This article was previously published on ProximoInfra.com
Historically, tax equity has often been used to monetize tax benefits afforded to projects from various Internal Revenue Code (IRC) sections, and has taken on a variety of structures. Some of the established structures include single-tier partnerships, while others utilize lease structures, whether in a partnership form or not.
One of the determinants influencing 1) whether an investor is first interested in a deal and 2) how they structure a deal is how they’ll recognize their accounting impact of the investment under U.S. Generally Accepted Accounting Principles (GAAP). GAAP has often been thought of as a secondary step in evaluating a transaction, but in truth it’s potentially the first step. Tax equity investors are often large corporations, banks, or insurance companies seeking to minimize their income tax obligations. Their internal accounting department must evaluate how a tax equity investment may impact their income statement and earnings per share.
Within partnership-based structures, tax equity investors typically account for their investment using a method called hypothetical liquidation at book value (HLBV). HLBV calculations can be complex, often require quarterly updates, and, in certain circumstances, can lead to earnings volatility.
In March 2023, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2023-02, which, when certain conditions are met, allows a renewable energy tax equity investor to book their investment under a different method called the proportional amortization method (PAM). PAM simplifies the accounting for these investments, resulting in minimal pre-tax earnings, with most of the activity being reported in the income tax expense (benefit) line of the income statement.
Based on ASU 2023-02, in order to utilize PAM, the tax equity investor’s investment has to meet five conditions. Out of the five, only two are quantitative (the other three are qualitative):
- “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.” (In practice, most practitioners follow the rule of thumb that “substantially all” translates to 90%)
- “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.”
Both of these conditions are key to unlocking PAM. This ultimately means that cash distributions can’t be a major determining factor in how much equity an investor contributes. However, cash could be an important component to the investor’s ability to be treated as a partner in the partnership. Any partner in a renewable energy deal needs to have profit motive for the partnership to be respected for tax purposes. While there is no mandated test, general industry practice notes that a partner should receive a cash-on-cash IRR of around 2% over the life of the investment. That return calculation for the profit motive test normally includes both 1) the operational distributions an investor receives and 2) the tax credits, which are in form a substitute for cash tax payments. It’s important to remember that for this purpose, the lower the price/credit (“syndication price”) an investor pays, the less reliant they are on cash proceeds to meet the profit motive test.
The tax benefit component of the ratios includes both the tax credits and the tax loss benefits the investor realizes. This isn’t as straightforward as it seems because IRC Section 704(b) guides the allocation of losses between partners and may trigger a reallocation of losses from one partner to another. Among other limitations, an investor is limited to utilizing losses to the extent of their outside basis, which includes their share of debt proceeds. Losses also reduce an investor’s outside basis dollar for dollar in the same manner as do cash distributions, but don’t carry the same tangible benefit that cash does. That’s because every dollar of loss is only worth an amount equal to the loss times the tax investor’s marginal tax rate (MTR).
In reviewing the two quantitative conditions, it’s important to figure out where to start. The first condition deals with both tax credits/benefits/detriments and cash benefits in the ratio calculation, while the second condition only deals with tax benefits/detriments and credits. Given the focus on only one variable (tax), it makes sense to start with the second condition. In reviewing the second condition, it becomes helpful to look at what the total tax benefit could be to a tax equity investor without the influence of cash.
To solve for the maximum tax equity raise allowed where the tax equity investor’s projected yield, based solely on the income tax credits and other income tax benefits (the second test above), equals zero, consider the following examples. Note that to satisfy the second condition, this must yield a positive amount.
While not accounting for time value and assuming no cash distributions to the tax equity investor, in order to evaluate the total tax benefits of an Investment Tax Credit (ITC) and the value of tax losses (tax effected) in a single-tier partnership, we use the following formula, which includes the IRC 50(c)(3) reduction of the investor’s capital account:
[ITC + ((ITC*50%)*MTR)/(1-MTR)] = Total Tax Benefit
Using a $100 ITC and assuming a 21% MTR, the formula results in a total tax benefit of:
$100 + (($100*50%)*21%/(1-21%) = $113.29
To proof this formula:
A. Benefit of ITC: $100
B. Benefit of Tax Savings: ($113.29 – ($100*.5))*21% = $13.29
(A) + (B) = $113.29
Also, $13.29/.21= $63, which is the remaining capital account balance after the basis adjustment ($113.29-$50.00).
This means in this example, without accounting for any cash distributions, the investors would need to contribute less than $113.29 or have a syndication price less than $1.1329/$1 of tax credit in order to pass the second condition. Cash distributions would lower this result because cash distributions lower a partner’s ability to absorb tax losses under the partnership accounting rules.
Next, we take this a step further to account for cash flow (CF). If we now assume total distributions of $10 over the course of the five-year credit vesting period, the formula is:
[ITC + (((ITC*50%)-CF)*MTR)/(1-MTR)] = Total Tax Benefit
Using $10 of cash flow in this follow-on example to that above, we get to a total tax benefit:
$100 + ((($100*50%)-$10)*21%/(1-21%) = $110.63
This means in this example, the investors would need to contribute something less than $110.63 or have a syndication price less than $1.1063/ $1 of tax credit in order to pass the second condition.
In order to determine if this example passes the first condition, we then consider the “substantially all” (90/10 ratio) calculation, which for PAM equals:
[Discounted (Tax Credits + Income Tax Benefits)]/ [Discounted (Tax Credits + Income Tax Benefits + Cash Flow)]
By comparing the total tax benefits of $110.63 to the total benefits of $120.63 (including the $10 of cash), the result is 91.71%.
At this stage of the analysis, this investment may have a chance of passing both of the PAM quantitative thresholds (since it exceeds 90%), but the investors would still need to account for other factors before being sure.
Other variables include, but are not limited to: 1) time value in receiving those benefits, 2) deferred deductions due to the use of ADS vs MACRS, 3) possible 731(a) income, and 4) the investor’s yield/ ROI requirements. The writing on the wall therefore guides a user to project that the price a PAM-chasing investor may be willing to pay per tax credit may actually hover somewhere closer to the face value of the credit itself, or even lower. This would mean the PAM-chasing tax equity investor’s contribution would end up being less per credit than generally seen in the renewable market.
With these potential syndication prices, the developer may need to explore other financing/ITC monetization options, including simply transferring the credit under IRC Section 6418 to a third party. The market has indicated that transfer prices will likely be in the low- to mid-$.90s/credit for an investment tax credit. Assuming there will still be some amount of due diligence and transaction costs, a developer will need to evaluate whether the net benefit from a transfer deal comes close to, equals, or exceeds that of a potential PAM investor. Transfers do come with their own advantages to the sponsor (e.g., no partner and more operational cash) and disadvantages (e.g., potentially lower price point and recapture potential), so it’s not an automatic choice even after reviewing the comparable benefits. The registration for transfers hasn’t opened yet, and the door to achieving a PAM investment was only opened a short while ago, so time will be the major determinant for us to see which choices are made and which preferences are pursued.
Note: This article is addressing the application of the PAM from the perspective of a tax-paying parent which applies Topic 740.
Subject matter expertise
Principal, Project Finance & Consulting
CPA, Partner, Project Finance & Consulting
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