The New Markets Tax Credit (NMTC) program was enacted by Congress as part of the Community Renewal Tax Relief Act of 2000. The program was enacted to spur investment in low-income communities, with the hope that jobs would be created and lives would be improved in such communities. The program has been funded with a $40 billion allocation from Congress through 2013 (which includes a billion dollar allocation in the Gulf Opportunity Zone).[i] The CDFI Fund has made 836 allocation awards. To date $31.1 billion in credits have been invested in low-income communities through FY 2012. The expectation is that the program will be renewed in 2014 for a minimum of 2 years, if not permanently.
In addition, a number of states have enacted similar programs, which are often “twinned” with the Federal program; although the states’ interest in applying credits are expanding, the programs differ among the states and often have stricter requirements than the Federal program.[ii]
The program provides an opportunity for investors to subsidize or provide “gap” financing for improvements to property or expanding businesses that are located in a qualified census tract. In return, investors receive a 39% tax credit over 7 years provided the parties involved comply with the statutory provisions of the program outlined in Internal Revenue Code Section 45D. Investors, typically large financial institutions, such as banks, also have the opportunity to leverage their investment, which may provide a return in excess of 9 to 10 percent after tax.
NMTC projects have been used to provide financing to a number of projects around the country. Examples of project types include food processing facilities, a food bank, manufacturing facilities, and a biomedical office park. The University of Arizona’s medical school received $25 million in NMTC allocation and was a key element to the city’s strategy for revitalizing downtown Phoenix. The project led directly to permanent and construction jobs, as well as spurring follow-on investment.
Another example of a successful project was the financing of a charter high school in a major metropolitan area by which the equity investment was leveraged with a substantial loan by a third-party to provide needed financing for the project. The investor received tax credits in excess of its out-of-pocket cash investment, and the project received much needed financing. Similarly, a 105-unit affordable housing and ground floor retail space project utilized an innovative structure that allowed the project to utilize tax incentives offered by local housing agencies. This illustrates the opportunity to seek additional sources of incentive to aid in seeking investment.
II. Parties Involved
Before describing the mechanics of the NMTC Program and how an investment works, a brief description of the various parties involved will be provided.
A. Community Development Financial Institutions Fund (CDFI Fund)
The Treasury Department administers the NMTC program through the Community Development Financial Institutions Fund (CDFI Fund). The CDFI Fund was established by the Riegle Community Development and Regulatory Improvement Act of 1994 as a bipartisan initiative. The Fund’s purpose is to, “promot[e] economic revitalization and community development through investment in and assistance to community development financial institutions.”[iii] The NMTC program is but one of the programs the CDFI Fund administers to accomplish its objectives.[iv] The CDFI Fund is responsible for determining how NMTCs authorized by Congress will be allocated to community development entities.
B. Community Development Entity (CDE)
A qualified community development entity (CDE) is any domestic corporation or partnership whose primary mission is to serve or provide investment capital to low-income communities or persons, that maintains accountability to low-income communities through their representation on any governing or advisory board of the entity, and that has been certified by the CDFI Fund as a CDE.[v] CDE certification is perpetual for the life of the entity unless revoked or terminated by the CDFI Fund. A CDE is nonetheless required to certify annually to the CDFI Fund that the entity continues to meet the requirements of being considered a CDE. Only CDE’s can apply to the CDFI for NMTC allocation to offer their investors in exchange for equity investments.[vi] Only a for-profit entity can qualify as a CDE.
Investors in the NMTC program are typically large financial institutions such as Goldman Sachs, JP Morgan, and PNC. Investors, however, are not limited to such institutions; any taxpayer can be an investor in the program.[vii] Investors are defined by the investments they make, not by their corporate form (or lack thereof).
Investors in the NMTC program are those who make a qualified equity investment (QEI) in a CDE. A qualified equity investment is generally any equity investment in a CDE if the investor obtains the interest at its original issue solely in exchange for cash, substantially all of the cash is used by the CDE to make qualified low-income community investments, and such investment is designated as a QEI by the CDE on its books.[viii] The QEI cannot exceed the amount allocated to the CDE, however. Because the credit received by an investor is a percentage of the QEI, there is incentive for the investor to borrow funds to make the equity investment, and thereby increasing the return the investor receives.
D. Leverage Lender
A party that provides financing to an investor (through a “Fund”) is known as a leverage lender. The lender which is typically unrelated to the QALICB developer (developer but may be affiliated), see subpart E, infra., must provide bona fide debt to the investor in order to obtain the benefits of a leveraged structure. Examples of leveraged lenders are community banks and charities.[ix] A lender’s loan increases the amount of an investor’s cash investment, which in turn leads to a greater credit, and results in a benefit to both the investor and the QALICB.
E. Qualified Active Low-Income Community Business (QALICB)
The ultimate beneficiary of the investment is a QALICB, which is typically a developer or an operating business. The QALICB receives loan proceeds or an equity investment from a CDE and is the entity that generally engages in the community development activity in the low-income community.[x] The regulations prescribe the parameters of what constitutes a QALICB. For example, a QALICB must derive the majority of its income from the active conduct of a qualified business in a low-income community and must own assets and perform services within a low-income community.[xi] A low-income community is a statutorily defined term that includes areas where the poverty rate in an area is at least 20 percent.[xii] A qualified business generally includes any trade or business, but does not include “sin uses” such as golf courses, racetracks, country clubs, and gambling facilities. The rental of real property is a qualified business only if it is not residential real property and there are substantial improvements to it.[xiii]
III. NMTC Investment Mechanics: Steps
The first step in a NMTC transaction is for a CDE to secure a NMTC allocation from the CDFI Fund. For each round in which NMTCs are available, the CDFI Fund issues a Notice of Allocation Availability (NOAA). The NOAA provides the details about the application deadline and requirements for securing NMTC allocation. In order to secure an allocation, an entity must be a CDE or have met the application deadline for applying to become a CDE for a particular allocation round.
The CDFI Fund reviews all applications received by CDEs and subjects them to a competitive review process. Applications are initially reviewed and scored based on four criteria: Business Strategy, Community Outcomes, Management Capacity, and Capitalization Strategy.[xiv] Highly qualified applicants are sent to a panel for review. After panel review, the selecting official makes a preliminary determination before a final award determination is made. The CDFI Fund publishes annually a list of the allocatees for a given round of NMTCs and the allocated amount. The CDFI Fund’s award allocations may not exceed the statutorily prescribed amounts permitted by the Code.
In general, an equity investment in a CDE before the CDE has entered into an allocation agreement with the CDFI Fund is not eligible to be designated as a QEI.[xv] Thus only after a CDE secures a NMTC allocation may it seek an equity investment from an investor. A CDE has five years to secure a QEI. If the CDE does not secure a QEI within five years, the CDFI Fund can reallocate the amount awarded to the CDE.
An unleveraged QEI is made by an investor, such as a national bank or insurance company, in a CDE. In return the investor receives tax credits – NMTCs – equal to 39% of the QEI. The credits would be based on the cash investment in the CDE. The 39% tax credit is utilized by the investor over the life of a seven year compliance period. The credit is 5 percent for the first three years, and 6 percent for the last four years.[xvi]
The CDE then must use “substantially all” of the QEI to make a qualified low-income community investment (QLICI). A QLICI includes any equity investment in or loan to a QALICB, the purchase of a loan from another CDE of a QLICI, financial counseling and other services specified in the regulations to business and residents of low-income communities, and any equity investment in or loan to another CDE.[xvii] The safe harbor for “substantially all” of the QEI being used for QLICIs is 85%.[xviii] A CDE must make QLICIs within 12 months of receipt of the investors QEIs.
Once the QEI is made, there is a seven-year compliance period. If any “recapture event” occurs during that compliance period, the NMTCs claimed by the investor are recaptured and any future credits are forfeited. A recapture event is a statutorily defined term that includes: a CDE ceasing to be a CDE, the substantially all of the QEI ceasing to be used for investments in QLICIs, and the investment being redeemed by the CDE.[xix]
C. Leveraged Investment
A leveraged structure is often used to make an investment in a CDE even more attractive to investors. The basic difference in the leveraged structure is that an investor accesses borrowed money to maximize the credit obtained. Under a typical leveraged structure, the investor will form a single-member LLC, which it will fund with the investor’s equity for the NMTC transaction. The LLC (Fund) will then borrow additional funds from the leverage lender. The Fund, which is controlled by the investor, uses the combined money from the investor and the leverage lender to make a QEI in the CDE. The CDE is required to make a QLICI as described in B above. The investor will receive NMTCs based on the amount of the QEI, which combines the investor’s equity with the funds borrowed from the leverage lender.
Leverage lenders provide financing for projects to entice investors to enter into a NMTC transaction. While the leveraged lender may take a security interest in the Fund’s assets, it is not permitted to take a direct security interest in a QALICB’s property.[xx] Loans between the leverage lender and Fund are usually nonrecourse. Because the recapture rules require that an investor (including the Fund) remains invested in the CDE during the seven-year compliance period, leverage lenders will be required to forbear from exercising remedies until the end of the compliance period.
D. Exiting the Transaction
At the end of the seven-year compliance period, the investor will have received all the NMTCs for which it is eligible. The investor and CDE will likely want to unwind the transaction and exit the structure at this point. This is typically accomplished through the use of a “put/call” technique that generates a subsidy or grant equivalent to the QALICB. One version of this technique permits the investor to require the QALICB, over a specified period, to purchase the investor’s interest in the Fund for a specified price (the “put”). If the put is not exercised, the QALICB (or an affiliate) often has the right to purchase the investor’s interest in the Fund over a specified period of time for fair market value (the “call”). The put and call will likely be priced substantially below the investor’s original investment in the Fund
After the investor is removed from the structure, either through the exercise of the put or the call, the QALICB may then take steps to have the Fund, which it now controls, liquidate the CDE. Often the QALICB will use the QLICI note previously held by the CDE to repay the leverage lender. The result being that the structure leaves the QALICB on its own and the leverage lender holding the QLICI note.
The net benefit to the project can then be measured by looking at the amount of the investor’s original funds less fees, professional and administrative costs, and the price of the put/call. In the event that the leverage lender is a charity or is controlled by another section 501(c)(3) organization, it may decide to forgive all or a portion of the loan at the end of the compliance period. However, it must not be legally obligated to do so at inception or intimate that it might do so during the life of the compliance period. Otherwise the structure may trigger a recapture event if the loan was not true debt.
An additional point to note is that there is often tension manifested between the equity investor and the QALICB in negotiating the put/call structure. Equity investors are interested in protecting the value of their cushion while the QALICB is interested in an assurance that the investor will indeed exercise the put. Concern exists at the QALICB level that a change in administration and attitude by the investor at the end of the compliance period, especially by an institutional investor, may lead to an investor deciding not to exercise a put. To protect against this, the QALICB may use techniques to devalue the call over time to motivate the investor to exercise the put.
E. Cancellation of Indebtedness (COD) Income
Under section 61(a)(12) of the Code, a discharge of indebtedness constitutes gross income to the debtor. As relevant here, a debtor’s acquisition of its own debt for less than the principal amount of the debt constitutes cancellation of indebtedness and is gross income. Similarly, the Code provides that acquisition of debt by a related party to the debtor is considered to be acquisition of indebtedness by the debtor. Thus as a NMTC unwinds and notes change hands, the parties must be aware of the COD issue. A QALICB that has operating losses may offset COD ordinary income that it receives, or could pay the note over 25-30 years to defer taxability. However, the QALICB would need to pay interest annually during the life of the note.
The NMTC program provides substantial opportunities for investors to realize after tax returns on their equity investments. Similarly, projects in low-income areas such as shopping centers, schools and manufacturing facilities, can receive financing and investment they may not otherwise receive “but for” the program. All the parties to the transaction, if structured correctly, can benefit therefrom. It is imperative that the parties understand the issues involved and make a comprehensive plan to ensure that each party receives its anticipated benefit.
[i] See I.R.C. § 45D(f).
[ii] See a map of the state programs at www.novoco.com/new_markets/nmtc/state_nmtc_programs.php
[iii]CDFI Fund, “About the CDFI Fund,” available at: http://www.cdfifund.gov/who_we_are/about_us.asp (last visited June 5, 2014).
[iv] See, e.g., the Community Development Financial Institutions Program, the Bank Enterprise Award Program, Native Initiatives, and CDFI Bond Guarantee Program. Ibid.
[v] I.R.C. § 45D(c)(1)(A)-(C).
[vi] CDFI Fund, “CDE Certification,” available at: http://www.cdfifund.gov/what_we_do/programs_id.asp?programID=10 (last visited June 6, 2014).
[vii] See I.R.C. § 45D(a)(1) (allowing a credit to any taxpayer holding a qualified equity investment).
[viii] I.R.C. § 45D(b)(1)(A)-(C).
[ix] Note that no UBIT is realized by a nonprofit leverage lender if the project is substantially related to the exempt function of the organization, such as relief of the poor and underprivileged, or relieving the burden of the government.
[x] Other options are for the CDE to provide financial counseling and other services to a QALICB or residents of a low-income community directly or to make an equity investment in, or loan to, other CDEs if the other CDE uses the loan in a manner consistent with the qualifications of CDEs. See Treas. Reg. §1.45D-1(d)(1)(iii)-(iv).
[xi] Treas. Reg. §1.45D-1(d)(4)(i).
[xii] I.R.C. § 45D(e). I.R.C. § 45D(e)(2) was amended in 2004 to provide that target populations may be treated as low-income communities for statutory purposes.
[xiii] Treas. Reg. § 1.45D-1(d)(5)(ii).
[xiv] CDFI Fund, “CY 2013 New Markets Tax Credit (NMTC) Program Application Evaluation Process ,” available at: http://www.cdfifund.gov/docs/nmtc/2013/2013_NMTC_Application_Evaluation_Process.pdf (last visited June 6, 2014).
[xv] For exceptions, see Treas. Reg. § 1.45D-1(c)(3)(ii).
[xvi] I.R.C. § 45D(a)(2).
[xvii] Id. at (d)(1).
[xviii] Id. at (b)(3).
[xix] Id. at (g)(3).
[xx] Rev. Rul. 2003-20, 2003-7 I.R.B. 465.