On Appeal from the United States Tax Court (No. 11273-07) Judge: Hon. Joseph Robert Goeke
The opinion of the court was delivered by: Jordan, Circuit Judge.
Before: SLOVITER, CHAGARES, and JORDAN, Circuit Judges.
Page I. Background .................................................................. 9 A. Background of the HRTC Statute ...................... 9 B. Factual Background of the East Hall Renovation ....................................................... 15 1. NJSEA Background .................................. 15 2. Commencement of the East Hall Renovation ................................................ 16 3. Finding a Partner ..................................... 18 a) The Proposal from Sovereign Capital Resources .......................... 18 b) The Initial and Revised Five-Year Projections ..................................... 20 c) Confidential Offering Memorandum ................................. 22 d) Selection of Pitney Bowes .............. 23 e) Additional Revisions to Financial Projections ..................................... 25 4. Closing ...................................................... 26 a) The HBH Operating Agreement .... 27 b) Lease Amendment and Sublease .... 32 c) Acquisition Loan and Construction Loan ............................................... 33 d) Development Agreement ................ 34 e) Purchase Option and Option to Compel ........................................... 35 f) Tax Benefits Guaranty ................... 36 5. HBH in Operation ..................................... 37 a) Construction in Progress ............... 37 b) Post-Construction Phase ............... 41 6. The Tax Returns and IRS Audit ................ 44 C. The Tax Court Decision .................................. 46 II. Discussion .................................................................. 51 A. The Test ........................................................... 54 B. The Commissioner's Guideposts ..................... 56 C. Application of the Guideposts to HBH ............ 64 1. Lack of Meaningful Downside Risk .......... 69 2. Lack of Meaningful Upside Potential ....... 77 3.HBH's Reliance on Form over Substance .................................................. 80 III. Conclusion .................................................................. 85
This case involves the availability of federal historic rehabilitation tax credits ("HRTCs") in connection with the restoration of an iconic venue known as the "East Hall" (also known as "Historic Boardwalk Hall"), located on the boardwalk in Atlantic City, New Jersey. The New Jersey Sports and Exposition Authority ("NJSEA"), a state agency which owned a leasehold interest in the East Hall, was tasked with restoring it. After learning of the market for HRTCs among corporate investors, and of the additional revenue which that market could bring to the state through a syndicated partnership with one or more investors, NJSEA created a New Jersey limited liability company, Historic Boardwalk Hall, LLC ("HBH"), and subsequently sold a membership interest in HBH*fn1 to a wholly-owned subsidiary of Pitney Bowes, Inc. ("PB").*fn2 Through a series of agreements, the transactions that were executed to admit PB as a member of HBH and to transfer ownership of NJSEA‟s property interest in the East Hall to HBH were designed so that PB could earn the HRTCs generated from the East Hall rehabilitation. The Internal Revenue Service ("IRS") determined that HBH was simply a vehicle to impermissibly transfer HRTCs from NJSEA to PB and that all HRTCs taken by PB should be reallocated to NJSEA.*fn3 The Tax Court disagreed, and sustained the allocation of the HRTCs to PB through its membership interest in HBH. Because we agree with the IRS‟s contention that PB, in substance, was not a bona fide partner in HBH, we will reverse the decision of the Tax Court.
A. Background of the HRTC Statute
We begin by describing the history of the HRTC statute. Under Section 47 of the Internal Revenue Code of 1986, as amended (the "Code" or the "I.R.C."), a taxpayer is eligible for a tax credit equal to "20 percent of the qualified rehabilitation expenditures ["QREs"*fn4 ] with respect to any certified historic structure.*fn5 " I.R.C. § 47(a)(2). HRTCs are only available to the owner of the property interest. See generally I.R.C. § 47; see also I.R.S. Publication, Tax Aspects of Historic Preservation, at 1 (Oct. 2000), available at http://www.irs.gov/pub/irs-utl/faqrehab.pdf. In other words, the Code does not permit HRTCs to be sold.
The idea of promoting historic rehabilitation projects can be traced back to the enactment of the National Historic Preservation Act of 1966, Pub. L. No. 89-665, 80 Stat. 9156 (1966), wherein Congress emphasized the importance of preserving "historic properties significant to the Nation‟s heritage," 16 U.S.C. § 470(b)(3). Its purpose was to "remedy the dilemma that "historic properties significant to the Nation‟s heritage are being lost or substantially altered, often inadvertently, with increasing frequency.‟" Pye v. United States, 269 F.3d 459, 470 (4th Cir. 2001) (quoting 16 U.S.C. § 470(b)(3)). Among other things, the National Historic Preservation Act set out a process "which require[d] federal agencies with the authority to license an undertaking "to take into account the effect of the undertaking on any . site . that is . eligible for inclusion in the National Register‟ prior to issuing the license." Id. (quoting 16 U.S.C. § 470f). It also authorized the Secretary of the Interior to "expand and maintain a National Register of Historic Places." 16 U.S.C. § 470a(a)(1)(A).
The Tax Reform Act of 1976 furthered the goals of the 1966 legislation by creating new tax incentives for private sector investment in certified historic buildings. See Tax Reform Act of 1976, Pub. L. No. 94-455, 90 Stat. 1520 (1976). The pertinent provisions of the 1976 Act indicate that Congress wanted to encourage the private sector to restore historic buildings, and, to provide that encouragement, it established incentives that were similar to the tax incentives for building new structures. See, e.g., 122 Cong. Rec. 34320 (1976). Specifically, to equalize incentives affecting the restoration of historic structures and the construction of new buildings, it included a provision allowing for the amortization of rehabilitation expenditures over five years, or, alternatively, an accelerated method of depreciation with respect to the entire depreciable basis of the rehabilitated property. See I.R.S. Publication, Rehabilitation Tax Credit, at 1-2 (Feb. 2002), available at http://www.irs.gov/pub/irsmssp/rehab.pdf (hereinafter referred to as "IRS- Rehab").
The Revenue Act of 1978 went further to incent the restoration of historic buildings. It made a 10% rehabilitation credit available in lieu of the five-year amortization period provided by the 1976 Act. See Revenue Act of 1978, Pub. L. No. 95-600, 92 Stat. 2763 (1978); see also IRS-Rehab, at 1-2. In 1981, Congress expanded the rehabilitation credit to three tiers, so that a taxpayer could qualify for up to a 25% credit for certain historic rehabilitations. See Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, 95 Stat. 172 (1981); see also IRS-Rehab, at 1-2.
The Tax Reform Act of 1986 made extensive changes to the tax law, including the removal of many tax benefits that had been available to real estate investors. See Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085 (1986); see also Staff of J. Comm. on Tax‟n, 99th Cong., General Explanation of the Tax Reform Act of 1986 (Comm. Print. 1987) (hereinafter referred to as "General Explanation of TRA 86"). The HRTC survived, although it was reduced to its modern form of a two-tier system with a 20% credit for QREs incurred in renovating a certified historic structure, and a 10% credit for QREs incurred in renovating a qualified rehabilitated building*fn6 other than a certified historic structure. See Tax Reform Act of 1986 § 251, 100 Stat. at 2183; see also I.R.C. § 47. A Congressional report for the 1986 Act discussed the rationale for keeping the HRTC:
In 1981, the Congress restructured and increased the tax credit for rehabilitation expenditures [because it] was concerned that the tax incentives provided to investments in new structures (e.g., accelerated cost recovery) would have the undesirable effect of reducing the relative attractiveness of the prior-law incentives to rehabilitate and modernize older structures, and might lead investors to neglect older structures and relocate their businesses.
The Congress concluded that the incentives granted to rehabilitations in 1981 remain justified. Such incentives are needed because the social and aesthetic values of rehabilitating and preserving older structures are not necessarily taken into account in investors‟ profit projections. A tax incentive is needed because market forces might otherwise channel investments away from such projects because of the extra costs of undertaking rehabilitations of older or historic buildings.
General Explanation of TRA 86, at 149.
Evidently mindful of how the tax incentives it had offered might be abused, Congress in 2010 codified the "economic substance doctrine," which it defined as "the common law doctrine under which tax benefits . with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose."*fn7 I.R.C. § 7701(o)(5)(A). At the same time, however, Congress was at pains to emphasize that the HRTC was preserved. A Congressional report noted:
If the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such tax benefits be disallowed. . Thus, for example, it is not intended that a tax credit (e.g., . section 47[, which provides for HRTCs,] .) be disallowed in a transaction pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage.
Staff of J. Comm. on Tax‟n, Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010," as amended, In Combination with the "Patient Protection and Affordable Care Act," at 152 n.344 (Comm. Print 2010) (emphasis added). In sum, the HRTC statute is a deliberate decision to skew the neutrality of the tax system to encourage taxable entities to invest, both in form and substance, in historic rehabilitation projects.
B. Factual Background of the East Hall Renovation
In 1971, the State of New Jersey formed NJSEA to build, own, and operate the Meadowlands Sports Complex in East Rutherford, New Jersey. The State legislature expanded NJSEA‟s jurisdiction in 1992 to build, own, and operate a new convention center in Atlantic City and to acquire, renovate, and operate the East Hall. Completed in 1929, the East Hall was famous for hosting the annual Miss America Pageant, and, in 1987, it was added to the National Register of Historic Places as a National Historic Landmark.
In October 1992, before renovations on the East Hall began, NJSEA obtained a 35-year leasehold interest in the property for $1 per year from the owner, the Atlantic County Improvement Authority. About a month later, NJSEA entered into an agreement with the Atlantic City Convention Center Authority, the then-operator of the East Hall, to operate both the East Hall and the new convention center. In July 1995, NJSEA and the Atlantic City Convention Center Authority handed over management responsibility for both the East Hall and the yet-to-be-completed convention center to a private entity, Spectacor Management Group ("Spectacor").
2. Commencement of the East Hall Renovation
Once construction started on the new convention center in the early 1990s, NJSEA began planning for the future of the East Hall and decided to convert it into a special events facility. That conversion was initially anticipated to cost $78,522,000. Renovations were to be performed in four phases, with the entire project expected to be completed in late 2001.
The renovation project began in December of 1998. By that time, NJSEA had entered into agreements with the New Jersey Casino Reinvestment Development Authority*fn8 pursuant to which the Casino Reinvestment Development Authority agreed to reimburse NJSEA up to $4,146,745 for certain pre-design expenses and up to $32,574,000 for costs incurred in the East Hall renovation.
In a March 1999 document prepared in connection with a separate bond issuance,*fn9 NJSEA noted that it had received grants from the Casino Reinvestment Development Authority to pay for the first phase of the East Hall renovation and that "[f]unding for the remaining cost of the project . is expected to be obtained through the issuance by [NJSEA] of Federally Taxable State Contract Bonds." (J.A. at 708.) In June 1999, NJSEA issued $49,915,000 in State Contract Bonds to fund the East Hall renovation.
The first two phases of the renovation were completed prior to the Miss America Pageant held in September 1999, and Phase 3 began the following month. Through 1999, NJSEA had entered into rehabilitation contracts for approximately $38,700,000, and had expended $28,000,000 of that amount. Also at about that time, the estimate of the total cost of the project increased to $90,600,000. NJSEA‟s 1999 annual report stated that the Casino Reinvestment Development Authority had agreed to reimburse NJSEA for "all costs in excess of bond proceeds for the project." (Id. at 1714.) Thus, by the end of 1999, between the proceeds it had received from the bond issuance and funds provided -- or to be provided -- by the Casino Reinvestment Development Authority, NJSEA had assurances that the East Hall rehabilitation project was fully funded.
a) The Proposal from Sovereign Capital Resources
In August 1998, a few months prior to the beginning of renovations on the East Hall, Paul Hoffman from Sovereign Capital Resources ("Sovereign")*fn10 wrote to NJSEA regarding a "consulting proposal . for the sale of the historic rehabilitation tax credits expected to be generated" by the East Hall rehabilitation. (Id. at 691.) That proposal was "designed to give [NJSEA representatives] a better perspective on the structure of the historic tax credit sale, as well as the [potential] financial benefits (estimated in excess of $11 million) to the project." (Id.) As an initial summary, Hoffman stated that "the best way to view the equity generated by a sale of the historic tax credits is to think of it as an $11 million interest only loan that has no term and may not require any principal repayment." (Id.) Hoffman noted that although NJSEA, as a tax-exempt entity, would have no use for the 20% federal tax credit generated by QREs incurred in renovating historic structures, there were "entities that actively invest in [HRTC] properties . and are generally Fortune 500 corporations with substantial federal income tax liabilities." (Id. at 692.) Hoffman explained that because "[t]he [HRTC] is earned when the building is placed into service" and "cannot be transferred after the fact," "the corporate investor should be admitted into the partnership that owns the project as soon as possible." (Id.)
Hoffman next sketched out the proposed transactions that would allow NJSEA to bring an investor interested in HRTCs into co-ownership of the East Hall and yet provide for NJSEA to "retain its long-term interests in the [East Hall]." (Id. at 693.) First, NJSEA would sublease its interest in the East Hall to a newly created partnership in which NJSEA would be the general partner and a corporate investor would be the limited partner. The sublease agreement would be treated as a sale for tax purposes since the sublease would extend longer than the useful life of the property under tax rules. Next, that partnership would allocate 99% of its profit and loss to the limited partner corporate investor so that such investor could claim substantially all of the tax credits, but only be allocated a "small portion" of the cash flow. (Id. at 694.) Finally, after a sufficient waiting period, NJSEA would be given a purchase option to buy-out the corporate investor‟s interest. With all that said, however, Hoffman warned that "[c]orporate purchasers of [HRTCs] rarely accept construction risk," and "[t]ypically . provide no more than 10% of their equity to the partnership during the construction period." (Id. at 695.) Thus, Hoffman "recommend[ed] that NJSEA plan to issue enough bonds to meet the construction financing requirements of the project." (Id.)
Hoffman then provided a valuation of the HRTCs. He estimated that NJSEA could expect an investor to contribute approximately $0.80 to $0.90 per each dollar of HRTC allocated to the investor. In valuing the HRTCs, Hoffman "assume[d] that NJSEA would like to minimize the cash distribution to the investor and retain long-term ownership of [the East Hall]." (Id.) He also listed four "standard guarantees" that "[i]nvestors in the tax credit industry" would "require" as part of the transaction: (1) a construction completion guaranty; (2) an operating deficit guaranty; (3) a tax indemnity; and (4) an environmental indemnity. (Id. at 696.) Additionally, Hoffman noted that "the investor will expect that either NJSEA or the State of New Jersey be obligated to make debt service on the bond issuance if operating revenue is insufficient to support the debt payments." (Id.)
NJSEA decided to further explore the benefits described by Sovereign. In March 1999, NJSEA issued a request for proposal (as supplemented by an addendum on April 30, 1999, the "RFP") from "qualified financial advisors . in connection with a proposed historic rehabilitation tax credit transaction . relating to the rehabilitation of the East Hall." (Id. at 710.) The RFP provided that the selected candidate would "be required to prepare a Tax Credit offering Memorandum, market the tax credits to potential investors and successfully close a partnership agreement with the proposed tax credit investor." (Id. at 721.) In June 1999, after receiving four responses, NJSEA selected Sovereign as its "[f]inancial [a]rranger" for the "Historic Tax Credit transaction." (Id. at 750.)
b) The Initial and Revised Five-Year Projections
In September 1999, as the second phase of the East Hall renovation had just been completed, Spectacor, as the East Hall‟s operator, produced draft five-year financial projections for the East Hall beginning for the 2002 fiscal year.*fn11 Those projections estimated that the East Hall would incur a net operating loss of approximately $1.7 million for each of those five years. Sovereign received a copy of the projections, and, in a memo dated October 1, 1999, responded that it was "cautious about [Spectacor‟s] figures as they might prove excessively conservative." (Id. at 793.) In a December 10, 1999 memo to NJSEA representatives, Sovereign said that, for the yet-to-be-created partnership between NJSEA and an HRTC investor to earn the desired tax credits, the partnership "should be able to reasonably show that it is a going concern."*fn12 (Id. at 804.) To that end, Sovereign suggested that "[t]o improve the operating results, NJSEA could explore shifting the burden of some of the operating expenses from the [partnership] to the Land Lessor (either [the Atlantic County Improvement Authority] or NJSEA depending upon [how the partnership was structured])." (Id.)
Approximately two months later, Sovereign received revised estimates prepared by Spectacor. Those pro forma statements projected much smaller net operating losses, ranging from approximately $396,000 in 2002 to $16,000 in 2006. Within two weeks, Spectacor made additional revisions to those projections which resulted in estimated net operating income for those five years, ranging from approximately $716,000 in 2002 to $1.24 million in 2006. About 90% of the remarkable financial turnaround the East Hall thus was projected to enjoy on paper was due to the removal of all projected utilities expenses for each of the five years ($1 million in 2002, indexed for 3% inflation each year thereafter). When the accountants for the project, Reznick, Fedder & Silverman ("Reznick"), included those utilities expenses in their compiled projections one week later, Sovereign instructed them to "[t]ake [the] $1MM Utility Cost completely out of Expenses, [because] NJSEA [would] pay at [the] upper tier and [then] we should have a working operating model." (Id. at 954.)
c) Confidential Offering Memorandum
On March 16, 2000, Sovereign prepared a 174-page confidential information memorandum (the "Confidential Memorandum" or the "Memo") which it sent to 19 potential investors and which was titled "The Sale of Historic Tax Credits Generated by the Renovation of the Historic Atlantic City Boardwalk Convention Hall." (Id. at 955.) Although the executive summary in the Confidential Memorandum stated that the East Hall renovation would cost approximately $107 million, the budget attached to the Memo indicated that the "total construction costs" of the project were $90,596,088. (Id. at 1035). Moreover, the Memo stated that "[t]he rehabilitation [was] being funded entirely by [NJSEA]." (Id. at 962). The difference between the $107 million "estimated . renovation" (id. at 961), and the "total construction costs" of $90,596,088 was, as the Memo candidly put it, the "[p]roceeds from the sale of the historic tax credits" (id. at 963). The Memo did not contemplate that those proceeds, estimated to be approximately $16,354,000, would be applied to "total construction costs" but rather indicated that the funds would be used for three things: (1) payment of a $14,000,000 "development fee" to NJSEA; (2) payment of $527,080 in legal, accounting, and syndication fees related to the tax-credit transaction; and (3) the establishment of a $1,826,920 working capital reserve.
The Memo also provided financial projections through 2009. Those projections assumed that the investor would receive a 3% priority distribution (the "Preferred Return") from available cash flow on its $16,354,000 contribution, which contemporaneous NJSEA executive committee notes described as "required by tax rules." (Id. at 1135.) The financial projections provided for sufficient net operating income -- ranging from $715,867 in 2002 to $880,426 in 2009 -- to pay a portion of the Preferred Return on an annual basis (varying from $465,867 in 2002 to $490,620 in 2009), but also showed substantial tax losses through 2009 that were mainly attributable to depreciation deductions.
d) Selection of Pitney Bowes
Four entities, including PB, responded to the Confidential Memorandum and submitted offers "regarding the purchase of the historic tax credits anticipated to be generated by the renovation" of the East Hall. (Id. at 1143.) In a May 2000 letter supplementing its offer, PB recommended that NJSEA fund the construction costs through a loan to the partnership, rather than in the form of capital contributions, so that "the managing member could obtain a pre-tax profit and therefore the partnership would be respected as such for US tax purposes." (Id. at 1145.)
On July 13, 2000, PB and NJSEA executed a letter of intent ("LOI") reflecting their agreement that PB would make "capital contributions"*fn13 totaling $16.4 million over four installments in exchange for a 99.9% membership interest in HBH, which NJSEA had recently formed. The LOI further indicated that PB would also make an "Investor Loan" of $1.1 million. Consistent with PB‟s earlier recommendation, the LOI said that NJSEA, as the managing member retaining a 0.1% interest in HBH, would provide approximately $90 million in the form of two loans: (1) a purchase money obligation that represented the amount of QREs incurred by NJSEA in the East Hall renovation prior to PB‟s investment (the "Acquisition Loan"); and (2) a loan to finance the remainder of the projected QREs (the "Construction Loan"). According to the LOI, it was anticipated that the project would qualify for a minimum of $17,602,667 in HRTCs: $9,379,981 in 2000 and $8,222,686 in 2001. The LOI also noted that a 3% Preferred Return would be paid to PB. Although the LOI contemplated that PB would receive 99.9% of any available cash flow, HBH‟s financial projections from 2000 to 2042 forecasted no cash flow available for distribution during that time frame. Similarly, while the LOI mentioned that PB would receive 99.9% of the net proceeds from a sale of HBH, a pre-closing memo from NJSEA‟s outside counsel to NJSEA suggested that, "[d]ue to the structure of the transaction," the fair market value of PB‟s interest in HBH would be insignificant. (J.A. at 1162.) Thus, for its investment of $17.5 million ($16.4 million in capital contributions and the $1.1 million Investor Loan), PB would receive, in addition to the 3% Preferred Return, 99.9% of the approximately $17.6 million worth of HRTCs that would be generated from the QREs.
e) Additional Revisions to Financial Projections
Prior to the closing on PB‟s commitment to purchase a membership interest in HBH, an accountant from Reznick who was preparing HBH‟s financial projections, sent a memo to Hoffman indicating that the two proposed loans from NJSEA to HBH "ha[d] been set up to be paid from available cash flow" but that "[t]here was not sufficient cash to amortize this debt." (Id. at 1160.) To remedy the problem, Hoffman instructed the accountant to increase the projection of baseline revenues in 2002 by $1 million by adding a new revenue source of $750,000 titled "naming rights," and by increasing both "parking revenue" and "net concession revenue" by $125,000 each. Additionally, whereas the initial projections assumed that baseline revenues and expenses would both increase by 3% on an annual basis, the revised projections used at closing assumed that baseline revenues would increase by 3.5% annually, while maintaining the 3% estimate for the annual increases in baseline expenses. ...