A tax equity transaction with aggressive features was struck down by a US appeals court in August.

The decision calls into question whether a “fixed-flip partnership” structure that has been used to finance some wind and solar projects works, at least in its earliest form.

The decision may also require rethinking of some “pay-go” structures where tax equity investors pay for tax credits as the credits are received. The case is called Historic Boardwalk Hall LLC v. Commissioner.

The New Jersey Sports and Exposition Authority, or NJSEA, took on renovation of a sports arena and hall called East Hall in Atlantic City that was originally built in the late 1920’s and was the site of the Miss America pageant starting in 1933. The renovation work began in 1998. The state issued $49.5 million in bonds and used another $22 million from the New Jersey Casino Reinvestment Development Authority to fund the work.

Since East Hall is listed as a national historic landmark by the US government, the work qualified potentially for tax credits for 20% of the cost. The tax credits are claimed in the year the renovation work is completed. The state was not in a position to use the tax credits, so it essentially bartered them for capital to help fund the project in a tax equity transaction.

The transaction was complicated. NJSEA first leased East Hall from the Atlantic County Improvement Authority for 87 years at $1 a year. NJSEA then subleased East Hall to a partnership in which NJSEA retained a 0.1% interest. The partnership allocated 99.9% of depreciation and tax credits to Pitney Bowes. Pitney Bowes was also entitled to annual preferred cash distributions of 3% of the capital it contributed for an interest in the partnership. NJSEA had a call option to repurchase the Pitney Bowes interest after five years for the market value of the interest, but not less than any part of the 3% preferred cash return that Pitney Bowes had failed to receive. Pitney Bowes had a “put” to force NJSEA to buy the interest after seven years at the same price that NJSEA would have had to pay under the call option. (The options were never exercised.)

Pitney Bowes made capital contributions for its interest in the partnership. The first capital contribution, shortly before renovation was completed, was just $650,000. It contributed roughly another $19 million in three installments later as tax credits were received.

The partnership guaranteed Pitney Bowes that it would receive the expected tax benefits.

NJSEA guaranteed Pitney Bowes that it would cover any cost overruns or operating cost deficits on the project.

NJSEA described the transaction as a “sale of historic tax credits” in the offering materials and other documents while marketing the transaction.

The court said Pitney Bowes was not a real partner and was just attempting to buy tax benefits.

A partnership requires an intention to join together for the purpose of sharing in the profits and losses of a genuine business. Pitney Bowes was not exposed to operating losses because of the NJSEA guarantees. The court said it had no meaningful downside risk: it was not required to make its capital contributions, after the first $650,000, until after it had verified the amount of tax credits it was being allocated for each period. It was assured of receiving the tax benefits because of the tax indemnity. The tax benefits were not even at risk from the possibility the project might not be completed because the project was essentially fully funded by NJSEA before Pitney Bowes invested. Its capital contribution went to pay a developer fee to NJSEA and buy a guaranteed investment contract from an insurance company to ensure money would be available to buy out Pitney Bowes after the tax credit recapture period.

The court said that any upside potential for Pitney Bowes was illusory. In theory, the company could continue to share in cash, but in practice, the court said, the partnership was expected to lose money and avoided a write down of its assets only after persuading its accountants that the state would make good on the losses.

This is the second tax equity transaction involving tax credits for historic renovations with which the courts have found fault in a little over a year. A different US appeals court rejected a transaction in a case called Virginia Historic Tax Credit Fund 2001 LP et al v. Commissioner in 2011. (For earlier coverage, see the June 2011 NewsWire starting at page 29.)

Keith Martin