Adapting to Change Attorneys Modify Tax Credit Deal Opinions in Wake of Economic Substance Codification
By Caitlin Jones
5 min read
The enactment of the codification of economic substance doctrine generally shouldn’t hinder new transactions involving federal low-income housing, historic rehabilitation, new markets, or renewable energy tax credits, according to several prominent tax attorneys in the field.
They noted that they are modifying their tax opinions for new deals to address the newly enacted provision and to say that the economic substance test has been met. They said that they have already issued a number of standard “should” level tax opinions in recent weeks for new tax credit transactions that conclude that the codification of economic substance penalties are inapplicable.
Health care reconciliation legislation (H.R. 4872, Public Law 111-152) signed into law by President Obama contained a revenue-raising provision, effective March 30, to “codify” – that is, incorporate into the federal tax code – the economic substance doctrine, and to establish new 20% and 40% penalties for transactions that lack economic substance and are or aren’t disclosed, respectively.
Previously, the economic substance doctrine has been a federal tax rule developed and interpreted differently over the years in a series of court decisions. It provides that a taxpayer’s motivation for understanding a transaction can’t be to avoid federal taxes, but rather must have economic substance; that is the expectation or hope of a profit.
Three prominent tax attorneys who work on housing, historic, and new markets tax credit transactions – Jerome Breed, of Bryan Cave LLP; Forrest Milder, of Nixon Peabody LLP; and Anthony Freedman, of Holland & Knight LLP – said their firms are modifying their tax opinions for new tax credit deals to add language explaining and addressing the newly codified economic substance requirements. In essence, the opinions provide that the transaction at hand is consistent with the intended purpose (i.e. congressional intent) of the particular tax credit statute (e.g., LIHTC, HRTC); explains why the economic substance test is met; and says that the transaction therefore shouldn’t be subject to the new penalties.
Much of the basis for this position, and cited in the new opinions, is so-called Footnote 344, a footnote in the technical explanation of the economic substance codification provision in a congressional Joint Committee on Taxation document (JCX-18-10) explaining provisions in the health care bill. The footnote clarifies that if a transaction is consistent with congressional purposes the realization of the tax benefits generated is not intended to be disallowed. As examples, the footnote cites the federal low-income housing tax credit, historic rehabilitation tax credit, new markets tax credit, and Section 45/48 energy tax credits.
Footnote 344
If the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such tax benefits be disallowed. See, e.g., Treas. Reg. sec. 1.269-2, stating that characteristic of circumstances in which an amount otherwise constituting a deduction, credit, or other allowance is not available are those in which the effect of the deduction, credit, or other allowance would be to distort the liability of the particular taxpayer when the essential nature of the transaction or situation is examined in the light of the basic purpose or plan which the deduction, credit, or other allowance was designed by the Congress to effectuate. Thus, for example, it is not intended that a tax credit (e.g., section 42 (low-income housing credit), section 45 (production tax credit), section 45D (new markets tax credit), section 47 (rehabilitation credit), section 48 (energy credit), etc.) be disallowed 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.
Source: Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” As Amended, in Combination with the “Patient Protection and Affordable Care Act,” JCX-18-10, March 21, 2010, Joint Committee on Taxation.
“I think the vast majority of plain-vanilla, garden-variety low-income housing tax credit transactions, historic rehab transactions, and new markets transactions are not going to have any issues,” said Breed, who works on all three types of tax credit transactions.
“In the overwhelming proportion of situations, counsel is confident in the kinds of transactions they are doing, do not consider them to be overly aggressive, and therefore economic substance is met,” said Milder, who is also the current chair of the American Bar Association’s Forum on Affordable Housing & Community Development Law.
Noted Freedman: “The codification of the economic substance doctrine, because of the clarification, hasn’t done any damage in the field, which is really what I think most of us were looking for.” He added that there also shouldn’t be an issue for transactions with Section 1602 exchange funds but no housing credits.
LIHTC transactions have already had extra protection under federal tax rules, which provide that a profit motive is not required for LIHTC investments. Currently, most counsel are not opining that economic substance codification has sanctioned the extension of this profit motive exemption to other tax credits.
Milder noted that the prevailing view is that the tax law change doesn’t require a change in the typical structure of historic tax credit transactions, so that deals with common features such as a master lease pass-through structure or cash-on-cash return should still be fine and respected.
Still, Milder and Breed suggested that there may be some tax credit transactions with aggressive features that could make it difficult for a tax attorney to issue a standard tax opinion.
Breed advised developers and owners, for new tax credit deals, to “talk to their tax advisors about the transaction, and raise a question, “˜Look, do we have any issues here on codification of economic substance?’”
