Is the Traditional Tax Equity Structure Outdated by Transferable Credits?
For decades, tax equity has ruled the U.S. renewable market and has been the standard for monetizing federal tax credits.
A tax equity partnership flip, or a P-flip, is a structure where two parties form a partnership between a sponsor and a tax equity investor. The sponsor is the project developer, and the investor is a large, taxpaying corporation.
How Does a Tax Equity Partnership Work?
The investor makes an upfront capital contribution in exchange for an ownership stake. The partnership agreement first allocates a large majority of the project’s tax and cash flow benefits to the investor, typically 99% to the investor and 1% to the sponsor.
Why Is This Beneficial to the Investor?
The investor obtains the benefits of this structure, which include the Investment Tax Credits (ITC) or Production Tax Credits (PTC), and the Accelerated Depreciation (MACRS) deductions. The structure remains this way until the investor reaches a pre-defined return, or a set date arrives. Once the target is hit, the allocation flips, hence the name of the structure, and the investor’s share of tax benefits and cash flow decreases dramatically, usually to 5%, while the sponsor’s share is 95%. The sponsor then regains control and the majority of the project's long-term value. The sponsor would usually have an option to buy out the investor’s remaining interest after the flip.
But is this still the easiest and most efficient way to monetize renewable tax credits? Could there be a simpler way to avoid ownership shake-up and minimize the time period to realize value? Transferability offers a new method.
The Inflation Reduction Act (IRA) introduced Transferable Tax Credits, a new, simplified mechanism that has fundamentally altered clean energy finance.
How Does Transferability Work? And How Is It Simpler?
Instead of forming a complex partnership, transferring a tax credit is simply an agreement between two parties for the sale and purchase of tax credits for cash consideration: the seller, which is the project owner or developer who generates the tax credit, and the buyer, which is an unrelated corporate taxpayer with sufficient federal tax liability who wishes to purchase the tax credits to offset that liability. The sale price of the credits is at a discount to the buyer, often $0.90-$0.95 per $1 of credit.
But doesn’t a tax equity structure result in greater returns?
It is true that a tax equity structure may result in a greater return than the $0.05-$0.10 discount noted, but there are other factors to transferability that offer value.
Transferability is an efficient and cost-effective method to reduce effective tax rate. Cash is paid directly from the buyer to seller while the credit is transferred from seller to buyer. Since the buyer is not an equity partner in the project, they take on no project operating risk. Transferability also allows for smaller projects and taxpayers that were historically ignored by traditional tax equity to reap the benefits as well.
Transferability also cuts down on transaction time. Where a tax equity structure may take several months to complete, a transferable deal may be completed in as quickly as a few weeks.
The significant economic value for a buyer is realized with the timing of payments. Payment for a credit is timed to a buyer’s estimated quarterly tax payment. For the 45Z Clean Fuel Production Credit specifically, fundings can be set up on a quarterly basis to match a buyer’s quarterly payment schedule. On the day the buyer owes an estimated quarterly tax payment to the IRS, the buyer will instead apply the credit to the IRS payment and pay the seller the discounted cash purchase price. The internal rate of return for the buyer is essentially infinite as the time to realize the gain is zero.
With the introduction of transferability, there are now multiple options to monetize tax credits. The tax equity structure and transferability methods now co-exist. While tax equity provides the economic value by monetizing both credits and depreciation, the cost, complexity, and time commitment are prohibitive for some. Transferability offers an efficient and inexpensive way to monetize investments. Ultimately, the industry will rely on both models: tax equity to structure large projects, and transferability for greater speed and liquidity across the entire sector.
For more information, reach out to our renewables expert, Faith Larson, at faith@mickco.com or 605-977-4873 ext. 4.
The Company should seek independent legal, tax, and accounting advice as part of this process. Mickelson & Company is not providing legal or accounting services.