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The Current: Renewable Energy Rules of Thumb – Where Do They Come From?

Published by Forrest D. Milder on Friday, August 1, 2014

Journal cover August 2014   Download PDF

A number of “rules of thumb” are often used in renewable energy tax credit equity transactions. It’s worthwhile to know the source of those rules, so you can better judge when it may be OK to bend or break a few of them—as long as your investor is willing. Remember the “Golden Rule” of investing: “He who has the gold makes the rules!” This rule trumps all because, even if there is support for following or waiving one of these rules of thumb, the person who is putting up the cash must agree. Some investors are more aggressive than others, and others will simply take on any reasonable risk, but price their investment accordingly. So, you should never presume that an investor and a developer will agree that any of these rules of thumb apply to their transaction.

In general, this article refers to guidance and rules that may or may not formally apply to particular kinds of renewables, but which may be cited by analogy. For example, the wind revenue procedure (Rev. Proc. 2007-65) only applies to production tax credits (PTCs) and then, only to wind. Nonetheless, because wind is a source of renewable energy, the revenue procedure is commonly relied upon for other renewable energy transactions. The historic tax credit (HTC) safe harbor revenue procedure (Rev. Proc. 2014-12) doesn’t apply to energy property at all, but it is a popular source of guidance because of the similarity of the HTC to the energy investment tax credit (ITC). Each is a percentage of the cost of the facility, arises when the property is placed in service, is subject to a five-year recapture period and is eligible to be “passed through” to a lessee.

There is other relevant guidance. The equipment leasing revenue procedure (Rev. Proc. 2001-28) particularly covers leveraged leases, where the lessor borrows money to acquire the property, which is then leased to the user, although it can also apply to the simple “sale leaseback” where the user builds the property, sells it to an investor that then leases it back to the user, without need for a third party lender. Unlike the wind and historic revenue procedures, where the rules are intended to provide a “safe harbor” against audit, the equipment leasing guidance provides the actual guidelines used by the Internal Revenue Service (IRS) for advance ruling purposes. As discussed below, other rules have arisen with respect to other credits, such as the rule of thumb for development fees which is consistent with guidelines for the low-income housing tax credit (LIHTC).

Some of the more common rules follow.

Initial Capital Contribution
Both the wind revenue procedure and the HTC revenue procedure require that at least 20 percent of the investor’s investment be made on or before the placed-in-service date. The equipment leasing revenue procedure requires a minimum investment of at least 20 percent of the cost of the property at that time. Those who are active in tax credit equity will recognize how common “20 percent” is, and this is a popular, but not always the minimum, capital contribution for renewables.

Value of the Property
When leases are involved, the value of the property at the end of the lease should be at least 20 percent of its value at the time the property was placed in service. This rule of thumb comes from the equipment leasing revenue procedure, and that revenue procedure adds the further requirement that the determination be made “without including in such value any increase or decrease for inflation or deflation.” Remembering that the equipment leasing rules are strict rules used by the IRS before issuing letter rulings, whether to actually back out inflation in a renewable transaction will depend on the comfort level of the investor and its counsel.

Useful Life of the Property
At the end of any lease of the property, the useful life of the property should be at least 20 percent of the originally estimated useful life of the property. In computing the term of the lease, all renewal or extension periods are included, unless they are at the lessee’s option and are at fair rental value. These rules also come from the equipment leasing revenue procedure. It is common to get an appraisal that addresses this standard and the previous one in any renewable transaction that involves a lease. Of course, the reason for this rule and the one about value is to assure that the lessor did not part with so much of the life or value of the property that the transaction should be characterized as a sale to the “lessee,” which would cost the landlord the credits and depreciation that otherwise come with owning the property.

Puts and Calls
Experienced tax equity professionals know that “puts” (generally, the ability of the investor to force someone to buy its interest) and “calls” (generally, the ability of the developer to force the investor to sell its interest) are handled somewhat inconsistently in IRS guidance. While there is case law supporting both puts and calls at fair market value, the revenue procedures are not so lenient. Both the equipment leasing and wind revenue procedures allow calls at no less than fair market value, but not puts, regardless of price. On the other hand, the historic guidance allows puts at no more than fair market value, but it does not allow calls, again, regardless of price.

There also continues to be uncertainty about when to determine fair market value. For example, Section 7701(e)(4) of the Internal Revenue Code prohibits “fixed and determinable” purchase price options when distinguishing between leases and service contracts, but it exempts from this prohibition options that are “for fair market value,” suggesting that a pre-arranged fair market value option is OK. Similarly, Announcement 2009-69, which amends the wind revenue procedure, provides that a pre-arranged price between the investor and the developer that is “negotiated for valid non-tax business reasons at arm’s length by parties with material adverse interests” is acceptable. On the other hand, the historic revenue procedure provides that fair market value must be determined at the time a permitted put is exercised.

With renewable transactions not officially subject to any of these rules, the marketplace has set its own standards. Fair market value, determined at the future date of the put or call, seems to be the most common treatment. However, this is not universal. Some parties are comfortable with puts and calls with a predetermined fair market value, while some of their more conservative colleagues are only comfortable with puts or calls, but not both, and would further require that fair market value be determined at the time of exercise.

Development Fees
The IRS hasn’t published guidance on how long the payment of development fees can be deferred. Indeed, about the only IRS statement of any kind is Technical Advice Memorandum (TAM) 200044004, which involved a development fee in an LIHTC property that was due and payable not more than 13 years after the development was completed. Note that this 13-year period was not a requirement of the IRS; it was merely in the statement of facts. Moreover, the 13-year period is less than the 15-year “compliance period” that applies to the LIHTC as well as the typical 15 years (or longer) length of an investor’s investment. By comparison, renewables typically have a five-year recapture period, and similarly shorter lengths of investment. Accordingly, it is not clear that this 13-year time frame is appropriate for renewables.

Similarly, there is no published federal guidance on the amount of development fees. Consistent with the “qualified allocation plans” adopted by the states in connection with the LIHTC, much of the tax equity marketplace has taken the position that development fees on the order of 15 percent of other capitalized expenditures are appropriate. However, this is truly a “rule of thumb,” with little to actually support that percentage. Indeed, in administering the Section 1603 grant in lieu of tax credit program, the Treasury has been approving far lower percentages.

In 1989, in TAM 8931001 involving the HTC, the IRS indicated its lack of comfort with “flips,” essentially contending that it wasn’t meaningful to say that a person had a high percentage interest in profits (and therefore, the tax credit) at a time when the venture wasn’t generating profits. This persuaded many tax advisers to not use flips. This position changed some with the publication of the wind revenue procedure in 2007, which specifically permitted flips. As a result, flips have long been seen in renewable energy transactions. With the recent approval of flips again, now in the historic revenue procedure, this seems to not be much of an issue any longer.

The wind and historic revenue procedures are consistent in requiring that the managing partner or member of the entity start with at least a 1 percent interest that can be increased upward, while allowing the investor partner or member to flip to as little as 5 percent of its largest interest. Note that this is not an absolute number, it’s a relative one. For example, if the investor starts with a 20 percent interest, then the flip would be to 5 percent of that amount, or just 1 percent. Of course, flips don’t have to go to as little as 5 percent; they can wind up higher if the investor wants a larger interest, or the parties think that more is required to demonstrate “profit motive.”

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].

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