Another utility tax equity structure
A utility structure for raising tax equity solves a so-called section 707(b) issue with some utility tax equity partnerships.
Utilities want to raise tax equity on renewable energy projects and keep the electricity.
This can be a challenge because such projects usually throw off tax losses for the first three years due to accelerated depreciation. The US tax code bars claiming a loss on the sale of property to an affiliate. Electricity is considered property for this purpose.
A regulated electric utility formed a subsidiary to buy the development rights to a large solar project from an independent solar developer. The developer sold the utility the project company with the development rights and was then hired back by the utility to finish development and oversee construction.
The subsidiary plans to resell the project company near the end of construction to a separate partnership between the regulated utility and a tax equity investor.
The utility opted to treat the subsidiary that bought and will resell the project company as a corporation for US tax purposes. The regulated utility interposed a partnership between itself and the tax equity partnership as part of a strategy to step up the tax basis used to calculate the investment credit and depreciation on the project at the end of construction.
The tax equity partnership will allocate the tax benefits disproportionately to the tax equity investor. After the investor reaches a target yield around year eight, its economic interest will flip down to 5% and the utility will have an option to buy the investor’s post-flip interest for the fair market value at the time.
The project is in an organized market. MISO operates the transmission grid. The project company will sell the electricity from the project to the grid at spot prices. The utility will buy an equivalent amount of electricity from the grid.
Meanwhile, the utility will enter into a swap with the tax equity partnership where it pays the partnership a fixed price for a notional quantity of electricity that is expected to mirror the actual output in exchange for the floating revenue the project company receives on the same notional output. The utility will also pay the partnership for the renewable energy credits and zonal resource credits — RECs and ZRCs — to which the project company is entitled at current market prices.
At the end of the day, the utility will end up effectively with the electricity from the project for a fixed price. The floating revenue it receives from the project company should cover what the utility has to pay the grid for electricity.
The Internal Revenue Service blessed the structure in a private letter ruling made public in early February. The ruling is Private Letter Ruling 202205002.
Partnership-flip transactions raise several issues for utilities.
One is any investment tax credit on the project becomes harder to claim if the project is considered “public utility property.” A project is public utility property if the electricity is sold at rates that are established or approved by a utility commission on a rate-of-return or cost-of-service basis.
The IRS has confirmed multiple times in the last few years that projects owned by regulated utilities indirectly through partnerships are not public utility property as long as the electricity is sold at a negotiated or spot market price. (For earlier rulings, see “Utility Tax Equity Structures” in the December 2019 NewsWire, “Solar Projects and ‘Public Utility Property’” in the October 2020 NewsWire, “Public Utility Property: More IRS Rulings” in the December 2020 NewsWire, and “Utility Tax Equity Structures” in the August 2021 NewsWire.)
The other issue has been more difficult. Tax losses cannot be claimed on property sold to an affiliate. Independent generators using partnership flips to raise tax equity usually get around this issue between selling the electricity to the grid and acting as an agent to place the electricity for the partnership or, in cases where the tax equity investor requires a floor be placed under the electricity price, by entering into a swap to put such a floor in place, at least during the first few years until the project turns tax positive.
Many tax equity partnerships lately have been electing 12-year straight-line depreciation that may leave the partnership without net losses in any year.
Unlike a utility, independent generators do not need to keep the electricity. The ruling is a roadmap for utilities for how to keep the electricity.
The IRS suggested in its latest priority guidance plan last fall that it is revisiting loss disallowances in cases where a partnership sells property to an affiliate.