INVERTED LEASES will produce less benefit for some tax equity investors.
Inverted leases are a form of transaction used to raise tax equity to finance portfolios of rooftop solar installations in the United States. The US offers two tax benefits as an inducement to invest in new solar equipment: an investment tax credit worth 30¢ per dollar of capital cost and accelerated depreciation worth 26¢ per dollar of capital cost.
In an inverted lease, the solar company that owns the equipment leases it to a tax equity investor and elects to let the tax equity investor claim the investment tax credits on the equipment while the solar company retains the depreciation. For more information about the structure, see “Solar Tax Equity Structures.”
If the solar company kept both tax benefits, then it would only be able to depreciate 85% of the cost of the solar equipment rather than the full cost. US tax law requires the depreciable basis be reduced by half the investment tax credit. However, in cases where the tax credits are passed through to a lessee, rather than make the lessor reduce its depreciable basis, the lessee must instead report half the amount of the tax credits as income ratably over five years. This lessee income inclusion is required by section
50(d) of the US tax code.
Some tax equity investors have taken the position, where the lessee is a partnership, that they can deduct an amount equal to the lessee income inclusion later as a capital loss by withdrawing from the partnership.
Each partner has an “outside basis” in its partnership interest. Partnerships do not pay income taxes. Rather, any income at the partnership level is reported by the partners directly. As a partner has to report a share of partnership income, its outside basis in its partnership interest increases. If a partner disposes of its partnership interest, it has a gain or loss equal to the amount it receives for the interest less its outside basis.
The IRS issued temporary regulations in late July to prevent tax equity investors from recouping taxes they paid on such inverted lease income by later claiming the lessee income inclusion as a loss. It said the income is not a “partnership item” that increases the partner’s outside basis.
Rather it starts with the partner directly. The new regulations apply to solar equipment put in service on or after September 20, 2016. The IRS left open the door to challenge
losses already claimed by tax equity investors by saying no inference is intended about what US tax law required until now. The new regulations also address the consequences of terminating the inverted lease. Any termination of the lease within five years after the solar equipment is put in service will lead to recapture of the unvested investment tax credits.
The investment tax credits vest ratably over five years. The termination also accelerates the remaining lessee income inclusion in theory, but in practice, the lessee does not have to report more income than half the investment tax credits it is allowed to keep. It would already have done that in a solar inverted lease.
The tax equity investor should also make sure that the solar company does not transfer the equipment during the first five years, when the investment tax credits remain exposed to recapture, to a tax-exempt or government entity. There is no recapture of the investment tax credits if the lessee purchases the equipment from the lessor. There is also no recapture if the lessor sells the equipment as long as the sale is not to a tax-exempt, government or other entity that cannot pass through tax credits to lessees and the new owner takes the equipment subject to the lease.