Accounting for Investing in Tax Credit Structures

Developments aimed at improving simplicity and clarity

INVESTING in tax credit structures refers to investing in entities that own tax credits. Federal tax credit programs encourage private sector investment in a wide variety of projects that the government deems important, including renewable energy, low-income housing and the preservation of historic buildings. Also known as tax credit funds, they are a way for businesses to receive tax credits by investing in various projects that have been approved by the government. Tax credits can provide businesses with significant tax savings, making these investments an attractive option for many companies.

The accounting for tax credit structures has been in the profession’s mainstream recently as companies increase focus on environmental, social and governance (ESG) requirements and as the range of tax credits grows. The Financial Accounting Standards Board (FASB) has responded with outreach aimed at better understanding the practical accounting complications confronted by those in the profession. As a result, a new accounting standard update (ASU) is now in the process of being finalized with updated guidance aimed at simplifying the accounting for tax credit structures.       
    

Accounting Complications 

As noted, accounting for tax credit investments has been historically complex. While some of these structures allowed investors to account for the credits using a simplified approach, many have been accounted for using the equity or cost method, which then introduced continued complexities that would often result in investment gains and losses, impairment considerations, and tax credits being presented gross on the income statement across different line items as opposed to a net approach on the one tax line item. This all tended to potentially sabotage the motivation to engage in the transaction. 

While the federal government actively tried to stimulate private investment in tax credit structures, the related accounting complexity has been an unintended impediment. These cumulative and cumbersome accounting challenges have led to a concentrated effort from stakeholders to seek prioritization from the profession to simplify the accounting treatment of these investments. 

One such solution, called proportional amortization, was adopted by FASB in 2014, and offered relief from the accounting quagmire but applied only for treatment of low-income housing tax credit investments (LIHTC). The good news is that this move alone can be attributed to a significant increase in the investment in LIHTC tax structures in the ensuing years. 

What is the Proportional Amortization Method (PAM)?

The PAM of accounting allows an investor to amortize the cost of the investment in proportion to the income tax credits and other income tax benefits received. The amortization amount is calculated by multiplying the initial investment by the percentage of tax credits and benefits allocated in the current year to the total anticipated tax credits and benefits over the life of the investment. The resulting amortization is presented as a component of income tax expense (benefit), as opposed to being presented on a gross basis on an entity’s financial statements in different areas of the income statement, and better reflects fairly the substance and intent of the transaction. This method allows for the investor to account for the investment in a manner similar to a loan investment.

Emerging Issues Task Force Issue No. 21-A, Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method

Due to the potential expansion of tax credit programs and questions that arise in practice today, the FASB took on a project to expand the proportional amortization treatment comprehensively to all applicable credit structures. As such, in January 2023, FASB’s Emerging Issues Task Force (EITF) ratified a final consensus reached late in 2022 on the expanded use of the PAM for certain tax credit investments. Currently, as previously referenced, the use of the PAM has been only available for LIHTC investments as an alternative to either the cost or equity method. However, in response to the feedback from stakeholders, the consensus expands the use of the PAM to many more tax credit investments. This should provide for more consistent accounting, allow investors to better evaluate returns on their investments, and promote investment that had likely been paralyzed for accounting reasons. 

Criteria to Use the PAM

The following criteria must be met to use the PAM. These criteria are similar to the criteria that currently apply for investments in LIHTCs, with some clarification: 

1. It is probable that the income tax credits allocable to the investor will be available. 
2. The investor does not have the ability to exercise significant influence over the operating and financial policies of the underlying project. 
3. Substantially all the projected benefits are from income tax credits and other income tax benefits. Projected benefits include, but are not limited to, income tax credits, other income tax benefits and other non-income tax-related benefits, including refundable tax credits (i.e., those tax credits not dependent upon an investor’s income tax liability). When evaluating this criterion, tax credits that are accounted for outside the scope of Topic 740 (for example, refundable tax credits) are included in total projected benefits, but not in income tax credits and other income tax benefits. This criterion is determined on a discounted basis, using a discount rate that is consistent with the cash flow assumptions utilized by the tax equity investor for the purpose of deciding to invest in the project.
4. The investor’s projected yield based solely on the cash flows from the income tax credits and other income tax benefits is positive.
5. The investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the investor’s liability is limited to its capital investment.

Conclusion

The ability to apply proportional amortization across more credit structure programs removes long standing accounting complexity and is a win for the accounting profession and the programs that benefit from robust investment.

The FASB is now in the process of drafting a final ASU with the following effective dates:

• Public business entities — Fiscal years beginning after Dec. 15, 2023, including interim periods within those fiscal years.
• All other entities — Fiscal years beginning after Dec. 15, 2024, including interim periods within those fiscal years.

Be sure to follow further details once the ASU is released along with disclosure requirements to comply with. Please see your accounting and tax professional for more in-depth support.