Tax Strategies For Financing Landfill Gas Projects
Landfill gas operations in the United States throw off tax and other benefits that savvy developers and municipal landfill owners figure out how to tap.
These benefits are potentially a source of cash to help cover the capital or operating costs of a landfill.
The US government pays as much as 220% of the cost of a landfill gas collection system, 27% of the cost of equipment to turn the gas into electricity, and 31% of the cost of equipment to clean it to a point where it can be mixed in a pipeline with natural gas. State tax benefits are worth on average another 3%.
Most of these benefits are in the form of tax subsidies. The problem with tax subsidies is municipalities and smaller developers lack the tax base to use them. There are various ways to “monetize” the benefits by turning them into cash.
But beware: the nature of the tax benefits is changing — and this could lead to a change in how landfill gas projects are structured in the future. Most of the benefits in the past went to gas producers as a reward for producing landfill gas. In the future — assuming an energy bill that is currently stalled in Congress passes — the biggest rewards will go to companies that use landfill gas to generate electricity. Thus, until now, if a landfill owner wanted to share in the government subsidies for landfill gas, it might do so by selling its gas collection system to a large corporation with a tax base in exchange for ongoing payments that are a share of the tax credits that the government allows gas producers to claim on the landfill gas produced. In the future, a landfill owner might do better to keep the collection system and simply increase the price at which it sells the gas.
The Situation Today
Landfill gas projects qualify potentially for three tax benefits today.
One is basic tax depreciation, or the ability to deduct the cost the gas collection system and other equipment over its useful life.
The depreciation on the gas collection system is worth 27.78¢ for each dollar of capital cost. This is the present value of the tax savings from the depreciation deductions over time. The calculation assumes a 35% tax rate and uses a 10% discount rate.
The owner of the collection system can deduct his investment in it over seven years using the 200% declining-balance method. In most cases, this means he can deduct 14.29% of his investment in year 1, 24.49% in year 2, 17.49% in year 3, 12.49% in year 4, 8.93% in each of years 5, 6 and 7, and the remaining 4.46% in year 8. (Even though it is a 7-year depreciation schedule in theory, a small portion of the cost is spread into year 8.)
The cost of equipment to convert the gas into electricity or to clean it to pipeline quality is depreciated more slowly. The generating equipment must be depreciated over 15 years. Depreciation over 15 years is worth 19.92¢ for each dollar in capital cost. Equipment to clean the gas to pipeline quality must be depreciated over seven years. The tax savings from the depreciation on it are worth 27.78¢ per dollar of capital cost.
This is the depreciation that can be claimed in most cases. In some cases, the deduction the first year may be a different percentage, usually smaller. This might occur because the legal entity that owns the equipment was just starting in business so that it has a “short tax year” or because it was already in business, but made more than 40% of its total new investments for the year in the last quarter of the year, thereby tripping something called a “mid-quarter convention.”
If the project benefited from tax-exempt financing or the equipment is considered used by a municipality or other tax-exempt entity, then slower depreciation must be used and the tax savings are not as large. In such cases, the gas collection system would have to be depreciated over 10 years using the straight-line method. (This means that the same amount is deducted each year rather than a relatively large percentage in the early years and a small percentage in later years.) The cost of the generating equipment would have to be depreciated over 20 years, and equipment to clean gas to pipeline quality would be depreciated over 14 years.
Another tax benefit is a “depreciation bonus.” If the project qualifies, this will add another 3.61¢ to 7.54¢ in benefit for each dollar of capital cost.
The US government made a limited-time offer after the terrorist attacks on the World Trade Center and the Pentagon. It is offering anyone who invests in new equipment during a “window period” that runs from September 11, 2001 through December 2004 or 2005 — depending on the equipment — to deduct either 30% or 50% of the cost of the equipment immediately. Collection systems, electric generators and cleaning equipment tied to landfill gas projects must be “placed in service” for tax purposes by December 2004 to qualify. The remaining cost is deducted over the regular depreciation schedule. Thus, for example, anyone who put an expansion well into service at a landfill in December 2003 could deduct 50% of the cost of the well on his 2003 tax return. The remaining 50% would be deducted over seven years, with a fraction of it deducted in 2003 and the rest spread over the remainder of the period.
The tax savings from a 50% depreciation bonus on the gas collection system are worth 3.61¢ in present-value terms for each dollar in capital cost. The bonus on electric generating equipment is worth 7.54¢. The bonus on gas cleaning equipment is worth 3.61¢.
The bonus was only 30% for investments to which a company committed before May 6, 2003. Congress increased the amount to 50% starting on May 6 in the hope of giving a bigger boost to the US economy. Whether a company was “committed” to the investment before May 6, 2003 turns on whether it is viewed as building the equipment itself or purchasing it off the shelf from a vendor. In cases where a company is viewed as building the equipment itself, it was not “committed” to the investment until construction started at the site, and then only after at least 10% of the total project cost was incurred. In cases where a company is viewed as purchasing the equipment off the shelf, the company was committed to the purchase when it signed a binding contract to buy it. “Binding” is a term of art. Just because a contract was signed does not mean it was “binding” for tax purposes.
The bonus can be claimed only on new equipment — not purchases of used equipment. However, it applies to improvements to existing facilities. Thus, for example, it could be claimed on the cost of a replacement well at a landfill.
Tax credits at the average landfill gas project might cover another 190% of the capital cost of the gas collection system.
The average landfill in the United States contains 3.477 million tons of waste, according to US Environmental Protection Agency figures. A landfill that size would generate three to four megawatts of electricity, and the total cost of the collection system and generator would run around $5 million, with the collection system accounting for roughly 20% of the cost.
The US government offers a tax credit as an inducement to companies to produce landfill gas. The credit is in section 29 of the US tax code. The deadline for installing collection systems to take advantage of the tax credit has already passed. Most collection systems put into service between January 1993 and June 1998 qualify for tax credits on the gas produced through 2007. Collection systems put into service before 1993 no longer qualify for credits, although it is possible for gas from some wells at such older sites still to qualify.
The credit is currently $1.095 an mmBtu. The amount is adjusted each year for inflation. A landfill of average size produces 571,000 mmBtus a year of gas. The tax credits on that amount of gas output are $605,000 a year. The remaining tax credits on an existing collection system of average size between now and 2007 have a present value of $1.918 million.
The tax credits belong to the company that produces the gas. To qualify as a gas producer — and, thus, be able to claim the tax credits — a company must usually possess two things. First, it must own the gas collection system. Second, it must have the right legally to withdraw the gas from the ground. Thus, in cases where a municipality owns a landfill and cannot use the tax credits, the way to transfer the credits to a private developer is to sell the developer the collection system and enter into a gas lease giving the private developer the right to withdraw the gas from the ground.
The private developer should exercise care in the contracts it signs. It can hire someone else to operate the collection system. However, it must be careful in all its contracts — for example, with the landfill owner for the gas rights, with the company that will operate the collection system, and with whomever will buy the gas — to avoid transferring ownership of the collection system or shifting all the production risks effectively to someone else. For example, it would be a mistake for the gas lease to provide that the collection system will revert automatically to the landfill owner as soon as the tax credits expire. The Internal Revenue Service will assert that the landfill owner remained the owner of the collection system from inception.
A gas producer must sell the gas to an unrelated person in order to claim tax credits. This explains why landfill gas projects that qualify for tax credits are set up with the collection system and the generating or cleaning equipment owned by separate companies. A “gasco” owns the collection system, and a “genco” or “cleanco” owns the other equipment. There can be up to 50% overlapping ownership between the two companies. However, it is important to keep the companies separate in all other respects. Thus, for example, a bank should not lend against the combined revenues of both the gasco and the genco or cleanco as if they are a single large company.
There is an active market in projects that qualify for section 29 tax credits. Such projects have been selling for the equivalent of as much as $1.21 per dollar of tax credit, although most assets trade in a range of 70¢ to 95¢. The reason an institutional investor might pay more than a dollar for a dollar of tax credits is that he is also able to deduct the amount he pays for the project over time. Thus, if he pays the equivalent of $1 for $1 of tax credits, not only does he receive a tax credit of $1 but he also deducts the $1 over time, saving him an additional amount in taxes.
There are two main ways for a municipality or smaller developer that lacks the tax base to use the tax benefits to transfer them. One is to sell the collection system or gasco to someone else who can use them but share indirectly in tax benefits through the purchase price. Many recent sales use a “pay-as-you-go” structure. The institutional investor pays an amount in cash at closing plus installment payments each quarter through 2007. The Internal Revenue Service requires that at least half the total purchase price be fixed in present-value terms. Thus, each quarter, the institutional investor pays for the collection system a fixed amount plus a contingent amount. The contingent amount is a percentage of the tax credits that quarter. After 2007, the seller of the collection system can have an option to buy back the collection system. Ideally, he should do so for the fair market value determined when the option is exercised.
The other way to transfer tax credits is for a smaller developer to enter into a partnership with an institutional investor. (Partnerships work less well for municipalities because of complications in how tax depreciation would have to be shared.) The partnership would own the collection system. The institutional investor would make ongoing payments for his partnership interest. All the economic benefits in the partnership would be shared initially 99-1 in favor of the institutional investor. However, sometime after 2007, the ratio would flip to 20% for the institutional investor and 80% for the smaller developer. The smaller developer could have an option to buy out the institutional investor after the tax credits have expired.
The problem with landfill gas projects is the transactions are usually too small for the institutional market. There is a need for an aggregator to bundle together groups of projects.
Another problem with landfill gas deals is the existing contracts frequently have impermissible terms. A group of 12 projects might have 12 different sets of contracts, each with very different terms. This makes it expensive for institutional investors to do due diligence. Large institutions that play in this market would be well advised to have a set of standard-form contracts and, rather than try to parse all the contracts that come with a project, make it a condition to closing that the contracts be “amended and restated”— or replaced — with the standard forms. Thus, for example, all the operator contracts would be replaced with standard terms.
An energy bill stalled currently in Congress would throw more tax benefits at landfill gas projects and, in the process, will change how such projects are structured in the future.
The energy bill failed to clear Congress in late November by just two votes. It passed the House. It was the target of a filibuster in the Senate. Sixty votes are required in the Senate to cut off debate. The effort to invoke “cloture” — or cut off debate — fell two votes short. (Technically, it was three votes short, but the Senate majority leader, Bill Frist (R-Tennessee), voted against cutting off debate when it was clear the effort would fail so that he could make a motion to reconsider.) The fate of the measure remained up in the air as the NewsWire went to press. Republican leaders may make another effort to put all or part of it through Congress this year.
The energy bill would create two new tax benefits for landfill gas projects.
First, it would breathe new life into section 29 credits — but just barely. Section 29 credits can only be claimed currently on landfill gas from wells that were in service by June 1998, and then only on the gas produced and sold through 2007. The credits are currently $1.059 an mmBtu.
The bill would allow tax credits to be claimed on gas from wells put into service after June 1998 through 2006, but only at 51.7¢ an mmBtu. The credit would be only 34.7¢ an mmBtu on gas from landfills that are already required by US Environmental Protection Agency regulations to trap the gas. Both amounts — 51.7¢ and 34.7¢ — would be adjusted for inflation.
However, the total credits that could be claimed would be capped at $37,741 a year per project. And then they could only be claimed on four years of gas output. In the case of existing wells that went into service after June 1998, the four years would start to run on gas produced on January 1, 2004.
This is not enough to interest the institutional market.
It is not clear how the annual cap per project of $37,741 will be applied in cases where credits are being claimed on gas from expansion wells at a collection system that went into service in June 1998 or earlier. (Gas from the rest of the project qualifies for uncapped section 29 credits under existing law.)
The portion of the bill that extends section 29 credits is poorly drafted. There are two separate provisions that extend section 29 credits for landfill gas projects. The other provision would extend such credits on gas from wells put into service after the bill is signed into law by President Bush through the end of 2006. The advantage of relying on this other provision is the annual cap on the amount of credits that can be claimed per project would not apply. This is probably a drafting error. Tax bills in recent years have been followed in time by “technical corrections” bills, like a sweeper cleaning up at the circus behind the elephants. However, unless Congress fixes this bill through a technical correction, both readings of the bill — the extension with or without the cap — are equally valid.
The other new tax benefit is a tax credit for anyone using landfill gas to generate electricity.
This “section 45 tax credit” would be 1.2¢ a kilowatt hour. The amount will be adjusted for inflation. In contrast to section 29 credits, which go to the owner of the collection system, this credit goes to the owner of the generating equipment. It can be claimed for five years on electricity output sold to third parties from new generating equipment put into service during a window period that runs from the day after the bill is signed by President Bush through December 2006.
The average landfill in the United States produces enough gas to generate three megawatts of electricity. The tax credits on a project that size would run $315,360 a year. The present value of the full five years of credits is roughly $1.2 million.
If the energy bill passes, it will have a number of effects on how landfill gas projects are structured in the future.
The bill has language intended to prevent both section 29 tax credits and section 45 tax credits from being claimed on the same project. The language is not well drafted. The IRS will have to move by regulation to prevent companies from circumventing the intention.
However, because of this anti-double-dip language and because the section 29 credits are capped at such a low level ($37,741 a year per project), institutional investors will be more interested in the future in owning the generating equipment than the collection system. This is the reverse of the situation today.
That said, both the collection system and the electric generating equipment can be owned by the same company in the future. If the plan is to claim section 45 credits rather than section 29 credits, then there is no need for the gas to be sold to an unrelated party. However, it would probably still be wise to keep them in separate legal entities. That’s because if both the collec-tion system and the generating equipment are owned by the same legal entity, both assets will probably have to be depreciated over 15 years on grounds that the business of the owner is primarily generating electricity for sale. If the assets are in separate legal entities, one of the entities is in the business of collecting landfill gas. Equipment used in that business qualifies for faster depreciation (over 7 years rather than 15 years).
It will make less sense in the future to clean landfill gas to pipeline quality. The better use for the gas is to convert it to electricity since that is what the government will reward through tax credits.
Municipalities and smaller developers will still need institutional investors to take advantage of the tax subsidies. The projects will still be too small. There will still be a need to put together groups of projects.
One problem with tax credits in the past is they cannot be used against “alternative minimum taxes.” The United States has essentially two different tax systems for corporations. A company calculates its regular income taxes and then calculates its minimum taxes on a broader definition of taxable income but at a lower rate, and it pays whichever tax is greater. A company that is on the minimum tax cannot use section 29 or 45 tax credits currently. The energy bill would allow section 45 credits — but not section 29 credits — to be used against AMT liability, but only on the electricity output for the first four years after the project is put into service. This is another reason why the institutional market will be more interested in section 45 credits. Large corporations go on and off the minimum tax from year to year.
Anyone signing a gas sales contract in the future would be wise to ensure that the gas purchaser does not claim section 45 credits if the gas producer plans to claim section 29 credits — and vice versa. The energy bill will require a project to choose one or the other tax credit.
Renewable energy credits — called RECs — in eight states are a potential source of additional value in landfill gas projects.
They belong to the company that uses the gas to generate electricity. This is another reason why the institutional market is shifting focus from the gas collection side of the project to the generating equipment.
RECs are credits at the state level for using renewable fuels, like wind, biomass or sunlight, to generate electricity. To date, 13 states have adopted some form of “renewable portfolio standard,” or law requiring utilities in the state to ensure that a certain percentage of their electricity comes from renewable sources. Five other states have adopted voluntary goals to increase the use of renewable fuels. At least another five states are considering adopting RPS-type legislation.
Landfill gas qualifies as a renewable fuel in eight states: Arizona, California, Connecticut, Massachusetts, New Jersey, New Mexico, Pennsylvania and Texas.
The percentage of electricity that must come from renewable sources varies from state to state and over time. For example, Arizona requires utilities only to generate 1% of electricity from renewable fuels by 2005 and 1.1% by 2007. California ramps up to 20% renewable electricity by 2017.
A utility can meet its obligations by generating the electricity itself or by purchasing the electricity from a renewable supplier or, in some states, by purchasing RECs from an electricity generator who used a renewable fuel.
RECs have been trading this past year for between 0.5¢ to 2¢ a kilowatt hour.
Utilities tried earlier this year to persuade the Federal Energy Regulatory Commission that the RECs convey automatically to the utility that buys the electricity. In October, the commission ruled against the utilities. It said the RECs remain with the electricity supplier unless the power contract provides specifically for their transfer. However, the order left the door open to state public utility commissions to decide otherwise in their states. One state commission — in Maine — has already declared that RECs in that state convey automatically to the utility that buys the electricity, and the issue is pending before the Connecticut Department of Public Utility Control. The Maine decision is being appealed.
Electricity generators may be entitled to money back from utilities in cases where they had to pay for “network upgrades” — or improvements to the transmission grid — when they connected to the local grid.
Utilities usually make generators pay two kinds of costs as a condition for interconnection. One is the cost of the “direct intertie” — the radial line and related equipment that connects the plant to the grid. The other is the cost of any upgrades that are required to the grid itself to accommodate the additional electricity from the generator’s plant.
It is currently Federal Energy Regulatory Commission policy that independent generators should not have to bear the cost of the grid improvements. Rather, these should be borne by all users of the grid through the rates they pay for transmission service on the grid. A model interconnection agreement that FERC adopted in July 2003 allows utilities to require generators to advance the funds for grid improvements, but the money must be returned with interest within five years.
Several generators have asked FERC to order utilities to return money paid for network upgrades under existing interconnection agreements that predated the model agreement. These existing contracts did not require the utilities to give the money back. FERC has shown a willingness in some cases to modify existing contracts.
The energy bill currently stalled in Congress would overturn the FERC policy.
The bill would give utilities the option of asking FERC to let them charge the generator for the cost of network upgrades or to pass through the cost to all grid users in transmission rates. However, FERC could not allow the cost to be passed through to all grid users in situations where the grid improvements are only needed because of the addition of the generator’s plant. The bill would also bar FERC from requiring utilities to pay interest when returning amounts collected from generators for network upgrades. Entergy and Southern Company pressed Congress for this language.
The bill would not bar refund claims under most existing contracts.
Landfill Closing Costs
Landfills that are listed as “Superfund” sites got bad news from a federal court in August.
Landfill owners are required by law to prevent gas and leachate from decomposing trash from leaking into the atmosphere or the surrounding soil. They set aside money in a reserve account while the landfill is still earning tipping fees from garbage collection to cover their ongoing obligations after the landfill has closed. Ordinarily, no tax deduction is allowed for merely setting money aside in a reserve account. The amounts cannot be deducted until they are actually spent on cleanup. However, section 468 of the US tax code makes an exception in this case.
A federal district court in Michigan in August denied tax deductions for contributions that were made to a reserve to cover future closing costs in years when a landfill was listed on the “national priorities list” of Superfund sites. The court said section 468 bars deductions for reserve contributions in such years, presumably on grounds that no tax “carrot” is needed at that point for a landfill owner to set aside money once cleanup has been ordered by the environmental authorities.
The court rejected an IRS claim that the landfill owner had to reverse all the deductions he had taken for reserve contributions in years before the landfill was listed by reporting the full amount in the reserve as income. The case is South Side Landfill v. United States.