SPECIAL REPORT. tax notes. The Likely Features of Solar ABS. By Laura Hegedus

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1 The Likely Features of Solar ABS By Laura Hegedus Laura Hegedus is special counsel in the Washington office of Cooley LLP. She thanks Jim Scarrow (James W. Scarrow PLLC), Andrew Giudici (Kroll Bond Rating Agency), George Ashton (Sol Systems), and Herb Stevens (Nixon Peabody) for their helpful comments. The ideas expressed in this report are the author s and are not attributable to the generous souls named in the preceding sentence. In this report, Hegedus looks at some of the tax, structural, and financial questions that should be considered before solar-asset-backed-securities are brought to market. Copyright 2013 Laura Hegedus. All rights reserved. Table of Contents I. Background II. Designing the Right Structure A. Three Tax Equity Structures B. Accommodating Tax Equity C. Accelerating Receivables Income D. Getting the Cash Out E. Ideal Structure? III. Designing the Right Securities A. Solar Service Contracts Are Not Debt B. Passthrough Certificates, Pay-Through Bonds C. Fixed or Revolving Pool D. Single or Multiple Classes E. Fixed or Variable Payments F. Standardized Documentation G. Know-How of the Banks H. Crowdfunding I. Ideal Security? IV. Ad Hominem Over the last two years there has been a good bit of discussion about whether asset-backed securities (ABS) could be issued using solar energy companies customer receivables as collateral. Interest in developing new sources of capital for renewable energy projects has been acute since 2009 when the well of traditional financing so-called SPECIAL REPORT tax notes tax equity dried up. Although at least two dozen tax equity financing parties have now returned to the space (or been welcomed to it), demand for financing of high-quality wind and solar projects still exceeds supply. New ideas have emerged for expanding the capital base available to build renewable energy projects. The principal ones are master limited partnerships, real estate investment trusts, amending the passive loss and at-risk tax rules to enable investments by individuals, and securitizations. These ideas are most viable for solar projects, which generate a more predictable revenue stream and involve fewer operational risks than some of the other energy resource types. Only one of these proposals securitizations does not require a change in federal tax law in order to be implemented. Groups of very smart people (that is, the think tanks and the banks) have begun to study solar ABS in earnest. In March the National Renewable Energy Laboratory launched a three-year working group funded by the Department of Energy called Solar Access to Public Capital to study how securitizations could be used to finance solar projects. In April the Union of Concerned Scientists wrote to the House Ways and Means Committee that securitizations, along with other strategies like master limited partnerships and REITs, would significantly broaden the investor base for clean energy projects. The group predicts around a 4 percent yield for initial renewable energy ABS. An inaugural institutional finance and investment conference devoted to sunshine backed bonds was held in New York in May and drew participation from Credit Suisse, Morgan Stanley, Moody s, and Standard & Poor s. ABS has the potential not only to cut the cost of borrowing for solar developers but also reduce solar energy prices at the retail level. 1 Given the growing interest in solar ABS and that existing law permits them, why have we not yet seen a U.S. offering? 1 See Faten Sabry and Chudozie Okongwu, Study of the Impact of Securitization on Consumers, Investors, Financial Institutions, and the Capital Markets, American Securitization Forum, at 8 (June 17, 2009) (a 10 percent increase in securitizations is associated with a 22 to 64 basis point decrease in auto loan costs and an eight to 54 basis point decrease in credit card costs). TAX NOTES, August 12,

2 Receivables securitized to date have consisted mostly of real property mortgages, credit card receivables, and purchase money debt obligations like auto loans. A solar securitization that is marketed by ABS bookrunners and sold to the institutional investors that buy conventional ABS will need to wait for the banks, rating agencies, and investors to learn (and price) this new product. In readily marketable ABS, credit ratings largely function as a surrogate for investor due diligence and rating agencies assume that identical or nearly identical customer contracts are the basis for receivables in each pool. For that reason, developing standardized customer documentation for solar agreements has been viewed as a prerequisite to accessing the ABS market. Also, it is unclear whether tax equity investors, which currently represent the cheapest source of financing for solar projects, will go along for the ride if a securitization is layered over their investment. This report looks at some of the tax, structural, and financial questions that should be considered before solar ABS are brought to market. There will be a particular focus on the challenges of issuing ABS backed by revenues from projects that have also benefited from tax equity financing. I. Background Business owners of solar energy equipment are eligible for the investment tax credit under section 48. The credit is 30 percent of the cost of qualifying solar property, and it arises in the tax year that the property is placed in service. Solar property is also eligible for accelerated five-year depreciation (and, through 2013, 50 percent bonus depreciation). The ITC and five-year depreciation are not available on property that is owned by or leased to tax-exempt persons, including state and local governments and non-u.s. persons (except to the extent the property is used in a U.S. business that is subject to tax). However, solar property subject to a power purchase agreement (PPA) under which the power from the equipment is sold to a tax-exempt or foreign person remains eligible for the ITC and accelerated depreciation. Some or all of the ITC will be recaptured if property giving rise to the credit is disposed of within five years of the initial in-service year. The tax benefits of solar property are available to the equity owners of qualifying equipment only, although in some cases the tax credit may be passed through to a lessee. The dominant forms of financing for U.S. solar energy projects are tax equity financing provided by banks with an appetite for the tax credits and depreciation deductions accompanying ownership of the projects. A profitable bank or corporation purchases from a solar energy development company some or all of the equity in a project company (or a holding company that owns several project companies) that owns a utility-scale project, several large rooftop commercial projects, or hundreds to thousands of residential rooftop projects that have been aggregated into a single financed entity. Cash from that purchase is used by the solar company to pay off construction financing on the projects or to fund future development. There are three structures used to facilitate tax equity financing: the saleleaseback, partnership flip, and lease passthrough structures. Most of the return sought by the tax equity financing party is paid in tax benefits, with a more modest amount of its return paid in cash. The bank s return can be earned in different ways depending on the type of structure used, but in all cases the tax benefits will be heavily front-loaded in year one while the cash return is earned slowly over at least the five-year recapture period following the equipment s in-service date. Although the bank must assume real ownership risk on the projects, it takes no operational responsibility for them. All operation and maintenance (O&M) are performed by either the solar company that developed the project or by a third party under contract with the project company. The solar developer may or may not want the project back at the end of the natural life of the financing (as late as year 20 but often closer to year 6) and may or may not have a call option to buy the project at that time, but for tax reasons it is important that the bank bear risk of loss on the project and be entitled to the residual value of the project. In 2007 or 2008, tax equity financing began to benefit residential rooftop solar installations. Several solar companies now offer qualifying homeowners no- or low-money-down solar installations that are enabled by third-party tax equity financing. The solar developer originates an installation on the homeowner s roof. The homeowner signs a customer agreement in the form of either a PPA or a lease of the rooftop equipment. Under that agreement the homeowner is obligated to buy power or lease the solar equipment for 15 to 20 years, at either a flat monthly rate or a per-kilowatt rate according to how much energy the system produces during the period. Whether the customer agreement is a PPA or a lease, the solar company tries to set the customer s price at 80 to 90 percent of the customer s current payment to the utility so that the customer can begin to see electricity savings as soon as the system is installed. The solar developer promises to provide necessary O&M for the contract term so that system performance stays within agreed levels. 702 TAX NOTES, August 12, 2013

3 Commercial and industrial solar agreements can also come in the form of either a PPA or a lease, are generally in the 15- to 20-year range, and typically require the solar developer to provide O&M over the life of the agreement, although these agreements tend to vary from customer to customer and from state to state (or utility district to utility district) more than residential agreements do. II. Designing the Right Structure How would a securitization fit within the structure of a solar tax equity financing? What problems would arise in layering one type of financing over the other? A. Three Tax Equity Structures In a sale-leaseback, the solar development company sells a new project (or projects) to a bank and leases it back. The bank as lessor claims the ITC and depreciation on the solar equipment; the lessee makes rental payments to the bank over time (usually 20 years), operates the projects, and collects payments from customers. In a partnership flip, the solar developer sells the bank an interest in a joint venture to which the developer contributes new projects. About 99 percent of the income, loss, and credits of the partnership are allocated to the bank during the period in which the ITC and accelerated depreciation are generated, after which the bank s interest decreases to about 5 percent. A lease passthrough is a two-tiered structure in which the bank invests in both a lessee and a lessor partnership; the lessor elects to pass through the ITC to the lessee entity, which collects payments from customers and pays rent to the lessor. The bank is allocated most of the tax credits derived by the lessee and often about half of the depreciation deductions derived by the lessor. If a securitization were added to these structures, in each case the company that operates the projects and is the counterparty on agreements with customers could transfer customer receivables to a special purpose vehicle (SPV) created to hold receivables, in exchange for cash. The transferor of receivables in a sale-leaseback would be a lessee that is 100 percent owned by the solar developer, which could cause the lessee to distribute the cash. The transferor of receivables in a lease passthrough is also the lessee, but a lessee jointly owned by a developer and tax equity financing party. In a partnership flip, the transferor of receivables would again be a partnership jointly owned by the developer and tax equity investor. Alternatively, for each tax equity structure, the solar developer could retain the receivables and transfer to the project company only the remaining assets of the projects that will be financed by the investor. COMMENTARY / SPECIAL REPORT B. Accommodating Tax Equity If ABS and tax equity can coexist on the same projects, securitizations could be an additional source of reasonably priced financing for the solar industry. If not, ABS could replace tax equity as the cheapest financing available after the 30 percent tax credit expires, although ABS would still probably be three to four times more expensive than the cash return earned by tax equity. Are the cash flows from solar projects rich enough to support paying a yield to both the tax equity investor and ABS holders? Would the ABS holders be senior to the tax equity investor, and, if so, what accommodations would the latter need to accept that position? Assume that a project company benefiting from tax equity transfers its customer receivables to a trust in exchange for cash. For tax purposes this transfer could be characterized as either a sale or a pledge in connection with a financing. In either case, after the transfer, the receivables would support only obligations owed to ABS holders, not the tax equity investor. In this way a securitization would monetize the project company s receivables and eliminate the tax equity investor s exposure to solar customer credit risk (except to the extent that the project company agrees to replace underperforming receivables). The developer will then strip out the cash proceeds for use in financing other projects that are not part of the same portfolio, leaving the investor with little to look to inside the project company. Once the customer receivables are transferred out, the project company s contractual obligation to repay the tax equity investor its investment plus its desired yield would be supported only by (1) the residual value of the solar equipment after the customer agreements have terminated 2 ; (2) any cash proceeds from the ABS issuance that the tax equity investor insists remain inside the company; and (3) the solar developer in its capacity as the managing member of the project company or as the seller of interests in the project company to the investor, to the extent that the developer has provided the investor with warranties about the project or project payments. Would a tax equity investor ever permit project receivables to be securitized? Presumably yes, assuming the price was right and the developer was willing to provide whatever assurances were demanded by the bank. For example, the investor 2 The residual value of the solar equipment after the customer agreements have terminated is speculative but theoretically should be at least 20 percent of the equipment s value when placed in service, because solar customer agreements are rarely longer than 20 years and the useful life of solar panels is in the 30- to 40-year range. TAX NOTES, August 12,

4 could seek a higher return, a guarantee from the developer s parent company (although see below discussion on guarantees), and a reserve account set aside by the project company to help fund distributions or leasing payments to the investor. When renewable energy projects financed with tax equity also take out bank debt, the tax equity investor demands a significantly higher yield on its money and a forbearance agreement from the lender. The critical question about solar ABS may not be Will tax equity investors go for it? but rather Can the developer afford it? While a yield on ABS of 4 to 5 percent may look attractive, 3 if it causes the tax equity investor to demand a higher yield on its investment, the all-in cost of ABS may be a lot higher. The incremental tax equity cost of ABS will be less in a partnership flip or lease passthrough structure than in a sale-leaseback simply because a smaller percentage of project cost is financed by tax equity in those two former structures. What rate of return would a tax equity investor need to tolerate a securitization? It may demand an additional 500 to 600 basis points when the projects it is financing are burdened with other debt. Would the tax equity investor require that much more if its projects receivables are securitized? Maybe not. Very little of the tax equity investor s baseline return is being paid in cash; the bulk of its return is being paid in tax credits. So when term debt and tax equity financing coexist on a project and, for example, the tax equity investor demands a 13 percent return instead of an 8 percent return, it cannot be because of the risk that the highly leveraged project will no longer be able to afford the modest amount of cash that the tax equity investor is expecting to see. It must be primarily in exchange for assuming the ITC recapture risk of the loan and accompanying liens. In a securitization structured so that only the revenue stream and not the ITC-generating property has been transferred and there is no lien on the project assets for the benefit of the ABS, the tax equity investor may feel more confident in its return than it does when the project retains its receivables but takes on an additional layer of bank debt (or than it would if ABS holders benefited from a lien on the solar equipment). Guarantees from the developer (or from parties related to the developer) for the benefit of tax equity in partnership transactions can raise tax issues. To qualify for the safe harbor of Rev. Proc , under which a joint venture between a tax equity investor and a wind energy developer will be respected as a partnership and the tax equity investor will be treated as a bona fide partner, the developer may not guarantee the investor against risk of loss of (1) the capital it contributed to the project on day 1 of its investment (which must be at least 20 percent of its total anticipated investment) or (2) the available wind resource, if it is not as great as anticipated or projected. 4 (In a wind project, both tax credits and revenue are a function of generation, so an investor s assumption of wind risk means it is not assured of its tax credit return or its cash return.) While the revenue procedure applies only to wind projects claiming the production tax credit, not solar projects relying on the ITC, it may demonstrate where the IRS draws the line regarding limits on investors risks in energy tax credit partnerships. Although it could help reassure a tax equity investor that its cash return will be paid, a developer guarantee is probably not worth the tax risk. However, a guarantee or insurance provided by an unrelated third party, the cost of which is directly borne by the tax equity investor, is permitted under the revenue procedure. And a guarantee from the developer of the lessee s obligations in a sale-leaseback transaction would not pose a problem. Reserves for the benefit of the tax equity investor can also raise tax issues. A cash account owned by the project company and set aside as a source of future payments to the investor could be viewed as a defeasance of the project company s obligations to the investor. Defeasance of payment obligations to an investor can jeopardize the investor s status as a true owner of assets. In leasing transactions involving tax-exempt parties, the IRS and courts have found that full defeasance of the tax-exempt lessee s rental payment obligations to the taxable lessor significantly decreased the lessor s ownership risks on the property so that in combination with other circumstances the lessor was not the tax owner of the leased property. 5 In ABS/sale-leaseback transactions, those authorities would caution against a full defeasance that is, setting aside in a separate account cash from the ABS issuance that is sufficient 3 Yields on debut solar ABS could be even lower than 4 percent. By late 2012, yields had fallen significantly on new ABS issues. Some esoteric bonds that might have yielded around 7 percent just after the crisis were fetching 3-4 percent or less, depending on the rating. Steven C. Johnson, Hungry for Yield, Investors Turn to Pizza, Films, Vacation Homes, Reuters, Mar. 12, Rev. Proc , C.B. 967, section 4.07, modified by Announcement , C.B. 1175, and Announcement , C.B See, e.g., Wells Fargo & Co. v. United States, 91 Fed. Cl. 35 (2010) (sale-in, lease-out transaction lacked substance), aff d, 641 F.3d 1319 (Fed. Cir. 2011); and Notice , C.B. 630 (SILOs involving defeasance are listed transactions for purposes of reg. section (b)(2)). 704 TAX NOTES, August 12, 2013

5 to pay all the lessee s rental payments although one could argue that in an ABS issuance a defeasance would have more business purpose than it does in a sale-in, lease-out transaction. In partnership flips, the investor s status as a true owner of the project should be less controversial if a taxpayer follows the guidelines of Rev. Proc and in a lease passthrough the investor owns most of the lessee so defeasance of rent should not raise the same concerns. Although full defeasance of payments owed to the tax equity investor following an ABS issuance is inadvisable (and no doubt impractical), a more modest reserve fund 6 could provide some comfort to the tax equity investor and, in combination with a higher yield, may allow ABS and tax equity investment to coexist on the same portfolio of solar projects. C. Accelerating Receivables Income Securitizing solar customer receivables will involve transferring the receivables out of the project company to a trust or other entity that will issue bonds or certificates backed by future payments on the receivables. Those transfers will be treated for federal tax purposes as either a sale of the receivables or as a pledge of the receivables in connection with a borrowing by the project company. 7 Tax issues concerning the form of the securities issued (certificates or bonds) and the type of entity chosen as the ABS issuer are discussed below. One hurdle to ABS from the perspective of the developer and tax equity investor is the potential to trigger a large amount of taxable income when the receivables are transferred to the ABS issuer. In a typical securitization, each receivable is a loan in which the originator has an adjusted tax basis. In a long-term contract to provide electricity or to rent solar energy equipment to a customer, the developer or project company originating that contract may have little or no basis in the receivable because the bulk of the services to be rendered have not yet been performed and income has not otherwise been required to be accrued. 8 If the customer 6 Cf. section 470(d)(1) (defeasance of up to 20 percent of the fair market value (lessor s initial basis) of leased property is allowed for tax-exempt use loss purposes). 7 A sale has taken place if the investors purchasing the Class A certificates have assumed Taxpayer s risk of loss and opportunity for profit inherent in the Trusts and their underlying loans, within economically realistic limits. LTR , at 14 (transfer of auto loan receivables treated as pledge, not sale). 8 Cf. section 451(f) (when an accrual-basis taxpayer provides electricity to customers, income is accrued no later than when services are provided). Costs of performing under an electricity service agreement are not netted against customer revenue before the revenue is accrued in income. LTR COMMENTARY / SPECIAL REPORT receivables are treated as sold for tax purposes in connection with the securitization, the proceeds of the securitization would be ordinary income of the project company in the tax year of the sale, accelerating all of the income under the agreements. 9 Absent a tax equity investor in the project company, the project company s accelerated depreciation (and, through 2016, the 30 percent ITC) would be available starting in year 1 to help reduce the tax cost of this recognition event. Nevertheless, the cost of accelerating the receivables income may dictate that solar ABS take a form that can be characterized as a borrowing by the project company collateralized by the receivables, rather than a sale. If the significant benefits and burdens of ownership of the receivables remain with the transferor for example, the developer or project company agrees to switch out underperforming receivables from the pool and replace them with better quality receivables during the life of the ABS it should be possible to treat the transfer of receivables as a pledge in connection with a financing. Characterizing the ABS as a borrowing could have the additional practical benefit of speeding the ratings process in some cases. A large amount of historical data on solar customer defaults may not be as critical to the rating agencies process if a well-capitalized developer agrees to replace bad agreements with good ones for the life of the pool. D. Getting the Cash Out One challenge of layering a securitization over both the partnership flip and lease passthrough tax equity structures would be getting the cash proceeds to the developer without adverse tax consequences arising under partnership tax rules. Under the partnership disguised sale rules, a developer s transfer of receivables to the project company when the company is formed, followed by the distribution of ABS cash proceeds by the company to the developer, could be treated as a sale. Under the section 707 regulations, the proceeds of partnership nonrecourse debt released to a partner within 90 days of the partnership s incurring of the liability need not be treated as sale proceeds to the extent of the partner s allocable share of the liability. 10 A solar developer s allocable share of the project company s nonrecourse liability 9 See, e.g., Watkins v. Commissioner, 447 F.3d 1269, 1272 (10th Cir. 2006) (lump sum received in a sale of rights to future payments (lottery winnings) is ordinary income, not capital gain, reportable in the year of sale); the LTR (income accelerated by factoring of customer contracts; factoring proceeds retain the same (non-subpart F) character as payments on underlying contracts). 10 Reg. section (b)(1). TAX NOTES, August 12,

6 for ABS would generally track the developer s share of project company profits 11 (which is usually about a 1 percent interest in the entity that operates the projects when the ABS would be issued). For this reason a solar developer could recognize significant gain under section 707 when ABS proceeds are distributed to it, even when the securitization is not treated as a receivables sale for other federal tax purposes. 12 To avoid section 707, what if the developer retained the project receivables and transferred only the other project assets to the partnership with tax equity? The developer would thereafter transfer the receivables to the ABS trust. This could work to avoid the disguised sale rules, but it is unclear what effect this would have on the fair market value of the rest of the project that is transferred by the developer to the tax equity partnership. If the FMV appraisal of the project is reduced because the receivables have been stripped away, the investment by tax equity into the project would be affected. It is interesting to note that in saleleasebacks of solar projects, the project is generally sold to the investor without the PPA: The project is then leased back to the developer-lessee, which owns the PPA. The separation of the PPA from the rest of the project has not pushed appraisals of project value down in sale-leaseback transactions. But if it did so in securitizations, a host of challenges could arise in the tax equity transaction. 13 E. Ideal Structure? As a legal matter, all three tax equity financing structures used for solar projects could accommodate the transfer of customer receivables to a trust or other entity in exchange for proceeds of the ABS issuance. Securitizing receivables transferred out of a sale-leaseback structure would have the benefit of avoiding the partnership tax complications discussed above. In a sale-leaseback, the developer or developer parent could give the tax equity investor a guarantee of its return, there is no risk of taxing 11 Reg. section (a)(2)(ii); see reg. section (a)(3). 12 On the treatment of ABS proceeds under the disguised sale rules, see also James M. Peaslee and David Z. Nirenberg, Federal Income Taxation of Securitization Transactions and Related Topics, , n.36 (2011). 13 If a tax equity financing party invests the same amount of capital despite the appraisal, its investment may exceed the project s FMV, creating risk that the entire project would be deemed sold to the investor with no partnership established. If the tax equity financing party invests a reduced amount on account of the appraisal, the investor s yield will increase beyond the target return if the amount of tax credits and depreciation deductions allocated to it are unchanged. There is also some risk that the amount of the ITC will need to be decreased, because the ITC is 30 percent of the project cost based on the appraisal. the developer on receivables gain under the disguised sale rules, and it is already common practice to transfer customer contracts separate from the rest of the solar project without affecting the appraised value of the project. Use of a partnership flip or lease passthrough structure in combination with ABS could present less tax risk than the saleleaseback when the developer uses ABS cash proceeds to establish a reserve account for the benefit of the investor. And the partnership flip and lease passthrough structures come with lower financing costs than the sale-leaseback because only the saleleaseback requires that 100 percent of project value be financed in a tax equity transaction. No matter which tax equity structure is used, it will be important to structure the receivables transfer as a pledge in connection with a financing rather than as a sale for tax purposes to avoid triggering the ABS proceeds into the income of the project company. III. Designing the Right Securities This section looks at how solar ABS would compare with more traditional mortgage-backed or credit-card-backed ABS and the characteristics that we would expect to see in solar ABS given the nature of the underlying receivables. A. Solar Service Contracts Are Not Debt If ABS are issued in combination with tax equity financing, ownership of the solar equipment must remain with the tax equity investor (or a joint venture between the investor and the developer), necessitating that the receivable securitized be the service contract or lease with the customer. Solar ABS issued after the expiration of the 30 percent ITC, or otherwise not in combination with tax equity, could be backed by loans made to customers to purchase solar equipment. This subsection focuses on receivables that are customer service agreements or equipment leases. One of the significant distinctions between solar contracts and the receivables that are the basis for most ABS is that solar contracts are not debt. There are no interest or principal components to the payments made by customers. 14 The payments represent fees for nonfinancial services actually provided to customers each month. 14 Although the IRS has found that electricity is a good that can be inventory for purposes of reg. section (see LTR ; see also LTR (appearing to assume that reg. section applies to electricity)), it is not clear that electricity should be treated as property for section 483 purposes so as to impute an interest component to customer payments under long-term service contracts. 706 TAX NOTES, August 12, 2013

7 Early prepayments of solar PPAs and leases by customers are possible but, except in the case of one or two solar developers, uncommon. In commercial/industrial and utility-scale PPAs, there is typically no prepayment feature in the contract, although the customer may be required to pay a termination payment approximating the solar provider s unrecovered costs if the customer breaches the agreement. In their residential PPAs or leases, some solar companies do offer a prepayment option under which a customer can prepay all the payments that will be required during the term of the agreement, at a discount to the face amount of those payments. However, most residential customers are not interested in prepaying; they signed up for a no-money-down, long-term contract because they did not want to incur large upfront costs. While some PPAs or leases could be paid off early, relative prepayment risk is unlikely to become an important criterion distinguishing one pool of receivables from another in solar ABS the way it has in mortgage-backed securities. The fact that solar PPAs and leases do not pay interest or principal and are not paid off early to any significant degree will affect the types of ABS that are best suited to solar receivables. These factors will affect the kind of entity that acts as ABS issuer, whether the securities issued are passthrough certificates or pay-through bonds, whether the securities are issued in single or multiple classes, whether the receivables are held in fixed or revolving pools, and whether the ABS make fixed or variable payments to holders. One would expect that solar ABS will be fairly plain vanilla compared with the exotic array of securities that can be backed by aspects of mortgages and other loans. B. Passthrough Certificates, Pay-Through Bonds ABS can take multiple forms. Receivables that are the security for the financing are transferred to an SPV. Then equity interests in the SPV can be issued (passthrough certificates) or the SPV can issue debt (pay-through bonds). Variations on these include equity interests in issuers of pay-through bonds and equity interests in SPVs that are treated as debt instruments for tax purposes. 15 The commonality in these structures is that tradable securities either debt or equity are issued by an SPV that holds receivables. Owners of passthrough certificates are taxed on their shares of the income generated by the underlying receivables. If the ABS issuer is a grantor trust for tax purposes, the status of the trust as a separate COMMENTARY / SPECIAL REPORT entity is ignored and holders are treated as owning directly their shares of trust assets. The advantage of an ABS issuer that is a grantor trust is the avoidance of both an entity-level tax and all partnership tax laws and administrative obligations of partnership classification. Two disadvantages to using a grantor trust are that the pool of receivables must be a fixed rather than a revolving pool and there cannot be multiple sequential-pay (fast pay and slow pay) classes of interests in the trust. 16 Owners of pay-through bonds are treated as owning debt for tax purposes, and they accrue interest income. 17 Holders of pay-through bonds treated as debt for tax purposes are largely indifferent to the tax classification of the issuer. Again, a trust treated as a grantor trust for tax purposes is the preferred entity to serve as issuer whenever possible, because it reduces the administrative and legal costs of the issuance. Pay-through bonds may be issued in multiple classes with different maturity dates, even by an entity treated as a grantor trust for tax purposes. There is a risk that owners of paythrough bonds will be treated as owners of equity in the issuer for tax purposes when it appears that the issuer is a mere conduit for the funneling of receivables proceeds to the bondholders. This tax risk is reduced the more mismatch there is between the features of the bonds and the features of the receivables. If passthrough certificates were backed by solar receivables, holders would be taxed on their shares of the electricity service fees and equipment rental payments collected from customers. The character of these payments as fees and personal property rents would pass through to ABS holders. Some institutional investors and non-u.s. investors may not be permitted to derive income other than in the form of dividends, interest, and gains from the disposition of equity and debt instruments. Solar ABS in the form of passthrough certificates would not work for those investors. To market securities to as many investor types as possible, pay-through bonds (treated as debt for tax purposes) may be the best type of ABS for solar receivables. Note that if the IRS were to determine that solar equipment was real property for REIT purposes, the 1980 Foreign Investment in Real Property Tax Act purposes, or any other federal tax purposes, issuing pay-through bonds backed by solar receivables could create a risk that the issuer would be treated as a taxable mortgage pool subject to an entity-level tax if the bonds were issued in 15 This report assumes that passthrough certificates are equity for tax purposes, although that is not always the case. 16 Peaslee and Nirenberg, supra note 12, at This assumes the classification of the bonds as debt is not challenged by the IRS on account of their equity-like features. TAX NOTES, August 12,

8 more than one class with different maturities. 18 In advance of a solar pay-through bond issuance, a private letter ruling could be sought from the IRS that solar equipment is not real property for purposes of the taxable mortgage pool provisions. C. Fixed or Revolving Pool If ABS are backed by receivables of relatively long duration, the receivables in the pool are generally fixed for the duration of the securities, meaning the issuer does not reinvest payments in replacement assets. A pool of shorter-term receivables is more likely to be a revolving pool in which the trustee can reinvest proceeds in new receivables and thereby extend the life of the ABS beyond the term of any single receivable. A fixed pool could meet the needs of a solar ABS issuance arranged today. Solar customer agreements are generally long-term contracts spanning 15 to 25 years, although increased competition and reduced pricing may lead to shorter customer agreements in the future. If solar receivables are in a fixed pool, the pool may be owned by a grantor trust, which is generally the ideal issuer from a tax perspective since it is entirely transparent. 19 Rating agencies and investors may push to shorten the term of securities backed by solar receivables. In April a senior credit officer at Moody s said that solar ABS may need to be of shorter length than the underlying (20-year) receivables or risk lower ratings. 20 An alternative to shorter-term securities may be a revolving pool in which aging receivables are swapped out by the developer for newly originated contracts (although the developer s promise to replace receivables may help with the rating only when the developer is large and very well capitalized). However, rating agencies may get more comfortable with longerterm contracts in the form of PPAs (or leases with a per-kilowatt charge) as opposed to flat-rate leases, given that obsolescence risk should be less in contracts requiring payment only for energy actually delivered. 21 In a similar vein, some have suggested that solar ABS terms of longer than six or seven years may be problematic because the average homeowner stays in his home for only seven years before selling it. 18 See section 7701(i)(2)(A). 19 Peaslee and Nirenberg, supra note 12, at 7 and (use of grantor trust for fixed pool). 20 Marissa Capodanno, Moody s Calls Out Loan Length for Solar ABS, Securitization Intelligence, Apr. 24, Obsolescence risk would still be a large factor in projecting the future value of the project company s residual interest in the system after the customer contract has lapsed or the customer defaults. See Kroll Bond Ratings, Evaluating Credit Risks in Solar Securitizations, at 5 (Oct. 17, 2012). The concern is that residential solar agreements with a term of 20 years will be abandoned by many homeowners when the homes are sold. Residential PPAs and leases generally allow a customer to assign the solar agreement to a purchaser of the home, but assignment depends on the new homeowner s willingness to assume the contract and a credit score of the new homeowner that meets solar company requirements. As an alternative to shorter ABS terms, different interest classes based on the ages of the receivables could be created within a revolving pool, with the substitution of new receivables for aging ones as necessary within the more senior classes (although, again, the developer s guarantee that it will substitute receivables may not help the credit rating in many cases). D. Single or Multiple Classes ABS can be issued in a single class or multiple classes. When multiple classes are issued, it is usually to create sequential pay classes that receive principal prepayments in an established order. Fastpay classes are those that receive principal prepayments first until the entire principal owed is paid off; slow-pay classes receive principal allocations after the fast-pay classes are retired. A trust cannot be taxed as a grantor trust if it issues multiple classes of equity interests with different rights to principal payments on the receivables. However, a grantor trust may issue senior and subordinated classes of passthrough certificates. 22 Securities backed by solar customer receivables cannot be issued in sequential pay classes with varying rights to principal payments. A faster-pay class could be created that has priority over other classes for customers prepayments on their PPAs or equipment leases (and priority over termination payments in commercial agreements). But because such a small percentage of solar customers choose to prepay their agreements, it is unclear whether a meaningful quantity of fast-pay ABS could be issued by a single issuer. Senior and subordinated classes could be issued with varying priorities to payments on all receivables in the pool. Or different classes backed by different categories of receivables within the same pool could be issued. For example, a trust could issue a first class of securities backed by receivables of customers with FICO scores of more than 760, and second and third classes with FICO scores of 720 and 680, respectively. Lack of sufficient data on customer default rates in solar energy agreements has been cited as one major hurdle to getting a solar 22 Rev. Rul , C.B. 434; Peaslee and Nirenberg, supra note 12, at 27-28, 285, and 382, n TAX NOTES, August 12, 2013

9 securitization rated and sold. Creating different classes of interests in the issuer based on differing payment priorities or quality of underlying receivables might accelerate the ratings process and largemarket sales for the more senior classes of securities, leaving the subordinated classes to be placed with a smaller group of investors able to undertake due diligence. E. Fixed or Variable Payments Whether ABS are issued with fixed or variable payments depends on the structure of the securitization and the payments on the receivables in the pool. The payments on passthrough certificates issued by a trust will reflect the payments made on the underlying receivables. Passthrough certificates will pay a fixed rate only if every asset in the pool pays a fixed rate; the ABS rate will be the receivables fixed rate less the fees imposed to administer the pool, which are also generally fixed for the life of the ABS. If the underlying receivables pay a variable rate, passthrough certificates will pay the variable rate less the fixed fees of the pool. By contrast, the rate paid on pay-through bonds need not match the rate paid on the underlying receivables. Pay-through bonds allow greater variability between the payment features of the bonds and the receivables for example, receivables calling for monthly payments of a fixed interest rate can back bonds with a variable interest rate paid quarterly. In fact, for tax reasons, it may be necessary to vary the features of pay-through bonds significantly so that they do not match those of the underlying receivables, or risk recharacterization of the bonds as equity rather than debt of the trust, or risk characterization of the receivables transfer to the trust as a sale rather than a financing. 23 What payments would be made on solar ABS? Solar equipment leases with customers typically require the payment of a flat monthly fee. Solar PPAs usually call for payment of an amount equal to the electricity generated multiplied by a perkilowatt-hour charge. But the federal tax classification of the agreement as either a service contract or a lease does not depend on whether the customer pays on a per-month or per-kilowatt basis, and companies are free to offer leases at a per-kilowatthour rate. 24 On both flat and per-kilowatt contracts COMMENTARY / SPECIAL REPORT there also can be an annual inflation escalator of up to 3 to 4 percent, although some companies offer a slightly higher initial rate that is guaranteed to remain fixed for the full contract term. To scale up solar ABS to a size that interests the public market, it may make sense to pool all variety of residential and commercial PPAs and leases, bearing both flat and variable payments, as backing for the securities. Assuming a large variable pool, solar ABS could be issued as either variable rate passthrough certificates or variable rate bonds. The variability of payments on the securities would not correspond to the variability of any interest rate or other objective index. For this reason, a variable rate solar ABS could not function as a hedge against a fixed rate nor, presumably, as part of any investment strategy that values the variability of the ABS rate. There may be potential to use solar ABS, whether fixed or variable, as a hedge against utility/natural gas prices or inflation. F. Standardized Documentation Much of the due diligence that would otherwise be advisable before an ABS purchase is suspended because of the existence of standardized customer documentation for the underlying receivables. Current focus on the potential of ABS to raise capital for solar development has prioritized the acceptance of standardized solar contracts. 25 The recently launched National Renewable Energy Laboratory working group on solar ABS aims to develop proposed standardized residential and commercial solar contracts by the end of this year. 26 Although residential solar contracts are fairly standardized already (at least in northern California where the no-money-down solar financing product has been carefully aged into a full-bodied maturity), commercial solar contracts are still negotiated agreements in which both significant and not-sosignificant terms can be amended to accommodate customers requests. Unlike a credit card or auto loan, a solar energy agreement may contain terms concerning the provider s long-term access to the customer s real property or terms that are idiosyncratic to a provider/customer relationship but insignificant from a financing perspective. In the spirit of Dodd-Frank, will standardization of some 23 On the impact of matching ABS and receivables payments on the debt-equity and sale-financing issues, see Peaslee and Nirenberg, supra note 12, at 35, n.34, 44-47, 82, and Because some utility districts do not allow PPAs between residential or commercial customers and generators other than public utilities, some solar providers offer monthly equipment leases that bear a per-kilowatt-hour charge. 25 See Michael Mendelsohn and David Feldman, Financing U.S. Renewable Energy Projects Through Public Capital Vehicles: Qualitative and Quantitative Benefits, National Renewable Energy Laboratory Technical Report, at 5 and n.9 (Apr. 2013). 26 Michael Mendelsohn, Can the Solar Financing Industry Streamline and Standardize? National Renewable Energy Laboratory, Mar. 22, 2013 TAX NOTES, August 12,

10 of the key substantive elements of the solar contracts, rather than their form, provide comfort to investors and rating agencies? Key elements of the contracts relevant to credit quality and payment stream include the customer FICO score; the contract price and existence of an escalator; the payment schedule; the termination payment or exercise price of any customer purchase option; the term length; the existence of a guarantee, deposit, or other support from a commercial customer; and in residential agreements the ease with which a solar customer may assign the contract to a future purchaser of the home. A checklist of essential terms requisite to financing solar receivables could emerge. Could a rating be sought for a pool of receivables generated under different form contracts, but each bearing a uniform cover page listing agreed terms that are critical to the financeability of the receivables? Perhaps not, but it is worth identifying a couple of areas in which leeway could be permitted in solar agreements to accommodate commercial customers. G. Know-How of the Banks Three of the biggest players in domestic ABS are also three of the biggest tax equity investors in renewable energy. But with only one or two exceptions, the banks most intrigued by solar ABS have not previously made significant tax equity investments in renewable energy. This is good news in the sense that the number of banks interested in financing renewable energy projects may be growing but bad news if it signals that the banks with the most familiarity and comfort with solar assets are not yet involved in the dialogue about the viability of solar ABS. Cross-pollination of each bank s ABS team with its tax equity team may facilitate movement toward solar securitization. H. Crowdfunding Could crowdfunding serve as ABS light for solar finance, opening up a new reservoir of public capital to solar projects? One California financing company has begun offering retail solar investments that have hints of both crowdfunding (in the sense that the bonds appear speculative) and securitization (except that payments on the investments are not closely tied, in a legal sense, to payments on the underlying loans). Investments are offered to California and New York residents and to others who are accredited investors. In light of the Jumpstart Our Business Startups Act of 2012, which relaxes securities laws as applied to some crowdfunding mechanisms, there may soon be a bigger place at the solar table for social-media-enabled financial products. One difficulty may be transparency. Although the target audience for crowdfunding and the target audience for solar energy are likely to overlap, making it that much easier to look to crowdfunding to finance solar projects, it is hard to predict whether that audience will tolerate the financial and structural complexity of the investment. For example, a California resident with a modest income and net worth wants to help worthy local groups go green. He purchases a product online from a solar crowdfunder. He may come away from his quick online transaction believing that he just contributed to a 15-year note issued by Worthy Neighborhood Charity so that it could buy solar panels. In reality, he may have just bought an original-issue-discount-bearing, contingent payment debt instrument (which could be equity in the crowdfunder for federal tax purposes) issued by a for-profit corporation that made a market rate loan to an SPV partnership flip vehicle 99 percent owned by Investment Bank, which SPV sells electricity to Worthy Neighborhood Charity at a market-based rate. I. Ideal Security? Solar ABS could be issued as variable rate, single class passthrough certificates in a grantor trust that holds the receivables. Two or more classes of certificates also could be issued as long as the classes do not have different rights to principal (termination payments). However, as discussed above, because holders of grantor trust passthrough certificates are treated as directly earning the income paid on the receivables, some potential investors may not want to own ABS backed by solar service agreements/leases that are issued as passthrough certificates. A solar developer may be interested only in a transfer to an issuer of passthrough certificates that can be treated as a pledge of the receivables, not a sale, for federal tax purposes. If ABS are to be issued in multiple classes with different maturities, or backed by a revolving pool, or if tax-exempt and non-u.s. investors prefer purchasing through debt instruments, the securities could be issued as variable (or fixed) rate paythrough bonds issued by a grantor trust (or limited liability company), crafted with enough mismatch between the payments on the receivables and the payments on the bonds to ensure debt characterization of the bonds for tax purposes. Again, the transfer of receivables should be structured to qualify as a pledge of receivables to the issuer rather than a sale (for example, by having the developer retain risk of loss on the receivables through a duty to replace underperforming receivables with better quality contracts, or through assignment of a high credit rating to the pool). 710 TAX NOTES, August 12, 2013

11 IV. Ad Hominem A banker was asked recently whether solar ABS could work. He replied, I have no idea, but everyone keeps saying to me, When can I start trading this thing? If domestic solar ABS are issued, it probably won t be because an ideal structure marrying ABS with tax equity was identified, or because perfect answers for all the attendant legal/tax questions were found, or even because following sunset of Treasury s section 1603 grant program the solar industry needs new sources of capital. It likely will be on account of the large demand for something to buy and the large demand for something to sell. In the short term, however, it could be of great value to solar energy producers and consumers if we are able to sketch out both an entity structure and a security that work to bring lower-cost tax equity financing and ABS together on the same portfolio of projects. TAX NOTES, August 12,