The New Markets Tax Credit Program is an innovative tax policy that will help inject capital into underserved areas. However, the legislation needs targeted changes for it to truly spur entrepreneurial activity in low-income areas.
The Program, which is part of the Community Renewal Tax Relief Act of 2000, allows taxpayers to receive a credit against federal income taxes for making qualified equity investments in designated Community Development Entities (CDEs). Substantially all of the qualified equity investment must in turn be used by the CDE to provide investments in low-income communities. A credit provided to the investor can total up to 39% of the cost of the investment and is claimed over a seven-year credit allowance period. Investors may not redeem their investments in CDEs prior to the conclusion of the seven-year period, which is a major concern for private equity and venture capital funds.
The Program is administered by the U.S. Treasury’s Community Development Financial Institutions Fund (CDFI Fund) and the Internal Revenue Service. Credits are allocated annually through the CDFI Fund to CDEs under a competitive application process. The CDEs then sell the credits to taxable investors in exchange for stock or a capital interest in the CDEs. To qualify as a CDE, an entity must be a domestic corporation or partnership that (1) has been certified as a CDE by the CDFI Fund, (2) has a mission of serving, or providing investment capital for low-income communities or low-income persons, and (3) maintains accountability to residents of low-income communities through representation on a governing board or advisory board for the entity.
If the applicant CDE secures an allocation of credits, it will pass those credits to investors that put capital to work in “Qualified Equity Investments” within the CDE’s geographic location. Investors in a CDE will receive a credit against their federal income taxes that may reach as high as 39% over a seven-year period.1
How It Works
Investors receive a tax credit in the amount of 5% of the investment for each of the first three years and 6% for each of the next four years, totaling 39% of the investment. However, investors lose tax basis in the amount of credits claimed. As a result, investors may be subject to additional capital gain tax on the amount of the credit upon exit. Assuming a discount rate of 10%, an investor marginal tax bracket of 35% and capital gain tax paid in the year after tax credit expiration, the present value of the credit’s return enhancement to taxable corporate investors would be approximately 22 cents per $1 of investment on an after-tax basis.2
Throughout the life of the Program, the CDFI Fund is authorized to allocate credits to CDEs covering up to $15 billion in equity investments. The Fund published its first annual Notice of Allocation Availability (NOAA) in the Federal Register on June 11, 2002. The NOAA invited CDEs to compete for tax credit allocations in support of an aggregate amount of $2.5 billion in qualified equity investments in CDEs. On March 14, 2003, the Fund announced that 66 CDEs had been selected to receive the first credit allocations. The largest single recipient was the city of Phoenix, Ariz., which received $66.3 million in allocated credits through a non-profit entity it created – the Phoenix Community Development and Investment Corporation (PCDIC). The amount of credits allocated to this entity is sufficient to support investments of up to $170 million.
As an example of the types of investments that CDEs will be making, PCDIC plans to divide the proceeds it receives from the sale of New Market tax credits into $120 million for commercial real estate development, $30 million for venture capital (mostly for bioscience and information technology companies) and $20 million for loans to small businesses.
Only for-profit CDEs can apply to the CDFI for a tax credit allocation since nonprofit corporations cannot offer equity to investors. Most potential investors will be tax sensitive (i.e., entities with sufficient income tax liability to offset). Typical investors include banks, insurance companies and non-financial institutions with an interest in and ability to underwrite investment in low-income communities. Additionally, likely investors will include banks with Community Reinvestment Act obligations. Investors are unlikely to include “tax indifferent” entities (i.e. foundations, pension funds and other tax-exempt organizations that are unable to utilize tax credits) or individuals since the credits cannot reduce taxes below the alternative minimum tax imposed by the IRS.
An entity may be certified as a CDE by the CDFI Fund and designated as a vehicle through which Program investments must be made if it meets the following “Primary Mission” and “Accountability” tests. An entity will satisfy the Primary Mission test if at least 60% of its activities are dedicated to serving, or providing investment capital for, low-income communities or low-income persons. Similarly, the Accountability test is satisfied if the entity maintains accountability to residents of low-income communities by maintaining 20% community representation on any governing board or on any advisory board. The CDFI Fund recognizes that a non-resident may be a representative of a community because of the work he or she performs in that community.
The CDFI Fund will certify CDEs on a rolling basis. Once granted, certification continues until it is revoked or terminated by the CDFI Fund. A single CDE application may be submitted for multiple legal entities that are commonly controlled (i.e. parent and affiliates/subsidiaries). However, each individual entity must separately satisfy the Primary Mission and Accountability tests.
CDEs will have five years in which to secure investment capital and place credits with investors. For venture capital and private equity funds, the invested capital will be reflected by an equity position and/or an interest in a partnership. In return for the capital contribution, investors in a CDE receive an allocation of credits reflected by a tax credit certificate from the CDE to attach to their federal income tax forms.
The CDE then uses the investment capital generated from the sale of credits to provide loans, equity and other forms of capital to qualified low-income community businesses in targeted distressed areas. (Of course, most private equity and venture funds would take an equity position – common or preferred stock – as opposed to loans.) The Program is designed to allow the CDE to use its local knowledge of the community and expertise in community development to decide which businesses to invest in or lend money to.
There are a number of different types of investments a qualifying CDE may make with credit proceeds, including investments in a “Qualifying Business.” 3 A business will be deemed a Qualifying Business for purposes of investment by a CDE it meets the following tests:
* It is a low-income community business (i.e., a business within any population census tract where the poverty rate is at least 20%, family median income does not exceed 80% of the greater of statewide median family income or metropolitan area median family income, or any other areas designated by the Secretary of Treasury);
* At least 40% of the use of the tangible property of the business (whether owned or leased) is within a low-income community – the “Tangible Property” test;
* At least 40% of the services performed for the business by its employees are performed in the low-income community; and
* If neither of the two preceding tests above is satisfied at or above the 50% level, at least 50% of the business’s total gross income is derived from the active conduct of a qualified business within any low-income community.
Substantially all (85%) of the credit proceeds required from investors must be invested in qualified low-income community investments. This investment level must be satisfied annually during the seven-year tax credit period. However, there is an effective one-year grace period in the beginning contingent upon the proceeds being invested within one year.
Proceeds received by a CDE from an exit or liquidity event (dividends, distributions, principal repayment and cash or stock from a sale, but not interest received) must be reinvested in other community investments within one year of receipt. However, there is an exception that if capital is received in the final (seventh) year of the tax credit period, it does not need to be reinvested in another portfolio company.
Penalties for Noncompliance
Failure to comply with the requirements of the Program triggers what is known as recapture. 4 Recapture is retroactive, meaning that investors lose not only future credits on their investment, but also credits they have already claimed. Moreover, interest is due on the recaptured credits that have already been claimed.
Some typical events that might give rise to recapture include the following:
* A CDE redeems all or a portion of an investor’s investment before the end of seven years;
* A portfolio company falls out of compliance;
* A CDE loses its certification; or
* A CDE fails the “Substantially All” test.
A CDE could fail the Substantially All test if it receives a return of principal (whether from loan amortization or from an exit event) and does not reinvest it within a year in another community investment in accordance with the reinvestment requirements or if one of its portfolio companies ceases to satisfy any one of the Qualifying Business tests described above.
Notwithstanding the foregoing, the IRS may waive a requirement or extend a deadline in order to avoid recapture if doing so does not materially frustrate the purposes of the New Markets legislation.
Additionally, the temporary regulations promulgated by the Treasury Department provide for a safe harbor from recapture if the investor in a business had a reasonable expectation that a business would remain compliant throughout the seven-year investment period and the investor does not control the business (i.e., owns less than 33% of voting control). Accordingly, if such a reasonable expectation exists at the time of the investment, the CDE and its New Markets investor would be protected from recapture. The challenge of this safe harbor for venture capital funds is the necessity for continual vigilance with respect to the 33% control threshold.
The following discussion highlights some of the problems inherent in the Program as they apply to private equity and venture capital funds, as well as some suggested remedies.
Problem 1: Timing Issues and the 7-Year Requirement
Venture capital provides the ability to recognize rapidly growing businesses. The ultimate goal is to achieve a level of performance that warrants a liquidating event or exit strategy. Often, this may occur before the seven-year waiting period mandated by the Program. Mandating a time frame in which venture capital and private equity funds can begin harvesting their investments ignores the dynamics of the business in which the investment has been made and prevents responsive investment practices. Additionally, the one-year reinvestment requirement focuses on individual portfolio company investments in low-income communities rather than providing the tax incentive to support capital commitments to a fund of qualifying investments. This, in many cases, will undermine the venture capital financial model and performance. According to the Community Development Venture Capital Alliance, these untenable guidelines have resulted in most practitioners having shied away from the Program.5
Some possible solutions include the removal of the seven-year holding period altogether or, if the legislators insist on a holding period, allowing distributions to flow back into low-risk loans that service a CDE. Similarly, the definition of a qualifying reinvestment could be modified to include venture capital funds as opposed to limiting such reinvestment to portfolio companies. Expanding the application of capital to an overall fund focusing on identical low-income investing, rather than on a specific portfolio investment, would achieve the same developmental objectives of the current Program while decreasing the significant risk of recapture.
Problem 2: Ownership Creep, Down Rounds, Ratchet Provisions
A typical investment paradigm involves a venture capital fund making an early stage investment. For illustrative purposes we will say that the venture fund invests $250,000 in exchange for 20% of the company based upon a $1 million pre-money valuation. In this way, the CDE is well below the 33% control threshold.
However, as is typical in today’s economic climate, the portfolio company will likely spend the $250,000 without achieving its revenue or profitability milestones and will be in need of additional capital. Accordingly, its valuation will remain stagnant or may fall below the $1 million pre-investment valuation of the last round. If the venture capital fund/CDE invests additional capital it may result in ownership/control in excess of the 33% safe harbor threshold. Moreover, if a third-party purchases equity securities of the portfolio company at a valuation below the prior round, the first-round venture capital fund/CDE will typically have the benefit of anti-dilution protection provisions, which automatically increase its control without having to make any additional investment. This “ownership creep” can have severe consequences upon a CDE attempting to maintain compliance with the Program and the retention of valuable tax credits. The alternatives include allowing an unaffiliated third-party to invest the money and obtain the benefit of the upside potential, foregoing or capping the anti-dilution protections or abandoning the investment altogether.
There is another type of “ratchet provision” that is a common investment variation in the venture capital model and which can lead to conflicts with the Program requirements. These ratchet provisions are focused on company performance rather than serving as a protective mechanism for the sale of cheap stock. Specifically, the portfolio company works toward identified business performance measures. In the event of a shortfall in achieving these performance hurdles, the venture capitalist has the right to increase its equity stake and, consequently, its level of control over the portfolio company.
To avoid conflicts with the Program, the typical investment paradigm will need to change. For example, any future ratchets in ownership as a result of failed performance goals or dilutive financing could be capped at 32.9%, or additional board seats could be provided in lieu of a ratchet.
Problem 3: ‘Substantially All’ Test and Cash Flow
The Program requires that “Substantially All” (85%) of the cash proceeds of a tax credit investment be invested in qualifying investments. This leaves 15% of the proceeds for non-qualifying investments, operating expenses and other uses. (In practice, this will be management fee related.) This onerous result can make it difficult for traditionally structured venture capital funds to operate appropriately and pay management fees and other operating expenses.
Beyond the cash flow arrangements for most venture capital funds, the typical fund is structured with finite terms, usually 10 years. The timing of deal sourcing and subsequent “harvesting” often results in the venture capital fund making investments in the first few years and then seeking to cash-out of those investments to realize a return in the later years.
A venture capital fund ordinarily pays its operating expenses out of contributed capital. That is, the fund pays a management fee (typically 3% per year of funds under management for a community development venture capital fund) to a management company whose employees manage the fund. In addition, other operating expenses not included in the management fee, such as legal and accounting fees, may be paid from the corpus of the fund, on top of the management fee.
The fund ordinarily does not have much current income to pay for these costs, because equity investments produce income at the end of the life of the investment in the form of capital appreciation. Without current income, a venture fund must pay for operating expenses, such as the management fee and other expenses, out of contributed capital. This may run afoul of the Substantially All test. For example, a fund that pays a 3% per year management fee over a typical 10-year fund life would pay out 30% in fees, plus additional amounts for other expenses. Obviously, this would be impossible to do if only 15% of contributed capital may be used for purposes other than making qualifying investments.
This problem is alleviated somewhat by a provision in the tax credit legislation that makes “technical assistance” to portfolio businesses a qualifying use of tax credit funds, which counts toward the Substantially All test. It can be argued that a significant portion of the management costs of a community development venture capital fund go toward technical assistance to portfolio companies and prospective portfolio companies.
However, this still may not be enough to make the tax credit work for the traditional structure of a venture fund. Making the management fee of a traditionally structured community development venture capital fund count toward the Substantially All test would remove this issue from the list of problems that make it difficult to use the tax credit for equity investment. One solution would be to simply lower the Substantially All percentage to 75%. This would allow for normal management fees to be paid (2.5%-3% per annum) without encroaching on the 85% requirement.
This is no doubt an innovative tax policy that will assist in deploying capital into underserved areas. Private equity and venture capital funds seeking to utilize the new Market Tax Credits program should be aware of the structural limitations that the legislation imposes. However, with targeted changes, the program could go a long way in achieving its stated goal of spurring entrepreneurial activity in low-income areas.
Ross P. Barrett is Co-Founder of VC Experts, Inc. and a Partner with VCE Capital. Previously, he worked on Capitol Hill as a legislative aide to senior U.S. Sen. J. Bennett Johnston, where he specialized in risk assessment and regulatory reform.
Dan Mahoney is an attorney with the law firm of Rogers & Theobald LLP (www.rogerstheobald.com) in Phoenix, Ariz. His areas of focus include venture capital, securities, mergers and acquisitions and corporate compliance.
1. See generally the CDFI Web site. See also the Federal Reserve explanation at http://www.rich.frb.org/.
2. Phillip Bylund, Novogradac NMTC Report.
3. There are other qualifying assets that do not apply to venture funds, they include: (1) purchase from another CDE of a qualifying loan it made to a third party; (2) financial counseling and other services (advice provided by a CDE relating to the organization or operation of a trade or business that is provided to a qualified active low-income community business or residents of a low-income community); (3) loans or equity investments in CDEs; and (4) loan loss reserves not exceeding 5% of cash received from investors.
4. Recapture applies to the entirety of an investor’s investment in a CDE, even if the event is triggered by only one of many portfolio companies.
5. See CDVCA website www.cdvca.org
6. Phillip Bylund, Novogradac NMTC Report December 2002.