(Revised May 17, 2023)
The Inflation Reduction Act of 2022 (IRA) changed almost a century of federal tax law and allowed energy credits to now be sold. This change provides a new means of raising capital for owners of renewable energy projects that lack the tax appetite to use the federal tax credits their projects generate.
Currently, the potential buyers of the federal energy tax credits are large corporations with significant tax liabilities. The buyers have at least two motivations for buying the credits: to (i) effectively satisfy their liability to the IRS for less than one hundred cents on the dollar and (ii) demonstrate their support for clean energy initiatives.
Some of the buyers are banks that are experienced tax equity investors, while other buyers are “corporates” that are looking for a financial transaction that does not require learning about tax credit project aspects such as power purchase agreements, capacity factors or nodes. Corporates are looking for a simple arrangement: if the IRS disallows the tax credits they purchased, the seller will pay them an indemnity to make them whole.
The Need for Tax Credit Insurance
Some of sellers are well-known sponsors with large balance sheets that have the capability to provide meaningful indemnities. Other sellers are lightly capitalized sponsors that lack the balance sheet to satisfy a potential large indemnity. Some of the sponsors with large balance sheets may prefer to not expose their balance sheets to tax credit indemnities. Given these dynamics, some of these transactions will only be consummated if tax credit insurance can be provided.
Fortunately, the tax credit insurance market is available to underwrite the insurance, and the market has become competitive enough that the premiums are not too exorbitant, typically a one-time premium equal to two to three percent of the maximum insurance payout. However, premiums can be higher if the facts are hairy.
Despite the importance of tax credit insurance, it is not a one size fits all solution to all risks associated with purchasing federal income tax energy credits. Buyers still need to do some diligence and be sure they are transacting with trustworthy sellers.
Tax credit insurance is bespoke and can over a wide range of risks. Below are examples of risks that some policies cover.
Tax credit insurance often insures the risk that a transaction that appears to work, does not. For instance, in an investment tax credit transaction in which the tax credit is sized based on the eligible basis of the project, tax credit insurers commonly insure the risk that the IRS disagrees with the tax basis calculations made by the parties and their advisors. An example of such disputes is the Bishop Hill case. If tax credit insurance had been procured for the Bishop Hill project, it would have likely covered the dispute in that case.
In the right circumstances, tax credit insurance is also available to insure the question of whether a project is sited in an “energy community” and qualifies for a ten percentage point investment tax credit adder (e.g., 40 percent rather than 30 percent) or a ten percent production tax credit adder.
Further, for projects that have a capacity of at least one megawatt and began construction after January 28, 2023, the IRA imposes prevailing wage and apprentice (PWA) requirements that must be satisfied with respect to the construction and then alterations and repairs for five years for the investment tax credit and ten years for the production tax credit. Failure to satisfy PWA results in the tax credits associated with the project being only one fifth of what was expected (e.g., six percent rather than 30 percent). The tax insurance market is underwriting this risk, so long as a plausible strategy and process is presented to satisfy PWA.
Seller v. Buyer Procured Tax Insurance
Tax credit insurance transactions are bespoke and the coverage varies significantly by policy. Significant differences can be seen in policies procured by the seller of the tax credits versus policies procured by the buyer. The premium will vary based on the maximum amount of coverage and the scope of risks that are insured. A tax credit seller may be motivated to procure for the benefit of a buyer a narrower policy with a lower coverage level to secure a lower premium. This distinction is relevant to policies insuring the tax credit buyer; another application of tax credit insurance is a policy insuring the seller for its obligations under a tax credit indemnity.
It is important that a buyer obtains coverage that the seller’s representations to the buyer are true. If the seller procures the tax credit insurance and the seller makes representations in the policy, then there could be a gap in coverage. If one of those representations is inaccurate and that inaccuracy triggers a loss of tax credits, that loss is not covered. Representations vary by policy. For instance, if the tax credit seller represented that it owned 10,000 residential solar projects that it could sell the tax credits from but it owned only 1,000, the tax credit insurance is not going to cover the loss of tax credits when the IRS discovers that 9,000 of the solar projects did not exist. In contrast, if the coverage is purchased by the buyer and is structured to cover the buyer for a false representation by the seller to the buyer, the buyer would be protected from its loss of tax credits if the 10,000 residential solar projects did not exist. In such a scenario, the insurer’s due diligence process would likely include being provided comfort that the buyer did its homework and verified there were 10,000 residential projects.
Further, if the seller procures tax credit insurance, it is likely to covenant in the policy that it will properly elect to transfer the tax credits. For instance, if the owners and officers of the seller abscond to Brazil and never file the election with the IRS to transfer the credits, the insurer would not cover that risk due to the breach of covenant by the seller. Further, if the election is filed but is signed by an individual not authorized to bind the seller and the IRS disallows the election, that loss is likely excluded from coverage under a policy the seller procures. In contrast, if the buyer procures the insurance and ensures the policy covers the risk the seller fails to make the appropriate election, then it would be covered.
Recapture due to Transfers
The investment tax credit rules include recapture of tax credits if the project is transferred or destroyed in the first five years. The industry has advocated to Treasury that the seller should suffer the recapture because the buyer effectively has no control over (or even connection to) the project. We don’t know yet if Treasury is going to accept the industry’s position.
For investment tax credit deals, tax credit insurance often covers recapture risk. However, the insurer is not going to cover a voluntary transfer. The question is a “voluntary transfer” by whom? For instance, if the seller procures the insurance, the policy would typically exclude coverage for a voluntary transfer by the seller. Therefore, if the seller after two years decides it wants to cash out of its project and sells it, that policy is not going to cover the recapture that results.
In contrast, if the tax credit buyer procures the insurance, the buyer does not have an actual interest in the project to sell. Therefore, the policy would not cover a transfer of the project consented to by the buyer for the tax credits. Accordingly, if the seller of the tax credits decides to sell the project and the buyer does not consent to the sale (or has no right to consent to the sale) of the project, the insurance would cover the resulting recapture.
Change in Law Risk
Also, tax credit insurers typically do not insure changes in the Internal Revenue Code or the Treasury regulations. In contrast, tax credit insurance does typically cover adverse judicial opinions and IRS revenue rulings. Nonetheless, if the parties are undertaking a structure that the Treasury could opt to foreclose with regulation or Congress could respond to with a retroactive statute, tax credit insurance is not the answer. Accordingly, buyers need to make sure that the underlying facts and structure are generally consistent with what Congress contemplated and Treasury is expecting. For instance, until there is clarity, individuals who are not “active” in the renewable energy industry may not want to buy tax credits because that is an area that Treasury could possibly issue regulations that negatively impacts it.
Insurance Payout Cap
Another consideration is that tax credit insurance policies have caps on the payout for a claim. Tax credit buyers need to be sure that the policy is sized appropriately. For instance, if the IRS prevails in an audit or in court, it must charge interest on the resulting underpayment. The interest accrues from when the tax return was due to when the underpayment is paid which is, generally, when the audit or Tax Court litigation is over. Currently, the interest rate for large corporations is 9 percent, which floats quarterly, and it can take a number of years from the filing of the tax return to the resolution of the audit; therefore, there is considerable time for that interest to accrue. In addition, the IRA transfer rules include a 20 percent penalty for “excessive credit transfers” and if the penalty is sustained the interest accrues from the day the IRS asserted the penalty. Finally, there are the fees of the lawyers and accountants needed to defend the IRS audit.
Therefore, if a tax credit seller is selling $5 million of tax credits and says don’t worry there’s a $5 million policy, a conservative tax credit buyer may not be comfortable with that level of coverage due to its exposure in an audit to more than merely the loss of the credits. On the other hand, tax credit audits are rarely binary; therefore, if the buyer is comfortable that only a portion of the tax credits could be eliminated in an audit, then an insurance policy for the face value of the transferred tax credits may be more than sufficient.
Tax credit buyers who are relying on tax credit insurance need to do their diligence, rather than assuming that the tax credit seller’s interests are aligned with its interest or that the terms are standardized. The diligence process should include analyzing the representations the insurer is requiring and what events are excluded from coverage and the level of coverage versus the potential exposure, including IRS interest, professional fees, in certain circumstances penalties, and a gross up. If such a multi-level analysis is not in the buyer’s wheelhouse, there are tax insurance brokers, lawyers and financial advisors who can provide the necessary expertise.
 The authors thank the Aon tax insurance team for their assistance with this article.