Bad-boy guarantees do not turn nonrecourse debt into recourse debt for tax purposes, the IRS said.
Most power and other infrastructure projects are owned by special-purpose project companies. If the project company borrows to build the project, it tries to do so on a nonrecourse basis, meaning that if the project company defaults on the debt, then the only recourse the lenders have is to take the project. They cannot go after the owners directly for repayment of the debt.
Whether debt is recourse or nonrecourse has tax consequences.
For example, in a partnership, each partner has both a “capital account” and an “outside basis.” These are two ways of measuring what each partner put into the deal and what it is allowed to take out. A partner’s outside basis includes his share of debt at the partnership level. Therefore, the more debt he can put in his outside basis, the more room he has to be allocated tax losses and to be distributed cash by the partnership.
Nonrecourse and recourse debt are shared differently by partners in outside basis. One way a partner who wants to have more of the debt in his outside basis can do so is to guarantee repayment of the debt: in other words, make it recourse to him.
The IRS said in an internal memorandum made public in April that a bad-boy guarantee does not turn a nonrecourse debt into a recourse debt until the event that triggers the guarantee occurs.
A “bad-boy guarantee” is a guarantee that kicks in only when the partner does something wrong. For example, he transfers part of the security that backs the debt without getting consent from the lenders. Another example is he makes a voluntary filing for bankruptcy protection or admits in writing that he is insolvent.
Bad-boy guarantees are used by lenders to protect themselves against bad acts in cases where they are otherwise prepared to lend on a nonrecourse basis. They are more common in real estate transactions than in the broader project finance market.
The IRS analysis is in an internal memorandum, AM 2016-001.