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This information was published in the Novogradac Journal of Tax Credits. The complete version is available by paid subscription only. Click here for more information on subscribing.

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  • Q&A: Making Distributions Within Safe Harbor Provisions

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  • Q&A: Avoiding Foreclosure for Historic Tax Credit Properties

  • Army Aims to Attract $7.1 Billion to Renewable Energy Projects


October 2011, Volume II, Issue X Published By Novogradac & Company LLP



The Current: Combining New Markets Tax Credits with the ITC or Section 1603 Grant Programs

By Forrest David Milder, Esq., Nixon Peabody LLP

 

It has taken a few years, but the idea of combining renewable energy tax credits or grants with the new markets tax credit (NMTC) has begun to take hold. In this edition of The Current, I thought it would be useful to provide an overview of how the programs work together.

Because you're reading this column, I'll presume that you understand the basics of the energy investment tax credit (ITC) and Section 1603 grant rules, but want to know more about NMTCs. (I'm leaving out the production tax credit for this discussion).

Let's start with what you know. What follows is the briefest refresher of the ITC and Section 1603 grant programs. It is not intended to replace the thousands of words you've seen here and elsewhere providing a more detailed description of these rules.

Depending on the technology, and subject to differing expiration dates, the ITC is based on 30 percent/10 percent of the cost of the facility if claimed by the owner, or 30 percent/10 percent of its value if "passed through" to the lessee. A facility that is leased to a tax-exempt or government entity may be denied the credit as "tax-exempt use property," and the credit is also denied to the extent of such an entity's highest percentage interest in the owner of the facility.




The Section 1603 grant is similar to the ITC, but the credit is replaced by a 30 percent/10 percent cash payment from the government following submission of the appropriate paperwork. The grant can also be passed through to a lessee, in which case it is also based on value, rather than cost. The facility must be placed in service by the end of 2011, or the owner must "commence construction," typically by incurring at least 5 percent of the cost of the facility, not later than December 31, 2011 and place the facility in service before the applicable expiration date. Facilities can be leased to government entities or tax-exempts, but they cannot have any ownership by these entities, unless a for-profit "blocker corporation" is interposed.

The NMTC program is unlike either of these energy programs. In particular, it is not based on the cost or value of the facility built with investor funds.

Instead, the NMTC program is intended to facilitate projects in low-income communities (LICs) by providing a seven-year credit equal to a total of 39 percent of the amount of the qualified equity investment (QEI) made by an investor in a community development entity (CDE) or a sub-CDE formed for a particular investment. The CDE or sub-CDE then uses that investment to make qualified low income community investments (QLICIs) in qualified area low-income community businesses (QALICBs) doing business in appropriate LICs.

The NMTC starts with a fair amount of government participation. This is because the first step in getting NMTCs is Treasury having an application and allocation round through which it chooses among many CDEs seeking an allocation of NMTCs. These allocation rounds occur more or less annually, and are also subject to Congress renewing the program, which typically happens a year or two at a time.

Each time there is a new allocation round, CDEs — formed by private or tax-exempt parties — apply to the U.S. Treasury, stating how, if they win an award, they will use the NMTCs to raise funds and then make beneficial investments in businesses located in LICs. They do this by filing a detailed application that describes many factors relevant to their proposed investments: the types of businesses, projects and communities they will invest in, the favorable terms they will provide, and the quality and attachment to low–income communities of their directors and management. As part of each round, Treasury reviews the applications submitted and awards limited allocations of NMTCs to the winning CDEs, which are only a subset of the applicants. Note that an allocation doesn't mean that the CDE has cash to invest in a QALICB or its project, only that it can now encourage an investor to make a QEI in exchange for some of the credits that have been allocated to the CDE.



And how does this all work together? Well, an investor can structure its investment so as to take advantage of one of the 10 percent/30 percent ITC or Section 1603 grant and also the 39 percent NMTC, and this double benefit (as well as cash and depreciation deductions in some situations) can raise more money that would otherwise be available for a developer's project.

This might all be simpler but for several rules that add complexity to these transactions (and, luckily for many of us attorneys and accountants, make you need professionals who know what they are doing!).

First, if you haven't figured this out already, these transactions are complex. With all these programs and their different requirements, and the rules of the Treasury with respect to the awards of NMTC allocations, every transaction starts with a diagram that features one or two dozen boxes and circles with lines running in every direction. If nothing else, this means that these transactions are designed for developers and investors with staying power. They have to put in the time and effort to understand the chart for their transaction and how the flow of funds and benefits will work to help raise the maximum investment. And, of course, along with complex transactions are high professional fees. So, be sure to consult with your counsel and accountant about what size transaction justifies the fees that they expect to charge.

Second, the NMTC is not an "of right" credit or grant like the ITC and Section 1603 grant described above. A project has to be in an LIC, its proponents have to find a CDE with an interest in renewable projects that had an allocation of NMTCs that it hasn't already committed to other projects, and an investor prepared to make a QEI in the CDE on account of the proposed project. This often means that a fair bit of leg work is required to assure the project is eligible for the NMTC, and to find both the CDE and an investor. Treasury publishes a detailed guide about the awardees, complete with contact information, but this can still mean a lot of work.

Third, when properly structured, the IRS allows the 39 percent NMTC to be computed on not only the investor's own funds, but also on amounts that the investor borrows and then invests in the CDE. This can effectively "turbocharge" the NMTC, yielding a significant increase in what a new markets investor will provide to the transaction. In the renewable area, the source of the loan to the investor might include funds derived from the credit or the Section 1603 grant program. Regardless, these structures will also increase the boxes and lines in the transaction diagram.

Fourth, because of Treasury rules, most NMTC awards are made to CDEs that represented that they would not control the projects in which they make their QLICI. So, this results in lease pass-through structures and other arrangements intended to maximize the investment in a way that is consistent with Treasury's requirements. Of course, this also means a few more boxes to cover these additional parties.

Fifth, while the NMTC can benefit a project owned by a tax-exempt business, it can't be used by a government business. And the ITC is lost to the extent of tax-exempt ownership while the grant is lost if there is any tax-exempt owner. This means that for-profit blocker corporations may add another round of boxes to the deal structure.

Sixth, because the NMTC is allocated over seven years, the period in which an investor is associated with the project is increased from the five years attributable to the ITC and the Section 1603 grant program to the seven years that applies to new markets.

Seventh, most NMTC transactions are structured as loans by the CDE to the QALICB, with a portion eligible to be forgiven (or acquired by a friendly party) after the seven-year NMTC period has elapsed. While there is no fixed commitment that the loan will be forgiven, these "exit strategies" can result in a back-end tax liability due to "cancellation of debt" income, depending on how the transaction was structured and what happens with the debt at the end of the time period.

Plainly, combining the NMTC program with energy credits or Section 1603 grants is for the sophisticated developer that can stay the course to closure. But for those with that kind of commitment (and a project that meets the requirements of the NMTC program, especially the need to be in a LIC), the rewards can be very valuable.