THE TAX EQUITY MARKET is awaiting new guidelines that could affect how some deals are structured.
The Internal Revenue Service is working on a revenue procedure that will explain what it wants to see in tax equity transactions involving tax credits for renovating historic buildings. The tax credits work like the investment tax credit in renewable energy projects. They are claimed in the year a project is completed. They are 20% of the amount spent on renovations. Developers form partnerships with tax equity investors and allocate the credits disproportionately to the tax equity investors.
The IRS feels that some such partnership transactions have become too aggressive.
A US appeals court struck down one such transaction in August 2012. The case, called Historic Boardwalk LLC v. Commissioner, involved renovation of a sports arena and exhibition hall in Atlantic City that was originally built in the 1920s and was the site of the Miss America pageant starting in 1933. The state of New Jersey, which did the renovation and had no use for the federal tax credits on the project, entered into a complicated transaction to transfer the tax credits to Pitney Bowes. The transaction had a number of features that apparently are common in the historic and affordable housing tax equity markets, but that would be viewed as aggressive in the renewable energy market. (See earlier coverage in the September 2012 NewsWire starting on page 7.)
An IRS associate area counsel in Detroit said in an internal memo made public in March 2013 that another transaction was nothing more than a "circular flow of contracts" with no real partnership formed. (See the April 2013 NewsWire starting on page 27.)
The court decision and IRS memo have caused some tax equity investors to defer making further investments in transactions involving historic tax credits until there is more guidance from the IRS.
Senior IRS officials say it is easy to structure transactions to transfer historic tax credits so that the transactions pass muster, but that the market appears to be walking too close to the line in some cases to bare sales of tax credits. Broker presentations that pitch the transactions as tax credit sales do not help the situation.
The guidance is on a "fast track," according to Craig Gerson, an attorney-adviser in the office of tax policy at the US Treasury.
The goal is to create a zone in which the deals can be done. The IRS is expected to say it wants a meaningful upfront investment by the tax equity investor. Many investors put in a small amount of money shortly before the end of the renovation project and then invest the rest after the project has been completed. The agency also wants to see "entrepreneurial downside risk" and a potential upside for the investor.
An historic tax credit coalition submitted eight fact patterns that it asked the IRS to be sure to address. Two of the fact patterns describe "fixed-flip" partnerships, where the tax equity investor takes a small share of the cash as preferred cash distributions and virtually all the tax benefits until a fixed date in the future, and "overlapping" inverted leases that strip tax credits by having the developer lease the project to a tax equity investor to whom the developer elects to pass through the tax credits and the tax equity investor also takes an interest in the lessor. The fact patterns do not mention some of the more aggressive features that are typical of such transaction structures. Another fact pattern asks the IRS for its view if the investor buys tax credit insurance from a third party.
The guidelines are expected to be patterned after guidelines the IRS issued in 2007 for partnership flip transactions involving wind farms. Any new rules for historic tax credit transactions will be read with interest by the broader tax equity community.
The US Supreme Court declined in late May to review the US appeals court decision in the Historic Boardwalk case.
CHUCK RAMSEY, chief of the IRS branch that deals with energy-related tax credits, is retiring in July. A replacement has not been named yet. The agency will lose an important part of its institutional memory when he retires.
A SOLAR ROOFTOP COMPANY that entered into a long-term contract to supply electricity to a city building in Dubuque, Iowa from solar panels it mounted on the roof is not making retail sales of electricity, an Iowa court said.
The decision could open a hole in retail sale restrictions that prevent rooftop solar companies from entering into power purchase agreements with customers in other states if the logic the Iowa court used were to be adopted more widely. The court said the solar company is really in the business of making energy efficiency improvements that reduce the amount of electricity a customer takes from the grid rather than selling the customer electricity.
Many solar companies retain ownership of rooftop systems and lease them to customers. The customers pay rent that is roughly 85% of what they pay the local utility for power. However, it is not a good idea to lease a solar system to a government or tax-exempt entity because equipment leased to such an entity does not qualify for a 30% investment tax credit and accelerated depreciation. The only way to preserve the tax benefits is to enter into a power contract rather than a lease with such a customer. A special provision in the US tax code allows an agreement to be written in such a way that it is close to a lease in substance, but is still treated for tax purposes as a power contract. The key is to avoid four "foot faults" in how the agreement is drafted.
Eagle Point Solar signed a power contract to supply electricity to a city building in Dubuque. Interstate Power & Light Company, a regulated utility, has a monopoly to supply electricity to retail customers in the area. Eagle Point asked the Iowa Utilities Board for a declaratory order that it would not violate state law by entering into the arrangement. (Ironically, the power contract was drafted in a way that would have prevented Eagle Point from claiming any tax benefits on the solar system.)
The board said Eagle Point will become a public utility if it enters into the arrangement and will infringe on the IP&L monopoly as the sole authorized retail electricity supplier in the area.
Eagle Point filed for judicial review. An Iowa district court said Eagle Point would not be a utility. The key for the court was that Eagle Point was not selling electricity "to the public" as used in the state statute defining a "public utility."
The phrase "to the public" is not defined. The court relied in part on an eight-factor test that an Arizona court developed in a natural gas case.
The court said it was important to look at what Eagle Point actually does. The company installs solar panels and also provides financing options to its customers in the form of leases or power purchase agreements. These "financing options" are incidental to the company’s main business, the court said.
That business is installing solar panels on the customer side of the utility meter. The company is basically helping the customer reduce its electricity demand just like other energy efficiency installers. "[A] provider of behind-the-meter energy efficiency services in not subject to regulation as a public utility," the court said. Eagle Point "provides the customer with the same service [as energy efficiency companies that install better insulation, new windows and more efficient lighting, but it does so] by different means."
Eagle Point is not serving the broader public like a utility. Rather, each rooftop system is dedicated to a single customer on a single site. Rooftop solar companies are not natural monopolies and, as such, there is no policy reason to regulate them as utilities, the court said, particularly in view of the state’s policy to encourage use of renewable energy.
The case is SZ Enterprises, LLC d/b/a/ Eagle Point Solar v. Iowa Utilities Board. The court released its decision on March 29.
THE US TREASURY is expecting to pay another $12.5 billion in grants on renewable energy projects before the section 1603 program ends.
It expects another 100,000 applications, almost exclusively for solar projects with the vast majority of them for smaller systems mounted on rooftops. The only projects that still qualify for grants are projects that were considered under construction by December 2011. Many solar developers are sitting on solar panels and other equipment stockpiled in 2011. Projects that use this equipment can still qualify given the right facts.
Total payments through May 10 under the program were $18.5 billion.
The largest single grant to date was a $542 million grant paid in May 2011 to E.On Climate & Renewables in connection with a 781.5-megawatt wind farm the company built in Roscoe, Texas. The grants are 30% of the eligible cost or fair market value of the project, depending on how the project was financed.
Grants approved for payment through September 30 this year are subject to an 8.7% haircut due to budget sequestration.
The haircut percentage is expected to drop to 7.3% for grants approved on or after October 1, according to the latest estimate by the Office of Management and Budget. OMB said it will issue an update in August. The actual haircut will depend on budget decisions made between now and the start of the US government’s next fiscal year on October 1. Unless Congress turns it off, sequestration will remain in effect for another eight years after this year.
There has been continuing erosion in the "tax bases" that Treasury will accept for calculating grants. Treasury has been paring back the bases it will accept in some cases to the actual amount the developer can demonstrate a project cost to build. Many projects are financed in the tax equity market in a manner that lets tax benefits be calculated on the fair market value rather than cost. Treasury’s view is that the market value should not exceed the replacement cost, or the amount someone would have to spend today to build the same project. With solar panel prices falling, this has meant projects built today using equipment purchased in 2011 may have a lower replacement cost than the actual cost to build. Treasury has accepted the actual cost in some cases, notwithstanding the lower replacement cost, but after knocking out developer fees or other markups achieved in tax equity transactions. In other cases, it has been willing to entertain a small markup above actual cost. In other cases, it has used the income method to arrive at basis, but using the tax equity investor’s internal rate of return as the discount rate, unless the developer can produce a better market assessment of the riskiness of the customer revenue stream being discounted under the income method.
The Treasury is strictly enforcing a deadline to respond to any questions that its reviewers ask after looking at grant applications. Responses are due within 21 days. Grant applicants who need more time should be sure to ask for an extension before the deadline. At least one applicant who failed to respond in time has been told he is out of luck: the application has been treated as withdrawn and cannot be refiled.
There are currently five lawsuits pending against Treasury about the section 1603 program. A sixth suit was withdrawn by the solar company that filed it "with prejudice," after the government filed a counterclaim against the company charging it with fraud. The company claimed grants on bases as high as $45 a watt on solar systems mounted on flat-bed trucks.
In April, a biodiesel producer lost a round in one of the other pending suits. Clean Fuel, LLC filed suit against Treasury in February 2012 after being denied grants on new Cummins generators that it added to two existing biodiesel plants in Florida. The plants make biodiesel from waste soy, palm nuts and some waste animal fats. Clean Fuel bought them in early 2009 from the original owner and added the generators a year later to make electricity for use in the plants. Treasury appears to have denied grants on grounds that the company was asking for grants on used property. The government should have pointed out that the company would not have qualified for production tax credits on the electricity because there is no sale of the electricity to third parties. However, the Treasury does not appear to have raised this as a bar to a grant.
Clean Fuel sued not only for the grants it was denied but also for the net income it said it lost in 2011 as a result of not receiving grants. The company said its 2011 net income was down $8.977 million in the case of one of the two plants.
The government moved to dismiss the claim for lost profits — called "consequential damages."
The judge in the case agreed with the government. He said the claims court does not have the power to award consequential damages in a section 1603 case.
The Treasury has extended the deadline to apply for grants after projects are put in service. The deadline had been 90 days. It is now 180 days.
STATE INCOME TAXES may be owed in more cases than companies realize.
A survey by Bloomberg BNA found that 26 of the 50 US states believe a company has a sufficient "nexus" — or link to the state — to subject it to income taxes if the company leases space on a computer server in the state. Thirty-six states believe there is a sufficient nexus to tax if the company has an employee who works from home in the state and telecommutes.
Once a company has a sufficient nexus to tax, then the tax is on the share on the company’s income that is considered to have been earned in the state. Such income has a "source" in the state. Most states use some variation of a three-factor formula to allocate the company’s total income partly to the state by weighing the share of the company’s total payroll, property and sales in the state. However, some states provide different weighting to the factors and some have moved to use of just one of the factors.
Foreign companies doing business in the US are most likely to run into problems. Most foreign companies are familiar with the federal tax system but less familiar with state taxes. They may run up significant liabilities before they realize they owe money. Foreign companies are usually not subject to regular income taxes at the federal level unless their activities are regular enough to create a "permanent establishment." Most states do not use the same concept. They look for a "nexus," which can be created with a much smaller level of activity.
MASTER LIMITED PARTNERSHIPS took a step closer in late April to use in the renewable energy market, but they remain a hard sell in Congress.
MLPs are large partnerships in which the partnership interests are traded on a stock exchange or over-the-counter market. Publicly-traded partnerships are taxed like corporations in the United States. Thus, their earnings are taxed at the partnership level and then again when distributed as "dividends" to partners. However, the US tax code makes an exception for partnerships that receive at least 90% of their gross income each year from dividends, interest, rents from real property or from an active mineral or natural resources business.
Senator Chris Coons (D.-Delaware) reintroduced a bill in late April that would allow MLPs to own renewable energy projects as well as a long list of other types of new assets they are not able to own currently. The expanded list includes fuel cells, combined-heat-and-power projects of up to 50 megawatts in size, electricity storage devices, renewable chemicals companies, installers of energy efficiency improvements, large industrial facilities that capture and store their carbon dioxide emissions and gasification projects that gasify coal, petroleum residue, biomass or other materials and that capture and store at least 75% of the carbon dioxide emissions.
The bill inadvertently would block some rooftop solar systems from being owned by MLPs. Under the bill, solar systems on which customers have signed power contracts to buy electricity could be put in MLPs, but solar systems that are leased to customers could not be.
Coons has done an excellent job of building support for the bill. However, it is unlikely to be taken up until Congress tackles broader corporate tax reform, at which time Congress will have to decide how many industries it is willing to allow to operate without having to pay corporate income taxes. The more industries added to the list, the harder it is to sell. The renewables companies argue for parity with fossil fuel companies.
IMPROVEMENTS to power plants should be easier to distinguish from repairs in the future after an IRS revenue procedure in April that breaks power plants down into smaller "units of property" and "major components."
Power companies can deduct amounts spent on repairs immediately. They must capitalize amounts spent on improvements, meaning add them to basis in the power plant and recover them through depreciation of the power plant over time. It is usually preferable to claim something is a repair to get the faster tax deduction. However, in projects that qualify for investment tax credits, it may be better to treat the amount as an improvement so that an additional tax credit can be claimed.
The IRS said it will not challenge power companies that treat the cost of replacing a "unit of property" or "major component" as an improvement. The revenue procedure lists all the units of property and their major components at coal- and natural gas-fired and nuclear power plants. A coal-fired power plant can be broken into 27 units of property, and each unit of property has from zero to eight major components. Examples of units of property are boilers, turbines, scrubbers, cooling water systems, condensers and continuous emissions monitoring systems. A turbine, for example, has four major components: the shell and casing, the instrumentation and controls, the complete blade set and the shaft.
These classifications can only be used by companies in the business of selling electricity or steam. They do not apply to alternative energy facilities. The information is in Revenue Procedure 2013-24.
The trade association for the regulated utilities, the Edison Electric Institute, worked for years with the IRS on the classifications. Both sides hope it will reduce the number of disputes in tax audits.
A REPATRIATION STRATEGY that a US company used to bring back money parked in offshore holding companies for use in the United States ended up triggering US taxes, the US Tax Court said.
The Barnes Group manufactures and distributes precision metal parts and industrial supplies. The group has been in business since 1857. In the late 1990’s, the group brought in new management with the aim of growing the company through acquisitions. It made three significant acquisitions in 1999 and 2000 for $197.1 million.
As a consequence of the acquisitions, by the end of 2000, the company had $230 million in outstanding long-term debt and a debt-to-equity ratio that was high enough to cause its borrowing costs to increase.
The company was paying 7.13% to 9.47% interest to borrow while earning roughly only 3% interest on $43.7 million cash held in offshore holding companies.
The company’s tax director sought ideas from three of the big four accounting firms and eventually settled on a "reinvestment plan" suggested by PricewaterhouseCoopers. The plan came complete with an exit strategy to unwind the plan if Barnes wanted to return the funds to the offshore subsidiaries and a draft "business purpose" suggested by PwC.
The plan involved moving money held in a Singapore subsidiary to the US parent company, but through two new intermediate entities. Money was contributed to a new Bermuda company and then by the Bermuda company to a new Delaware company. The Delaware company then lent the money to Barnes in the US. Some of the money contributed as capital was the accumulated offshore cash. Some was money the Singapore subsidiary borrowed from a Japanese bank at a lower interest rate than the US parent could have borrowed because the Singapore subsidiary was generating significantly more cash than it needed.
PwC, which also acted as the auditors for Barnes, gave a tax opinion that repatriation done in this fashion would not trigger a tax in the United States. Earnings of a US-controlled foreign corporation become taxable in the United States if they are invested in US property. Shares in a Delaware corporation are normally such an investment. However, PwC relied on a 1974 revenue ruling that suggested the amount that should have become taxable in the US is the basis that the Bermuda company had in the Delaware company shares and that basis was zero in this case.
The US Tax Court invoked the step-transaction doctrine to treat the money as coming back to the US directly from Singapore. It said intermediate entities and complicated steps served no business purpose other than to avoid taxes, and the purported loans by the Delaware company were not real loans. There was no evidence that any interest or principal had been paid on loans in the company’s general ledgers or bank statements.
The case is Barnes v. Commissioner. The Tax Court released its decision in April. The courts have been showing less and less patience for complicated transactions intended to achieve a tax result based on a narrow technical reading of the law.
SERIES LLCs are gaining ground, but slowly.
Nine US states, the District of Columbia and Puerto Rico have statutes that allow limited liability companies to create different pockets or cells of investments, each potentially with different owners, a different managing member and different assets. In at least three of the nine states, each series can have a separate right, in its own name, to sign contracts, hold title to assets and grant liens and security interests in the assets belonging to that series. The debts of a particular series may be enforceable only against the assets of that series.
The structure opens a number of possibilities. For example, wind companies that build out projects in 100- or 200-megawatt increments using a single interconnection agreement may have trouble getting consent from the utility to divide up the interconnection rights among separate project companies. If a series LLC were used, then the interconnection agreement could remain in the name of a single LLC.
A big open issue is how each of the separate LLC subsidiaries is treated for tax purposes. The IRS proposed in 2010 to treat each subsidiary as a separate entity for tax purposes. Therefore, some could be treated as separate partnerships or disregarded entities at the same time that the parties might to choose to treat others as corporations.
The American Bar Association tax section surveyed all 50 states about their treatment of series LLCs. Thirty-one states had responded by May.
The survey found that series LLCs are gaining popularity, but the numbers are not staggering. In Delaware, 8,068 series LLCs have been formed and, in Illinois, 6,320. Twenty-two states said they would follow the federal lead and let each LLC subsidiary make its own income tax election. Six states were undecided. Texas will not follow the federal lead and will treat all the LLCs in the series as a single entity for purposes of the state’s "margin" tax, which is effectively its corporate income tax.
The Uniform Law Commission is working on a uniform draft law for use by the states, but the draft will not be completed until 2015 at the earliest.
A WINDFALL PROFITS tax in the United Kingdom can be credited against US income taxes, the US Supreme Court said.
PPL Corporation, a US utility holding company, bought a 25% interest in a regional electric distribution company in Britain when the British government privatized all 12 of its regional distribution companies in 1990. The Labour party was opposed to the privatizations. After it regained control of parliament in 1997, it imposed a one-time windfall profits tax on the owners of the companies.
In form, the tax was 23% of the difference between what the Labour government felt the companies’ flotation values should have been and the prices at which they were actually sold.
US companies can claim income taxes paid on foreign earnings to other countries as a credit against US income taxes on the earnings when the earnings are repatriated to the United States. However, foreign tax credits can only be claimed for taxes whose "predominant character" is that of an "income tax in a US sense."
The IRS argued that the taxes in this case were not income taxes because they were calculated on a hypothetical windfall for "underpaying" for shares in the privatization.
The Supreme Court analyzed the formula for calculating the tax and concluded that it was in fact a tax on actual income. What the formula did, the court said, was to calculate the amount by which a company’s actual profits over the first four years after privatization were "excess" and impose a tax on it. The actual formula was 23% times the daily average profit during the initial post-privatization period of up to four years times 365 times 9 (the price-to-earnings ratio the Labour government thought should have been used to value the companies in the privatization). It then subtracted the actual flotation price.
However, the court said the formula was mathematically the same as a 51.71% tax on the company’s actual profits over the first four years, minus what the government thought it was reasonable for the company to earn. The amount subtracted from actual earnings in the formula was mathematically equivalent to a fraction — the flotation price at which the company was sold in the privatization divided by 9 — multiplied by 4.0027. In other words, the tax was on the actual profits to the extent they exceeded an amount the government considered reasonable.
The court released its decision in late May. The case is PPL Corp. v. Commissioner. Entergy, another US utility holding company that bought London Electricity, won a similar case at the appeals court level. The Supreme Court declined to review the decision in the Entergy case.
A CARBON TAX remains in play.
Such a tax was included on a list of options that members of the Senate tax-writing committee were given by committee staff in April. Senators on the committee have been holding a series of closed-door meetings to talk about corporate tax reform. The options are merely a laundry list of all the possibilities and should not be viewed as having been endorsed by the staff that assembled them. However, the committee chairman, Senator Max Baucus (D.-Montana), said in late May that "everything is on the table, including a carbon tax. It’s being considered, it is being discussed." The Congressional Budget Office estimated in 2011 that a tax of $20 a ton on the carbon content in fossil fuels would raise $1.2 trillion in revenue over 10 years from 2012 to 2021.
Interest in a carbon tax seemed to peak early in the year as a possible element of a grand bargain on the budget and then recede quickly after attracting strong opposition from Republicans and indifference from the Obama administration.
FOREIGN PARTNERS in partnerships engaged in business in the United States are subject to income taxes at regular corporate income tax rates when selling their partnership interests, the IRS says.
The Obama administration is asking Congress to codify the position. The IRS views the partners as owning directly a share of each partnership asset. Therefore, when a partner sells his partnership interest, he is treated as selling his share of the assets directly. Since the assets are used in a US trade or business, tax must be paid on the unrealized gain in each asset.
The IRS position is explained in Revenue Ruling 91-32. The agency is in the process of writing the position into its regulations, but the regulations are still at an early stage.
In the meantime, the Obama administration is asking Congress to write the same thing directly into the US tax code and to require anyone buying a partnership interest in a partnership engaged in business in the United States to withhold 10% of the gross purchase price unless the seller certifies that the seller is not a nonresident alien individual or foreign corporation. If the buyer fails to withhold the correct amount, then the partnership would be liable for the under-withholding. The partnership would satisfy the withholding obligation by withholding on future distributions that otherwise would go to the new partner.
The typical partnership agreement in the United States has an entire article that addresses when partners can transfer their interests. Careful draftsmen should make sure the agreement requires a partner who transfers his interest to include a clause in the sales document requiring the buyer of the interest to withhold if the seller cannot produce the required certificate.
COST REIMBURSEMENTS to partners are getting attention at the IRS.
The IRS is concerned about double dipping in partnerships as follows. A developer borrows to pay its costs to develop or build a project. The developer contributes the development rights or project to a partnership and a money partner is brought in as the other partner. The partnership assumes the debt. The money partner will be allocated most of the economics, leaving the developer with only a carried interest.
The developer is distributed cash to reimburse it for its spending on the project in the two years before the partnership was formed.
Under the US tax rules, the money partner gets to include the debt the partnership assumed in its "outside basis." Its outside basis is a way of measuring what the partner contributed to the partnership and what it is allowed to take out. The additional outside basis gives the money partner more room to claim depreciation and other tax losses and be distributed cash without having to pay taxes on the cash.
Meanwhile, the developer may be able to receive the cash distribution to reimburse it for its spending on the project before the partnership was formed tax free under something called a "pre-formation expense safe harbor."
The IRS believes it is double dipping to let the developer receive this cash tax free and set up the money partner also to receive the same amount of cash tax free because the debt that funded the spending has now been moved to its outside basis.
The IRS is expected to deny use of the pre-formation expense safe harbor in such cases to the developer. The cost reimbursement to the developer would not be tax free. Instead, the developer would be treated as having made a "disguised sale" of the development rights or project to the partnership for the money it was distributed. This is expected to be addressed in regulations on disguised sales that the IRS hopes to release later this year.
MINOR MEMOS: It would cost the US government $24.7 billion over 10 years in lost tax revenue to make production tax credits for wind, geothermal, biomass, landfill gas, incremental hydroelectric and ocean energy projects permanent as the Obama administration has proposed, according to a Joint Committee on Taxation estimate in May. Some wind industry lobbyists believe that Congress will extend the tax credits again in 2014 if it has not taken up corporate tax reform by then . . . . The Defense Department is expected to announce another round of military base closures in 2015. This could complicate efforts by various bases to sign up long-term contracts to buy electricity from renewable energy suppliers . . . . The difficulty ahead for corporate tax reform can be seen in the fact that the corporate revenue raisers in the budget that the Obama administration delivered to Congress in early April would add up only to $94.6 billion over 10 years. A 1% reduction in the corporate tax rate would lose $100.6 billion in revenue over the same period, according to the Joint Committee on Taxation. Both political parties want to reduce the tax rate significantly as part of corporate tax reform. The Democrats want to reduce the rate to 28% from the current 35%, and the Republicans want to reduce it to 25%. . . . . Congressional insiders put the odds of corporate tax reform in a poll by the National Journal in May as follows: excellent 0-1%, good 5-8%, fair 33-39% and poor 56-58%.