Solar tax equity has been growing steadily in popularity since the expansion of the energy investment tax credit in 2008. With the value of the investment tax credit (“ITC”) stepping down for projects that commence construction after 2019, now is a particularly good time to assess whether banks and corporations can benefit from tax planning with solar tax equity.
Frequently, a solar power user is unable to capitalize cost of the project efficiently. In such cases, a developer will agree to own the property at the user’s facility and sell the electricity to the host under a power purchase agreement or energy services agreement. If the developer is unable to utilize the available tax benefits, the developer will identify a party, typically a corporation or bank that can to help capitalize the project in exchange for tax benefits and cash flow. This position is frequently referred to as the tax equity.
Most tax equity investments are structured to provide the tax equity investor with most (99%) of the tax benefits plus a preferred position on operating cash flows until a specified return hurdle is met. At that point, most of the cash flow goes to the cash partner (most likely the developer) until the tax equity position is redeemed, which is typically at the beginning of the 6th year of the project.
Tax equity returns for commercial and industrial solar projects generally range from 15.0% to 20.0%+ after tax. At a 21% corporate income tax rate, this is equivalent to a 19% to 25% before tax return. These are considered very attractive risk-adjusted returns, especially taking into account that up to half of invested capital can be returned in the first year.
Energy Investment Tax Credit
Internal Revenue Code (“IRC”) Section 48 allows for a credit of 30% of the basis of each “energy property” placed in service during the tax year. Under IRC §48(a)(3)(A)(i), energy property includes “equipment which uses solar energy to generate electricity…” Importantly for investors, IRC §48(a)(3)(B) requires that if the energy property is acquired by the taxpayer (as opposed to developed), the original use of the property must commence with the taxpayer. Thus, an investor must acquire the energy property prior to, or concurrent with, placing the property in service.
Note that the ITC begins to decline for projects that commence construction after 2019. The ITC ramps down based on the following schedule:
Tax equity investors may also be able to take advantage, at least in part, of accelerated deductions through bonus depreciation. 100% expensing of adjusted tax basis is available for energy property acquired and placed in service after September 27, 2017 and before January 1, 2023. Adjusted tax basis is the original cost of the energy property less one-half of the tax credit allowed. Note that insufficient “outside” basis may limit the amount of losses that tax equity can benefit from in the first year.
Though the value of depreciation deductions fell in 2018 when corporate income tax rates were reduced from 35% to 21%, the tax equity market has adjusted by reducing the tax equity share of total capitalization.
Tax Equity Partnership Flip Structure
As previously noted, tax equity is structured so that most off the tax benefits are allocated to tax equity position. Typically this is done using the partnership flip structure (more fully discussed in Rev. Proc. 2007-65).
Tax equity is allocated up to 99% of tax items (ITC and bonus depreciation) and subsequently flips down to as little as 5% after reaching the pre-determined after-tax IRR. The tax equity position is redeemed by the cash equity after the mandatory five-year holding requirement.
As noted above, though 99% of the net loss (driven by bonus depreciation) is allocated to tax equity, the investor’s outside basis may limit the amount of loss (and tax benefit) that the tax equity investor can take in the first year. Disallowed losses are carried forward to offset future allocated taxable income and cash flow.
There are many variations on this basic structure all of which generally share the objectives to a) allocate tax benefits to the party best able to utilize them, and b) deliver target investment returns to tax equity.
Tax Equity Example
Consider a $10M solar project where the tax equity invests 40% of the total cost, or $4M. The ITC is 30% of $10M, or $3M. Adjusted basis is $8.5M, all of which is expensed under the bonus depreciation rules.
Assuming tax equity receives 99% of the ITC and losses, tax equity is allocated $2.97M of ITC and $8.415M of losses, of which only $1.03M can be used given tax equity’s outside basis. The remaining $7.385M of losses are suspended until additional basis is available. In total, tax equity receives after-tax returns of $3,186,300 ($2.97M plus $1.03M times 21% tax rate), or 79.7% of the original $4M investment.
The remaining investment returns come from the allocation of operating cash flow, which is typically tax- free to tax equity due to the suspended losses.
This example demonstrates the key financial benefits of tax equity. So long as the investor has sufficient taxable income to receive the allocated credit and losses, a significant amount of the investment is returned in the first year, all of which is from reduction in tax liability. The investor’s tax liability actually allows it to achieve excess investment returns with minimal risk and contribute to reduction in greenhouse gas emissions, the primary cause of global warming and climate change.
Tax Equity Market Conditions
The tax equity market for utility-scale projects has been highly efficient for at least half a decade, with a limited but steady stream of investors and projects. The success of the utility market has driven down returns, however, encouraging greater interest and activity in smaller, commercial and industrial projects. Today, high quality C&I projects are available with tax equity commitments ranging from $500,000 upward to $20M. Returns for C&I projects remain strong, with most projects offering 5 year IRRs of 15.0% to 20.0% and up.
Tax equity offers unique tax planning opportunities for corporation and banks with regular taxable income. Tax equity allows companies to turn tax liabilities into safe, reliable investments with strong economic returns and environmental benefits. Tax advisers, CPAs and CFOs would be well served to take the time to understand the benefits of solar tax equity and make these opportunities a regular part of the tax planning process.
Windmill Capital Management and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.