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The Current: Treasury Reveals Some of What’s Behind the Curtain

Published by Forrest D. Milder on Monday, August 1, 2011

Journal cover August 2011   Download PDF

I’ve been referring for quite a while to the Treasury’s handling of applications for Section 1603 cash grants in lieu of renewable energy tax credit as occurring “behind a curtain.” And while we so-called “experts” were able to give pretty good “guesstimates” about how Treasury evaluated Section 1603 applications, we certainly had to acknowledge that we were limited to just that − guessing and estimates.

This brings us to a remarkable new publication from Treasury. In a short and straightforward document entitled “Evaluating Cost Basis for Solar Photovoltaic Properties” (Evaluating Cost Basis), Treasury has now disclosed much of what goes on behind the curtain. And, it’s not surprising that we successfully guessed many of the rules and guidelines. No, the real surprise is that Treasury pulled back the curtain at all, providing some lucid explanations of how it thinks about valuations and grants.  

Here’s my take on Evaluating Cost Basis:

Solar Photovoltaic
First, note the title, especially the words “solar photovoltaic.” As we’ve observed previously, there can be little doubt that Treasury’s database of numbers and project details is by far the broadest for solar panel projects. It’s also the area of the renewables industry where we see the most applicants and applications, as well as the most creative (for lack of a better word) structuring. That’s not to say that Evaluating Cost Basis won’t often apply to renewables other than PV solar, but it is a recognition that photovoltaic is what Treasury knows best. As a corollary, Treasury likely finds it somewhat harder to set price per watt benchmarks and similar standards for other technologies for which it doesn’t see nearly as many applications.

Basic Rules
Treasury begins its analysis by observing that cost is the best measure of a project’s basis for computing the amount of a Section 1603 grant in most situations. Citing the regulations under Section 263A, Evaluating Cost Basis acknowledges that certain capitalized costs are included in basis as well, such as costs of permitting and engineering, as well as construction period interest.  

At the same time, Treasury observes that cost may not be the correct measure in situations where the transaction is not at arm’s-length or where it is based upon “peculiar circumstances” that influence the purchaser to agree to a price in excess of the property’s fair market value. Accordingly, Treasury observes that it will more closely scrutinize basis where there are related parties, related transactions, or other unusual circumstances, all of which are discussed below.

It is not necessary that an applicant’s computation of basis be made with bad intent in order to justify a reduction. As Treasury notes, “If the review team determines that the basis was not properly calculated or represented, the review team may adjust the basis on which a 1603 payment is made[,] to a level consistent with the review team’s view of the property’s true cost, as informed by documentation provided by the applicant and other relevant information and analysis.” Presumably, this statement is intended to be consistent with the court’s decision in ARRA Energy Company I v. United States. For a discussion of this case, please see The Current in the March 2011 Novogradac Journal of Tax Credits.

Benchmarks
Treasury then provides the benchmarks that it uses for evaluating the cost of a PV solar project. The benchmarks are intended to reflect the dealings of “entirely unrelated parties with adverse economic interests.” Furthermore, Treasury tells us that the benchmarks are updated continuously, based on public and confidential information, including analyses by experts, and data from Section 1603 applications.

Treasury’s benchmark PV solar market expectation numbers apply to four kinds of projects, as follows:

A – Residential – with a size range of less than 10 kilowatts (kW) and a typical size of 5kW, for which Treasury’s benchmark “turnkey price” is +/- $7 per watt;
B – Residential/Small Commercial – described as 10 to 100 kW, typically 25kW, for which the benchmark is +/-$6 per watt;
C – Commercial – described as 100 to 1000 kW, typically 250kW, yielding a benchmark of +/-$5 per watt; and
D – Large Commercial/Utility – described as greater than 1 MW, typically 2MW, and resulting in a benchmark of +/-$4 per watt.

Treasury has observed that the use of the notation +/- was intentional. These numbers are not intended to be locked in, and for any particular project, a higher or lower number may be appropriate. Note also that the benchmarks are intended to be based on the use of “high quality equipment … installed by reputable companies” and to include profit. Nonetheless, Evaluating Cost Basis notes that technology choices, regional differences and differences in size can affect the benchmark for a particular project.  

Treasury’s Analysis
In computing the grant for a project, Treasury goes through a several step process. First, it determines whether the claimed basis is consistent with the appropriate benchmark. If it is, Treasury typically will limit its review to ensuring that only eligible items have been included and that no costs have been inappropriately attributed to the property. If a particular line item is too general, more detail may be requested.  Items that Treasury considers ineligible will be removed from the computation. Costs of a fence or an operations and maintenance building are cited as examples of ineligible costs.  

On the other hand, applications with a claimed basis that is materially higher than the benchmarks will receive closer scrutiny. This review starts with an analysis of ineligible costs, like that described in the preceding paragraph. More importantly, these applications will be reviewed for related party considerations, or other unusual circumstances. These include related transactions, discussed below, as well as situations in which the grant applicant is related to the developer, installer or supplier due to common ownership or control, or because two parties to a transaction may not be adverse, such as sale leaseback transactions.

Note that these contrasting analyses provide the clearest indication yet that a related party development fee is unlikely to be adjusted if it results in a total cost per watt that is within the relevant benchmark. On the other hand, even a modest development fee for a project with an above benchmark cost will be subject to closer scrutiny.

Related Transactions
The closer scrutiny standard brings us to one of two especially interesting observations made by Treasury. In an illustration of a related transaction, Treasury states that the price may merit closer scrutiny if “a power purchase agreement [is] acquired at the same time the Section 1603 eligible property is acquired.” Of course, this statement is addressing a common practice in the renewables industry (and elsewhere, I might add) of concluding that a facility is worth more when it benefits from a favorable contract.  

Stated differently, many (if not most) in the renewables community contend that a facility that has a contract to sell its power for 15 cents per kWh is worth more than an identically located, identically sized facility that only has a contract paying 14 cents. Treasury, on the other hand, appears to be taking the position that the two facilities are worth the same, but that the contract is worth more for the first project than the second. I won’t go into each side’s arguments here, but suffice it to say that Treasury’s view can have a negative impact on certain grant submissions, especially those based on turnkey projects (where the buyer pays a price that is higher than the cost of building the facility, on account of a favorable contract that is in place at the time of the sale) or the lease pass through structure, in which the grant is computed using the value of the facility instead of its cost.

Requests for More Information
When a transaction is closely scrutinized by Treasury, additional data may be requested, e.g., original manufacturer’s invoices/costs to the developer, as well as enumeration of subsequent markups by the developer or owner. As discussed below, a detailed and credible third-party appraisal may be appropriate in some situations, for the purpose of demonstrating that the claimed basis is consistent with a market transaction between unrelated parties with adverse economic interests.  

Fair Market Value
Treasury notes that it does not prepare appraisals for energy property. Rather, it evaluates appraisals provided by applicants and prepared by independent, certified appraisers with expertise in solar PV properties.

Evaluating Cost Basis notes that the first common method for determining value is cost, which must include only eligible property and can include a markup “that is consistent with industry standards and with the scope of work,” specifically noting that  “appropriate markups typically fall in the range of 10 to 20 percent.” The appraisal “should explicitly address the appropriateness of the selected markup in light of the activity, capital investment, and risk.”

A second approach is based on sales of comparable properties, recognizing that thousands of solar PV properties have been installed in the last two years. Again addressing the related transactions issue that I described above, Treasury notes that the comparable prices must reflect only the value of eligible property.

Treasury then notes that the third valuation method is an income approach, based on the discounted value of future cash flows. This brings us to the second especially interesting observation in Evaluating Cost Basis”  Because many assumptions must be made, “including forecasts of all relevant project revenue and cost streams, cost of capital (debt and equity), rates of inflation and taxes, number of periods of income, and residual value,” Treasury considers the income approach to be the least reliable method of valuation due to “the number of variables that are subject to speculation and open to debate.” It also feels that the income method is especially likely to inappropriately (in Treasury’s judgment) increase the value of the facility on account of income that is actually attributable to other ineligible assets, such as a power purchase agreement.  

Accordingly, Treasury asks that applicants relying on the income approach submit appraisals that address the fair market value of the eligible property specifically, and not the larger project in which that eligible property is being used. Nonetheless, Treasury notes that a “credible” income approach should consist of a detailed spreadsheet showing annual revenue and expenses over the term of the contract, with a reasonable residual value at contract termination. Treasury also requires support from credible sources for items like inflation rates, speculated revenue, operating expenses, major maintenance, taxes and other considerations, and discount rates should reflect an appropriate risk premium. Obviously, Treasury doesn’t know quite what to do with its competing directives – if we are going to consider the credible income expected to be generated by the eligible property, then a PPA with a higher electricity price will yield a higher value (and a larger grant) than would be obtained for the same facility with a less favorable contract.  

Summing Up
I’ve heard it suggested that Evaluating Cost Basis is sending the Section 1603 grant rules in a new and not necessarily welcome direction, especially in its tests for determining fair market value. I continue to think that much of the document is simply Treasury telling us that it is actually doing what we were already observing. Thus, for most purposes, reviewing and complying with the rules of Evaluating Cost Basis simply makes us better prepared to argue with Treasury about whether our project is the one for which the benchmarks and other rules should be “bent.” On the other hand, Treasury’s attitude toward the income approach (and allocating some value to assets other than the facility itself) is perhaps the one area where the renewables community may wish to actively pursue a change in the government’s analysis.

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