Primary Tax Equity Finance Structures Common to the U.S. Domestic Solar Energy Industry: June 2012

Transcription

1 Primary Tax Equity Finance Structures Common to the U.S. Domestic Solar Energy Industry: June 2012 The following paper discusses in a very general manner the three main tax-equity structures used in many solar energy projects located in the United States. However, given the unique nature of project finance in general, and the specific needs of the parties to any given solar transaction at any given moment in time, it is not possible to catalogue every possible variation of fact and circumstance that might impact one or more aspect of any particular transaction structure as described below. Nonetheless, there is a certain level of standardization in the solar industry so that it is still possible to make a number of generally accurate statements about common features of each of the three primary structures in today s marketplace. As such, the sole purpose of this paper is to instruct, in a general way, persons not experienced or familiar with the intricacies of solar tax equity finance with the basic concepts most commonly deployed by those active in the solar finance marketplace in the U.S.. As always, changes in law, energy regulatory policy, tax rules or GAAP accounting rules or regulations may materially alter the descriptions below. Discussed below are the three most common types of structures: The Partnership Flip structure The Sale-leaseback structure The Inverted Lease Important Note: In any case where a lease is relied upon, there are special rules and limitations that apply to federal Investment Tax Credit (ITC) transactions involving governmental or tax exempt parties. Though too complex to cover in this brief overview, in general, the reader should keep in mind that the ownership or lease of ITC eligible equipment by a government or tax exempt entity or taxpayer will prevent the full realization of the ITC and can also trigger a material deferral of the federal income tax depreciation benefits associated with such equipment. Therefore, special structuring must be relied on in most cases where a lease to a governmental or tax exempt entity is required. The same is true of most cases where a government or tax exempt directly, or in some cases indirectly, owns an interest in the solar equipment or an entity that owns such equipment. Overview of Partnership-Flip Structure The single-entity or simple partnership structure most common to the solar industry is often referred to by tax equity specialists as the partnership flip structure. As a partnership, for federal income tax purposes the entity must have at least two, generally unrelated owners. One owner, commonly known as the sponsor who is often the project developer, and a separate owner, primarily federally tax motivated, known as the investor or tax-equity. In general, the flip structure entails a private owner (i.e., an owner that is neither a government nor a taxexempt for federal income tax purposes) in the legal form of a state law Limited Liability Company (LLC) or partnership which directly (or through another entity or entities) owns (for federal income tax purposes) the renewable energy generating plant that is eligible for federal income tax credits and other tax benefits such as federal income depreciation deductions, and where at some point in the future (timing discussed below), the ownership percentages of the respective partners will change or flip. Lee J. Peterson, Esq. Page 1

2 Importance of The Partnership Tax Classification Under the partnership flip structure, the legal entity that owns the renewable energy equipment is required to be taxable as a partnership for federal income tax purposes because under current federal tax law (unlike the law in some states) federal income tax credits and depreciation tax deductions cannot literally be sold to investors. Therefore, instead of the investor literally buying federal tax benefits, a federal tax credit investor ( tax-equity investor) would invest, in the form of a contribution to the partnership of cash in exchange for a capital and profits interest in the partnership. Therefore, as a bona fide and contributing partner/owner of the underlying solar partnership property, each partner is subsequently allocated their respective share of federal (and in some cases state) partnership tax benefits such as income, gain, deductions, loss, and tax credits under general federal income tax rules. This process is governed by longstanding federal income tax law. The Basics of the Flip In the partnership flip structure, there is either at least one managing or General Partner (GP) of the partnership, or a Managing Member of the LLC and that is typically the project sponsor and one or more separate and unrelated Limited Partners (LP) or LLC investor members who are primarily motivated to obtain federal, and in some cases, state tax credits. In most every case, there will be a federal investor primarily motivated to obtain federal tax benefits but they might also choose to take both federal and state benefits if there are both. More complex transactions have separate unrelated federal and state tax-equity investors so that there are a minimum of three, rather than two partners. As indicated, the project sponsor may be the project developer as well, but these persons may or may not be the same person. Therefore, the sponsor may or may not have the right to earn a developer fee for their efforts as project sponsor and business manager of the project, in addition to being entitled to their share of tax and other economic benefits as a project owner. The lender, providing either construction or permanent debt, if any, is typically an unrelated third-party financial institution. The Capital Stack Total project capital costs in the typical tax equity finance structure may be covered by any combination of sponsor equity (sometimes referred to as cash equity, tax investor contributed equity (i.e., tax-equity), equity raised from a state tax credit investors (state tax-equity, if any), state or local grants, rebates, subsidies, etc., revenue from sales (including pre-sales) of either energy, renewable energy certificates or carbon offsets or credits (commonly referred to a RECs or in the case of solar RECs, SRECs), or both, with the balance of construction funding sources, if any, being typically made up with some form of thirdparty debt. Some projects may have mezzanine debt for a period, or so-called mini-perm or short-term permanent debt, and ultimately conventional, longer-term true permanent debt which takes out the initial construction or other debt. In some cases however, there may be no project partnership entity-level debt because of the use of socalled back leverage. This is where project partners borrow cash and contribute that cash as equity in an amount sufficient to, eliminate or reduce the need for project entity debt. Accordingly, there are high equity and even all-equity versions of financing, and in rare cases, even a non-back-levered all equity transaction, typically only executed by larger, so called balance sheet investors. Lee J. Peterson, Esq. Page 2

3 Depending on the specific transaction, the amount of tax equity contributed by the typical institutional investor may comprise as much as nearly 40% of the projects capital requirement, assuming no state tax equity is involved. The timing of the investor s cash contribution may also vary. Typically, tax-equity investors in today s marketplace prefer to wait until the commercial operation date or (COD) to make their full contribution, and some may prefer a pay-as-you-go structure. But again, this varies by project and tax credit. With a solar investment tax credit (ITC) project and the partnership flip structure, the partner receiving the tax benefits must be a partner in the project entity prior to the project (COD) for federal income tax purposes. Also, with an ITC, if the inverted lease structure (see details below) is not used, the depreciation benefits for ITC projects are required to be reduced by 50% of the investment tax credit amount, thus reducing the value of that specific tax benefit to the investor and sponsor, thereby impacting the amount of tax equity raised by the partnership. Investor Yield Depending on the specifics of the partnership flip transaction, investors may evaluate their investment in terms of a target yield. That yield is often compared by the investor to other investments it might make or compared to the percentage of project cost that is expected to be covered by their tax equity investment, i.e., the amount of return expected from their proportionate share of capital employed in the overall project as compared to how much capital the investor must put at risk with another investment in order to obtain a similar yield. Note that this yield analysis differs from that of an investor in a sale-leaseback transaction (discussed separately below). Regardless, much variation among investors exists in how they each evaluate and calculate yield. However, if a tax equity investor compares the financial accounting treatments of an investment in the form of a sale-leaseback (described in detail further below), as compared to an investment in the form of a partnership flip structure, under Generally Accepted Accounting Principles (GAAP), in most cases, the investor in a partnership structure will often realize a more favorable impact on their financial statement than would a lessor in a sale-leaseback structure. This is due in large part to the impact that project level debt typically has on the GAAP treatment. In the case of a sale-leaseback, the lessors direct ownership of both the project assets and liabilities, is contrasted with the GAAP treatment of ownership of a partnership interest, where, the tax investor s equity contribution will cover up to 40% of total project cost giving rise to an unfunded balance required to be financed through some combination of debt, sponsor equity, state and local subsidies, or economics. Therefore, in many cases, the ability to reduce the amount of liabilities that are required to be shown on the investor s financial statement by virtue of the tax equity contribution has a materially positive impact on the investor, often reflected in the form of reduced GAAP liabilities. In many cases, this then translates into an improved ability to borrow by the investor and as such, may represent an enhancement to the overall credit rating of the investor. Clearly a favorable financial accounting outcome. Moreover, in a partnership flip structure, though the partnership or LLC agreement will generally contain any number of indemnification provisions, the indemnifications provided in a partnership structure are generally less onerous than in a sale-leaseback structure. Lee J. Peterson, Esq. Page 3

4 The partnership structure therefore generally maximizes the economic benefit of the federal tax benefits by using the partnership income tax accounting rules to simply and efficiently allocate materially valuable tax benefits to tax equity investors. How It Works In most cases, the construction of the project is financed by initial funding commitments from the developer (and/or third-party construction period debt providers). Once the project is placed in service, the tax equity contribution repays all or a portion of the construction period financing. In general, the partnership agreement allocates among the parties taxable income or loss and cash distributions in a manner designed to optimize the desired after-tax economics of each party. Once the project is placed in service and the tax equity investor has funded its contribution, 99% of the tax benefits are typically allocated to the tax equity investor. In many cases, once the tax benefits to the investor are vested and determinable, the investor may immediately adjust (i.e., reduce) their federal income tax withholding payment to reflect the expected income tax liability reduction, thereby effectively realizing the economic return on investment up front and benefitting from the cash-flow freed up by the reduced federal cash tax payment. Inside the partnership however, the cash flow from operations of the solar project is typically allocated up to 99% to the investor once the developer has first recovered some or all of its equity investment. Those allocations (99% to the investor and 1% to the sponsor) generally remain in place until the investor has achieved an agreed yield on its investment (generally this occurs around year 10, when all of the tax benefits have been accrued although given the 5-year ITC recapture period and accelerated federal tax deprecation period for solar, shorter periods such as 5-7 years may be agreed to and are quiet common). Regardless, at that end-point, the partnership ownership and tax allocations flip with the developer/sponsor taking up to 95% of the cash and tax attributes and the tax equity investor reduced down to the remaining percentage. To accomplish this, generally, the developer has a fair market value option to buy out the tax equity s remaining 5% interest in the project. This is often achieved by exercising a call option to buy out the investor for the greater of fair market value of the ownership interest or the amount required to achieve an agreed-upon internal rate of return. It is common for the sponsor to have, as part of the flip transaction, a fee, or return of capital provision, for the benefit of the sponsor, so that the sponsor receives the majority of the cash. Generally, this is done on flip transactions where the flip is date certain as opposed to a flip transaction whose flip date would be determined by the achievement of a specified IRR. The mechanism to accomplish the flip is typically either a put or a call option where the developer typically has an option to buy out the investor s interest for fair market value when the option is exercised. For federal income tax purposes, these options must not be continuous, but may be exercised at predetermined times. Lee J. Peterson, Esq. Page 4

5 Unlike the sale-leaseback structure (discussed and compared further below), where the back-end residual value of the capital assets in the project can be retained by the tax equity, the flip structure reserves to the developer the upside potential and downside risk in the residual. By the same token, the developer s return on its investment is delayed and also more dependent on the residual in the partnership, whereas in the sale-leaseback, the developer realizes an up-front profit on the outright sale of the project to the tax equity investor (that sale also steps-up the federal income basis of the project in the hands of the tax equity for both ITC and depreciation purposes often increasing those amounts). Another distinction is in the area of management rights and powers. In a partnership structure, these can be difficult to negotiate, in contrast to leases which have been used for a long time and with respect to which an accepted practice exists. However, the developer may be able to negotiate for greater flexibility in a partnership structure that would be afforded through a lease covenant package. However, this structure is not, in general a matter of simple agreement amongst the parties. Rather, most flip transactions are actually a function of compliance with an IRS ruling or safe harbor, which most tax equity investors seek great comfort from. This is explained in more detail immediately below. Why The Flip Structure is Among The Preferred Tax Equity Structures In October 2007 the IRS issued guidance for financing of wind projects using the partnership flip structure. Since it s issuance, most tax professionals have taken the position that this guidance is equally applicable to ITC and solar projects. Specifically, the IRS ruling (Rev. Proc and its subsequent amendment) provides that unless the following guidelines are met, the IRS will closely scrutinize the validity of wind (and it is assumed solar) energy partnerships. Per the Rev. Proc et seq. safe harbor provisions: The developer/sponsor must maintain a minimum 1% interest in tax attributes, and the investor must maintain an interest equal to 5% of their greatest prior position (i.e., 5% of their prior 99%). The tax equity investor must maintain a capital investment at least equal to 20% of the sum of its fixed capital contributions plus anticipated contingent capital contributions. The initial investment can be delayed until the project is placed in service. At least 75% of an investor s total capital contributions must be fixed and determinable obligations that are not contingent either in amount or in certainty of payment. The exercise price of any purchase option held by the developer, the investor or any related party to purchase the project or any interest in the partnership must be at fair market value as determined on the date of exercise of the option. Developer purchase options are not permitted during the first five years. The partnership may not have a right to require any party to buy the project, and the investor may not have a right to require any party to buy its partnership interest. Neither the developer nor a related party may loan any funds to the investor to invest in the partnership, or may guarantee any debt connected to that investment. There can be no guarantee to the investor of any amount of, or allocation of, the PTC, except the investor may obtain a third-party guarantee of wind resource availability. The production tax credit, if applicable, must be allocated the same way gross income from sale of electricity is allocated. Lee J. Peterson, Esq. Page 5

6 Therefore, as stated, the partnership flip is typically used by developers that desire ownership of the residual interest of the project. General Issues With The Flip Structure Some commonly seen issues pertaining to the partnership flip structure include deferred developer fees/installment notes (the issue being whether they can be supported by the project cash flow, term of payment, potential tax consequences to the developer, etc) and capital accounts (Internal Revenue Code Section 704(b) issues and potential reallocation of tax losses required by these rules). Other common and business issues, which apply to all the structures discussed here, include install costs, PPA rates, competition for hosts, debt terms (credit crunch implications), investor equity return requirements and residual (call) value. Also, some tax considerations relevant to all structures include ownership (whether the tax investor has enough upside and downside to be an owner), protection against loss (whether any other person other than the sponsor have enough interest in profits and risk of loss to be a partial owner), economic substance (whether the transaction is real or just simply tax motivated). Overview of Sale-Leaseback Structure For Tax Benefit Monetization The sale-leaseback structure differs substantially from the partnership flip structure in that the renewable energy project sponsor who is otherwise directly entitled to their share of the tax benefits upon COD instead ends up in a sale-leaseback transaction sharing only indirectly in the federal tax benefits by virtue of their realizing the economic benefit of reduced rent for the use of the renewable energy project. Under the sale-lease-back structure, the way to finance a renewable energy project is for the renewable energy project developer/sponsor to construct and sell the energy project to an institutional investor but then immediately lease that project back from the new institutional owner under terms that are typically a net, or so called high-or-hell water lease. Typically, investors utilize a lease optimization model. With the sale-lease-back, the developer/lessee is obligated to pay fixed rent (or specified termination value in the event of a loss of the assets) to the investor/lessor for the term of the lease irrespective of the actual performance of the system, existence of force majeure events, etc. One of the advantages of this structure is that the fixed rent stream and the ability to stretch out the term of the lease allows the lessee to keep the upside if the project generates greater returns than anticipated. However, in a partnership structure, the principal effect of greater returns is simply to accelerate the date of the flip. Also, in a sale-leaseback structure, the lessor gets a predictable rent stream. A key issue is that the lease must be respected as a lease. Therefore, given that the developer typically sells the solar property to a financial institution such as a bank or insurance company, or other tax equity investor ( lessor ) which leases the property back to the developer ( lessee ) under a long-term net lease, in order to ensure that the lease is respected as a lease for federal tax purposes, many practitioners strive to follow the lease safe harbor laid out in IRS Notice Although it s not the only authority on point that may be relied on for this particular tax concern, renewable energy transactions tend to follow this guidance more closely than other industries otherwise Lee J. Peterson, Esq. Page 6

7 might. Accordingly, in general, most transactions are arranged so that the lease cannot run longer than 80% of the expected life and value of the project so as to be respected as a lease for federal income tax purposes. NOTE: The leasing industry often generically characterizes leases as being one of either two types of lease, i.e., either a capital or operating lease. While these definitions have important and relatively concrete meaning in the financial accounting or GAAP context, the nomenclature is not literally recognized in federal income tax parlance. However, the distinction indicated by the terms capital or operating is HIGHLY relevant to a tax equity transaction, and thus in every case where a lease transaction is involved, there must be a very clear understanding of the facts and circumstances regarding the solar equipment lease involved. This is because, in general, the federal ITC is available to the owner of the equipment that is eligible for the ITC. Therefore, in some cases, the terms and conditions, i.e., the facts and circumstances, and the substance of the transaction will be such that for federal income tax purposes, the owner of the leased equipment under a state law capital lease will not be deemed to be the owner for federal income tax purposes, and thus, the person one would expect to be entitled to the ITC will not in fact be deemed to be entitled to the ITC for federal income tax purposes. As such, in the discussion below, one should assume that we are talking about operating leases, NOT capital leases, even though the federal income tax rules regarding the ITC don t literally use such terminology. Despite such tax subtleties, given the general simplicity of its structure and cost-effectiveness, the saleleaseback structure is a tried and true means of project finance for projects that have substantial federal investment tax credit benefits associated with them. There are also many traditional banks and project finance lenders that are experienced and familiar with the sale-leaseback structure. Unfortunately, in many cases, the banks and finance companies most comfortable with sale-leaseback financing as a means for the lender to obtain the federal tax benefits for their own use are the same lenders and finance companies that are unfamiliar with renewable energy in general, and even less familiar with the other and more traditional tax equity finance structures, such as the partnership flip or the inverted lease structures. The Business Deal To secure its rent payment obligations under the sale-lease-back, the lessee grants to the lessor a collateral assignment of the PPA and other revenues (such as funds from the sale of RECs). If the developer-lessee wants to continue using the project after the lease ends, then it must either negotiate an extension at then current market rent or buy the project. The lessee can have an option to buy back the project for a fixed price negotiated in advance, but the price will be the expected value of the project this is unlike a partnership flip (above) where the developer gets back 95% of the project without any additional cash outlay (other than the cost to acquire the investors flipped interest) and thus has to pay the market value of only a 5% interest to recover the balance of the project. From the tax-equity lessor s perspective, the residual value of the property at the end of the lease term, combined with the rents, the ITC and the tax depreciation deductions, will generate a target after-tax yield to the lessor. The transaction can be structured to also generate a positive pre-tax yield and cash-on-cash return without regard to tax benefits. Lee J. Peterson, Esq. Page 7

8 Another interesting aspect of the sale-lease-back structure, and one difference between the sale-leaseback structure and the partnership flip structure is that even though, in general, the federal ITC and depreciation tax benefits accrue to the owner of the eligible project at the time the project is placed in service (COD), under special federal income tax rules that apply expressly to sale-leaseback transactions for investment tax credit projects, an investor/purchaser in a sale-leaseback transaction has up to 3 months following the project s placed in service COD date in which to acquire the project and not lose eligibility for the investment tax credit. This, places far less time pressure on the developer/sponsor to delay placing the facility in service if the investor is not yet a partner in the project partnership if a flip structure were otherwise being contemplated. Again, this 3-month rule is not applicable in the partnership flip structure or inverted lease structures, and in order to qualify for that special 3 month tax treatment, the project must be leased back to the same person that originally placed it in service. Roles of the Parties In a Sale-Lease-Back In a sale-leaseback transaction, the tax motivated tax investor will legally (and also for federal income tax purposes) purchase and retain ownership of the soon to be leased assets, versus holding an interest in the partnership that owns the assets in a partnership flip. Typically, the original sponsor later turned lessee retains profits in excess of their rent and during the lease period, the sponsor will have been deducting their lease payments for federal income tax purposes. Boiled down, this arrangement, in the end substantially resembles a loan with a scheduled set of payment. However, the rate on this loan is the after-tax return but with fixed payments. The residual risk at the end of the lease makes the lessor an equity participant rather than a lender because the most commonly agreed to set of IRS true-lease tax rules require a 20% residual to be retained by the lessor. Most often, a large up-front rent payment by the sponsor optimizes the return. The Exit Strategy With the sale lease back, risk becomes the fair market value of the residual with that risk borne by the tax investor or lessor rather than by the sponsor. Therefore, the exposure to the ultimate end of lease buyout is one of the determinants as to whether to use a sale-leaseback structure versus a partnership flip or other partnership structure (e.g. inverted lease discussed in detail further below). How the acquisition of the residual is financed is also a consideration. Comparison to the Flip The lessee s purchase option under a sale-lease-back is generally more expensive than in a partnership flip structure, because in a sale lease back transaction, the investor/lessor owns all of the residual value of the asset. However, once the initial developer or project sponsor sells the project to the tax investor and later comes to the ultimate end of the lease term, the sponsor will often buy back the asset, either at a fixed price early buyout option (EBO) or at fair market value at the lease end. How the acquisition of the residual is financed is also a consideration nonetheless remains a consideration. Lee J. Peterson, Esq. Page 8

9 Another difference between a partnership flip transaction and a sale-leaseback transaction is that in a saleleaseback transaction, the sponsor is focused on the net present value (NPV) benefit, which is the reduction in the cost of the equipment and an implied interest rate/cost-of-capital realized through the form of the lease as compared to the mere interest rate on straight debt. In the partnership flip transaction (where investors evaluate their investment in terms of a target yield to the investor) that yield is compared by the investor to other investments it might make, or compared to the percentage of project cost that are expected to be covered by their tax equity investment (see above). One other distinction between a partnership flip transaction and a sale-leaseback transaction is that a lease transaction provides 100% of the project financing, unlike a partnership flip structure where the developer has to fund its portion of the partnership interest. This of course means that the entire asset, as well as all the debt and liabilities of the asset, are reflected on the balance sheet of the project owner/lessor. If one compares the financial accounting treatment under GAAP of the lessor s direct ownership of both the project assets and liabilities to the GAAP treatment of a tax credit partnership flip structure, in general, the tax investor s tax equity position will cover as much as 40% of total project cost with any unfunded balance required to be financed through some combination of debt, sponsor equity, state and local subsidies, or economics. In most cases, the investor in the partnership flip or inverted lease structure can potentially realize a more favorable impact on their financial statement than would a lessor in a sale-leaseback structure in large part due to the impact that the project debt may have on the GAAP treatment. Note however that the 100% financing mentioned above can be deceptive when making a comparative analysis because of the many ways in which debt can be introduced into a partnership flip structure, whether through so-called back-leverage discussed above, or other means. A further difference between a sale-leaseback and partnership flip structure is that the lease transaction typically transfers 100% of the tax benefits to the buyer, whereas in a partnership flip structure, typically no more than 95-99% of the tax benefits are transferrable to the tax investor. However, this may or may not be a material consideration depending on the investor profile. Business Considerations of The Sale-Lease-Back As stated, commonly perceived downside of the sale-leaseback transaction is that the renewable energy project sponsor/developer must pay fair market value of at least 20% residual to regain ownership of the project at the end of their lease term in order to maintain its use of the equipment. However, another disadvantage is that the developer is generally required to make scheduled rent payments and comply with extensive covenants and, as such, there is a risk of default and thereby a loss of the developer s investment. This is generally not the case in partnership flip structures. Moreover, unlike a partnership structure where the tax investor s return is typically known upfront, the developer may not have transparency with respect to the tax investor s return. This means that the developer may be at a negotiating disadvantage. Another distinction is in the area of indemnifications. Typically, the sponsor/developer/lessee will indemnify the investor for the loss of tax benefits in a lease, while in a partnership flip structure, though it will generally contain any number of indemnification provisions, the indemnifications provided in a partnership structure are generally more limited. This coupled with extensive representations, warranties, and covenants, means leasing deals are traditionally more document and time-intensive as it relates to transactional costs. Lee J. Peterson, Esq. Page 9

10 Another consideration is that in a sale-leaseback situation, if there is an early termination of the lease caused by the lessee, the lessee is typically required to make a loss value or termination value payment to the lessor in order to make the lessor or lender whole. Generally, an appraisal is almost always required for each project. In a partnership flip structure, an appraisal is optional. Finally, in a sale-leaseback transaction, the initial sale of solar equipment (which is for federal income tax purposes the sale of tangible personal property rather than real estate) is generally not subject to state sales taxes because the sale is considered a sale for resale. Instead, sales taxes are collected on each rent payment. With a partnership flip structure, sales taxes may be collected on the initial sale of the equipment to the project sponsor partnership certain states do, however, offer both sales and property tax exemptions for many renewable energy properties. The Bottom Line With all these distinctions in mind, the question that a typical renewable energy project partner will ask is whether or not the sale-leaseback structure is a better method of monetizing the tax benefits as compared to a partnership flip structure or the inverted lease structure given how the investor must account for their investment in addition to the investor s anticipated yield. Exposure to buyouts is a primary determinant between partnership flip and sale-leaseback financing structures. This is because, raising equity by receiving capital contributions in exchange for tax-equity partnership interests typically reduces the investor s capital investment while having a relatively small impact on net value. Tax equity in a flip transaction generally maintains present values and increases yields with less risk because the typical sale-leaseback structure requires a buyback of the residual in the property of 20%, whereas, compared to the more limited residual exposure in a partnership flip, the risk in a partnership form is comparatively nominal. However, it is absolutely critical to remain sensitive to how nuances of any particular project structure will affect the generalizations discussed above. Variables such as the timing of the funding (for example, whether the investor enters the transaction in January versus June versus December), whether the transaction contemplates post-flip buyouts, the fair market valuation at the time of buyout, the term of the flip, the existence of cash sweeps, whether or not cash grants are utilized, whether the investor s target yield remains constant for both the exit buyout and full term of the project, the projected residual value, whether or not the structure in a sale-leaseback transaction has truly optimized prepaid/deferred rents, and the extent of leverage in the transaction are all relevant. All these ultimately make it a case-by-case analysis when assessing which structure, sale-leaseback, partnership flip, or inverted lease is the best structure for any particular investor. However, it is clear that in most cases, the inverted lease structure (discussed below) will often provide the investor with the most positive impact to their GAAP financial statement, and often despite the initial bias or first impression of the investor that the sale-leaseback structure offers a higher return. When the GAAP and other risk factors are assessed, it is often the case that the inverted lease structure that is ultimately chosen. NOTE : Because a significant determinant of the optimal financial structure may, in many cases, be GAAP driven, it is critical that the generalizations with respect to GAAP discussed herein be vetted and approved by certified public accountants specializing in the accounting treatment of renewable energy project investments. Lee J. Peterson, Esq. Page 10

11 Overview of Inverted Lease Structure Investment Tax Credit Eligible Projects The lease-pass-through, more recently renamed Inverted Lease structure has been part of the federal income tax law and the tax regulations for decades. It is however limited to the federal section 46 investment tax credits, which expressly includes the section 48 solar tax credit, and thus does not apply to other general business credits such as the production tax credit, bio-fuel credits, or carbon sequestration credits. A material incentive for using the inverted lease structure is that investors typically perceive that this structure gives them specifically what they want, i.e., an annual preferred return on capital (typically between 1-5% in keeping with federal income tax economic substance doctrine), flexible profit/loss ownership (investor does not have to absorb 99% of losses), write off of capital account (capital loss) upon disposition of ownership interest in master tenant, ownership interest may flip down to approximately 5% after 5-year recapture period, and a put/call (cash payment equal to the greater of fair market value of ownership interest (after flip) or amount of cash required to achieve desired internal rate of return (IRR) (note, some attorneys do not allow a put option). Moreover, despite the general rule that energy related federal income tax benefits belong first to the legal owner of the qualified ITC property, there is an express exception in the federal Internal Revenue Code (IRC) and tax regulations that allows lessees of energy investment tax credit eligible property to claim the tax credit instead of the owner/lessor of that property without actually having to own the ITC eligible property, thus eliminating ownership risk. Therefore, it is this esoteric feature of the federal tax Code allowing the lessee of ITC eligible solar equipment to claim the investment tax credit otherwise only available to the owner that caused one well-known tax attorney in the energy industry to coin the description of this transaction the inverted lease. Regardless of name, this structure has a long accepted history and in general, is known to many tax practitioners as a bona fide tax structure respected by the IRS due to it being expressly provided for in the federal income tax Code and Regulations. Of note, and to avoid confusion, is the fact that prior to the coinage of the term inverted lease, those familiar with real estate related historic rehabilitation investment tax credits have relied upon, and applied these very same federal tax credit pass-through rules and this form of tax equity finance structure for decades. To many tax practitioners, developer/sponsors and investors these structures continue to be also known either as pass-through credit structures, or also as master-tenant or master-lease structures. The Basic Structure This tax structure simply takes advantage of Internal Revenue Code and Treasury Regulations that allow eligible lessees of eligible 48 property to claim the ITC in lieu of the actual legal and tax owner. See, IRC 50(d)(5). Though organized substantially like the single entity partnership flip structure on both the sponsor side, the structure differs in that the renewable energy property is leased to a second entity, also structured as a partnership, but it is this separate lessee entity, and not the lessor/owner entity that is entitled to the federal income tax credits. Of further note, is that ultimately, when it s time for the tax- Lee J. Peterson, Esq. Page 11

12 equity investor to exit its investment in the lessee entity, the flip mechanism described above will often be used to achieve the tax-equity investor s exit. NOTE: As of the date of this writing, about 75% of the solar tax equity structures that author s firm has advised on are ultimately partnership flips (with 20% of that 75% using inverted leases, where there is a flip at the lessee level in the inverted lease structure), and the other 25% use sale-lease-backs. In general, the tax-equity investor will be admitted into the lessee entity, usually specially formed for this purpose (and often at 95-99%) after the investor makes a capital contribution to the lessee entity in order to receive their ultimate allocation of the passed through tax credits as a partner participating in the profits of that lessee entity. In most cases, given the federal income tax requirement that the partner be an owner of the ITC eligible equipment at the time it is placed in service, most tax equity investors will make a relatively nominal cash capital contribution to secure their required ownership stake in the lessee entity, and later, immediately prior to COD, contribute additional cash capital. NOTE: Some lenders are also not comfortable making a loan at the level of the lessor entity while the operations of the project are on the lessee side of the transaction. Since many lenders have done back leverage on other structures (see above discussion under Flip explanation), lenders might be more comfortable making a back levered loan on an inverted lease transaction than they might be on a flip transaction involving a solar project. Upon commencement of operation, the lessee company, of course, makes a lease payment for the solar equipment to the lessor and begins operation of the project. In order to cover its expense of the lease payment, the lessee entity will in turn have typically entered into a power purchase agreement (PPA), sub-lease (not typical) or other energy services contract with the end-user or off-taker of the energy generated by the leased energy property being a primary source of revenue for the project. Investors interested in investing in only the tax credits (i.e., not depreciation deductions or operating losses) would invest in the lessee entity only and the lessee entity would not own any share of the lessor entity. This is because when the investment tax credits are passed through to the lessee entity, then are allocated to the investors in the lessee entity, the depreciation deductions would, by operation of general federal income tax rules, stay with the lessor/owner entity for tax purposes and thus the depreciation deductions must flow only to the owners or investors in the lessor entity and not the investors in the lessee entity unless the lessee entity was also an owner of some percentage of the lessor entity. 1 This latter case is however common, and in some transactions, the lessee entity will also be a partner in the lessor entity. Specifically, in many cases, the tax-equity investor may wish to receive an allocation of depreciation deductions and tax losses. In that case, the lessee entity may choose to also and separately own an equity interest in the lessor entity. Then in that case, because the lessee is now also an owner/partner of the entity which owns the tax credit property for federal income tax depreciation purposes, the investor would be entitled to an allocation of the tax depreciation and operating losses from its share of the lessor entity, while also getting its separate 1 In that case, under special tax rules, there would be no reduction to depreciable basis for the lessor entity, but income equal to the amount of the tax credits would be recognized by the lessee entity over the length of the recapture period. Lee J. Peterson, Esq. Page 12

13 allocation of tax credits from the lessee entity which have separately been passed through to it by the lessor. Clearly, a number of complex tax rules arise under such structures. Therefore, expert tax counsel is required. One example of a practical issue which arises with the lessee owning an interest in the lessor is funding the lessor. With ownership in the lessor entity, the lessee entity simply makes a capital contribution in exchange for its ownership in the lessor entity. In cases where the lessee did not have an ownership interest in the lessor entity, cash from the lessee entity may take the form of a prepaid lease payment equal to the tax equity investor capital contribution, thus, triggering taxable income. Yield Because the investment tax credit is claimed in its entirety during the initial year of the investor s investment, the timing of this benefit substantially improves the yield to the investor. These transactions are, therefore, structured and sized according to the investor s preferred return and the lease payment. However, in today s market, tax equity is typically looking for yields in the high teens on an after-tax unlevered analysis, based primarily on the federal tax benefits, with a nominal interest in economics. Although the investor must have a profit motive for federal income tax purposes, tax benefits nonetheless comprise the majority of the investor s yield. Therefore, in order to obtain tax based yields in the high teens, the lessee entity may also require an allocation of depreciation as described above simply so that the investors in the lessee entity can attain their target yield through a combination of cash profits from operations of the lessee, tax credits, and depreciation deductions, as well as any operating losses. From an investor s standpoint, there are several advantages to the pass-through lease structure on a renewable energy transaction. Its appeal comes largely from the fact that, from the perspective of the tax equity investor (who in essence exchanges their capital for tax benefits) the transaction is easy to exit after 5 years. However, of even greater importance to many tax equity investors is the preferable form of GAAP treatment. Investors sensitive to how their investments reflect on earnings will often not invest in any other form. Conclusion As stated at the outset, this paper merely attempts to usefully discuss, in a very general manner, the three main tax-equity structures used in many solar energy projects located in the United States. However, given the unique nature of project finance in general, and the specific needs of the parties to any given solar transaction at any given moment in time, it is not possible, or even desireable, to catalogue every possible variation of fact and circumstance that might impact one or more aspect of any particular transaction structure as described below. Nonetheless, there is a certain level of standardization in the solar industry so that it is still possible to make a number of generally accurate statements about common features of each of the three primary structures in today s marketplace. As such, the sole purpose of this paper was to instruct, in a general way, persons not experienced or familiar with the intricacies of solar tax equity finance Lee J. Peterson, Esq. Page 13

14 with the basic concepts most commonly deployed by those active in the solar finance marketplace in the U.S.. As always, changes in law, energy regulatory policy, tax rules or GAAP accounting rules or regulations may materially alter the descriptions above. Therefore, the reader should seek the advice of both experienced and competent accounting and legal counsel before entering into any transaction. CIRCULAR 230 DISCLAIMER To ensure compliance with the requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of: (i) (ii) avoiding penalties under the Internal Revenue Code or promoting, marketing, or recommending to another party any transaction or matter addressed herein. LEGAL DISCLAIMER No legal opinion is herein or hereby implied and no opinion should be inferred by this writing. Neither the firm not the author of this paper have a responsibility to update this memorandum as to subsequent changes in fact and law. This memorandum cannot be reproduced for any purpose without express written permission from the author. - End of Document - Lee J. Peterson, Esq. Page 14