By Eli Katz and John Marciano

The challenges are only just beginning for companies that were awarded $2.3 billion in tax credits in January as an inducement to build new factories to supply components for the “green” economy.

They must now move quickly to line up financing structures that will enable them to use the tax credits they were just awarded.

This will not be easy or cheap.

The tax equity market still has far more sellers than buyers, and conventional tax equity investors may be reluctant to finance manufacturing equipment with highly uncertain profit projections.

What Challenges?

Most tax credit deals have historically been done on fully-contracted assets where technology and asset performance risk were relatively low. Tax equity investors will now be asked to finance a new asset class: factory equipment with short-term or no customer supply contracts that are far more variable in pricing and terms than is typical in conventional project financing.

Nonetheless, companies with strong balance sheets should be able to attract tax equity investors into lease financing or other tax credit monetization structures if they can find ways to manage the key risks inherent in owning and operating manufacturing equipment.

The tax credits are found in section 48C of the US tax code. The owner of a new factory that makes wind turbine blades, solar modules, fuel cells or similar equipment can claim a credit against its federal income taxes for 30% of the capital cost. The credit is taken when the new factory is placed in service. Congress authorized $2.3 billion in such credits nationwide in an economic stimulus bill in 2009. The Internal Revenue Service made awards in January to companies who applied for them. The companies who received awards promised to build 183 new factories.

The awardees generally fall into three categories. The first are US multinational corporations with large projected tax liabilities. These companies may well decide to use the tax credits themselves to offset taxes that they would otherwise owe the government. A second subset of tax credit awardees are small companies, with little or no current or projected tax liability. This group will be looking to trade its tax credits for upfront equity but will likely struggle to do so because it will have to attract tax equity investors into complex financing structures where they have limited ability to protect against some key risks that these investors may be unwilling to bear. The tax equity market is likely to coalesce around the third group of tax credit awardees: those that have deep financial backing through private equity funds or foreign-based parent companies that have little or no use for the tax credits but are willing and able to use their balance sheets to wrap risks that are obstacles to raising tax equity.

Key Rules

The tax credit has many of the same features now familiar to developers and investors in projects that generate renewable power. The tax credit can be claimed by anyone who received an allocation of tax credits from the government and who owns or leases manufacturing facilities that will make components for a wide range of green projects. The credit is claimed on the cost of equipment for the factory, but not any building. It vests ratably (20% per year) over five years. The unvested portion of the credit must be returned to the government if the property is disposed of any time during the first five years after the factory starts operating. The credit may also be partially disallowed if tax-exempt entities lease the manufacturing equipment or take a stake in the manufacturing equipment or the entity that owns it.

When the owner of the manufacturing equipment claims the credit, it must reduce its tax basis in the equipment by the full amount of the credit. This leaves less basis to depreciate in the future. A key exception to this rule is when the credit is claimed by someone who merely leases the equipment rather than owns it. In this case, the owner (the lessor) is not required to reduce its tax basis because it is not claiming the tax credit; instead the lessee must pay tax on a stream of hypothetical income equal to the credit.  The income is claimed over the depreciable life of the equipment. For example, if the equipment has a 7-year depreciable life, and the tax credit is $1 million, then the lessee must report $1 million of income ratably over seven years.

Credit awardees must have executed an agreement with the IRS by March 15, 2010. Once the IRS countersigns and returns the agreement, the awardee has just one year to follow up with a certification showing that it has obtained all the key permits to move forward with the project. It then has three years to commission the factory or risk losing its tax credit allocations. In a recent notice, the IRS cautioned that it reserves the right to disallow tax credits if the applicant changes its plans in a significant way. Nonetheless, the IRS has indicated informally that it will not consider investment by a tax equity investor as a significant change in plans, although it will ask any new investor to sign off on the terms of the program.

Tax Credit and its Discontents

The government’s decision to give out tax credits to incentivize the building of the clean-tech supply chain was somewhat surprising in that it reverses a trend that saw green energy subsidies moving away from tax-based subsidies to cash-based subsidies. A recent example is the wildly successful Treasury cash grant program that temporarily replaced the investment and production tax credits as a means to subsidize renewable energy power projects. At last count, the Treasury had already given away nearly $3 billion in cash grants to hundreds of power projects built in the US.

A tax credit is a right to offset a tax that is otherwise owed to the government. A tax credit is almost always more valuable than a tax deduction because a tax credit reduces the amount of tax that is owed dollar-for-dollar, while a tax deduction simply reduces the amount of income on which the tax is charged. For example, if a company earns $4 and pays tax at a 25% rate, it will owe tax of $1.  A $1 tax deduction reduces income to $3, tax owed to 75¢, and is therefore worth 25 cents; a $1 tax credit on the other hand can be used to offset the $1 tax liability owed by the company and is therefore worth a full $1. In other words, the value of tax deductions depends on the tax rate while tax credits have full value regardless of the tax rate.

The awardees of the tax credits would have to earn over $6.5 billion in profit collectively to have a tax liability large enough to use the $2.3 billion in tax credits fully at current tax rates.

Incentivizing behavior by doling out tax credits is a poor policy choice because most tax credits suffer from three fundamental problems: they are not “refundable,” they are not easily used by anyone other than large corporations and they are not freely transferable.

Tax credits are not refundable in that they can be used only against a current tax liability; if you don’t owe the government any tax, then a tax credit has no immediate use to you. The government will not refund or “cash in” the tax credit. Also, strict limitations enacted in the 1980’s make it hard for individuals and most closely-held businesses and S corporations to use the tax credits. Lastly, tax credits cannot be transferred freely among taxpayers; you cannot sell a bundle of tax credits to a buyer for a lump-sum payment.

Monetization Strategies

Almost all tax credit monetization strategies rely on bringing an investor that can use the tax credits into the business or activity that produces the tax credits. The tax credits are diverted to the investor who accepts the credits as part or most of its return on its investment.

The three most common transaction forms that use this technique are partnership flip transactions, lease financings (often done as sale-leasebacks) and lease pass-through transactions.

There are two common themes in almost all tax equity deals. First, the tax equity investor is motivated primarily by the tax credits and, therefore, seeks to minimize its exposure to the commercial risks inherent in the activity that produces the credits. Second, the sponsor views the investor as mostly an accommodation party and, thus, tries to minimize the investor’s right to share in the upside potential of the business.

All government-sanctioned tax equity transactions put tension on these themes because they require (or should require) the investor to have meaningful equity exposure to either fluctuations in asset value or asset performance.

In a partnership flip transaction, the tax equity investor would purchase an interest in a limited liability company that owns the manufacturing facility. Almost all the economic returns (including the tax credits) would be paid to the investor until it achieves a hurdle rate after which its share of the deal economics would drop to as low 5%. In a flip transaction, the investor takes the risk that the equipment will produce enough revenue and tax credits to repay its investment.

In a sale-leaseback transaction, the investor takes title to the equipment and leases it to the sponsor in return for fixed or variable lease payments. The lease payments can be supported by the revenue from the leased equipment or they can be backstopped by a corporate credit and secured by assets other than the leased equipment.

The manufacturer’s obligation to pay rent is typically not dependent on the performance of the equipment or whether the revenue and expense projections have materialized. Because manufacturing equipment does not naturally lend itself to project financing, tax equity investors may gravitate to lease financing — where the lessor has recourse to credit and assets other than the leased equipment. Full or partial recourse financing structures may well be the leading tool for enabling “green” manufacturers to monetize the tax credits and other tax benefits of their equipment.

More Challenges

Many tax credit monetization transactions are closed alongside a project financing. Project financing is generally non-recourse financing, where the investors and lenders look to the project contracts to support and repay their investments. Sponsors are generally not required to guarantee or backstop project financings except for certain limited risks that are heavily negotiated.

In a typical project financing, the input or feedstock costs are fixed or hedged by contracts and the offtake or revenue stream is supported by a creditworthy buyer who agrees to buy the output for an extended period of time at a fixed price, with very few or no exceptions. Tax equity investors prefer these types of projects that they can underwrite tax credits in the context of a fairly stable investment.

Some of the manufacturing equipment that qualifies for tax credits is likely to be equipment with technology risk. Some of the credits were used to incentivize equipment that the government thought might not otherwise be built without the tax incentives. The equipment will manufacture components that will be sold into a still nascent industry — the green economy — which itself is greatly dependent on future government subsidies and policies for continued growth. Also, the economic viability of manufacturing equipment is dependent on the ability of the factory owner to purchase and refine raw goods into a saleable product where it is difficult to fix the price of the raw commodities, the refining process and the output components for any considerable period of time. In this way, a manufacturing facility is much like a merchant power plant (one with no firm offtake contract) that has little chance of attracting project financing in a capital-constrained market.

A partial solution to this problem might be the Department of Energy loan guarantee program that was established to support borrowing by a subgroup of these manufacturing facilities. Another solution might be tax monetization structures, including, in particular, leasing structures where the factory owner guarantees all or some of the lease payments to the investor, regardless of whether the equipment or line of business is profitable.

In a sale-leaseback transaction, a bank, insurance company or other tax equity investor buys the equipment from the sponsor and then leases it back to the sponsor. The lessor’s investment is the purchase price for the equipment and its investment is repaid through the rents it collects from the sponsor over the lease term plus whatever value is left in the equipment at the end of the lease. The lessor, as owner of the equipment, is entitled to the tax credits and other tax benefits of ownership. The lessee bargains for a reduced rental rate on account of the tax benefits retained by the lessor.

Leasing is attractive to tax equity investors for a number of reasons, none more important than tax and accounting. First, it allows for the separation of the owner — the one who is entitled to the tax benefits — from the user of the equipment. In this way, it allows for a user to continue using the equipment and attract a favorable financing rate because the lessor can subsidize its rate through the use of tax benefits. Second, it allows the lessee, in certain cases, to avoid capitalizing the future lease obligations on its balance sheet, reducing the size of its stated liabilities for GAAP purposes.

Most equipment leases do not follow the project finance model. The lessee’s obligation to pay rent is not dependent on the future profitability of the business in which the leased equipment is used. Instead, the lessee’s promise to pay rent is typically guaranteed by a creditworthy parent company.

The lessor in a lease financing can claim the tax credits, depreciation and other tax benefits only if the lease is a “true lease" for tax purposes. Simply transferring title to the equipment to the lessor and leasing it back is not enough to enable the lessor to claim the tax benefits. The lessor must be the tax owner of the equipment. To be the tax owner, the lessor must generally have what the tax law calls the benefits and burdens of ownership. The lease term must not run longer than 80% of the expected useful life and value of the equipment and the equipment user cannot have a purchase option to buy the equipment at a bargain price.

A lessor of equipment can elect to pass through the tax credit to the lessee. Only the tax credit is passed through to the lessee; the right to take tax depreciation deductions and other tax benefits of ownership remains with the lessor. To claim the tax credit, the lessee must establish a real position as a lessee with some variability in risk and economics between its payment obligations under the lease and its earning potential from operating the equipment.

The pass-through election brings a number of unique rules into play. First, the lessor, as owner of the equipment, does not reduce its tax basis because it has not claimed the credit. The lessee has no tax basis to reduce because it does not own the equipment for tax purposes. As already noted, the lessee must report income equal to the tax credit over the depreciable life of the equipment. Second, the tax credit may be recaptured if it transfers the equipment (including returning the equipment to the lessor) at any time within the first five years after the equipment is first put into use. Certain transfers by the lessor can also cause the lessee to suffer a recapture liability.

Special Issues in Leases

One of the key advantages of a leasing structure is that it allows the lessee to guarantee or wrap its lease payment obligations during the lease term. If the lessee’s credit is strong enough, it may be able to raise capital through a lease at a lower cost, on a pre-tax basis, than if it held onto the tax credits itself and used another method of financing.

There are a number of techniques that might enhance the returns to both the lessor and lessee.

One of the biggest challenges for investors who offer lease financing is the very high loan-to-value ratio on their investments. Unlike a conventional asset-backed loan where the lender sizes its loan to a comfortable coverage ratio and advances only part of the cost of the asset, a lessor must fund 100% of the cost of the equipment by buying it for fair value and then leasing it back to the lessee.

Various techniques have developed to “right size” the lessor’s investment. By far the most common and usually the most efficient is to require the lessee to prepay part of the rent at the outset of the lease. This is economically equivalent to giving the lessor back part of what it just paid the lessee for the equipment. Rent prepayments are governed by complicated tax accounting rules in section 467 of the US tax code. The tax rules treat the rent prepayment as a loan by the lessee to the lessor to be worked off over the lease term. The lessor receives additional tax deductions for the interest it owes the lessee in theory on this loan. Another option is closing a sale-leaseback on only part of the equipment and using the balance of the equipment to secure the lease obligations. In this way, the lessor can structure a deal where its loan-to-value ratio is closer to that of a conventional lender. Other techniques that are sometimes used include requiring the lessee to set aside a portion of the purchase price as a reserve to cover future rent payments or requiring the lessee to post collateral to secure ongoing rent payment obligations.

Another feature commonly employed to both minimize the risk the lessee will be unable to pay rent and allow the lessor to share in some of the operating profits is to have the rent fluctuate based on certain agreed-upon metrics. One example might be to make the rent a fixed percentage of gross receipts from sales of the goods produced by the leased equipment. Alternatively, the lessor might be allowed to sweep all free cash until it has achieved a certain hurdle rate at which point the rents are reduced. Each of these techniques complicates tax accounting rules for lease rental payments, but may be worth the trade off in the right circumstances.

Perhaps the greatest downside of leasing is that it does not permit the lessee to take back its equipment once the lessor has been repaid its investment and earned a return. To qualify as a “true lease, ” the lessor must own the rights to the equipment at the end of the lease term; therefore, it cannot automatically transfer the equipment back to the lessee. Nonetheless, the tax rules permit the lessee to have a buyout option at a fixed price as long as the price is not less than the projected value at time of exercise or the option is not otherwise certain to be exercised. A fixed-price buyout placed somewhere in the middle of the lease term should permit the lessee to price and evaluate its all-in-yield at the inception of the deal and permit a comparison to its other financing options. Another feature that has seen some use lately is the right of the lessor to sell (or “put”) the equipment back to the lessee at the end of the recapture period. Puts create tax risk to the lessor. However, a number of lessors in the current market seem prepared to use them provided the “put” price is set at the fair market value of the equipment when the put is exercised or at a fixed price clearly below what the value of the equipment is projected to have at that time. The put provides the lessor liquidity and more certainty on its investment return.