Opportunity zones and renewable energy
Opportunity zones have been something of a disappointment so far to renewable energy developers. Developers have been looking at them as a possible way to raise equity for their projects.
The US government made a limited-time offer in the tax reform bill at the end of 2017 to investors sitting on assets that have appreciated in value. The offer has two parts.
Part one is if an investor will sell assets and reinvest the capital gain in a business in a low-income area called an “opportunity zone,” then taxes on the asset sale can be deferred until the end of 2026. When the taxes are ultimately collected, the government will tax only 90% of the reinvested capital gain if the new investment in the opportunity zone has been held, by 2026, for at least five years, and it will tax only 85% of the reinvested capital gain if the new investment in the opportunity zone has been held, by 2026, for at least seven years. Thus, the investment in the opportunity zone would have to be made by the end of 2019 to get the maximum benefit from this part of the offer.
Part two of the offer is if the new investment in the opportunity zone is held for at least 10 years, then the government will not tax the gain on the new investment when it is sold.
Renewable energy developers have viewed this as presenting two opportunities.
One is a chance to raise equity more cheaply from investors with big capital gains from recent asset sales. An investor must reinvest the capital gain within 180 days in an opportunity zone fund that invests, in turn, in businesses in opportunity zones.
The other opportunity may be for renewable energy developers who have sold projects, including into tax equity vehicles at a gain as a way of stepping up the tax basis for investment credit purposes, to defer tax on the gain by plowing the money, within 180 days, into another project the developer has under development. However, the sales would have to produce capital gains rather than ordinary income for there to be any capital gain to reinvest. Developers may be considered to be selling inventory, which produces ordinary income.
Opportunity zones are low-income areas. State governors had until April 20, 2018 to nominate areas within their states to be designated. In all, roughly 8,700 such zones have been designated, or 12% of US Census tracts. Renewable energy projects tend to be in rural areas that are often opportunity zones. A comprehensive list of all the designated zones can be found at www.cdfifund.gov/Pages/Opportunity-Zones.
The Internal Revenue Service issued proposed regulations in October 2018, and then updated them in April 2019, to fill in detail about how the zones are supposed to work. The regulations are dense and full of traps not only for the unwary, but also for the wary. Tapping into opportunity zone funding for a renewable energy project is like trying to navigate through an intricately constructed maze. The zones work best for real estate projects. They are harder to make work for investments in operating businesses. Twenty opportunity zone funds have announced plans to raise funds to invest at least partly in renewable energy projects. To date, none of them appears to have closed on such an investment.
Into the Maze
There are four main impediments for renewable energy projects to take advantage of opportunity zone funding. Some additional guidance would be helpful from the IRS.
Renewable energy projects are owned by legal entities.
An investor who has just sold assets at a gain has 180 days to invest the gain in a fund that, in turn, invests the money into businesses in opportunity zones. Almost by definition, since any investment in a renewable energy project will be made alongside the sponsor in a legal entity that owns the project, the investment will be considered to have been made in a “fund.” The fund must be certified as a “qualified opportunity fund” when the investment is made.
Funds self-certify by filing a Form 8996 with the IRS. The form is filed with the fund’s tax return for the first year the fund will be a qualified fund: for example, in 2020 for a fund that will first qualify in 2019.
The fund can specify the first month it wants to be considered a qualified fund. A clock then starts to run on when the fund must pass a 90% assets test. This is the first difficult turn in the maze.
At least 90% of the fund’s assets must be “qualified opportunity zone property” or “QOZ property” each tax year.
There are generally two test dates each year for determining compliance with the 90% test: June 30 and December 31 for a fund using a calendar tax year, and the results on the two dates are averaged. However, unless the fund declares itself qualified as of January 1 of a year, its first year will have less than 12 months. In that case, the first test date is six months after the first day the fund considers itself qualified or, if shorter, whatever time is left in the first tax year. If there is room for a second test date the first year, it is the last day of the year.
The fund can choose what date it wants to declare it is qualified. However, once it does so, it has six months to pass a 90% assets test. It must specify a date no later than when it takes the investor’s money.
A major issue is that cash being held for use in a project still under development will generally count as a bad asset under the 90% test. However, if the fund invests the money into a subsidiary partnership or corporation, instead of developing the project directly, then this will buy up to 31 months to expend the cash without it counting against the 90% assets test in the meantime.
Therefore, assume the fund will interpose a partnership between itself and the project. This will let the fund treat the partnership interest as QOZ property on each six-month test date if three things are true.
First, the fund must acquire the partnership interest solely in exchange for cash. It should make a cash contribution to the partnership for an interest rather than pay the sponsor for an interest. The problem with paying the sponsor is this is treated for tax purposes as the purchase of an undivided interest in the project assets and contribution of that share of the project assets to the partnership in exchange for an interest in the partnership. In other words, the fund may not have acquired its partnership interest solely for cash.
Second, the partnership must be a “qualified opportunity zone business” or “QOZ business” when the fund acquires an interest in the partnership “or, in the case of a new partnership, the partnership was being organized for purposes of being a qualified opportunity zone business.” The partnership can buy time, if it is not already in business, by having a detailed “written schedule” for getting to QOZ business status within 31 months.
Finally, during at least 90% of the period the fund owns an interest in the partnership, the partnership must actually be a QOZ business. The fund can buy time by having a detailed written schedule for getting to a QOZ business status within
Diving Below the Partnership
Consider a simplified example where the first-tier partnership is the sole asset of the fund. The fund has to satisfy a 90% assets test within six months. The partnership interest is a good asset if the interest in the partnership is acquired solely for cash and the partnership has a plan to become a qualified opportunity zone business within 31 months.
What does it take to be a QOZ business by the end of the 31 months?
The partnership must have jumped through a series of hoops.
First, it must pass a tangible assets test.
At least 70% of its tangible assets must be acquired from third parties that are unrelated to the partnership. Two parties are related if there is more than 20% overlapping ownership. Thus, using a related construction contractor to build the project may be a problem.
The challenge is even greater because the fund cannot have tiers of partnerships below it. Therefore, the partnership immediately below the fund must also act as the tax equity partnership if the renewable energy project will be financed in the tax equity market. In solar tax equity deals, the project company is often sold to the tax equity partnership for the appraised value as a way of stepping up the tax basis for calculating the investment tax credit. Any such sale would have to be by someone who will not have more than a 20% interest in the partnership.
There are still more requirements to pass the tangible assets test. The project must be brand new when the partnership puts it into service. At least 70% of the equipment and other tangible property owned by the partnership must be used in the zone during at least 90% of the period the partnership owns them. Also, the partnership cannot have an option to buy any site it leases for a fixed price, and any site lease must have arm’s-length terms.
Next, the partnership must pass a 50% gross income test each tax year. The partnership cannot wait until the end of the 31 months to start passing it.
At least 50% of the partnership’s gross income each tax year must be earned from the “active conduct of a trade or business” by the partnership inside the zone.
When the first set of IRS regulations was issued in October 2018, they did not seem to leave room for businesses to qualify that make goods inside the zone and sell them outside. The income in such cases may have been considered earned outside the zone.
The April 2019 regulations tried to address this problem, but issues remain when it comes to utility-scale power projects.
There are three “safe harbors” that can be used to demonstrate that at least 50% of gross income is earned in the zone. The first two treat income as earned inside or outside the zone based on where the work is done to earn the income. Safe harbor #1 looks at the division of compensation to employees and independent contractors who help with the project inside and outside the zone, and safe harbor #2 looks at the breakdown of hours. These safe harbors may be hard to meet where company management and the lawyers, permitting specialists, independent engineers and other consultants who work on the project are outside the zone.
Under safe harbor #3, the 50% gross income test is met if the “tangible property [located] and the management or operational functions performed” in the zone are each necessary for generating at least 50% of gross income. This is another place where more IRS guidance would be helpful. It is unclear whether the word “operational” is offered as a synonym for management or as a separate category and, if the latter, what the IRS has in mind.
Some tax equity deals in the solar market are structured as inverted leases. In that case, the partnership immediately below the fund would lease the project to a tax equity investor. The partnership would make an election to pass through the investment tax credit to the tax equity investor as lessee.
It is not clear whether the lease can be a traditional “triple net lease,” meaning a lease where the lessee is responsible for maintaining the project, buying casualty insurance and paying property taxes during the period the lease is in place.
The proposed IRS regulations say that merely entering into a “triple net lease” of real property to a third party is not the active conduct of a trade or business by the lessor partnership in the zone. Some counsel recommend making the inverted lease into the equivalent of where someone leases a car and driver rather than just the car. This will convert the lease from a triple net lease into an operating lease, but also create tension with a tax equity investor as to whether it has enough risk to be a true lessee of the solar project. The tax equity investor must be a true lessee to be able to claim the investment tax credit on a project.
There is still more to be done by the end of the 31 months.
Third, the partnership must be in a position by the end of the period to pass a 40% intangibles use test.
The partnership must use at least 40% of its intangible property inside the zone. Power contracts are intangible property as is software in computers, outside the zone, for monitoring and operating the equipment inside. It is not clear where a power contract is considered used if the power is delivered to a point of interconnection with a utility offtaker outside the zone.
Fourth, the “nonqualified financial property” owned by the partnership cannot amount to 5% or more of its assets by “unadjusted asset basis.”
This is measured by looking at what the partnership paid for the assets. Partnership interests and forward contracts are considered nonqualified financial assets. (A power contract is a forward contract.) Therefore, as a practical matter, the first-tier partnership cannot own an interest in another partnership, and the amount it is considered to have paid for a power purchase agreement and other financial instruments cannot amount to 5% or more of the total amount paid to buy the project rights plus build the project.
The first-tier partnership must have a “written schedule” for spending its “working capital” — cash — on getting to a position, within 31 months, where it will pass the tests to be a QOZ business.
The schedule must be a detailed plan showing what will be acquired with the cash. The cash must be used in a manner “substantially consistent” with the schedule.
Notwithstanding the 31 months, the partnership must pass the 50% gross income test in each tax year, including year 1. However, the partnership gets a pass during the 31 months on use of at least 40% of its intangible assets in the zone. It also gets to ignore the cash it plans to spend under the schedule in applying the 5% limit on “nonqualified financial property.” (Cash beyond the amounts that the partnership plans to spend under the schedule is nonqualified financial property.) Finally, during the 31-month start-up period, the assets contemplated by the written expenditure schedule count toward the 70% tangible assets test even if expenditure has not yet occurred.
The IRS has made tapping into opportunity zone dollars complicated.
Probably the biggest challenge is that it is not clear whether a partnership owning a utility-scale renewable energy project can pass the 50% gross income test. It is unclear whether a wind or solar project that brings development, but few jobs other than construction labor, to a zone is consistent with what the IRS is trying to encourage.
Moving back up to the fund level, once a fund declares itself qualified, failure to pass the 90% asset test by the next six-month test date will subject the fund to a significant penalty: each month during which a fund was self-certified as qualified will be scrutinized to determine the amount by which the fund fell below the 90% standard, and this amount will be multiplied by 3% plus the federal short-term interest rate for each shortfall month. The penalty is currently 5.35%. On top of the penalty, a fund could owe an indemnity to investors for lost tax benefits if it incorrectly self-certified, depending on what representations are made to the investors. These challenges have made the market slow to take the plunge.
There has been a debate among potential fund investors about whether choosing tax deferral is sensible since tax rates may be at a low. Rates could increase in the next Congress if the Democrats win the 2020 elections. They could increase by 2026, even if Republicans retain control of the Senate or White House, because of the ballooning federal budget deficit.
Because of the delay getting the concepts ironed out, the Senate sponsors of the opportunity zone provision are now urging Congress to push back the 2026 date when deferred taxes come due. There will not be enough time for anyone investing after 2019 to have held an opportunity zone investment for at least seven years to qualify to be taxed on only 85% of the invested deferred gain.