The IRS released a ruling this week that opens the door to Indian tribes playing a much larger role in renewable power projects.
It allows an Indian tribal government to be an owner or lessee of these projects. The rationale: An Indian tribal government is not a governmental unit or tax-exempt organization for purposes of tax subsidies.
The taxpayer in the ruling leased a power plant from an Indian tribe and planned to sell power to a third party. The taxpayer and tribe agreed to let the taxpayer (the lessee) claim an investment tax credit. The option to let a lessee claim an investment credit is not available if the lessor could not have claimed the credit. The IRS ruled that the tribal government could have claimed the credit.
Why do we care?
First, the industry had assumed that, because they do not pay taxes, Indian tribal governments could not effectively participate in renewables projects.
Second, the rationale used raises some questions about other potential structures involving tax-exempts and governmental entities.
The Pickle Rules
The US government subsidizes renewable power projects by providing tax benefits to their owners. These benefits mainly are tax credits and accelerated depreciation (i.e., the ability to write-off the cost of a project over time).
Tax-exempt and governmental entities generally do not pay taxes, so the benefits present little value to them. At the same time, these entities are facing increasing pressure to cut power costs and make their operations more green.
Congress wants to provide tax benefits as an inducement to build projects, but it views the benefits as an investment. That is, it wants to be paid back with taxes in the long term. It is not in the business of handing out free money.
So, in 1984, it passed a series of rules — the Pickle rules — that make it difficult for nontaxpayers to get the benefit of subsidies, directly or indirectly. The rules do not apply to persons that could be taxpayers if they only had income.
The rules (and similar later rules) stretch out depreciation and disallow certain tax credits for property considered to be used by these nontaxpayers. For example, solar property, which is normally depreciated over 5 years on an accelerated basis, instead would be depreciated over 12 years on a straight-line basis to the extent it is used by one of these entities. Investment tax credits are disallowed to the same extent. Tax credits based on production generally are still available, but without accelerated depreciation, deals with nontax-exempts become hard to pencil.
Property subject to this rule is called “tax-exempt use property.” That is, property leased to such a nontaxpayer and property owned by a tax-exempt through a partnership with shifting profit sharing ratios.
Where a nontaxpayer owns an interest in a partnership, the rules extemd tax-exempt taint to the extent of the high-watermark of its interest in the partnership’s profits if the partners’ shares of profits are slated to change during the deal.
This rule was designed to prevent tax-exempts from monetizing tax benefits, but never paying the government back through taxes. One way the tax-exempt could do this was to develop a project and barter away the tax benefits to an institutional investor by giving the investor most of the profits (and tax benefits) for a short period of time. Then, the investor’s interest would be reduced substantially, leaving the future profits largely with the tax-exempt. These profits wouldn’t be taxed and the government would get no return on its investment. For leases transactions, Congress presumed that lease payments would be reduced artificially, causing the lessor to have reduced income on which to pay taxes.
On their face, the rules do not prohibit a tax-exempt from taking a bare ownership interest in a project or a nonshifting interest in a partnership. Presumably, this is because the government either earned its return through a taxable lessee’s income derived from the use of the property (where the lessee claimed a tax credit) or the government never needed to earn a return since tax-exempt’s would not claim the benefits because they do not pay taxes.
This is supported by some exceptions to the rule that permit a tax-exempt entity to claim the tax benefits if it would have to claim income from the use of the project as unrelated business taxable income (UBTI) and thus pay tax on the income.
The IRS reasoned in the ruling that the tribal government could join with the lessee to permit the lessee to claim the investment credit. A lessor may let a lessee claim a credit only if the lessor was eligible for the credit itself.
The IRS ruled that the tribe was not a “governmental entity,” and since the income tax rules do not apply to tribes, there was nothing from which the tribe could be exempt. This meant that the Pickle rules described above did not apply to the tribe and it was eligible for the credit.
It is curious that the IRS did not answer the question by ruling that the tribe was not “using” the property under the Pickle rules. This would have been consistent with the statutory rules on tax-exempt use property, on which the tax credit rules are based. The project was not leased to a tax-exempt person. It also was not owned by a partnership where a tax-exempt partner had a shifting interest.
By choosing to rule that the tribe was not subject to the Pickle rules, the IRS made way for increased opportunities for Indian tribes to participate in renewable energy projects. Although Indian tribes cannot take advantage of the tax benefits because they do not pay taxes, we now know that the IRS believes a tribe can own a renewable project without causing it to be considered tax-exempt use property.
Like tax-exempt and governmental entities, most developers cannot use tax benefits efficiently, either because they do not have tax liabilities or they are subject to special rules that make it hard for all but the wealthiest of individuals and large corporations to use them. Large corporations are usually the best users of tax benefits because they have very few limitations on using tax credits. For this reason, developers often barter the tax benefits to someone who can use them immediately as an efficient way to raise capital. Indian tribes should be able to raise capital the same way.
There are three common ways to barter tax benefits AND still retain control over the facility: a partnership-flip transaction, a sale-leaseback transaction or an “inverted” lease.
In a partnership flip, an investor either would purchase an interest in a limited liability company that owns the facility or make a contribution to the LLC in exchange for an interest in the LLC. For tax purposes, the LLC would turn into a partnership when the investor becomes a member.
The economic returns (including the tax credit), except possibly cash, would be allocated 99% to the investor. Once the investor reaches its specified return, its share of the deal would flip down to 5%. Because an Indian tribe is not a tax-exempt entity, its participation in a partnership with shifting profits will not cause the project to be tax-exempt use property, and the tax benefits will be preserved.
In a sale-leaseback, the tribe would place the facility into service. The tribe would then sell the equipment to an investor within the next three months and lease it back. (In a partnership flip, the investor must be a partner before the project is placed in service. In a sale-leaseback, he has up to three months after the project is completed to invest.) The investor would own 100% of the equipment. The tribe, as lessee, pays rent and shares the value of the government subsidies (tax credits and depreciation) with the investor in the form of a reduced rent.
An inverted lease passes the tax credit to an investor who leases the facility from the tribe. This is the structure described in the IRS ruling. The tribe generally maintains operating control of the facility. After the five-year tax credit period is over, the lease term ends, and the facility is returned to the tribe.
In addition, by choosing to conclude based on the fact that the tribe was not a governmental or tax-exempt entity, rather than that the tribe was not “using” the project, the IRS seems to suggest that it believes no tax-exempt ownership is permissible. This is contrary to the Pickle rules that apply to depreciation.
If the IRS were to apply to the investment tax credit the same rules that apply to depreciation (arguably, it is required to do so), a church, school or pension fund could participate in an inverted lease in ways other than merely as a power purchaser. It would also permit these entities to purchase operating renewable power assets and lease them back to the original owner. These structures effectively would provide financing to true taxpayers. Plus, and more importantly, they would give the tax benefits to a person that would pay the government a return on its investment in the end.
This reading would expand participation in renewables, which is a goal of the Obama administration, and it would not violate the policy of giving benefits to nontaxpayers.