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The Role of Tax Equity Partnership Financing in Facilitating the Development of Wind Farms
The United States Department of Energy (DOE) is committed to achieving a wind-based electricity generation portfolio equivalent to about 20% of US electricity needs by 2030. In an effort to achieve this objective, the US Government has been encouraging a national electricity portfolio of renewable energy (including wind) through tax policies by enacting the investment tax credit (largely used by developers in California to develop "green energy" projects but expired since 1985), enacting the production tax credit (a part of the Energy Policy Act of 1992), providing grants to fund conventional renewable energy generation projects and, lately, discussing the potential for carbon-based taxes or the implementation of a cap and trade regime to deal with carbon-based or "dirty" energy. Taxand US considers how the US has been shifting its energy infrastructure and looks at the investment in clean and renewable forms of electricity production.
Many states in the US have jumped on board by requiring utility companies to purchase a minimum level of electricity from renewable energy resources. With Iowa and Texas leading the way, more than 20 states have followed suit. This trend will likely continue, thus further stimulating future investments in renewable electricity generation projects. According to the DOE, achieving a wind-based electricity equivalent to 20% of US electricity needs would require US wind power capacity to grow from 11.6 gigawatts ("GW") in 2006 to more than 300GW over the next 20 years.
The number of utility-scaled wind turbine manufacturers with sales in the US increased to 14 in 2008 (GE, Vestas, Siemens, Suzlon, Gamesa, Clipper, Mitsubishi, Acciona, Repower, Fuhrlander, DeWind, AWE, Entegrity and DES), up from eight in 2007 and six in 2005. Of these manufacturers, six now have a US based presence for building wind turbines.
Production Tax Credit
The renewable energy production tax credit (PTC), as provided for in Section 45 of the Internal Revenue Code, is a tax credit of 2.1 cents per kilowatt-hour. Since its enactment in 1992, the PTC has undergone a series of short-term extensions, and eventually lapsed in 2003. In 2009, the Congress provided a three-year extension of the PTC through 31 December 2012, as part of the American Recovery and Reinvestment Act. The DOE also has a grant program in place whereby the PTCs could be given up for an investment tax credit (ITC) for facilities placed in service before 2013 as long as the construction begins before the end of 2010. The ITC can be exchanged for a grant from the Department of the Treasury. Both the PTC and the ITC/grant-exchange program can provide a significant amount of financing for renewable wind projects.
Tax Status of the Developer and/or Owner of a Wind Farm
Most utility companies and independent power producers in the US today have sufficient net operating losses (or even current tax losses) to eliminate any current regular federal income tax liability. Even without net operating losses, the current taxable margins of utility companies and independent power producers are relatively small. Thus, tax credits have generally limited use to these taxpayers. However, the use of a tax equity partnership structure may allow taxpayers to use the PTCs in a more tax-efficient manner, thus realising a greater value for them. The PTCs' value can be maximised from a financial perspective while achieving the Congress' overriding goal of making investments in "green energy" attractive and stimulating the economy through "green energy" investments.
Tax Equity Partnership Allocations
Generally, partnership allocations of income, loss, deductions, etc. must have "substantial economic effect" under the Treasury Regulations (Section 1.704-1) for the allocations to be respected for US income tax purposes. Since tax credits do not affect partners' capital accounts, they cannot have substantial economic effect. Thus, credits are generally allocated to partners in accordance with their partnership interests. To maximise the value of PTCs, the financer of a wind farm project can be made a partner of the partnership and allocated as much tax benefits as possible. The financer's partnership interest can then be reduced to a smaller amount after the financer's pay-back period.
Maximising the Utilisation of PTCs using a Tax Equity Partnership Structure
For example, a developer would like to produce and operate a wind farm and sell the off-take to a utility company. In producing the wind farm, the developer will likely need third-party financing and the cost of the financing will affect the developer's decision as to whether the project should be undertaken. Whilst the financer may be willing to finance the production of the wind farm, it is not likely to be interested in owning a substantial interest in the wind farm for an extended period of time.
Assuming the financer simply loans its cash to the developer or the utility company to produce the wind farm, the developer or the utility company will be the owner of the wind farm and will be entitled to the PTCs. This may not be the most efficient structure because the PTCs may not be utilised by their expiry date due to high possibility that these companies will incur losses (or earning a marginal profit). One way to maximise the utilisation of the PTCs is to have the developer and/or the utility company place the wind farm in a partnership with the financer contributing cash to the partnership. With that, the financer may be a partner and receive allocations of PTCs (and other tax deductions). The financer's ability to use the PTCs increases their value and is likely to reduce the overall financing costs of the developer and/or the utility company. This will in turn increase the developer or the utility company's margin from the wind farm.
However, if the financer's interest in the partnership is large in the early years and flips to a small percentage in later periods (say, after the pay-back period for the financer's investment), the financer's interest in the partnership may be challenged for the earlier periods. In any event, there could be value leakage associated with PTCs.
Enter the Tax Partnership Safe Harbour Rules and "Tax Equity Financing"
To facilitate the efficient use of PTCs (and carry out the legislative intent to encourage the development of wind farms), the Treasury has set forth safe harbour rules under Revenue Procedure 2007-65 (2007-45 IRB 967) (revised in Ann. 2007 - 112, 2007 - 2 CB 1175 and further revised in Ann. 2009 - 69, 2009 - 40 IRB) that govern arrangements whereby the financer acts as a partner for purposes of receiving allocations of PTCs in a partnership flip structure. The flip structure is a partnership structure whereby the financer is treated as a majority partner in the early years of the partnership (essentially during the pay-off period), and thereafter, the financer's partnership interest "flips" to a minority position. The flip is needed because the financer is not looking for a long-term investment in a wind farm. Instead, the financer is essentially an "accommodation" partner looking for a shorter maturity on its investment with the ability to use the PTCs and thus give a value for them. During the financer's pay-back period, it will have a large partnership interest. After the pay-back period, it will usually want as small an interest as allowed under the relevant laws.
Safe Harbour Tax Partnership Rules
Revenue Procedure 2007-65 (as modified) sets forth the following requirements to be satisfied in order to have an economic arrangement treated as a partnership that includes the sharing of PTCs:
- The financer's return is reasonably anticipated to come from both the PTCs and operating cash flow
- The developer must have at least a 1% interest in the partnership during the life of the project
- The financer's partnership interest cannot fall below 5% of the financer's largest partnership interest
- The financer contributes 20% of its total commitment (including foreseeable contingencies) at the time the project is placed in service or at the time the financer acquires its partnership interest
- At least 75% of the financer's capital commitment must be fixed and determinable
- The developer, financer or any related party can have a purchase right over the wind farm, but only for valid non-tax reasons and based upon fair market value principles, and the developer cannot have a right to purchase the wind farm until at least five years after the facility is first placed in service
- The project company cannot have a contractual right to require anyone to buy the wind farm assets (except the electricity generated from the wind farm)
- The financer may not have the right to require someone to purchase its interest in the partnership
- The financer's right to the PTCs cannot be guaranteed in any way (power purchase agreements are not treated as guarantees under the Revenue Procedure).
These are essentially the rules applicable to tax equity partnerships and the flip structure that allows the financer to be treated as a partner and receive allocations of PTCs. Under the example above, the financer will contribute cash to the project company (usually an LLC treated as a partnership for US income tax purposes) and the developer will contribute cash and development services. During the pay-back period, the financer will have a 95% partnership interest and the developer will have a 5% interest in the partnership. Note that the utility company could act as the developer or also be a party in this transaction. During the pay-back period, 95% of all partnership items, including all PTCs will be allocated to the financer. The financer's pay-back period and the cost of capital are then reduced due to the financer's ability to use the PTCs. After the pay-back period, the financer's interest flips to 5% and is a minority passive investor.
To achieve a 20% wind-based energy portfolio in the US by 2030, there will clearly need to be further investment in this sector. Growth in this sector will also be fuelled by states increasing requirements for renewable energy purchases by utility companies. The Federal Government will also add to growth both by providing financial incentives (such as PTCs and funding grants) and by requiring a minimum level of energy to be produced in the US based upon renewable resources - the carrot and stick approach. The US Government has been upfront about upgrading the national electric grid (not only to increase efficiency of moving electricity now, but also to support moving electricity from wind farms to utility companies for distribution), creating more incentives for "green energy" and increasing taxes on "dirty energy" (carbon taxes and cap and trade regimes). As demand builds for wind farms and other "green energy" projects, the use of the tax equity partnership structure will become more and more popular.
Your Taxand contact for further queries is:
Layne J. Albert
T. +1 212 763 9655
Tax equity partnership structures can be complicated and need to be modelled from a tax perspective so that the values associated with the depreciation deductions and PTCs can be determined. All PTCs, tax deductions and other front-loaded tax benefits (organisational costs, etc.) must be fully modelled and understood. Knowing the tax values upfront allows the developer and the financer to enter negotiations with all relevant facts and an understanding of how and when the financer can have its investment returned. It is important to thoroughly review the partnership agreement (even being involved in drafting the provisions) to be sure it fully complies with the safe harbour rules mentioned above concerning the flip structure. It is also important to keep close watch of the tax rules associated with PTCs and other forms of renewable energy.
As the Federal Government continues to stimulate the economy (shifting the energy infrastructure to a base with more renewable generation and creating new jobs in the industry) it will continue to change the tax laws. The Federal Government has telegraphed its desire to provide tax incentives for "green energy" and tax increases for "dirty energy". The tax equity partnership structure is a vehicle sanctioned by the US Treasury to achieve tax efficiency for PTCs.
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