An accounting rule that was specifically developed for reporting low-income housing tax credit (LIHTC) investments will soon be expanded to include more federal and state tax credit investment programs. A narrow-scope accounting standard will allow other tax credit programs, beyond LIHTC investments, to qualify for the proportional amortization method.
This simplified model allows the initial cost of the investment to be spread out in proportion to the tax credits and other tax benefits allocated to an investor. The new rule from the Financial Accounting Standards Board (FASB) comes at a time when more entities are making tax equity investments to meet environmental, social and governance objectives and for certain regulated entities to meet their Community Reinvestment Act goals.
Accounting Standards update (ASU) No. 2023-02, Investments – Equity Method and Joint Ventures, Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method, is designed to provide enhanced information about certain income tax credits and other income tax benefits. Many stakeholders welcome the change as the use of tax credit programs has increased in recent years.
Specifically, the LIHTC program is designed to encourage investment of private capital for use in the construction and rehabilitation of low-income housing projects. Examples of other federal tax credit programs that have similar objectives and will qualify for the simplified model are:
The New Markets Tax Credit. This program is intended to attract financing for the development of projects that will bring economic expansion to specifically designated areas.
The Historic Rehabilitation Tax Credit. Under this program, a credit is available that aims to encourage the restoration of designated historic sites.
The Renewable Energy Tax Credit. This program awards either production-based or investment-based tax credits for the creation of energy through renewable projects (for example, federal solar investment tax credits, on-shore wind production tax credits and off-shore wind investment tax credits).
In addition, investors that take advantage of future tax credit programs may have the option of using proportional amortization if they meet the qualifying criteria. For instance, several state-specific tax credit programs attract tax equity investors, and the Inflation Reduction Act, which was signed into law in August 2022, provides additional federal tax incentives for entities to invest in clean-energy technologies.
How the guidance is applied
To qualify for the proportional amortization method, a company must meet the following five conditions:
- It’s probable that the income tax credits allocable to the tax equity investor will be available,
- The tax equity investor can’t exercise significant influence over the operating and financial policies of the underlying project,
- Substantially all the projected benefits, determined on a discounted basis, are from income tax credits and other income tax benefits,
- The tax equity investor’s projected yield, based solely on the cash flows from the income tax credits and other income tax benefits, is positive, and
- The tax equity investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the tax equity investor’s liability is limited to its capital investment.
The election to use the proportional amortization method is made on a tax-credit-program-by-tax-credit-program basis, rather than at the reporting-entity level or to individual investments. A reporting entity that applies the proportional amortization method to qualifying tax equity investments must account for the receipt of the investment tax credits. This is done by using the flow-through method under Accounting Standards Codification Topic 740, Income Taxes, even if the entity applies the deferral method for other investment tax credits received.
In addition to expanding the simplified model to more tax programs, the new rules will also require specific disclosures for all investments that generate income tax credits and other income tax benefits from a tax credit program for which the entity has elected to apply the proportional amortization method. This includes investments within an elected program that don’t meet the conditions to apply the proportional amortization method. These disclosures include 1) the nature of the entity’s tax equity investments, and 2) the effects on its financial position and results of operations.
How the guidance may fall short
Until the upcoming change takes effect, only LIHTC investments can use the proportional amortization method. Under the current rules, investments in other tax credit structures are typically accounted for using the equity or cost method. This results in investment gains and losses and tax credits being presented gross on the income statement in their respective line items. The current methodology is complex and may not fairly represent the economic characteristics or profitability of such investments.
While many stakeholders welcome a simpler model, some believe the FASB could have gone further. Specifically, they wanted the new standard to expand the qualifying criteria so that more types of tax credit investments can qualify for the favorable accounting treatment.
For public companies, ASU 2023-02 takes effect for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. For private companies, it’s effective for fiscal years beginning after December 15, 2024, including interim periods within those fiscal years. Early adoption is permitted. The guidance must be applied either on a modified retrospective or a retrospective basis, except for LIHTC investments not accounted for using the proportional amortization method.
For more information related to the expansion of the simplified accounting model for tax credit investments or how the new guidance may impact your tax equity investment decisions, contact Rob Kitchen.