On September 21, 2009, the Internal Revenue Service (the "Service") issued guidance in the form of Announcement 2009-69 (the "Announcement"), which liberalizes the safe harbor for wind energy partnership flip structures and should eliminate a significant impediment to participation by individuals in such transactions. These changes, which are discussed below, will likely lead to new structures and open a new source of equity funding for these transactions.
Background–Flip Structure Safe Harbor and Treatment of PTCs under the Passive Activity Loss Rules
In Revenue Procedure 2007-65 (the "2007 Guidance"), issued in October, 2007, the Service established the requirements (the "Safe Harbor") under which the Service would respect the partnership structure and allocation of "production tax credits" ("PTCs") in a wind energy partnership, provided that each requirement of the Safe Harbor was satisfied. The Service also provided guidance as to the treatment of PTCs for purposes of the "passive activity loss" rules, which limit the ability of individuals and certain other taxpayers to use losses and credits derived from passive activities against income from non-passive activities (e.g., personal services and portfolio income).
In order to meet the requirements of the Safe Harbor under the partnership agreement, among other things, neither the developer, the investors in the partnership (the "Project Company") nor any related parties were permitted to purchase property included in the wind farm or an interest in the Project Company (a "Purchase Option") at a price less than its fair market value determined at the time of exercise. In addition, neither the developer nor any person related to the developer was permitted to have a Purchase Option that was exercisable earlier than 5 years after the project was first placed in service (the "5 Year Rule").
Under the passive activity loss rules (which generally affect individuals, trusts, estates, closely-held C corporations and personal service corporations), losses and credits from an investment in a passive activity may generally only be used against the income from that activity or certain other passive activities that are permitted to be grouped together. Under the 2007 Guidance, for purposes of the passive activity loss rules, each investment in a wind farm was treated as a separate activity. Although investments in certain types of wind farms could be grouped together, losses and PTCs derived from a wind farm investment could not be used to offset income from other (non-wind farm) passive activities. Consequently, under the 2007 Guidance, only entities not subject to the passive activity loss rules could offset non-project income with losses and PTCs derived from an investment in a Project Company.
The Announcement Liberalizes the Rules for Purchase Options and Treatment of PTCs
The Announcement modifies the Safe Harbor in two respects to allow for fixed price Purchase Options. First, the Purchase Option must either be at a price that is not less than the fair market value of the property determined at the time of exercise or, if the price is fixed prior to exercise, at a price that the parties believe, based on all of the facts and circumstances at the time that price is determined, will not be less than the fair market value of the property at the time that the Purchase Option may be exercised. Second, the Purchase Option must be negotiated for valid non-tax business reasons at arm's length by parties with material adverse interests. The use of a fixed price Purchase Option will likely result in more efficient pricing of the benefits inherent in wind farm transactions.The Announcement, however, does not change the 5 Year Rule.
The Announcement also modifies the treatment of PTCs under the passive activity loss rules. According to the Announcement, taxpayers that are subject to the passive activity loss rules may now utilize passive activity credits from a wind farm transaction (i.e., PTCs) to offset income from passive activities, to the extent of their tax liability allocable to passive activities, whether from a wind farm or from other sources. This change will likely be of interest to individuals and private equity funds and should increase the potential pool of equity investors for wind farm transactions.