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Washington Wire: Accounting for the Unique Nature of Tax Credit Investments

Published by Michael J. Novogradac on Wednesday, August 1, 2012

Journal cover August 2012   Download PDF

The need for a broad and varied investor base was one of many market tenets underscored by the Great Recession and the resulting market disruption. In the years since the start of the recession, affordable housing, community development, historic preservationand renewable energy professionals have sought support for various legislative improvements that would boost investor interest in the low-income housing tax credit (LIHTC), new markets tax credit (NMTC), historic tax credit (HTC) and renewable energy tax credits (RETCs). Regrettably, those enhancements have been largely stymied by perennial gridlock in Congress.

But despite the legislative logjam that will persist for at least the next several months, the tax credit community should not lose hope. A number of options to expand the investor base exist that don’t require federal tax legislation, including an effort to change accounting rules for tax credit investments. Proponents of this effort believe a new accounting method could promote transparency and increase the benefits of tax credit investments to both investors and other stakeholders.

The Federal Accounting Standards Board (FASB) is currently conducting a project on accounting for financial instruments that presents a terrific opportunity to make improvements to the accounting methods for tax credit investments. Accordingly, the Effective Yield Working Group, a group formed in 2010 to advocate for expanding the effective yield method, of which Novogradac & Company is a member, drafted a white paper that addresses issues related to the accounting methods that FASB currently required to be applied to tax credit investments. The group’s white paper, “Significant Changes Needed in Accounting for Affordable Housing and Other Tax Credit Investments,” also discusses potential accounting issues being considered in connection with the FASB’s current project, and the need for a new, more principles-based approach to accounting rules that reflects the unique nature of tax credit investments.

About the Current Methods
Generally, the equity method of accounting is required in accounting for limited partnership investments, except in certain circumstances when the less-desirable consolidated method of accounting is required or when the more desirable effective yield method is available. (Note: the effective yield method is only authorized for LIHTC investments). Limited partners that meet three criteria may elect to use the effective yield method in recording their LIHTC investment through a limited partnership investment. One of the criteria for using the effective yield method is that there is a positive rate of return from the tax credits. The other two criteria are that there is a creditworthy guarantor of the tax credits and the investor is a limited partner in the affordable housing project for both legal and tax purposes.

Under all three current accounting methods, tax credits are recorded as reduction of income tax expense. On a company’s financial statement that is often referred to as a “below the line” benefit, meaning it is recorded below the pre-tax operating income line. But, a key benefit to using the effective yield method is that the amount invested to purchase the tax credits is recorded as amortization expense, and the amortization expense is also recorded “below the line” as a component of income taxes. This compares to the equity and consolidated methods, where rental real estate losses, principally from depreciation and impairment expense, are recorded “above the line” or as a reduction of pre-tax income. This means that under the equity and consolidated methods, book losses are reflected “above the line” and income tax benefits are recorded “below the line.”

White Paper: Significant Changes Needed
The Effective Yield Working Group found that the increased use of equity investment structures has resulted in increased use of equity investments where the tax credit investor has little participation in the underlying operations of the investee. Moreover, the group determined that application of the equity method to tax credit investments distorts financial reporting of investment performance, which is confusing and potentially misleading to users of financial statements.

In fact, the paper states that none of the currently available methods of accounting other than the effective yield method report net investment performance as a single, understandable amount. As a result, the group found that many investors limit or altogether avoid tax credit investments in order to avoid what is perceived to be adverse pre-tax accounting impacts from a net accretive investment. As such, the group suggests that an entirely new method of accounting for tax credit investments is needed.

The Proposal
In its white paper, the Effective Yield Working Group urges FASB as part of its project on accounting for financial instruments to develop a new, principles-based accounting method that could be applied to all types of tax credit investments that share similar characteristics: the tax credit investment method. The group asserts that simply requiring all equity investments to be accounted for as financial instruments would ignore the unique nature and benefits of tax credit investments. Instead, the group recommends that qualifying investments should be accounted for as purchases of tax benefits or, at a minimum, suggests that the tax benefits should be treated as a tax-exempt component of pre-tax earnings.

Under the proposed method, a proportionate amount of the cost of the investment would be amortized against the related tax credits and reported as a component of the tax credit investor’s income tax provision. The group suggests the amount of investment amortization recognized as a cost in each reporting period would be calculated as a percentage of the original investment based on the portion of tax credits received during the reporting period in comparison to the total tax credits expected to be received. In other words, investment costs would be recognized on a pro rata basis with the tax credits actually received.

If a broad and varied investor base is vital to the continued success of programs such as the LIHTC, NMTC, HTC and RETC, then the tax credit community should give serious consideration to the proposal put forward by the Effective Yield Working Group. The FASB’s current project on accounting for financial instruments could provide a rare opportunity to improve the appeal and usefulness of these important programs without congressional involvement.

If you have thoughts about this proposal, or would like to join the effort in support of this change, please contact Bentley Stanton, a partner in Novogradac & Company’s Atlanta, Ga. office, at [email protected] or (678) 867-2333.  You can also download a copy of “Significant Changes Needed in Accounting for Affordable Housing and Other Tax Credit Investments.”

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