TAX CREDIT MONETIZATION STRATEGIES FOR LFG ELECTRICAL GENERATION FACILITY DEVELOPERS

Transcription

1 TAX CREDIT MONETIZATION STRATEGIES FOR LFG ELECTRICAL GENERATION FACILITY DEVELOPERS 9 th Annual EPA LMOP Conference and Project Expo Baltimore, Maryland January 18, 2006 Paul A. Burkett Rath, Young and Pignatelli, P.C. One Capital Plaza Concord, New Hampshire (603) pab@rathlaw.com Presentation Summary I. Overview II. The Production Tax Credit III. Sale to Investor IV. Tax Issues on Sale V. Post-Sale Operations VI. Unwind at End of Tax Credit Period Attachment Form of Closing Checklist Circular 230 Notice: These materials are not intended by the author to be used and may not be used by any person for the purpose of (1) avoiding penalties under the United States Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

2 ABSTRACT So, you ve successfully navigated the economic, engineering and regulatory obstacle courses and have brought on-line a landfill gas (LFG) electrical generation facility. Throughout the process, you had heard from fellow developers, your bank, your lawyers and your accountant about something called the production tax credit (PTC). Sounds good! Now, however, your accountant and lawyer are saying that you can t use these credits right away, or maybe ever. What will you do? What WILL you do? Fear not! The financial world is full of investors hungry for tax credits and willing to pay for them! In this presentation, we will address the various operational, economic and tax aspects of partnering with a tax credit investor. LFG electrical generation facility developers sometimes have limited access to capital. They often also have relatively little (and sometimes no) need or appetite for income tax credits. Tax credit monetization creates a win-win opportunity in these circumstances developers can effectively divest themselves of tax credits that they cannot use efficiently while accessing capital that might not otherwise be available to them, and tax credit investors are allocated tax credits that they can use currently. We will analyze the section 45 PTC and different monetization strategies and structures that can be used to create value. Key issues for developers that we will address include: (1) pricing; (2) maintaining operational control; and (3) unwinding at the end of the tax-credit period. This presentation will be focused primarily on issues and opportunities for developers, but we anticipate that the information and resulting discussion will be valuable to potential tax credit investors and anyone else interested in the LFG industry. * * * * * Paul Burkett is a member of Rath, Young and Pignatelli s Tax Practice Group. Paul represents energy developers and investors in complex tax-credit monetization deals and other transactions in the alternative and renewable energy industries. In addition, he has an active practice in the area of federal partnership tax law, as well as representing clients on all aspects of federal and state tax law, including business transactions, business formation and tax compliance, tax legislation, and tax audits. 2

3 I. Overview A. The opportunity B. Why monetize? C. Win-Win D. Basic deal structure II. The Production Tax Credit and LFG Facilities A. The basics 1. $9/MWh in Facilities first placed in service after October 22, 2004 and before January 1, Credit period (a) 5 years for facilities placed in service between October 22, 2004 and August 8, 2005 (b) 10 years for facilities placed in service between August 8, 2005 and January 1, Utilization and carryforward of credit (a) Part of the Section 38 general business credit and may be carried forward up to 20 years (b) May be used against the Alternative Minimum Tax ( AMT ) if generated during the first four years after a facility is placed in service B. Limitations 1. Must sell the electricity to an unrelated party 2. Tax-exempt financing, grants, etc. reduce credit rate 3. May not claim credit for electricity produced using gas from a facility that ever was allowed the Section 29 nonconventional fuels credit 4. May not be used against the AMT after the first four years C. Who may claim the credit? 1. Owner of the facility if also the producer of the electricity (a) Not lessees of facilities (b) Must be sure owner and not operator under O&M agreement is the producer of electricity who bears the burdens and realizes the benefits of production? 3

4 2. Partners allocated credits in proportion to their respective ownership interests in the gross sales from the facility (a) Must ensure that tax credit investor ( Investor ) is a partner (b) Must ensure that no one else (e.g., lender or operator) is a partner III. Sale to Investor A. May need to form a new clean entity as vehicle for Investor to buy-in Developer creates New Holdings to own Project Co. B. Investor buys special Class B Interests in New Holdings 1. Investor allocated up to 99% of electrical generation revenues and expenses (both cash and non-cash depreciation) and up to 99% of tax credits 2. Developer allocated remainder of these items 3. Renewable Energy Credits may be allocated solely to Developer C. Pricing 1. $X/credit for credits realized by Investor (<$1/credit to >$1/credit) 2. Generally all positive cash flow to be distributed to Investor and then paid over to Developer as purchase price (a) This is often the most difficult part hard to model and cannot have a fully transparent flow-through (b) Can pursue other ways to strip out cash (e.g., management fees) may simply distribute cash to Developer, but this option is likely limited by the size of Developer s capital account and the IRS s substantial economic effect rules for partnerships D. Payments 1. Upfront payment (may be prepayment for credits or cash, or both) 2. Fixed deferred payments for tax credits 3. Variable deferred payments for tax credits Investor gets credit for any capital contributions to New Holdings (New Holdings contributes to Project Co.) 4. Deferred payments for cash component may be fixed in whole or in part 5. To obtain a private letter ruling ( PLR ) from the IRS, at least 50% of the total consideration on a present value basis as of the closing date must be fixed upfront payment, fixed tax credit note and fixed cash note 4

5 6. Investor will usually form a special purpose Buyer entity for transaction Developer will need a guarantee or other commitment from Investor to fund Buyer s note obligations E. Purchase and Sale Agreement 1. Fairly standard representations, warranties, covenants and indemnities as for any other asset sale 2. Will also have special tax representations and indemnities scope of these is heavily negotiated 3. Investor likely will seek to escrow payments attributable to tax credits (but not cash) until get PLR and upon the occurrence of any event that threatens tax credit allocations to Investor IV. Tax Issues on Sale A. Developer will usually choose to treat the sale as an installment sale 1. Developer s basis spread over term of payments and recovered as payments made under the notes 2. Each note payment must be analyzed to see how much is interest and how much is principal (a) Fixed notes may have negative amortization in the early years (b) Variable notes analyzed as each payment made and amount of principal determined by discounting the payment back to the closing date using IRS mandated interest rate (c) Interest is taxable as ordinary income and principal will create capital gain to the extent greater than basis recovered 3. Cannot get installment treatment for gain attributable to previously claimed depreciation may not be a big factor as facility likely is new 4. Special interest charge if all installment obligations >$5 million only fixed notes count under this test and only tested at time of transaction 5. Deferred gain accelerated if transfer or cancel notes or if pledge notes to secure new debt B. If there is significant debt on the project, must consider whether Developer has income from relief from debt C. Investor may want to get a PLR there is only limited ruling precedent under Section 45 V. Post-Closing Operations A. Developer generally retains control over day-to-day operations 5

6 B. Investor will have consent rights with respect to Major Decisions C. Lender must consent to the sale 1. If Developer had pledged interests in Project Co., then Lender may require Developer and Investor to pledge their interests in New Holdings 2. Lender may also require Developer to pledge notes relating to tax credits (but not cash) 3. Investor likely will require Developer to contribute or loan any funds required to cover obligations under the project loan not covered by project cash flow VI. Unwind at End of Tax Credit Period A. Investor usually only wants to be a partner as long as there are tax credits B. Generally cannot give Investor a straight put right because that risks Investor s basic partner status C. Some Investors may view this issue with more urgency 1. If investment is short-term, Investor may avoid having to consolidate New Holdings and Project Co. for financial reporting 2. Some regulated Investors may need a date certain for exit D. Developer may have call right 1. Often at fair market value at time of exercise formula-based strike price may create both business and tax problems 2. Developer likely wants to limit its out-of-pocket cash obligation (a) May try to structure notes so that outstanding obligation at call point roughly equal to fair market value at that point (b) Even if can limit cash obligation on repurchase, must consider possible tax cost of accelerating gain if cancel notes E. Another alternative may be to change the partners percentage interests in revenues and expenses at the end of the tax credit period (or on a date determined under a return-based formula) 1. This is reportedly common in the wind industry 2. When combined with a call, this may reduce the repurchase price 3. There are no rulings or other authority from the IRS addressing this alternative 6