The Current: Renewable Energy Projects and the Historic Credit Safe Harbor

The February column, “Historic Tax Credit Guidance Holds Significance for Renewable Energy Industry,” discussed Revenue Procedure 2014-12, often referred to as the “historic credit safe harbor” and its relevance for renewable energy developments. Rev. Proc. 2014-12 provided approximately 20 tests. Meeting the requirements of all of those tests gives confidence to investors in partnerships (or LLCs) that invest in historic tax credit projects that the Internal Revenue Service IRS won’t challenge their status as partners for federal income tax purposes.

Although the tests of the safe harbor only provide protection to historic investors, they do give insight into how the IRS’s “pass throughs and special industries” branch views certain features often found in tax credit investments.

One of the fundamental concepts of the revenue procedure is that the investor should have an interest in the partnership’s non-tax economics that is “commensurate” with its share of the tax benefits. Section 4.02(2)(b) of the revenue procedure provides:

Requirements regarding the Investor’s Partnership interest. The Investor’s Partnership interest must constitute a bona fide equity investment with a reasonably anticipated value commensurate with the Investor’s overall percentage interest in the Partnership, separate from any federal, state and local tax deductions, allowances, credits and other tax attributes to be allocated by the Partnership to the Investor.

Recognizing that it is easy enough to include a line in a partnership or LLC agreement that gives the investor a 99 percent interest in distributions only after fees and similar amounts have been paid or distributed, the revenue procedure includes a second provision intended to assure that these other amounts don’t prevent the partnership or LLC from reaching this line in the distribution waterfall. The safe harbor provides the IRS view in Section 4.02(2)(c):

Arrangements to reduce the value of the Investor’s Partnership interest. The value of the Investor’s Partnership interest may not be reduced through fees (including developer, management, and incentive fees), lease terms, or other arrangements that are unreasonable as compared to fees, lease terms, or other arrangements for a real estate development project that does not qualify for § 47 rehabilitation credits … [emphasis added]

For example, imagine an LLC expected to generate $100,000 of cash flow per year, and an LLC agreement that gives the investor 99 percent of available cash only after the payment of a $200,000 annual fee to the general partner. In such a situation, the investor will get 99 percent of nothing, because the cash flow will entirely go to paying the $200,000 annual fee. This raises the question of whether the fee is unreasonably deflecting the company’s cash flow away from the investor.

In the historic rehabilitation industry, this rule has been interpreted to call for “reasonableness opinions,” whereby an expert provides a written report that supports the premise that the “fees … lease terms, or other arrangements” are reasonable when compared to the non-credit industry.

Of course, it cannot be said enough times that the revenue procedure only applies to historic transactions, and accordingly, to date, these opinions are rare in renewable investing. Nonetheless, it’s difficult to argue with the notion that a transaction shouldn’t have unreasonable fees.

So, suppose that an investor in a renewables partnership sets out to establish that the fees, lease terms and other arrangements were reasonable. What should it do?

First, in public appearances, IRS and Treasury officials indicated that they are expecting professional reports to back up the fees and other arrangements. However Rev. Proc. 2014-12 doesn’t actually call for an expert’s written report. Query whether an experienced investor should be considered competent to make these judgments without need for an expert’s report. Regardless, even if third-party review is not obtained, it’s probably a good idea for an investor to document its analysis of the reasonableness of fees, leases and other arrangements that have the potential to be suspect.

Second, the revenue procedure calls for a comparison to non-tax credit investments. While the historic community has abundant real estate investments to which it can compare an historic transaction, it is a good deal harder to find non-tax credit renewables transactions, unless we are going to include projects based on the Section 1603 renewable energy cash grant program. Of course, Section 1603 is a “grant in lieu of tax credit” program, so it seems unlikely that relying on such transactions is consistent with the spirit of Section 4.02(2)(c) of the revenue procedure.

Perhaps it is appropriate to compare renewables investments to equipment-leasing transactions generally. Again, in public appearances, the IRS has indicated that, in the historic world, it believes that the comparisons should be to similar projects. For example, it is anticipated that the comparison will consist of fees charged in hotel transactions eligible for credits with hotel transactions that are not. Still, remembering that the revenue procedure does not apply to renewables, any sensible comparison should go a long way toward satisfying the more generalized concern about fees being reasonable.

Third, it is important to remember that the IRS is interested in more than just fees. In addition, the revenue procedure refers to “lease terms” and “other arrangements.” Interestingly, setting aside the “non-tax credit” provision of the revenue procedure, it may well be easier to find comparable leases where equipment is involved, as is the case with renewables.

This brings us to the important “other arrangements” reference in Section 4.02(2)(c) of the revenue procedure. Sometimes, the pass-throughs and special industries branch of the IRS refers to a “no-monkey-business rule,” and no doubt they are thinking of clever taxpayers (and their clever tax advisors) who develop ways to fund reserves, distribute refinancing proceeds, and other arrangements intended to move project funds from investors to developers and project sponsors without the use of something as simple as a “fee” or “lease payment.” It’s hard to describe what should and shouldn’t work here; but remember, if it “looks too good to be true,” then it certainly justifies close scrutiny with a tax advisor who brings some skepticism to the analysis.

Finally, it is important to recognize a second series of tests that can apply to the analysis of arrangements. Section 4.02(2)(b) provides:

An Investor’s Partnership interest is a bona fide equity investment only if that reasonably anticipated value is contingent upon the Partnership’s net income, gain, and loss, and is not substantially fixed in amount … 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 [emphasis added]

Consider any transaction structure that distributes some cash to the investor as a preferred return, and also has the potential to distribute 99 percent of “leftover cash” to the limited partner, but which assures that all excess cash flow will instead go to pay a reasonable fee. For example, assume that an investor contributes $4 million to a venture that is expected to generate $200,000 of cash each year. Assume further that out of this cash, the partnership will pay a 3 percent preferred “cash on cash” return to the investor, followed by an $800,000 reasonable deferred development fee, with any excess distributable 99 percent to the investor.

On these facts, the investor should expect to get $120,000 each year, and the investor will get the balance, about $80,000 annually, for an indefinite period, perhaps 10 years or so, before any cash might be left over to be distributed 99 percent to the investor. In other words, while the fees and payments are reasonable, and nothing appears to be a prohibited arrangement, we nonetheless have a structure where the return to the investor looks to be “substantially fixed in amount” for at least the next 10 years,

Accordingly, when considering the payment of a “preferred return,” it may be a good idea to leave over some amount of cash that may or may not be there each year, adding a sense that the investor is not only getting a preferred return that is in the nature of a payment for capital.

To sum up, while the historic tax credit safe harbor does not apply to energy transactions, it’s likely worth reviewing a renewable transaction under its rubric to have a higher level of confidence that the IRS will respect the deal’s structure and the fees and arrangements for paying or distributing the available cash.

Forrest David Milder is a partner with Nixon Peabody LLP. He has more than 30 years’ experience in tax-advantaged investments including the tax credits that apply to affordable housing, energy, new markets and historic rehabilitation, as well as the tax treatment of partnerships and LLCs, tax-exempt organizations, and structured financial products. He can be reached (617) 345-1055 or [email protected].