Tax credit transfers: A potential opportunity, but not without planning
The Inflation Reduction Act (IRA) was a game changer for the renewable energy industry, especially for those projects utilizing tax credits that have been commonly monetized through tax equity partnerships. In addition to extending and enhancing the respective tax credits, the IRA provided a new Internal Revenue Code (IRC) Section 6418 which allowed for a number of the energy related tax credits to be transferred (literally sold) to an unrelated third party.
This transfer allowance triggered excitement in the industry because it was seen as a path to simplify transactions, potentially expand the investor universe, and alleviate complex financial accounting. While the clean energy industry anxiously waited for regulations on the transfer of tax credits, countless analyses were performed behind the scenes to see whether a transfer versus a tax equity partnership resulted in similar or better economics. That guidance, in the form of a proposed Treasury regulation (RIN 1545-BQ64) was released on June 14, 2023, and contained the initial explanation of how such sales of credits may be conducted, as well as a discussion of the policy considerations that led to the proposed rules.
The proposed regulations were relatively straightforward, but they do contain IRC Section 48 investment tax credit (ITC) recapture provisions which could potentially trip-up a developer who intends to later sell their ITC eligible assets/ownership interests during the five-year recapture window. Our discussion below highlights some of the considerations that an asset owner should be aware of when contemplating the potential structuring of a credit transfer and whether there’s the potential to trigger a material recapture event under IRC Section 50.
The potential ownership in a renewable energy project requires many considerations, including:
1) How will I finance the purchase/construction?
2) How and when will I exit my ownership position?
Prior to the IRA, renewable energy developers planning to utilize a Section 48 ITC to help finance their project lived in a binary world where the project either qualified for the ITC or it didn’t. While structuring tax equity financing is by no means easy, the IRA introduced new options to consider when making financing plans, thus making the entire decision process even more complex than before the IRA became law. For example, new considerations now include:
1) Should I use the ITC or the IRC Section 45 Production Tax Credit (PTC)?
2) Should I try to qualify for the so-called tax credit adders now available under either IRC Section 45 or IRC Section 48? If so, which adders am I qualified for, and how much will it cost?
3) Should I transfer/sell the chosen credit instead of pursuing a traditional tax equity structure?
These new options bring with them varying developer returns when assessed through the lens of the cost of the capital stack and its relation to project cash flows. These analyses are integral in shedding light on which tax credit and financing structure(s) best supports the project’s financial viability.
What was apparent in the proposed Section 6418 transfer regulations is another consideration which needs to be accounted for in a developer’s planning: If I choose the ITC instead of the PTC, and then sell my asset/interest during the ITC recapture period, will I trigger a large recapture charge?
In most conventional ITC tax equity partnership structures, developers have historically received 1% of the ITC with the other 99% structured to be allocated to the tax equity investor. Developers are aware that selling at least one-third of their ownership interest during the recapture period will trigger recapture on their 1% share of the unvested credits. This is generally an immaterial amount and doesn’t factor much into the decision-making process to either sell down or not.
In contrast, the option to transfer the ITC brings with it some new and potentially material recapture considerations that developers now need to account for in their business plans. Specifically, the Section 6418 guidance notes that “...these [recapture] rules continue to apply to a disposing partner or shareholder in a transferor partnership or transferor S corporation, respectively.”
This means that, in the event the developer owns an ITC eligible project asset via an interest in a partnership with an unrelated third party and sells their interest in that partnership (this is referred to as an indirect transfer of the ITC eligible asset in the proposed regulations) during the recapture period, the developer will recognize a liability for their proportionate share of any recapture triggered. The developer’s proportionate share of recapture is equal to that portion of the transferred credits which the developer would have been allocated had the credits not been transferred. But because that could be more than 1% of the tax credits, and possibly substantially more than 1% of that amount, the resulting recapture payment needs to be accounted for when evaluating a potential sale.
As a side note, if the partnership is the direct owner of the qualified facility and subsequently sells the facility, the transferee bears the burden of ITC recapture. This is called a ‘direct’ transfer under the proposed regulations.
Therefore, a core issue under the new Section 6418 guidance is that if an owner sells an ownership interest in a qualified facility with a transferred ITC (whether directly or indirectly), a recapture event is triggered. Whether the developer directly or indirectly triggers recapture, the developer will likely bear the economic responsibility associated with the recapture payment even if the tax liability rests with the tax credit purchaser. While the transferors didn’t use the credit themselves, the most recent guidance makes it clear their ownership interest is tied to the ITC during the five-year vesting period. This is different than the 1603 grant program where an owner could sell their ownership interest during the vesting period so long as they avoided selling to an ineligible party.
Here's a hypothetical example:
- A developer owns 95% of a partnership which owns an ITC eligible project and would otherwise be allocated 95% of the ITC, but transfers 100% of the credit to a third party
- The total cost of the ITC eligible project was $100 and the ITC was $30
- The developer during the second year of operations sells their ownership interest to a different third party
- Because the ITC was only 20% vested, the developer is faced with a recapture payment of $22.8 or 76% (80% x 95% ownership) of the face value of the ITC’s transferred (ignoring consideration of interest and penalties), despite the transferee (not the transferor) having used the credits to reduce its tax liability
This is now an important consideration due to the amount of available tax credits and how the project financing is structured. In the above example, a developer should consider the financial implications resulting from a potential sale of their ownership interest under a tax credit transfer prior to executing any such tax credit transfer. Simply put, does the sale of credit continue to make sense if, in the above example, $22.80 of the purchase price is held back for a recapture payment?
This recapture rule raises certain planning considerations when evaluating a credit transfer, including:
1) Do you want to own the project for five years directly or indirectly? Or do you want flexibility for those five years?
2) Do you want to structure a partnership to own the project?
3) If you do decide to form a partnership:
a. What will be the profit/loss and tax credit allocation?
b. Is the partner an economic investor focused on cash returns, or a tax equity investor interested in the tax losses and wants the flexibility to instruct the partnership to transfer the credits?
When evaluating these scenarios, it becomes clear that a developer should not only evaluate the various tax credit alternatives and structures, but also understand their own business plans and whether retaining their ownership interest for the next five years is within bounds for them. If not, without the proper planning, an ITC transfer may not make the most sense. Instead, it may make sense to consider a conventional ITC tax equity structure and/or utilizing a PTC instead of the ITC. Maintaining a conventional ITC tax equity structure brings potential recapture on their 1% share which, again, doesn’t generally weigh heavily on the decision to sell or not. Separately, one redeeming feature for PTC’s is that there is no recapture triggered via the sale of either an interest or asset during the 10-year PTC credit period. This means that whether the PTC is transferred or used within a tax equity structure, the developer is free to sell their interest without any tax credit recapture restriction. Analyzing and understanding the financial impacts associated with these different structures, while understanding the limits that each brings, should not be taken lightly.
While the IRA brought with it more than 30 different credit structuring options after accounting for the ITC, PTC, Adders, and Transfers, it’s necessary, now more than ever, to have a solid understanding of the tax pros and cons associated with these different options. Having the right tax advisor to help navigate through the confusing and complex set of options available under the IRA can make all the difference for an organizations’ success as it evaluates how best to make the right choices on determining the right next steps and investments for their company.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.