The recent presidential election has caused significant uncertainty in the wind energy sector. This includes uncertainty not only with respect to energy policy, but also with respect to potential changes in tax policy and the impact those changes might have on tax equity financing transactions.
In response to this uncertainty, many investors have begun negotiating (and, in some cases, re-opening for negotiation) certain provisions in tax equity financing documents relating to the allocation of risk between the investor and the developer with respect to changes in tax law.
The principal concern among investors relates to President Donald Trump’s campaign proposals to significantly reduce the corporate federal income tax rates. Part of the tax plan described in the presidential campaign was to reduce the top marginal corporate income tax rate from 35% to 15%. Investors have expressed concern that, if enacted, this proposal could significantly reduce the value of some of the federal income tax incentives available with respect to wind energy projects.
There are two primary federal income tax incentives for qualified renewable energy projects: income tax credits and tax losses created by accelerated depreciation deductions. Tax credits applicable to qualified projects include the production tax credit (PTC) and the investment tax credit (ITC). Most qualified projects also are eligible, under the modified accelerated cost recovery system (MACRS), for dramatically accelerated depreciation deductions.
The bulk of assets in many projects may be depreciated over five years using a double declining balance method of calculating tax depreciation deductions. In addition, certain projects qualify for bonus depreciation in the year the project is placed in service. These depreciation deductions can create significant tax losses that an investor may be able to use to offset income from other sources, resulting in meaningful tax savings in the early years after a project is placed in service.
The primary concern regarding a potential reduction in the top marginal corporate income tax rate is that the tax losses created by MACRS and bonus depreciation deductions would be less valuable than under current law because they would offset income that would be taxed at a lower rate.
The value of the ITC and the PTC generally would not change if the tax rate is reduced because the credits apply to reduce tax liability on a dollar-for-dollar basis. In other words, $1 of tax credit offsets $1 of tax liability regardless of what rate was used to arrive at that tax liability. [adleft zone=’190′]
Tax losses, on the other hand, are applied as a deduction to arrive at net income that is subject to federal income tax. A $1 tax loss that is used to reduce income that otherwise would have been taxed at 35% generally results in a tax savings of $0.35. A $1 tax loss that is used to reduce income that would have been taxed at 15% generally results in a tax savings of only $0.15. Although this example is oversimplified, it is apparent that tax losses generally are less valuable if the marginal corporate income tax rate is reduced.[adleft zone=’190′]
Tax equity financing investments, regardless of the structure used, are priced to take into account the value of tax credits and any tax losses expected to be generated and made available to the investor. Prior to the presidential election in November 2016, most tax equity investments were sized based on an assumption that the investor would be subject to tax at the highest marginal income tax rate in effect on the date of funding (which generally was assumed to be 35%).
Although many investors had protection in the form of additional cash returns if the tax rate subsequently changed (thereby delaying the flip date in a partnership flip transaction, for example), the investments in those transactions still would be sized based on the current rate even if the parties anticipated that the tax rate would be reduced shortly after closing. In light of the election results, many investors became concerned that they would be required to fund transactions based on the higher income tax rate existing on the funding date and then would hope to be made whole over the life of the project.
To address this potential reduction in value, many investors, at the end of 2016, began negotiating terms to reduce the amount of their investments based on concern regarding potential tax rate changes. The terms of these provisions have varied widely by investor, developer and transaction. Some terms are quite specific and mathematical, and others are more general and conceptual. Generally speaking, however, the range of possibilities has fallen into three broad categories:
Most Investor-Favorable Approach: Some investors negotiated very investor-favorable terms under which, in the event a legislative proposal is made before funding to reduce the federal income tax rate, the investment would be sized based on an assumption that the legislative proposal would be enacted. Many investors drafted the applicable language to include not only proposed reductions in the tax rate, but also proposed changes to the law regarding depreciation deductions and other legislative or regulatory changes that would have the effect of reducing the benefit of tax losses to the investor. These transactions typically included terms providing for additional funding by the investor if the proposed legislative or other changes did not take effect within a specified amount of time after funding.
Less Investor-Favorable Approach: Other investors negotiated terms under which funding would be sized based on the federal income tax rate that exists on the funding date (even if proposals are in place to reduce the rate), but the investor would be made whole at the time of a subsequent change in the tax rate (or other depreciation benefits) in the form of either an indemnity payment from the developer or additional cash distributions from the project at the time the change takes effect.
Least Investor-Favorable Approach: Still other investors negotiated terms that provide simply that the parties will negotiate in good faith to try to preserve the investor’s return on investment if the tax rate is decreased.
Regardless of the language used to address potential changes in federal income tax rates, investors and developers negotiating these provisions should be cognizant of a number of different considerations.
For example, if language is drafted to include legislative proposals, the parties should think very carefully about how a “proposal” is defined (frequently using the term “Proposed Tax Law Change”). Some agreements include very broad language in this regard that would include almost any written description of a plan for legislation.
Indeed, the Trump campaign proposals might constitute a legislative proposal under some versions of this language. Other agreements are drafted very narrowly to limit “proposals” to include bills that have been introduced in Congress, assigned to a specified committee or even enacted by one house of Congress. In addition, some agreements address not only proposed changes to the income tax rate, but also legislative, regulatory or other changes to depreciation that would reduce the benefit of losses to the investor. This language also should be reviewed very carefully so that the parties understand what types of IRS pronouncements or other communications might constitute a proposed change in tax law.
Developers also may want to consider negotiating parameters around what changes in tax rates or other changes are to be taken into account in resizing the investor’s investment.
For example, some developers negotiated terms under which only legislative changes or proposals within a specified number of years after the signing date would be taken into account under the newly negotiated language. Others have negotiated thresholds under which only certain incremental changes in the income tax rates (e.g., a reduction of 10 percentage points) would implicate the new provisions.
Some investors accepted these proposals, and others did not, but the concept is that, if the investors are specifically concerned about President Trump’s tax rate proposals, the newly negotiated terms should only relate to changes that arise from those proposals, not to changes that occur later without regard to any specific proposal by President Trump. Another consideration is whether and how investor-favorable changes should be taken into account in adjusting the investment. Obviously, any legislative or other change that reduces the tax rate also could provide additional incentives for the investor, and developers should consider proposing language that would take those favorable changes into account, as well as any reduction in the tax rate.
These newly negotiated provisions have created a number of ancillary issues.
For example, in many partnership flip transactions, the investor must undertake a capital account deficit restoration obligation (DRO) to help ensure that all of the tax credits will be allocated to the investor. If the size of an investment is reduced to take into account a reduction in the income tax rate, the investor will essentially have paid less for the same amount of tax losses. This means that the investor’s DRO may need to be increased to reflect the adjustment to the size of the investment. Most investors are very sensitive to DRO issues, however, and some have refused to increase their DROs to address this issue. A number of alternative approaches have been explored, some with more potential merit than others. These and numerous other issues are still largely unresolved and remain to be worked out over the coming months as the investment community understands more about any tax reform proposals that may be made.
Kevin Pearson is tax partner and head of the tax practice at law firm Stoel Rives. For nearly the past 20 years, a significant portion of his practice has been devoted to renewable energy finance transactions, including partnership flip transactions, various forms of leasing transactions, and other forms of tax-motivated project finance arrangements. He can be reached at email@example.com.