2015 NMTC Allocation Round

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Significant New CDFI Restrictions Are Imposed

The Community Development Financial Institution Fund (CDFI), which provides credit and financial services to underserved populations and oversees the distribution of New Markets Tax Credits, made a number of changes for the 2015 application round, the most significant being the imposition of restriction on the use of Qualified Low Income Community Investments (QLICI) proceeds. The initial concern voiced by the IRS and Treasury was the use of related party leverage loan and short term bridge financing. To address their concerns, IRS and Treasury announced that they had opened a guidance project to address perceived “abuses” in the structuring of New Markets Tax Credit (“NMTC”) transactions. While it was initially thought that such guidance might be issued on an expedited basis, no guidance has been issued to date and the estimated issue date of the guidance has been deferred.

In response to the opening of the Treasury guidance project, the Novogradac NMTC Working Group and the New Markets Tax Credit Coalition circulated detailed examples and commentary for public review and submitted the resulting product to IRS, Treasury and CDFI. (“IRS Submission”) The IRS Submission proposed restrictions on Qualified Active Low Income Community Business (QALICB) payments to related parties from QLICI proceeds as a way of limiting the size of leverage loans. The proposed restrictions included a three year window on reimbursed costs with reimbursed amounts to be limited to the greater of fair market value or cost for contributed assets and rights. To avoid the application of new rules which were inconsistent with prior practices to closed transactions, the proposal also suggested that CDFI address these concerns through the issuance of some new frequently asked questions (“FAQs”) applicable to the current application round.

Treasury, IRS and CDFI concerns regarding the appropriate use of leverage loans and short term bridge financing came to a focus with the publication of a series of newspaper articles which criticized a 2012 NMTC investment into the Great Northern Paper Mill in East Millinocket Maine (“Great Northern”). The Great Northern investment was structured to benefit from federal NMTCs and a recently enacted Maine New Markets Capital Investment Credits (the Maine Credits). Two different community development entities provided a combined federal NMTC allocation authority of $40,000,000. A one-day loan was used to provide the sponsor with the funds needed to make a leverage loan and QLICI proceeds were allegedly used to overpay the sponsor for the QALICB’s acquisition of the mill’s paper machines and equipment. Almost a year after the investment was made, Great Northern closed its doors, the owners filed for bankruptcy protection, and the jobs preserved by the NMTC program vanished. The controversy surrounding the Great Northern transaction and the desire to be able to advise congressional staff and other interested parties that CDFI had “resolved” the Great Northern issue encouraged CDFI to limit the ability to use short term bridge financing and to restrict the use of QLICI proceeds.

In the absence of IRS guidance and after considering a number of options to address the leverage loan/use of proceeds concern, CDFI included new FAQs 42, 43 and 44, which, consistent with the IRS Submission, are effective for transactions closed under the 2015 allocation round, as part of the 2015 application package materials. The effect of the new FAQs is to reduce the cash available to fund related party leverage loans.

Pursuant to FAQ 42, a QALICB may reimburse a related party from QLICI proceeds only for expenses or capital costs incurred within 24 months of the closing of the NMTC transaction or, in the alternative, up to 5% of the amount of the QLICI proceeds received by the QALICB. Since NMTC transactions may take a number of months to close, the effective reimbursement period may be substantially shorter than 24 months.

FAQ 43 requires that CDEs enforce the requirements of FAQ 42 through use of covenants in their investment documents and must have the documentation available for review by CDFI, as well as documentation supporting that QALICB disbursements are made in compliance with FAQ 42 requirements. Pursuant to question 13(a) in the 2015 Application, all CDEs applying for allocation of NMTC authority MUST agree to enforce compliance with FAQ 42.

FAQ 44, which must be read in conjunction with FAQ 42, provides that a QALICB may not “monetize an asset” transferred to the QALICB from an affiliate of the QALICB. It is not clear exactly what “monetize an asset” means, but until further defined, prudence dictates that FAQ 44 should be broadly interpreted. That means that QALICBs should neither purchase assets from, nor reimburse, an affiliate for the cost of an asset acquired before the 24 month window described in FAQ 42.

“Monetization” can be viewed as a proxy for transfers of cash outside the confines of the QALICB’s business. In other words, the subsidy provided by the NMTC program should stay in the business and should not be diverted into the sponsor’s pocket in a “cash out” transaction.

The result of FAQ 42, 43 and 44 is that the amount of the cash that may be removed from a QALICB and used to repay short term bridge financing has been significantly reduced. These restrictions may fall most heavily on two types of potential QALICBs: first, non-profits that do not have sufficient available cash to fully fund a leverage loan and, second, cash-strapped operating businesses that need to refinance high interest debt. We should note that these new rules are NOT applicable to transactions closed from prior round allocations.

We believe, consistent with the revised FAQs that were issued by CDFI shortly after the initial issuance of FAQs 42, 43 and 44, that transactions currently being closed and that may fall outside FAQ 42, 43 and 44 should not be negatively scored in the application process. CDEs should, however, avoid abusive transactions where fees, reimbursements or the purchase price of assets exceed fair market value. Given the difficulty of finding lenders willing to make leverage loans, and the harsh terms frequently required by such lenders, FAQs 42, 43 and 44 will change the selection of QALICBs which are funded in whole, or in part, from the CY2015 round and make it more difficult for cash poor non-profits and start-up businesses to secure NMTC financing.

Jerry Breed focuses his practice on tax planning and the structuring of low-income housing tax credit, historic rehabilitation tax credit, new markets tax credit and renewable energy transactions. Mr. Breed has closed many low-income housing, historic rehabilitation, new markets tax credit and renewable energy transactions that permit his clients to maximize tax benefits and investment returns, all within the framework of the client's business goals. He has substantial experience in the taxation of community development and new markets credit investments. Mr. Breed also has represented clients with respect to audits of tax credit investments. Clients of Mr. Breed include syndicators and investors in low-income housing, historic rehabilitation, new markets tax credit and renewable energy transactions as well as developers of these credit projects. In the New Markets Tax Credits area, Mr. Breed represents the owners of qualified active low-income community businesses and community development entities. Mr. Breed also represents state housing authorities that allocate low-income housing tax credits. Frequently, these federal credits include state credits and other federal, state and local subsidies. Mr. Breed has given presentations at numerous seminars and conferences on the low-income housing, historic rehabilitation, new markets tax credits and renewable energy credits including presentations on partnership taxation, and real estate tax issues. He also is author of a number of articles on tax credits and other federal income tax matters.