Will the new markets tax credit stimulate low-income communities?

EXECUTIVE SUMMARY

* A CDE must use substantially all the cash contributed in exchange for the equity interest to make qualified low-income community investments.

* Domestic S and C corporation and partnerships (including multiple-member limited liability companies and business trusts) can qualify as CDEs.

* A taxpayer investing directly in a non-CDE qualified active low-income community business does not qualify for NMTCs.

As part of the Community Renewal Tax Relief Act of 2000, Section 121(a), Congress enacted Sec. 45D, the new markets tax credit (NMTC) program. Sec. 45D is designed to attract $15 billion in taxpayer investments in low-income community businesses, by providing investors with a 39% Federal income tax credit. Investors will benefit from the NMTCs; low-income community businesses will benefit from the tax-subsidized equity and debt financing NMTCs create. The complexities of the NMTC program will no doubt also provide significant work for CPAs, attorneys, underwriters, financial advisers, loan broken, lobbyists and other professionals.

Under the program, a taxpayer obtains NMTCs by making an equity investment in a Federally certified for-profit entity (a "qualified community development entity" (CDE)) that has received a Federal NMTC allocation permitting it to designate NMTCs to its equity investors.

Apparently, the premise is that taxable investors will accept a somewhat lower pre-tax return (or somewhat higher business risk) from CDE investments in recognition of the NMTCs. Accordingly, CDEs should be able to offer equity financing and loans at below prevailing risk-adjusted market yields to qualified active low-income community businesses, which are the intended beneficiaries of the NMTC program.

This two-part article discusses (1) how an entity obtains CDE status; (2) how CDEs receive NMTC allocations; (3) how taxpayers receive NMTCs by reason of their equity investment in CDEs; (4) permissible uses by CDEs of taxpayers' NMTC-eligible capital contributions; (5) NMTC recapture; (6) availability of NMTCs in addition to other Federal tax incentives; and (7) limits on NMTC use. Part I, below, examines the first three listed items.

Who Benefits?

Most active businesses conducted in low-income census tracts (except for rental apartments and developing intangible property for sale or license, for which other types of tax benefits may be available), can be active low-income community businesses that qualify for low-cost loans and equity investments from a CDE. Thus, practically any class of retail, wholesale, manufacturing or service business (and their equity investors and lenders) can potentially benefit from the tax-advantaged financing the NMTC program generates. The commercial real estate industry (including shopping centers, offices and warehouses) is expected to be a major beneficiary. Exhibit 1 on p. 391 illustrates how the NMTC program will work.

[EXHIBIT 1 OMITTED]

Certifying CDEs

Treasury has delegated to its Community Development Financial Institutions Fund (Fund) the certification of CDE status and allocation of NMTCs to CDEs. As of April 1,2002, the Fund had issued extensive guidance and application forms for obtaining CDE sums, but had not yet done the same for obtaining NTMC allocations. (1) Such Fund guidance, comments from the public in response to the Fund's solicitation of comments, CDE status application forms and related Fund materials are available at www.cdfifund.gov/programs/nmtc/ index.asp.

In response to its request for comments in Ann. 2001-49, (2) the IRS received numerous suggestions on how to address various tax issues in regulations. In response, it issued Temp. Regs. Sec. 1.45D-1T, which addressed some tax aspects of the NMTC program.

CDE Status

Under Sec. 45D(c), to qualify its taxable equity investors for NMTCs, an entity must first apply for and receive certification as a CDE. Domestic S and C corporations and partnerships (including multiple-member limited liability companies and business trusts) can qualify as CDEs.

Applicants for CDE certification have to present organizational documents to the Fund that prove they directly or indirectly serve low-income communities or persons. An applicant must show that it dedicates at least 60% of its activities to serving these communities or persons. The CDE application must show such dedication through its limited partnership agreement, articles of incorporation or other relevant organizational documents.

The Fund guidance also requires that at least 20% of the membership of either the governing board of (or advisory board to) the applicant or its controlling entity (e.g., the managing general partner of a limited partnership applicant) reside in the low-income community served by the applicant or represent the interests of the community's residents. While non-low-income individuals living outside the community (e.g., small-business owners in the community or charitable organization officers serving the community) can count as representatives toward the 20% test, the Fund guidance encourages applicants to appoint some low-income residents from the community served.

The Fund guidance also confirms that a CDE is not limited in the number of low-income communities that it may serve. Thus, CDEs whose activities are national, regional or local in scope can qualify. In larger service areas, a CDE may have to establish multiple advisory boards (each meeting the 20% test), or select at least 20% of the members of a single advisory board from a cross-section of communities served or nonprofit community development organizations.

If the applicant chooses to meet the 20% test by an advisory board rather than by governing board membership, the CDE application has to describe how the advisory board was selected, how frequently the board meets (at least annually), how the board will solicit feedback from the low-income communities served (e.g., through surveys or meetings) and how the advisory board will use such information to inform the governing board (e.g., through written reports).

The Fund guidance specifies that both for-profit and nonprofit entities (including governmentally controlled entities properly classified as domestic corporations or partnerships for Federal income tax purposes) can apply for CDE certification. CDE status can be advantageous, even absent an allocation of NMTCs. A non- or for-profit CDE, without a NMTC allocation, can receive a loan or equity investment from (or sell a loan it originated to) a second ("umbrella") CDE that has received a NMTC allocation. The umbrella CDE's cash transfer to the first CDE qualifies under the Sec. 45D requirement that the umbrella CDE, as a condition to designating NMTCs to the umbrella CDE's investors, use substantially all the cash raised from the umbrella CDE's investors for qualified uses. A Small-Business-Administration-licensed specialized small-business investment company, or an entity determined by the Fund to qualify as a community development financial institution under 12 USC Section 4702 and the regulations thereunder (but not its subsidiaries), can automatically receive CDE certification, without filing a CDE application.

For efficiency, the Fund guidance permits a group of "subsidiary" CDE applicants (defined generally as entities whose voting power is directly or indirectly majority controlled by a "parent" CDE applicant) to file a single consolidated CDE application. However, in such case, each subsidiary applicant (like a separate applicant) must, on its own, be formed before applying, and meet the 60% low-income activities test and the 20% low-income governing or advisory board representation test.

A CDE's certification will normally remain in effect unless revoked or terminated by the Fund (e.g., for failure to annually certify that it continues to meet the requirements). CDE certifications may be applied for at any time and will be reviewed on a rolling basis. The Fund anticipates that it will only accept NMTC applications from entities that have filed CDE applications at least 30 days prior.

A taxpayer investing directly in a non-CDE qualified active low-income community business cannot qualify for NMTCs. The question thus arises as to whether a non-CDE taxpayer (e.g., a publicly traded corporation) contemplating a direct majority investment in a qualified active low-income community business can avoid NMTC unavailability for such a direct investment by forming an affiliate that will receive a capital contribution from the taxpayer and invest it in such business. If that affiliate were approved for CDE status and received an NMTC allocation, the taxpayer could then receive NMTCs for the equity it invested in the affiliate, a result unavailable if the taxpayer itself directly invested in the business. While theoretically feasible, this strategy may be made more difficult (particularly for businesses' without a track record of providing capital to disadvantaged communities) by an expansive interpretation by the Fund of Sec. 45D(f)(2), an issue on which the Fund guidance requested comments. Sec. 45D(f)(2) provides that, in allocating NMTCs among eligible CDEs, the Fund has to give priority to CDEs that intend to invest substantially all of the proceeds from their investors in businesses in which persons not related to the CDE (applying the majority common ownership test of Secs. 707(b)(1)(B) and 267(b)) hold the majority of the equity interests, or to CDEs with a record of having successfully provided capital or technical assistance to disadvantaged businesses or communities.

Fund NMTC Allocations

Once an entity is certified as a CDE, it can apply to the Fund for an allocation of NMTC designation authority. The allocation permits the CDE to designate the allocated amount of equity investment in the CDE as eligible for NMTCs. Sec. 45D(f)(1) authorizes the Fund to allocate to CDEs NMTCs for up to $2.5 billion in equity investment in 2002, $1.5 billion in 2003, $2 billion in each of 2004 and 2005, and $3.5 billion in each of 2006 and 2007. The Fund can carry forward unallocated amounts to any subsequent year up to 2014. (Technically, the dollar amount of equity invested in the CDE can be designated NMTCs by the CDE; the NMTCs themselves are not allocated to the CDE by the Fund, but both the Fund guidance and Temp. Regs. Sec. 1.45D-1T view the Fund as allocating NMTCs.)

To apply for an NMTC allocation, the CDE must submit to the Fund a comprehensive investment plan. This plan must contain a description of the CDE's track record, its plan for raising equity capital from taxpayers if it is awarded an NMTC allocation, and its strategy for using the proceeds from the allocation (including its financial and community-development underwriting criteria). In reviewing applications, the Fund will take into account the Sec. 45D(f)(2) preference for investments in unrelated entities or those with a track record (and may also consider geographical and other diversity desired in this national program) before allocating NMTCs among the applicant CDEs.

A for-profit CDE can make subsequent Fund-approved transfers of its allocated NMTCs to "subsidiary" CDEs. Likewise, a nonprofit CDE (although itself lacking equity investors who can use NMTCs) may be allocated NMTCs for subsequent Fund-approved transfers to its for-profit "subsidiary" CDEs.

QEIs

Under Sec. 45D(a), investors owning a qualified equity investment (QEI) in a CDE will receive, over seven years, NMTCs equal to 39% of the amount contributed to the CDE. The NMTCs are 5% of the QEI in each of the first three years of the investment, and 6% in each of the next four years.

Sec. 45D(h) provides that an investor's tax basis in the CDE equity interest is generally reduced by the NMTC designated to that investment. Temp. Regs. Sec. 1.45D-1T(f) requires the basis of interests in higher-tier S corporations or partnerships owning NMTC-eligible CDE interests to be likewise reduced. The basis reduction does not apply for purposes of calculating the capital-gain exclusion under Sec. 1202 (small business stock), 1400B (DC Zone stock or partnership interests) or 1400F (renewal community stock or partnership interests) on a sale of that CDE equity interest.

Only a QEI in a CDE can qualify for NMTCs. In the case of a CDE classified as a partnership, Sec. 45D(b)(6)(B) deems a capital interest in that CDE partnership as an equity investment. For a CDE that is an S or C corporation,"equity investment" is defined by Sec. 45D(b)(6)(A) as any stock (other than nonqualified preferred stock described in Sec. 351(g)(2)). Amounts paid for straight debt, convertible debentures and warrants issued by a CDE are not characterized by Sec. 45D(b)(6)(A) as equity investments and do not qualify for NMTCs.

Sec. 45D(b)(1) sets forth three requirements for an equity investment in a CDE to be an NMTC-eligible QEI. First, the equity investment must be acquired by its first holder, for cash, at its original issue directly from the CDE or through its underwriter. Under the favorable step-into-the-shoes rules of Sec. 45D(g)(3) and (b)(4), however, there is no NMTC recapture on a transfer of a QEI; subsequent transferees from the original and successor owners of QEIs can continue to claim NMTCs.

Second, the equity investment must be designated as such by the CDE from the NMTC allocation granted by the Fund to the CDE. Temp. Regs. Sec. 1.45D-1T(c)(3) provides that, except for a transitional rule for certain investments made in 2001 and 2002 in CDEs that receive allocations later in 2002, no NMTC can be allocated by a CDE for investments made before the CDE has entered into an allocation agreement with the Fund concerning those NMTCs. If a CDE fails to fully designate its NMTC allocation to investors within five years of the allocation agreement, the undesignated NMTCs revert back to the Fund for reallocation to other CDE NMTC applicants. The NMTC-eligible investment must be designated by the CDE as a QEI on the CDE's books by any reasonable method, and must be reported to the investor as NMTC-eligible within 60 days of the investment.

Third, under Sec. 45D(b)(1)(B), "substantially all" the cash contributed in exchange for the equity interest must be used by the CDE to make qualified low-income community investments. In addition, this test must be met throughout the seven-year credit period to avoid recapture. Thus, the substantially-all test is the key instrument by which the Code seeks to ensure that taxpayers' NMTC-eligible contributions to CDEs are in fact channeled to qualified low-income community investments.

Temp. Regs. Sec. 1.45D-1T(c)(5) generally interprets the substantially all test as requiring that at least 85% of the taxpayer's cash contribution be specifically traced to qualified low-income community investments. Temp. Regs. Sec. 1.45D-1T(c)(6) permits all QEIs made the same day to be treated as one investment. Under an alternative safe-harbor rule, if at least 85% of the aggregate gross assets of the CDE are invested in qualified low-income community investments, the substantially-all test will be deemed satisfied without any need to trace the actual use of the taxpayer's or simultaneous investors cash contributions.

The taxpayer's initial cash investment is treated as invested in a qualified low-income community investment only to the extent the cash is so invested no later than 12 months after the cash is paid by the taxpayer to the CDE. This short deadline may tend to discourage blind pools and focus investment in pre-designated real estate or other deals.

Conclusion

The first part of this two-part article addressed status, allocations and investments. The second part, in the July 2002 issue, will discuss uses of taxpayers' capital contributions, recapture, other Federal tax incentives and limits on use.

For more information about this article, contact Mr. Lederman at [phone].

(1) See 66 Fed. Reg. 65806 (12/20/01) and 66 Fed. Reg. 21846 (5/1/01).

(2) Ann. 2001-49, IRB 2001-20, 1183.

Alan S. Lederman, P.A., MBA, J.D., CPA
Partner
Broad and Cassel
Miami, FL