On June 28, Mayer Brown and Alfa Energy Advisors presented the webinar Tax Structuring and Impact of Potential Tax Reform. An audio recording of the presentation with video of the slides is available here. A pdf file with just the slides is available here.
Below are the questions submitted by the webinar audience with answers:
1. Question: For solar projects that use a third-party investor to monetizes the tax benefits, what is the split between the use of a sale-leaseback, partnership flip or an inverted lease structure in the market today?
Answer: There is no published data on this question. An educated guess in the current market is that partnership flips are more than half the market, inverted leases are less than ten percent of the market with the remaining portion made up of sale-leasebacks.
2. Question: In today’s solar tax equity market, are time- or yield-based flips more prevalent?
Answer: Yield-based flips are more prevalent. However, one very large tax equity investor prefers time-based flips. A generalization is that solar tax equity investors that started in wind projects prefer yield-based flips as that is what is sanctioned in the safe harbor for wind projects in Revenue Procedure 2007-65, while investors that started in tax equity by investing in historic tax credits prefer time-based flips.
3. Question: When the webinar presentation refers to tax equity investors earning 7-8.5% ATIRRs for utility scale wind and solar projects, do those return levels reflect P50 or P90 generation?
Answer: Generally, the “base case model” that a tax equity investor and the sponsor will use to determine the size of the tax equity investor’s capital contribution is based on P50 generation (i.e., the independent engineer would have determined that there is a 50% probability that the forecasted level of electricity production will be realized by the project). So those ATIRRs are based on P50 generation. However, a tax equity investor will typically require constraints in the base case model such that in a more conservative production scenario (i.e., lower production than the P50 scenario, such as P95) the point in time at which the base case model predicts the tax equity investor to achieve its ATIRR is not more than a stipulated number of months later than the date it is projected to achieve its ATIRR in the P50 scenario.
The returns for wind projects are more sensitive to P50 versus P99 production than solar projects are. There are at least two reasons for this. First, the amount the wind blows is more variable (and accordingly more difficult to predict) than the amount of radiation from the sun. For instance, over the life of a wind project, the electricity production in the windiest year will be far higher than production in the least windy year, while for solar the radiation in the best year is not that different than the radiation in the worst year. Second of all, the PTC is based on “production” so the credit varies with production and accordingly the tax credit is greater in the P50 than it is in the P99 scenario, while for solar the level of actual production has no impact on the ITC (so long as the project remains “in service” for at least the first five years to avoid “recapture” of the ITC).
4. Question: Is the ATIRR’s range for community solar projects the same 7-8.5% range that applies to utility scale solar?
Answer: First, it is helpful in answering this question to provide some background regarding community solar. Community solar projects are utility scale projects that consumers in the project’s utility district “subscribe” to effectively purchase their power from the project. It allows consumers that do not own their homes or have shaded property to purchase electricity generated by solar. Community solar is only allowed in certain states; Minnesota and Vermont being leading examples. In the states where community solar is allowed, the laws governing community solar vary. The market for tax equity for community solar is relatively new, so it is difficult to generalize. It appears that the regulatory nuances associated with community solar means that tax equity investors are demanding slightly higher returns than they do for a utility scale solar project with a power purchase agreement with a utility.
5. Question: Why would a reduction in the corporate tax rate have a greater negative impact on the after-tax internal rate of return (ATIRR) of wind projects than solar projects?
Answer: First, there is less depreciation for solar because the depreciable basis is reduced by half of the investment tax credit (ITC), while a wind project that uses the production tax credit (PTC) is not subject to a basis adjustment. Second, power purchase agreement rates for solar projects are generally higher than power purchase agreements for wind; therefore, solar projects have more revenue than wind projects, and paying income taxes on that revenue at a lower tax corporate tax rate is a benefit.
6. Question: In light of the fact that there is less depreciation in an ITC transaction due to the basis reduction equal to half of the ITC, if there is a reduction in the corporate tax rate, do you expect owners of wind projects to elect the ITC in lieu of the PTC?
Answer: The answer to that question will vary by wind project. In today’s market, a small minority of wind project owners opt for the ITC in lieu of the PTC. If a reduction in the corporate tax rate is enacted, it is not expected that there will be an increase in utility scale wind project owners claiming the ITC in lieu of the PTC. As discussed above, a significant reason that solar projects are impacted less by a corporate tax rate cut is that solar projects generally have higher priced power purchase agreements. Electing the ITC would not change the pricing of a wind project’s off-take contract. Further, with the capacity factors that today’s wind turbines can realize, the ten year PTC stream is often more valuable than a 30% ITC.
7. Question: All else being equal, it seems counterintuitive that a lower tax rate on an operating solar project, would have a positive impact on an existing tax equity investor in a project. Can you summarize why?
Answer: The hypothetical operating project in the presentation was placed in service in 2015 and the reduction in the corporate tax rate is assumed to be in 2018. In a project that was placed in service in early 2015, even one that did not elect bonus depreciation, 71.2% of its deprecation would have been claimed by the end of 2017 (i.e., before the reduced corporate tax rate is assumed to be effective). Then adjusting the depreciable basis by the amount ITC basis reduction, only 24.48% (i.e., (100% less 71.2%) multiplied by (100% less 15%)) of the basis remains when the tax cut is effective in 2018. The negative impact of the lower corporate tax on those remaining depreciation deductions is less than the beneficial impact of the tax equity investor paying tax on its share of the revenue at the reduced corporate tax rate.
8. Question: Are projects going to struggle if a developer signed a PPA in early to mid-2016 and was expecting to raise tax equity with the depreciation monetized at a 35% corporate tax rate?
Answer: For the reasons discussed in Q&A 5. and 6. above, the federal corporate tax rate being reduced below 35% is more of an issue for wind projects than solar projects. If the corporate tax rate is in fact reduced materially below 35%, wind projects with a power purchase agreement having a particularly low price may struggle and run a risk of not being financed and accordingly not constructed.
9. Question: If there is a reduction in the corporate tax rate and accordingly tax equity investors will be willing to invest less in a particular project, will developers risk missing their return thresholds given they have to put in more equity to make up the difference?
Answer: That answer will vary by project and will be more of an issue for wind than for solar. Certainly, wind developers that were assuming a 35% corporate tax rate close to their return hurdle may find themselves below their return hurdle if there is a corporate tax rate cut and they must fund more sponsor equity to make up for reduced tax equity. If developers then decide not to proceed with such projects, it remains to be seen if other parties involved in the project (such as the equipment suppliers, the construction company or the maintenance provider) would offer concessions to make the project economically viable for the developer.
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