What does a U.S. Supreme Court case on a historic building in New Jersey have to do with the solar investment tax credit (ITC)? Because the Historic Boardwalk Hall (HBH), like many renewable energy projects, involves a tax equity partnership, HBH's court case could very well have implications on the way tax accounting is treated in solar project deals.
On Jan. 17, 2013, the taxpayer filed a petition with the Supreme Court to have the HBH case reconsidered by the court. It remains to be seen whether the Supreme Court will even hear the case.
In the meantime, here is a brief history of this important case: On Aug. 27, 2012, the U.S. Court of Appeals in the Third Circuit issued its ruling on the case. As mentioned, this ruling impacts the renewable energy industry because it concerned one of the few federal ITCs and specifically involved a tax equity partnership.
The actual subject is a project involving the federal historic rehabilitation tax credit (the Section 47 credit), providing an incentive to rehabilitate older buildings. The federal energy credit under Section 48 of the Internal Revenue Code and the Section 47 credit are both considered ITCs. Therefore, some of the issues raised in the HBH case are similar in many tax accounting respects to those in solar energy projects.
The HBH case is believed by some tax practitioners to have implications for all transactions in which a developer and an investor share both economic and federal income tax benefits. However, not all tax equity deals are the same.
The HBH case began when the New Jersey Sports and Entertainment Authority (NJSEA) undertook a $90 million rehabilitation of HBH, a historic building in the state. Because NJSEA is a tax-exempt governmental entity, property it owns is generally not eligible for the ITC.
An outside advisor group recommended that if the facility were to be privately owned, the private owner (because it would not be tax-exempt) could claim the Section 47 historic-building ITC. This would ultimately raise another $15 million to $20 million, which could then fund a substantial development fee payable to NJSEA, essentially reducing NJSEA's investment. NJSEA agreed and the transaction proceeded.
The project was then restructured, ending up as a tax equity structure. Pitney Bowes (PB) was approached and later committed to be the tax equity partner. However, by the time the tax equity investment was closed and funded, PB's first investment occurred after approximately $50 million was incurred on the project.
PB invested in the tax equity partnership, which allocated 99.9% of the ITC to PB after placing the eligible property in service. The parties also agreed to a 3% annual priority cash return, in addition to guarantees of many tax benefits and cashflow to be provided to PB in the form of a guaranteed investment contract (GIC) that was in place before PB made its second capital contribution.
The Internal Revenue Service audited this structure and entirely disallowed the allocation of the tax credit to PB, contending, for the most part, that the transaction was a ‘sham’ expressly intended to improperly pass tax benefits to PB, and alleging that PB had no meaningful stake in HBH's success or failure – i.e., a lack of any ‘upside participation’ or ‘downside risk.’
According to the IRS, this meant that PB should not be treated as a partner for federal income tax purposes. Accordingly, if PB was not a partner, PB was not entitled to the expected allocation of any portion of the ITCs. The IRS did not question the amount of the reasonable developer fee, nor did the IRS question the eligible basis or qualified rehabilitation expenditures upon which the ITC is calculated.
The issue was strictly limited to the issues of whether the transaction was a ‘sham’ and whether PB was a partner.
The case next went to Tax Court, which ruled in early 2011 in favor of the taxpayer, overruling the IRS. The Tax Court confirmed the economic substance of the transaction, confirmed that PB was a partner for federal tax purposes and ruled that PB was entitled to its anticipated federal ITC allocation.
However, the IRS appealed this ruling, and it is this last ruling by the Third Circuit Court of Appeals that has just reversed the prior and favorable Tax Court's decision.
In doing so, the Court of Appeals focused on whether PB was a partner for tax purposes. Specifically, the court examined whether PB had any meaningful stake in the success or failure of the ITC-eligible project.
HBH v. solar projects
The HBH project was already in progress prior to the investor's commitment and was adequately funded before the developing authority decided to restructure the financing as an ITC project, with the investor's equity being used to simply pay for the GIC and the development fee. The project's success was therefore virtually insured, and in the court's view, this indicated little or no completion risk.
Some of the preliminary communications between the parties referred to a ‘sale’ of credits. Under federal rules, such tax credit may not literally be sold. The Appellate Court viewed this as an indication of the true intent of the parties.
PB's investment return was guaranteed by a combination of the NJSEA and a GIC backed by an insurance company – in the court's view, more indicia of little or no risk.
Most of PB's investments were to be made by PB only when it was clear that there was little risk the credit would not be obtained. Due to the combination of various debts and fees, and seeing what little cashflow the project generated, the court concluded that the tax equity investor had virtually no chance of realizing any upside in cashflow beyond its agreed-upon 3% annual preferred cash distribution.
In its brief to the Appellate Court, the taxpayer actually cited an old renewable energy case involving solar-powered water heaters.
In this case, the court had approved the transaction even though it was profitable only after taking into account congressionally enacted tax credits used for legitimate business purposes. The view of the Appeals Court was that Congress had purposely used tax incentives to redirect investors' investments, notwithstanding whether there was a pre-tax profit on the investment.
Questions to consider
Overall, the final ruling in HBH did not provide taxpayers and their advisors with any new bright-line rules or lists of factors to enable them to conclude that an investor is or is not a partner for purposes of ITC tax equity transactions.
However, the HBH ruling by the Court of Appeals does raise important questions to consider when attempting to assess the degree of risk/reward that an ITC tax equity investor must have in order to be considered a partner for federal income tax purposes.
Specifically, what kind of upside should be available to the investor? What risk-limiting features can be provided to the investor? How much should the investor make its initial investment in the venture? How early should the investor make its initial investment?
It is also important to note what the court did not say, and what it agreed with. In HBH, the court did in fact respect a fairly substantial multimillion-dollar developer fee. The court also respected the economic substance of the transaction, noting that it can exist even where substance over form issues also appear.
Plus, unlike a number of renewable energy projects, the HBH transaction was not a date-certain ‘partnership-flip’ structure, which presumably could be covered under the safe-harbor provisions of Revenue Procedure 2007-65.
Also, most renewable energy projects are distinct from the facts on HBH in that the tax equity investor typically participates in both upside and downside risks in the partnership, particularly in a five-year flip structure.
In other instances, the tax equity investor may be contributing as much as 20% of its committed capital during construction and any withdrawals are relatively small – thus addressing the court's requisite economic risk of concern.
HBH also had consent options that effectively functioned as a put option, while in the typical solar energy transaction, it remains generally agreed that calls at a fair market value at the time of exercise remain acceptable per the safe harbor provisions – important given that the IRS continues to be suspect of puts.
Finally, there was further risk reduction provided to PB by virtue of the GIC, as well as no overall cash-on-cash internal rate of return for the investor and no realistic opportunity for cashflow participation – features typically present in ITC tax equity finance and that give comfort on the tax issues.
The issues for the Appellate Court were strictly limited to the risk and reward required to be a partner – the economics, structure, tax accounting, basis calculation and developer fee were not questioned.
In the case of solar energy project flip transactions, the structuring safe harbors provided by Revenue Procedure 2007-65 still apply. Tax practitioners still look to the Sacks case for authority, and it remains true that good old-fashioned economics and assumption of risk can satisfy a multitude of federal income concerns.
Timothy Kemper is the national director of CohnReznick's renewable energy industry practice. He can be contacted at firstname.lastname@example.org.