Recent Developments in Solar Securitizations: Promising Opportunities for Both Developers and Investors

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1 Recent Developments in Solar Securitizations: Promising Opportunities for Both Developers and Investors Novogradac Financing Renewable Energy Conference April 24, 2014 Robert A.N. Cudd Polsinelli PC. In California, Polsinelli LLP

2 Importance of Securitizations Securitizations of solar assets present promising opportunities for both developer/owners and investors. Loss of tax and other incentives has deterred equity investors from investing in solar projects or demand higher returns which may not be possible. The cash grant of Section 1603 of the American Recovery and Reinvestment Act of 2008 ( ARRA ) has expired and is not expected to be renewed. The 30% Investment Tax Credit for energy property under Section 48(a)(2)(A)(i)(II) of the Code is scheduled to revert to 10% on January 1,

3 Importance of Securitizations Bonus depreciation expired at the end of The expiration on September 2011 of the Section 1705 Loan Guarantee Program of the Department of Energy added by ARRA has made leverage more costly which in turn adversely affects both developers/owners and tax equity investors. The tax equity guidelines of Rev. Proc , designed to address the Boardwalk Hall decision regarding the historic tax credit has made tax equity investment more difficult and expensive. Many tax advisors believe similar rules apply to partnerships claiming investment tax credits for energy property. 3

4 Importance of Securitizations Tax issues with partnership flip structures under Rev. Proc , can make such structures uneconomical in fixed yield deals if cash flow does not meet projections. The flip structure has other disadvantages because the developer-owner must contribute capital for its 1% share of the profits and not all of the tax benefits can be transferred to the tax equity investors. Tax equity investors and developers in unleveraged energy deals may use securitization techniques as a partial exit strategy for extracting cash in a tax-efficient manner. This basic strategy may be most useful for smaller projects which can be combined in a basic CLO structure. Securitization may be the most efficient way for developers/owners to attract capital for yield conscious investors in the current tax and equity climate. 4

5 Investor Appeal Investors seeking steady yield and cash flow are attracted to securities producing interest and dividend income. Tax-exempt investors can avoid UBTI with securities producing interest or dividend income. Foreign investors can avoid being engaged in U.S. trade or business or having to file U.S. income tax returns under many securitization structures. Securities issued in most securitizations are more liquid than equity interests in individual projects. Diversification of projects and reduction of risks are attractive features for investors in securitizations. 5

6 Investor Appeal The ability to monetize cash flows from equity investments without triggering a taxable event is an appealing option to tax-equity investors. The securitization vehicle is usually a special purpose vehicle ( SPV ) which is a bankruptcy remote entity which so reduces the bankruptcy risk for investors. 6

7 Advantages for Developers Securitization results in a lower cost of capital because the securities are readily marketable. The developer-owner of the solar project receives immediate reimbursement for capital expenditures. The security is less expensive than the cost demanded by tax-equity capital. The owner-developer has the option to structure the securitization as a financing or sale. This will be important to both the developer and the tax equity investors. 7

8 Collateral Effects of Securitizations On deciding whether a securitization is appropriate consideration must be given to the effect on the tax equity investors and on the owner-developer. In addition, lender permission may be required or other contractual requirements must be satisfied. For example, there may be recourse covenants or obligations. A securitization which is viewed as a sale of the solar energy asset could cause a recapture of ITC and depreciation and result in taxable gain to the tax-equity investors. This is especially true if the sale occurs or is deemed to occur within the first 5 years of the project when the ITC is subject to recapture. A securitization of a partnership interest must be carefully structured as a financing to avoid treating the transaction as a sale of the partnership interest which could also result in the termination of the partnership under Section 706 of the Code. 8

9 Collateral Effects of Securitizations A securitization of lease cash flows should not result in a disposition of the solar property as long as only the lease payments and not the residual value of the property is securitized. A securitization of the power purchase agreement ( PPA ) contributed by the developer to the project partnership could result in a disguised sale, if the securitization occurs within 2 years of the contribution of the PPA. Consent of the lenders may be required for the securitization since it will probably be viewed as a loan. Certain contractual provisions of the PPA or other agreements may be fully recourse and prevent a securitization without consent. Securitizations work best when anticipated at the time the project is commenced. 9

10 Definitions and Attributes of Securitizations The National Renewable Energy Laboratory ( NREL ) defines securitizations as the means by which illiquid assets are pooled and processed into financial vehicles (securities) which are sold to investors. This process not only confers liquidity by providing investors a standardized tradable product but it can also reduce risks associated with the individual assets. See NREL Technical Report, NRL/TP-6A , December, Securitizations generally require a steady stream of cash flow from leases, power purchase contracts, loans or royalties, or partnership interests. Unlike a direct equity or debt investment in a single asset or project, the security issued in a securitization is backed by a pool of assets which provides diversification and reduction of risk in both the type and location of assets. For example, solar and other renewable assets can be combined in a securitization with traditional energy assets and cover a diverse geographic area. 10

11 Definitions and Attributes of Securitizations Securitization structures allow the tax benefits associated with solar assets, such as MACRS depreciation and investment tax credits, to be efficiently used to shelter cash flows of the securitization vehicle where investors themselves are unable to use the tax benefit. Different vehicles and structures allow securitizations to be tailored to the needs of particular developers and investors. For example, securitizations can be structured as an equity or debt interest in the cash flow and various vehicles such as trusts, partnerships, REITs and MLPs are available to pool the assets. 11

12 Definitions and Attributes of Securitizations There are various types of solar debt securitizations: Collateralized Loan Obligations ( CLO ) consisting of an equity interest in a trust (or debt instrument of a corporation) owning a pool of loans to commercial entities to purchase or provide solar assets; Asset Backed Securities which are debt obligations secured by solar contracts, or power purchase agreements or other customer contracts; Project Bonds which are issued by the project partnership or owner. Debt instruments secured by pools of equity interests in various partnerships. 12

13 Definitions and Attributes of Securitizations There are also securitizations structured as equity interests: Shares of REITs which own a mixture of conventional and solar and renewable energy assets. Shares of YieldCo s which own a mixture of conventional and renewable energy assets. Partnership interests holding debt obligations secured by equity interests in projects. 13

14 Basic Analysis of Securitizations The starting point for analyzing the consequences of securitizations is whether the security being issued is treated as any equity or a debt instrument. For Federal income tax purposes, the economic substance as well as the form of the transaction must be analyzed to make that determination. Thus, an instrument may constitute a debt for corporate purposes and be treated as equity for Federal income tax purposes. In the case of interests in REITs and MLPs, it is generally clear that the investment in the shares of the REIT or in the MLP is an equity interest. In the case of hybrid securities, an analysis must be made to determine what would be the appropriate classification. For example, some junior tranches of debt instruments of trusts or partnerships may be treated as equity even though denominated as notes or other debt like names such as certificates. 14

15 Basic Analysis of Securitizations There are 2 basic trust structures which are traditionally used to securitize assets and which have some fairly well defined rules. The first structure is referred to as a pass through or grantor trust structure in which the holders of the certificates own all of the equity in the trust which may not issue any debt instruments. The second structure is referred to as the owner trust structure in which the owner of the assets to be securitized retains the equity of the trust which issues certificates which are intended to be treated as debt obligaitons of the trust, or in some cases, of the owner. The owner may also sell off its interest in the equity of the trust. 15

16 Basic Analysis of Securitizations A variant of the owner trust structure uses a corporate vehicle as the issuer of the debt obligations divided into tranches. The corporation is often organized in a tax-heaven where there are no corporate level taxes and the owner of the equity may be a charity or the most junior tranche of the debt instruments. 16

17 Grantor Trust Under this structure the owner contributes assets to a trust which issues certificates to investors. The trust is classified as a grantor trust under Section 671 of the Code and the certificate holders are treated as the owners of the assets held by the trust. The contribution by the owner is treated as a taxable sale for Federal income tax purposes in which the owner will recognize gain or loss. The assets are no longer on the balance sheet of the owner-sponsor. Normally, the grantor trust structure is used as a vehicle to pool loans made to commercial entities and could also be used to pool loans to various solar projects. 17

18 Grantor Trust No equity investments can be pooled in a grantor trust structure which must be passive. Since the trust agreement cannot contain a provision which would vary the investment of the investors, it is a very basic structure which merely permits the sponsor to pool debt obligation assets. There is little ability to tranche the certificates, except for subordination. This structure is the least expensive to implement. See Treas. Reg. Section (c)(2). Usually the pass-through trust is not leveraged, which is another limitation. All of the risks inherent in the trust assets must be borne directly by the certificate holders so that defaults and deficiencies in cash flow are borne by the investors. 18

19 Grantor Trust The pass-through structure would not generally be appropriate where a reserve or other guarantee is required since this certificate holders must be treated as the direct owner of the assets and bear the risk of loss. If any reserve is required, it must be established outside of the grantor trust. 19

20 Owner Trust Under the owner trust structure the owner of the assets establishes a trust which issues debt securities but the owner continues to be treated as the owner of the assets for Federal income tax purposes. Thus, there is no taxable sale and no gain or loss is recognized as long as the securities issued by the trust are treated as debt obligations of either the trust or the owner. The trust generally drops the assets down into a special purpose vehicle (SPV) wholly owned by this trust. The SPV is a bankruptcy remote entity and treated as a disregarded entity of the owner trust. 20

21 Owner Trust The entity may also be organized as a limited liability company or as a partnership. Even if a trust entity is used, it would likely be treated as a partnership for Federal income tax purposes. The owner/sponsor may transfer all or a portion of the equity interests in the trust/partnership to unrelated investors in which case a taxable sale would occur. The trust or limited liability company could be classified as a partnership if it is viewed as conducting a business and has more than one owner. It would be a disregarded entity if it is wholly owned by the owner. The most important tax issue in the owner-trust structure is that the certificates issued to investors be treated as debt obligations of the trust or in some cases of the owner of the equity in the trust. In that case, the trust itself may be ignored and viewed as a security device for Federal income tax purposes. 21

22 Owner Trust In a typical owner trust structure, the debt securities will be collateralized by the assets of the trust which may be over collateralized. A reserve fund or guarantee by the owner of the trust or another person is also typical. Normally the debt securities will be tranched with different maturities and priorities. To avoid treating the certificate holders as having an equity interest in the trust the trust certificates must be viewed as securities separate from the collateral of the trust. Thus, the payments of principal and interest on the trust certificates should not match or correlate with the cash flows from the trust. 22

23 Owner Trust The timing and amount of payments on the collateral or assets held by the trust should not mirror the timing and amount of payments on the trust certificates. The entity is sometimes organized as a foreign corporation in a tax-haven jurisdiction which imposes no corporate level taxes. The equity may be owned by a foreign entity or a charity. Alternatively, one of the junior tranches of debt may be treated as the equity owner. 23

24 Example of ABS with Owner Trust Structure The SolarCity ABS deal is a recent example of an owner-trust securitization of solar assets. Solar City LMC Series I LLC, an indirect subsidiary of SolarCity Corp., issued $ million solar asset backed notes (Series ) in November 2013 (the Notes ). The issuer was a bankruptcy remote Delaware limited liability company wholly owned by SolarCity Series Holdings I, LLC, another Delaware limited liability company which in turn was wholly owned by SolarCity Corp. For Federal income tax purposes, both the issuer and the intermediate LLC were disregarded entities. 24

25 Example of ABS with Owner Trust Structure A schematic diagram of the structure is set forth below. Solar City Corp. 100% Solar City Holdings LLC Disregarded Entity 100% Solar City LMC I LLC Series Disregarded Entity (Customers Agreements) Asset Backed Debt Obligations 25

26 Example of ABS with Owner Trust Structure Since SolarCity Corp. owned all of the interests in the LLC s, both LLC s should be treated as disregarded entities. Thus, the Notes should be treated as direct obligations of SolarCity Corp. which recognized no gain or loss on the establishment of the LLC s or the issuance of the Notes. To ensure that the Noteholders were not treated as owning an equity interest in the LLC s which held the pool of assets consisting of leases and power purchase contracts with customers of SolarCity, the Notes contained several features: The Notes were over-collateralized by almost 40% meaning that the principal amount of the notes equaled only 62% of its aggregate discounted solar asset balance. 26

27 Example of ABS with Owner Trust Structure An interest reserve was established equal to six months of interest on the Notes. There was a diversity of assets and a large number of PV systems (5,033). The term of the Notes was shorter than the weighted average life of the customer agreement. The life of the Notes was thirteen years (2016 maturity date) but the weighted average life of the customer agreements was years. 27

28 Example of ABS with Owner Trust Structure SolarCity Corp. agreed to repurchase solar assets for which certain representations and warranties were breached. Under the Notes, an early amortization period would begin if the debt service coverage ratio (DSCR) for any three month period was less than or equal to 1.15x for such period. 28

29 Alternative Structures Other structures available to securitize solar assets include real estate investment trusts ( REITs ), master limited partnerships ( MLPs ), collateral loan obligations and corporations structured as YieldCos which are a relatively recent development. Except for the YieldCo Structure and collateralized loan obligations, changes in the Federal income tax law are needed for both REITs and MLPs to be fully attractive vehicles for the securitization of solar or renewable projects. In the case of REITs, the definition of real estate under Section 856 of the Code must be expanded to specifically include solar and wind assets, although the Internal Revenue Service has issued rulings interpreting the definition of real estate to include cell towers, outdoor signboards, and data and storage centers. 29

30 Alternative Structures In the case of MLPs, the definition of qualifying income must be expanded to include income from the generation of electricity and rent from the use of solar or wind assets. Currently, the qualifying income is from the transportation and exploration of natural resources subject to depletion. The Master Limited Partnership Parity Act (S.795) has been proposed in the Senate on a bipartisan basis. Collateralized loan obligations ( CLO ) secured by a pool of loans by banks or other lenders to tax-equity investors or owner-developers and secured by their interests in the partnership equity in solar projects may be a viable solution for smaller projects. No change in law is required for CLO structures. The entity issuing the securities can be a trust in a partnership. 30

31 Alternative Structures The loans can be easily pooled so that investors in small projects do not need to establish their own securitization structure. There could be tranches if the issuer is organized as a partnership. However, use of a grantor trust would be easier to establish but there could be no tranches. An example of a partnership securitization structure is illustrated by the PEPS structure in which both debt and equity instruments were issued. 31

32 Alternative Structures The CLO securitization structure should not be treated as a sale or disposition of the equity interest in the partnership and therefore should not trigger a taxable event and recapture. The equity in the CLO structure could be owned by the banks or other lenders. Since the CLO would represent an interest in the loans made to the equity investors or developers rather than an equity interest in the partnership itself there should be no MLP issues. Since the loans would be secured by the equity interests in the partnerships, no approvals from lenders or parties to the PPA or leases should be required. 32

33 PEPS Private Equity Partnership Securities A U.S. subsidiary of Aon plc ( Aon-US) issued PEPS to securitize its equity interests in various partnerships owning real estate, energy projects and start-up technology businesses. From an accounting perspective, Aon-US was no longer required to carry the equity partnership interests on its balance sheet, and was no longer required to include in income fluxuations in the value of the partnership interests. PEPS was formed by a contribution of various partnership interests by Aon-US to a limited liability company (Aon LLC) which, in turn, issued all of its common units to Aon-US and all of its preferred interests to PEPS. The PEPS structure illustrates a CLO securitization using an owner partnership s structure. There is a concern that the structure could be viewed as a complete disposition of the partnership interests thereby triggering a taxable event unless Aon-US retained a sufficient amount of equity in the partnerships. 33

34 PEPS Private Equity Partnership Securities PEPS issued 2 tranches of Notes treated as debt obligations. Series A tranche of Notes was issued in the principal amount of $170 million and the junior Series B tranche of Notes was issued in the principal amount of $50 million. Principal and interest on the Notes were payable from the preferred interests of Aon LLC owned by PEPS which, as noted, represented substantially all of the distributable cash flow from the underlying partnerships. The preferred interests in Aon LLC were entitled to substantially all of the distributable cash flow from the underlying partnerships. 34

35 PEPS Private Equity Partnership Securities The Series A Notes were substantially over-collateralized by the cash flow and value of the assets held by PEPS and there was a third party guarantee of principal. The Series B Notes were slightly over-collateralized and there was no guarantee. For Federal income tax purposes it was not clear that the Series B Notes were debt. Tax counsel did not issue a more likely than not opinion but did issue a substantial authority opinion under Treas. Reg. Section (d). PEPS also issued a series of preferred equity interests in the partnership for approximately $160 million and a series of junior preferred interests of $105 million. 35

36 PEPS Private Equity Partnership Securities The preferred equity interests provided for stated current distributions. Aon retained the common units of the intermediate LLC which allowed Aon to benefit from the residual value of the partnership interests securing the PEPS. Aon controlled all of the voting power of both Aon LLC and PEPS. PEPS structure is illustrated on the next page. 36

37 PEPS Private Equity Partnership Securitiesle Aon-US Debt Holders Class A Notes Class B Notes Preferred Equity Holders PEPS 100% Preferred Units Aon LLC 100% 49.9% 100% 49.95% 48.95% 100% 100% 100% Real Estate Energy Technology Real Estate Energy Technology Real Estate 37

38 REIT Structure The REIT or UPREIT structure has been greatly expanded to cover assets not strictly viewed as real estate. In addition, the use of the umbrella partnership or UPREIT structure has been used both for real estate outside of the REIT area because of the flexibility of the partnership rules on contributions, carried interests, and so-called profits interests. Under Treas. Reg. Section (g), the REIT is deemed to own its proportionate share of each of the assets and each item of income from the partnership. 38

39 REIT Structure Thus, the character of the assets and income in the hands of the partnership retain the same character in the hands of the REIT. The REIT s proportionate interest is based on its capital interest in the partnership. The UPREIT structure can also be used with the partnership units being exchangeable into regular C corporation stock. This structure is referred to as the UPC structure. An illustration of the basic UPREIT and UPC structure is set forth below and can also be used in connection with the partnership units being exchangeable into regular C corporation stock. The UPC structure may be used as part of a YieldCo structure. 39

40 UPREIT Basic Structure UPREIT AND UPC STRUCTURE BASIC REIT or C Corp. (YieldCo) Managing Partner A Member Operating Partnership Investors Exchangeable OP Units Real Estate and/or Energy Assets 40

41 REIT Structure The key limitation on the use of a REIT is that 75% of its assets and income must be derived from real estate assets as defined in Section 856(c) of the Code. Generally, an equity REIT satisfies the 75% real estate assets requirement through qualifying rents from real estate assets. Alternatively, a REIT can satisfy the 75% requirement by investing in debt obligations secured by real estate and interests in real estate, in which case the interest income is treated as derived from real estate assets and the mortgage debt instrument is treated as a real estate asset REITs may also establish taxable REIT subsidiaries ( TRS ) as long as the value of the TRS s do not exceed 25% of the value of its total assets. 41

42 REIT Structure While a REIT could invest in the underlying real estate to which the solar panels are secured, the IRS has been unwilling to rule that rental income from a solar project could be qualifying rental income for the REIT. Proposals by House Ways and Means Committee Chair Dave Camp would, among other things, restrict the definition of real estate to traditional types of real estate and impose immediate taxation on conversions of C corporations to REIT. As a technical matter, part of the Camp proposals would restrict real estate eligible to be held by a REIT to real estate having a class life of at least 27.5 years. This would include only residential and noncommercial real estate. Most renewable resource projects would not qualify as real estate assets for REIT purposes since their class life is considerably shorter, such as 5 years. 42

43 REIT Structure Since it is difficult to separate the rental stream for the naked real estate from the rental for the solar project, equity REITs have not invested in such structures and would probably not do so without a private letter ruling from the IRS. Investing in mortgages secured by real estate or interests in real estate provides some flexibility because the mortgage can be secured by all of the real property which may consist of qualifying real estate assets and non-qualifying assets as long as the principal amount of the mortgage is collateralized by qualifying real estate. The fair market value of the qualifying real estate assets securing this mortgage should equal or exceed the highest principal amount of the mortgage loan. Under Treas. Reg. Section (c)(ii) all of the interest income is treated as derived from real estate assets if the fair market value of the qualifying assets securing the mortgage debt equals or exceeds the highest principal amount of the loan. The determination is made on the date the REIT is committed to make the loan or acquires the loan. 43

44 REIT Structure Under Treas. Reg. Section (d) real estate includes land or improvements thereon, such as buildings and inherently permanent structures. Importantly, the term also includes structural improvements of a building such as the wiring in a building, plumbing systems, central heating or air conditioning machinery, pipes or ducts, elevators or escalators or other items which are structural components of a building or other permanent structure. Thus, energy related improvements to the heating or cooling system of a building would qualify as real estate for REIT purposes. Since only 75% of the assets and income of the REIT must be derived from and consist of real estate assets, the other 25% may be derived from other assets as long as such assets produce passive income such as dividends, rents and interest. 44

45 Hannon Armstrong REIT Hannon Armstrong Sustainable Infrastructure Capital, Inc. ( Hannon ) completed its public offering on April 23, 2013 as a publicly traded REIT. It is organized as an UPREIT, illustrated on the following slide. 45

46 Hannon Armstrong REIT Public REIT Structure]]]]]11 Stockholders Common Stock (8.2%) Directors and Officers Other Existing Stockholders Common Stock (82.3%) Hannon Armstrong Sustainable Infrastructure Capital, LLC (98%) Common Stock (9.5%) Limited Partners Hannon Armstrong Sustainable Infrastructure Capital, LLC Hannon Armstrong Capital, LLC 100% (2%) Taxable REIT Subsidiary Large Institutional Investors, primarily insurance companies and commercial banks Notes Various Project Owning Special Purpose Entities (LLCs) Hannon Armstrong Securities LLC (Broker Dealer) Origination Companies (LLCs) Hannon Armstrong Multi-Asset Intrastructure Trust 46

47 Hannon Armstrong REIT Hannon describes its business model as making debt and equity investments in sustainable infrastructure projects. Those include energy efficiency and clean energy financing arrangements. Its basic model for energy efficiency projects is making loans to energy service companies ( ESCO s) which make energy efficient improvements for governments, universities, hospitals, etc. which are secured by the improvements and payments for these improvements. The ESCO typically obtains all the necessary approvals and financing for these improvements. It would appear that most loans are secured by energy efficient assets or a mixture of renewable and energy efficient assets many of which would qualify under current law. In addition, other types of assets include distributed generation and micro-grids which should also be qualifying real estate assets under current law. 47

48 Hannon Armstrong REIT In the case of clean energy projects, Hannon makes construction loans to the project developer, an ESCO, for a specific project which can be combined with other energy efficient projects designed to sell power to electric utilities or large users. The loans are secured by all of the project including the power purchase contracts. It is likely that the mix of clean energy assets and qualifying real estate assets securing the construction loan would cause the loans to be treated as mortgages secured by interests in qualifying real estate. However, as long as the fair market value of the qualifying real estate assets equals or exceeds the highest principal amount of the loan, the entire loan is treated as a mortgage secured by real estate assets. In that case both the mortgage loan and the interest thereon are qualifying assets and income, respectively. Treas. Reg. Section (c)(ii). 48

49 Hannon Armstrong REIT Hannon received a Private Letter Ruling from the IRS with respect to its balance sheet without addressing whether solar or other renewable assets qualified as real estate assets for REIT purposes. Thus, it is likely that the PLR only addressed financings secured by assets qualifying under current law as real estate assets, a mix of qualifying and non-qualifying assets where the fair market value of the qualifying assets equal or exceeded the principal amount of the loan. Hannon indicated that approximately 50% of its assets would consist of energy efficient projects, 25% clean energy projects and 20-30% other sustainable projects. Nonqualifying assets, including its interest in the TRS cannot exceed 25% of the value of its total assets. 49

50 MLPs MLPs own a substantial amount of infrastructure in the U.S. particularly pipelines and under recent private letter rulings the IRS has expanded the scope of permitted income to include income from fracking and storage of run-off water. Under Section 7704 of the Code, a publicly traded partnership will be taxable as a corporation unless 90% of the gross income of the MLP consists of qualifying income. Under Section 7704(d)(I) of the Code, qualifying income includes, in pertinent part, income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber). 50

51 MLPs The term mineral or natural resource means a mineral or natural resource depletable under Section 611 of the Code. Renewal energy projects would not qualify for depletion allowances under Section 611 of the Code. Qualifying income does not include income from the generation of electricity using renewal energy nor does it include rental income derived from the leasing of renewable energy projects. Thus, income or gains derived from electricity powered by renewable energy or rental income from the use or storage of renewal energy projects does not currently qualify as qualifying income under the 90% test. MLPs would be a perfect securitization structure for solar projects with PPAs by providing liquidity, limited liability and current steady income. MLPs have substantially less detailed asset and income requirements than REITs. 51

52 MLPs Unlike REITs, 90% of the MLP gross income must be qualifying income so that there is no significant leeway for non-qualifying income as there is in the use of REITS which must meet only a 75% test. Without a change in the definition of qualifying income, MLP s are not available as a vehicle to securitize renewable energy projects. The Master Limited Partnership Parity Act (S.795) (the Act ) was introduced in the Senate on April 24, 2013, by Senator Coons of Delaware and has gained bi-partisan support from Senators Moran (R-KS), Stabenow (D-MI), Murkowski (R-AK) and Collins (R-ME). The Act would expand the definition of qualifying income to include income and gains from renewable and alternative fuels, such as solar, wind, thermal, waste, renewable, chemicals, efficient buildings, gasification. It has been read twice in the Senate and referred to the Senate Finance Committee but has not been voted on by the Senate Finance Committee. 52

53 MLPs Among other things, the Act explicitly refers to income from the generation of electric power exclusively utilizing any resource described in Section 45(c)(1) of the Code or energy property described in Section 48 of the Code which would include solar, wind, biomass, etc. as well as the production, storage or transportation of any renewable fuel described in the Clean Air Act. The Act also includes the generation, storage or distribution of thermal energy. Section 45(c)(1) includes all major renewable energy resources from wind and solar to marine and hydrokinetic renewable energy. 53

54 YieldCo Structure No additional tax or other legislation is required to effectuate the YieldCo structure. The YieldCo structure also can provide tax results similar to those of REITs and MLPs since most YieldCo s are not expected to pay a significant amount of corporate income tax. The YieldCo structure refers to a transaction in which a corporate owner, often a utility, owns conventional and renewable energy assets, contributes those assets to a new corporation ( YieldCo ) and then distributes and or sells shares of YieldCo to its shareholders and the public. The YieldCo intends to pay a consistent and growing dividend from its cash available for distribution. Thus, the YieldCo will be a bond like vehicle which converts the cash flow from its diverse projects into dividend income or a return of capital. 54

55 YieldCo Structure The YieldCo structure achieves all of its goals of a securitization for both owners of solar energy projects and investors by reducing risk, raising capital in a tax efficient manner, providing a steady increasing stream of dividend income, and a liquid market based investment. A number of utilities have indicated an intent to issue shares of a YieldCo. On February 18, 2014, SunEdison Inc. submitted a confidential S-1 draft registration statement to the SEC for the issuance of common stock of a YieldCo vehicle. Abengoa, a Spanish entity, has indicated it planes to submit a similar confidential draft for an offering of shares of a so-called yield company. 55

56 NYLD Structure On July 16, 2013, NRG Yield Inc. ( NRG Yield ) made an initial public offering of its Class A common stock. NRG Yield was formed by NRG Energy Inc. ( NRG ). The NRG Yield Class A common stock is listed on the New York Stock Exchange under the symbol ( NYLD ). The NYLD structure offers a good example of how a securitization can combine 21 energy properties consisting of both conventional and renewable and thermal generation assets across 9 states thereby providing diversification and growing dividend income to investors. Depreciation deductions and investment tax credits attributable to the new renewable energy projects can be used to offset income from older conventional projects. 56

57 NYLD Structure A substantial portion of the distributions should constitute a tax-free return of capital since NYLD does not expect to generate a substantial amount of earnings and profits for the foreseeable future. Any distributions by NYLD which are treated as dividends should be eligible for the favorable 20% Federal income tax rate in the case of individuals and qualify for the dividends received deduction in the case of corporations. The NYLD structure is tax efficient for NRG Energy and the Class A shareholders since all of the projects are owned by limited liability companies, classified as partnerships for Federal income tax purposes, which permits NRG Energy and NYLD to realize the income of the projects directly as if they were filing consolidated returns. 57

58 NYLD Structure More importantly, the structure permits the depreciation deductions and investment tax credits of newer projects to reduce income of other projects. NYLD stated that it does not expect to pay any significant amount of Federal income tax for 10 years. The NYLD structure is illustrated on the following slide. 58

59 NYLD Structure NRG Energy, Inc. ( NRG ) NYSE: NRG Public Stockholders Class B Common Stock 70% Voting Interest 0% Economic Unit NRG Yield, Inc. ( Yield Inc. ) Ticker: NYLD Class A Common Stock 30% Voting Interest 100% Class B Units 70% Economic Interest NRG Yield LLC Sole Managing Member 100% Class A Units 30% Economic Interest 100% 100% NRG Yield Operating LLC Disregarded Entity 49.9% 100% 49.95% 48.95% 100% 100% 100% Other Utility Scale Solar Projects and Distributed Solar Projects Other Utility Scale Solar Projects and Distributed Solar Projects Other Utility Scale Solar Projects and Distributed Solar Projects Other Utility Scale Solar Projects and Distributed Solar Projects Other Utility Scale Solar Projects and Distributed Solar Projects Other Utility Scale Solar Projects and Distributed Solar Projects Other Utility Scale Solar Projects and Distributed Solar Projects 59

60 NYLD Structure Note that the conversion by NRG of its Class B Units in NRG Yield LLC into Class A Shares of NYLD would be a taxable event for NRG but NRG is expected to have net operating losses ( NOLSs ) carry forwards from its ownership of its Class B Units in NRG Yield LLC to offset such income. The NYLD structure is in effect on UPC Corp. structure since NRG Energy retains its interest in the projects through its Class B Units in NRG Yield LLC which is a partnership with NRG Yield as the other partner. The Class B Units NRG Energy owns in NRG Yield LLC are exchangeable into Class A common stock of NRG Yield Inc. This is similar to investors in an UPREIT structure which can exchange their operating partnership units with stock of the REIT. This structure would also permit other equity investors to invest in NRG Yield Operating LLC to avoid corporate level taxation and contribute other assets on a tax-free basis. 60

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