On June 30, the U.S. Department of the Treasury (“Treasury”) released an additional guidance document outlining the process used to evaluate the amount of a renewable energy project’s basis that is eligible for a payment in lieu of tax credits (a “Cash Grant”) under Section 1603 of the American Recovery and Reinvestment Act of 2009. This newly-published guidance document is linked here for your convenient review. The guidance is generally consistent with observed practice and general principles of tax law applied to the issue of Cash Granteligible basis. Thus, although the guidance applies specifically to solar PV properties, at least the methods it describes for determining tax basis and appraised fair market value, and the principles underlying those methods, apply to all types of properties eligible for the Cash Grant.
Cash Grant-eligible tax basis generally consists of the direct “hard” cost of the eligible property, but also includes other direct and indirect “soft” costs related to buying or producing the eligible property that are properly capitalized into the tax basis of the property for federal income tax purposes.
However, the guidance document cautions that, in those “certain circumstances” where the taxpayer’s stated cost does not reflect its “true economic cost,” the taxpayer’s stated cost will be ignored. In particular, the guidance notes, as examples of these “certain circumstances,” (a) cases where the stated cost is determined by related parties not acting at arm’s length in the manner of parties acting in their own self-interest, and (b) other “peculiar” circumstances, where parties (presumably acting at arm’s length) nevertheless have an incentive to inflate the agreed-upon purchase price of property above its fair market value. In these circumstances, the guidance provides that Treasury will more closely scrutinize the Cash Grant application to ensure that the applicant’s claimed basis reflects the property’s fair market value.
Treasury acknowledges in the additional guidance that “each system is different,” and that the cost basis of eligible property may therefore vary based upon its specific characteristics, including differing technology and size and, even for projects of presumably the same size and technology, regional market differences. In this respect, the guidance does not particularly come as a surprise in that it reflects practices that, as we have observed, have already been used by Treasury to evaluate basis.
Nevertheless, Treasury’s first step in evaluating the stated cost basis of eligible solar PV systems is to compare it to a set of standardized, “benchmark” turnkey prices per watt that vary solely based upon market (e.g., residential v. commercial) and megawatt size. The guidance provides that these benchmarks are continuously updated and reflect the most recent information, analyses, and data available to Treasury from various sources. According to the guidance, these benchmark prices reflect a “high quality of equipment” and “include profit.”
The particular benchmarks set out in the guidance reflect cost basis amounts that are less than those experienced by several of our clients, This result may be expected given that the guidance recognizes that each property is different, and that the specific facts of a particular property may lead to higher (or lower) eligible costs than the benchmark amounts. The concern for market participants is that the new guidance may be applied, contrary to its text, without taking into account the relevant factors presented in each application, thus creating a high burden in order to justify deviating from the benchmarks.
If the Cash Grant-eligible basis claimed by an applicant is consistent with these benchmark prices, Treasury focuses its review on examining the detailed cost breakdown to ensure that only eligible cost items have been included in basis and ineligible costs (e.g., a fence) are excluded. As part of this process, Treasury may ask for additional detail with respect to specific cost items.
Applications that claim a Cash Grant-eligible basis that is materially higher than the relevant Treasury benchmark will receive closer scrutiny, focusing not only on eligible versus ineligible costs, but also on related transactions, related party considerations and other “unusual” circumstances.
Related transaction considerations include whether a proper allocation of cost should have been made to other ineligible assets, rights or contracts conveyed as part of the same transaction, for example, a power purchase agreement.
Further, related party considerations or other “unusual” circumstances include cases where the stated cost is determined by related parties not acting at arm’s length, and circumstances where unrelated parties have a similar economic motivation, as opposed to sufficiently adverse interests, to overstate the basis of the eligible property. The guidance gives, as an example of such a possible transaction, the sale-leaseback of a system.
We would note that sale leaseback transactions and related party suppliers and developers are in fact not “unusual,” but very common in the solar industry. Further, the new guidance asserts that the foregoing considerations are no different than the scrutiny the IRS applies in evaluating the tax basis of property for which an investment tax credit is claimed. This link to a long-established body of tax law is helpful in applying these otherwise somewhat briefly stated considerations. We would also note that saleleaseback transactions are accepted under federal income tax law. Therefore, we hope that whatever additional scrutiny is applied to such situations should not prevent an applicant from obtaining a Cash Grant based on the full fair market value of the property.
The reference to existing federal income tax law regarding the investment tax credit is consistent with the touchstone of the guidance’s analysis that basis must otherwise be consistent with the fair market value of the eligible property. As part of demonstrating that the submitted Cash Grant eligible basis is consistent with that touchstone, the applicant may also submit a detailed and credible third-party appraisal demonstrating that the claimed Cash Grant-eligible basis is consistent with a market transaction between unrelated parties with adverse economic interests. The additional guidance focuses a great deal of attention on the determination of fair market value through an appraisal.
The new guidance provides that, out of the three broad valuation methods (cost, market, and income approaches) used in appraisals, Treasury tends to favor the cost approach, viewing it as the most concrete and supportable analysis, given the fact that cost data for PV systems is increasingly timely and available. Treasury will accept a cost approach that includes the cost of eligible property and a markup that is consistent with industry standards and the scope of work for which the markup is received. The guidance states that Treasury has found that appropriate markups typically fall in the range of 10 to 20 percent. The valuation should, however, explicitly address the appropriateness of the markup in light of the activity, capital investment, and risk for which the markup is compensating.
Interestingly, the new guidance does not suggest that there must be a “mark down” of the tax basis of eligible property in circumstances where, due to unanticipated or uncontrollable cost overruns or market price fluctuations, the actual cost of eligible property to an applicant is greater than the price at which the property could currently be sold to a third party. We believe that this use of actual costs is consistent with the investment tax credit body of law generally referenced in the guidance.
Treasury views the income approach as the least reliable method of valuation, given the number of assumptions that must be made, including forecasts of revenue and cost streams, cost of capital, rates of inflation and taxes, and residual value. Moreover, when receiving an appraisal using the income approach, Treasury will carefully review the allocation of value to the eligible energy property in cases where the income approach yields a value that exceeds the cost to build the property by a “significant” margin. According to the guidance, this raises a question of whether a portion of the claimed value should be allocated to other assets, rights or contracts that are associated with the project but are ineligible for a Cash Grant payment, such as a power purchase agreement.
Certainly, in some cases, associated project contracts or rights may be allocated separate value for federal income tax basis purposes, for example where the market for power purchase agreements materially shifts such that a power purchase agreement executed before the project becomes commercial moves “into the money.” However, in the great majority of cases, a power purchase agreement with an unrelated offtaker, entered into in connection with a project becoming commercial, still reflects current arm’s length terms and pricing, and should not be attributed separate value from the project. The concern for market participants is that the new guidance may be applied, contrary to its reference to federal income tax law, to value the relevant solar system other than “in place” subject to existing rights and contracts.