- New Section 4965 May Significantly Affect Tax-exempt Entities That Are Parties to Section 42 and Other Tax-credit Transactions
- August 2, 2006
- Law Firm: Nixon Peabody LLP - New York Office
On May 17, 2006, Section 4965 became part of the Internal Revenue Code with the enactment of the Tax Increase Prevention and Reconciliation Act (TIPRA). The Code section provides new excise taxes that can apply to tax-exempt organizations that engage in many tax-credit-related transactions, as well as their managers. In addition, TIPRA amends Section 6033 and 6652 of the Code to provide new disclosure rules for tax-exempt organizations that participate in these transactions. Now, in Notice 2006-65, dated July 11, 2006, the IRS has spelled out some of the rules under these new provisions, with a possibly chilling effect for tax-credit projects that involve tax-exempt organizations. This Affordable Housing Tax Alert summarizes the new rules, but before you read them, we call to your attention the fact that the IRS has invited comments on the new rules to be submitted by August 11, 2006. This is one time that such comments will be especially important.
New Section 4965 applies to many tax-exempt entities and their managers that engage in “prohibited tax shelter transactions,” defined to include (among others) transactions “with contractual protection” as defined in regulations prescribed by the Treasury Department.1 The notice defines this term using the recently adopted regulations on “reportable transactions” which we discussed in a previous alert.2
Here’s a short summary of the definitions included in the reportable transaction rules: In its Section 6011 regulations, Treasury defined a transaction with “contractual protection” as one in which a taxpayer “has the right to a full or partial refund of fees…if all or part of the intended tax consequences from the transaction are not sustained.” For this purpose, “fees” are defined as being “paid by or on behalf of the taxpayer or a related party to any person who makes or provides a statement, oral or written, to the taxpayer or related party (or for whose benefit a statement is made or provided to the taxpayer or related party) as to the potential tax consequences that may result from the transaction.” Note that regulations under Section 6112 provide: “A fee does not include amounts paid to a person, including an advisor, in that person's capacity as a party to the transaction. For example, a fee does not include reasonable charges for the use of capital or the sale or use of property.”
There are three possible situations to which the new Section 4965 rules might apply, and each should be reviewed in light of the definitions described in the preceding paragraph. These are: (a) when an exempt organization is the developer, and it adjusts the development fee (or makes a payment to the investor) if tax credits are less than expected; (b) when an exempt organization serves as the “syndicator” and adjusts its fees or returns part of an investor’s capital contribution if tax credits are less than expected; and (c) when a third party (e.g., a for-profit syndicator) provides a guarantee of benefits, and an exempt organization is merely a “party” to the transaction.
Based on the definition of “fees” described above, an excellent argument can be made that development fees that might be reduced or refunded (as described in item (a)) are not subject to these rules, since they are paid for the services rendered as a “party to the transaction.” Indeed, the IRS recently endorsed the practice of exempt organizations returning development fees as part of a tax-credit guarantee, in an internal memorandum discussing its approval process for applications for tax-exemption status.3 However, the argument may be harder where either the exempt organization or another person serves as the syndicator, and the investor is either guaranteed the tax benefits or entitled to a refund from the syndicator (i.e., items (b) and (c) in the preceding paragraph). Note that the new rules do not require the tax-exempt entity to be the one providing the “contractual protection;” only that it be a party to a transaction that has such protection.
In any event, many exempt organizations will want more than an “excellent argument.” When only the “reportable transaction” rules were at issue, it seemed easy enough to make a “protective filing,” and it is not surprising that participants chose to comply with those rules, rather than risk an adverse IRS interpretation.
Now, the new TIPRA provisions have raised the level of concern about these rules, because new Section 4965 provides for a very high excise tax—as high as the greater of (a) all of the entity’s “net income” from the transaction or (b) 75% of the proceeds received by the entity for the taxable year attributable to the transaction—if the entity “knew, or had reason to know” that the transaction was a prohibited tax shelter transaction. Furthermore, “the person with authority or responsibility similar to that exercised by an officer, director, or trustee” with respect to the transaction is subject to a fine of $20,000 for each approval. Finally, new amendments to Sections 6033 and 6652 require disclosure to the IRS of these transactions, with a $100-per-day penalty for failure to disclose (up to a maximum of $50,000), as well as an additional $100 per day (up to a maximum of $10,000) for failure to comply with a specific demand from the IRS. Note that disclosure of a transaction does not insulate the exempt organization from liability. Effectively, the provisions are requiring the organization to notify the IRS if it is engaging in a transaction that could subject it to liability.
Remarkably, the new excise taxes are effective for taxable years ending after May 17, 2006, with respect to transactions entered into at any time, provided that income or proceeds are “properly allocable” to any period ending after August 15, 2006 (i.e., ninety days after TIPRA became effective). In other words, transactions entered into many years ago, with outstanding development fees subject to adjusters if anticipated tax credits are not achieved, might be subject to these penalties.4
The new disclosure requirements apply to disclosures “with a due date after May 17, 2006.” Neither the code provisions nor the notice provide a form or a specific due date for transactions covered by the new rule. Section 6033(a)(2) simply requires a filing “in such form and manner and at such time as determined by the Secretary.” Accordingly, it is possible that disclosures could be required for transactions that occurred before TIPRA but for which the organization continues to receive income or proceeds. While the “better view” is that only “new” transactions must be disclosed, the effective date language suggests that “old” transactions can be subject to the rules as well.5
As a result, unless and until Congress addresses these issues, or the IRS amends either the notice or the reportable transaction regulations, it is not clear whether exempt organizations should participate in transactions that arguably have “contractual protection.” An alternative may be to structure transactions using tax-paying subsidiaries of exempt organizations, but this can be a high price to pay if it means conceding that fees earned by the organization would now be subject to tax. Similarly, it is not easy to advise on what should be done with transactions that have outstanding fees subject to adjusters. Currently, there is nothing in the notice or elsewhere that provides any kind of “grandfathering,” other than the August 15 reference that appears above.
Unofficially, the IRS has acknowledged that these issues are on their radar screen, but they haven’t yet settled on how to treat them, or just when additional guidance will be provided. Recognizing the enormity of the issue, we will be preparing a letter to the IRS urging that transactions described in Sections 42 (low-income housing), 45D (new markets), and 47 (historic rehabilitations) of the code be excluded from the definition, and we would be pleased to receive your thoughts and comments in this regard.
You should feel free to contact us to find out more about Section 4965. Please contact Forrest Milder, 617-345-1055 or [email protected]
1. The new rules also apply to the especially egregious transactions known as “listed transactions” and to “confidential transactions,” but these will not be discussed in this alert.
2. See “IRS Disclosure Requirements Affecting Tax Credit Transactions” dated April 21, 2005, available on the Nixon Peabody website, at http://www.nixonpeabody.com/linked_media/
3. See “IRS Releases New Internal Memorandum on Qualifying Housing Organizations for Tax-Exempt Status,” dated May 2, 2006, also on our website, at http://www.nixonpeabody.com/publications_detail3.asp?Type=P&ID=1351
4. It may be possible to make contrary arguments based upon the wording of the code section that refers to “prohibited tax shelter transaction,” a term that was not defined until TIPRA became law. However, it is difficult to recommend this approach. Plainly, the “effective date” of the excise tax provision is “tax years ending after May 17, 2006, with respect to transactions before, on, or after such date ….”
5. Like the excise tax provision, the “effective date” of the disclosure provision is “tax years ending after May 17, 2006, with respect to transactions before, on, or after such date ….”