Tax credit investments play an important role in strategic planning for tax professionals. We wanted to delve deeper into the crevices of this issue and turned to Paddy O’Brien, vice president of investments at Foss & Co., for answers. Tax Executive’s senior editor, Michael Levin-Epstein, interviewed O’Brien in February.
Michael Levin-Epstein: Tell us what tax credit investments are.
Paddy O’Brien: Let’s scale back a little bit and go to the very top of where these are created. If the government wants to disincentivize something, they will tax it. For example, we have a tax on alcohol and cigarettes. And vice versa—if the government wants to get something done, they will subsidize it, make it easier. So, with renewable energy projects, historic building rehabilitations, low-income housing developments, the government will allow these projects to generate tax credits. The tax credits are the subsidy. Tax credits, as many of your readers know, are a dollar-for-dollar reduction in your tax liability. The developers of these projects, the renewable energy, historic building rehabilitations, and low-income housing projects, don’t have large enough federal tax liabilities. That’s where tax credit investments will come into the fold and help monetize that subsidy. A tax credit investment is where we have a C-corp or a financial institution that has a large federal tax liability, and they invest capital into the project in exchange for the tax credits, other tax benefits such as depreciation, and cash flows from that project. In whole, this mechanism allows a productive corporate or financial institution to put their money into economy-sustaining infrastructure, and they earn a return at the same time. They are able to make a big-impact investment and also keep their capital as productive as possible.
Levin-Epstein: You just touched on a few of the benefits of tax credit investing—can you expand on that a bit and even more about the profile of taxpayers who tend to incorporate tax credit investing in their tax management strategy?
O’Brien: Of course. Like I said, the benefits come in three main parts on paper. You have the tax credits, which are a dollar-for-dollar reduction on your tax liability. You have the depreciation, which these companies can use to deduct from their taxable income. And also you have the cash flows and buyout that are generated by projects. Usually, with a renewable energy project, you pay a premium for these tax credits, but you also have large cash flows that are coming from them as well. You may pay $1.10 or a $1.12 per dollar of tax credit, and in exchange you’ll get tax credits, an annual preferred return on the amount invested, depreciation, and a buyout at the end. The benefits on an investment like this are clean energy being added to the grid and a financial return of ten to fifteen percent. As an example, if a company invested in a project that was generating $100 in solar investment tax credits [ITCs], they would contribute $112.00 in capital to the project. In the weeks following their capital contribution they would receive [that] $100 in tax credits. Then, each year for five years they would receive approximately $3.30 in the form of a preferred return along with depreciation. Finally, the investor exercises their option to exit the investment receiving a buyout of approximately $9.00. Adding that all up will deliver a return in the range of twelve to thirteen percent. The taxpayers that most often participate in these transactions are C-corps and financial institutions. This is because they have large tax liabilities, the expertise to fully comprehend the investments, and, lastly and most importantly, they’re often looking for a productive way to invest back into the community. These entities face the choice of either sending a check to the IRS or they can put it into these projects, have a big, positive impact on society, and earn a positive, significant return.
Levin-Epstein: Could you give some specific examples of the kinds of infrastructure projects that these taxpayers are likely to claim as tax credit investments?
O’Brien: Certainly. Some public goods the government is responsible for directly funding, such as national security, sewers, roads, etc., things that our tax dollars are going to ordinarily. The projects that we will see the government is subsidizing with tax credits are renewable energy facilities, for instance, a solar photovoltaic station or a wind farm. And, on the real estate side, you’ll see low-income housing and historic building rehabilitations subsidized with tax credits. Historic tax credits are the rehabilitation of buildings that are fifty years or older. These are particularly interesting, because these projects are very low risk, downside protected, and have higher yields than renewable energy tax credit transactions. As we saw in the solar ITC example, the price was $1.12 per dollar of tax credit. In historic tax credit transactions [HTCs], the investors typically pay $0.88 per dollar of tax credit. Another great trait of the HTCs is that the majority of these projects directly benefit low- to moderate-income neighborhoods and counties by providing housing and revitalizing old, worn-out historic buildings.
Levin-Epstein: You said that this would apply to any building that’s more than fifty years old. Does it have to be designated in any way, or just the fact that it’s fifty years old would be enough?
O’Brien: There are more requirements for it to qualify for the tax credit, and the main thing is it has to go through certain steps with the National Park Service so they can certify that this is actually a significant historical building. The fifty-year timeline in the first requisite for it to get to that test. But you’re right in assuming that not all fifty-year-old buildings will qualify for the tax credit.
Strategic Decision Makers
Levin-Epstein: Who would be involved in these types of strategic decisions for taxpayers?
O’Brien: In my experience, it tends to be the head of the tax function. Your senior tax director, your vice president of tax, or head of the tax department. And you also have inputs from treasury and legal teams, because the investors have additional responsibilities such as managing cash and understanding the operating agreement. The tax team will evaluate their tax credit appetite, which is the amount of tax credits that this taxpayer can utilize [in a given tax year]. The treasury team will be involved in determining that amount based on the company’s cash and liquidity position. Finally, the legal team will help the tax and treasury teams understand the operating agreements as well as any other legal implications that relate to their business.
Levin-Epstein: I guess there are probably people who are going to read this and say to themselves, “Well, this is a no-brainer, using these tax credit investments.” Why aren’t they more widely used in corporate America today?
O’Brien: Yeah, you’re right in assuming it does sound too good to be true sometimes, because the returns are so great and you get to send an investment out the door into something that has a really positive benefit for society and your net earnings instead of directly to the IRS. The reason that is—and it’s easy to forget—is that this is a subsidy. The government wants corporate America and all the financial institutions to participate in these infrastructure-building opportunities. This fact is a good reminder that the government created this program to incentivize companies to participate. We’ve been doing this with our institutional partners for over forty years. Lots of times, we’ll see the tax functions interested in turning their departments into a profit center, but they typically don’t have the resources to participate in these transactions on their own because they already have full-time jobs. Participating in these transactions involves going out and finding the project—you have to find a project that works economically and that may be a renewable energy project, a historic building rehabilitation, or a low-income housing transaction. Moreover, some of the new project types involve very novel technologies such as commercial and utility-scale battery energy storage. They need to learn something that is not necessarily in their job description. Once they find a suitable project, they must underwrite it, go through a closing process, and then they have to asset-manage it throughout the whole lifetime of the investment, which for solar and historic tax credits is going to be about five years. But for low-income housing, it’s going to be about fifteen. When it comes to these types of tax credits, it’s a long-term investment. If you don’t have the expertise and resources, it’s going to be difficult and costly for heads of tax to participate in those transactions without seeking external assistance. Luckily that’s where someone like Foss & Co. comes in. We do all that work for the whole life of the investment. All the investor has to do is evaluate their appetite—how many tax credits do they want in a given year—and understand how to account for the investment. But once investors get an idea for it, they fully utilize this strategy every year.