Solar Tax Equity Investor GAAP Accounting Update: The Deferral Method and Hypothetical Liquidation at Book Value
As the solar asset class has continued to develop and mature over the past 10 years many large and small corporate and other institutional investors have made significant solar tax equity investments in transactions structured to efficiently monetize the 30 percent investment tax credit (ITC).
Accounting for such tax equity investments has proven challenging, as industry practice has continued to evolve. Tax equity investors, including those that are publicly traded, meanwhile are focused on maximizing economic return and mitigating business risk while also attempting to optimize the earnings impact (i.e., the generally accepted accounting principles (GAAP) accounting impact) on their financial statements. Optimization of GAAP accounting around tax equity investments includes but is not limited to, minimizing pre-tax volatility, lowering the effective tax rate and enhancing one’s earnings per share profile.
While there are many ways to structure tax equity investments in solar transactions, investors have historically gravitated to the partnership-flip
transaction structure, due to its relative simplicity, well-defined tax guidance and industry wide acceptance and use of the structure. Despite the partnership-flip transaction’s relative structural simplicity, the GAAP accounting for these transactions is still considered complex by many market participants, with overlap between multiple areas of authoritative accounting guidance.
Many tax equity investors have historically applied the deferral method of accounting for the ITC as a means to mitigate pretax earnings volatility. Tax equity investors seek to avoid future write-downs or impairments to their equity method investment by reducing the equity method investment carrying value by the amount of the ITC. Traditionally, many tax equity investors, after reducing their investment by the ITC, have used a simplified method by allowing their investment to amortize gradually over time via the cash distributions received, yielding a marginal impact to pretax earnings. While this methodology is often viewed as an economic-friendly accounting solution, accounting firms often advocate new tax equity investors to record hypothetical liquidation at book value (HLBV) adjustments in addition to deferral method of accounting as a means to appropriately reflect the equity method of accounting. Use of HLBV often leads to additional pretax earnings volatility that many investors hope to avoid. While many investors avoid HLBV on their first transaction based on materiality grounds, often continued investment in more renewable energy tax equity deals eventually leads to HLBV considerations as the materiality no longer holds true.
At a high level, HLBV is a liquidation-and-balance-sheet-focused approach as prescribed by Accounting Standards Codification (ASC) 970-323-35 in situations where a liquidation-based approach is more appropriate than the traditional equity method of accounting. Solar tax equity investments have disproportional allocations of cash distributions, capital contributions and varying profit-and-loss allocations that make the application of the traditional equity method accounting problematic under the guidance. Most practitioners, in applying HLBV, follow the methodology prescribed in Proposed Statement of Position 11-21-00 that was never formally adopted by the Financial Accounting Standards Board, the standard setting body for GAAP.
HLBV calculations incorporate a three-step process as follows:
- Assume the solar asset owned by partnership-flip entity is sold at the GAAP net book value as of the relevant reporting date (e.g. 12/31) and compute the hypothetical taxable gain or loss based on the difference between the GAAP net book value and tax basis of partnership flip entity.
- Based on the liquidation provisions pursuant to the operating agreement of partnership-flip entity, allocate the hypothetical gain or loss to each partner on top of each partner’s respective tax capital accounts. The liquidation provisions in the operating agreement can vary widely.
- Liquidate each partner’s capital account, including the allocated gain or loss, to get each partner’s capital account to zero. The amount to get each partner’s capital account to zero is equal to the HLBV carrying value of each partner’s interest.
The HLBV calculation is a blend of both tax and GAAP rules and methodologies that makes the calculation challenging for many accountants who are traditionally trained in either tax or GAAP. Underlying tax capital account mechanics are complex and liquidation provisions, including targeted yield calculations, can be difficult to implement, calculate and operationalize; making the HLBV calculation complicated
HLBV: A Flawed Methodology?
While there are few who would dispute that HLBV calculations are complex, there are many who would agree that HLBV results are often seemingly uneconomic and counterintuitive. Tax capital accounts, often the main driver of HLBV results, are designed to be economic for the most part–but may not be in some instances. For example, a tax equity investor who is monetizing the ITC recognizes the full credit, but only reduces their tax capital account by 50 percent of the allocated ITC for the 50 percent basis reduction. This asymmetry alone may sometimes lead to investors with a higher initial-year HLBV value than their carrying value in the investment after application of the deferral method.
Liquidation provisions may also lead to unintended accounting consequences. Most partnership-flip operating agreements would allocate a majority of the liquidation gain to the sponsor and tax equity investor under the post-flip percentages. This typically results in the sponsor receiving a majority of the liquidation proceeds, as the tax equity investor in theory has already earned most of their return via the monetization of ITC (tax credit recapture is usually ignored in the HLBV calculation). The percentages as drafted can easily be flipped, however, where most of the liquidation gain/proceeds end up being allocated to the tax equity investor. This may not always be ideal for a GAAP-sensitive investor, who after applying the deferral method will likely need to write up the investment under HLBV only to have to write down the investment in subsequent periods. As much as industry participants believe in the economic benefits of investing in renewable energy, unfortunately the economics of many tax equity deals may not necessarily support these unintended artificial HLBV write-ups, which ultimately from an accounting perspective need to be offset with subsequent write-downs.
Living with HLBV
There are a multitude of options and a combination of options that industry participants have considered to cope with HLBV including, but not limited to, the following:
- Materiality: sometimes works.
- Proactive structuring of liquidation provisions: liquidation mechanics are a main driver of HLBV results, so due care should be exercised in drafting liquidation provisions to the extent they are drafted in such a way to achieve an economic result. We will note that there is limited flexibility in structuring liquidation provisions, as HLBV practitioners generally expect there to be consistency with the commercial terms of the transaction.
- Proactive structuring of tax capital account mechanics: not always easy to balance unfortunately, as there is sometimes inherent friction/constraints between a desired HLBV result and the business terms of the transaction. In addition tax allocation strategies may vary widely between tax equity structures used.
- Proportional amortization: unfortunately, only technically available to low-income housing tax credit investments.
- Fair value option: available for equity method investments and ostensibly minimizes volatility relative to HLBV at times. However this method requires additional disclosures, so in reality very few tax equity investors have gone down this route.
- Equity method impairment: arguably in situations where HLBV artificially writes up an investment beyond its actual economic value, impairment should be considered to help “rein in” the initial HLBV write up that leads to downstream HLBV write downs.
- Defer “day one” differences for HLBV purposes: useful for deferring and smoothing HLBV volatility, often originated in the initial year of the transaction–while discussed in the proposed HLBV statement of position, does not appear to be universally accepted among HLBV practitioners.
Most investors seem to be coalescing around a combination of materiality and proactive structuring of both liquidation provisions and tax capital account results to achieve a more economic and sensible result. Investors sometimes may be able avoid quarterly HLBV calculations altogether, should the HLBV impact to their earnings be considered immaterial. Achieving this outcome requires much proactive investment in modeling and forecasting HLBV, as well as monitoring its interaction with the deferral method of accounting. Involvement of different groups within a tax equity investor may also be necessary in this process, including tax, legal and accounting departments. Lastly, based on prior experiences, proactive planning on the front end tends to result in better outcomes versus addressing the issue after a transaction has closed.
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