/>iTax equity investments in 2023 were about $20 billion annually. To meet the goals of the Inflation Reduction Act (IRA)[1], “many forecasters estimate that tax equity will need to increase […] to over $50 billion.”[2]
Will the new IRA monetization provisions changed traditional tax equity financing for renewable energy projects?
Yes and no. “Tax equity is expected to remain the most common and preferred option for project developers because it monetizes both the tax credits and other tax benefits, such as tax depreciation.”[3] Although the Inflation Reduction Act (IRA) monetization provisions will not replace tax equity financing, they have already started to affect how renewable energy projects are being financed and funded. Because monetization alone does not provide a credit holder with access to all the tax benefits available to tax equity investors through a partnership structure, monetization will not replace traditional tax equity structures. Monetization, however, has already started to change the traditional structures in ways that should increase the number and type of market participants active in project financing.
Some investors will limit their involvement in the renewable market to the purchase and sale of tax credits. They will not invest in partnerships that own renewable energy projects, and they will not share in the partnership flow-through items of depreciation, amortization, income, losses, credits, and deductions. Other investors, however, will incorporate monetization of credits into the investment partnership structure.
How were renewable projects structured before the IRA?
Before the IRA and continuing after the IRA, a renewable energy project was commonly structured as a “flip partnership” between the project developer and a high-income investor (referred to as a tax equity investor). A tax equity investor would typically buy an interest in the partnership from the developer, or make a capital contribution directly to the partnership. To receive a step-up in tax basis in the facility to increase the amount of available depreciation and amortization, the partnership would typically buy the project from the developer shortly before the project is placed in service.
Why were flip partnerships a common structure?
Flip partnerships were and remain the most common investment structure in the U.S. renewable market. A partnership flip transaction typically involves a project developer or sponsor and an equity investor forming a partnership that, in turn, owns a renewable energy project. “The tax equity investor is typically allocated 99 per cent of the income, loss, and tax credits and some portion of the cash (usually around 30 percent or less, depending on the project) until the tax equity investor reaches a target yield or a fixed date passes. . . . Once tax equity reaches the applicable benchmark, its share of tax items will decrease (usually down to 5 per cent) along with its share of cash. The developer will receive the bulk of the cash and tax items for the remaining life of the partnership.”[4]
The flip partnership structure was common because developers often would not have enough taxable income to benefit from the full value of the available tax credits, accelerated depreciation, amortization, and other business deductions. Meanwhile, a tax equity investor may be seeking to benefit from tax credits, accelerated depreciation, and amortization in return for their investment.
Why are these partnerships called “flip partnerships”?
They are called “flip partnerships” because at the start of the partnership the tax equity investor typically receives 99 percent of the tax benefits but a significantly smaller proportion of the available cash.[5] The tax equity investor continues to receive this allocation until it obtains an agreed upon after-tax return. After that, the allocation would “flip” down to a much smaller percentage of the tax credits (if any), deductions, and income, such as, perhaps, five percent.
Why would the partnership typically buy the project shortly before it starts operation?
The tax basis used to calculate the investment tax credit (ITC) is the partnership’s cost to acquire or produce the energy property or project. “If the partnership purchases the project from a developer, its credit-eligible basis is generally the purchase price, subject to adjustment to remove certain items that are not eligible for the credit, such as transmission equipment and intangibles. If the developer contributed the project to a partnership, rather than selling it to the partnership, the tax basis is the developer’s cost. Once the credit-eligible basis is determined, the energy credit is computed by multiplying the basis by the applicable energy percentage.”[6]
When do ownership percentages flip in a flip partnership?
The flip date is either the date when the tax equity investor receives its targeted return amount pursuant to the partnership’s agreed to allocation schedule, or a date that was specified in the partnership agreement.
What typically happens once the percentages flip?
In a flip partnership, the developer might hold a call option giving it the right, but not the obligation, to buy the investor’s interest for a pre-determined amount. This allows the sponsor to “call” the tax equity investor’s interest. Sometimes, the investor holds a put option, giving it the right, but not the obligation, to sell its interest in the partnership to the developer. This allows the tax equity investor to “put” its interest to the sponsor.
“The initial allocation of benefits is sustained until a specific predetermined benchmark is reached. In a yield-based flip, the benchmark is a specific internal rate of return (IRR) target; in a time-based flip, the benchmark is a fixed date.”[7] Once the flip date is reached, “the tax allocations and cash distributions received by the tax equity investor decrease, usually to about 5%. The developer then inherits most of the remaining financial and tax benefits and has the option to buy the investor’s remaining interest at its fair market value.”[8] ITC-based tax equity partnerships typically have a fixed flip date after the five-year ITC recapture period expires.
For production tax credit (PTC)-based tax equity partnerships, the flip date is typically based on when the equity investor has received its agreed-to partnership allocation amount. Because PTCs are available for 10 years, the partnerships typically remain in place for more than 10 years with a PTC-based project. Similar to ITC-based tax equity partnerships, the flip date is typically based on the tax equity investor receiving an agreed-to IRR, and the flip does not take place until that date.
What are some of the tax requirements of flip partnerships?
Partnership flip structures generally follow IRS safe harbor rules for wind projects. In 2007, the Internal Revenue Service (IRS) issued safe harbor requirements for PTCs under Section 45 in Rev. Proc. 2007-65.[9] IRS Announcement 2009-69[10] subsequently modified the Revenue Procedure on September 21, 2009; and on June 12, 2015. In addition, the IRS released internal memorandum CCA 201524024[11] in which it clarified applicability of Rev. Proc. 2007-65 to Section 48 Energy Credit Partnerships.
“If all of the rules are followed, the IRS will respect the partnership’s allocation of tax credits. The IRS has technically adopted the position that the safe harbor rules only apply to wind projects, but the renewables industry largely applies the rules across technologies in the absence of any other technology-specific guidance.”[12]
For the partnership to be respected as such for tax purposes, the tax equity investor needs to be treated as a partner for tax purposes. The investor is typically shielded from most of the project risks based on the way in which the partnership can be structured.
Does a tax equity investor hold a senior equity position?
Yes. “The tax equity investor has limited downside exposure as the investment will receive most of its return from more predictable tax credits and accelerated depreciation deductions, and it has other protective features, such as no senior debt in the project and its priority over a sponsor’s return.”[13] A tax equity investor holds a senior equity position above that of the sponsor’s junior equity. “The tax equity investor has a priority in earning its return, is senior to the project sponsor in terms of distribution, and the sponsor takes the first dollar loss as a practical matter. Projects typically do not allow for senior debt that is secured by the project’s assets.”[14] In general, “the principal sponsor typically provides 100% of the sponsor guaranty standing behind any indemnities or covenants in the tax equity partnership. The tax equity investor thus has limited exposure to the arrangement, and the other cash equity investors the sponsor attracts typically are not investors in the project LLC itself.”[15]
Is the flip partnership a thing of the past?
No. The traditional flip partnership structure—subject to likely future evolutions—will continue to be used as a commonplace financing structure for clean energy projects. The partnership structure is still needed so that the developer can monetize not only tax credits, but also the additional available tax benefits. In addition, a well-conceived partnership structure and documentation allows the energy project developer to lock in multi-year commitments from the tax equity investor—providing longer-term clarity and certainty in the planning processes.
There have been some changes, however, to the traditional flip partnership. In the last part of this series on credit monetization[16], I discussed the IRA’s direct pay (also known as “elective pay”) and transfer/sales (also known as “transferability”) elections available to certain classes of project owners and investors. These unique innovations under the IRA have resulted in the development of a new class of partnership: the “hybrid flip structure” that incorporates the transferability of tax credits.
What is the new hybrid flip structure?
Hybrid flip partnerships combine traditional flip partnerships with the ability to monetize certain tax credits. Some tax equity investors may have concerns that they might not be able to use all the credits that may be available to them over the lifetime of the partnership. As a result, an equity investor might invest in a flip partnership that requires the partnership to sell a portion (or all) of the tax credits to a third party. This allows a tax equity investor the ability to receive on a tax-free basis a previously agreed-to portion of the sale proceeds from tax credits if they are sold by the partnership.
What are some advantages of the hybrid flip structure?
Because a flip partnership’s allocations run over multiple years, the hybrid flip structure can be attractive to a tax equity investor that might not have the capacity in subsequent years to use the full amount of available tax credits. With the hybrid flip structure, a tax equity investor can decide whether it wants to use the credits available to it or to have the partnership sell the credits. There is also flexibility to the partnership as it can sell a portion of its credits and allocate those proceeds to certain partners, while simultaneously retaining a portion of its credits and allocating the credits to other partners.[17]
Another possible advantage is that lenders might, through credit monetization (similar to receivable financing), lend against the income stream from tax credits.[18] As a developer enters into agreements to sell tax credits in the future at an agreed-to price, loans can be structured that rely on the tax credit purchaser’s credit worthiness. The payment stream for the sale of tax credits can provide a source to amortize project indebtedness.
What are the tax risks to tax equity investors?
For an ITC-based project, a tax equity investor might face the risk of the recapture of some or all of the ITC credit. This is because the ITC vests 20 percent per year over a five-year period. “ITCs are subject to recapture if a project is removed from service within the first five years after it is placed in service or if there is a change in ownership. Actions that can trigger recapture include the project suffering a casualty loss or the project being sold to a third party after placement in service. If the ITC is recaptured, the investor loses a portion of its previously claimed tax credits.”[19]
It is not likely in ITC-based projects, however, that there will be a change in ownership because these transactions typically do not have senior debt. If they do have senior debt, it is likely that the project will negotiate a forbearance agreement with the lender. If an investor wants to obtain additional protections, “property and casualty insurance coverage protects investors against losses from recapture or disallowance, and the historical impacts of recapture on investors’ overall portfolios are limited.”[20]
Of course, the IRS could audit the partnership and disallow some or all of the ITC—subject, of course, to judicial review. “Tax equity investments include appraisals by valuation experts supporting the fair market value of the asset. In addition to the risk mitigation above, tax equity investors require the project sponsor to fully indemnify them in the event of a recapture event or ITC adjustment. The credit support of that indemnity is provided via parent guaranties and project cash sweeps in the event the parent defaults on its guaranty obligations, and often tax insurance is procured.”[21]
What are the considerations for tax recapture?
Certain events can trigger ITC recapture before it has fully been vested over five years. To protect against recapture, a tax equity investor typically requires the sponsor to indemnify it against recapture. There are basically two types of recapture risk. “First, there is true recapture where the project company loses the invested portion of tax credits as a result of some event that occurs after the project becomes operational. Examples of events that can result in a recapture include taking the project out of service or selling it to a third party. Transfers of partnership interests to an entity with tax-exempt or foreign owners is also problematic. Such events are largely within the parties’ control.”[22]
As to the second type of recapture, “disallowance can result from a failure to properly calculate the tax credit benefit, often as a result of a misallocation of costs as eligible to benefit from the tax credit that later are found to be inflated or ineligible. This scenario is more challenging for a sponsor trying to quantify disallowance risk. To address this concern, sponsors typically will obtain detailed appraisals on the value of the project. In addition, tax equity investors sometimes will obtain insurance coverage for any losses resulting from investment tax credit recapture or disallowance (and the costs of interest and penalties that may be assessed by the IRS in connection with such recapture or disallowance. . . . To address this risk, sponsors often provide the lenders with an indemnity covering these cash diversions.”[23]
Is an active market developing for buyers to purchase energy tax credits?
Yes. An active market in energy credits has been developing alongside renewable energy projects. This IRA energy credit market can offer significant benefits, as was demonstrated in August 2023 when a renewable power developer, Invenergy, sold $1.5 billion worth of energy tax credits to Bank of America.[24] With the money netted from the sale, Invenergy acquired a portfolio of renewable energy projects from the public utility American Electric Power.[25] Of course, the development of this market requires a willing buyer and a willing seller, with buyers typically looking for deep discounts. Obviously, extensive due diligence is critically important in structuring these sales, and tax insurance can also be available in some situations.
Conclusion
This Part IX ends our Q&A with Andie series on Energy Tax Credits for a New World, with specific emphasis on the significant changes in U.S. energy tax credit frameworks, and new methods of access and monetization made possible by the passage of the Inflation Reduction Act of 2022.
As the government continues to work out the details, there have already been many new project financings. I began this series with a review of the societal implications for development of a clean energy economy in the United States. I next considered the IRA’s Internal Revenue Code implementation involving investment and production tax credits.
Parts III through VII examined the central role of bonus credits, looking at the Prevailing Wage and Apprenticeship Credit, the Domestic Content Credit, the Energy Community Credit, and the Low-Income Communities Credit. These bonus credits crucially encourage investments in underserved and marginalized communities, and in areas where local employment and municipal tax income streams are grounded in those communities’ involvement with the fossil fuel industries.
I next turned to the IRA’s monetization techniques: direct pay and transfer/sales. The direct pay frameworks enable nonprofits and governmental entities for the first time to benefit from and monetize energy tax credits. The transfer provisions allow for-profit entities and individuals to sell credits they earn to willing buyers. And I wrap up with this series with an overview of the implications for traditional tax equity financing mechanisms. The key to developing and bringing online new client energy projects turns on how they are structured and financed, and that brings us full circle.
As I noted at the beginning of this Q&A with Andie series, the IRA is the most significant long-term commitment the U.S. government has made to date to encourage and support a clean energy future. It is an extraordinarily farsighted statute designed to ensure that the U.S. economy remains at the forefront of renewable energy development. Already, the IRA has changed the clean energy landscape in the ways in which tax credits are designed and awarded. It has also reframed the marketplace with new monetization techniques encouraging new investment opportunities and tax strategies. My colleagues and I continue to stay on top of the many related developments, and we will continue to update this series.
The firm extends gratitude to Nicholas C. Mowbray for his comments and exceptional assistance in the preparation of this article.
[1] The Inflation Reduction Act of 2022, Pub. L. No. 117-169, 136 Stat. 1818 (2022) (IRA), August 16, 2022.
[2] “The Risk Profile of Renewable Energy Tax Equity Investments,” November 20, 2023, American Council on Renewable Energy (ACORE), p. 2, available at https://acore.org/resources/the-risk-profile-of-renewable-energy-tax-equity-investments/.
[3] Ibid, p. 1.
[4] “Project Finance Law Review, Third Edition,” Ch. 17, Brian Greene et al, Law Business Research Ltd., June 2021.
[5] Tax benefits consist of tax credits, depreciation deductions, and cash distributions.
[6] “Project Finance Law Review, Third Edition,” Ch. 17, Brian Greene et al, Law Business Research Ltd., June 2021, p. 155.
[7] “The Risk Profile of Renewable Energy Tax Equity Investments,” November 20, 2023, American Council on Renewable Energy (ACORE), p. 2, available at https://acore.org/resources/the-risk-profile-of-renewable-energy-tax-equity-investments/. Emphasis in the original.
[8] Ibid.
[9] Rev. Proc. 2007-65, IRS, available at https://www.irs.gov/pub/irs-drop/rp-07-65.pdf.
[10] 2009-69, IRS, available at https://www.irs.gov/pub/irs-drop/a-09-69.pdf.
[11] CCA 201524024, IRS, available at https://www.irs.gov/pub/irs-wd/201524024.pdf.
[12] “Project Finance Law Review, Third Edition” Ch. 17, Brian Greene et al, Law Business Research Ltd., June 2021, p. 156. Unedited footnote to the original chapter excerpt: “This approach was confirmed to an extent in a 2015 internal memo in which the IRS national office analysed a transaction using the criteria from the wind safe harbour, even though the memo formally concluded that the wind safe harbour did not apply to solar projects as a technical matter. See Chief Counsel Advice 201524024 (12 June 2015).”
[13] “The Risk Profile of Renewable Energy Tax Equity Investments,” November 20, 2023, American Council on Renewable Energy (ACORE), p. 2. available at https://acore.org/resources/the-risk-profile-of-renewable-energy-tax-equity-investments/.
[14] Ibid, p. 8.
[15] Ibid.
[16] See Part VIII: Monetizing Energy Tax Credits in this series.
[17] Treas. Reg. § 1.6418-3(b)(2).
[18] The Inflation Reduction Act: How New Rules Fuel New Financing (Nov. 17, 2023), p. 4, available at https://www.infrastructureinvestor.com/the-inflation-reduction-act-how-new-rules-fuel-new-financings/.
[19] “The Risk Profile of Renewable Energy Tax Equity Investments,” November 20, 2023, American Council on Renewable Energy (ACORE), p. 10. available at https://acore.org/resources/the-risk-profile-of-renewable-energy-tax-equity-investments/.
[20] Ibid.
[21] Ibid.
[22] “Project Finance Law Review, Third Edition” Ch. 17, Brian Greene et al, Law Business Research Ltd., June 2021, p. 159.
[23] Ibid.
[24] “US investor group clinches tax credit deal for $1.5 bln renewable power acquisition,” Isla Binnie, Reuters, August 16, 2023, available at https://www.reuters.com/sustainability/us-investor-group-clinches-tax-credit-deal-15-bln-renewable-power-acquisition-2023-08-16/.
[25] “New Tax-Credit Market Aims to Funnel Billions to Clean Energy,” Amrith Ramkumar, Wall Street Journal, August 16, 2023, available at https://www.wsj.com/finance/banking/new-tax-credit-market-aims-to-funnel-billions-to-clean-energy-6221fc6f.
