The Current: Anticipating Tax Issues in Renewable Energy Investment Tax Credit Transactions. Part 2

Published by Forrest D. Milder on Wednesday, May 1, 2013
Journal thumb May 2013

Last month, The Current discussed how post-closing items can greatly complicate trying to claim an investment tax credit (ITC) or Section 1603 grant, or even result in recapture. In that issue, we looked more closely at Section 1603 grants; this month, we’ll review ITCs and the rest of the issues that are most likely to arise in a renewable energy tax equity transaction, including an important concept: structure risk.

The ITC for renewables is provided by Internal Revenue Code (IRC) Section 48, and it is generally 30 percent (10 percent for a few technologies), and it temporarily incorporates many of the technologies described in Section 45 that would otherwise be eligible for the production tax credit (PTC). There are substantial similarities to the Section 1603 grant, but also significant differences.

Of course, the credit is not a cash award; it is applied to reduce tax liability, and it is typically used by the owner of the facility. Like the grant, it is possible to pass the credit through to a lessee in a lease pass-through transaction. In the past, credits were not limited to grandfathered projects, but were instead required to be placed in service by certain deadlines. However, at the end of 2012, most wind, biomass, geothermal, landfill gas, solid waste, hydropower and marine and hydrokinetic were made subject to a “begun construction” requirement with the deadline set at Dec. 31, 2013. We’ll discuss the IRS’s recent guidance on this test. Solar, fuel cells, some geothermal and cogeneration are generally subject to a Dec. 31, 2016 placed in service deadline, with the credit for some declining to 10 percent, and for others, eliminated entirely.

So, what might go wrong here?

The New IRS Rules about “Begun Construction”
On April 15, 2013, the IRS published Notice 2013-29, providing two tests, either one of which must be passed in order for most wind, biomass, geothermal, landfill gas, solid waste, hydropower and marine and hydrokinetics to be eligible for the PTC or ITC. The two tests are largely the same as the two tests under the Section 1603 program, which also has a grandfathering rule, i.e., the “physical work test” and the “five percent safe harbor.” The physical work test requires the taxpayer to undertake physical work such as pouring concrete or building equipment; it must be “integral” to the project, so transmission towers are ineligible, and it must be part of a continuous program of construction, that can only be stopped by certain enumerated disruptions, including natural disasters, labor stoppages and “financing delays of less than six months.” Alternatively, the project can pass the five percent safe harbor, which requires that expenditures equal to 5 percent of the project’s cost be paid or accrued in accordance with the Section 461 regulations. One significant change from the Section 1603 rules is that the IRS requires “continuous efforts to advance towards completion of the facility” in order for this test to be passed. The standards are a bit easier to meet than for the physical work test. For example, paying or incurring additional amounts, or obtaining necessary permits are sufficient to show continuous efforts, and the same list of permitted disruptions are allowed.

There are a few other items worth noting. First, there is no preliminary application for credits, like there is under Section 1603. And second, when work is done by others, it must be pursuant to a “written binding commitment”, and unlike Section 1603, the commitment must have no limit on damages. Section 1603 allowed damages to be capped at five percent of the amount of the contract; at the time of this writing, there were indications the IRS might change this rule and adopt a 5 percent damage provision like the one that applies to grants. And third, like Section 1603, there is not a requirement to identify the project, although the continuous work requirements under both tests may make it impractical to not identify the project.

Failure to Meet the Timing and Expenditure Standards
Like the grant, the credit can be lost or substantially reduced if the applicable deadline is not met, i.e., begun construction before 2014 for the many facilities described in the preceding section, and placed in service before 2017 for solar, fuel cells, and several others. Cost overruns present a second possible problem for facilities subject to the begun construction requirement. At the end of Notice 2013-29, the IRS distinguishes between a multi-facility project (e.g., a wind farm) where the number of turbines comprising the project could be reduced, if necessary, so that the remaining ones would pass the 5 percent safe harbor and a single boiler/turbine project where it would not be possible to reduce the number of facilities if cost overruns amounted to more than twenty times (i.e., the inverse of 5 percent of) the amounts incurred in 2013.

Regardless, unlike the grant, a determination that the deadline has been met or that the 5 percent test has been passed is only made by the taxpayer (with his counsel and/or accountant). There’s no preliminary finding for credits like the one made by Treasury under the Section 1603 program. Obviously, when a project involves wind, biomass, geothermal, landfill gas, solid waste, hydropower and marine and hydrokinetic, it is important that an investor verify that the tests of Notice 2013-29 have been met, and this can put a higher premium on review by qualified professionals.

Computations and IRS Audits
Here’s another category that is similar to, but different from, grants. While IRS audits are not that common, and if they ever come, they typically come years after the project is placed in service, it is important for the person claiming the credit to exercise care in the positions taken. Because the determination is made by the taxpayer and claimed on a tax return, it is not literally subject to any kind of advance governmental valuation standards, or limitations on development fees, and so on. Once again, relying on knowledgeable professionals can be an important safeguard against an IRS audit, although this is not absolute protection. (See the discussion of structure risk below.) Importantly, as a tax credit, and not a cash payment, the ITC is not subject to sequestration. Indeed, many investors reserve the right to choose between credits and grants in their investment documents, and the 8.7 percent haircut for grants may be a strong incentive for them to pursue Section 48 instead of Section 1603.

Tax-Exempt Use
The tax credit is also subject to tax-exempt use rules, but they are different from those that apply to the grant. Like the grant, ownership by a tax-exempt entity, or a partnership or LLC that includes a tax-exempt entity, can result in recapture, although unlike the grant, the measure of tax-exempt use is proportional to the tax-exempt’s highest percentage interest in a partnership or LLC. On the other hand, leases to tax-exempts, which do not affect the computation of the Section 1603 grant, can be a large problem for the investment tax credit. As a result, it is common for tax professionals to assure that a contract to sell electricity to a tax-exempt entity won’t be recharacterized as a lease under IRC Section 7701(e).

Dispositions
Credits are subject to recapture if during the five year recapture period, either the facility is transferred or the taxpayer’s interest in a pass-through owner is reduced by more than one-third (e.g., a reduction from a 90 percent interest to a 59 percent interest would be more than a one-third reduction.) Transfers include involuntary dispositions, such as a foreclosure. As you can see, there’s even more incentive for an investor to have a subordination, non-disturbance and attornment (or SNDA) agreement (as described in Part 1) to assure that the project isn’t transferred, resulting in recapture. Of course, this can be a tough negotiation between a lender who doesn’t want to surrender any rights and an investor who doesn’t want the lender threatening to foreclose and risking its credits.

Depreciation
Another significant tax feature of a renewables project is losses, generally derived from the rapid depreciation that applies to renewable facilities. But, there are important technical rules. When a partnership or LLC structure is used, an investor’s share of the depreciation can generally be allocated to the investor only to the extent of the investor’s investment plus its share of the project’s nonrecourse debt. Accordingly, it can be important to assure that the general partner or managing member of the facility’s owner has not taken on personal liability for the debt, either through guarantees, or because it (or a related party) is the lender. Any of these would cause the facility’s losses attributable to the debt to be allocated to the general partner or managing member. Obviously, this could reduce the value that the investor is willing to contribute to the venture as part of its investment.

Damage or Destruction
Credits, grants and depreciation are all subject to loss, and grants and credits are subject to recapture if the property is destroyed during the five-year recapture period. The tax treatment of repairable damage is less certain, but the prevailing view is that prompt and diligent repair of a damaged facility will enable the project to avoid recapture.

Structure Risk
Like any marketplace, tax equity for renewables has developed a range of features that are common to many deals. Nonetheless, the industry is not the final arbiter of what works for tax purposes. Instead, governmental authorities (Treasury and IRS) and, especially, the courts often have the final say. For example, as you have read here, the 3rd Circuit Court’s decision in Historic Boardwalk Hall LLC v. Commissioner (HBH) has significantly affected risk sharing between general partners and investors, and whether the investor would be recognized as a partner who can be allocated the tax benefits associated with owning and operating a renewable project.

This brings us to an important consideration in any investment based on the protections and assurances sought by the parties; the investor may want assurance that the project will stay solvent and generate the anticipated tax benefits and cash flow, while the general partner may want confidence that it can get back control of the project after the tax benefits are no longer subject to recapture for a reasonable amount. But the IRS may have other ideas about whether these kinds of rights are consistent with the investor and developer being partners for tax purposes. This raises the question of who bears the risk if the IRS challenges how these assurances are provided, i.e., the deal structure itself. For example, the investor in HBH benefited from extensive guarantees of the benefits and a guaranteed investment contract that provided cash for distributions and a buy-out, but the partnership was also subject to significant fees that would significantly limit the possibility that there would be any upside cash distributed to the investor, even if the partnership did exceptionally well. Having features such as these obviously provided certain protections to the parties. However, they were also thought by the IRS and the courts to indicate that the investor was so protected that it wasn’t really a partner, so that it wasn’t entitled to the tax benefits, regardless of their availability.

Accordingly, it is important that the parties agree in advance as to which party will bear this structure risk, i.e., the risk that the partnership relationship of the parties will be respected, or the risk that a contract that purports to be a lease will be treated as a lease, and so on. Remember that it isn’t always easy to predict the IRS’s handling of a tax structure. Before the court’s decision in HBH, the parties likely felt that the lower court’s taxpayer-favorable decision bode well for future transactions that featured guarantees and the protection provided by a guaranteed investment contract, etc., while the court of appeals’ reversal generated the opposite belief. Obviously, careful attention to the changing IRS view of certain deal features, and thoughtful advice from your professional advisers, can be key.

Hopefully, this leaves you a bit better prepared when negotiating, closing, and operating a renewables project that benefits from tax equity!

Forrest David Milder is a partner with Nixon Peabody LLP. He has more than 30 years’ experience in tax-advantaged investments including the tax credits that apply to affordable housing, energy, new markets and historic rehabilitation, as well as the tax treatment of partnerships and LLCs, tax-exempt organizations, and structured financial products. He can be reached (617) 345-1055 or [email protected].