by Patrick M. Cox, Brown Rudnick LLP
The Emergency Economic Stabilization Act of 2008 extended federal renewable energy tax benefits that give incentives to project developers, financial investors and sponsors. They include: the production tax credit (PTC); investment tax credit (ITC); and accelerated depreciation, or the Modified Accelerated Cost Recovery System (MACRS), a method of depreciation applicable to tangible property used in a trade or business or held for the production of income.
The following charts illustrate tax benefits associated with each type of energy project and the act’s impact on each. Investors must fully evaluate the economic impact of the available credits and depreciation. Some benefits will be short-term, such as the ITC. Some benefits will be realized over the life of the project, such as the PTC and MACRS. And some benefits may extend beyond the life of the project, such as the potential carryforward of unused credits. ITC or PTC benefits may be combined with MACRS, but the ITC and PTC may not be used for the same project. Most important, an investor must determine whether a project will be operational in time to take advantage of either the ITC or PTC.
Production Tax Credit
The PTC allows the owner of a qualified facility (see chart) to take an income tax credit based on the amount of electricity the facility produced. The PTC may be taken each year for 10 years after the qualified facility is placed in service. Because the PTC is a component of the general business credit, unused credits may be carried back one year and forward up to 20 years.
To be eligible for the PTC, a facility must be placed in service before the PTC expiration date (see chart). If a facility meets the deadline, then the PTC is available to its owner for 10 years beginning the year the project is placed in service (the duration). Generally, -placed in service occurs when a property is ready and available for a specifically designed function. Decades of case law and Internal Revenue Service (IRS) guidance, however, have interpreted -placed in service differently in various contexts, so the transaction facts must be considered when determining whether all or a portion of a facility meets this requirement by the deadline.
The act extended the PTC expiration date for wind facilities by one year and by two years for all other projects. The act also made the PTC available to marine and hydrokinetic energy projects. Marine and hydrokinetic energy generally includes energy produced from the natural movements of water (waves, tides, currents, free-flowing water and differentials in ocean temperature) but does not include energy derived from any source that uses a dam, diversionary structure or impoundment for electric power purposes.
The duration for PTCs is 10 years, unless there is an issue regarding whether upgrades, modifications or additions to the facility would cause it to have a new placed-in-service date. In determining whether a new placed-in-service date was created, the general rule is that the used property value cannot be more than 20 percent of the new facility’s fair market value. It’s known as the 80/20 test.
The PTC is available with respect to energy produced by the taxpayer and, therefore, the taxpayer must own the facility. If the owner is not also the producer, however, then the person eligible for the credit is the lessee or operator. For these purposes, partners in partnerships are treated as owners and producers.
Investment Tax Credit
The ITC is a nonrefundable income tax credit allowed for the cost of certain new property categories used to produce, distribute or use energy. Unlike the PTC, the ITC may be taken only once. Like the PTC, the ITC is a component of the general business credit and unused credits may be carried back one year and forward 20 years.
To be eligible for the ITC, the taxpayer must construct, reconstruct, erect or be the first user of the energy property. The term -energy property includes the type of property listed in the following chart, but generally excepts property if it is used predominantly in the taxpayer’s trade or business of selling electricity, water, sewage, local gas or telephone services.
The ITC is calculated by taking a percentage of the cost basis of the energy property placed in service during the taxable year. The amount of the ITC is 30 percent or 10 percent. For example, if an investor constructs and places in service qualified solar property at a cost of $100,000, the ITC will equal $30,000. -Placed in service has the same definition as given in the section of this article discussing the PTC. If the project’s construction time is expected to equal or exceed two years, however, the credit may be claimed as progress expenditures are made on the project, rather than when the property is placed in service. In both cases, the basis of the property will be reduced by 50 percent of the credit claimed.
The ITC was set to expire Dec. 31, 2008, but the act extended the ITC until Dec. 31, 2016. In addition, the act modified the definition of energy property to include combined heat and fuel property, small wind energy property and geothermal heat pump systems.
Finally, the act allows the ITC to offset the alternative minimum tax.
Structuring to Maximize Tax Benefits
To finance projects, developers and others (private equity sponsors, for example) must maximize the tax benefits.
Tax benefits for a project have a limited duration (typically spanning five to 10 years). To maximize the value of the tax benefits, it is essential to match the tax benefits with taxable income. Typically, developers are in less demand for the tax benefits in the early years of a project, while some investors can gain an upside from their investments if they can fully utilize the tax benefits. As a result, structures typically are arranged to allocate tax items (including credits) disproportionately to investors for an initial period of years. After this period of initial allocation, there is a flip so that the developer thereafter is allocated 90 percent to 95 percent of the tax items in similar percentage amounts as their partner. These are often called flip partnership structures.
Flip partnership structures raise a number of tax issues that investors and developers must understand and negotiate at the outset of business relationships. For example, allocation of depreciation deductions take on an added significance and complexity where the developer contributes appreciated equipment. Also, there are pitfalls that must be avoided when devising an exit strategy. A carelessly structured partnership may either not take full advantage of tax opportunities or may be so aggressive that the IRS will not respect the allocations. Either is unacceptable as tax savings is a critical component to the transaction.
The IRS has issued guidelines on these types of allocations in Revenue Procedure 2007-65. Although this revenue procedure is not law, specifically only addresses wind projects and partnership allocations are not described, the revenue procedure may very well pass scrutiny as a practical matter financial investors are demanding that their transactions be structured to comply with Revenue Procedure 2007-65 guidelines.
Federal tax benefits have been critical to closing the financial gap faced by renewable project developers and providing a vibrant source of equity in the renewable sector notwithstanding the historical start-stop nature of Congressional enactments. The act provides the long-awaited extensions of the PTC and the ITC tax benefits. Moreover, the ITC extension is lengthy enough to allow project developers to be more confident that their projects will be complete prior to expiration.
It is unclear how the economic environment will affect investment in renewable energy. Projects could stall because of a lack of credit or financing. It is also possible that taxpayers considering investments in renewable energy projects are not in a position to use tax credits (the taxpayer expects to have losses and therefore would not have to pay tax). The credits may be carried forward for 20 years. Therefore, it will be necessary for taxpayers in a loss position to complete a present-value analysis to discount the value of the credit to account for the delay in its use.
The author thanks Nicole M. Bourchard for her significant contribution to this article.
Patrick M. Cox is a partner in Brown Rudnick’s Corporate Department. He focuses his practice on taxation law and has extensive experience in general tax planning including issues of partnership, real estate, international and corporate taxation. E-mail him at email@example.com.