While corporate tax reform and reduced tax rates were the hallmark of sweeping 2017 legislation (the Tax Cuts and Jobs Act, or TCJA), and thus the focus of the media and tax professionals, the renewables industry was largely unaffected by these sweeping changes. At the same time, renewable energy producers have started running out of time to utilize tax credits upon which many rely, leaving these taxpayers scrambling to meet requirements while simultaneously hoping for reprieve through post-tax reform legislation or IRS guidance.
There generally are two credits for renewables, the production tax credit (PTC) and the investment tax credit (ITC), each of which is governed by an area of law comprised largely of IRS guidance and rulings. The PTC, the credit of choice for onshore utility-scale wind developers, has been phasing down since 2017, and the credit is unavailable for many types of renewable energy unless construction on their systems commenced either on or before December 31 of 2017 or 2018, depending on the technology. However, a reduced PTC remains available for onshore wind developers if construction is commenced by December 31, 2019. As a result, unless extended by Congress, 2019 will be the last year in which taxpayers can start construction and claim the PTC. Meanwhile, the ITC, the preferred tax credit for solar and offshore wind developers, among others, has received a small reprieve in its own phasedown schedule thanks to IRS Notice 2018-59, which was released this summer. However, despite this extension, 2019 still is the final year in which the taxpayer can start construction and claim the full credit. For example, for solar property the construction of which begins before January 1, 2020 and which is placed in service by January 1, 2024, a taxpayer still will be eligible to receive the full ITC (assuming all other requirements for the credit are met). However, the ITC initially will be reduced for solar property the construction of which begins on or after January 1, 2020 and again for construction that begins on or after January 1, 2021, before finally leveling out for projects for which construction begins on or after January 1, 2022 (again, in each case, assuming all other requirements are met).
As a result of these phasedowns, taxpayers utilizing either credit likely will move quickly to begin construction on new projects. The uptick in projects, particularly salient for utility-scale wind producers whose developments typically take around 18 months to complete, is expected to strain third-party suppliers who build the equipment necessary to begin construction. This, in turn, may create some difficulties for developers as they jockey for priority with the limited number of renewable energy equipment suppliers that exist worldwide. Supply bottlenecks and shortages (along with recent applicable tariffs) may increase delays and make it difficult for developers to meet the end of the year deadline for either credit. This especially is true for wind developers who often depend upon the 5% safe harbor to satisfy each of the credits’ “start of construction” requirement. Under the 5% safe harbor, wind developers may qualify as having started construction once they spend an amount equaling or exceeding 5% of the total cost of the project (click here for more). However, in addition to spending the requisite amount, they also must receive the items for which they paid by the deadline.
That said, to the extent that delays reach the fourth quarter, there remains a possible path to meet the requirement. Taxpayers wishing to claim the credit in a taxable year when the equipment may not yet have been delivered by year-end sometimes have relied on the so-called “economic performance rule” to meet the test. This rule generally would permit a taxpayer to pay for, say, the number of wind turbines necessary to qualify for the 5% safe harbor in a given year if it (i) makes payment in that year and (ii) receives the equipment within three and a half months of the date of payment. For example, an onshore wind producer hoping to take advantage of the PTC’s 40% phasedown rate would need to meet the 5% safe harbor by December 31, 2019. In order to do so, it may take advantage of the economic performance rule and receive the equipment anytime within three and a half months of having paid for the parts. Moreover, a taxpayer can further hedge its bets by “receiving” the ordered equipment near the producer (e.g., by renting a storage facility to house the completed equipment before it is to be delivered to the taxpayer), thereby cutting out time for delivery. This could be particularly important in situations where there are few producers of the component parts, requiring the domestic developer to cast its eyes worldwide in order to complete the order in time.
This possible supply and demand issue, and possible solution, also will be a salient issue for taxpayers wishing to take advantage of the ITC. Whereas taxpayers utilizing the PTC only can hope to salvage a portion of the credit before it disappears entirely at year’s end, taxpayers utilizing the ITC have until the end of the year to qualify for the full credit before the phasedown begins. With these short timelines and possible supply and demand inequity, taking advantage of the economic performance rule in order to satisfy the 5% safe harbor may prove anxiety-inducing for taxpayers who find themselves entirely dependent upon a third party’s ability to complete and deliver equipment within the three and a half month grace period. Moreover, the economic performance rule on which this strategy depends is subject to further development and limitation by “additional rules in regulations, revenue procedures or revenue rulings” which largely comprise the ever-developing rules governing renewable energy credits. Thus, in addition to the practical challenges of relying on this rule where delivery might take place in 2021, this approach could be challenged, perhaps even retroactively.
To the extent supply meets demand, developers can act quickly and without reliance on the economic performance rule in order to satisfy the 5% safe harbor. The fast-approaching deadline for the PTC and ITC, however, will create both a need for developer funding and a potential opportunity for those interested, including private equity funds, either through tax equity structures or through direct investment. With respect to the latter, the TCJA introduced for individual and certain other non-corporate taxpayers a significant, though complex, deduction for qualified business income (“QBI”) from each of the taxpayer’s qualified trades or businesses (click here for more). Recently released final regulations provide guidance on some of the more challenging aspects of the new deduction. To the extent these projects and the form of the investment generate QBI eligible for the deduction, the timing of the new deduction and the need to expedite development projects dovetail into investment opportunities, as developers may be in need of capital to actively pursue meeting the start of construction requirement. Similarly, interest in tax equity structures may start to increase as developers seek funding and investors become aware of the limited opportunity to enjoy the maximum benefits from renewable tax credits.
In particular, beyond specific projects, new or existing private equity funds whose investors otherwise may benefit from the new pass-through deduction, could be encouraged to seize upon this opportunity. Private equity funds, which themselves are organized as partnerships, typically invest in corporations and are not engaged in a trade or business, usually to avoid adverse tax consequences to their tax-exempt and foreign investors. This is because partners of a partnership generally are treated as engaged in the partnership’s trade or business. Tax-exempt investors that are not otherwise subject to tax would be taxed on their share of the partnership’s business income as unrelated business taxable income (UBTI). Foreign partners of a partnership engaged in a trade or business are treated as so engaged and subject to tax on the income as “effectively connected” to the conduct of a U.S. trade or business (ECI), and that “ECI taint” could spread to their other U.S. investments (click here for more). However, in the energy space, including renewable energy, private equity funds typically invest in other pass-through entities, and might be a sought-after resource by developers, particularly where the fund investors may be able to take advantage of the new pass-through income deduction (again, if and to the extent the activity around the solar or wind project constitutes a business for tax purposes). Where there is no underlying business income, tax equity structures that rely on the value of renewable credits may be attractive opportunities in 2019 before time runs out. Of course, these structures by their nature are more attractive to taxable U.S. investors who can benefit from the credit that the developer is seeking to monetize. Even with lower rates, investors typically seek out tax efficient investments, and thus might be encouraged to act now when the need for capital appears high – and deal terms more attractive.
To the extent an existing fund with foreign and tax-exempt investors wishes to invest in a pass-through entity, such as a renewables project, it typically has the ability to do so if the structure avoids ECI and UBTI to the foreign and tax-exempt investors, respectively. To that end, where an underlying investment in a renewables project might generate business income, a “blocker” corporation could be used as the vehicle for these investors, a strategy made more attractive with a new, lower 21% rate for corporations. Particularly where the corporation does not pay dividends, this structure could be even more tax efficient than a pass-through structure. Moreover, blocker corporations may leverage the investment (something that generally cannot be done directly by tax-exempt investors, or funds with tax-exempt investors), which, if done within certain parameters and respected, could reduce the corporate level tax via interest deductions. Of course, any such structure would need to be mindful of the new interest deduction limitation, which generally limits interest deduction to 30% of adjusted taxable income. For more about corporate tax reform and the new interest deduction limitation rules click here and here.
Finally, the concerns regarding the phasing down of the PTC and ITC discussed at the beginning of this article could be abrogated by the passage of legislation by Congress extending the time horizon for the tax credits or creating new subsidies or incentives to replace them. In our next installment, we will focus on proposed legislation that intends to extend the incentives for renewable energy producers using an updated approach and whether its passage (either in part or in whole) is possible in the current political environment, including calls for a Green New Deal.