NMTC 101: The Leveraged Structure
Shortly after a person begins investigating New Markets Tax Credits they encounter the term “Leveraged Structure” and then are barraged with unfamiliar acronyms. It can be very intimidating and confusing - but we can help.
Below is a diagram that in one form or another appears in almost every discussion about NMTC transactions. Essentially, the structure is designed to leverage the tax credit investors equity, and thereby generate larger investor returns.
Below is a diagram that in one form or another appears in almost every discussion about NMTC transactions. Essentially, the structure is designed to leverage the tax credit investors equity, and thereby generate larger investor returns.
In the structure, a lender, usually referred to as the “Leveraged Lender” makes a loan to an entity that the tax credit investor has a majority interest in. Typically this is a limited liability company, but it can also be a corporation that the tax credit investor owns at least 80% of. The entity is referred to as the “Investment Fund”, or “IF”. The tax credit investor contributes equity to the IF equal to the net present value of the tax benefits that will flow through to them over the life of the deal. These tax benefits include the 5% NMTC in each of the first three years and 6% for the four years thereafter (an aggregate of 39%). The total capitalization of the IF, less an amount reserved for administrative expenses and fees, is then contributed to a Community Development Entity, or “CDE”. The capital contribution is referred to as a “QEI” or Qualified Equity Investment. It is the contribution of this capital that triggers the ability to take the NMTC. The NMTC taken over seven years equals 39% of the QEI. CDE's compete annually for the right to allocate NMTCs, and are granted that right by the U.S. Treasury through its administrative arm, the Community Development Institutions Fund, or the "CDFI". The CDE also reserves some funds for administrative expenses and fees, and then uses “substantially all” of the remaining QEI to fund “QLICIs” or Qualified Low Income Community Investments. These are typically loans, but QLICIs can be in other forms, including equity (but generally not grants). QLICIs are usually in the form of low interest, little to no fee, deeply subordinated loans.
The QLICIs are made to “QALICBs” or Qualified Active Low-Income Community Businesses in “LICs” or Low Income Communities. QALICBs can be, among other things, commercial real estate projects or renewable energy projects. QALICBs typically must agree to provide certain community benefits, but in exchange they can expect to receive a NMTC derived economic subsidy to the project of between 15% to 20% of the total project cost, depending on the tax credit investors required yield and the complexity of the project structure. Under the NMTC program, the subsidy is meant to get deals financed that otherwise wouldn't "but for" the utilization of the NMTC. This notion is often referred to as the "But For Test".
The NMTC program requires compliance with various regulations in order to avoid recapture of the tax credit and various rules to remain qualified for future CDE allocations.
The QLICIs are made to “QALICBs” or Qualified Active Low-Income Community Businesses in “LICs” or Low Income Communities. QALICBs can be, among other things, commercial real estate projects or renewable energy projects. QALICBs typically must agree to provide certain community benefits, but in exchange they can expect to receive a NMTC derived economic subsidy to the project of between 15% to 20% of the total project cost, depending on the tax credit investors required yield and the complexity of the project structure. Under the NMTC program, the subsidy is meant to get deals financed that otherwise wouldn't "but for" the utilization of the NMTC. This notion is often referred to as the "But For Test".
The NMTC program requires compliance with various regulations in order to avoid recapture of the tax credit and various rules to remain qualified for future CDE allocations.
NMTC Compliance
There are several levels of compliance that must be monitored and controlled as part of an effective NMTC compliance and asset management program. What follows is a summary outline of the significant compliance areas. Each item has many sub-items that aren’t detailed here, but can have very significant economic impacts if violated. It is essential that tax credit investors are satisfied that the CDE overseeing NMTC compliance is familiar and experienced with the IRC Section 45D program and regulations.
The most significant risk is the risk of tax credit recapture. NMTCs can be recaptured if:
To maintain status as a CDE, the CDE must demonstrate that
To demonstrate that substantially all of QEI proceeds are invested in QLICIs, records must be maintained that show that at least 85% of QEI proceeds are invested in QLICIs within one year. This is usually done by directly tracing amounts through bank statements of the CDE (the “direct trace test”) for each QEI, or by methods of aggregating QEIs (the “safe harbor test”). If this test is failed, there are provisions which allow for a one time correction. It is important that CDEs track the age of their QEIs if they are using the direct trace test to ensure that all QEIs are invested in QLICIs before the requisite twelve-month period.
To avoid redemption of a QEI, the CDE must not make a capital distribution in excess of its Operating Income. There is a specific calculation for Operating Income that must be applied. This is an annual test and should be performed prior to the end of a test period to allow time for corrective measures.
Returns of capital from a QALICB to a CDE must be reinvested in another QALICB within 12 months. CDEs typically try to minimize the amortization of QALICB investments in order to avoid the requirement to reinvest. The requirement to reinvest does not apply in year seven.
In addition to recapture risk, CDEs must maintain compliance with their allocation agreement with the CDFI in order to remain eligible for future allocation awards. An individual CDE’s allocation agreement may require that greater than 85% of QEI proceeds be invested in QLICIs.
The most significant risk is the risk of tax credit recapture. NMTCs can be recaptured if:
- A CDE fails to maintain its status as a qualified CDE, or
- Substantially all of the QEI proceeds fail to be invested in a QLICI, or
- A QEI is redeemed during the seven year compliance period.
To maintain status as a CDE, the CDE must demonstrate that
- at least 60% of its products and services are directed towards serving Low Income Communities or Low Income Persons, and
- at least 20% of its governing or advisory board members are representatives of low income communities within the CDE’s service territory.
To demonstrate that substantially all of QEI proceeds are invested in QLICIs, records must be maintained that show that at least 85% of QEI proceeds are invested in QLICIs within one year. This is usually done by directly tracing amounts through bank statements of the CDE (the “direct trace test”) for each QEI, or by methods of aggregating QEIs (the “safe harbor test”). If this test is failed, there are provisions which allow for a one time correction. It is important that CDEs track the age of their QEIs if they are using the direct trace test to ensure that all QEIs are invested in QLICIs before the requisite twelve-month period.
To avoid redemption of a QEI, the CDE must not make a capital distribution in excess of its Operating Income. There is a specific calculation for Operating Income that must be applied. This is an annual test and should be performed prior to the end of a test period to allow time for corrective measures.
Returns of capital from a QALICB to a CDE must be reinvested in another QALICB within 12 months. CDEs typically try to minimize the amortization of QALICB investments in order to avoid the requirement to reinvest. The requirement to reinvest does not apply in year seven.
In addition to recapture risk, CDEs must maintain compliance with their allocation agreement with the CDFI in order to remain eligible for future allocation awards. An individual CDE’s allocation agreement may require that greater than 85% of QEI proceeds be invested in QLICIs.