Right-side, left-side issues in tax equity deals
Right-side, left-side issues are getting more attention in tax equity transactions.
It is common in partnership flip transactions involving solar and other renewable energy projects on which investment tax credits will be claimed for the developer to sell the project company to a tax equity partnership, when the project reaches mechanical completion, for the appraised value the project is expected to have at the end of construction.
The partnership uses its purchase price as the starting point for calculating the investment tax credit and depreciation on the project.
In many such transactions, the parties have a single loan agreement for the construction loan, a tax equity bridge loan and the back-levered term debt to which the construction loan will convert at the end of construction.
The developer entity that will sell the project company to the tax equity partnership, and the affiliated developer entity that will be the “class B member” in the tax equity partnership, are sometimes co-borrowers of all the debt during the construction period.
In addition, the parties sometimes treat all of the assets on both the right side of the structure — meaning the developer entity that will sell the project company to the partnership near the end of construction — and the left side — meaning the class B member and tax equity partnership — as one big package of assets that is pledged as collateral to support the construction and tax equity bridge loans, as if there were not two separate sides to the structure.
This is not the best approach.
The project company or development company that owns it should be the borrower of the construction and tax equity bridge debt without the class B member also being a co-borrower.
The lenders will not want to make a tax equity bridge loan to the project without a commitment from the tax equity partnership to buy the project and by the class B member and tax equity investor to make capital contributions to fund the purchase price.
The tax equity partnership should be a party to an equity capital contribution agreement, or ECCA, with the class B member and tax equity investor requiring them to make capital contributions, provided a series of conditions precedent are satisfied.
The tax equity partnership should pledge the ECCA as collateral to secure its obligation under a separate membership interest purchase agreement, or MIPA, to buy the project company. The seller can then pledge the security interest in the ECCA in turn to the lenders. The class B member and tax equity investor should acknowledge the pledge and the ability of the lenders to enforce the capital contribution obligations.
When the project company is sold, the tax equity partnership will have a tax basis for calculating tax benefits equal to the sum of three things. It will pay part of the purchase price in cash. It will be treated for tax purposes as assuming the construction and tax equity bridge debt. It will take the project company with an obligation to pay the construction contractor the remaining amounts owed under the construction contract. The cash portion of the purchase price is the appraised value minus the debt assumed and the remaining amount that will have to be paid to the construction contractor.
If the seller remains liable on the construction and tax equity bridge loans after the sale, this calls into question whether the debt was really assumed by the tax equity partnership when the project company was sold. It is like buying a house that is subject to a mortgage. If the buyer assumes the mortgage, that is considered part of its purchase price. If the seller remains liable on the mortgage, the debt may not have been assumed.
It is helpful if the entity selling the project company is a real development company. It is helpful if it uses the cash portion of the purchase price to fund development spending on other projects that it has under development.
Some tax counsel prefer that the seller agree to cover any cost overruns on the construction contract above the remaining amount owed when the project company is sold. This helps to justify any premium the partnership pays above the bare cost to construct the project.
Some tax counsel prefer that the partnership pay the full cash portion of the purchase price when the project company is sold at mechanical completion using capital contributed by the tax equity investor.