By Drew Goldman, Vice President, Investments
This is the first in a series of discussions on how companies can convert tax liabilities into high-quality sustainability investments, which may also produce cash flow.
Every year, many sophisticated corporations divert over $20 billion of federal tax payments into projects in renewable energy, affordable housing, and historic preservation, in exchange for tax breaks and investment benefits. Some perceive a significant level of complication in these programs, and therefore delay taking a closer look. The very word ‘investment’ moves many people outside their comfort zones.
As a manager of funds delivering Renewable Energy Tax Credits (Sec. 48 of the Internal Revenue Code), Foss & Company is in the business of making it easy to take advantage of this high-impact federal tax incentive. ITC (investment tax credit) Funds provide a well-defined system for dealing with project and developer selection, project structuring, negotiation and closing, as well as potential tax benefit delivery including:
- Determining project eligibility and focusing on any hurdles to placing site(s) into service
- Structuring the transaction to address developer and investor needs
- Underwriting the developer, underlying power purchase contract and pro forma operations
- Valuing and appropriately pricing tax credits and other projected benefits
- Delivering Tax documents and financial reporting for annual federal filings
In terms of physical asset protection, potential losses at a solar farm typically to fall into two categories:
‘Acts of God’– fire, floods, earthquakes, or storms that damage the array or interrupting operations; and
‘Acts of Man’ – such as terrorism, a vehicle or plane crash, negligent maintenance, or faulty equipment.
These risks can be insured against potential losses. One risk typically not covered in conventional policies is fraud. Foss & Company conducts due diligence and background checks on each developer and its principals prior to closing any project. The lender and the long-term power buyer (typically a utility, municipality, or large corporation) conduct their own independent evaluations as well.
We believe that the most substantial investment risks in a solar ITC transaction include:
Recapture Risk – The full value of the ITC is earned once a project is placed in service. Then, for a five-year compliance period, the tax credit is subject to recapture if (1) the property ceases to be a qualified energy facility, or (2) a change in ownership occurs. During the first year, the recapture would be 100 percent. The recapture rate declines by 20 percent each year thereafter until the end of the fifth year.
Ceasing to Be a Qualified Energy Facility – For a solar project to cease being a qualified energy facility, the project would have to: 1) become permanently destroyed and not placed back into service; or 2) start selling something other than electricity derived from solar energy.
First, the IRS has no required rebuild time after an insurable event. As long as there is intent and action to replace the assets, there is usually no recapture risk. Foss & Company retains the right to replace an operator in the event of non-performance. Lenders are required to forego foreclosure during the 5-year ITC compliance period.
Second, working with reputable partners can help ensure projects are built and operated according to the plans and specs. Foss asset management identifies and proactively seeks to remedy issues related to this risk.
Lastly, in the event the credits delivered are less than projected, it triggers a “credit adjuster” where the investor may receive a return of capital plus penalties.
Change in Ownership – This can be a significant risk without experienced legal and accounting advisors. Foss & Company only works with firms who have long track-records in tax credit transactions, specifically dedicated solar practices. This risk can be mitigated through properly structured partnership documents. The manager is the only party who can change ownership allocations (except investor non-performance).
Foreclosure – From available data and lender conversations, Foss understands overall solar default rates to be under 1% (including smaller rooftop arrays). Also, as stated above, creditors may agree to forego foreclosure during the tax credit compliance period; while this is not a guaranty, it can provide significant structural protection to investors.
Foss & Company has a rigorous pre-closing checklist to evaluate every solar project and developer. We address a wide spectrum of risks proactively and can tailor our workflow to suit each investor. We make ITC investing as ‘turn-key’ as possible. We manage and verify:
- Feasibility and Financial Projections
- Proper system design, specifications, and equipment installation
- Solar resource and generation capacity
- Proper Legal, Engineering, Accounting and Partnership documentation
- Energy Production Company and Developer ability to perform all obligations
- Creditworthiness of power purchaser(s)
- Required financing and documentation thereof
- Site Permitting, Appraisals and Cost Segregation Analysis
- Financial reporting, and timely delivery of tax and investment documentation
How Long is Capital Outstanding Until Payback in a Solar ITC investment?
In typical real estate deals, capital must be called upfront, in order to achieve physical completion. Typically, the return of capital depends upon the passage of time; then, stabilized operations may generate cash flow to repay loans and equity.
The ITC partially mitigates this timing concern. Although the IRS requires a 5-year period when capital is ‘at risk’, the lion’s share of tax equity flows into each project as the final piece of funding:
- After review of and commitment to a Fund, 1% of investor capital is called.
- Once construction has been fully completed, an additional 19% of the investor’s capital is called.
- Then the project(s) are connected to the grid and the remaining 80% of capital is called into the Fund. A final cost segregation analysis is received, and the tax credits may commence, typically within a few months, along with potentially accelerated depreciation and possibly some preferred cash distributions.
- Compared with commercial real estate, ITCs provide a short window when capital is outstanding. By the end of year one of a Foss Fund, investors may begin to see a return on their tax equity. An apartment building, by contrast, may be under construction at the end of year one, with a minimum of 12-18 months remaining before its ability to produce any positive returns.
Preferred Cash Returns
Since ITC investors sign up not only for their tax credits but also a five-year stream of potential cash distributions, it is essential to understand the long-term perspective. Is the power buyer creditworthy, and what if there are delays in placing the array into service? How leveraged is the developer and the project?
Foss & Company seeks to provide an elegant solution to these and other questions. We fully evaluate each counterparty, and require minimum contractual standards, such as power purchase terms, equipment used, developer size and expertise, and actions in an effort to remedy any potential problems.
The inclusion of multiple projects in a fund may also spread risk versus a single utility scale site. In the case of an insurable event, a fund allows the investor to extend its timing, to potentially make up for any shortfall of cash flow.
Capitalizing on the Current Economic and Tax Environment
While large direct investors such as utilities deploy full-time teams to underwrite, negotiate and execute the many issues mentioned above, the typical company has limited in-house resources to focus on ITC’s. In large utility-scale projects, investor returns are often in the single digits. Foss & Company’s funds are fully passive in terms of required taxpayer resources, while targeting a higher level of reward by aggregating commercial-scale projects with high-quality long-term power purchasers in place. Our funds are structured to reduce the investors’ position in the early months. If the federal tax rate rose to 28% today, the impact of more depreciation would increase ROI by 280-300 basis points.
In summary, corporations have two options to satisfy federal tax liabilities: either simply pay the government, or invest in federal tax credits, which may eliminate tax liability, while potentially providing needed social benefits, and allowing some control over how tax dollars are spent. As mentioned above, ITCs may reward investors with a front-end loaded return of tax credits and attractive net positive returns on equity.
Those interested in learning more, can contact me at Drew@fossandco.com.