On September 21, 2009, the Internal Revenue Service ("IRS") issued Announcement 2009-69, which modifies the safe harbor rules for partnership flip transactions, a common method of structuring investments in the renewable energy market.
The renewable energy market relies on tax credits to help generate competitive returns. The primary tax credits available are (i) the production tax credit (the "PTC"), which is principally used for wind, biomass, geothermal, small irrigation, municipal solid waste, qualified hydropower and marine and hydrokinetic renewables, and (ii) the investment tax credit (the "ITC"), which is principally used for solar property, certain geothermal property, qualified fuel cell property, qualified microturbine property, combined heat and power system property, small wind energy property, and geothermal heat pump property.
The PTC is claimed over a 10-year period and is based on the number of qualified kilowatt hours of electricity produced and sold during the tax year to unrelated persons. The amount of the credit is adjusted each year for inflation and currently equals 2.1 cents per kilowatt hour for electricity generated by a wind facility (1 cent per kilowatt hour for most biomass, small irrigation, landfill gas, trash, hydropower and marine and hydrokinetic renewable energy facilities). The ITC for energy property equals 30 percent of the eligible cost of qualified energy property placed in service during the year (10 percent for geothermal heat property, combined heat and power property, and qualified geothermal property).
Section 1603 of the American Recovery and Reinvestment Act of 2009 permits taxpayers to elect to receive a cash grant ("Cash Grant") in lieu of the ITC or the PTC on specified renewable energy property placed in service during 2009 or 2010, or by a later credit termination date if the property is not placed in service during 2009 or 2010 but construction has begun during 2009 or 2010.
Structuring Renewable Energy Projects
Renewable energy projects that are not self-financed are generally structured as partnership flip transactions or leases. Although the precise form of the transaction varies depending on the amount and placement of debt and the amount of the developer's contribution, the general intent is to structure the arrangement so that a tax equity investor receives a bargained-for return consisting of tax benefits, cash flow and a buy-out, and the developer receives most of the project upside.
A basic partnership flip transaction involves a partnership between a tax equity investor and a developer which allocates the vast majority of income, loss and tax credits to the tax equity investor until it receives its bargained for return (which generally occurs after tax benefits are realized and any investment tax credit recapture period has expired), and then flips, allocating the vast majority of income and loss thereafter to the developer. The developer generally receives an option to acquire 100 percent ownership of the project after the flip.
A basic lease transaction involves a lease of renewable energy property by a tax equity investor to an end-user, with the end-user having an option to acquire ownership of the energy property after the tax equity investor has achieved its return and the investment tax credit recapture period has expired. In many instances, the lease and partnership structures are combined, utilizing a lessor which is structured as a partnership between a tax equity investor and a developer. As in the basic partnership flip transaction, the vast majority of the lessor's income, loss and tax credits is allocated to the tax equity investor until it receives a bargained for return, at which time the partnership flips, allocating the vast majority of income and loss to the developer, which has an option to acquire 100 percent ownership of the lessor after the flip.
Revenue Procedure 2007-65
In 2007, the IRS issued Revenue Procedure 2007-65 (the "Revenue Procedure"), which established a safe harbor for "wind farm" partnerships and limited liability companies (each, a "Project Company") between project developers and one or more tax equity investors. Although the Revenue Procedure is limited by its terms to wind farms intended to benefit from the PTC, it is widely relied on in structuring renewable energy projects generally.
In general, the IRS stated that it would respect the allocation of the PTC among the partners of a Project Company if specified safe harbor provisions are satisfied.* Under the safe harbor, the developer must have at least a one percent interest in each material item of partnership income, gain, loss, deduction and credit at all times, and each investor must have a minimum interest in each material item of income and gain equal to five percent of the investor's percentage interest in partnership income and gain for the tax year in which the investor's share of income and gain will be the largest. The safe harbor also includes a minimum unconditional investment by investors, limits on contingent consideration, purchase rights and sale rights, and a restriction on guarantees and loans.
In Announcement 2009-69, the IRS has made several important modifications to the Revenue Procedure:
- In the Revenue Procedure, the IRS stated that it "will closely scrutinize a Project Company as a partnership or [i]nvestors as partners if the Project Company's partnership agreement does not satisfy each requirement of" the Revenue Procedure.
- Announcement 2009-69 deletes this sentence from the Revenue Procedure and replaces it with the following neutral statement: "Returns claiming wind energy production tax credits under §45 are subject to examination by the Service."
- As a result, a partnership that fails to come within the safe harbor is not necessarily subject to heightened scrutiny by the IRS.
- The Revenue Procedure required that neither the developer, the investor nor any related party has a contractual right to purchase, at any time, the wind farm, any property included in the wind farm, or an interest in the Project Company at a price less than its fair market value determined at the time of exercise. Announcement 2009-69 liberalizes this rule as follows:
- The contractual right must be negotiated for "valid non-tax business reasons at arms' length by parties with material adverse interests."
- The purchase price must either be (i) not less than the fair market value of the property determined at the time of exercise, or (ii) if the purchase price is determined prior to exercise, a price that the parties reasonably believe, based on all the facts and circumstances at the time the price is determined, will not be less than the fair market value of the property at the time the right may be exercised.
The ability to have a fixed option price on the "flip" date as opposed to an appraised value on such date brings the safe harbor rule more in line with current industry practice.
Although the Revenue Procedure by its terms applies only to flip partnerships that claim the PTC for electricity generated by wind farms, tax practitioners have used the safe harbor to structure other types of renewable energy projects (such as solar, geothermal and biomass) that intend to make use of the ITC as well as the PTC. Because of the industry-wide reliance on the safe harbor, the changes made to the Revenue Procedure by Announcement 2009-69 should be welcomed by all investors in renewable energy projects.