What Are the Accounting Implications for Investors who Participate in the New Markets Tax Credit Incentive?
Although generally accepted accounting principles (GAAP) remain silent on the specifics of accounting for new markets tax credit (NMTC) investments and investments in qualified community development entities, principles and guidelines from various other authoritative literatures prove relevant and helpful to investors and their accountants in determining proper accounting treatment for such investments.
Accounting Standards Codification (ASC) 970, which contains much of the accounting guidance for investments in real estate ventures, is one of these authoritative sources that professionals in the NMTC world frequently cite as most relevant and helpful in analyzing NMTC investments through the GAAP lens. In particular, ASC 970 details the cost, equity, and consolidation methods of accounting for investments in real estate.
Questions and Answers
Q: Which method of accounting does an NMTC investor use to record their investment in subsidiary investees?
A: The decision of which method is correct for a particular investor depends on an assessment of the degree of influence the investor may exercise over its investee. The consolidated method is used when the investor has a controlling financial interest over the investee. Under the consolidated method, the investee’s entire financial position and activity is combined with like-categories of the investor. Intercompany activity and balances are eliminated and the noncontrolling interest portion is removed from the equity section of the investor’s balance sheet.
If the investor does not have a controlling financial interest but can still exercise significant influence, the equity method is likely most appropriate to account for the investor’s investment. Under the equity method, the investor generally records its initial cash investment at cost and periodically recognizes its share of the investee’s earnings or losses in its income statement. The earnings or losses result in adjustments to the carrying value of the investment asset on the investor’s balance sheet.
In the event that the investor holds neither a controlling financial interest nor significant influence over the investee, the cost method is the appropriate method to use. Under the cost method, the initial investment is recorded at cost and subsequent dividends or cash distributions are recognized as income to the investor.
Investors in qualified affordable housing projects are afforded one additional method of accounting for their investment, the proportional method. We discuss the relevance of this method to NMTC investors in greater detail later in this article.
Q: How do NMTC investors account for their receipt of NMTC?
A: Most professionals look to ASC 740-10 and its coverage of accounting for the investment tax credit (ITC) when determining appropriate accounting treatment to recognize receipt of the NMTC. ASC 740-10 presents two differing methods for accounting for the ITC. The deferral method applies the total amount of the ITC as either a contra asset against the initial cost of the underlying asset or investment or as a deferred income liability. This contra asset (or deferred income liability) is amortized into income over the productive life of the asset or investment. Conversely, the alternative method applies the ITC as a reduction of federal income taxes in the year which the ITC arises.
Q: What is a variable interest entity and how does that affect the accounting for NMTC investor’s investment in subsidiary investees?
A: There are times when the consolidation method must be used to account for investments in subsidiary entities even when the investor does not maintain a controlling interest through conventional voting rights. ASC 810-10 defines a variable interest entity (VIE) as a legal entity whose investors do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. If an investor is determined to be the “primary beneficiary” (with the power to direct the activities of the VIE most significantly impacting the VIE’s economic performance and as the party absorbing the greater portion of expected losses or returns) the investor is required to use the consolidation method to report their investment in the VIE.
Q: What potential issues does the current accounting treatment pose?
A: The determination of which accounting method is most appropriate for a particular investor to use in relation to a NMTC investee is often not a clear-cut decision. How the investee is structured for legal and liability purposes, the role the investee’s other members play in the investee’s operations, the nature of the investor as a general or limited partner and the respective sharing of profits, losses and residual benefit all play a role in the determination of whether the investor is truly exercising control, significant influence, or neither in relation to its investment in the investee.
In addition, GAAP treatment allows most qualified affordable housing projects the benefit of using an alternative method of accounting, the proportional amortization method, in place of the three traditional methods previously discussed. The main advantage afforded to an investor using the proportional method lies in the opportunity of the investor to amortize the initial cost of the investment over the period that tax credits are allocated to the investor. While petitions to the Financial Accounting Standards Board by NMTC stakeholders have been mighty, to date there have been no pronouncements indicating that the effective yield method and the proportional amortization methods can be appropriately used in relation to investments in anything but qualified affordable housing projects. Most practitioners and industry participants believe that updates to GAAP guidance allowing NMTC investors to use the proportional method of accounting would result in increased investor participation in the NMTC program and an unmistakable boost to tax credit pricing.