Close Enough? How to Measure “Substantially Similar” under FASB’s New LIHTC Investment Guidance

Published by Michael Novogradac on Wednesday, February 5, 2014 - 12:00am

Recently, the Federal Accounting Standards Board (FASB) released Accounting Standards Update 2014-01, which revises and clarifies accounting guidance for investments in low-income housing tax credit (LIHTC) properties. The new accounting guidance provides that qualifying LIHTC investments should generally be amortized in proportion to the tax credits and other tax benefits, but also states that, “as a practical expedient, an investor is permitted to amortize the initial cost of the investment in proportion to only the tax credits allocated to the investor if the investor reasonably expects that doing so would produce a measurement that is substantially similar to the measurement that would result from [amortization in proportion to both the tax credits and other tax benefits].” (Emphasis added.)

The guidance begs the question as to what substantially similar means. Unfortunately, the new guidance does not include an actual definition. (One place that GAAP does indicate some criterion for substantially similar (323-10-15 Scope and Scope Exceptions) applies specifically to stock ownership and does not seem relevant to tax credit calculations.)

A few other sources provide some clues, however.

Black’s Law dictionary defines “substantially” as:

“Essentially; without material qualification; in the main; in substance, materially; in a substantial manner. About, actually, competently, and essentially.”

Oxford Dictionary defines “substantially” as:

“1. to a great or significant extent,

2. for the most part; essentially:”

Oxford defines “similar” as:

1. Resembling without being identical.”

The compounding of these two Oxford definitions of “substantially” and “similar,” results in this:

“To a significant extent … resembles without being identical.”

Another approach to distilling the meaning of “substantially similar” is to attempt to convert the concept to percentage measurements. Contemplation of the meaning in percentage terms would lead many to view “substantially” as more than 50 percent, but not too much more. Though some could argue that substantial should be viewed as merely large, even perhaps the largest, but not necessarily more than 50 percent. On the other hand, “substantially identical” would likely imply a high correlation, say, more than 90 percent. “Substantially similar” is likely somewhere in between. “Substantially similar” implies less than perfect similarity; if the FASB authors had intended perfect similarity, they would most likely have used a term such as “completely similar.”

A specific, quantitative example best illustrates the concepts presented. The difference between the two proportional amortization methods is how rapidly the investment is amortized. Under the tax credits only period, amortization is more rapid than using the tax credits and other tax benefits period, because tax credits are generally generated over 10 years, and other tax benefits are generally generated over 15 years. The two methods create differences in the annual reported book balance of the investment and annual amortization expense.

To compare the effect of the two proportional methods, and the degree to which the measurements are “substantially similar,” Novogradac ran illustrative calculations using both approaches. The calculations compared the annual reported book balance of an LIHTC investment to the original dollars invested, as well as the annual difference in amortization expense, as compared to the original investment. The calculations were based on the example provided by FASB in its guidance, with some key modifications. In order to put the example more closely in line with current LIHTC pricing, it was modified to have a tax credit price of 90 cents and begin with an initial investment of $144,000 rather than $100,000.

Specifically, Novogradac ran comparative calculations for illustrative 100 percent rent restricted, 9 percent and 4 percent LIHTC investments. These calculations showed that if the tax credits only period is chosen, the annual difference in book value between the two approaches never exceeded 10 percent of the original investment. The difference in annual amortization expense between the two methods never exceeded 2 percent of the original investment. These differences are narrow and appear to be well within the concept of “substantially similar.”

Because the interpretation of “substantially similar” is likely much broader than the 10 percent and 2 percent differences we observed, we expect that nearly all LIHTC investments will yield “substantially similar” measurements when amortization is based on tax credits only as compared to amortization proportional to tax credits and other tax benefits.

The exceptions would likely occur in unique situations where tax credits are significantly less than other tax benefits. An example of such an exception would be an 80/20 tax-exempt bond transaction where only 20 percent of the property is eligible for LIHTCs, but 99 percent of the depreciation expense is being allocated to the investor.