As Clean Energy Tax Incentives Expand, Transaction Structure Decisions are More Crucial
A report by the Joint Committee on Taxation, a nonpartisan Congressional committee, estimates that clean energy tax incentives will add up to about $550 billion over the next decade and those in the tax credit community estimate the clean energy tax incentive equity market will settle at around $50 billion annually, making it the largest community development tax credit equity market.
Last year’s passage of the Inflation Reduction Act of 2022 (IRA) extended and enhanced many existing tax incentives for clean energy–such as the investment tax credit (ITC) and production tax credit (PTC)–and then went well beyond that, creating many more. The expansion of clean energy tax incentives has led to a dramatic increase in the number of clean energy developers/sponsors, lenders, cash flow and tax equity investors.
To better maximize the financial viability of a given clean energy development, sponsor/developers–whether they’re developing a facility in an energy field in which they have great experience, are an experienced developer working with one or more new technologies or are new to clean energy tax incentives–must focus on investor needs and preferences. It’s not as simple as getting the highest price per dollar of credit. Sponsor/developers must also negotiate sharing with their investor(s) many other key economic benefits, such as tax losses, operating cash flow and residual value.
Understanding the desires of their tax equity investor is crucial for a sponsor/developer to have a successful negotiation, closing and ongoing partnership.
For starters, sponsor/developers should understand the benefits and challenges of the three most common transaction structures investors use, as well as the areas that are negotiable. Sponsor/developers must also evaluate a new energy tax credit monetization option created by the IRA, namely, transferability.
The partnership flip is arguably the most-used structure for owning and operating most types of renewable energy facilities. This is because it tends to be popular with sponsor/developers and investors. Sponsor/developers like the structure because it often allows them to buy out the tax equity investor for a lower amount than in a sale leaseback structure (see next page) and the greatest number of tax equity investors are comfortable with the structure. Tax equity investors tend to be comfortable with the structure because it has a long track record, having been used in renewable energy for decades, and there is consensus in the tax adviser community with respect to documenting ownership terms and conditions and the treatment of various tax issues.
The key transaction points that sponsor/developers and tax equity investors negotiate are the contribution to tax credit ratio (aka price per credit), annual priority return amounts and call option buyout terms.
The inverted lease uses two partnerships: one partnership to own the facility (often referred to as the owner or lessor) and a second partnership to operate the facility (often referred to as the operator or lessee). The tax equity investor makes its investment in the lessee, because this is the partnership that reports the ITC. The lessor, as the owner of the facility, reports the tax depreciation expense. It’s common for the lessee to take a minority ownership interest in the lessor to benefit from some of the tax depreciation benefits.
Sponsor/developers are known to like this structure primarily because the ITC is calculated based on the facility’s fair market value (FMV) and if the facility’s FMV is higher than its cost basis, this can result in more tax equity being raised. Sponsor/developers also like this structure because they don’t have to reduce depreciable basis for what is known as the ITC basis reduction. As a result, tax depreciation deductions are higher in this structure. The catch is that the taxpayers who are allocated the ITC must recognize the ITC basis reduction equivalent in taxable income, which for the ITC is 20% per year over five years and not prorated for partial years. This structure is widely considered more complex than the partnership flip and therefore not all tax equity investors are interested. This structure cannot be used for PTCs or to transfer the ITC.
The key transaction points that sponsor/developers and tax equity investors negotiate are the contribution to tax credit ratio (aka price per credit), annual priority return amounts, put option buyout terms and the amount of ownership, if any, the lessee takes in the lessor.
The sale leaseback is also common. In this structure, a sponsor/developer will sell the completed facility to an investor, often a bank, and then the investor and sponsor/developer enter into a lease agreement whereby the sponsor/developer agrees to make periodic lease payments to the investor in exchange for the rights to operate the facility. An advantage of this structure when compared to the partnership flip or inverted lease is that the investor does not have to be an owner on or before the facility is placed in service: There is a 90-day period following commencement of operations for the investor to become an owner. Another advantage is that this structure is widely considered to be less complex than the partnership flip or inverted lease and therefore often less complex to close on.
Noteworthy drawbacks of this structure are that it cannot be used for PTC transactions and there is no ownership flip and therefore if the sponsor and investor want to end their relationship before the end of the lease term, the sponsor/developer needs to buy the investor out for the full fair value of the investor’s ownership interest of the facility. That makes it more expensive for the sponsor/developer to regain ownership versus the partnership flip and inverted lease structures.
The most talked-about provision of the IRA is transferability, which allows taxpayers ineligible to take the new direct-pay option (which is available largely for nonprofits and government entities) to transfer clean energy credits (including the ITC and PTC) to an unrelated third party in exchange for an untaxed payment. There are 11 types of clean energy technologies eligible for transfer and a credit can only be transferred once.
This is expected to be used most by sponsor/developers who own facilities that lack access to more traditional forms of tax equity (i.e., smaller facilities and/or facilities featuring a lesser-known clean energy technology).
Some of the primary benefits of transferability include that taxpayers can monetize the tax credits after the date the facility is placed in service, it provides traditional tax equity transaction participants the option of transferring the credits in the event their ability to use the credits changes and it allows sponsors of smaller facilities or facilities using lesser-known technologies a financing option without trying to use traditional tax equity structures.
The primary challenges of transferability include that transferring the tax credits does not also monetize tax depreciation deductions or cash flows and therefore generally requires the sponsor/developer to invest more of their own money into the facility. Another challenge is that the inverted lease structure cannot be used to transfer ITCs, limiting the structure options. Also, tax credit transfers are subject to at-risk rules which, depending on how the facility is financed, might result in fewer credits that can be transferred in the year the facility is placed in service.
With multiple structures and other options, clean energy sponsor/developers face decisions. Investors may insist on a specific structure or may demand concessions to go with the structure sought by the project sponsor/developer. With multiple moving pieces–developer fees, tax credit equity pricing, tax losses, priority return, exit fees, puts, etc.– sponsor/developers should be aware that there are plenty of areas open for negotiation and each change can affect other areas.
Here are five key items to remember when considering options in clean energy transaction:
- Tax losses. When industry participants talk about “tax losses” they are usually referring to tax depreciation benefits, which are usually significantly less than the tax credits but still valuable. Investors calculate tax depreciation benefits by multiplying their annual tax loss by their effective tax rate. Thus, if a corporate investor is allocated tax losses in 2023 of $1 million and their effective tax rate is 21%, then their tax loss or depreciation benefit is $210,000. We say “depreciation benefit” because renewable energy facilities generally generate positive net operating income, and they ultimately report a tax loss because of the tax depreciation expense. For internal rate of return (IRR) investors, being allocated tax losses from tax depreciation sooner increases their after-tax IRR. For investors that primarily evaluate their return based on the after-tax return on investment (ROI) measure, the timing of tax depreciation is less relevant: Although an ROI investor may want the tax losses sooner rather than later, the timing has no impact on their actual after-tax ROI.
- Priority returns/distributions of net operating cash flow: Sponsor/developers place a tremendous value on the net operating cash flow generated by the facility. As such, they have a strong tendency to lean toward investors that require the least amount of cash flow to achieve minimum investor return levels. That said, investors usually require a certain cash flow, not only to achieve return levels but to achieve a cash-on-cash profit, which is an important benchmark to meet for tax analysis reasons. Therefore, this aspect of negotiations often gets a significant amount of attention.
- Call/exit payment: Call/exit payments are generally structured to approximate the FMV of the investor’s interest at the time they are bought out. The FMV is often calculated as the net present value of what the investor reasonably expects to get from the facility over the remaining useful life of the transaction. As a result, sponsor/developers naturally want that amount to be as low as possible and investors want the opposite. Although the parties are known to negotiate in their respective best interests, call/exit payments are generally structured to equal fair market value. That said, if the parties are trying to ensure a higher or lower FMV, this is often achieved by increasing or decreasing the investor’s post-flip ownership interest or priority return requirements, while also making sure they satisfy important tax analysis criteria (i.e., cash-on-cash profit).
- After-tax ROI/IRR. Investors often require a minimum after-tax ROI or IRR. To achieve these, the investor will allow the developer/sponsor some flexibility in how these minimum hurdles are achieved. For example, the investor may not be particularly concerned with how much of their return is achieved from tax depreciation benefits vs. cash flow and an exit payment. However, since sponsor/developers place the most value on cash benefits, they intuitively work hard to make sure the investor’s return is achieved as much as possible with tax credits and tax depreciation benefits to minimize the amount of cash flow they need to distribute to the investor.
- Financial reporting: Financial reporting tends to be a bigger issue when an investor is first trying to determine whether they are willing to invest in renewable energy tax credit-financed facilities. At a high level, most tax equity investors want to ensure they don’t have to consolidate their investment. This is a threshold issue: If an investor must consolidate, that’s often a show-stopper. Fortunately, the way most partnership flips and inverted leases are structured means it is rare for an investor to meet consolidation criteria. Instead, most partnership flip and inverted lease investments qualify for equity method accounting treatment under generally accepted accounting principles (GAAP). The next financial reporting obstacle for investors is determining if the investment qualifies for the heavily favored proportional amortization method (PAM) or if they must apply the unpopular hypothetical liquidation at book value (HLBV) method. Without going into great detail on both, most renewable energy ITC investments have a difficult time qualifying for PAM based on the size of the investment relative to the tax credits received. PTC investments and below-market ITC investments are the least difficult to qualify for. If an equity method investment in a fairly standard renewable energy tax credit partnership flip type arrangement doesn’t qualify for PAM, then it’s wise to assume the investor will have to apply HLBV. The HLBV method is viewed as complicated, subject to a great deal of interpretive judgment, the results can be unpredictable and erratic and often lack a resemblance to the perceived economic reality of the investment. Most importantly, the consensus is that HLBV results do not provide investors and financial statement users with information that helps them make informed business decisions about renewable energy investments. HLBV is so unpopular that it has resulted in many investors either deciding not to invest in renewable energy at all, or it has stymied investment and/or delayed investment.
Conclusion: Consider Your Options
The clean energy tax incentive world has expanded tremendously in recent years and will continue to do so, bringing additional project sponsor/developers and investors into the marketplace. With an estimated $50 billion per year in clean energy tax incentive equity, there’s plenty of action–but it’s not a one-size-fits-all transaction world.
Participants should consider a variety of issues while negotiating: Both the structure of the transaction and the specifics of the agreement are open to negotiation, so those involved should consider options and their likely effect on the agreement. Guidance from experienced tax advisors and legal professionals is critical to making better informed, educated decisions.