A Word About Wind has published our article What Is the Impact of Tax Reform on US Wind Tax Equity Deals? in its blog (subscription required) and newsletter.  If you are unable to open the blog post, the text of the article is available below:

On 22 December 2017, President Trump signed the first major reform of the United States tax code since 1986. Here are some of the ramifications of the reforms on wind tax equity transactions.

Corporate Tax Rate Reduced to 21%

In 2018, the corporate tax rate has been reduced from 35% to 21%. The rate reduction means that US corporations will pay significantly less federal income tax, so the supply of tax equity will decline. However, most tax equity investors are expected to still pay enough tax to merit making tax equity investments.

Importantly, the rate reduction means sponsors of wind projects will be able to raise less tax equity as depreciation deductions are worth only $.21 per dollar of deduction rather than $.35 per dollar.

100% Bonus Depreciation

A partial mitigant to tax rate reduction is that the act provides the option of claiming 100% bonus depreciation (i.e. expensing), so depreciation deductions can be available in the first year (rather than over multiple years). However, the partnership tax accounting rules hamper the efficient use of 100% bonus depreciation.

For instance, assume a wind project costs $105m. The sponsor and tax equity investor form a partnership with contributions of $45m from the tax equity investors and $60m from the sponsor. The project has $5m in revenue from selling power in 2018 and $3m of production tax credits (PTCs).

The partnership can deduct the full $105m in 2018. That means the tax equity partnership has a $100m tax loss in 2018 (i.e. $5m of revenue less $105m of depreciation) that is allocated 99% to the tax equity investor and 1% to the sponsor. The tax equity investor only contributed $45m. Therefore, the “outside basis” rules mean the tax equity investor can take a deduction for only $45m, and the remaining $54m (i.e. $99m less $54m) is “suspended”.

That “suspended loss” can be used in either of the following ways: (i) income is allocated to the tax equity investor in later years or (ii) the tax equity investor contributes additional capital.

Further, the ‘capital account’ rules mean that the equity investor must agree to a “deficit restoration obligation” whereby, if the partnership liquidates, the tax equity investor agrees to contribute $54m to the partnership. Although we are not aware of a wind partnership ever liquidating in a way to trigger payment on such an obligation, some tax equity investors have risk management constraints on how large an obligation they can agree to.

If, for instance, the tax equity investor was only permitted by its management to agree to a deficit restoration obligation equal to 60% of the capital it contributed (i.e. $27m, which is 60% of $45m), then it could be allocated only a $72m dollar loss (i.e. $45m of capital and $27m of deficit restoration obligation). That would mean the partnership could not elect 100% bonus deprecation. It would have to fall back to the 40% bonus depreciation available for projects acquired in 2018 prior to the enactment of tax reform. That would mean a $42m bonus depreciation loss and double declining balance depreciation over a five years on the remaining $63m.

Alternatively, the partnership could avoid bonus depreciation entirely and merely claim double declining balance depreciation over five years for the whole $105m.

The partners could opt to allocate less than 99% of the loss to the tax equity investor in 2018. For instance, the partnership could allocate 45% of the 2018 loss to the tax equity investor and avoid having a suspended loss or deficit restoration obligation. But that would mean that the tax equity investor would only be allocated 45% of the PTCs for 2018, so over $1.5m of the $3m in PTCs would be allocated to the sponsor. Wind sponsors for a variety of reasons typically do not have much use for tax benefits, so $1.5m of PTC value would be effectively lost.

Leasing Alternative?

The partnership rules could be avoided by the sponsor selling the project to the tax equity investor and leasing it back. However, in a lease structure, the PTC is not available.

An investment tax credit (ITC) equal to 30% of the tax basis of the project is available (assuming construction on the wind farm started before 2018) but, given improvements in wind turbine technology, the ITC amount for land-based projects is often less than the present value of the 10-year PTC stream. Therefore, sponsors are typically willing to wrestle with the partnership tax accounting rules in order to capture the PTC value.

PTC Inflation Adjustment: A Bullet Dodged

The version of tax reform initially passed by the House of Representatives would have removed the inflation adjustment from the PTC. For wind projects that started construction prior to 2018, the inflation adjustment results in PTCs generated in 2017 being worth 2.4 cents per kWh, rather than 1.5 cents per kWh.

Fortunately, the conference committee bill that reconciled differences between the House and Senate versions and was enacted into a law did not alter existing the inflation adjustment.

Base Erosion Anti-Abuse Tax (BEAT): Hit By a Ricochet

The BEAT provisions target earning stripping deals between US corporations and related parties in foreign jurisdictions. This has relevance to the tax equity industry because some tax equity investors are banks or insurance companies with foreign parents or significant foreign operations.

The BEAT would be a tax (at a phased-in rate discussed below) on the excess of an applicable corporation’s (i) taxable income determined after making certain BEAT required adjustments, over (ii) its ‘adjusted’ regular tax liability (ARTL), which is its regular tax liability reduced by all tax credits other than, through the end of 2025, certain favored tax credits. The favored credits are research and development tax credits; and up to a maximum of 80% of the sum of the low-income housing tax credits and the renewable energy tax credits (including the wind PTC).

However, the ability to exclude the renewable energy credits from the ARTL calculation ends beginning in 2026. As the PTC is a 10-year stream, BEAT could discourage investment in wind farms by tax equity investors subject to BEAT. As a result, such tax equity investors could favour investment in solar projects that qualify for the ITC that arises in the first year, rather than wind projects with their 10-year PTC stream.

Alternatively, tax equity investors could try to use their market strength to persuade sponsors of wind projects to elect the ITC. As discussed above, this would also mean that a lease structure could be used, which is a more efficient means to monetize 100% bonus depreciation. However, for land-based projects the ITC is often less valuable than the 10-year PTC, so such a decision would typically mean a loss of project value for the sponsor.

The act provides a phase-in of the BEAT rate. Under the phase-in, the BEAT would be 5% for tax years beginning in 2018, 10% for tax years beginning between 2019 and 2025, and 12.5% thereafter. In the case of banks and securities dealers, the general BEAT rate would be increased by one percentage point.

As tax equity transactions are modeled, diligenced and executed, the full ramifications of tax reform will become more apparent. The wind industry has proven itself resilient over several decades and that resilience will serve it well as it adapts to the changes in the market’s landscape due to tax reform.