In a much anticipated decision, the Court of Appeals for the Third Circuit reversed the Tax Court and held that the tax credit investor in a historic rehabilitation project was not a bona fide partner for tax purposes, and therefore could not be allocated any of the federal historic tax credits generated by the project. The unanimous decision found that the investor, Pitney Bowes, was not a partner because it had no meaningful downside risk or any meaningful upside potential in the business conducted by the purported partnership. While no clear rules were established by the decision, tax credit industry participants can expect to see deal structures modified to:

  • Require the investor to bear more of the risk associated with the actual performance of the project by limiting some or all of the guarantees provided to the investor; and
  • Increase the level of participation by the investor in the non-tax returns generated by the project above any preferred cash return on its investment.

The business venture in question was the rehabilitation of the "East Hall" convention center located on the boardwalk in Atlantic City, New Jersey, which is famous for hosting the annual Miss America Pageant. Shortly before the New Jersey Sports and Exposition Authority ("NJSEA") began the estimated $90 million renovation, a tax credit consultant approached it with a plan to generate additional funds by forming a partnership that would be eligible for federal historic tax credits.

The partnership was ultimately formed and Pitney Bowes invested as a 99.90% partner, but not until nearly three of the four phases of the renovation were already complete. In addition to its 99.90% interest in residual cash flow and tax credits, the partnership agreement also provided Pitney Bowes with a 3% preferred cash return. Standard tax credit deal guarantees were also part of the transaction, including construction, operating deficit, environmental, and tax benefit guarantees. Moreover, Pitney Bowes' had a put option and NJSEA had two call options, with both the put and one of the call options being backstopped by a guaranteed investment contract.

Downside Risk

The court noted that while there may have been risk associated with the rehabilitation project, the relevant question was how the parties to the transaction agreed to divide such risk. Factors the court cited in concluding that Pitney Bowes' downside risk was effectively eliminated by the transaction documents included:

  • Pitney Bowes was not required to make an installment contribution until NJSEA had verified that renovations were completed that would generate enough historic tax credits to at least equal the aggregate investment made by Pitney Bowes;
  • The tax benefits guaranty, which covered any tax credits disallowed, penalties, interest and up to $75,000 in legal costs incurred, eliminated any risk that Pitney Bowes would not receive at least the cash equivalent of the bargained for tax credits;
  • The project was fully funded by various deep-pocketed government entities prior to Pitney Bowes agreeing to make its investment, thus eliminating any risk that the project would not be completed; and
  • The purchase price of the put and call options were effectively equal to Pitney Bowes' accrued and unpaid 3% preferred cash return, which was further enhanced by the guaranteed investment contract.

The court concluded the above factors showed that Pitney Bowes was assured of receiving the value of the historic tax credits and its preferred return regardless of the success or failure of the rehabilitation.

Upside Potential

Pitney Bowes' avoidance of downside risk was accompanied by a lack of any meaningful upside due to the following factors:

  • Pitney Bowes' 99.90% residual cash flow interest was illusory due to, among other reasons, the significant amount of priority debt payments in the cash flow waterfall, and the financial projections showed no residual cash would be available for distribution through 2042; and
  • The various options held by NJSEA effectively precluded Pitney Bowes' from sharing in any upside, as one option simply required NJSEA to pay Pitney Bowes the then present value of any yet-to-be realized projected tax benefits and cash distributions due to Pitney Bowes through the end of the five-year historic credit recapture period.

Dismissing the substantial due diligence efforts of Pitney Bowes in structuring the investment, the court stated that a partnership, "with all its tax credit gold," cannot be conjured from a zero-risk investment of the sort at issue in Historic Boardwalk Hall where the substance of the transaction is a sale of tax credits. The court concluded its opinion by recognizing Congress's policy goal of encouraging rehabilitation of historic buildings, and stressed that the holding was not an attack on the historic tax credit statute, but a challenge to the prohibited sale of such credits.

Although the structure and the underlying facts of the Historic Boardwalk Hall transaction were fairly aggressive, they were not atypical of the structures currently used in transactions involving low-income housing tax credits, energy credits, new markets tax credits and historic tax credits. Because of this, we expect the industry to closely review the impact and necessity of the various guarantees typically provided to tax credit investors, as well as the share of economics that tax credit investors should receive on their investment. The consequences of this decision on the tax credit industry will continue to unfold over the coming months and will be closely monitored by the Paul Hastings tax credit group.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.