Repost of the original article in the Novogradac Journal of Tax Credits, which can be found here.
As the renewable energy market continues to grow, the popularity of transferable tax credits as a way to fund projects and reduce corporate tax liabilities is on the rise. Following the passage of the Inflation Reduction Act, provisions enabling the transfer of tax credits have become hot topics for both developers and investors. In this article, we’ll discuss several common misconceptions regarding transferable tax credit transactions.
Transferable Tax Credits Overview
Transferable tax credits are a valuable financial instrument that allows businesses to reduce their tax liabilities by investing in projects that generate economic, social or environmental benefits. These tax credits can be sold or transferred between taxpayers, enabling companies with little or no tax liability to monetize the credits and create a new revenue stream. As attractive as this financial tool may seem, it’s essential to understand the associated risks.
Myth #1: Transferable Tax Credit Buyers Have No Risk
When speaking to project developers or prospective investors, we often hear transferable tax credits compared to state certificated tax credits which have almost no risk associated with them. Unfortunately, there are some risks associated with transferable tax credit transactions and it is important for investors to understand those risks.
The risks associated vary across the different types of tax credits eligible for transferability. For example, clean energy investment tax credits (ITCs) are subject to recapture risk for five years following the project being placed in service. Carbon sequestration tax credits are subject to a three-year recapture period and the triggering events for recapture are quite different. Clean energy production tax credits (PTCs) are not subject to recapture, but do face volume risks which could lead to under delivery of tax credits in some years.
Myth #2: Recapture Risk is Not a Concern Due to Insurance
As discussed above, the primary risk associated with transferable tax credit transactions is the possibility of recapture. Recapture occurs when a tax credit is reversed or “taken back” by the government due to a failure in meeting the requirements of the underlying project or investment. This can lead to financial losses for investors and businesses involved in the transaction.
To address the risk of recapture, some companies promote the use of tax credit insurance. While insurance can provide a layer of protection for investors, it’s essential to understand that it does not guarantee a complete safeguard against recapture risk. Insurance policies often have exclusions, coverage limits and conditions that can leave investors exposed to significant financial losses.
We fully expect tax credit insurance will play an important role in the transferable tax credit market and will be used to cover risks such as a recapture due to change in ownership during the compliance period or the IRS disagreeing with the eligible basis calculations of the project. However, there are some tax risks which tax insurance may not fully cover, including:
- contractual default of the sponsor (e.g., failing to facilitate the transfer);
- misrepresentations from the sponsor to the insurance company that lead to a loss or recapture;
- fraud committed by the sponsor leading to recapture, such as attempting to transfer tax credits more than once.
It is also important to ensure that the insurance policy is sufficiently sized. Sizing an insurance policy at 100% of the tax credit amount may not be sufficient due to interest and penalties that the buyer could face in a recapture scenario. This means that an appropriately sized tax insurance policy may need to be far larger than the actual amount of tax credits involved in the transaction.
Myth #3: If You Have Insurance, You Don’t Need a Sponsor Guaranty
We have seen some transferable tax credits marketed with tax insurance as the only risk mitigant, with no guaranty from the sponsor. This is likely an insufficient risk mitigant for tax credit investors. As described above, these insurance policies may not fully cover every risk. In addition, the policy often relies on representations from, and actions taken by, the sponsor. If the sponsor has no “skin in the game” by way of a guaranty, they will not be properly incentivized to prevent recapture of tax credits. For example, if a project lender is threatening to foreclose on a project, the sponsor may not be motivated to pay off the lender and avoid a recapture due to their lack of a guaranty.
Myth #4: There’s No Need to Due Diligence or Manage a Transferable Tax Credit Deal
As discussed above, tax credit insurance may not fully mitigate all aspects of risk on transferable tax credit transactions. The most effective way to mitigate recapture risk is to adopt a comprehensive investment strategy. This could include the following:
- Due diligence: Perform thorough due diligence on the underlying project or investment to ensure it meets all the requirements necessary to mitigate the risk of recapture.
- Legal and tax expertise: Work with experienced legal and tax professionals to structure the transaction in a way that minimizes recapture risk and complies with all applicable laws and regulations.
- Monitoring and compliance: Regularly monitor the project’s progress and maintain compliance with all the requirements to prevent potential recapture events. For example, ongoing monitoring to ensure the property insurance has been renewed is an important mitigant against recapture from natural catastrophe.
- Diversification: Invest through a managed fund that spreads your tax credit purchases across a diversified portfolio of projects to reduce the impact of a single recapture event on your overall portfolio. This is a similar concept to buying a diversified mutual fund instead of a single stock.
Myth #5: Transferable Tax Credits Can Offset Quarterly Estimated Payments
In traditional tax equity transactions, investors sometimes begin applying tax credits against their quarterly estimated payments immediately after the tax credit is generated. It is not yet clear that the same will be possible for transferable tax credits. Without knowing the mechanism that the IRS will put into place for effectuating the transfer, there is still some uncertainty about the timing of when the actual transfer will occur. For example, if the IRS were to only allow the transfer to occur once per year at the time of tax filing, it may not be possible to “receive” the credits earlier in the year and apply them against quarterly estimated payments. We recommend that investors take this ambiguity into account when negotiating the pricing and terms of their tax credit transfers.
Myth #6: Basis Reduction Travels with the Tax Credits
Many sponsors and investors are considering hybrid structures whereby the portion of the tax credits generated by a project would be sold using the transferability provisions. These structures typically involve a tax equity investor being allocated the balance of the tax credits through a tax equity structure such as a partnership flip, thereby monetizing the depreciation. It is important for sponsors and investors to work with third-party accountants in modeling these transactions. A common mistake we have seen is a failure to correctly account for the basis reduction in these transactions. The basis reduction of the full tax credit amount stays with the entity selling the tax credits. Therefore, a tax equity investor who is transferring 50% of the tax credits from a project must still recognize a basis reduction on 100% of the tax credits. This can lead to structuring challenges, such as deficit restoration obligations.
Myth #7: There is No Tax on the Purchase of Transferable Tax Credits
If an investor buys a tax credit for $0.95, we have seen a misconception that they face no taxable income as part of the transaction. Hopefully, the IRS will offer guidance on this topic, as there appears to be some ambiguity. It is possible that investors will be taxed on the discount that they buy the tax credit for ($0.05 in the above example). This potential tax could dilute their return, and should be considered when negotiating transfer transactions.
As the renewable energy market flourishes, transferable tax credits have gained traction as an attractive financing tool for funding projects and reducing corporate tax liabilities. However, it is crucial for investors to recognize and navigate the myths and misconceptions surrounding these transactions. Risks, such as recapture, must be acknowledged and properly managed through due diligence, legal and tax expertise, monitoring and diversification. Investors should not solely rely on insurance and sponsor guaranties, but rather adopt a comprehensive investment strategy. Understanding the nuances of tax credit transfer mechanisms, basis reduction and potential taxation on purchases is essential to maximize returns and mitigate risks. As the transferable tax credit market continues to evolve, staying informed and working with experienced professionals is the key to success in this complex financial landscape.