Smoothing the Transition:
NMTC Exits and Dispositions
Warren Sebra
Novogradac & Company LLP
Portland, OR
Assumptions for our Discussion
Related-party leverage
lender is used
Leverage
Lender
Investors
• Creates some flexibility with
the timing
30-year loan
Fund
Typical leveraged
structure is used
SubCDE
QALICB is a taxable entity
QALICB
• Different set of considerations for
nontaxable entities (i.e. UBTI)
NMTC Subsidy’s Uneasy
Relationship with Taxation
Free money often comes
with strings
NMTC program
not designed to
deliver tax-free
subsidy
Strategies for
mitigating taxable
income typically
just address the
timing
Leverage Lender
Equity
Loan
7% Int.
($490k/yr)
100%
Fund
99.99%
QEI
NMTCs
CDE Allocatee
7 Years
0.01%
Sub-
Fees
CDE
A Loan
5.16% Int.
($361k/yr)
B Loan
5.16% Int.
($129k/yr)
Leverage Lender
Equity
Loan
7% Int.
($490k/yr)
100%
• Maximize value?
• Leave quietly; deliver residual to QALICB
Fund
• Preserve industry standing
99.99%
QEI
NMTCs
CDE Allocatee
7 Years
0.01%
Sub-
Fees
• Eliminate ongoing reporting and
monitoring
CDE
A Loan
5.16% Int.
($361k/yr)
Residual
B Loan
5.16% Int.
($129k/yr)
• One last blast of community benefit
• Capture of back end fees?
Once Year 7 arrives…
Stay with the
same deal
and repay all
loans over
the originally
documented
loan terms
Exercise the
put or the call
and unwind
Attempt to
negotiate
something
new
Leverage Lender
Equity
Loan
100%
Fund
99.99%
QEI
CDE Allocatee
7 Years
0.01%
Sub-
Fees
CDE
A Loan
B Loan
Leverage Lender
Equity
Loan
100%
• Contractual right to sell
interest in fund for nominal
price ($1k)
Fund
• Usually a limited window of
time to exercise (90 days)
99.99%
QEI
CDE Allocatee
7 Years
0.01%
Sub-
Fees
CDE
A Loan
B Loan
QALICB
Affiliate
Leverage Lender
Equity
Loan
100%
• Contractual right to purchase
the investor’s interest in fund
for FMV
Fund
• Can exercise if investor
doesn’t exercise put option
99.99%
QEI
CDE Allocatee
7 Years
0.01%
Sub-
Fees
CDE
A Loan
B Loan
QALICB
Affiliate
Leverage Lender
Equity
Loan
• Contractual right to sell
interest in fund for nominal
price ($1k)
100%
• Usually a limited window of
time to exercise (90 days)
Fund
99.99%
QEI
CDE Allocatee
7 Years
0.01%
Sub-
Fees
CDE
A Loan
B Loan
• Contractual right to purchase
the investor’s interest in fund
for FMV
• Can exercise if investor
doesn’t exercise put option
QALICB
Affiliate
QALICB
Affiliate
Leverage Lender
QALICB
Affiliate
Equity
Loan
100%
Does this trigger cancelation of
debt (COD) income for the
QALICB?
Fund
99.99%
QEI
CDE Allocatee
0.01%
Sub-
Fees
CDE
A Loan
B Loan
QALICB owes sub-CDE
Fund owes leverage lender
$ 9.5 Mil
7 Mil
Difference
$ 2.5 Mil
Income?
QALICB
Affiliate
Potential for gain
(excluding purchase price)
Investor Taxation and Strategies
QALICB
Affiliate
Equity
Loan
100%
Fund
99.99%
QEI
CDE Allocatee
0.01%
Sub-
Fees
CDE
A Loan
B Loan
QALICB
Affiliate
$3M
$2.999 Mil loss, right?
Equity
Loan
100%
Sales price: $1k
Basis in
Fund
($900k)
Fund
99.99%
QEI
NMTCs
CDE Allocatee
0.01%
Sub-
CDE
$901k GAIN
Equity
Loan
100%
Sales price: $300k
Basis in
Fund
($900k)
Fund
99.99%
QEI
NMTCs
CDE Allocatee
0.01%
Sub-
CDE
$1.2 Mil GAIN
Exit Strategies for Investor
• How to capture value?
– Don’t exercise the put
– Don’t allow special features that minimize the value of
your position
• How to deliver value to QALICB?
– Exercise your put
• Plan up-front to have gain; price your
interest accordingly
$3.9M
$10M
$6.1M
Fund
NMTCs
Basis in
QLICI
Sub-CDE
Loans
Liquidates
QEI
Sub-
CDE
A Loan
§332
(Sub-CDE is a Corporation)
B Loan
• In some cases, taxation of sub-CDE as
a C-Corp may provide for some
favorable treatment
• §332 liquidation may allow the
investor to exit the transaction without
experiencing the NMTC basis
reduction
• Conversion from a partnership to a
corporation will result in basis
reduction taken to date being applied
to the assets of the sub-CDE under
IRC §732(f)
•
Takeaway is to not wait to convert, if that
is your strategy
Collapsing the Structure
QALICB
Affiliate
Leverage Lender
Equity
Loan
100%
Fund
99.99%
Fund liquidates, distributing
B Loan to QALICB Affiliate
QEI
A Loan
Fund assigns A Loan to
0.01%
Leverage Lender in
satisfaction of Leverage A Loan Sub- B Loan
CDE
Loan
A Loan
B Loan
CDE Allocatee
Fees
Sub-CDE liquidates, distributing
A and B Loans to Fund
QALICB
Affiliate
Leverage Lender
A Loan
B Loan
Smoothing the Transition:
NMTC Exits and Dispositions
COD Income Issues
Presented by Michael A. Lee
Pepper Hamilton LLP
WHEN THE ISSUES ARISE
COD issues arise if:
• QALICB is a for-profit entity
• QLICI is debt, not equity
• Sub-CDE lender is not “related” to QALICB
• Leverage Lender is “related” to QALICB
• Put/call party is “related” to QALICB
KEY POINTS
• Beware of the A Note
• Related Party Debt is Better than Cancelled Debt
• Put/Call Party Should be an Affiliate of QALICB, not QALICB
Itself
• With Proper Structuring, Amount of COD Income Should be
Limited to the Difference Between FMV and Face Amount of
B Note
GENERAL RULES
• The acquisition of outstanding indebtedness by a person
related to the debtor from a person who is not related to the
debtor results in the realization by the debtor of income from
discharge of indebtedness (to the extent required by section
61(a)(12) and section 108) in an amount determined under
paragraph (f) of this section. Reg. 1.108-2(a).
• This rule applies if indebtedness is acquired directly by a
person related to the debtor in a direct acquisition or if a
holder of indebtedness becomes related to the debtor in an
indirect acquisition. Id.
RELATED PARTY
• For purposes of the COD rules, persons are considered related
if they are related within the meaning of Code section 267(b)
or 707(b)(1), with certain modifications.
• This generally means there is more than a 50% overlap in
ownership between two entities, after applying constructive
ownership rules.
• For this purpose, the family of an individual consists of
his/her spouse, children, grandchildren and parents, and any
spouse of the individual’s children or grandchildren. It does
not include brothers and sisters.
Reg. 1.108-2(d)(2).
DIRECT ACQUISITION
• A direct acquisition of debt occurs if a person related to the
debtor (or a person who becomes related to the debtor on
the date the indebtedness is acquired) acquires the
indebtedness from a person who is not related to the debtor.
Reg. 1.108-2(b).
• Example: QALICB affiliate acquires 100% of Investment Fund
after QLICI note is distributed to the Fund.
INDIRECT ACQUISITION
•
An indirect acquisition of debt occurs when a holder of
outstanding indebtedness becomes related to the debtor, if the
holder acquired the indebtedness in anticipation of becoming
related to the debtor.
– Bright line: anticipation test is met if holder acquired the indebtedness less
than 6 months before holder became related to debtor.
– Otherwise, facts and circumstances test applies regarding anticipation of the
relationship
– Reg. 1.108-2(c).
•
Example: Sub-CDE distributes QLICI notes to Fund in
redemption of Fund’s interest in Sub-CDE. QALICB affiliate then
(within 6 months) acquires more than 50% (but less than 100%)
of Investment Fund pursuant to the put/call.
HANDLING THE A NOTE
• If Leverage Lender is not related to QALICB, A Note can be
distributed by Sub-CDE to the Fund and then used by the
Fund to satisfy its Leverage Loan obligation.
• If Leverage Lender is related to QALICB, A Note should be paid
off by QALICB rather than distributed upstream.
– Cash proceeds would be distributed by Sub-CDE to the Fund and then
used by the Fund to pay the Leverage Loan.
– If A Note instead were distributed upstream, it would end up being held
by a party related to QALICB and thus trigger COD income to QALICB.
ACQUISITION OF B NOTE
• If QALICB itself acquires 100% of the interests in the Fund, the
holder and debtor will be the same, and the B Note will be
deemed cancelled.
– Bad result: 100% of face amount of B Note is COD income to QALICB.
• If purchaser of Fund interests instead is an affiliate of QALICB,
result is related party indebtedness.
– Related party directly acquires B Note if it acquires 100% of the Fund
interests.
– Related party indirectly acquires B Note if the Fund remains in existence
with two members. There is an indirect acquisition because the Fund
acquires the B Note less than 6 months before QALICB affiliate acquires
Fund interest.
AMOUNT OF COD INCOME
• The amount of COD income recognized by QALICB is
measured by reference to the fair market value of the
indebtedness on the acquisition date if the holder (or the
transferor to the holder) did not acquire the indebtedness by
purchase within 6 months before the acquisition date. Reg.
1.108-2(f)(2).
• The amount is measured by reference to the adjusted basis of
the related holder (or of the holder that becomes related to
the debtor) if the holder acquired the indebtedness by
purchase within 6 months before the acquisition by the
related party. Reg. 1.108-2(f)(1).
AMOUNT OF COD INCOME
(continued)
•
When QLICI note is distributed to the Fund at exit, the Fund does
not acquire it “by purchase” because the note is “substituted
basis property” in the Fund’s hands. Id.
•
Therefore, in an indirect acquisition, COD income should be the
difference between the face amount of the QLICI note and its fair
market value, without regard to the purchase price paid by
QALICB affiliate for interests in the Fund.
– This should apply where the Fund remains in existence with at least two
members—by having two different parties acquire the Fund interests (e.g.,
the investor’s 99% interest and the managing member’s 1% interest).
•
In a direct acquisition, QALICB affiliate acquires B Note by
purchase; therefore, COD income arguably could the difference
between face amount of B Note and purchase price.
EXAMPLE
• Assumptions:
–
–
–
–
–
–
–
Leverage Lender and put/call party are related to QALICB.
QALICB pays off A Note (e.g., via one-day loan).
Sub-CDE distributes B Note to Fund.
Face amount of B Note is $2.5 million.
Fair market value of B Note is $1 million.
QALICB affiliate acquires investor’s 99% interest in the Fund for $990.
A different person acquires managing member’s 1% interest in the Fund
for $10.
– The Fund remains in existence with 2 members.
• Result: QALICB has $1.5 million of COD income (difference
between face amount and fair market value of B Note).
SUBSEQUENT TAX TREATMENT
• QALICB is treated as issuing to the Fund a new $1 million
obligation, with $1.5 million of Original Issue Discount (OID).
• The OID will give rise to offsetting income and deductions for
the related holder and QALICB.
• If QALICB pays the balance of the B Loan, affiliate will
recognize $999,000 of gain (the difference between the $1
million issue price and the $1,000 basis of the affiliate).
• Thus, tax on the amount not recognized as COD income at
exit is deferred, not eliminated.
See Reg. 1.108-2(g).
COLLAPSING THE STRUCTURE
Tax Credit
Investor
4
Sponsor
Managing
Member
Leverage
Lender
6
5
2nd Affiliate
Investment Fund
3
Sub - CDE
A Loan
CDE
B Loan
2
1
7
QALICB
One-Day Lender
8
1.
2.
3.
4.
5.
6.
7.
8.
QALICB obtains a $7 million one-day loan.
QALICB repays $7 million A Loan.
Sub-CDE distributes $7 million + B Note in redemption of Fund’s interest in Sub-CDE.
Investor sells its 99.9% interest in Fund to Sponsor (QALICB affiliate).
Managing Member sells its 0.1% interest in Fund to a QALICB “friend”.
Fund repays $7 million Leverage Loan.
Leverage Lender contributes $7 million to QALICB.
QALICB repays one-day loan.
POSSIBLE EXCLUSIONS
• Insolvency Exclusion
– Insolvent debtor can exclude COD income to the extent of its insolvency
– However, insolvency is measured at partner level
• Qualified Real Property Business Indebtedness
– B Loan must be used to acquire or construct real property used in a
trade or business and must be secured by such property.
• Substantial amount of B Loan proceeds are used to pay NMTC transaction
costs.
– Excluded amount is limited to the excess of qualified debt over the net
FMV of such real property
– Basis of depreciable real property must be reduced by the amount
excluded.
– Not available to C corporations
– Applied at partner level
PLANNING OPPORTUNITIES
• Set higher interest rates on QLICI loans to increase their FMV.
– But this will increase the call price if investor does not exercise put.
– Also will impact true debt analysis.
• Convert B Loan to equity interest in QALICB before investor
exercises put option.
– COD will be limited to difference between face amount of B Loan and
FMV of the equity interest.
– Again, what if investor does not exercise put?
• Structure QLICI initially as all equity or enough equity to make
Sub-CDE a related party lender at the outset.
– But adversely affects sponsor’s economics.
– And deprives CDE of “reasonable expectations” test.
PLANNING OPPORTUNITIES
(continued)
• Make put/call party unrelated to QALICB by having at least
50% owned by “friendly” unrelated persons.
– For example: brothers or sisters
– B loan gets repaid per its terms.
• Assign put/call options to a charity
– B loan gets repaid per its terms
– Possible charitable deduction for donation of the options
Smoothing the Transition:
NMTC Exits and Dispositions
Restructure Prior to 7-Year
Compliance Period
Presented by Michael I. Sanders
Blank Rome LLP
7-YEAR COMPLIANCE – WHAT
IS REALLY LOCKED?
• QEI needs to remain in place.
• Investor and CDE may be changed.
• After QEI is made QALICB can be
changed.
• §45D(g)(1) & Treas. Reg. §1.45D1(e)(1) provide for recapture of the
credits and the payment of tax and
interest in the event there is a
“recapture event” during the 7-year
period beginning on the date of the
original issue of a QEI.
RECAPTURE EVENTS
§45D(g)(3); Treas. Reg. §1.45D-1(e)(2)
• CDE ceases to qualify as a community
development entity;
• Substantially-All Requirement is not
met (85% of QEI used in QLICI); or
• QEI is redeemed or otherwise cashed
out by the CDE. (Treas. Reg. §1.45D1(e)(3)
LEVERAGE LENDER
• Outside of NMTC Structure
• Options
– Third Party Loan Acquisition (e.g.,
Day Loans)
– Repayment
• No statutory/regulatory requirement
to remain in transaction; however,
may have contractual obligations.
INVESTOR
• Treas. Reg. §1.45D-1(c)(7) re QEIs:
Subsequent purchasers: A QEI includes
any equity investment that would be a
QEI in the hands of the taxpayer if it
was a QEI in the hands of the prior
holder.
• QEI = equity investment in CDE; for
cash; substantially all used in QLICI;
and designation.
INVESTOR CONSEQUENCES
• Credit taken on date of QEI & on each
anniversary date for 6 years.
• Prior to 6th Anniversary
– Investor foregoes remaining credits;
taken by new Investor/Purchaser (sell
credit-cash out)
• After 6th Anniversary
– All credits already taken; Purchaser only
gets residual cash flow, if any.
• Assumes no Redemption of QEI.
CDE
• Section 45D(d)(1)(B): A QLICI includes the
purchase from another CDE of any loan
made by that CDE which is a QLICI (at time
loan was made or at time of purchase).
• New CDE enters structure; original CDE
needs to reinvest cash.
• QLICI includes:
– Loan to any QALICB; and
– Any loan to a qualified CDE.
• Reinvestment requirement
• Intermediary CDEs
QALICB
• Options for change at QALICB level;
documents may prevent, but may be
amended
• Repayment of QLICIs to CDE
– CDE must reinvest within 1 year.
• QALICB owners may sell interests in QALICB;
Guarantee and Indemnification issues
• New QALICB may acquire the project and
assume the QLICIs and provide substitute
guarantees/indemnification.
NEW QALICB
• In the event of the incorporation of
new QALICB - representations and
warranties that there are no existing
recapture defaults
• Impact of potential COD income on
note modification; when is COD
triggered?
• Reexamination of NQFP tests
• New QALICB/QLICI opinion
OTHERS ISSUES IN
WORKOUTS/LOAN
MODIFICATION
• Review of Tax Credit Indemnifications;
due diligence, existing defaults?
• Attract new equity
• Valuation (tax opinion – true debt)
• Viability of Project in hands of new
QALICB
• Control issues; Reasonable
Expectation test
Example: Troubled Project – Year Six
Acquisition Project from QALICB,
Subject to Modified QLICI Loan
• Mixed Use project: hotel, residential apartments
and commercial retail space
• New QALICB #2 borrower will acquire all of SellerQALICB #1 right title and interest in property,
located in a low-income community.
• Borrower will assume senior loan (existing QLICI)
which will be modified (as provided below), be
extended for 7 years, interest only for 5 years,
with balloon payment at termination.
• The principal balance of the QLICI loan shall be
modified by “reducing” the principal by 50%,
effective immediately prior to closing.
Example
Loan
Original
Investor
QALICB2
CDE
Year 6
Year 1
QALICB1
Sale of Property
Subject to
modified
QLICI