WIND DEVELOPERS have been helped by two favorable tax rulings. The United States encourages construction of wind farms by allowing anyone generating electricity from wind at a US location to claim “production tax credits” of 1.9¢ a kilowatt hour on the output. The credits are claimed for 10 years after a plant is placed in service. However, they are subject to reduction by up to 50% to the extent the project benefits from government grants, tax-exempt financing, “subsidized energy financing” — meaning financial help under a government program directed at energy projects — or “other credits.”
The Internal Revenue Service ruled in February that state or local tax credits are not “other credits.” It said Congress had in mind only other federal tax credits.
The ruling is Revenue Ruling 2006-9. It represents a welcome change in position by the IRS. The agency’s view previously had been that state tax credits that are tied to the capital cost of the project cause a haircut in the production tax credits that can be claimed, but state tax credits that are tied to output do not.
Some projects in California, Hawaii, Montana, North Carolina, Oregon and Utah may be entitled to tax refunds from the US government.
In another significant development, the IRS ruled privately that the standard “partnership flip” structure that many wind developers use to “monetize” tax credits on their projects works. In the transaction at issue in the ruling, the sponsor brought an institutional equity investor who can use the tax credits into a partnership that owns a wind project. The partnership allocates all the cash flow to the sponsor until it gets back its capital. It allocates the institutional investor all the taxable income, depreciation deductions and tax credits — and cash once the sponsor has gotten back its capital — until a “flip date” after the tax credits have run. After that, the investor’s interest in the partnership flips down to less than 10%. The IRS ruled essentially that the institutional investor is entitled to all the tax credits.
The ruling is significant for three reasons. First, while most tax counsel in the industry had been taking the position that production tax credits must be shared among partners in the same ratio they share in taxable income, this was not absolutely clear. IRS regulations require credits to be shared in the same ratio as the partners share in “receipts” from electricity sales. Partnerships where cash is allocated differently than taxable income tested the proposition that “receipts” from electricity sales are taxable income rather than cash. The IRS now agrees the word “receipts” means taxable income. Second, many tax counsel take the position that investors in wind farms and other assets that throw off large tax benefits must expect at least a modest pre-tax return from the investment; their return cannot be solely in the form of tax benefits. The IRS acknowledged in the ruling that production tax credits can be treated like cash for purposes of any pre-tax return calculation. Finally, the ruling also acknowledges that the post-flip percentage interest owned by the institutional investor can be in the single digits.
In related news, Union Bank of California, N.A. secured an opinion from the US comptroller of the currency that it can invest as an equity participant in wind farms because the partnership flip structure that project developers use to “monetize” tax credits is merely a form of financing rather than a true equity investment. Banks can finance — but not own — real estate, except in limited situations.
At first glance, the conclusion is at odds with the position that the parties to these transactions are taking with the US tax authorities. However, inconsistencies are possible where two laws — for example, the tax code and the banking regulations — define terms differently. In this case, it appears that the bank had to make promises to the comptroller that will strain the tax analysis.
The bank said that it would take nonvoting interests in wind farms. It also assured the comptroller that it would hold an interest in a project only for 10 years until the tax credits have run and that, “promptly on expiration of this holding period, the Bank would sell its interest” in the project back to the sponsor. The comptroller based his conclusion that the bank is merely providing financing — and not taking a real ownership interest in the project — in part on a finding that the bank will not share in the appreciation or depreciation in value of the project.
The bank will need to show the US tax authorities that it is not legally compelled to exit the project after 10 years in a manner that leaves it unexposed to any change in value of the wind farm.