New guidelines that the Internal Revenue Service issued for tax equity transactions in late December apply only to transactions involving tax credits for rehabilitating buildings, but they are having an effect on refined coal and fixed-flip partnership transactions and eliciting discussion about inverted leases.
The new guidelines reflect three general principles, according to a Treasury source.
The tax equity investor must have entrepreneurial upside potential and downside risk.
There must be variability in the tax equity investor’s potential return.
Things should happen consistently with what would happen in a transaction without significant tax benefits ― for example, developer and management fees should be the same amounts that would be paid in a non-tax equity deal.
The new guidelines are in Rev. Proc. 2014-12. They are a reaction to a tax equity transaction that a US appeals court set aside in August 2012 in a case called Historic Boardwalk. (For earlier coverage, see September 2012 NewsWire starting on page 7.)
The new guidelines do not apply to renewable energy or refined coal transactions. The initial reaction of many tax counsel has been that the new rules are so specific to tax credits for rehabilitating buildings that they are unlikely to have much effect on the broader tax equity market. The Treasury and IRS team that wrote them largely agrees, but believes the market cannot help but reflect on some new lines the IRS has drawn.
The guidelines are a mix of bright lines and general principles. The effect of mixing in general principles is like a photo- graph whose image is clear in the middle of the frame but blurred as one moves away from the center.
Until now, the IRS has had two sets of guidelines for tax equity transactions: a “safe harbor” for partnership flip trans- actions involving wind farms in Rev. Proc. 2007-65 and advance ruling guidelines for anyone who wants a private letter ruling that a leveraged lease of equipment is a “true lease” in Rev. Proc. 2001-28.
The market has generally complied with the wind partnership flip safe harbor.
It has strayed over time from IRS true lease guidelines after deciding that a number of the guidelines are more conservative than what the courts require.
Early indications are that the market may stray from the new Historic Boardwalk guidelines, if only because the photograph is still a little too blurred outside the center. The real test will be over time as the photograph comes more clearly into view.
Dos and Don’ts
Here are the new guidelines and what the Treasury and IRS team that wrote them have said about particular rules.
The tax equity investor must invest at least 20% of its anticipated total investment at inception. Inception means before the building is placed in service. The investor cannot put in less than 20% and then wait to invest the rest until it sees whether the building has been properly renovated. The guidelines do not address situations where a tax equity investor has com- mitted to invest in multiple buildings over time.
At least 75% of the investor’s expected total investment must be fixed in amount. Only 25% can be contingent on future events. The investor must be expected to be able to meet the fixed portion of its funding obligations as they arise. The Treasury and IRS team said this is not a net worth test. It is an intention test.
The sponsor must have at least a 1% interest in income, losses and tax credits. This refers solely to the partnership claiming tax credits. There are two forms of inverted lease in use in the solar rooftop market. In the more conservative form, the sponsor has no interest in the lessee. Since the lessee is not a partnership, such transactions are outside the scope of the new guidelines. The new guidelines are focused on use of partnerships to transfer tax credits.
The investor’s partnership interest must have “a reasonably anticipated value commensurate with the Investor’s overall percentage interest” apart from tax benefits. Another way of saying this is the sponsor cannot have stripped out the economics, leaving the investor largely with tax benefits and an interest in the remaining economics that is inconsistent with the investor’s sharing ratio. For example, suppose the tax equity investor has a 99% interest until a flip date, and 5% thereafter. After stripping out the tax benefits, the investor’s interest must have a value commensurate with what someone who cannot use the tax benefits would assign to an interest with those sharing percentages. This is not a pre-tax yield test. The project does not have to be economic absent the tax benefits. It is a general statement that the government does not want to see cash stripped out through developer, management and other fees that are above what a third party would be paid for the same services in a non-tax credit deal or through lease terms in an inverted lease, leaving the investor with little else besides tax benefits and certainly less than what someone with a 99% interest initially and 5% interest later in the business would expect to receive.
The sponsor cannot be distributed a disproportionate amount of cash ― for example, it cannot receive all the cash above preferred cash distributions to the tax equity investor. There was a view within the IRS that sharing ratios should be straight up, meaning the partners should share in all income, loss, cash and tax credits in the same ratio before the flip, but that group lost. The position was considered “too constrictive.” It is clear that the investor cannot be left with annual cash distributions equal to 2% of the initial capital it contributed. It is clear that a straight- up deal works. Anything beyond that is in the blurred part of the photograph.
If the tax equity investor leases assets in an inverted lease, then it cannot turn around and sublease them to someone else unless the term is shorter than the inverted lease. Some tax counsel have felt uncomfortable with inverted lease deals unless the customer agreements are shorter than the head lease because they want the tax equity investor to have mer- chant exposure for a period before the head lease ends. They take this position as part of the analysis whether the head lease is a true lease. The new guidelines say the sublease must be shorter than the head lease, but without setting a minimum period for the merchant exposure. It appears the IRS wants the tax equity partner to have some downside risk after the customer agreement ends as part of its analysis whether the tax equity investor is a real partner, but the failure to set a minimum period is peculiar.
A Treasury source cautioned against trying to apply the new guidelines to inverted leases in the solar rooftop market. The Treasury and IRS team did not spend any time thinking about application of the principles in the new guidelines beyond the rehabilitation tax credit fact patterns in which the team was immersed. The team is not familiar enough with the energy world to know whether importing the new guidelines to that world makes sense.
Does that mean that if he were a solar company tax counsel, he would not lose any sleep over the new guidelines? He would not necessarily go that far. It would be useful to test any structure against the three general principles at the start of this article.
The sponsor can take some traditional business risks. It can promise to do things that are required for the partnership to be entitled to tax credits and to avoid recapture. It can provide completion guarantees, operating deficit guarantees, environ- mental indemnities and make financial covenants. However, these guarantees cannot be “funded,” meaning the sponsor cannot set aside money or property to ensure payment on the guarantees. Requiring the guarantor to have a minimum net worth is considered funding a guarantee. The sponsor can fund a reserve to cover up to 12 months of reasonably projected partnership operating expenses. However, the sponsor cannot set aside other money or property to secure its obligation to pay the guarantee. A parent guarantee is okay. Related parties are treated as the same entity, so the parent guarantee disappears in the analysis.
The sponsor cannot indemnify the tax equity investor against loss of tax credits or guarantee the “cash equivalent of tax credits” if the IRS challenges the transaction structure. The sponsor can enter into a tax indemnity agreement that puts risks on the sponsor that are within the sponsor’s control, like when the building is put in service. However, other risks must be borne by the tax equity investor. The sponsor cannot agree to make ongoing capital contributions to the partnership to ensure the partnership will have enough cash to make cash distributions to the tax equity partner. The sponsor cannot pay the tax equity investor’s “costs” or indemnify its “costs” if the IRS challenges the tax credits the investor claimed. “Costs” means legal fees and other costs of defending against an IRS challenge. It does not mean the underlying tax liability, penalties or interest.
Neither the sponsor nor the partnership can have a call option to repurchase the investor’s interest in the future. The IRS believes that call options have the effect of shaving the investor’s residual interest. The investor has a minority partnership interest, so the value will be discounted. The IRS does not want to get into arguments about appropriate discount rates.
The investor can have a “put” to force the sponsor or the partnership to repurchase the interest, as long as the put price is not above fair market value when the put is exercised. The price can be the lesser of a fixed amount and fair market value at time of exercise.
This position on options is such a break with established tax law precedent that it is unlikely to make sponsors forego call options, but it will put pressure on tax counsel to allow puts.