On March 29, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2023-02 (ASU 2023-02) allowing tax equity investors to elect the proportional amortization method (PAM) for eligible tax equity investments. The election will allow tax equity investors in partnerships to avoid hypothetical liquidation at book value accounting (HLBV) for eligible investments. As discussed below, some tax equity investments may not be eligible for PAM.
PAM means the tax equity investor “amortizes the initial cost of the investment in proportion to the income tax credits and other income tax benefits received and recognizes the net amortization and income tax credits and other income tax benefits in the income statement as a component of income tax expense (benefit).”
ASU 2023-02 may expand the tax equity market by enticing investors that were displeased with the highs and lows associated with income recognition pattern of HLBV or its complexity. However, there remain questions the answers to which impact how widely PAM will be elected and how many investors it will entice into the tax equity market.
The election is available for public companies in fiscal years starting after December 15, 2023 and for private companies in fiscal years starting a year later.
I. The Five Conditions to Qualifying for PAM
Each of five conditions must be satisfied for the election of PAM to be available:
- It is probable that the income tax credits allocable to the tax equity investor will be available.
- The tax equity investor does not have the ability to exercise significant influence over the operating and financial policies of the underlying project.
- Substantially all of the projected benefits are from income tax credits and other income tax benefits. Projected benefits include income tax credits, other income tax benefits, and other non-income-tax-related benefits. The projected benefits are determined on a discounted basis, using a discount rate that is consistent with the cash flow assumptions used by the tax equity investor in making its decision to invest in the project.
- The tax equity investor’s projected yield based solely on the cash flows from the income tax credits and other income tax benefits is positive.
- The tax equity investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the tax equity investor’s liability is limited to its capital investment.
Probable: The first requirement that it be probable that the tax credits will be available is relatively clear given extensive accounting literature about the meaning of “probable” and should not be problematic.
Significant influence: The second requirement that the tax equity investor does not exercise significant influence over the underlying project uses concepts that are present in other areas of GAAP (e.g., consolidation). There is some subjectivity to this requirement, but there are market conventions that should make it application manageable.
Substantially all: The third requirement is that the tax credits and other tax benefits must constitute substantially all of the projected benefits (i.e., tax and cash benefits) from the investment. EY has advised that “substantially all” means 90 percent. This requirement poses three challenges. First, the tax benefits and the other benefits must be present valued using the same discount rate that the tax equity investor used to evaluate the investment. Financial modeling is needed to see if that rule is compatible with the “economic substance” rule of thumb used by some tax equity investor that the pre-tax internal rate of return treating the tax credits the same as cash must be at least two percent.
Second, refundable tax credits are treated as other benefits in the “substantially all” test. That is refundable tax credits are included only in the denominator. However, in a key omission ASU 2023-02 does not define refundable tax credits. For instance, are section 45Q carbon capture tax credits and section 45V hydrogen production tax credits that qualify for a direct payment from the IRS, even in the hands of a taxable entity, considered “refundable”? What if the tax equity partnership does not opt for refundability?
Third, the examples in ASU 2023-02 provide “The investor expects that the estimated residual investment will be nominal (zero is assumed for simplicity).” However, the IRS safe harbors require the tax equity investor have at least a 4.95 percent (i.e., five percent of 99 percent) residual interest after its return is achieved or tax credit period is over. Since the non-tax benefits have to be ten percent or less of the total benefits, complying with the IRS safe harbor may leave little room for cash distributions to the tax equity investor. This may cause some tax equity investors to not structure their investments to qualify for PAM.
Positive yield: The fourth requirement has the potential to be particularly problematic: the projected yield based solely on the “tax credits and other tax benefits” must be positive. The key question is does the reference to “other tax benefits” allow tax costs to be excluded from the calculation. The FASB included two examples, but each example dodges this question by having zero tax cost; however, some tax cost is inherent in most energy tax credit deals. How could the FASB not address this fundamental question?
Limited liability: The fifth requirement is unlikely to be problematic, but it is vague. ASU 2023-02 requires that the tax equity investor is “a limited liability investor in the limited liability entity for both legal and tax purposes.” Presumably, “limited liability … for legal … purposes” means the tax equity investor is not responsible for the debts of the limited liability company (LLC) that is the tax equity partnership. What is less clear is what does the FASB mean by limited liability for tax purposes? To pass-through the tax credits to its owners, the LLC must be a partnership for tax purposes, and partners pay the income taxes of their partnership; therefore, in a sense, the tax equity investor has liability for tax purposes. However, the FASB could not have intended that interpretation, which leaves the question of what did the FASB intend with respect to limited liability for tax purpose?
II. Election Applies to Each Tax Credit Programs
Once a tax equity investor makes the PAM election for a tax credit program, it must use PAM for all eligible investments under that tax credit program. ASU 2023-02 provides that renewable energy, low income housing, new market and the historic building tax credit incentives are each a separate program. Further, the solar investment tax credit (ITC) and the wind production tax credit (PTC) are separate programs, and even more granularly on-shore wind and off-shore wind are separate programs. This is helpful as tax equity investors may want to elect PAM for their ITC deals but not their PTC deals, or vice versa.
One would think that the solar ITC and the solar PTC are separate programs, but ASU 2023-02 does not state that expressly. In any event, if a tax equity investor wants to use PAM for some investments but not all investments under a “tax credit program,” it appears it would not be particularly difficult to structure certain investments to “fail” one of the five conditions and be ineligible for PAM.
III. FASB's Disinterest in IRS Safe Harbors
An example in ASU 2023-02 provides “After 10 years, the investor has a right to require the project sponsor to purchase the investor’s equity interest for a nominal amount (zero is assumed for simplicity).” A “put” right for a “nominal amount” is not permitted by any of the IRS’s tax credit partnership safe harbors.
The wind safe harbor prohibits any “put.” The historic tax credit safe harbor and the carbon capture tax credit safe harbor allow a “put” (but not a “call”); however, the “call” price must not be fixed. Would it be asking too much for the FASB’s tax credit examples to be consistent with an IRS safe harbor, so that the examples have some reflection of commercial reality and greater utility to investors.
The creation of the PAM election is supposed to simplify the accounting for tax equity and expand the market for clean energy tax equity investors. Unfortunately, due to some of the conditions to electing PAM, there is a possibility that PAM only applies in certain niches of the energy tax credit market. That may not be a surprise to the FASB as it wrote in ASU 2023-02 “investment in certain tax credit structures are unlikely to meet the conditions to be accounted for using” PAM. Thus, PAM may not be the hoped for answer to the imbalance between supply and demand in the renewable energy tax equity market.
 For an overview of HLBV, see slides 23 and 24 available at https://www.projectfinance.law/media/5412/nrf-alfa-dnvgl-renewable-energy-presentationpd.pdf.
 See N.Y. State Bar Ass’n, Sec. Tax’n, Report on Codification of Economic Substance, 24-25 n.61 (Jan. 5, 2011).
 See, e.g., Rev. Proc. 2007-65, § 4.02 (“Each Investor must have, at all times … a minimum interest in each material item of partnership income and gain equal to 5 percent of the Investor’s percentage interest in partnership income and gain for the taxable year for which the Investor’s percentage share of income and gain will be the largest” (emphasis added).)
 Id. at § 4.05.
 Rev. Proc. 2020-12, § 4.06; Rev. Proc. 2014-12, § 4.06 (“The Investor may not have a contractual right or other agreement to require any person … to purchase or liquidate the Investor’s interest … at a future date at a price that is more than its fair market value determined at the time of exercise of the contractual right to sell.”)