Utility tax equity structures
A tax equity partnership between a regulated utility and a tax equity investor received a partial blessing from the IRS.
Utilities are looking for ways to finance renewable energy projects in the tax equity market without turning the projects into “public utility property.”
Investment tax credits and accelerated depreciation cannot be claimed on “public utility property” unless the state utility commission refrains from forcing the utility to pass through these tax benefits to ratepayers more rapidly than under a “normalization” method of accounting.
Tax equity investors would rather not deal with such complications.
The IRS released a private letter ruling in late November describing a proposed transaction. The ruling is Private Letter Ruling 201946007.
A regulated utility agreed to buy a wind farm from an independent developer. The developer plans to build the project and then sell it to the utility under a build-transfer agreement. The utility is part of a group of regulated electric and gas utilities under a common holding company operating in multiple states.
The utility plans to form a partnership with a tax equity investor. The sale under the build-transfer agreement will be of the special-purpose project company that owns the wind farm. The developer will sell the project company to the tax equity partnership directly.
The project company has a long-term power purchase agreement to sell electricity from the wind farm to the utility that it won in a competitive bidding situation, presumably in response to the utility’s request for proposals from private generators. The project company will have market-based rate authority from the Federal Energy Regulatory Commission to sell at the prices in the power contract.
The utility will resell the electricity to its ratepayers. The ruling is silent about whether the utility will put its investment as a partner in the tax equity partnership into rate base. Presumably the price it pays under the long-term PPA will simply be passed through to ratepayers as a purchased power expense.
The utility will have an option to buy the tax equity partner’s interest in the partnership for fair market value after a future flip date.
The utility asked the IRS for two rulings.
The tax equity partnership will claim two tax benefits on the wind farm: production tax credits on the electricity output and accelerated depreciation. Production tax credits are not affected by whether a project is public utility property. Accelerated depreciation is affected.
The IRS said the project will not be “public utility property.” A project is public utility property if the rates at which electricity from the project is sold are set on a rate-of-return basis. The IRS said no purpose would be served by requiring normalization accounting for the partnership to claim accelerated depreciation in this case since the project company selling the electricity will not be subject to rate-of-return regulation.
The IRS declined to give the utility the other ruling it wanted.
A partnership that owns a wind farm will usually have net losses due to depreciation for roughly the first three years after the project is first placed in service. Section 707(b) of the US tax code does not allow the partnership to claim a net loss to the extent the electricity is sold to an affiliate. A partner who owns more than a 50% profits or capital interest in the partnership is an affiliate.
The utility asked for a ruling that net losses can be claimed to the extent they are allocated to the tax equity investor rather than the utility partner. The IRS said it will not rule on “an issue that cannot be readily resolved before a regulation or any other published guidance is issued.”
The latest IRS priority guidance plan does not show it working on any guidance in this area.
One way to avoid the problem is to convert the power contract to sell electricity into a “virtual” PPA or swap rather than a contract for physical delivery for the period the partnership will run net losses. Section 707(b) disallows losses only on sales to affiliates.
The ruling that the wind farm will not be public utility property is consistent with other private rulings the IRS has issued in the past.
For example, earlier this year, the IRS ruled that a Utah utility did not have to treat a solar project as public utility property. The utility planned to buy the solar project from a private developer in a similar build-transfer arrangement. The project came with a long-term power contract to sell the electricity to a corporate customer. The power sales were at the rates negotiated by the solar developer directly with the corporate customer rather than at regulated rates set on a rate-of-return basis. (See “Solar Projects and ‘Public Utility Property’” in the June 2019 NewsWire.)
Separately, the IRS suggested in September that a regulated utility can pass through a form of accelerated depreciation called a “depreciation bonus” on a project to a tax equity investor by selling the project to the tax equity investor and leasing it back. A 100% depreciation bonus can be claimed on equipment put in service through 2022. The percentage bonus allowed phases down after that. A 100% bonus allows the owner to deduct the entire cost in the year the project is put in service.
A depreciation bonus cannot be claimed on “public utility property.”
Under proposed IRS regulations in September, a project sold to a tax equity investor in a sale-leaseback transaction will not be public utility property for depreciation bonus purposes, even though the user of the asset — the lessee — is a regulated utility. (For more information, see “Depreciation Bonus Questions Answered” in the October 2019 NewsWire.) This makes sense. The lessor is not subject to utility regulation, so there is no possibility of the regulators requiring the bonus claimed by it to be passed through to ratepayers.