Revenue Procedure 2014-12 provides a safe harbor for historic tax credit (i.e., the Section 47 rehabilitation tax credit) partnership transactions. On January 8, the IRS issued a revised version of it that provides a clarification of two technical issues. The revised revenue procedure is available here and a redline comparison against the prior version is available here. The clarifying revisions are certainly welcome; however, the revised revenue procedure still suffers from all but one of the ambiguities discussed in prior blog posts available here and here.
The revenue procedure provides that a tax equity investor may have the benefit of a “put” option; provided, the option price is the fair market value of the tax equity investor’s interest as determined at the time of the exercise of the option. The original revenue procedure required that in determining the fair market value of the tax equity investor’s partnership interest that contracts between related parties were not to be considered. As discussed in the blog post here it was unclear as to how the tax equity investor’s interest in master tenant partnership structure (i.e., an inverted lease) was to be determined because in that structure the head lease is between related parties and is the source much of the economics for the tax equity investor. A diagram of the master tenant partnership structure is available here.
The IRS recognized this problem and revised the revenue procedure to permit consideration of related party contracts in the fair market value determination, so long as such contracts are on arm’s length terms and with economics consistent with arrangements in real estate development projects that do not qualify for historic tax credits.1
Second, the section of the revenue procedure that addresses the allocation of the tax credits was revised. This change is extremely technical. The revised provision provides that a master tenant’s partnership’s allocation to its partners of the inclusion of phantom income that results from the election to pass through the tax credit to the lessee2 (i.e., the master tenant) is not taken into account for purposes of determining whether or not the allocations meet the revenue procedure’s mandated compliance with Section 704(b) (i.e., the “substantial economic effect” rules) of the Internal Revenue Code.3 The IRS did not provide a rationale for this change.
The rationale for this change appears to be that the phantom income inclusion is intended to create revenue for the Treasury to offset a portion of the cost to the Treasury of the investment tax credit; it is a substitute for the investment tax credit rule’s standard reduction in the basis of the asset generating the credit; the phantom income inclusion is necessary because the lessee that claims the investment tax credit as a the result of the pass through election does not own the asset and accordingly does not have a basis to reduce. However, under Section 704(b), when income is allocated to a partner, the income allocation is supposed to result in a corresponding increase to the partner’s tax basis in its partnership interest (i.e., the partner’s “outside” tax basis). However, such an increase in outside basis would be inconsistent the objective of the phantom income being a revenue source for the Treasury and is unnecessary as the phantom income by its nature generates no cash to be distributed to the partners.4 The change to the revenue procedure appears to possibly be intended to preclude taxpayers from asserting that an increase to the partners’ outside tax bases from the phantom income (i.e., an unintended tax benefit) is mandated by the revenue procedure.
Many tax practitioners hope that light is shed on the other ambiguities in the revenue procedure when government lawyers speak about the revenue procedure at tax conference in the coming weeks.
1 § 4.06(3) (referencing § 4.02(2)(c)).
2 § 50(d)(5) (referencing old § 48(d)(5)). In a Section 47 tax credit transaction, the lessee’s income inclusion is recognized straight line over rehabilitated asset’s applicable depreciation recovery period (i.e., 39 years for nonresidential real property and 27.5 years for residential real property). The income inclusion in total is equal to the amount of the rehabilitation investment tax credit (i.e., pursuant to Section 47(a) 20 percent of eligible amounts for a certified historic building and ten percent for a building built before 1936 that is not certified as historic). This is in contrast to an energy investment tax credit transaction (e.g., a solar project). For energy investment tax credits, the inclusion period is five years (i.e., the depreciation recovery period for renewable energy assets eligible for the credit), and Congress generously required only 50 percent of the tax credit, which is 30 percent of eligible amounts, to be recognized as taxable income.
3 § 4.07.
4 William S. McKee, et al., Fed. Taxation of Partnerships and Partners, ¶11.02 at fn. 211.