Renewable Energy Tax Credit Community Faces Challenges, Opportunities during COVID-19 Pandemic

Published by Forrest D. Milder on Thursday, June 4, 2020
Journal Cover Thumb June 2020

The global COVID-19 pandemic has dramatically affected everything, including the renewable energy tax credit world. This month, we’ll review the state of that world.

The State of the Market

With the four-year “continuous construction” safe harbor running out for wind projects that began in 2016, it was thought that 2020 would be a banner year for wind. Solar was expected to have a big year as well. However in the throes of the pandemic, expectations have fallen from a 20 percent or more increase to a 25 percent or more decline.

Obviously, the state of the market affects the overall ability to find investors and close investments. Between simple issues of supply and demand, and the uncertainty caused by the wait for a more certain ending to the pandemic, many investors are projecting reduced income and even losses. Accordingly, the marketplace is at least temporarily restrained. Of course, this kind of thing can have an “equal and opposite” reaction at the other end; we have seen predictions of as much as a 200 percent increase in renewable investing for 2021.

The Light to Quality

There may be fewer investors looking for deals and they will want their deals to have fewer flaws and potential issues. Given the narrowing of the 2020 marketplace, it’s not surprising that project sponsors are expected to upgrade every aspect of the investment–better “begun construction” support, better access to the equipment that will be used to construct the project, better permits and approvals, and perhaps most important, better financial condition of the project sponsor to back up those indemnities and guarantees.

Everything is gone over more thoroughly and everything is expected to be a bit more perfect. That’s not to say that longstanding relationships are not respected and valued, but every project sponsor should expect a higher level of scrutiny and demand for a little bit extra at each step of the way.

Debt Restructuring

Projects that are under construction or already in service may have cash shortfalls and have to renegotiate construction or permanent debts. These can cause a default under the particular debt instrument, or other instruments and contracts. In addition, debt modifications, even where the same instrument remains outstanding, have tax consequences. The tax implications of waivers, modifications, and extensions are covered by Treasury Regulations Section 1.1001-3. While many changes to a debt instrument can be considered a “substantial modification” that must be analyzed to determine if there are tax consequences, many of these changes do not result in a problem.

Consider one of the following scenarios, each of which is a substantial modification:

  1. waiver of a default for more than two years, with no ongoing negotiations;
  2. change in interest rate by more than a quarter of a percent;
  3. extension of the due date for an instrument by more than the greater of five years or half the original term of the instrument;
  4. significant modification of the pledged property in the case of a nonrecourse debt; or
  5. change in the obligor in the case of a recourse one.

If any of these (and there are others as well) occurs, then the debt before and after the change must be compared to see if there is “cancellation of debt” (COD) income. For example, if the term of a five-year debt is extended by three years, this is a “substantial modification.” However, if the interest rate payable on the extended debt continues at the same rate, or at least at the “applicable federal rate” announced by the IRS, and there are no other changes, then the “new” debt is likely considered to have the same value as the “old,” for federal income tax purposes, and there is no COD income. Of course, in this, as in so many things tax, any change should be carefully reviewed by someone with solid knowledge of the regulations. Sometimes the smallest foot fault can materially change the tax treatment.

New Sources of Equity

The new decade brought us some new sources of funding. Opportunity zones (OZ) investing is the most notable addition. As you have read here and elsewhere, OZ investments have a broad appeal to both corporate and individual investors, and the flexibility of the statute invites a wide range of investment structures.

Any new kind of funding can require more deal structuring time and new clauses and documents. At the same time, any new kind of investor or new kind of transaction can create new reasons for delay and added costs as experts evaluate and make recommendations for how the deal should be structured. Should the OZ investor be a pure equity investor or should it acquire tax equity too? If the latter, how do we assure that it has sufficient basis to absorb the tax credit basis adjustment? If it is an individual (or a group of individuals), have we attended to the problems of the passive activity and at risk rules? And so on. Before you think that there will be smooth sailing with your new investor, or new kind of investor, be ready for all of these kinds of considerations that can affect timing, documentation, and pricing.

Construction in the Era of Social Distancing

Depending on where we are in the history of the pandemic, different energy sources and different state rules can affect the ability to complete the project. While it is common for states to encourage “social distancing” such that workers are generally six or more feet apart, many states also consider the development of energy projects to be an essential business that should continue. Even when the six-foot rule applies, it can easily be possible for certain projects, many solar facilities, for example, to be built by individual workers who can stay that far apart. But don’t assume that your state has any particular rule. A project sponsor should be sure to comply with the local rules; it’s undoubtedly a covenant in its loan and tax-equity documents.

Getting Government and Other Approvals

We all know the age-old problem of getting timely permits, approvals, and especially “permission to operate” or whatever approval is required in order to place a project in service. With so many government and other employees working from home, it’s important to facilitate approvals as best and as early as you can.

Chinese Sources, Tariffs and Other Concerns

At the end of 2019, and into the current year, project sponsors were hit with late or cancelled deliveries because of the incredible demand for parts and materials in order to establish “begun construction.” Notwithstanding the IRS rule based on “reasonable expectations,” many investor commitments were based on passing an outright requirement to take delivery within 3½ months. So pandemic delays were followed by a newfound interest in whether sponsors reasonably expected the delivery of equipment within that time, even as COVID-19 troubles in China made manufacture and delivery difficult, and at times impossible.

Then came the scramble to determine if “worldwide pandemic” met the definition of “force majeure” found in the law and many contracts. Finally, we had the varying role of the Trump administration’s tariffs rendered Chinese goods too expensive or too difficult to bring to America. It can be important to have alternative sources, and to clear any problems with the investor as soon as they are recognized. Some problems may be addressed by representations and indemnitees, while others may require also persuading tax counsel to write an opinion.

Legislative and Administrative Proposals

Finally, we come to the many proposals to solve tax problems both with administrative and legal remedies. Pursuant to its general power to extend deadlines in emergencies and disasters provided by Internal Revenue Code Sections 7508 and 7508A, many hope that Treasury will extend deadlines, in particular, the deadline for the decline in credit rates depending on when a project begins construction, including the 3½-month rule I noted above and the four-year deadline for qualifying a project for the “continuous construction” safe harbor.

Indeed, as I write this, a Treasury letter to Senate Finance Committee Chairman Chuck Grassley and other senators has assured that such extensions are coming. At the same time, Congress is considering legislation to extend the deadlines for longer periods, reinstate something like the Section 1603 grant program that provided funds in the Great Recession or even give taxpayers a refundable credit on their tax bill as if they had made payments toward their tax liability equal to a percentage of the credit for which the facility would otherwise qualify.

Of course, any proposals like these, as desirable as they may be in a vacuum, are fraught with difficulties. Many investors are eager to see someone else develop the documents and close a transaction first and there is always a fear that anything less than 100 percent clear wording will require an IRS interpretation before anyone is prepared to risk unfavorable guidance after they have laid out their cash. If nothing else, any new incentive or program requires education, and many investors are reluctant to incur the cost of learning the rules that apply to a short-term cure. So, be on the lookout for extensions of existing programs and incentives. These tend to be the easiest to absorb for the broadest community.

Well, as they say, “May you live in interesting times!”