TELPs: A Financing Tool for Municipal Solar
By Jake Seligman
TELPs, or tax-exempt lease purchases, may see more use in the US distributed solar market for projects with municipalities.
The structure allows a municipality that wants to own a project, but needs to finance the purchase, to do so without the complication of issuing bonds.
Municipalities have used TELPs in the past to fund construction projects, including energy efficiency upgrades. They can also be used for renewable energy projects.
Solar economics are not as good when a municipality, as opposed to a private party, owns a project. The US government offers a 30% investment tax credit and allows 85% of the project cost to be depreciated on an accelerated basis over five years. However, municipalities do not pay income taxes, and so these benefits go unused in any project that a municipality owns. This has led to use of third-party ownership structures, where a private solar company owns the project and sells electricity to the municipality under a long-term power purchase agreement at a price that reflects a sharing of the tax benefits.
A TELP is essentially an installment sale of a project to a municipality. It is set up in form to look like the sponsor is leasing the project to the municipality, but the municipality has an option to purchase the project at the end of the lease term for a nominal price.
The municipality is essentially buying a construction project, but it pays the purchase price through lease payments over time. In one recent transaction, the municipality paid the equivalent of $2.50 a watt for a commercial-scale solar project.
There may be an operation and maintenance arrangement with the developer during the lease term. Care should be taken in setting the terms of any such arrangement because it could prevent the developer entering into the TELP with the municipality from treating part of each lease payment as tax-free interest on the installment debt. A lender to a municipality can usually treat the interest it receives as tax-exempt interest for federal income tax purposes. However, the debt by the municipality to the developer for the purchase price of the project could be labelled as a “private activity bond,” depending on the terms of any O&M agreement, which would make it harder for the interest to qualify as exempted from income taxes.
Inability to claim the federal tax benefits is still a big hit to the economics.
State policies can help make up part of the gap.
The municipality might qualify for renewable energy credits that can be sold in the market. For example, under the ZREC program in Connecticut, the local utility pays owners of solar projects roughly 5¢ a kilowatt hour for helping reach the state’s renewable portfolio standard. Contracts are for 15 years.
Municipalities may also be able to benefit from net metering where excess electricity can be fed into the grid, causing the utility meter to run backwards and reducing the amount the municipality must pay the local utility for the electricity it uses from the grid.
How TELPs Work
In a tax-exempt lease purchase, the developer leases the project to the municipality. Title can reside in either party. The lessor could keep title until all the lease payments have been made. More commonly, the lessee takes title to the system on day one, or at the end of construction, and the lessor retains a security interest to ensure receipt of the lease payments. The lessee has an option to purchase the system at the end of the term for a nominal price.
There are a number of benefits for the municipality as lessee. The obligation to make lease payments is not treated as debt for purposes of state law limits on the amount of debt a municipality may have outstanding. Certain local approvals may not be required that could be required under other financing structures (such as debt). There may be savings from not having to pay a developer to own and operate the project.
Avoiding having the lease characterized as debt for state law limits on municipal debt is usually the main reason for choosing the structure over a straight purchase. The meaning of “debt” in this context varies from one state to the next. Some states view these arrangements as a way for municipalities to avoid public input during the municipal bond process.
A factor in determining whether a lease is subject to municipal debt limitations is whether termination of the lease would result in the municipality giving up more than the unpaid balance of the lease. The term of the lease also should not exceed 120% of the expected useful life of the system.
Non-appropriation provisions also help the lease avoid being characterized as debt for state law purposes. Tax-exempt lease purchases typically include non-appropriation clauses that condition the obligation to pay rent each year on an appropriation from the city or county council. Such clauses are also found in municipal power purchase agreements. If the municipality fails to appropriate, then the developer can terminate the lease and take back the project.
As in power purchase agreements, language can be included to reduce non-appropriation risk to the sponsor. The municipality can be required to use best efforts to appropriate and acknowledge that the electricity from the project is essential to its operations. The municipality can also agree not to purchase power from anyone other than the local utility if it fails to appropriate and the lease is terminated.
By avoiding appropriating funds for more than one year at a time, a municipality can make lease payments out of operating expense dollars rather than capital expense dollars. This allows the municipality to make lease payments the same way it makes utility payments; no additional funds need to be appropriated and no debt needs to be assumed to pay for the project. Municipal debt requires bond issuances, which are more complicated than paying operating expenses, and usually require voter approval.
The municipality is responsible for operating and maintaining the project, but it can contract out for the work.
A TELP is not a “true” lease for federal income tax purposes. The municipality is considered the owner of the project for federal income tax purposes from inception. As a general rule, the lessee will be considered the owner in any case where the lessee is expected to end up with the assets at the end of the lease term. A nominal purchase option will make the lessee the tax owner from inception.
Municipal leases are usually classified as capital leases for accounting purposes.
They are treated as installment sales for federal income tax purposes. Rental payments are in amounts sufficient to amortize the costs of the project over the term plus interest. The installment paper is considered a debt obligation for federal income tax purposes. The sponsor reports its profit on the transaction over time. It must be careful not to pledge the installment paper as security for a borrowing or the full profit will become taxable upon the making of such a pledge.
With the municipal lease considered debt for tax purposes, the interest component of amounts received by the sponsor under the municipal lease may be exempted from federal, and sometimes state, income tax. However, hiring a private party under a long-term contract to operate and maintain the project could cause loss of the tax exemption on the interest. The interest on municipal debt may become taxable to the lender if there is more than 10% “private business use” of the system. The Internal Revenue Service has rules in Rev. Proc. 97-13 for when a contract with a private operator goes too far. The installment debt would be treated as a “private activity bond.” Municipalities are limited in the volume of private activity bonds that may be issued each year, and there are other rules that apply to such bond issues with which the municipality would probably not have complied in order to preserve the tax exemption on the interest element of the rents paid to the sponsor.