Federal Tax Credits

Adrian Fenton, BNY-MellonBrian DaveyBill ReillyMel Schwarz

all of Grant Thornton

The Many Flavors of Tax Incentives

Principal types of tax incentives:Additional or accelerated deductionsExclusions from incomeCreditsGrantsFinancing vehicles

• Tax-exempt bonds• Tax-credit bonds

Non tax incentives:• Direct payments• Government sponsored loans

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General Rules for Business Tax Credits

Most business credits governed by General Business Credit rules (IRC sec. 38)• Offsets tax dollar for dollar• Can only offset tax, does not generate refunds.• Cannot be used against alternative minimum tax• Carryback one year, carryforward 20 years.• Generally require current deductions to be reduced by the amount of the

credit, limiting benefit of credit.

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Expense Reduction Limits Benefits of Credits

Example: A $100 investment eligible for a 30% credit produces a tax benefit of $19.50.

• $30 credit• LESS $30 lost deduction times 35% tax rate (-$10.50) • EQUALS benefit of $19.50.

Generally same result for government grants, since taxpayer will not take basis equal to amount of grant.

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Comparison of Benefits

Additional deductions – cash and financial statement benefit equal to additional deduction times tax rate.

Accelerated deduction – cash benefit resulting from time value of money, no financial statement benefit

General business credits and grants – cash and financial statement benefit equal credit/grant times (one minus tax rate)

Financing vehicles – lower borrowing costs, other factors may influence.

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Major Federal Tax Credit ProgramsIncentive Snapshot

New Markets Tax Credits• $40 billion federal statutory program• For every dollar invested by the CDE, a

39% federal tax credit is generated over a 7 year period.

• Approximate after-tax yield range from 4.5 –7%

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Investment Tax Credits• 30& credit for the cost of the installation

earned the year the project is placed in service; permanent benefits will include accelerated depreciation and cash flow.

• 5 year compliance period• Approximate after-tax yield range from 7-20%

Historic Tax Credits• 20% credit for certified historic structures,

10% credit for rehabilitation of non historic, non-residential buildings built before 1936

• 5 year compliance period, 20% vesting/year

• Approximate after-tax yield range from 8 –20%

Low Income Housing Tax Credits• Pursuant to Section 42, created by Congress

in 1986 and made permanent in 1993• Generated for 10 years with a 15 year

compliance period• Approximate after-tax yield range from 5-10%

New Markets Tax Credits

• The New Markets Tax Credit Program is a $40 billion federal statutory program created in 2000 to encourage investment in low‐income communities.

• Administered by the Community Development Financial Institutions Fund, a branch of the U.S. Department of the Treasury.

• The New Markets Tax Credit is 39% of the investment amount. The credit is claimed over a seven‐year period, with 5% percent taken in each of the first three years and 6% taken in each of the next four years.

• An allocation of NMTCs is first awarded to Community Development Entities by the CDFI Fund and then allocated to qualifying projects.

• In order for an investment to qualify for the NMTCs, the investment must be made through a CDE to either a business or a non‐residential, commercial property that is located in a designated low‐income community.

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Renewable Energy/Investment Tax Credits

• Renewable Energy Tax Credits (Section 45) were created for projects involving the production and sale of electricity from renewable resources including wind, solar energy, biomass, geothermal deposits, and municipal waste.

• The Production Tax Credit is a per‐kilowatt‐hour tax credit for electricity generated by qualified energy resources. Enacted in 1992 and renewed numerous times, this credit expired at the end of 2013 and is awaiting reauthorization.

• The Investment Tax Credit (Section 48) is a 30 % credit of the cost of certain qualified property. The ITCs are realized when the asset is placed in service (“PIS”). The recapture period for ITCs is five years from the PIS date.

• These incentives include tax credits and grants for production and facilities using wind, refined coal, geothermal, biomass, solar, and combined heat and power systems.

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Historic Rehabilitation Tax Credits

• The first federal tax incentive for historic preservation was approved by Congress in 1976 and has since become one of the federal government’s most successful and cost‐effective community revitalization programs.

• The Historic Tax Credit (“HTC”) Program is administered by the National Park Service and the Internal Revenue Service in partnership with State Historic Preservations Offices.

• There are two tax incentives for preservation established by IRC 47 including:• A 20% tax credit for a certified rehabilitation of certified historic structures; and• A 10% tax credit for the rehabilitation of non historic, non‐residential buildings built before1936.

• HTCs are claimed during the first year subject to a 5 year compliance period, 20% vesting each year.

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Low Income Housing Tax Credits

• Section 42 of the Internal Revenue Code was passed by Congress in 1986 in The Tax Reform Act and the LIHTC became permanent in 1993 to encourage development and investment of low‐income housing units.

• Congress delegates to state housing agencies the authority to allocate a limited pool of LIHTCs.

• LIHTCs are claimed over a 10 year period, subject to a 15‐year compliance period.

• Dollar for dollar tax credit, other tax benefits, and cash/residual are claimed and earned over 10 years.

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Low-Income Housing Tax Credits

Low-income housing credit (§42)New method of accounting for low income housing deals

ASU 2014-01 – Accounting for Qualified Affordable Housing ProjectsIf certain conditions met, investor may amortize cost of investment, in proportion to the tax credits and other tax benefits it receives, and present as a component of tax expense

Conditions: probable that the tax credits allocable to the investor will be available investor does not have the ability to exercise significant influence of the limited liability

entity substantially all of the projected benefits are from tax credits and other tax benefits –

e.g - operating losses projected yield from project is, based solely on cash flows from the credits and losses,

is positive investor is a limited liability investor in the limited liability entity for both legal and tax

purposes

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Low-Income Housing Tax Credits

Low-income housing credit (§42)New method of accounting for low income housing deals

Proportional method replaces effective yield methodEffective yield method was limited in application as certain criteria required to be met (e.g. – guaranteed tax credits)

If investor does not qualify for proportional method or elects not to apply -cost or equity method used to account for investment

Impairment of Investment Tested for impairment when changes in circumstances indicate that it is

MLTN that the carrying amount of the investment will not be realized Impairment loss – fair value of investment less carrying value

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Low-Income Housing Tax Credits

Low-income housing credit (§42)New method of accounting for low income housing deals

Disclosures amount of LIHTC and other tax benefits recognized during the year carrying value of the investment on the balance sheet amount of any commitments or contingent considerations amount of amortization recognized in income taxes amount of investment income (for those under the equity method) amount and nature of impairment losses

Effective DateEffective for interim and annual periods beginning after December 15, 2014

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Research Credit

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Research Credit ExaminationHistorical Context

Late 1990sMarket Development

IRS focused on Activities

Early 1990sConcept Development

Limited IRS focus

2000sMarket Optimization

Final RegulationsIRS Regroups and more Contentious 

CurrentMature Market

IRS focused on Documentation

R&D Credit ExaminationLife Cycle

R&D Credit Issues

Business Component 4‐Part Test Exclusions QREs

• What• When• Why• Who

• Permitted• Uncertainty• Testing• Technical

• Production• Adaptation• Duplication• Survey / QA• IUS• Foreign• Social Sci.• Funded

• Nexus• Direct R&D• Supervision• Support• Prototype• Supply "used"• Contract R&D

Tax Credit Bonds

Provide bond holders with a credit in lieu of all or a portion of the interest the bond would otherwise have to pay.

Generally require income recognition in the amount of the credit, as if it were interest income.

Limited to tax liability after other credits, but can be used against alternative minimum tax

Tax credit bonds include;• Qualified zone academy bonds• Qualified school construction credit bonds• Forestry conservation bonds• Energy conservation bonds• New renewable clean energy bonds

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Employment Based Credits

Work Opportunity Tax Credit

Empowerment Zone Employment Credit

Indian Employment Credit

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Credits for InvestorsApportionment Rules

General rule – the credit follows the expenditure to which it relates• Example – if wage expenses are specially allocated, the employment

based credits will follow the same allocation Investment tax credits – only the owner of property is eligible for the

credit.

Application to partnerships• Must satisfy "substantial economic effect" standard

• Credits do not by themselves affect income or basis• Correlative adjustments such as basis adjustment must be considered• Issues of inside and outside basis – where should substantial economic effect be

tested?

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Credits for InvestorsLessor Passthrough to Lessee

Applicable to rehabilitation, energy, qualifying advanced coal project, qualifying gasification project, and qualifying advanced energy project credits

Full pass through• Must be new property AND

• class life of 14 years or less OR• leased for a 80% or more of class life OR• net lease

Partial pass through if leased for less than 80% of class life, class life longer than 14 years and not a net lease.

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Historic Boardwalk Hall caseMust be "bona fide" partner to claim credits

What does a tax exempt do with its credits?• Sell them?• Get legislation to allow direct transfer?• Bring in a partner who can claim them.

What standards must be met?• Partnership agreement cannot be a disguised sale – Virginia Historic (CA-

4)• In order to be a "partner," the investor must have a "meaningful stake in

the success or failure of the partnership." Historic Boardwalk (CA-3)• “[t]he realistic possibility of upside potential - not the absence of formal

caps - is what governs this analysis." Castle Harbour (CA-2)

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Historic Boardwalk Hall caseWhere did things go wrong?

No meaningful stake in the success or failure of the partnership; Return on investment was guaranteed prior to its contribution.

• historic rehabilitation tax credits that were equivalent to its investment• investment risk was nonexistent because it was not required to make a

capital contribution until a certain level of renovation progress generated tax credits equivalent to the contribution.

Tax benefit guaranty Project was fully funded before the partnership was formed, making

partnership contributions unnecessary for the completion of the project.

No potential upside because the transaction was structured in such a manner that the corporation would not receive any interest in the rehabilitated property.

Background indicated a sale of credits was contemplated

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Historic Boardwalk Hall caseIRS Safe Harbor: Rev. Proc. 2014-12

IRS will NOT challenge allocation of a rehabilitation credit IF:• Investor's has a minimum partnership interest of at least 5% of all

partnership items during each taxable year• Return on investment is contingent on income or loss from venture and not

substantially fixed in amount.• Value of investor's interest not reduced through arbitrary charges• Investor contributes at least 20% of total expected capital contributions by

date building placed in service and maintains that level of investment• At least 75% of investor's total expected capital contributions fixed in

amount before building placed in service• No impermissible guarantees

• tax credit guarantees, including costs of IRS dispute• distribution guarantees unless related to a fair market sale

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Political Aspects of Federal Tax CreditsExpired and Expiring Credits

Credits expired at the end of 2013• Research and experimentation credit• Work opportunity tax credit• Alternative fuel vehicle refueling property credit• Two- or three-wheeled plug-in electric vehicle credit• Second generation biofuel producer credit• Biodiesel and renewable diesel credits• Credit for production of Indian coal• Indian employment tax credit• New markets tax credit• Credit for certain expenditures for maintaining railroad tracks• Credit for construction of new energy efficient homes• Credit for energy efficient appliances• Mine rescue team training credit• Employer wage credit for activated military reservists• Empowerment zone credits

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Political Aspects of Federal Tax CreditsThe problem created by "temporary" credits

Financial statement dislocations

Inability to make proper plans and projection

Historic tendency for Congress to provide retroactive extension

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The Retroactive Extension Tradition

Political Aspects of Federal Tax CreditsCan Credits Survive Tax Reform?

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Political Aspects of Federal Tax CreditsCan Credits Survive Tax Reform

Camp "discussion draft" proposes repeal of 27 different credits, including:• Alternative energy generation credit• Alternative energy investment credit• Rehabilitation credit• Work opportunity tax credit

Tax Reform has become a revenue game – how do you pay for the reduction in rates?• Extension of expired credits loses revenue• Repeal of existing credits raises revenue

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Why tax reform is not deadCompetitive impetus for tax reform

The U.S. is out of step with its trading partners.• Our 35% statutory corporate rate exceeds the OECD

average of 25.1%• Most of our trading partners use an essentially

territorial, rather than a worldwide, system of taxation• These differences are seen to:

• put U.S. multinationals at a competitive disadvantage compared to those of other nations

• discourage free flow of capital into the U.S.• encourage U.S. companies to invert out of the U.S.

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What will it take for tax reform to succeed?

New players that can reach a bipartisan solution Continued pressure to address inversions Make tax reform part of overall spending/budget/deficit reform Relieve some of the revenue pressure

• Separate extension of expired provisions• Growing acceptance of dynamic scoring

Treat all businesses equally

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Tax Professional Standards Statement

This presentation supports Grant Thornton LLP’s marketing of professional services, and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document we encourage you to contact us or an independent tax advisor to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from Disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this document is not intended by Grant Thornton to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

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