits in the event the IRS
challenges all or a portion of the transactional structure of the
partnership. Additionally, no person involved in the transaction
may guarantee that the Investor receives partnership distributions
or consideration in exchange for its partnership interest except
for a fair market value sale right (described below). No person
involved in the transaction can pay the Investor's costs or provide
an indemnity for the Investor's costs if the IRS challenges the
Investor's claim of rehabilitation credits. The Safe Harbor
provides, however, that these requirements do not prohibit the
Investor from procuring insurance from parties unrelated to the
partnership or the rehabilitation project.

Lastly, neither the Developer Partnership, Master Tenant
Partnership nor the Principal may lend any Investor the funds to
acquire any part of the Investor's interest in the partnership or
guarantee or otherwise insure any indebtedness incurred or created
in connection with Investor's acquisition of its interest.

These requirements expand upon similar requirements in the Wind
Safe Harbor and seem to be tailored to addressing the set of
guarantees in place in Historic Boardwalk. The Wind Safe
Harbor did not specifically preclude the developer party from
indemnifying the Investor against an IRS denial related to the
transactional structure, although it did provide that no person may
guarantee or insure the allocation of production tax credits to the
Investor. The Safe Harbor requirement that permissible guarantees
be "unfunded" was not in the Wind Safe Harbor.

Purchase and Sale Rights  

Under the Safe Harbor, neither the Principal nor the partnership
is permitted to have a call option or other right or agreement to
purchase or redeem the Investor's interest at a future date.
However, the Investor may have a put right, exercisable at a future
date if the exercise price is no greater than fair market value at
the time of exercise.

This requirement of the Safe Harbor conflicts with the purchase
and sale right requirements in the Wind Safe Harbor.  In the
Wind Safe Harbor, call options are permitted, but put options are
not. Call options under the Wind Safe Harbor are permitted if the
purchase price for the project is not less than the fair market
value of the project determined at the time of exercise or, if the
purchase price is determined prior to exercise, is a price that the
parties reasonably believe, based on all facts and circumstances at
the time the price is determined, will not be less than the fair
market value of the project at the time the right may be exercised,
pursuant to Announcement 2009-69. Query which of these requirements
(if any) should be met by partnerships claiming credits other than
the rehabilitation tax credit or the production tax credit?

The Safe Harbor also provides that an Investor may not acquire
its interest in the partnership with the intent of abandoning the
interest after the rehabilitation has been completed.  If an
Investor abandons its interest at any time, the investor will be
presumed to have acquired the interest with the intent of
abandoning it, unless the facts and circumstances clearly establish
that the Investor did not acquire its interest with such intent.
Presumably, this requirement indicates that the IRS does not want
rehabilitation credit investors to take an ordinary loss upon the
disposition of the partnership interest.

Satisfaction of Code Section 704(b)  

Finally, the Safe Harbor requires that allocations under the
partnership agreement satisfy the requirements of §704(b) and the
regulations thereunder. Solely for purposes of determining whether
this requirement is satisfied, allocations of the §50(d)(5) lessee
income inclusion are not taken into account.

Effective Date  

The Safe Harbor applies to allocations of rehabilitation tax
credits by a partnership to its partners on or after December 30,
2013, and the IRS will not challenge such allocations. In addition,
if a rehabilitated historic building was placed in service prior to
December 30, 2013, the IRS also will not challenge a partnership's
allocation of rehabilitation tax credits, provided the allocations
satisfied the Safe Harbor at the time the building was placed in
service and thereafter.

Conclusion  

The Safe Harbor expands upon and adds some requirements to
rehabilitation credit transactions that were not previously
applicable under the Wind Safe Harbor for production tax credits.
Despite the fact that these safe harbors expressly apply only to
the rehabilitation credit and production credit, they address
issues not specific to either credit. Thus, investors in other
credit projects may have to consider the impact of the Safe Harbor
and whether its requirements (or those of the Wind Safe Harbor,
where the requirements conflict) should be met.

For more information, in the Tax Management Portfolios, see
Milder and Borod, 584 T.M.
, Rehabilitation Tax Credit and
Low-Income Housing Tax Credit,  and in Tax Practice
Series, see ¶3140, Investment Tax Credit.

© 2014 McDermott Will & Emery