Spotlight on Section 45 credits

Spotlight On Section 45 Credits

September 01, 2000 | By Keith Martin in Washington, DC

The federal government offers a tax credit of 1.7 cents a kilowatt hour for generating electricity from wind, closed-loop biomass or poultry waste.

This article explains what qualifies for the credit and how to structure deals to transfer credits in cases where the developer lacks the tax appetite to claim them.

Credits run for 10 years after a power plant is first placed in service. However, the project must be in service by December 2001 to qualify. There is a fairly good chance that the US Congress will extend the deadline next year and also expand the list of eligible fuels.

Eligible Fuels

“Closed-loop biomass” means plants that are grown “exclusively” for use as a fuel in a power plant. Congress had in mind so-called electricity farms where plants are grown specifically to be burned as fuel. A Congressional committee report said in 1992 when the tax credit was enacted,

“Accordingly, the credit is not available for use of waste materials (including, but not limited to, scrap wood, manure, and municipal waste) to generate electricity. Moreover, the credit is not available to a taxpayer who uses standing timber to produce electricity.”

Congress added poultry waste to the list of eligible fuels in 1999 after lobbying by Fibrowatt, a UK developer of chicken litter projects. “Poultry waste” is defined as “poultry manure and litter, including wood shavings, straw, rice hulls and other bedding material for the disposition of manure.”

Congress did not address what happens if a project mixes an eligible fuel with another fuel that does not qualify for credits. An example is where 20% of the fuel is poultry waste and the rest is wood chips. The Internal Revenue Service views this as a question without an answer and has not yet taken a position. There is precedent for looking to the primary fuel in terms of Btu content or to awarding the credit on the same percentage of electricity as the eligible fuel going into the plant.

New Projects

Congress intended the credit as an inducement to build new projects. Thus, wind projects qualify for tax credits only if they were “originally” placed in service during the period 1994 through 2001. (The credit was enacted at the end of 1992.) The window period for closed-loop biomass projects is 1993 through 2001. It is 2000 through 2001 for poultry waste projects.

The IRS said in a 1994 revenue ruling that an existing power plant might be considered brand new if it is extensively rebuilt. A windpower developer planned to make extensive upgrades to an existing wind farm in 1994. The IRS said it would look at each turbine, tower and pad as a separate facility, and it would treat each one as brand new – thus qualifying for tax credits – if the cost of the upgrades accounted for more than 80% of the facility’s value after the renovations.


The credit is adjusted each year for inflation as measured by the GDP implicit price deflator.

It is subject to a haircut to the extent the project benefited from tax-exempt financing, federal, state or local government grants, other tax credits, or “subsidized energy financing.” An example of subsidized energy financing is “governmental programs to compensate financial intermediaries for extending low-interest loans to taxpayers who purchase or construct qualifying facilities.” Only subsidies paid by a government in the United States are taken into account. Thus, for example, export credits from Sweden or Germany on equipment purchased in those countries would apparently not reduce the credit.

The haircut is calculated by putting in the numerator of a fraction the amount of the tax-exempt bonds, government grants or other benefits. The denominator is the total capital cost of the project.

Once tainted, a project remains tainted even in the hands of future owners. However, additional capital spending on improvements has the effect of reducing the haircut.

The credit begins automatically to phase out if the “reference price” for electricity ever tops 9.0 cents a kWh. It phases out as electricity prices move across the next three cents from 9 cents to 12 cents per kWh. Thus, if the reference price in 2002 is 10 cents, then taxpayers will qualify for only two-thirds of the normal credit that year. (The 9 cents is adjusted for inflation. The 3-cent range is not.)

There seems little danger of a phaseout in the near term. The IRS said the reference price for wind electricity was 4.836 cents in 1999. It was 0.0 cents for electricity from closed-loop biomass and poultry waste (because there were apparently no such projects in operation.)

The reference price is the average price at which electricity produced using the same fuel was sold in the United States during the year. Only sales under post-1989 “contracts” are taken into account. Thus, spot sales through power pools are not counted.


The project must be in the United States to qualify. “United States” is defined broadly to include US possessions, like Puerto Rico, the US Virgin Islands and Guam. There is no bar against selling the electricity across the border – for example – into Canada or Mexico. However, Canada recently complained to the World Trade Organization that the United States is using so-called section 29 tax credits to reward US producers of syncoal – some of which is sold in Canada at subsidized prices that make it hard for Canadian coal companies to compete.

Whose Credit?

The credit belongs to the company that is the “owner” of the power plant and the “producer” of the electricity. It must be both. Thus, for example, if Company A owns the power plant but leases it to Company B, neither will qualify for tax credits since one is the owner and the other is the producer.

There is one exception: credits may be claimed by a lessee or operator of a power plant that burns poultry waste when the power plant is owned by a “governmental entity.”

A contract operator of a power plant is not the producer. The company hiring the operator is still considered the “producer” as long as the operator contract is not recharacterized by the IRS as some other relationship due to profit sharing or other unusual contract terms.

Electricity Sales

Tax credits are triggered by sale of the electricity to an “unrelated person.” In general, the electricity purchaser must be unrelated to the owner of the power plant. The IRS has ruled privately that there can be up to 50% overlapping ownership. Thus, for example, a utility can own up to 50% of a power plant in partnership with a developer – and claim half the tax credits – and also buy all the electricity.

It is unclear to whom the electricity purchaser must be unrelated in poultry waste projects where credits are claimed by the lessee or operator of the project.

Certain Wind Projects

Congress voted last year, after lobbying by the California utilities, to deny section 45 tax credits to any wind project that the taxpayer places in service after June 1999 to the extent the electricity is sold under a power sales agreement with a utility signed before 1987. The only exception is if the contract is amended to limit the electricity that can be sold under the contract at above-market prices to no more than the average annual quantity of electricity supplied under the contract in the five years 1994 through 1998 or to the estimate the contract gave for annual electricity output. “Above market” means for more than the avoided cost of the electricity to the utility at time of delivery.

This provision could come into play if an existing wind project is sold to a new owner.

Other Rules

Tax credits cannot be used by a company to reduce its corporate income taxes below a floor. The floor is 75% of the company’s regular tax liability or the amount it would owe under the alternative minimum tax. Any credits that go unused because of this limitation can be carried back one year and forward for 20 years.


Many power plant developers have too little tax appetite to use tax credits efficiently. There are ways to transfer tax credits to other companies that can use them.

The simplest approach is to sell the project. The developer can be hired back as the operator.

An alternative is to sell limited partner interests in a partnership that owns the project but to remain part owner as the general partner. Developers ask about the possibility of allocating the tax credits disproportionately to the limited partners in such cases. IRS regulations require that tax credits like this one must be shared among partners in the same ratio as they share in gross receipts from electricity sales.

The IRS ruled privately in 1994 that a developer could sell interests in his project to limited partners and remain the general partner. The partnership planned to hire the developer as the operator for a fixed fee “plus a variable fee dependent on the [project’s] productivity.” It also planned to pay the developer a percentage of gross receipts under a separate contract for handling administrative services. (Paying the general partner a percentage of gross receipts is not a good idea – even with a ruling – because of the risk the IRS will reallocate credits to the general partner.)

The IRS has approved a “pay-as-you-go” structure for use in section 29 projects. This structure should also work in transactions to transfer section 45 credits. Under this structure, the developer sells the project to an institutional equity participant for an amount in cash plus contingent payments over time that are a percentage of the tax credits. The IRS requires that the contingent payments be no more than 50% of the total purchase price in present-value terms. The developer can be hired to operate. The institutional equity will probably require the developer to get a private letter ruling on the structure from the IRS. The equity usually has an option to unwind the transaction if the developer cannot get a favorable ruling. If the project expectedly runs operating deficits, tax credit payments are diverted to cover operating costs, although the equity remains liable to the developer for the amount ultimately with interest.

The following variation would not require an IRS ruling. The developer sells the project to an institutional equity for a fixed purchase price. The purchase price is paid partly in cash at closing and a note is given for the balance with the note to be paid gradually over time with interest. There is some leeway to suspend payments on the note in quarters when the project has too little cash flow to make debt service. There can be a one-time reset in the purchase price up to two years out after the equity gets a better sense for what the project is capable of producing.


Most projects qualify for depreciation over five years using the 200% declining-balance method.

There are differing views among equity participants in pay-as-you-go structures about how to treat the portion of the purchase price tied to tax credits. Some equity treat this is part of the cost of the project and claim depreciation on the amount, but not until the amounts are actually paid. IRS contingent debt regulations require the equity to back out the portion of each payment that is interest. That part gets deducted immediately. The balance is added to the tax basis of the project for depreciation. A more conservative approach is to treat the balance as basis in an intangible asset – almost like “going concern value” since someone had the foresight to put all the pieces of the project together in time to qualify for tax credits. In this case, the balance is recovered on a straight-line basis over 15 years. There is a risk the IRS will disallow any cost recovery above the hard replacement cost of the project under a line of cases that denies deductions for payments for tax benefits.


Congress is expected next year to have a large budget surplus to spend on tax relief. Chances are fairly good that it will extend the credit. The odds are higher if Albert Gore, Jr. wins the presidential election.

Many groups are lobbying to expand the list of eligible fuels.

Biomass groups want the list to include all types of biomass – not just closed-loop – but to exclude municipal garage and recyclable paper products. This proposal was part of the budget that the Clinton administration sent Congress earlier this year. Congress did not act on it. Gore has said it will be part of his platform if he is elected president. It is also part of an omnibus republican energy bill that was introduced this summer by Senate majority leader Trent Lott (R.-Miss.) and Rep. Wes Watkins (R.-Okla.). The biomass groups also want a rule that it is enough to burn at least 75% biomass in a power plant – all the electricity would qualify for credits – and they want a 1 cent credit (as opposed to 1.7 cents) for electricity from coal-fired power plants that burn up to 25% biomass.

Meanwhile, landfill gas companies want tax credits for electricity produced from methane gas. The Clinton budget this year would have permitted this, but the credits would have been at a reduced rate. The rate was 1.0 cents per kWh in cases where the landfill is already obligated by federal “new source performance standards” the US Environmental Protection Agency issued in 1996 to dispose of the gas. It would have been 1.5 cents per kWh for gas from other landfills. The landfill gas provision is not included in the omnibus republican energy bill.

Steel companies want credits for electricity from “steel cogeneration,” meaning from a power plant at a coke, iron ore, iron or steel factory. The power plant would have to use waste gases or heat from the mill.

Finally, Alaskan fisheries are lobbying for section 45 credits on the Btu value of the heat they produce from burning fish oil.

by Keith Martin, in Washington