Tax triggered when partnership formed?
Project developers are more likely to have to pay taxes on any appreciation in project value when forming a partnership or joint venture with a money partner under new IRS regulations issued in early October.
The developer may be considered to have made a “disguised sale” of the project to the new partnership.
This result may be triggered when forming a tax equity partnership for a renewable energy project.
Often when a new partnership is formed, the developer contributes the project and a money partner contributes cash. The money partner may be a tax equity or strategic investor. The cash is then distributed to the developer.
Under US tax rules, the developer is usually treated as having sold the partnership part of the project if cash contributed by the money partner is distributed to the developer within two years. The part sold is the distributed cash as a percentage of the fair market value of the project.
However, a pre-formation expenditure “safe harbor” lets the developer receive the cash tax free as long as the cash merely reimburses the developer for capital spending on the project during past two years. The amount of cash the developer can receive tax free is limited to 20% of the fair market value of the project at time of contribution. However, there is no cap on reimbursement if the project is worth no more than 120% of the “tax basis” that the developer has in the project at time of contribution.
The IRS said in new regulations in early October that whether there is a cap on reimbursement, and how much, will have to be determined on a “property-by-property basis.”
The regulations do not explain how to break down a wind, solar, geothermal or other power project into separate properties. The IRS said in 2013 that a coal-fired power plant consists of 27 separate pieces of property. Examples of them are boilers, turbines, scrubbers, cooling water systems, condensers and continuous emissions monitoring systems.
The IRS also said in early October that it is studying whether the safe harbor is appropriate or should be eliminated. It asked for comments by January 3.
Things become complicated if there is already project debt when the partnership or joint venture is formed. In that case, the cash that the developer is considered to have been distributed may include part of the debt.
The developer could also be considered to have been distributed cash solely on account of the project debt, thus triggering a disguised sale, even if no cash is distributed.
Taking these situations one at a time, formation of the partnership will not be treated as a disguised sale of part of the project if there is project debt, but no cash is distributed and the debt is a “qualified liability.” Most debt should be a qualified liability.
Turning to the other case where there is project debt and cash is distributed, the developer is treated as having been distributed not only the cash, but also relieved of a share of the debt. The sum of the two can only reimburse the developer for capital spending on the project during the past two years and cannot exceed any cap on reimbursements.
Of how much project debt was the developer relieved? The answer is the amount of project debt that US tax rules treat as shifting to the money partner.
The disguised sale rules require a special calculation. In most cases, the money partner will be treated as having assumed its profits percentage: the share of income it will be allocated times the principal amount of the debt. However, the developer can claim less debt was shifted under an alternative formula. The alternative formula is to divide the actual cash the developer was distributed by the equity value the developer has in the project. The equity value is the fair market value of the project minus the project debt.
Any use of the pre-formation expenditure safe harbor must be reported to the IRS. Any claim that project debt is a “qualified liability” must also be reported.
The new rules apply to property transfers on or after October 5, 2016. Thus, a new tax equity partnership formed on or after October 5 will be affected.
Sometimes a partnership borrows more money to fund a cash distribution to the developer. The cash distribution must be taken into account in determining whether there was a disguised sale of part of the project by the developer to the partnership. However, the developer is not treated as receiving the full cash. Its cash distribution for this purpose is only the cash that exceeds the developer’s share of the new debt used to fund the distribution.