Historic Boardwalk Hall: What Does It Mean to the Tax Credit Industry?
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Historic Boardwalk Hall: What Does It Mean to the Tax Credit Industry?

It’s been a little more than a month since the Court of Appeals for the Third Circuit (Third Circuit) reversed the Tax Court’s favorable Historic Boardwalk Hall (HBH) decision, leaving the historic tax credit industry wondering, “What now?”

The facts of the case are as follows:

  1. The convention authority in New Jersey embarked on a $90 million rehabilitation of HBH, home of the Miss America pageant. After it had assurances that the project was fully funded, it decided to structure the transaction so that the rehabilitation would generate a 20 percent federal historic tax credit, allowing them to raise another $15 to $20 million that could fund a large development fee payable to the convention authority.
  2. Pitney Bowes (PB) was admitted to a partnership as the tax credit investor. As the project was completed, the partnership claimed federal historic tax credits and allocated 99.9 percent of such credits to PB. The partnership agreement also entitled PB to receive a 3 percent priority cash return.  PB was also the beneficiary of several guarantees that limited any downside for the firm.
  3. Upon audit, the IRS disallowed the allocation of the tax credits to PB, and the dispute went to Tax Court. In January 2011, the Tax Court held in favor of HBH, allowing PB to receive the allocation of historic tax credits from the partnership after concluding that PB should be respected as a partner, since they had a legitimate business purpose of restoring HBH.
  4. On August 27, the Third Circuit reversed this decision, ruling that PB was not a partner in the rehabilitation project for tax purposes because they did not have a realistic possibility of upside potential or downside risk.
  5. The Third Circuit maintains that the historic rehabilitation tax credit was not under debate, emphasizing that the ruling was based on what it deemed the “prohibited sale of credits.” Still, this leaves many developers and investors looking to structure historic tax credit transactions in an awkward position: how does this case affect transactions going forward?

We do not anticipate formal guidance to be forthcoming anytime soon. However, we do have a few recommendations to help developers and investors avoid a similar situation.

Be Careful What You Communicate.

Federal tax credits can be allocated to a partner, but never sold. When the New Jersey convention authority sent out its RFPs to seek a historic tax credit investor, the term “sale of credits” was included in the title of the document. Although such loose terminology might help people understand the result of the transaction, the parties to the transaction should never refer to the transaction as a “sale of tax credits.” The lesson here is simple: be careful what and how you communicate.

Ensure Financial Projections are Supportable.

As accountants, we often help our clients develop financial projections that demonstrate the expected results of a transaction.  Such projections have many uses, including the fact that they provide support that the transaction has economic substance (e.g., that the investor expects to make a profit). In the HBH transaction, the initial projections reported significant expected losses, but subsequent projections were revised to demonstrate that the project would be profitable. In the end, the Third Circuit held that such projections were based on unrealistic and unsupportable assumptions.

In the aftermath of HBH, it’s more important than ever to make sure that the underlying assumptions reflected in the financial projections are supportable, as such projections are more likely to be scrutinized and challenged (with the benefit of hindsight) if the transaction is audited by the Internal Revenue Service.  A third-party market study or an appraisal is a best practice to support operating cash flow projections; even if the actual numbers come out markedly different than the projections, having contemporaneous third-party support for the assumptions reflected in the projections could make all the difference.

Ensure There Is Upside/Downside Potential.

In a true partnership, the partners have both upside and downside potential. In the HBH transaction, PB’s economics were designed with limited variability. The parties used option agreements and guarantees to limit the variability of PB’s potential profit and loss from the transaction.  As a result, PB was basically assured of receiving the historic tax credits (or a cash equivalent) plus a 3 percent return on the cash it contributed — no more, no less — regardless of the success or failure of the partnership’s activities. There was no realistic scenario in which PB would gain additional profits or stood to lose any of its investment.  As a result, the Third Circuit applied the substance-over-form doctrine to conclude that PB was not a partner and that their role in the transaction was more like a lender or a purchaser of an asset (i.e., tax credits) due to the limited variability of their expected return. 

It’s interesting to note that the Third Circuit assumed, without deciding, that the transaction had economic substance, since such issue became irrelevant in determining if PB was entitled to claim the historic tax credits after they concluded that PB was not a partner.  Consequently, the Court did not need to opine on the parties’ dispute as to whether historic tax credits can be considered in determining whether a transaction has economic substance. 

To avoid a result similar to the HBH case, it’s important to structure tax credit syndication transactions so that the tax credit investor has potential for both upside and downside and that their returns are at least partially dependent upon the success or failure of the partnership’s activities.  One way to do this would be for an investor to contribute funds earlier in the construction process—before the credits are available to be claimed.  Based on the facts in the HBH case, it appears that PB made its capital contributions after the credits were already earned.  Consequently, such contributions weren’t subject to the construction risks inherent in the partnership’s activities.  Similarly, capital contributions that are deferred until the tax credit recapture risk has expired should also be avoided, since such contributions are not subject to risk. 

Do not use guaranteed contracts.

In addition, PB’s 3 percent priority return was guaranteed and such guaranty was backed by a guaranteed investment contract that the partnership had purchased with PB’s capital contributions.  Consequently, PB’s priority return was not dependent upon the success or failure of the partnership’s operating activities.  To the extent that a tax credit investor has a right to a priority return on its capital contributions, such return should be dependent upon the cash flows of the project.  Consequently, guaranteed investment contracts and reserves should generally not be used to ensure that the investor will receive its priority return. 

The projections should also demonstrate that the investor has the potential to receive cash flow in excess of its priority return, either from operations or sale proceeds.  The terms of subleases and fee agreements should be carefully structured so that they don’t substantially eliminate the investor’s potential to participate in the upside of the transaction. 

The Third Circuit also concluded that there were guarantees in place that went too far in protecting PB from any downside risk. Consequently, investors should consider limiting guarantees so that there’s a risk that the investor could lose part of its investment. We don’t expect to see limitations added to construction completion and environmental indemnification guarantees.  However, we expect to see limitations added to tax credit recapture/adjuster and operating deficit guarantees.  The nature of such limitations will vary from transaction to transaction.  \

Structure option agreements carefully.

Finally, option agreements should be carefully structured to ensure that they don’t effectively eliminate the upside and downside potential of the tax credit investor. In the HBH case, the Third Circuit’s decision was heavily influenced by the fact that the convention authority had an option to buy out PB’s interest in the partnership for an amount that was not dependent upon the fair market value of such interest.  Consequently, any option that the developer has to “call” the investor’s interest in a project should be structured so that the purchase price is equal to the fair market value of such interest at the time that the option is exercised.  Also, to the extent that the investor has an option to sell its interest in the project at an amount that’s not based on the fair market value of such interest, it’s important to make sure that the investor couldn’t be viewed as having an economic compulsion to exercise such option (i.e., if the option price is greater than the net present value of the investor’s projected share of future cash flows).

There’s No Magic Solution.

Every historic tax credit transaction is unique; there’s simply no one-size-fits-all solution to avoid a result similar to the HBH case. As discussed above, the key is to structure the transaction so that the investor has both upside potential and downside risk and to ensure that the assumptions underlying the financial projections can be supported. It’s also worth noting that investors could reduce the pricing of credits to the extent that they’re accepting greater risk that they could lose part of their investment and/or that they may not receive their full priority return.  For more information on the HBH case and what it means to the tax credit industry, contact Gordon Goldie at 248.375.7430, Rob Edwards at 517.336.7460, or Tim Frens at 847.628.8789.


A Conversation with John Leith-Tetrault


To dig a bit deeper into the HBH case, we sat down with our friend, John Leith-Tetrault, a pioneer in historic and new markets tax credit syndication. As president at the National Trust Community Investment Corporation and chair of the Historic Tax Credit Coalition, John’s take on the case is unique, as historic tax credits are part of everything he does. Here’s what he had to say about the case and its ramifications on the historic tax credit industry

What concerns you most in the aftermath of the HBH case?

The unwillingness of the appeals court to lay out a framework for what’s acceptable in terms of structuring state and federal historic tax credit transactions. They’re clear on the fact that they didn’t like the HBH structure but are reluctant to set general guidelines going forward. Decisions like this don’t help the industry; they create uncertainty and make developers and investors nervous. We’re actually in a position now where we know less about what’s acceptable than before the case was heard.

What effect do you think the HBH case will have on the historic tax credit industry?

Historic tax credits are a part of everything National Trust Community Investment Corporation does. We had six transactions caught in mid-closing by the HBH decision, and we’re seeing a lot of discussion among developers, investors, and attorneys regarding what may need to be modified regarding terms and conditions of the investment or the structure to ensure the deal is sufficiently differentiated from the facts in HBH.

We see a focus on three areas: is there a way to build in potential upside for the investor? Are there ways to reel in guarantees so there’s a reasonable sharing of risk between the investor and the developer? And how is the equity being paid in? (Is the investor taking sufficient risk  by putting in some percentage of equity at the construction closing?) We’re seeing adjustments made in these areas to most of the deals we’re closing, but the facts are different in every case.

How are members of the Historic Tax Credit Coalition reacting to the case?

The Coalition is considering drafting a potential revenue procedure for U.S. Treasury consideration that would address issues raised by both the HBH and Virginia Historic Tax Credit Funds Case. I can’t really discuss the details because it’s just too early. I will say that any request for guidance would go beyond the issues in these cases to create a safe harbor for future deals. Our focus would be on the federal credit versus the state credit. If any law firm or accountant wants to contribute to this initiative,  they can go to www.historiccredit.com and join the Coalition via our membership page. Our hope is that out of this adversity will come something positive.

Do you expect the IRS to increase its audit activity related to historic tax credit transactions as a result of the HBH decision?

So far, we haven’t seen anything. My hope is that some of the things we do in the short term to create industry best practices will render that a moot point.

In light of the HBH decision, how would you advise a nonprofit developer that’s considering using historic tax credits to help finance the rehabilitation of a historic resource? 

If I were executive director of a nonprofit, I’d Google the issue and read everything I could. Then I’d engage an attorney that’s at the center of this discussion (versus someone new to this area) for guidance. Ask what adjustments are being made now on deals that are closing. Finally, I’d have someone knowledgeable speak to my board about Boardwalk implications, so that if there’s a decision to apply for the historic tax credits, the board can make informed decisions early before it incurs expenses.

What is your perspective on how this case may affect the pricing for investors of historic tax credits?

We haven’t seen any pricing impact yet. None of our deals in closing has been affected. There’s some reason to believe that asking investors to take more risk may have an impact on the internal rate of return and pricing, but it’s too early to tell.

Are you hearing anything that would indicate that there are investors who will simply drop out of the market for new historic tax credit deals due to the perception of increased risk?

No. Those on the periphery of the historic tax credit market are more reticent; they’re less used to credit and how it works. But we haven’t heard anyone announce that they’re getting out of this line of business. In fact, some of the industry’s largest investors have said that they feel their approach pre-Boardwalk was conservative that they don’t expect to make many adjustments to their credit policies. The market in general has reacted relatively calmly. It was a jolt initially—our closing calls were cancelled two weeks in a row after the decision—but now we’re back and closing. We’re optimistic about the industry going forward.

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