Utility tax equity partnerships
Utilities are financing solar projects in the tax equity market in a manner that produces enhanced benefits.
The Internal Revenue Service described two such transactions in a pair of private letter rulings that the agency made public in late July and early August.
In one of the cases, a utility signed a build-transfer agreement with a solar company to buy a solar project near the end of construction. Rather than buy the project directly, it assigned the build-transfer agreement to a tax equity partnership. The partnership will buy the project using capital contributed by the tax equity investor and the utility.
Around the same time, the utility will sign a long-term power contract to buy electricity from the project for monthly payments that are either a fixed amount per megawatt hour of electricity or a fixed monthly charge. The payments are a negotiated amount rather than the retail rates that the utility charges its ratepayers for electricity. The utility will resell the electricity to its ratepayers at the retail rates.
Tax equity accounts for roughly 35% of the capital stack in a typical solar tax equity partnership, plus or minus 5%. The rest is capital put in by the sponsor — in this case, the utility.
The structure produces two benefits for the utility.
First, the utility puts its capital contribution for roughly 65% of the project cost into rate base. Thus, this factors into the calculation of the retail rates it can charge ratepayers.
Second, it passes through to ratepayers as a purchased-power expense the amount it pays the partnership for the electricity.
Utilities have been asking the IRS to confirm that projects owned through such structures are not “public utility property.” Investment tax credits and accelerated depreciation are harder to claim on such property. Neither tax benefit can be claimed on such property if the owner is forced to pass through the value of the tax benefits to ratepayers more quickly than under a “normalization” method of accounting.
The IRS has confirmed in multiple rulings in the past two years that projects owned through tax equity partnerships are not public utility property. (For more details, see “Utility Tax Equity Structures” in the December 2019 NewsWire, “Solar Projects and ‘Public Utility Property’” in the October 2020 NewsWire and “Public Utility Property: More IRS Rulings” in the December 2020 NewsWire.)
IRS regulations treat a power plant as public utility property only if the rates at which electricity is sold are established or approved by a regulator on a rate-of-return or cost-of-service basis.
The IRS has focused in rulings on the intermediate sale of the electricity by the partnership to the utility and ignored the resale at regulated retail rates.
The most recent ruling is Private Letter Ruling 202131004.
Solar tax equity partnerships normally throw off net tax losses for the first three years due to accelerated depreciation.
A partnership cannot claim a net loss on sales of goods — including electricity — to a related party. A partner is considered related if it owns more than a 50% profits or capital interest in the partnership.
It is not evident from the ruling how the parties dealt with this “section 707(b) issue.”
Most sponsors (in this case, the utility) are careful to structure the offtake contract so that it is not a power contract. They make it a financial swap to put a floor under the electricity price to support the tax equity deal or a commission arrangement where the sponsor affiliate is paid a fee to sell the electricity for the partnership into an organized market, with the partnership keeping all of the revenue after paying a fee.
The IRS has explicitly declined to give any comfort on the issue in recent rulings.
If the utility pays a fixed monthly charge to the partnership instead of a per-MWh charge for the electricity, it might turn the power contract into a lease in substance of the power plant to the utility. A power plant leased to a utility is considered public utility property or not based on whether the lessee sells the electricity at regulated rates. That might be a problem in this case.
However, the ruling suggests a way past the section 707(b) issue for independent solar and wind companies. If the power contract is really a lease of the power plant to an independent generator, then there is no sale of goods by the partnership to a related party and no section 707(b) issue. The sponsor is merely renting the power project. The IRS uses a list of factors in section 7701(e) of the US tax code to assess whether a purported power contract is really a lease of the power plant.
In the other ruling, the utility did a more complicated transaction.
It plans to sign build-transfer agreements with multiple developers to buy the project companies and then liquidate them, taking ownership of the assets directly. It will then form two tiers of new entities: holding companies that will turn eventually into tax equity partnerships and multiple shell project companies below each of the holding companies.
According to the ruling, the utility plans to sell each set of project assets to a project company near the end of construction, although it is hard to understand why. Asset sales are difficult because they require assigning contracts. They may also trigger sales taxes that could be avoided by selling a project company.
The utility plans to have each project company sell the electricity from its project into an organized spot market and buy back the electricity it needs to supply ratepayers in the same spot market at market prices, but the timing and quantity of its electricity purchases will be determined by customer demand rather than the solar output from the projects.
The IRS ruled that the projects will not be “public utility property.” The electricity from the projects is not sold at regulated rates.
The utility plans to put its capital contributions for a share of project cost into rate base. It plans to recover the amounts it pays in the spot market to buy electricity as a purchased-power expense directly from ratepayers. The utility will reduce its “cost of service” by the cash it is distributed by the partnership.
There is no section 707(b) issue with the structure because the partnership will not sell any electricity to the utility.
The utility asked the IRS to rule that the projects will not be public utility property. The IRS said they are not such property in the hands of the tax equity partnerships, but that the analysis must also be done at the partner level if the partnerships are able to elect out of partnership status so that each partner is treated as owning an undivided interest in the projects.
The utility represented to the IRS that no such election is possible.
An election is usually permitted where each partner is distributed its share of the electricity in kind to dispose of separately.
The ruling with the more complicated fact structure is PLR 202130005.