Drafted three days after the Third Circuit’s decision in Historic Boardwalk Hall LLC v. Commissioner, No. 11-1832 (3d Cir. 2012), but only recently released, Field Attorney Advice 20124002F describes the IRS’s position in a historic rehabilitation partnership analogous to the type of situation that was the subject of HBH. This internal memorandum is relevant to renewable energy transactions as the transaction structures used to monetize historic rehabilitation credits are nearly identical to those used to monetize investment tax credits available for Section 48 energy property.
The facts set forth in the internal memorandum nearly mirror those included in HBH. The memo describes a partnership between an investment fund (the “Fund”) and a sponsor (the “Sponsor”) in which the Fund contributed $0.90 of each dollar in historic rehabilitation credits allocated to the Fund. If the credits were more or less than anticipated, the Fund’s remaining capital contributions would be adjusted accordingly. If the credits were recaptured, the Fund would be entitled to a refund, including interest, penalties, and expenses. The Fund was entitled to an annual priority return on its then paid-in capital and was provided protections in the event of foreclosure or bankruptcy. Put and call options on the interests in the partnership existed between the Fund and the Sponsor. The partnership provided certain other features benefiting the Fund but not the Sponsor.
In the memo, the IRS determined that the Fund was not a bona fide partner in the partnership because the Fund lacked any meaningful upside potential or downside risk. Using arguments nearly identical to the government’s brief to the Third Circuit in HBH, The IRS noted that the delivery of the bulk of the benefit to the Fund – the tax credits – was assured and that the Fund’s priority return on its capital contributions, protections against incurring any obligations beyond its capital contributions, and the guarantees provided in the transaction insulated the Fund from virtually all risk in the transaction. Further, the IRS determined that there was no upside potential beyond the priority return for the Fund, as the expected cash distribution waterfall and the put and call rights effectively limited upside for the Fund to an agreed upon rate of return on its capital contribution.
In addition to finding that the Fund was not a bona fide partner, the IRS also ruled that the partnership itself was a sham. The IRS determined that the parties did not intend to join together to share in the economic benefits and risks of renovating and operating the project, as evidenced by the Fund’s expectation not to face any risk on its investment and the Sponsor’s willingness to shield the Fund from all risk of loss associated with the renovation and operation of the project and the Sponsor’s retaining of the right to any long-term profits that may be generated from the project by virtue of its call option.
The IRS internal memorandum does little more than to translate the IRS’s appellate win in HBH into guidance for its audit teams. As such, the IRS’s positions as expressed in the memo are not particularly surprising. However, we note the following items of interest:
- The partnership in HBH had a governmental entity and a guaranteed investment contract that stood behind the option and guarantees. The partnership described in the internal memorandum provides weaker guarantees in that the come from non-governmental entities. This suggests that the IRS will view with suspicion any guarantee provided to an equity investor that is included in a tax credit transaction.
- The IRS argued that apart from the Ninth Circuit’s holding in Sacks v. Commissioner – which the IRS distinguished on the ground that the transaction at issue in Sacks otherwise had economic substance in terms of risk and reward – case law did not support the notion that a court may consider tax benefits in evaluating the economic substance of a transaction involving a purported partnership engaged in tax-favored activity.
- The memo does not address the economic substance doctrine as codified in Section 7701(o) of the Tax Code and whether this statutory provision changes the IRS’s analysis. We note that HBH involved taxable years predating the enactment of Section 7701(o).
- By referring to various case law precedent and the circuits in which such precedent is applicable, the memo suggests that the IRS will continue to pursue tax credit partnership transactions on a circuit-by-circuit basis, if necessary.
- The release of the memo underscores the need for the IRS to provide some meaningful guidance to distinguish between utilizing partnership vehicles to encourage investment and the impressible sale of tax credits.
Following the Third Circuit’s decision in HBH, participants in tax credit transactions began focusing more closely on providing more upside potential and downside risk to investors. As such, while the internal memorandum may implicate closed transactions, we expect it to have little impact on transactions closed following the HBH decision.