The Treasury Department recently issued additional guidance (the "Guidance") that permits the owner of renewable energy property to qualify for a cash grant under section 1603 of the American Recovery and Reinvestment Act of 2009 (the "Cash Grant"), even if the property is leased to a tax-exempt entity such as a hospital or a municipality. Prior to the issuance of the Guidance, it was widely believed that the Cash Grant would not be available for property leased to tax-exempt entities. As a result, renewable energy transactions with such entities have been structured as power purchase agreements ("PPAs"), and not as leases. Although a PPA remains preferable for tax purposes because of the availability of accelerated depreciation, a lease structure is now viable if a PPA is unattractive for other reasons.
The renewable energy market relies on tax benefits to help generate competitive returns. The primary tax benefits currently available are (i) accelerated depreciation, and (ii) a Cash Grant generally equal to 30 percent of the cost of eligible 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 if construction has begun during 2009 or 2010.
Eligible property generally includes equipment used in producing energy from wind, biomass, geothermal, small irrigation, municipal solid waste, qualified hydropower, and marine and hydrokinetic renewables, as well as 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 Cash Grant is elective. Taxpayers who do not elect to receive the Cash Grant, or who do not qualify under the placed-in-service rules, can often qualify for either (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, or (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 ITC is generally available for qualifying property placed in service before January 1, 2017, and the PTC is generally available for qualifying property placed in service before January 1, 2014 (in the case of wind, January 1, 2013).1
Since early 2009, most newly financed renewable energy projects have made use of the Cash Grant and accelerated depreciation.
Structuring Renewable Energy Projects for Tax-Exempt Entities
Tax-exempt entities such as hospitals and municipalities are generally not able to benefit from tax credits or deprecation since they generally are not subject to tax. Similarly, tax-exempt entities are not eligible for Cash Grants. Accordingly, in order to obtain tax benefits from a renewable energy project where a tax-exempt entity is the end-user of the power, the traditional approach has been for a taxable entity to own the renewable project and sell power to the tax-exempt entity under a PPA. Because the taxable entity receives the Cash Grant and accelerated depreciation, it is able to sell the power at market rates and still achieve its desired return.
Traditionally, it has been important to structure the PPA to avoid lease characterization under Internal Revenue Code ("Code") Section 7701(e). The reason for such a structuring is that accelerated depreciation is not available in a lease structure involving a tax-exempt entity and, prior to issuance of the Guidance, it was widely believed that the Cash Grant was unavailable as well.
Under a safe-harbor provision contained in Code Section 7701(e), a PPA with a tax-exempt entity will not be considered a lease so long as:
- The tax-exempt entity does not operate the facility
- The tax-exempt entity does not bear any significant financial burden if there is nonperformance (other than for reasons beyond the control of the project owner)
- The tax-exempt entity does not receive any significant financial benefit if the operating costs of the facility are less than the standards of performance under the PPA
- The tax-exempt entity does not have an option to purchase, and cannot be required to purchase, the facility at a fixed and determinable price (other than fair market value)
Additional Program Guidance
The Guidance provides that the owner of qualifying energy property is eligible to receive the Cash Grant even if the property is leased to a tax-exempt entity. Otherwise qualifying energy property that is leased to a tax-exempt entity remains ineligible for ITC and PTC. Thus, a PPA structure is still required for renewable energy transactions involving a tax-exempt entity if the project owner does not elect to receive the Cash Grant, or if the property is placed in service after 2010 (unless construction of the property begins before the end of 2010).
In addition, property leased to a tax-exempt entity is not eligible for accelerated depreciation. (Alternative energy property that is not leased to a tax-exempt entity is generally depreciated over five years under the double-declining balance method; alternative energy property that is leased to a tax-exempt entity is generally depreciated over 12 years under the straight-line method.)
The Guidance provides that the owner of alternative energy property that is leased to a tax-exempt entity is not eligible for the Cash Grant unless the lease is a true lease for tax purposes. The most recent pronouncement by the Internal Revenue Service (the "IRS") on the question of lease characterization is laid out in Rev. Proc. 2001-28, which sets forth the circumstances (the "Ruling Guidelines") under which the IRS will generally rule that a leveraged lease will be respected as a true lease for United States federal income tax purposes. In general, under the Ruling Guidelines, the IRS will issue a ruling that a purported lease of property constitutes a true lease for United States federal income tax purposes if the following criteria are met:
- The lessor must have, and must maintain throughout the entire term of the lease, a minimum "at-risk" equity investment in the property (i.e., the consideration paid, and personal liability incurred, by the lessor to purchase the property) equal to at least 20 percent of the cost of the property
- The lessor must represent and demonstrate that an amount equal to at least 20 percent of the original cost of the property is a reasonable estimate of what the fair market value of the property will be at the end of the lease term. For this purpose, fair market value must be determined (i) without including in such value any increase or decrease for inflation or deflation during the lease term, and (ii) after subtracting from such value any cost to the lessor for removal and delivery of possession of the property to the lessor at the end of the lease term.
- The lessor must represent and demonstrate that a remaining useful life of the longer of one year or 20 percent of the originally estimated useful life of the property, is a reasonable estimate of what the remaining useful life of the property will be at the end of the lease term
- The lessor must represent and demonstrate that it expects to receive a profit from the transaction apart from tax benefits (i.e., tax deductions, allowances, credits, and other tax attributes arising from the transaction)
- Neither the lessee nor any affiliate of the lessee may have a contractual right to purchase the property from the lessor at a price less than its fair market value at the time the right is exercised, and the lessor may not have a contractual right to cause any person to purchase such property (regardless of price)
- Neither the lessee nor any affiliate of the lessee can lend to the lessor the funds necessary to acquire the property, or guarantee the debt of the lessor created in connection with the acquisition of the property
- It must be commercially feasible, at the end of the lease term, for parties other than the lessee or its affiliates, to purchase or lease the property from the lessor
- The lessee must not make certain types of improvements to the equipment during the lease term
The courts have not treated the Ruling Guidelines as determinative in evaluating whether a lease will be respected for tax purposes. Rather, courts generally look to whether the lessor has sufficient benefits and burdens of ownership to support lease status. In making this determination, however, courts generally look to many of the same factors specified in the Ruling Guidelines. In many instances, courts have held that a purported lease constitutes a true lease even though various criteria contained in the Ruling Guidelines were violated. The test is ultimately a factual one in which the courts examine all of the relevant facts and circumstances.
The Guidance offers increased flexibility in structuring renewable energy transactions, where the power-user is a tax-exempt entity, by providing Cash Grant availability for lease structures if the eligible property is placed in service in 2010, or if construction begins in 2010 and the property is placed in service before the credit termination date. A PPA structure remains preferable from a tax standpoint since accelerated depreciation is also available. In addition, ITC and PTC remain unavailable when otherwise qualifying property is leased to a tax-exempt entity.