How Would Tax Reform Affect NMTC Investors’ GAAP Financials?

Published by Michael Novogradac, Michael Kressig on Tuesday, January 24, 2017 - 12:00am

In previous posts we have examined the likely effects of corporate tax reform on the generally accepted accounting principles (GAAP) financial statements of corporate investors in low-income housing (LIHTC), and historic (HTC) tax credits. This post addresses the likely GAAP effects of lower corporate tax rates on new markets tax credit (NMTC) investments. As previously emphasized, the actual effects of any tax reform will depend on the specific provisions of such legislation, including any modifications to existing tax rates, deductions, exemptions and credits, as well as the accompanying transitional rules and effective dates.

Economic Overview
Before exploring the GAAP effect of lower corporate tax rates on NMTC investments, it is useful to review the overall economic impact of lower rates on NMTC investments.

If all other factors remain constant, in a lower tax rate environment NMTC investments would be more profitable on a cumulative after-tax cash basis and on an after-tax GAAP net income basis. This result is similar to what we found with HTC investments because, like the HTC, the NMTC is a taxable credit; that is, there is a nondeductible basis reduction associated with claiming the tax credit. At a lower tax rate, the cost of this basis adjustment would be less, so after-tax cash and net income would be higher.

Because after-tax cash would be higher, internal rates of return (IRR) or net present values (NPV) of NMTC investments would also generally be higher. NMTC investments typically are not structured with the expectation of significant tax losses so unlike certain other tax credit investments, the timing of tax losses and their subsequent recapture at disposition is usually not a significant factor in the IRR or NPV calculations.

The timing of recognizing the larger GAAP after-tax net income will depend on the GAAP accounting policies adopted by the investor. Most investors recognize GAAP income over the seven-year credit period in a manner generally proportional to that in which the credits are claimed.

With that in mind, the following discussion examines two major GAAP considerations with respect to NMTC investments if the corporate tax rate is lowered:

  1. current impairment of existing investments, and
  2. the effect of lower corporate tax rates on deferred tax assets or liabilities.

Impairment Considerations
NMTC investments are typically accounted for either by consolidation or using the equity method of accounting.  

In circumstances where investors consolidate their NMTC investments, these investments are typically carried on their balance sheets as loans. A loan is considered to be impaired when it is probable that not all of the related principal and interest payments will be collected. Lower corporate tax rates aren’t expected to affect the impairment analysis for consolidated NMTC investments carried as loans. (Note, under the consolidated method some investors will write-down the carrying value of some of their NMTC subsidized loans below their principal value, as tax credits are claimed.)

If corporate tax rates decline, investors would also need to consider whether their equity method NMTC investments require impairment. Additional impairment isn’t expected to be a common occurrence.  Investors commonly impair the asset over the seven year credit period, as credits are claimed.  As a result, the carrying value of an NMTC equity investment is often less than the remaining credit stream.  Lower corporate tax rates would not affect the cash value of the future stream of tax credits, so additional impairment would likely not be necessary.

For example, assume an investor’s qualified equity investment is 85 percent of the expected credit stream, and for each year during the seven year credit period the carrying value of the equity investment is amortized by an amount equal to 85 percent of the credits claimed. At any point in time, the unamortized investment balance would equal about 85 percent of the remaining credits associated with the investment.

Deferred Tax Considerations
The principal effect of a corporate tax rate reduction on the GAAP financial statements of NMTC investors would relate to deferred taxes. Deferred tax assets (DTAs) and deferred tax liabilities (DTLs) are measured using the enacted tax rate expected to apply to the taxable income in the periods in which the DTAs or DTLs are expected to be settled or realized. A deferred tax asset arises when an item is expensed for book purposes before it is expensed for tax. The DTA created equals the expected tax savings when the tax deduction is expected to be claimed. Accordingly, the GAAP financial statements of taxpayers with net deferred tax assets would be adversely affected (resulting in recognition of additional book expense) in the year in which lower tax rates are enacted. Conversely, the GAAP financial statements of taxpayers with net deferred tax liabilities would benefit from the enacted lower tax rate changes (resulting in recognition of an income tax benefit as a result of the remeasurement).

Largely as a consequence of the requirement to reduce the basis of the investment by the amount of the credit, NMTC investments will likely be in a DTL position. And because the basis reduction is taken annually along with the credits, the DTL will likely increase as a given investment progresses through the typical seven year NMTC investment cycle. Accordingly, if corporate tax rates are lowered, NMTC investments would recognize GAAP income (in the form of an income tax benefit) at the time such lower tax rates are enacted.

It’s important to note that these observations are general in nature and the specifics of a given investor or a given transaction structure may yield different results. It is important that investors review their NMTC portfolio with these considerations in mind to fully understand the impact of potential lower corporate tax rates on the GAAP accounting for these investments. Novogradac & Company’s professional services teams are available to assist you in assessing the possible effects of tax reform.