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Q&A: Monetizing Depreciation Benefits: Be Careful What You Bargain For!

Published by Tony Grappone, Novogradac & Company LLP RETC Working Group on Thursday, August 1, 2013

Journal cover August 2013   Download PDF

Question: Which renewable energy tax credit transaction structure better allocates tax benefits to tax credit equity investors in exchange for the capital invested?

Answer: Common sense suggests the standard partnership flip would do a better job of raising tax equity in exchange for delivering tax benefits. However, when it comes to tax credit investments, common sense may not always apply and the devil is in the details.

There are three commonly used tax equity structures for renewable energy investments: the partnership flip; the inverted lease (also referred to as the master lease or lease pass-through); and the sale leaseback. There are many differences between the structures, including how each monetizes tax depreciation benefits. The sale leaseback is a non-partnership structure that typically involves one owner so it’s clear who is “allocated” the tax credits and depreciation benefits. The standard partnership-flip and inverted lease partnership structures involve partnerships that share benefits between partners. However, because of partnership tax rules and issues related to accelerated tax depreciation, the actual benefits allocated to the various partners under these last two structures can be the opposite of what the partners intend.

Partnership Flip
One goal of the standard partnership flip structure is to allocate substantially all of the partnership’s investment tax credits (ITCs) and accelerated depreciation deductions to the tax credit equity investor (tax investor). This is accomplished by creating a single partnership that owns and operates the renewable energy facility and allocates the tax credits and depreciation deductions to its partners. Often the partnership flip is structured so that the managing member/sponsor and tax investor acquire a 1 percent and 99 percent, respectively, pre-flip interest in the partnership’s profits, losses and tax credits and a 95 percent and 5 percent, respectively, post-flip interest. Therefore, project sponsors often lead with the standard partnership flip structure when negotiating with a tax investor that values both the ITCs and accelerated depreciation deductions.

Inverted Lease
One of the primary goals of the inverted lease structure is to bifurcate the ITCs from the accelerated depreciation deductions. This is accomplished by employing a dual partnership approach that separates the ITC benefits from the accelerated depreciation benefits. One partnership will own the renewable energy facility and generate 100 percent of the facility’s depreciation deductions and the other partnership will operate the facility and generate the ITCs. This works well with tax investors that place more value on the ITCs and less value on the tax depreciation deductions. This also works well for developers that can use more of the tax depreciation benefits. Therefore, in situations where a tax investor primarily values the ITCs, the developer/sponsor usually leads with the inverted lease structure.

The value that tax investors place on the ITCs and accelerated tax deprecation often translates into the amount of equity they are willing to invest. Some tax investors are often willing to invest more equity in a partnership flip structure than in an inverted lease structure because they think (and often expect) they are going to be allocated substantially all of the accelerated tax depreciation deductions. Conversely, in the inverted lease structure some investors assume they should be investing less because they expect to be allocated fewer deprecation benefits. However, because of complicated partnership tax rules, it is common for the standard partnership flip structure to end up allocating less tax deprecation than initially intended. Likewise, the inverted lease structure can result in substantially more tax depreciation than expected. As a result, in the standard partnership flip structure, the tax investor can be left feeling as though it received less than it bargained for, and in the inverted lease, the sponsor can feel as if it “gave away” benefits that didn’t raise equity. In both situations, counterintuitive results often exist between the amount of equity raised and the benefits delivered. That is likely to change as industry participants become savvier about how these structures ultimately deliver tax benefits.

Federal tax requirements require partners in partnerships to maintain capital accounts. The rules for maintaining capital accounts can limit the amount of ITCs and/or tax losses that can be allocated to each partner. In short, capital accounts are maintained by increasing them by the cash and property a partner contributes plus their allocable share of partnership income (taxable and tax-exempt) minus any distributions they receive and less their allocable share of losses (deductible and nondeductible).

In partnerships involving renewable energy facilities, it is common for the tax investor’s capital account to be reduced to zero within the first few years. This is due in large part to accelerated depreciation generated by the facilities that often produces large enough tax losses in the first few years that the allocable share of losses to the tax investor quickly reduces its capital account to zero. From that point forward, the tax investor has no tax basis in the partnership to be allocated future losses (barring some creative tax planning). In these cases, any remaining losses are often allocated to someone other than the tax investor. (They are often reallocated to the developer/sponsor). The result is that a large amount of the partnership’s tax losses will be allocated to one of the partners that didn’t expect it.

To analyze what a tax investor participating in a renewable energy project can expect to be allocated in loss benefits, let’s consider the partnership items that will increase and decrease its capital account:

Increases:
1. Capital contributions
2. Allocable share of annual taxable income
3. Allocable share of taxable “anti-depreciation” (only applies to inverted leases)
4. Allocable share of tax-exempt income (i.e., its share of Section 1603 cash grant income, if applicable)

Decreases:
5. Allocable share of depreciable basis reduced by 50 percent of ITC (n/a for inverted leases)
6. Receipt of preferred return distributions
7. Receipt of operating cash flow distributions
8. Allocable share of losses (including non-deductible expenses)

The net result of items 1, 3, 4, 5 and 6 will essentially determine the amount of tax loss benefits available to the tax investor and can usually be forecast with a high degree of confidence early in the investment period.

To illustrate the forecast loss benefit capacity, let’s consider a hypothetical project.

Assume an energy facility incurred total development costs of $11 million and was financed with the following sources:

Next, increase the tax investor’s capital account by its total expected contributions. Assume that the eligible basis of the facility is $10 million resulting in an ITC of $3 million, of which 99 percent is allocated to the tax investor thus allocating it $2.97 million of ITCs. For simplicity, assume a typical tax investor involved in a partnership flip structure is willing to invest roughly $3.87 million in exchange for an expected 99 percent of ITCs and tax losses plus some basic cash returns. Assume for the inverted lease structure that the tax investor would be willing to invest roughly $3.27 million for 99 percent of the ITCs, approximately 40 to 50 percent of the tax losses plus some basic cash returns.

Another increase to consider is with respect to tax-exempt income that applies to renewable energy facilities financed in part with Section 1603 cash grants. The receipt of Section 1603 grants is non-taxable, but the facility owners get an increase in their capital account with respect to their share of the Section 1603 tax-exempt grant income. For this item, neither transaction structure has an advantage or disadvantage. Finally, if the partnership is expected to generate positive taxable income then its allocable share of taxable income would increase its capital account. Most of the tax depreciation is generated during the first five years, which often results in taxable losses. Thus, for this exercise ignore the concept of potential taxable income during the depreciation period.

Next, increase the tax investor’s capital account by the amount of “anti-depreciation” the investor will be allocated through the inverted lease structure. This increase equates to the amount of the basis reduction that is applied as a capital account reduction in the standard partnership flip structure (50 percent of the ITC – see below). In the inverted lease structure, the Internal Revenue Service (IRS) requires partners to recognize this amount as taxable income over the life of the depreciable property. For simplicity, assume five years, which is consistent with the bulk of how long the assets are depreciated over for tax purposes. Each structure results in opposite results for capital accounts. In the standard partnership flip structure, the tax credit equity investor records a basis reduction. In the inverted lease structure, the tax investor’s capital account is increased through its allocable share of income attributable to anti-depreciation.

Another factor to take into account is the anticipated capital account decreases. To do that, first consider the total depreciable basis of the facility using both structures. In the partnership flip structure the partnership is required to reduce its depreciable basis by 50 percent of the ITC. Furthermore, each partner is required to reduce its investment basis in the partnership by its allocable share of the 50 percent depreciable basis reduction. The inverted lease seems better than the partnership flip in this regard because the inverted lease structure doesn’t require a basis reduction. However, investors in inverted lease structures are required to recognize income with respect to this amount as anti-depreciation (see above).

The last decrease to factor in relates to preferred returns. It is common for tax investors to want a preferred return on the equity they have invested. Although specific terms vary, for discussion purposes assume an annual preferred return on investment of 2 percent for each year of the five- year ITC compliance period (or 10 percent of its total investment). The effect of this decrease is fundamentally the same under both structures, but the amounts usually end up being different because the amount invested under each structure.

Now that the typical increases and decreases to capital accounts under both structures have been determined, consider the potential tax depreciation deductions the tax investor can be allocated under both structures.

As you can see from the table, the difference in the tax investor’s potential basis in that partnership investment for determining its future accelerated depreciation deductions is not only substantial but also counterintuitive. The standard partnership flip structure is, in spirit, designed to allocate substantially all of the ITCs and tax losses (i.e. 99 percent) to the tax investor, and the inverted lease structure is designed to bifurcate these benefits and thus allocate substantially less tax losses to the tax investor. However, as illustrated here, after applying partnership tax rules the inverted lease structure actually lends itself to allocating more tax losses to the tax investor.

For more information on structuring renewable energy tax credit investments please contact Tony Grappone via email at [email protected].

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