Q&A: Issues to Consider When Using the Section 1603 Grant Program

Published by Daniel J. Smith on Friday, January 1, 2010
Journal thumb January 2010

Question: Can the cash grant in lieu of investment tax credit created under Section 1603 of the American Recovery and Reinvestment Act of 2009 (Recovery Act) be used in a transaction and still monetize the depreciation benefits with a tax investor?

Answer: Maybe. The Recovery Act included numerous significant incentives for financing renewable energy projects, including the ability of renewable projects that qualify for the production tax credit to elect out of the production tax credit and elect instead to claim the 30 percent investment tax credit. In addition, those projects opting to claim the investment tax credit can further elect to receive a cash grant in lieu of investment tax credit under Section 1603 of the Recovery Act. This cash grant program was intended to deal principally with the lack of liquidity in the tax equity markets.

Reception to the Section 1603 program has been very positive in the renewable energy finance market. Private tax equity has largely been replaced by the Section 1603 cash grant. There have been a number of construction financings closed with the Section 1603 cash grant as part of the capital structure. In those transactions, the 1603 cash grant has replaced the tax investor equity in the transactions. Prior to the issuance of Treasury guidance, transactions were closed with the sponsors guaranteeing the funding of the 1603 cash grant. Once Treasury provided clarification and guidance was issued, the finance market quickly adapted to provide non-recourse funding against the 1603 cash grant.  

While taking the Section 1603 cash grant in lieu of the investment tax credit may seem like a perfect solution, without a tax investor the depreciation benefits can end up being “stranded.” If the owner of the renewable energy project can’t use them, there is currently a limited ability to monetize depreciation benefits. Large corporate investors do not want depreciation losses added to their published generally accepted accounting principles (GAAP) financial statements. Both smaller and larger corporate investors either don’t have a current tax liability or are not confident that they will have one going forward.

There are also technical issues associated with monetizing depreciation benefits. The following example illustrates one of those issues:

Example
$       10,000,000    Eligible cost
           1,500,000    Deduct ½ of 1603 grant from depreciable basis
           8,500,000    Depreciable basis
X                   40%    Investor tax rate
$         3,400,000    Total tax benefit
$         3,000,000    Estimated capital contribution
$         3,000,000    1603 cash grant

An investor in this example would have tax basis of $6 million, which is derived from the $3 million capital invested and a tax-exempt income allocation of $3 million from the receipt of the Section 1603 cash grant. In this scenario, the investor would only be permitted to take depreciation deductions up to its $6 million basis. This is $2.5 million less than the $8.5 million necessary for the investor to obtain the desired return on investment.

One possible solution is for the renewable energy project to be financed with non-recourse financing. The investor would derive tax basis from this financing in an amount equal to its interest in the project. So in the above example if the project were financed with the $3 million Section 1603 cash grant and $4 million of non-recourse financing, the investor may have enough basis to claim the depreciation deductions.

Another option would be to sell the project to a party that has the ability to utilize depreciation and has an interest in acquiring and operating the renewable energy project going forward. Even in this case, structuring the transactions to accommodate the Section 1603 cash grant, then monetizing depreciation and cash flow in the project is an approach that permits developer/owners with limited tax appetites to stretch their tax capacity allowing them to purchase more projects.

It is possible to monetize project depreciation; however, it is difficult and the right investor and tax structure is a necessity.