Developer fees are becoming more common in renewable energy projects.
Developers are using them to increase the tax basis on which Treasury cash grants are paid under section 1603 of the American Recovery and Reinvestment Tax Act.
In the typical arrangement, the project company that owns the project pays the company that did the actual development work a fee at the end of construction. Fees of 8% to 15% on top of project cost are not unusual. Ellen Neubauer, the cash grant program manager at Treasury, said that the agency focuses more on whether the final basis claimed is reasonable than on the amount of any developer fee.
Tax counsel are using the following rules of thumb for when to allow a developer fee in basis.
The amount must be reasonable.
The sum of the developer fee and the project cost should not exceed the fair market value of the project.
The fee should not be paid out of circled cash. An example of circled cash is where the developer injects cash into the project company that is then paid back to the developer as a fee. Developer fees are common in many real estate projects, and they were common during the 1980’s and 1990’s in the independent power industry where a project company would pay the developer a fee that was often leftover construction loan proceeds or additional borrowing from a term lender as a reward for bringing the project across the finish line.
A development services agreement should be put in place as early as possible in the development process between the project company that will own the project and the development company describing the development work to be done in exchange for the fee, the fee amount and how and when it will be paid. If the development process is already far along before such an agreement is drafted, then the agreement should memorialize the understanding that the parties have had all along about a fee.
The fee should be paid to a real development company with the employees who did the work. It is best if the development company is not also a partner in any partnership that owns the project. The fee should not be paid to all the owners of the project in the same ratio as their ownership percentages or it may be viewed simply as a cash distribution that does not add to basis in the project.
Some developers have proposed having project companies pay a developer fee over time to the extent there is operating cash flow to cover it. Deferred fees with payments delayed up to 15 years are being proposed in some deals. A deferred fee does not go into basis for the Treasury cash grant unless it is a real debt of the project company that is fixed in amount . It should not be subordinated to cash distributions to tax equity investors. It should be paid with interest. The deferral period should not be longer than a few years. It should be clear from the base case model for the project that the project will have the cash to pay the fee on schedule.
Fees paid between companies that join in filing a consolidated federal income tax return or to related parties in foreign countries raise special issues.
The developer must report the fee as ordinary income. Any fee that the parties intend to put into basis in the project should accrue in full at the end of construction. Payment should not be contingent on additional work or other events after construction.
What the parties in a transaction are calling a developer fee may not be one in fact. The term is used loosely in the market to refer to one of three things. One is a true developer fee. Another is a preferred cash distribution by a partnership to a partner that does not ordinarily have to be reported as income by the partner and does not get put into the basis the project company has in the project. Many developers also talk about receiving a developer fee when what they are really receiving is gain on the sale of part of the project to an investor.
The project company must allocate any fee it adds to basis among the various services the development company performed. Thus, for example, if part of the developer fee was for helping to arrange a tax equity transaction or permanent debt, then that part would not go into basis for the Treasury cash grant. Cash grants are paid only on basis in equipment—not in contracts, long-term loans or other intangible assets. However, a fee paid for arranging construction debt goes into basis in the equipment, since it is a cost of construction.
A fee may do nothing at the end of the day to increase the basis in a project, depending on how the project is financed. It is irrelevant to the basis calculation in projects that are financed through sale-leasebacks or inverted leases.
Few developers can use the tax depreciation on their projects. The depreciation can be worth as much as 26¢ to 31¢ per dollar of capital cost in terms of tax savings. Many enter into tax equity transactions in which they effectively barter the depreciation for capital to cover part of the project cost.
In a sale-leaseback transaction, the developer sells the project within three months after completion to a bank leasing company or other tax equity investor and leases it back. The depreciation and Treasury cash grant are claimed by the lessor on the fair market value purchase price the lessor pays for the project. The fact that the lessee paid a developer fee to a development company is irrelevant.
Cash grants are also calculated on the fair market value of the project—rather than its cost—in inverted lease transactions. Such leases are common in the solar market.
The basis for calculating the grant in partnership flip transactions depends on how the transaction is implemented. There are two different forms of flip transactions—a “purchase model” where the tax equity investor pays the developer for an interest in the project and a “contribution model,” where the tax equity investor makes a capital contribution to the project company or partnership for an interest in the project, and the capital contribution is usually used to repay construction debt.
Cash grants are calculated on the project cost in partnership flip transactions that use the contribution model. They are calculated partly on the fair market value and partly on cost in flip transactions that use the purchase model. The partnership takes a fair market value basis in the share of the project sold to the tax equity investor and a cost basis in the share retained by the developer. Thus, only a fraction of the developer fee adds to basis in transactions using the purchase model. The fraction is the share of the project sold to the tax equity investor.