We in the United States, whether in the name of ideological principal or political necessity, have decided to incentivize renewable energy deployment through our tax code. This has produced a byzantine system of rules and regulations surrounding the financing of solar facilities. The result is the proliferation of innumerable complex partnerships with dynamic equity interests, guided by a cabal of accountants and lawyers. In an increasingly competitive marketplace, where margins are shrinking and return hurdles are continually being squeezed, success can hinge on efficiently allocating every last drop of tax benefit across equity members while managing transaction costs.
The principal incentive for deployment of utility-scale solar is the §48 Investment Tax Credit (ITC), which provides for a federal tax credit, equal to approximately 30% of a project’s fair market value, to offset federal tax liability on a dollar-for-dollar basis. The first irony of the ITC’s design is that most sponsors (those who develop or ultimately own solar assets) do not have enough positive tax liability to set off against the credit. As a result, sponsors seek investors that have tax capacity (the ability to monetize tax benefits like depreciation expense and the ITC), with whom they form tax equity partnerships in order to more efficiently monetize the ITC.
The tax equity investor, typically a bank, insurance company or corporation with significant annual tax liability, contributes equity into the partnership. In exchange, the tax equity investor is allocated the ITC and tax losses (depreciation) to the extent their capital is at risk (as measured via the provisions of IRC 704(b)), as well as an annual minimum cash distribution. The sponsor, again typically the developer or a later-stage buyer/owner of the asset, collects the majority of cash distributions after debt service. At the conclusion of the ITC compliance period (five years), the tax equity investor will typically exit the partnership, collapsing the multi-investor holding company to a simpler single-member entity.
The vast majority of the tax equity investor community relies upon what is referred to as the Partnership Flip structure to allocate 99% of the ITC to the tax equity investor. There are a number of flavors of the Flip, but most are identified as either time-based or yield-based. In both cases, the tax equity investor is a majority equity holder in the holding company (HoldCo) through a specified period often slightly beyond the ITC’s 5-year compliance period, after which its ownership interest flips down to something on the order of 5% and an option permits the sale of the tax equity investor’s interest in the HoldCo to sponsor. This structure enables the tax equity investors to absorb the majority (up to 99%) of the tax benefits associated with the project until those tax benefits are exhausted before the majority project ownership flips back to the sponsor.
The allocation of losses during the “pre-flip” period is both complicated and economically impactful for the sponsor and tax equity investor. Both the sponsor and the tax equity investor are limited in the amount of tax losses they are allowed to take under the Internal Revenue Code. Equity partners are allowed to take cash distributions and absorb tax losses only to the extent that they have capital at risk in the partnership. The IRS determines whether a partner has capital at risk based on whether they have a positive or negative 704(b) capital account.
Each partner builds their capital account through either a contribution of capital or property, or through income. Once the tax equity investors have made their investment, every dollar of cash distributed and every dollar of loss (depreciation expense) allocated to them reduces their capital account by a dollar.[1] So in rough terms, assuming a tax equity investor’s total contribution to a tax equity partnership represents 40% of the capital stack and the partnership agreement allocates 99% of losses to them (in order to maximize allocation of the ITC), the tax equity investor’s capital account would be quickly depleted with more than half of depreciation still remaining to be allocated 99% their way.
A series of mechanisms established by the internal revenue code either prevent a partner’s capital account from running negative, or allow for it via a number of remedies. Generally speaking, two schools of thought permeate the market on the reallocation of losses during the “pre-flip” period. Some tax equity investors prefer to reallocate tax losses during the pre-flip period to sponsors, others prefer to utilize the losses and depend upon a Deficit Restoration Obligation (DRO), as detailed below. Both have advantages.
Scenario 1 - Reallocation
The simplest partnership arrangement (typically time-based Partnership Flips) will reallocate losses in excess of the tax equity investor’s capital account from the tax equity investor to sponsor once the tax equity investor has depleted their capital account. This is a clean solution, which happens automatically and only needs to be quantified by accountants at the conclusion of each tax year when issuing K1s. Typically, within 1-2 years the tax equity investor reallocates all losses to the sponsor, who then carries those losses forward until they can be utilized against income.
The problem with this solution is that the partners reallocate depreciation, a tax benefit with real-time value, to a sponsor, that more often than not has little to no tax liability and thus no means to monetize the tax benefit. Those losses will simply sit with the sponsor and be carried forward years into the future to offset future project-level taxable income once the depreciation shield is burned off. That’s a real drag on the time-value of those benefits and reduces returns either for the sponsor, the tax equity investor, or both
Scenario 2 – Deficit Restoration Obligations
An alternative is a more sophisticated, dynamic flip that employs a Deficit Restoration Obligation (DRO) to permit the tax equity investor’s capital account to go negative (though up to a defined amount as specified in the partnership agreement). This structure adheres to the most conservative tax opinion on loss and ITC allocation, as discussed in more detail below. As the DRO permits loss allocation to the tax equity investor in excess of the partner’s capital account, no reallocation of losses occurs.
This is a complex mechanism and not all tax equity investors are comfortable taking the risks associated with it. The main risk of allowing the tax equity investor’s capital account to go negative is in case of a liquidation event. If the partnership were to liquidate, the tax equity investor would be obligated to contribute additional capital in an amount equal to any capital account deficit, hence the name “deficit restoration obligation”. For practical purposes, there is usually sufficient gain upon liquidation to restore capital account deficits. Nonetheless, this arrangement does present a risk to the burdened partner.
Further complicating this arrangement, the tax equity investor’s allocation of income and losses is typically optimized via dynamic ownership interests. Starting out at a 99% interest maximizes allocation of tax attributes in Year 1 (the year the ITC is allocated), before dropping to 67% (the maximum permissible reduction in the tax equity investor’s equity interest in Year 2) in order to minimize loss allocation in Years 2-5 and thus limit the extent to which the tax equity investor is pushed into a capital account deficit. Finally, once the MACRS depreciation is burned off (the conclusion of Year 5), the tax equity investor’s ownership flips back to 99% to allocate the maximum permissible taxable income to the tax equity investor. The positive taxable income digs tax equity investor out of its deficit position until fully restored, at which point an option is executed and tax equity investor exits the partnership. Simple.
This structure checks the box for tax counsel (more below), but like the time-based Partnership Flip, it inefficiently allocates losses to a partner who cannot monetize them. Although the tax equity investor is allocated losses commensurate with its ownership of the partnership (even in excess of capital at risk), those losses cannot be monetized in real time. A number of rules (namely those provided in IRC 704(d)) effectively place those losses on ice via a carryforward-like mechanic. This bag of excess losses is stockpiled until they can be used to offset positive income allocated to tax equity investor (thus the 99% flip back after the majority of depreciation is burned off).
Why? Reallocations jeopardize tax equity investor’s perceived true ownership interest in the partnership. The ITC follows, depending upon who you ask, allocations of income OR allocations of income and losses. Moreover, there is no agreement across the industry as to whether that rule applies only to the year in which the ITC is minted (i.e. reallocations in Year 2 and beyond are OK), or whether reallocations at any point during the entire life of the partnership jeopardize the initial allocation of the ITC (bouncing ownership interests, DROs, etc.).
Optimal efficiency – the Inverted Lease + Tax-efficient Sponsor
One way to manage loss allocation to match capital at risk is to structure the partnership via an Inverted Lease (a.k.a Lease Pass Through or Master Lease), which permits the members to deliberately structure the partnerships (yes, there are multiple tiers here) such that the partners’ interests in the upper tier partnership (HoldCo or Lessor) are sized to allocate losses to the lower tier partnership (Master Tenant or Lessee).
These losses are sized so that the tax equity investor fully depletes its capital account, with the remaining losses flowing to the sponsor (more below on further optimization). The Lessee entity can then be structured such that the tax equity investor owns 99% of that lower-tier partnership. The ITC is passed through to the MT entity via the master lease, and which can then allocate 99% of the ITC to the tax equity investor, while controlling loss allocation and the extent to which their capital account goes negative. An additional benefit of the Inverted Lease resides in the ability to establish the Fair Market Value of the asset without an asset sale, permitting a ITC benefit comparable to that in a Partnership Flip but without the taxable gain that accompanies the asset sale required in Flips.
Further enhancing this structure, a sponsor who can monetize losses in real time changes the economic proposition as well. Currently, most sponsors (or investors who take equity stakes in sponsors) are pension funds, sovereign funds, or other non-tax-paying entities. Showering losses upon them does nothing to alter their valuations – they focus on pre-tax yield. A sponsor who values tax benefits, however, may be willing to accept a lower pre-tax yield if there are other tax attributes they can monetize. This tax-efficient sponsor, via the Inverted Lease, can even benefit from the 100% expensing made possible via the 2017 Tax Reform, a benefit seldom, if ever, pursued by Flip Investors. As Managing Member of the Helios InfraCo fund, which effectively utilizes this structure to enhance our cost of capital, Sol Systems has seen firsthand how It can positively impact pricing to developers.
Conclusion
Aside from contributing to the advancement of renewable energy, there are strong economic incentives to detangling the complexity inherent in solar finance. Sol Systems currently manages approximately $450M in Tax Equity and Sponsor Equity, across a wide swath of asset classes applying numerous structures and leverage solutions. We’ve learned that, amongst the myriad components to solar finance, the essential ingredient to successful execution is trustworthy and experienced partners and advisors. Investors all have unique profiles and objectives, so the approach for any new entrant will always have to be tailor-made. At least you’ve got options.
[1] This scenario assumes back-leverage debt. Project-level debt introduces an additional level of complexity that we won’t examine here.
This is an excerpt from the Q1 2019 edition of The SOL SOURCE, a quarterly electronic newsletter analyzing the latest trends in renewable energy development and investment based on our unique position in the solar industry. To receive future editions of the journal, please subscribe.
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