The past two years have been surreal economic times. In the fourth quarter of 2008, the finance world as we knew it came crashing down, leaving in its dust new financing rules across the gaming industry and, more generally, across Indian country as well. Capital became increasingly difficult, if not outright impossible, to obtain. Problems in the finance markets for the gaming industry and Indian country were exacerbated as various casino properties entered bankruptcy as a result of questionable decisions by certain borrowers. (The words “Lac du Flambeau” should conjure up a reaction for those involved in Indian country finance.)
While the past two years have presented challenges, Congress has offered some tools designed to spur economic development, albeit they are tools generally inaccessible to most gaming businesses. The watershed American Recovery and Reinvestment Act introduced Tribal Economic Development (TED) Bonds, which ostensibly allowed Indian tribes to issue tax-exempt bonds for economic development projects on the same basis as state or local governments. Significantly, TED Bonds eliminated the “essential governmental functions” test in order for Indian tribes to issue federal tax-exempt bonds. The bonds could not be used to finance facilities where Class II or Class III gaming is conducted, a result consistent with respect to limitations imposed on state or local governments when issuing tax-exempt bonds. The bonds were also subject to a national $2 billion volume cap, which required Indian tribes to apply for an allocation. Tribes were generally limited to an initial $30 million bond allocation pursuant to a notice issued by the Internal Revenue Service. Congress has not acted, and there has been no indication that Congress will act, to extend TED Bonds or more generally visit the disparity the “essential governmental functions” test imposes on Indian country vis-à-vis the rules under which state and local governments can issue tax-exempt bonds. Thus, with the expiration of the tax-exempt bond provisions under the Recovery Act, Indian tribes have lost one finance tool for economic development projects.
However, a financing tool that has gained significant popularity, the New Market Tax Credit, remains available. The New Market Tax Credit program was recently extended by the 2010 Tax Relief Act. The credit, perhaps due to its scarce availability and the complex federal tax rules to gain and maintain eligibility, has not necessarily been widely used as of yet, but with awareness and a basic understanding of how to use it, the New Market Tax Credit may introduce an untapped financing tool for much of Indian country.
What It Is and What It Is Not
A 30,000-foot level understanding of the complicated web of tax law rules governing the New Market Tax Credit is a necessity to assess the practicality of pursuing a financing using the credits. The Internal Revenue Code is infamous for its contradictory language and definitions that defy traditional logic. A couple of observations are helpful in wrapping one’s mind around the New Market Tax Credit program.
1) The person seeking financing does not receive the credits. Rather, a tax credit investor will infuse the money, which will ultimately be contributed or loaned to the person with an eligible project.
2) The Internal Revenue Code limits the types of projects that are eligible to be financed by New Market Tax Credits.
Not all projects are qualifying activities that will generate New Market Tax Credits. The Internal Revenue Code specifically identifies the types of activities that are ineligible. A simple rule of thumb is that business activities that one may enjoy in partaking during the weekend are usually ineligible activities. The specific business activities identified under the federal tax law that are ineligible include: gambling or racetrack facilities; the operation of golf courses or country clubs; massage parlors; tanning businesses; hot tub facilities; or any store that has the principal business of selling alcohol for off-premises consumption.
Community Development Entities (CDE) that receive allocations of tax credits from the United States Department of the Treasury may also impose limitations on the types of projects they will finance. For example, some CDEs will focus their resources on particular geographic regions, business activities (e.g., charter schools) or types of borrowers, such as Indian country borrowers.
Suffice to say, if the project that is seeking financing is a casino or convenience store, then the New Market Tax Credit program will not be an option. However, a hotel, housing project, mixed-use commercial building or convention facilities could potentially be eligible projects.
3) The ultimate project must entail the operation of a “qualified business.”
A corollary to this observation is that a qualifying investment must be made in what the tax law labels a “qualified active low-income community business” (QALICB). The activities of the QALICB must constitute a “qualified business” in order to be eligible to generate New Market Tax Credits. For purposes of the New Market Tax Credit, almost any “trade or business” can be a “qualified business.” A “qualified business” is also not limited to purely for-profit businesses. A non-profit can qualify provided the activity to be financed is in furtherance of its exempt purposes.
4) The tax credits are generated at the CDE level and are used by an investor that contributes capital. The entity seeking financing, the QALICB, receives capital typically in the form of an equity contribution or a loan.
A “qualified equity investment” in a CDE will actually generate New Market Tax Credits. Without overly complicating an already complicated subject matter, a CDE must first receive an allocation of New Market Tax Credits from the United States Department of the Treasury. Under the 2010 Tax Relief Act, the New Market Tax Credit program was extended for 2011 and 2012 with a $3.5 billion limitation for each year. CDEs apply on a competitive basis to receive an allocation.
Investors must make a “qualified equity investment” in a CDE. The CDE, in turn, must make what is known in the tax law as “qualified low-income community investments.” This means that the CDE—or a subsidiary of the CDE—must make a qualifying investment in a QALICB. The qualifying investment can be in the form of any capital or equity investment or loan to the QALICB.
The effect of these rules is that complicated structures are employed to make qualified equity investments.
5) The New Market Tax Credit is a 39 percent tax credit received over a seven-year period. Because credits are received over a seven-year period, the tax law imposes recapture rules.
Tax credit recapture is a very bad event for all involved parties. Tax credit recapture means that the investor actually receiving the credits has lost the benefit of the tax credit. In other words, the investor is likely compelled to repay to the Department of the Treasury the amount of the credit claimed. As a result, New Market Tax Credit financings will impose stringent requirements on the borrower (a.k.a. the QALICB) during the seven-year recapture period, which effectively commences on the closing date of the financing.
6) The New Market Tax Credit is limited to investments in “low-income communities” or certain “targeted populations.”
It is a significant point to recognize that an otherwise qualifying investments may not be eligible to generate New Market Tax Credits unless the investment is made in a “low-income community” or with respect to certain targeted populations. “Low-income communities” are defined by reference to a census tract where the medium family income does not exceed 80 percent of the statewide or metropolitan area median family income. In a typical New Market Tax Credit financing, it is necessary to review census tract data to determine whether the physical location where the QALICB conducts its activities is located within a low-income community.
For Indian tribes, the analysis under the New Market Tax Credit is much simpler. The IRS has issued guidance that identifies an Indian tribe as a targeted population. In other words, activities of Indian tribes can be eligible communities to generate New Market Tax Credits.
7) New Market Tax Credit transactions involve complicated transactional structures.
A New Market Tax Credit financing structure is straight from Rube Goldberg. Several entities are introduced into the mix, resulting in funds and tax credits flowing through more than one entity. Be prepared for complex transactions and the need for highly specialized professionals.
The above observations demonstrate the limitations and challenges with New Market Tax Credit financings. But while the deals are complex, the benefits are significant. The New Market Tax Credit program allows eligible borrowers to obtain financing at interest rates well below typical market interest rates. The reduced interest rates can often serve as the requisite financial incentive to deal with the attendant restrictions and complications with closing a financing and during the credit recapture period.
For Indian country, the New Market Tax Credit program presents an opportunity. While gaming facilities and golf courses are not eligible activities to be financed, many other economic development projects in Indian country could benefit from New Market Tax Credit financings. Indian country is placed in a desirable category because it has been identified as a targeted population eligible for New Market Tax Credit investments. Thus, facilities such as mixed-use developments, housing projects and other tribal businesses could be prime candidates for a New Market Tax Credit financing. Other types of tribal projects that could benefit from the New Market Tax Credit program are business activities that are ancillary to casino developments— just remember that golf courses are ineligible.
The economic climate appears to show signs of life, but with so many false starts and the prospect for continuing setbacks, even the most optimistic seem to have adopted a reserved view of the what the near-term future may bring. While capital has become more readily available in 2011, the cost of funds can still carry a substantial interest rate for the gaming industry and Indian country.
Indian country is acutely aware of the challenges of obtaining financing. The Recovery Act offered a short-term solution to eliminate the disparity for Indian tribes to issue bonds on a tax-exempt basis. Congress has not, however, recently shown any indication that it will seek a long-term solution to this disparity. While Indian country has some, albeit more limited, access to the tax-exempt bond market, other financing tools exist that may prove beneficial to Indian country. The New Market Tax Credit program is one such example.
Indian country has been identified as a targeted population eligible for New Market Tax Credit investments. Hence, Indian country has the ability to clear an obstacle that often presents challenges to other projects seeking New Market Tax Credit financing—satisfying that the project is located in qualified low-income community. The potential benefit for Indian country is the ability to access capital for much-needed economic development projects at lower—and potentially significantly lower—borrowing costs. A basic understanding and awareness of the tax credit financing program is the first step to identifying potentially eligible projects and exploring whether a New Market Tax Credit financing makes sense.
Author’s Note: In response to IRS Circular 230 requirements, any discussions of federal tax issues in this article are not intended to be used and may not be used by any person for the avoidance of any penalties under the Internal Revenue Code, or to promote, market or recommend any transaction or subject addressed herein.
Peter J. Kulick is a tax and gaming attorney with Dickinson Wright PLLC, which has an international gaming law practice with offices in Michigan, Nashville, Washington, D.C., Toronto and Phoenix. He received his LL.M in tax law from New York University. Kulick may be reached at pkulick[at]dickinsonwright.com.