History and the Hill: Can Effective-Yield Accounting Boost Investor Interest in the HTC?
Any tax credit syndicator interested in economic survival during the great recession has been working overtime to identify new investors. Speaking from personal experience, nothing is more frustrating than trying to convince a company CFO to try something new when revenue is down and cash is tight. Arranging the first phone conversation isn’t so hard. But getting past that first phone call to a face-to-face meeting without the help of a powerful door opener can be a daunting task. I have found that having 20 of these conversations going at once is essential because 19 of 20 conversations will go nowhere. Getting to a “no” can often take months. Getting to a “yes” can take a year or more.
New Investor Tax Credit Appetite
So what’s behind this investor reticence, aside from the normal human tendency to duck and cover when the economic future is so hard to read? Discussions with potential new investors that are not derailed by a prospective investor’s concerns about lack of taxable income or its inability to use the capital losses generated by the write-off of 90 to 95 percent of its capital account upon exit often focus on the historic tax credit’s negative impact on the company’s profit and loss statement (P&L).
Most investors must currently account for their tax credit investments using the equity method, which requires that the investor’s activities in tax credit partnerships be shown in its operating results. The equity method of accounting leads to the so-called “above the line” and “below the line” dual impacts of tax credit transactions. Losses from operations (including paper losses from depreciation) and the write-off of the investor’s capital account in anticipation of exercising the put option all have the above the line effect of reducing pre-tax profits. The below the line impact is, of course, the credit’s reduction of tax liability.
In the case of the historic tax credit, the recognition of the capital account write-off typically occurs the year the property is placed in service when the entire 20 percent credit is taken. The immediate impact on the P&L for low-income housing tax credits (LIHTCs) and new markets tax credits (NMTCs) is not as severe because those credits vest over 10 and seven years respectively and the capital account write-off can be taken on the P&L over the compliance period. So while the early vesting of the historic tax credit (HTC) simplifies tax planning in uncertain times, publicly traded companies that are typically judged by Wall Street on pre-tax earnings are very wary of the HTC’s especially harsh negative impacts on their P&L. The retreat from the HTC market by key financial institutions over the past two years can be largely traced to its early vesting characteristic and P&L impacts.
The Potential of Expanding Effective-Yield Accounting
Investors in guarantied-yield LIHTC funds can currently take advantage of Accounting Standards Codification 323-740, formerly issued as FASB EITF 94-1 - “Accounting for Tax Benefits Resulting from Investments in Affordable Housing Projects” - to achieve more favorable P&L treatment of operating and capital losses associated with affordable housing tax credit investments. This FASB rule provides LIHTC guarantied-yield fund investors with a method of avoiding the volatility in earnings from tax credit investments. It allows investors with an expected positive yield to recognize the benefit of the tax credits and the costs of the investment together in income taxes so that the effect on the investor’s financial statements is equal to the constant effective yield to the investor over the holding period.
“The key benefit of effective-yield accounting treatment is that the deductions and losses generated by federal income tax credit investments are recorded below the line as part of a company’s income tax expense,” explains Michael Novogradac, CPA, managing partner in Novogradac & Company’s San Francisco office. “The effective-yield accounting treatment appropriately nets income and expenses in the same place on a company’s income statement.”
Importance to the Historic Tax Credit Industry
It should not surprise the readers of History on the Hill that the impact of equity method accounting rules has a greater impact on investor appetite for the HTC than the LIHTC and NMTC. We know from the discussion of economic substance in May’s edition that the burden of showing a pre-tax investor motive falls most heavily on the HTC. The June edition reported that the HTC has the most to gain from a change in the IRS definition of CDE control (as it relates to the new NMTC related party test) because twinned HTC/NMTC investments typically provide more than 50 percent of a transaction’s equity.
The HTC industry has been at the table on the latter two issues. It needs to step up to table on potential expansion of effective-yield accounting as well. How easy will this be? Novogradac made the following assessment: “We are optimistic that this below the line treatment of deductions and losses can be expanded to a broader array of tax credit investments and investment structures. But, such an expansion will not be easy, and will not be quick.”