Maximizing Benefits: How to Make the Most of Transferable Tax Credits
This blog is the third and final in a January 2023 series that will explore the opportunities in the transferability of renewable tax credits for investing in renewable energy and reducing tax liability. Consider reading the first and second blogs on this topic.
The Inflation Reduction Act, signed into law on August 16, 2022, has created new opportunities to invest in a sustainable future. There are many options, but one of the more promising is new transfer provisions which allow for the transfer of renewable energy tax credits between taxpayers. With these new transfer provisions, a taxpayer can purchase a tax credit generated from an eligible project, for example, at $0.90 per $1 of tax credit and then apply the credit to reduce required tax payments to the Internal Revenue Service (IRS) by the full $1.
In this blog, we’ll cover some of the considerations both investors and developers should keep in mind as they explore participating in the transferred tax credit market. The specific considerations we will explore are those associated with tax credit “step ups” on transferred ITCs, monetizing depreciation on transferred tax credit deals, recapture and eligible basis risk for transferred tax credits.
Eligible basis risk and tax credit “step ups”
Investment tax credits – whether a transferable or a traditional tax credit investment – are 30% (or more, if adders apply) of the eligible (cost) basis of the development of renewable energy development. What is allowed to be included in the eligible basis of a renewable energy development (e.g., solar system, battery storage facility, etc.) is subject to the rules of the IRS. In traditional tax equity transactions, it’s common for the project assets to be contributed into a holding company at a fair market value, thus establishing an eligible basis that is higher than the hard costs of the project. This fair market value is typically supported by a third-party appraisal. The difference between the eligible basis and the hard costs is referred to as the tax credit “step up”. Developers have an incentive to maximize the appraised value of the projects they develop in order to maximize the tax credits that may be generated by the project. There is risk that the IRS audits a tax credit transaction and determines that the step up is excessive. This could lead to a partial disallowance of tax credits, as well as penalties. To avoid purchasing a tax credit that is disallowed, it’s important to validate the hard costs and appraised value of the subject renewable energy assets prior to purchase. Many investors lack the experience in the renewable energy market needed to evaluate and effectively mitigate risk associated with eligible basis and excessive ‘step ups’ on a project and so engage a tax credit adviser, such as Foss & Company, to apply its expertise to do so.
Monetizing depreciation
One of the benefits enjoyed by traditional investment tax credit investors is the benefit of booking depreciation expense over the 5-year compliance period (or life of) the investment tax credit. Depreciation expense benefits taxpayers by reducing earnings subject to income tax. The ability to book depreciation expense and offset net earnings contributes to the premium price of the tax credit in traditional tax equity transactions. Because buyers of transferred tax credits do not have ownership in the respective project, they have no basis eligible for the depreciation typically recognized by investors in these projects. To the extent the seller of the tax credits is also unable to fully utilize the depreciation due to limited taxable income, the tax benefit associated with the depreciation goes unrealized; this “leakage” of value translates to relatively less attractive economics for the developer, which may dissuade developers from choosing to transfer credits versus allocate them through a traditional tax equity partnership.
Recapture risk for transferred tax credits
As with traditional tax equity investments, certain tax credits are subject to recapture risk (e.g., the investment tax credit is subject to a 5-year recapture period following the placed in-service date). The same events that would cause a recapture in the case of a traditional tax equity investment are expected to cause recapture of transferred credits. However, these risks are expected to be much greater in an unstructured transferred credit transaction due to the lack of structural risk mitigants present in traditional tax equity transactions. Recapture or disallowance events for investment tax credits include change of ownership, system no longer being placed in service, non-compliance with prevailing wage or apprenticeship requirements, failure to properly qualify for adders (e.g., not actually using domestic manufactured equipment but claiming the domestic content adder), and many more. To avoid recapture or disallowance, it is advisable that investors establish proper mitigating terms in their purchase agreement and institute robust portfolio monitoring and asset management practices. These methods of addressing the risk of recapture are as effective as your practices are informed by experience. Partnering with experts in the renewable energy tax credit market is recommended. Tax credit insurance alone is not a sufficient mitigant. There are many recapture events that would not be covered by insurance (e.g., adding project debt after the policy is in place that leads to foreclosure), or actions performed by the sponsor that could void coverage (e.g., not notifying insurers of an audit).
The important takeaway from this blog is that transfer credits, while a viable way to access renewable tax credits and one that many taxpayers will prefer over traditional tax equity (see blog 1), it is not without trade-offs and risks. Foss & Company has over forty years of negotiating meaningful projected returns in tax equity transactions and monitoring assets to manage the risks associated with tax credits, including the risks of disallowance and recapture. With zero recapture in its four-decade history, Foss & Co has a stellar track record of helping its clients. To learn more about how Foss & Company can help you achieve your tax credit goals, check out our website or contact us. For more on the transferability of tax credits, listen to our latest podcast episode IRA Insights: Transferability of Tax Credits.