Third Circuit Holding Denies Special Allocation

Third Circuit Holding Denies Special Allocation of Historic Rehabilitation Tax Credits to Tax Equity Investor Partner 

In an important decision with potential widespread implications to syndication (often referred to as  “tax equity” partnership investment) structures allocating congressionally targeted tax credits (e.g., renewable energy credits in certain renewable energy development projects), the Third Circuit of Appeals Court (Court) recently overturned an earlier Tax Court decision in favor of the taxpayer.

The Court effectively concluded that the tax equity investor partner (Pitney Bowes, Inc., or PB) was not a bona fide partner in a project partnership (Historic Boardwalk Hall, LLC, or HBH) to rehabilitate the Historic Boardwalk Hall (Project) in Atlantic City, New Jersey and thus could not receive an allocation of historic rehabilitation tax credits (HRTCs). The Court determined that PB did not have any meaningful upside potential, nor was exposed to meaningful downside risk, in respect of its investment in HBH.

In reaching its conclusion, the Court importantly did not specifically find that PB’s investment in HBH lacked economic substance, thus not directly deciding whether the value of HRTCs, a tax credit specifically enacted by Congress to encourage the rehabilitation of historic landmark properties, could be considered in analyzing the economic profit potential of PB’s investment in HBH. A number of real estate industry groups filed supporting briefs in the case, urging the Court to affirm the prior decision of the Tax Court.

The facts of the case are very complex and lengthy, and were interpreted and analyzed differently by the Third Circuit than by the Tax Court. The Court concluded, in short, that PB was not a true partner in the partnership based on the following:

1. PB’s investment in HBH provided PB with no meaningful opportunity to participate in any upside in the Project through its 3% preferred return and the residual profit in the value of the Project after repayment of all Project financing.
2. The consent right held by the public sector entity partner (NJSEA) in HBH could be used under certain conditions to repurchase PB’s interest in HBH at a price unrelated to fair market value.
3. PB had no meaningful downside risk in the Project as PB made its investment in HBH after a significant amount of the progress of the Project had occurred.
4. Were the allocation of HRTCs to PB successfully challenged, NJSEA was obligated to reimburse PB for the value of the HRTCs (plus penalties and interest) and for an agreed level of transaction-related expenses.

The Third Circuit’s decision will necessitate the rethinking of the economics and transaction structures of a number of project development partnerships seeking tax equity partners to realize the cash flow benefits of congressionally sanctioned tax credits that are generated by the underlying project activity.

Interested persons should expect a significant amount of multi-media interchange and commentary related to this decision as the Court’s holding is further analyzed and dissected by project developers and their professional advisors.