Tax change risk in tax equity deals
A review of 16 renewable energy tax equity deals since tax change risk became a major concern for tax equity investors after President Trump was elected shows that there is a common set of issues, but the market is all over the map on how it addresses them.
In the meantime, the likelihood that Congress will be able to pass a tax reform bill this year is receding quickly. White House economic adviser, Gary Cohn, said on June 2 that the Trump administration plans to submit a detailed tax plan to Congress in early September after spending the summer working with Republican leaders in the House and Senate in an effort to come up with a common plan that can clear both houses.
The last major tax overhaul in 1986 took 13 months from when the House tax-writing committee started voting on a detailed plan and when the bill was signed by the president.
There may be some further evolution in how tax equity deal papers deal with tax change risk if it becomes clear that tax change risk is a 2018 or later problem.
Thirteen of the deals were partnership flip transactions. One has a fixed flip date. The others flip when the tax equity investor reaches a target yield.
Three of the deals are sale-leasebacks of utility-scale solar projects.
All of them make it a condition to each funding by the tax equity investor that there has not been a material adverse change in tax law before the funding. Most make it a condition that there has also not been a material adverse proposed change in tax law.
How early in the legislative process a proposal can be an excuse not to fund varies. All the deals pick up a proposal after it has been reported by either tax-writing committee in the House or Senate. Most pick it up at the point it is proposed by the chairman of either tax-writing committee. Some go earlier in the process and pick up proposals by the Trump administration. Some pick up a proposal in an executive order, a budget resolution or formal administration or leadership proposal. None treats a tweet or the one-page tax “plan” the administration released to great fanfare in late April as a tax reform proposal.
Most make it a condition to use a proposal as an excuse not to fund that the proposal must be reasonably likely to be enacted. Others say a proposal cannot be used as an excuse not to fund if “it is reasonably clear it will not become law.” Another variation is that a proposal must be “not unlikely to be enacted.” There is no standard for determining whether this subjective element has been satisfied. Rather, the objective test of how far the proposal has moved in the legislative process acts as a check on what is considered a proposed change in tax law for purposes of the tax equity papers.
In many deals, a proposed or actual change in tax law is not an excuse to stop funding if it can be reflected in the pricing model.
Pricing and repricing
In all the deals, the pricing model is re-run before each funding to reflect actual changes in tax law and, in many cases, proposed changes.
Focusing on initial pricing, in close to half the deals the tax equity investor is already assuming a reduced corporate tax rate in the range of 20% to 28%. In some deals, the rate is assumed to be 35% in 2017 and 20% in 2018 and later years. In half the deals, the tax equity investor prices based on current law.
Wind deals are more likely to assume reduced rates. Solar deals are more likely to be priced at current tax rates. A panel of tax equity investors at the SEIA finance and tax workshop in New York in early June said that they are prepared to go either way based on the desires of the sponsor and other factors.
In many deals, there is a one-time repricing and the tax equity investor may be required to invest more if the final tax rate is higher than was assumed for initial pricing. The investor can almost always sweep cash to return any amount it over invested if the final tax rate is lower than originally assumed for pricing. In some deals, the transaction is re-optimized and the sharing ratios are adjusted before any cash sweep.
This repricing usually occurs when the current Congress ends at the end of 2018 or, if earlier, when a corporate tax reform bill clears Congress. In some deals, the model may be re-run through the end of 2019 or 2020. One tax equity investor is seeking tax-change protection for six years. The investor also takes into account in its original pricing a mixture of adverse tax law changes in different proposals. It can mix and match, choosing a combination of the most adverse proposals.
The repricing usually takes into account not only a change in tax rates, but also cost recovery and tax credits. Interest deductions are also in play in the current tax reform debate. Alternatively, the repricing may use any changes that improve the tax equity investor’s position as an offset against negative changes, but not as a basis for requiring the investor to make an additional investment.
Sometimes the original pricing remains unless the tax law changes are projected to delay the target flip date by more than three months or some other period.
In one deal that used current tax rates, the parties agreed to work in good faith to restructure the deal if tax rates are reduced by 10% or more post-funding. If sharing ratios cannot be adjusted enough for the tax equity investor to maintain its investment targets, then there may be a cash sweep to give the tax equity investor back the amount it overinvested. The sweep is usually a sweep of 100% of cash.
If a tax law change occurs after the final re-running of the model, then the flip date will be delayed or accelerated from what was anticipated. For example, a lower tax rate two or more years after closing is more likely to accelerate the flip date, especially if the tax equity investor has taken a depreciation bonus.
A cash sweep, adjustment to the cash sharing ratios or delayed cash flip can cause problems in a transaction where there is back-levered debt at the sponsor level. Some back-levered lenders have been requiring “cash diversion guarantees” from the sponsor’s parent to cover any reductions in cash flow to the sponsor member as a result of tax law changes. In some back-levered deals, sponsors are reserving the right to make capital contributions to the tax equity partnership for immediate distribution to the tax equity investor as a way of eliminating or reducing deferral of the flip date. At least one set of deal papers signed before the election was amended to allow for such a contribution by the sponsor and distribution to the tax equity investor.
In almost all of the deals, the tax equity investor takes a depreciation bonus to accelerate deductions into 2017 before tax rates change as a way of mitigating tax-rate-change risk. The math may not work in deals with portfolios of projects. Claiming a bonus on all the projects may push the capital account of the tax equity investor into deficit in year one, potentially causing tax credits to shift to the sponsor along with a share of the year-one losses. In some cases, a bonus is claimed on fewer than all the projects, as a way of avoiding this problem, by putting one or more of the projects in separate partnerships below the tax equity partnership.
Electing bonus depreciation can lead to loss absorption issues for the tax equity investor. Each partner in a tax equity partnership has both a “capital account” and an “outside basis.” These are two ways of tracking what the partner put into the partnership and what it is allowed to take out. When a partner’s capital account hits zero, then any further losses that would be allocated to the partner shift to the other partner. Taking the depreciation bonus causes a capital account to reduce more quickly. One solution in many tax equity deals is for the tax equity investor to agree to a deficit restoration obligation, or DRO. A DRO is a promise by a partner to contribute more capital to the partnership at liquidation if the partner has a deficit capital account. A partner is allowed to take losses up to the amount of its DRO after its capital account hits zero. DROs in the current market can hit 40+%.
In wind deals, pay-go structures are sometimes being used as a way to mitigate tax change risk. This means the amount the tax equity investor invests is tied partly to the tax credits it is allocated. IRS rules allow no more than 25% of the total tax equity investment to be tied to tax credits or output. In at least one deal, the tax equity investor must make pay-go payments after the flip date if the flip date occurs before the 10-year period for production tax credits has run. This is a way of addressing the potential for tax law changes to leave the tax equity investor with a windfall. In other deals, use of a pay-go structure may be a way for the investor to defer part of its investment until the tax law is clearer.
In two deals, the sponsor must indemnify the tax equity investor for tax law changes through the end of 2018. The indemnity is sized to refund to tax equity what would have been an overinvestment by it if the tax law changes had been taken into account when the initial pricing model was run.
In partnership flip transactions, there is a list of “fixed tax assumptions” that are used for tracking when the investor reaches its flip yield. It was almost always a fixed tax assumption in the past how depreciation is calculated in the base case model. In many of the latest deals, depreciation is no longer a fixed tax assumption or, if it is, it is a fixed tax assumption only as long as the depreciation rules are not changed.