Pre-tax returns are an area of controversy

Pre-tax returns are an area of controversy | Norton Rose Fulbright

November 01, 2006 | By Keith Martin in Washington, DC

PRE-TAX RETURNS are an area of controversy. The United States offers generous tax credits to encourage private investment in renewable energy, coal gasification, biofuels, pollution control equipment, low-income housing and other endeavors. Many developers who under- take such projects have too little tax base to use the tax subsidies. They bring in partners who can use them. The large pool of potential investors, compared to the relatively small number of deals, has driven down returns to a point where most, if not all, of the return earned by the investor comes from tax benefits.
Many tax counsel insist that investors in energy deals must show they expect at least a 2% or 3% pre-tax return — meaning return before the tax benefits are taken into account — in order to prove they are in the deal for more than just tax benefits. The US does not allow pure sales of tax benefits. There is debate about whether such a return is required in the case of tax subsidies that are supposed to induce companies to undertake projects that would other- wise be uneconomic. It makes no sense to require someone in such a position to show he does not need the tax subsidy in order to claim it.

A bank that invests in community development entities — called CDEs — that make loans to businesses in low-income areas has asked the US Treasury to confirm that its return on such investments can come solely from tax benefits. Investors in CDEs earn “new markets tax credits” of 39% of the amount of equity invested. The credits are claimed over seven years. The bank met with senior Treasury officials in early October and described how new markets tax credit deals work.

IRS officials concede privately that it makes no sense to require a pre-tax return in production tax credit and similar deals that would be uneconomic absent the tax subsidy. They are reluctant to say so publicly, even though numerous private letter rulings have acknowledged in the statement of facts that a taxpayer did not expect a pre-tax profit. The same logic might not apply to lending transactions backed by new markets tax credits since the a lender usually earns at least some return. In wind deals, tax counsel still apply a minimum profit test, but treat the production tax credits as equivalent to cash for this purpose. The tax credits are a supplement for electricity revenues.

The bank is unlikely to get the public statement it wants from the Treasury. It asked as a fallback for the same relief that investors in low-income housing projects enjoy from challenge under section 183 of the US tax code. That section bars individuals and S corporations from deducting “hobby losses.” Investors in low-income housing projects take comfort from a statement in the IRS regulations that section 183 will not be used to deny tax credits for investing in such projects.

Keith Martin