California Ridge: Developer fees struck down - again
Developer fees in renewable energy projects took another blow on May 21 after a US appeals court declined to overrule a lower court that barred developer fees paid to related parties from being added to the tax bases of two wind farms.
The market had already been moving away from such developer fees before the lower court decision last summer.
The case is California Ridge Wind Energy, LLC v. United States.
While developer fees paid to a related party remain permitted in theory after the decision, the developer had better be able to prove both that the resulting tax basis is no greater than the fair market value of the project and that the fee is appropriate compensation for the specific services provided. The funds used to pay the fee should also come from a tax equity investor or lender rather than cash circled by the developer to pay itself.
People use “developer fee” to refer to different things. The classic developer fee is where a developer is paid a fee by the project company at the end of construction as a reward for bringing the project to fruition.
The term is also sometimes used to refer to the profit that a developer earns on a project by selling the development rights or the completed project. (For an explanation of the different ways the industry uses the term developer fee, see "Developer Fees" in the March 2011 Project Finance Newswire, and “Project Finance Developer Fees Explained” in Tax Equity News, November 25, 2014).
Invenergy developed two wind farms in central Illinois called California Ridge and Bishop Hill. Both projects were completed in 2012. California Ridge had been under development since 2008. Bishop Hill had been under development since 2005.
Invenergy formed a partnership with US Bank, as a tax equity investor, to own the two project companies that each owned one of the projects.
Each project company paid an Invenergy affiliate a classic developer fee at the end of construction that the project company then added to its tax basis in the project.
At the time, owners of new renewable energy projects had the option to receive a cash payment from the US Treasury for 30% of the tax basis, generally meaning the cost, of the generating equipment in lieu of claiming tax credits. The payments were made under a so-called section 1603 economic stimulus program.
The developer fee on the California Ridge project was $50 million, or 12.3% on top of construction cost. It was $60 million in Bishop Hill, or 16.1% on top of construction cost.
The Treasury paid the project companies smaller cash grants than requested. It allowed developer fees of 4.6% of construction cost on California Ridge and 3.9% on Bishop Hill.
Invenergy sued for the difference.
The government then filed a counterclaim urging the court to deny any developer fee. (For earlier coverage of the case, see “Treasury Cash Grant Update” in the February 2016 Project Finance NewsWire, “PPAs and Developer Fees” in the February 2018 NewsWire, “Court Finds Related-Party Developer Fee Lacks Economic Substance” in June 2019, and “Developer Fees” in the August 2019 NewsWire.)
The lower court decided for the government. It said that developer fees are allowed to be added to tax basis, but the fees in this case were little more than circled cash and lacked substance.
The US appeals court agreed.
Invenergy faced an almost impossible burden because of the way the appeals court framed the issue. The court said it would limit its review to whether the developer fees claimed were a “reliable indicator of the true development costs” for the wind farms and then only overrule if the lower court reached a “clearly erroneous” conclusion. It did not, the appeals court said. Invenergy might have fared better if the case had turned on how to interpret the law rather than how the lower court viewed the facts.
Both courts found several faults with the particular fees.
Each fee was little more than a “round-trip transaction in which the funds left from and returned to the same pocket on the same day,” the appeals court said. Invenergy made a capital contribution to each project company that the project company used to pay Invenergy the fee.
The courts said the fees were not tethered to the actual services provided. Each fee appeared to be the difference between the actual cost to construct and what an appraiser said was the fair market value of the project at the end of construction.
Each project company signed a development services agreement with an Invenergy affiliate, but not until 2011 or 2012 when the project was already near or under construction. Each agreement described the services to be provided in general terms – for example, negotiation of the project contracts and financing terms. The courts said it was hard to tie the fee paid on each project to the actual services provided. The appeals court suggested the development services agreements should have been signed before the services were “substantially completed.”
Deloitte attested that the developer fees were appropriate to include in tax basis and were consistent with fees paid in other projects. The appeals court said it would have been more helpful if the accounting firm had dug into the numbers and confirmed that they “accurately reflected the value of the premium on development work.”
Developers can draw a number of lessons from the decision.
There is a danger of coming out in a worse position than before by suing the Treasury for a cash grant shortfall.
Any developer fee paid by the project owner to a related party should be paid out of capital contributed by the tax equity investor or remaining construction loan proceeds at the end of construction: for example, as a reward for bringing the project in under budget. That said, the appeals court said there is “not a general bar to properly valued transactions within the Invenergy family.”
The amount should reflect the capital the developer had at stake and the time and difficulty it took to develop the project. The Treasury suggested in 2010 that developer fees should not normally exceed 10% to 20% of the cost of a solar project, but quickly backed away from that number, coming eventually to believe that such fees should normally be in the 3% to 5% range absent unusual circumstances. The appeals court accepted the range of 10% to 20%, but suggested the markup still had to be commensurate in amount with the value of the development services.
Developer fees have been less common in the last two years. Much of the market had already moved by the spring 2018 to sales of project companies as a better way to step up tax basis. The sale of the project company avoids two issues that troubled the courts in the Invenergy case: the sale agreement, unlike a development services agreement, does not have to be signed in advance of the development of the project and there is no need to prove a fee is fair value for specific services.
Inverted leases have also made a comeback in the solar market. In one version of an inverted lease, the tax equity investor leases the project from the sponsor; the sponsor keeps the depreciation, but makes an election to let the lessee claim the investment tax credit on the project. IRS regulations allow the tax credit to be claimed in such cases on the fair market value of the project, although no party to the transaction in fact paid that amount.
The decision reinforces the trend toward sales of project companies to tax equity partnerships (rather than use of developer fees).
It does not create any negative implication for true third-party developer fees: for example, where a big developer who has taken over a project from a smaller developer pays the latter a fee or additional purchase price when the project reaches financial closing.