Improving tax incentives for wind energy production: the case for a refundable production tax credit.

• Author: Layser, Michelle D.
• Position: III. Legal Uncertainty Surrounding Wind Tax Equity Investment Financing B. Uncertainty About Enforcement After Historic Boardwalk through V. Conclusion, with footnotes, p. 484-517

2. Uncertainty About Enforcement After Historic Boardwalk

   The second area of legal uncertainty--uncertainty about IRS enforcement following a 2012 U.S. Court of Appeals for the Third Circuit ruling and subsequent agency guidance--has received little attention in academic literature and will therefore be the focus here. In Historic Boardwalk Hall, LLC v. Commissioner, the Third Circuit applied a substance-over-form analysis to deny a tax equity investor the benefit of rehabilitation tax credits, reasoning that the parties had failed to form a real partnership but had instead engaged in a prohibited sale of the tax credits. (187) In reaching this conclusion, the court relied on a facts-and-circumstances test, which was first articulated in the Supreme Court's case Commissioner v. Culbertson (188) and more recently applied by the U.S. Court of Appeals for the Second Circuit in the TIFD III-E, Inc. v. United States (189) ("Castle Harbour") line of cases and the U.S. Court of Appeals for the Fourth Circuit in Virginia Historic Tax Credit Fund 2001 LP v. Commissioner. (190)

   In late 2014, the IRS released its own guidance in response to Historic Boardwalk, creating a safe harbor for tax equity investment in rehabilitation tax credit deals. (191) The new IRS guidance differed in several respects from the earlier safe harbor guidance relied upon by wind energy tax equity investors. Though the scope of the new safe harbor is limited to tax equity investment in rehabilitation tax credits--and the earlier guidance continues to apply only to tax equity investment in the production tax credit by wind energy investors--the guidance drew close attention by tax practitioners and renewable energy industry observers who questioned whether it signaled a shift in the IRS's position on tax equity investment transactions. (192)

   Though it is hard to know how Historic Boardwalk may have affected the tax equity investment market in wind energy, the legal uncertainty introduced by the case would not inspire many new investors to enter the tax equity market. The remainder of this Part explains the tax treatment of wind tax equity investment transactions prior to Historic Boardwalk and then considers how Historic Boardwalk and the IRS's subsequent guidance may cast doubt on the future of tax equity transactions used to monetize the production tax credit.

   1. The Revenue Procedure 2007-65 Safe Harbor

      Historically, the tax equity investment structures used to monetize the production tax credit have presented the issue of whether the IRS will respect the parties' attempt to allocate the credits to tax equity investors. (193) Under Subchapter K of the Internal Revenue Code ("IRC"), partnership income, gain, loss, deductions, and credits are determined at the partnership level, but those tax items are allocated among the partners and reported on the partners' individual tax returns. (194) The IRS generally respects the allocations prescribed by the partnership agreement; (195) however, Section 704(b) authorizes the IRS to re-determine the allocations under certain circumstances, including cases when the proposed allocations lack substantial economic effect. (196)

      Substantial economic effect is a highly technical concept within the partnership tax code and regulations. A taxpayer can establish economic effect by meeting three regulatory requirements. (197) If these requirements are met and the allocation is reasonably likely to substantially affect the dollar amounts received from the partnership independent of tax consequences, then the allocation will be deemed to have substantial economic effect and no further analysis is necessary. (198) First, the partnership must maintain its capital accounts in compliance with the regulations. (199) Second, upon liquidation, distributions must be "made in accordance with the positive capital account balances." (200) Third, partners must be required to restore any capital account deficits upon liquidation. (201)

      The first of these requirements, the capital account requirement, is not met by the allocations of tax credits made in tax equity investment transactions. (202) Under the regulations, "Allocations of tax credits and tax credit recapture are not reflected by adjustments to the partners' capital accounts.... Thus, such allocations cannot have economic effect under [the capital account requirement]." (203) For this reason, the regulations explain, tax credits and tax credit recapture must be allocated in accordance with the partners' interests in the partnership as of the time the tax credit or credit recapture arises. (204) Section 704(b) authorizes the IRS to re-allocate partners' distributive shares of income, gain, loss, deductions, or credits in cases when the partners' allocations would otherwise lack "substantial economic effect." (205)

      The partners' "interests in the partnership" refers to how the partners have agreed to share the economic benefit or burden corresponding to the income, gain, loss, deduction, or credit that is allocated. (206) Among the factors to be considered to determine the partners' interests in the partnership are the partners' relative contributions to the partnership, their relative interest in economic profits and losses which may differ from taxable income or loss, and their relative interests in cash flow and other non-liquidating distributions. (207) In a tax equity transaction with allocations that are disproportionate to the parties' contributions and right to cash distributions, there is a risk that the IRS will adjust those allocations.

      Prior to 2007, tax equity investors would ask tax counsel to provide "should" opinions that concluded that the allocations made under the tax equity investment structure should be respected by tax authorities. (208) Until 2006, tax advisors could also seek further assurance from the IRS by seeking a private letter ruling stating that the proposed allocations would be respected, (209) but the IRS stopped issuing private letter rulings on any partnership tax issues for partnerships claiming credits under I.R.C. [section] 45 in 2006. (210) As a result, despite the willingness of some tax advisors to issue opinions on the matter, some degree of uncertainty remained as to whether the tax equity investment structures employed by wind developers would survive an IRS challenge.

      The IRS provided some comfort to the wind industry, however, with the issuance of Rev. Proc. 2007-65, which announced that the IRS would not challenge the substantial economic effect of tax equity investment structures used to monetize wind energy production tax credits as long as the taxpayers structure the transactions according to its guidelines. The safe harbor, which is specific to wind energy tax equity investment deals, "establishe[d] the requirements (the Safe Harbor) under which the [IRS] will respect the allocation of [section] 45 wind energy production tax credits by partnerships in accordance with [section] 704(b)." (211)

      The safe harbor goes a step further, however, stating: "The [IRS] generally will closely scrutinize a Project Company as a partnership or Investors as partners if a Project Company's partnership agreement does not satisfy each requirement of this revenue procedure." (212) In other words, if a tax equity investor fails to comply with the revenue procedure, the IRS may not only exercise its authority to re-allocate the production tax credits, but it may also disregard the partnership structure entirely--the result that was later seen in Historic Boardwalk.

      The question remains, however, as to under what circumstance the IRS may disregard a partnership on the basis of the substance-over-form doctrine in a transaction that does comply with the safe harbor. While it is tempting to conclude that the safe harbor forecloses the possibility, this is not necessarily the case. The safe harbor promises the IRS will not challenge compliant transactions on the basis of IRC [section] 704(b), but it makes no promises as to the substance-over-form doctrine. For this reason, it would be a mistake to disregard the Historic Boardwalk decision and related agency guidance.

   2. Historic Boardwalk and Substance Over Form

      Historic Boardwalk arose after the IRS recharacterized a tax-equity investment transaction used to monetize rehabilitation tax credits as an impermissible sale of tax credits, thereby denying the tax benefits. Like the production tax credit, the rehabilitation tax credit can only be claimed by a taxpayer who owns equity in the property generating the credit. Under the facts in Historic Boardwalk, the New Jersey Sports and Exposition Authority ("NJSEA") had engaged in certain rehabilitation activities expected to generate the rehabilitation tax credit. As a state agency, NJSEA was a tax-exempt entity that was unable to use the tax credits directly. (213) For this reason, NJSEA entered into an agreement with a third-party investor with substantial federal income tax liability, under which the investor agreed to make capital contributions to an LLC named HBH in exchange for certain tax benefits, including the rehabilitation tax credit. (214)

      Through the operating agreement, the tax equity investor agreed to make an initial contribution, followed by three additional contributions that were contingent upon completion of certain project-related events, including confirmation of the amount of rehabilitation costs that would qualify for the credit. (215) The tax equity investor was entitled to cash distributions for the following purposes: repayment of an "investor loan" it extended to the partnership; a three percent preferred return from any cash flow available after the loan payment to offset any tax owed on income allocations; and the balance of any remaining cash after certain distributions were made to NJSEA. (216)

      In addition, the parties entered into several option agreements and a tax benefits guaranty that protected the tax...