Reed Smith's renewable energy practice group recently submitted a proposal to the Obama administration that is designed to increase the pool of potential tax equity investors for renewable energy clients. The text of the proposal is below:

Per our prior correspondence, a major goal of the American Recovery and Reinvestment Act of 2009, P.L. 111-5 (the "Recovery Act") is to spur activity in the renewable energy sector. A technical tax flaw in the legislation is preventing it from accomplishing its objective in the marketplace. We have spoken about the issue with a number of tax and industry people, and everyone recognizes that it is a serious problem that must be rectified before activity in the renewable sector can increase to the level contemplated by the President. Here's the problem:

In order for a renewable energy project to be economically viable, investors have to be able to take advantage of certain tax incentives—viz., depreciation and tax credits. In general, the current value of these tax incentives can be as high as 60 percent of the initial cost of the project. Approximately half of the value is attributable to tax credits, and the other half is attributable to depreciation.

The problem is that in order to benefit from these tax incentives, an investor has to have taxable income. Unfortunately, many of the banks, insurance companies and other large financial institutions that have previously financed renewable energy projects have large losses. Consequently, these entities are not able to use the tax benefits that are required for a renewable energy project to be economically viable, and many of them have left the market.

The Recovery Act attempts to solve this problem by permitting taxpayers to receive cash in lieu of tax credits. However, investors do not have the ability to convert depreciation into cash. Because depreciation represents approximately half the tax incentive by value, and because investors have to be able to use the depreciation for a renewable energy project to be viable, the market remains frozen.

The best solution to this problem is to expand the investor pool beyond the banks, insurance companies and other financial institutions that have previously participated. This will require amending the Internal Revenue Code to provide an exemption for renewable energy projects from the passive loss rules contained in Section 469.

The reason is that, under the passive loss rules, individuals and certain other types of taxpayers are not able to utilize losses and tax credits from so-called passive activities to offset income attributable to wages, income from portfolio investments or income from active businesses. Because individual investors in renewable energy projects would generally be passive investors, they would be subject to the passive activity rules with respect to such investments, and therefore would not be able to utilize losses and credits from renewable energy projects to offset active business or portfolio income.*

The only reason that banks, insurance companies and other financial institutions are able to invest in renewable energy projects is that these taxpayers are already exempt from the passive loss rules. Thus, exempting renewable energy projects from these rules will simply serve to level the playing field.

There is precedent under Section 469 for exempting income from other types of businesses from the passive loss rules. For example, Section 469(h) contains an exemption for certain types of real estate investments. Section 469(c)(3)(A) provides an exemption for working interests in oil and gas properties. It seems incongruous to provide an exemption for working interests in oil and gas, but to deny an exemption for investments in clean renewable energy.

Providing an exemption from the passive rules for investments in renewable energy projects would permit wealthy individuals to pool their resources through partnerships and other investment vehicles to provide financing in an economically viable manner, and thereby provide the capital required to expand the renewable energy market. We would be pleased to discuss this further at your convenience.