Tax equity and construction delays

Tax equity and construction delays

June 23, 2022 | By Keith Martin in Washington, DC

The tax equity market is wrestling with a series of issues tied to inflation and construction delays.

Developers form a separate special-purpose project company to own each project. Most renewable energy tax equity is raised in partnership flip transactions.

In the typical solar tax equity transaction, the developer sells the project company to the partnership once the project has reached mechanical completion, but before any part is placed in service, for the appraised value the project is expected to have at the end of construction. The partnership assumes any outstanding construction debt and the obligation to pay any remaining amounts owed to contractors.

Some projects are coming in at lower appraised values this year than the projects cost to construct. That’s because inflation and construction delays are pushing up construction costs while the expected revenue under long-term offtake contracts remains unchanged.

In such situations, the developer may contribute the project company to the partnership — rather than sell it — in order to preserve the ability to use the construction cost as the tax basis for calculating tax benefits.

The partnership will have a “built-in loss,” meaning it will have a higher tax basis than the project is worth.

US tax rules require that the tax depreciation on the built-in loss basis must remain with the developer.

The question is what happens to the investment tax credit.

The Internal Revenue Service says the built-in loss ITC must be allocated to partners in the same ratio as the investment credit on the rest of the project. Thus, 99% of the full ITC — including on the built-in loss — should be allocated to the tax equity investor.

The IRS declined in May to issue a private letter ruling to that effect on grounds that the law is clear. The IRS does not issue “comfort rulings” that repeat what is already clear, it said.

A related issue is what happens if the power contract is amended later to increase the electricity price.

In the typical solar tax equity deal, the investor funds 20% of its investment when the project reaches mechanical completion. The other 80% is funded when the project is completed.

Many developers are trying to renegotiate power contracts to increase the electricity price to reflect higher than expected costs.

In cases where this happens during funding, developers are asking for an adjustment to the purchase price the partnership paid for the project company. Tax equity investors are being asked to invest more to reflect the higher value.

Some tax equity investors cap the amount of “step up” in tax basis they are willing to accept above the actual cost to construct at 15% or 20%. A current issue in deals is whether the investor should allow a higher step up to reflect the additional value tied to the improved power contract.

Higher costs are also creating difficulties for developers who relied on the 5% test to start construction. The tax credits are phasing out. The amount of tax credit for which a project qualifies depends on when construction started.

One way to start construction is to “incur” at least 5% of the total project cost before the deadline. Some developers who incurred more than 5% of the expected project cost are finding, several years later, that escalating construction costs are making the incurred costs fall short of 5%.

An IRS notice explains what happens in such a case. If the project can be broken into separate parts — like individual turbines in a wind farm or separate circuits or blocks in a solar project — then the developer can multiply the costs incurred before the construction-start deadline by 20 and however many turbines, circuits or blocks it can fit inside such a 20-times circle qualify for the tax credit.

Some developers look for spare equipment whose costs were incurred in time to move to the project with the shortfall.

That said, tax equity investors report they are seeing few projects today start construction under the 5% test. Most projects claim to have been under construction based on limited physical work before the deadline on the main step-up transformer.

Another common problem is delays are pushing parts of projects into another tax year. For example, part of a wind or solar project may be completed in year 1 and the rest is not finished until year 2. The big tax equity investors report that anywhere from 25% to 40% of 2022 projects are at risk of slipping at least partly into 2023.

In some cases, the tax equity investor may be confident of its ability to use tax benefits in year 1 but not year 2. In such cases, a second tax equity investor may be found to claim the year 2 tax benefits. The challenge is the investment tax credit must be shared by partners in the same ratio they share in “general profits” or income. The investment credit claimed by the first tax equity investor in year 1 risks being recaptured if that investor’s share of income drops by more than a third in year 2. Partnerships are dealing with this problem by treating the different parts of the project that were completed in year 1 versus year 2 as two separate businesses and keeping two sets of books, even though everything is in a single partnership. IRS regulations allow such an approach.

A related challenge is that a tax equity investor who invests only 20% of its total investment in year 1 may not have enough capital account and outside basis — two metrics for tracking what the investor put into the partnership and can take out — to absorb the full year 1 tax benefits. This leads to an interim tax equity funding at the end of year 1 to push its capital account and outside basis high enough to absorb the year 1 tax benefits.