Tips For Tax Equity-Tax Credit Transfers That Pass IRS Muster

This article was published on August 14, 2024 with Law360.

By Ian Boccaccio and Michael Messina

The Internal Revenue Service has recently increased scrutiny around the economic substance of complex partnership structures.

Despite this renewed level of oversight, previous IRS guidance and case law provide a reliable road map to valid tax equity structures that have both economic substance and valid business purpose.

The Oct. 31, 2023, U.S. District Court for the District of Colorado's ruling in Liberty Global v. U.S., discussing the necessity of economic substance to validate a transaction, has created consternation around the viability of hybrid tax equity-tax credit transfer arrangements.

On April 30, the taxpayer filed an appeal in the U.S. Court of Appeals for the Tenth Circuit, but the lower court's interpretation and application of the economic substance doctrine codified in Internal Revenue Code Section 7701(o) provides a warning signal for structures that could be perceived as taking advantage of tax law with the sole intent of maximizing tax benefits, rather than having any legitimate business purpose.

The district court found that the taxpayer engaged in multiple steps to create earnings and profits within a foreign disregarded entity solely for the purpose of taking advantage of a deduction under Section 245A in order to offset what would have been $2.4 billion in taxable gains. The deduction was ultimately disallowed due to a violation of Section 7701(o).

Hybrid tax equity and transfer flip transactions come with various tax benefits, but can also satisfy the economic substance doctrine as well as the congressional intent associated with the tax legislation that these structures rely on. This article intends to shed light on the combinations of case law and revenue procedures that strengthen the validity of these unique structures.

Section 6418, enacted as part of the Inflation Reduction Act, allows renewable energy tax credits to be transferred to unrelated third parties. This creates a new wrinkle for traditional tax equity structures. The sponsor-developer sells the credit property at fair market value to the partnership entity before it's placed in service, and the partnership entity sells the tax credits on the open market.

The partnership entity must be respected for federal income tax purposes, as a sale to the partnership at fair market value potentially results in a step-up in the basis of the credit property, which yields an increase in the tax credit that can be sold.

The economic substance doctrine under Section 704(b)(2) is the main obstacle for tax equity structures. Otherwise, partnerships would be allowed to allocate tax attributes to partners pursuant to an underlying agreement.

Section 7701(o) statutorily clarified the doctrine by stating that a transaction is treated as having economic substance if:

1. The transaction changes the taxpayer's economic position in a meaningful way; and
2. The taxpayer has a substantial purpose, apart from the federal income tax effects, for entering into the transaction.

Taxpayers may rely on profit potential to achieve economic substance only when the present value of the expected pretax profit from the transaction is substantial in relation to the present value of the expected net tax benefits of the transaction.

However, the Joint Committee on Taxation's explanation of codified Section 7701(o) makes clear that it was not intended to disallow a tax credit "in a transaction pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage."

This is reflected in Liberty Global, where the district court held that Section 7701(o) applied to the taxpayer, as the tax result was violative of the congressional intent behind the statute at hand.

In Historic Boardwalk Hall LLC v. Commissioner, Pitney Bowes was denied Section 47 credits because the U.S. Court of Appeals for the Third Circuit found that the corporation was not a bona fide partner in a partnership that had economic substance.[²]

In 2009, the U.S. Tax Court had found that the partnership had economic substance, and granted Pitney Bowes its share of historic rehabilitation tax credits.

However, the Third Circuit overturned the Tax Court's decision when it found that Pitney Bowes lacked meaningful downside risks in the transaction overall, due to the timing of Pitney Bowes' investment in the partnership, and the guarantees made around the attainment and payout of the Section 47 credits.

Before the Historic Boardwalk decision, however, Revenue Procedure 2007-65 established safe harbor requirements respecting the allocation of Section 45 tax credits in accordance with Section 704(b).

While the Historic Boardwalk ruling relates to production tax credits, the requirements should be a guide for effectuating a valid tax equity partnership.

First, the investor's return should include credits and project cash flows. The sponsor and each investor must retain a minimum 1% and approximately 5% interest, respectively, in each material partnership distributive item.

Second, each investor must make a minimum unconditional investment in the partnership, equal to at least 20% of all fixed capital contributions, and the investor cannot be protected against the loss of any of that investment.

Finally, at least 75% of the sum of the investor's fixed capital contributions must not be contingent on the amount or certainty of payment.

Following its victory in Historic Boardwalk, the IRS released Revenue Procedure 2014-12, creating a safe harbor similar to Revenue Procedure 2007-65, but this time focusing on the allocation of Section 47 historic rehabilitation tax credits in accordance with Section 704(b).

More recently, the IRS released Revenue Procedure 2020-12, creating a similar safe harbor, but this time for Section 45Q carbon capture sequestration credits.

In this latest revenue ruling, the prescribed safe harbor once again sets forth minimum partnership interests for the sponsor and investor, as well as a minimum investment of 20% of the sum of the fixed capital investment plus any reasonably anticipated contingent investment required, to be made by the investor under the partnership agreement.

The 75% fixed and determinable obligations that are not contingent in the amount or certainty of payment outlined in Revenue Procedure 2007-65 are now reduced to 50% in Revenue Procedure 2020-12, demonstrating the evolution toward more flexible approaches. The IRS' track record illustrates consistency in what the agency views as a legitimate and valid tax equity structure.

The Inflation Reduction Act's transferability mechanism certainly adds a new layer of potential scrutiny; however, the careful structuring of a partnership in consideration of these IRS safe harbors may provide the necessary comfort to the sponsor and investor in the project that the partnership has economic substance and will be respected for federal income tax purposes.

Ian Boccaccio is principal and practice leader of income tax at Ryan. Michael Messina is director of international income tax at Ryan.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

¹ https://casetext.com/case/liberty-glob-v-commr-of-internal-revenue-11.

² Historic Boardwalk Hall, LLC Commissioner, 694 F.3d 425 (3d Cir. 2012).