Proportional Amortization Applicable to Renewable Energy Tax Credit Investments

Published by Nat Eng on Tuesday, June 6, 2023

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Thanks in large part to the passage of the Inflation Reduction Act last year, renewable energy deployment is poised for a record year in 2023. Fueling this wave of renewable energy projects is the monetization of tax credits provided by tax equity investors through tax equity investments.

Traditional tax equity investments have historically been accounted for by investors as equity method investments utilizing the hypothetical liquidation at book value method (HLBV). Many investors and transaction participants found HLBV application to be both challenging operationally and at times frustrating due to some of the pretax income volatility that the methodology can sometimes introduce. While many investors were able to find workable accounting results and were ultimately able to close on transactions, there has been much optimism around the expansion of proportional amortization to renewable energy investments.

Benefits of Proportional Amortization

The proportional amortization method is generally viewed as a simplified accounting method for tax credit investments in that an investor amortizes the initial cost of the investment in proportion to the realization of tax credits and benefits. The amortization is then recognized “below the line” as a component of income tax expense/benefit. This effective netting of the profit and loss activity of the tax equity investment through income tax expense helps the investor avoid income statement geography issues and aligns the economics of the transaction with the accounting in a more appropriate manner.

History of Proportional Amortization

Previously, Accounting Standards Update No. 2014-01 (ASU)–issued in 2014–introduced the option of applying proportional amortization to tax credit investments with the primary intent of monetizing tax credits and benefit. Unfortunately, the scope of the ASU was limited to low-income housing tax credit (LIHTC) structures. Fast forward nearly seven years to November 2021, when the Emerging Issues Task Force (EITF) reopened the door to expanding proportional amortization to other tax credit investments, including new market tax credits (NMTC) and renewable energy tax credits. In January 2023, the EITF reached a final consensus on items in EITF Issue No. 21-A Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method, with the final standard published March 29 to expand proportional amortization to tax credit investments in general and allow proportional amortization to be applied on a “tax-credit-program-by-tax-credit-program” basis.

Hurdles in Applying Proportional Amortization: Positive Yield and Substantially All Criteria

While proportional amortization is poised to be greatly expanded, it has retained some limiting criteria that may impact the broader application of the proportional amortization to renewable energy investments across the board. The two criteria that the industry is focused on are the positive yield and substantially all criteria, which overlap to a large extent. However, it is entirely possible that an investor passes one of the criterion, but does not pass the other.

The positive yield criterion is generally viewed as the total aggregate tax benefits and credits should exceed the investor’s capital criteria to the extent the investor achieves an overall positive return on their investment solely from a combination of tax credits and benefits. Many renewable energy investment tax credit (ITC) transactions struggle with passing the positive yield criterion due to the fact that investors typically contribute more than $1 per credit received because the ITC is recognized upfront and accelerated depreciation tax benefits and cash flows are often realized by the investor. This is in juxtaposition to the LIHTC, NMTC, historic tax credit, and renewable energy production tax credits that are collectively recognized over a time period ranging from five to 10 years.

The substantially all criterion is slightly easier for non-renewable investors to satisfy. In applying the substantially all test, investors applying proportional amortization to an investment must receive more than 90% of their benefits from tax credits and benefits on a discounted basis. Renewable energy investments struggle with satisfying this criterion more so than other tax credit investments due to the cash flows received in form of distributions and buyout proceeds from the transaction. Meanwhile, in LIHTC transactions it is often the expectation that the investor will receive little or no cash during the life of the transaction.

Passing the Hurdles

Industry participants have come up with several solutions to satisfy the positive yield and substantially all criteria for renewable energy ITC deals, including, but not limited to the following:

  • Resizing investment commitments. Tax equity investors typically invest based on achieving a certain return on investment. In anticipation of proportional amortization, many investors downsized their future tax equity investments on a per-credit basis while lowering their cash distribution requirement from sponsors. This lowers the amount of cash relative to the tax credits and benefits. Investments sized below $1.09 per credit tend to have an easier time satisfying both the positive yield and substantially all criteria.
  • State tax benefits. Transaction models often use a 21% federal tax rate. Using a higher blended rate including state tax benefits will increase the tax benefits relative to capital contributed and cash.
  • Transaction fees. Tax credit syndicators who charge tax credit investors fees for asset managing and placing tax credits may be able to structure their fees to allow their investors to more easily pass the positive yield and substantially all criteria. This may include a combination of both deferring and increasing their fee.

Conclusion

While many legacy transactions may not satisfy proportional amortization criteria, existing and new tax equity investors can structure tax equity transactions to accommodate proportional amortization. Existing tax equity investors will likely have legacy transactions continue under HLBV accounting and will need to disclose to the extent material those transactions reported under the proportional amortization methodology. Early adoption is permitted, and several investors are already looking forward to apply the new guidance in 2023.

Bryen Alperin of Foss & Company contributed to this article.

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