NMTC: Can a Leverage Structure Alleviate Investors’ Concerns?

In December 2000, Congress established the New Markets Tax Credit (NMTC) program as part of the Community Renewal Tax Relief Act of 2000. It intended the program to attract $15 billion in private equity investment in low-income or distressed communities over a seven-year period. While the program has noble goals, it is fraught with risk for the investor. In comparing it to similar tax credit investment vehicles, potential investors raised concerns as to the risks associated with recapture, the complex compliance issues facing qualified entities and the uncertainty caused by the program’s newness. As a result, practitioners began to develop various structurings to apply the concepts of leveraging without violating the NMTC rules. On Jan. 23, 2003, the IRS issued Rev. Rul. 2003-20, which addresses a specific leverage structure.

Background

A detailed analysis of the NMTC program appeared in the June and July 2002 issues of The Tax Adviser; see Lederman, “Will the New Markets Tax Credit Stimulate Low-Income Communities? (Part I),” TTA, June 2002 (Part II), TTA, July 2002. To summarize, the program allows investors to take a 39% Federal tax credit over a seven-year period on the equity invested in qualified entities, known as community development entities (CDEs). The investor claims the credit at a 5% rate in years one through three and at 6% in years four through seven, on its original equity investment in the CDE. The CDE uses the equity proceeds to make qualified low-income community investments in the form of loans, equity investments or financial counseling and other services provided to low-income community businesses.

Program administration is the responsibility of the Community Development Financial Institutions Fund (CDFI), a branch of Treasury. In April 2001, the CDFI published initial guidance, and, in December 2001, the IRS issued temporary regulations to assist CDEs and investors; see Temp. Regs. Sec. 1.45D-1T. Each year, the CDFI specifies the amount of tax credits available and awards it through a competitive application process. In March 2003, it awarded the first round of tax credit allocations to 66 CDEs, for $2.5 billion of equity investment. It has combined the 2003 and 2004 allocations, which total $3.5 billion. Applications for this round are likely due in fall 2003; the CDFI will most likely announce the awards in spring 2004.

Investment Risks

Although the NMTC incentive was supposed to attract investment into low-income communities (similar to the established low-income housing tax credit program), the NMTC’s process and rules make it different and complicated. For example, investors would be subject to full recapture during the entire seven-year credit allocation period if a recapture event occurs. They would also incur a nondeductible interest penalty (at the underpayment rate) on previously used recaptured credits, even though events that could trigger recapture would likely result from the CDE’s actions.

In comparison to the low-income housing credit and other historic tax credit programs, the NMTC program provides a much smaller subsidy (5%– 6% annual return). The main reason for the difference is that these other programs allow taxpayers to leverage their investment with the debt of the underlying business or project, thereby increasing the return on equity, such that the tax credit becomes the only source of return the investor requires. In the NMTC program, credits are available only on the equity that taxpayers invest in the CDE; thus, the investors will likely require an additional economic return besides the credits, as well as a substantial return of capital at the end of the investment period.

This problem is exacerbated by the increased recapture risk outside of the investor’s control. As a result, investors will need not only a greater return, but will have to be comfortable with the CDE’s management and operations, to protect their tax credits from recapture. They will also have to be equally concerned about the viability of the underlying low-income community investments generating the cashflow and ultimate return of capital.

Rev. Rul. 2003-20

In this ruling, the IRS specifically addressed a leverage structure. An intermediary entity was set up between the NMTC investor and the CDE. The entity was established as a limited liability company (LLC), classified as a partnership for Federal tax purposes. It received the NMTC investor’s equity contribution and borrowed additional funds from a third-party lender on a nonrecourse basis. Its debt would be secured by its equity interest in the CDE. All of the LLC’s funding (debt and equity) was contributed to the CDE as equity. The CDE would pass the credits to the LLC (its qualified equity investor), which, as a flow-through entity, would pass the entire tax credit up the chain to its equity investor (the NMTC investor).

In Rev. Rul. 2003-20, the Service approved the use of this type of arrangement, by permitting the LLC to invest cash from a nonrecourse loan in the CDE as a qualified equity investment.

Implications

Although the ruling provides an outline for a leverage structure, the industry is still working out the practical and legal implications of these transactions. For example, because the loan proceeds from the nonrecourse lender are required to be invested in the CDE as equity, it is unclear whether the lender can take a direct collateral position in the underlying assets of the low-income community business or project. In the ruling, the debt was secured only by the LLC’s investment in the CDE. Lenders may be unwilling to accept only a security interest, as they would not be in a priority position as to the assets supporting the CDE’s underlying loans to low-income community businesses. If the lender could assume management of the CDE, it could indirectly provide some level of security in the underlying assets in the event of a default.

The situation would be further complicated if the CDE received equity from multiple sources and invested in several different projects. Because of the potential problems resulting from the commingling of funds at the CDE level, it is likely that, for each investment made by the CDE, a separate subsidiary CDE and LLC will need to be established to provide adequate protection for the lender.

Further, several problems might arise if, on default, the lender steps into the CDE’s shoes to take possession and liquidate the assets. For example, if the lender uses the liquidation proceeds to repay its loan (originally made to the LLC), this might trigger recapture for the NMTC investor, because a redemption of an equity investor is a recapture-triggering event. Presumably, a reduction in the original capital invested in the CDE would be deemed a partial redemption.

Another practical consideration of the leverage model stems from requiring qualified equity investments to be maintained for seven years. Because the loan proceeds ultimately become a qualified equity investment in the CDE, the lender will not receive principal payments on the underlying loan for seven years. This may require the lender to become comfortable with nonconventional financing terms, such as interest-only payments for seven years. If the CDE makes a loan to a qualified low-income community business that provides for principal repayments within the seven years, the CDE must reinvest these in other qualified low-income community investments by the end of the following tax year to avoid recapture. The lender will then have the additional burden of due diligence and monitoring these smaller principal amounts invested each year in new projects.

In addition to the numerous complicated lending issues in the leverage model, there are additional tax issues for the NMTC investor. Under the temporary regulations, a taxpayer’s basis in his or her investment is reduced dollar-for-dollar by the tax credits claimed. In the leverage model, the tax credits claimed over the seven-year period will likely exceed the taxpayer’s basis. Taxpayers subject to the Sec. 465 at-risk rules, may find their tax credits suspended or unavailable. Generally, individuals and closely held corporations are subject to the at-risk rules and may only be able to use the credits to the extent of their cash investment. The nonrecourse debt provided by the lender in the leverage model will generally not be deemed at-risk to these NMTC investors (although, in the leverage situation, it might be possible to increase the credit amount to 100% of the equity). It is unclear how the at-risk rules will apply to the NMTC and at what level.

Another problem is the passive activity rules, which apply to certain taxpayers and may further limit their ability to use the credit. If the CDE is deemed to be a trade or business, the activity will be subject to the passive activity rules. If the investor is passive in that activity, the NMTC might only be used to offset income generated from passive activities, until the year of disposition. Thus, investors need to consider the ramifications of these limits in calculating their overall return. Based on these and other tax issues (including alternative minimum tax limits), it is likely that the pool of qualified investors will consist primarily of widely held corporations, rather than individuals.

Conclusion

Rev. Rul. 2003-20 is a start in addressing some of the concerns in structuring an NMTC transaction. However, its facts are relatively simple and do not address many of the additional issues that may arise.

The NMTC compliance provisions are fairly complicated; their practical application is still uncertain. The legal and tax structures are new and untested. As the program develops, many of these complexities and uncertainties will be worked out; industry standards will begin to evolve. Despite the complicated legal, tax and compliance issues, the NMTC program has already experienced overwhelming demand. The first round of allocations was oversubscribed tenfold. The CDFI decided to combine the 2003 and 2004 allocation amounts, making tax credits for $3.5 billion of equity available. If this demand continues and the NMTC program proves successful in revitalizing low-income communities, industry experts believe Congress will extend the program beyond the initial seven-year period.

From Annette L. Stevenson, CPA, Cohen & Company, Ltd., Cleveland, OH