Energizing Green Energy Financing: Analyzing the Stimulus Package's Jolt to the Green Energy Sector
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1 Energizing Green Energy Financing: Analyzing the Stimulus Package's Jolt to the Green Energy Sector Contributed by: Patricia Hammes, Mitchell Menaker, Robert Freedman, and Derek Kershaw, Shearman & Sterling LLP It seems fairly straightforward: if the fuel is free, can be grown or is otherwise relatively abundant, shouldn't renewable, or "green," energy already be a larger mix of our generation resources? Notwithstanding the obvious cost benefits of the fuel source, the fact remains that development of green energy is generally a more costly endeavor than fossil fuel project development. Historically this cost disparity was addressed through government investment subsidies, primarily in the form of tax incentives, going back to the early 1980's with the introduction of a federal investment tax credit for renewable energy. 1 As the recent credit crunch and recession took hold, however, even the subsidy that was most effective in catalyzing the boom in the wind industry from the federal production tax credit lost much of its usefulness. While the push for green energy gained momentum through the 2008 election year, and the Obama administration made a commitment to the sector, the ability of developers to obtain financing for projects was stalling. Two key government actions have sought to resuscitate the green energy sector. First, a number of provisions of the American Recovery and Reinvestment Act of 2009 (ARRA) 2 provided a response to the stress placed on green energy development. By many indications, this new stimulus is just now starting to have its intended effect by addressing some of the root causes of the recent inability to finance projects. In tandem with ARRA, there has been a push to increase the use and effectiveness of the U.S. Department of Energy's (DOE) loan guaranty program for renewable energy (DOE Program). Although originally authorized in 2005, the DOE Program did not play a significant role in the expansion of renewable energy through 2008, as evidenced most prominently by the fact that no guaranty commitments had been issued until March However, with the introduction of a new DOE Program solicitation in July 2009 there appears to be a real desire by the DOE to play a larger part in the next wave of development. ARRA's enactment and subsequent clarification and the progress of the DOE Program reflects an unusual level of cooperation between the government and market participants that bodes well for green energy development. Tax Incentives and Grants Under ARRA ARRA provided a benefit to the green energy industry in the form of a number of tax provisions that subsidize investments in projects such as wind, solar and biomass electricity generation facilities. ARRA extended the availability of per-unit-ofproduction tax credits (PTCs) for renewable energy projects, and Congress also greatly expanded eligibility for the Investment Tax Credit (ITC). The ITC is a direct offset against an investor's federal income tax liability equal to 30 percent of the cost of a qualifying renewable energy project and is available in the year the qualifying project is first placed in service. The ARRA ITC for qualifying new wind, biomass,
2 landfill gas, hydropower and marine hydrokinetic energy projects is equal to 30 percent of the project's capital cost basis. The generosity of ARRA's 30 percent ITC is limited by the fact that, because the ITC is not a refundable credit and cannot be used to offset alternative minimum tax liability, not every investor can use the ITC currently. However, in addition to making the ITC available for many kinds of facilities that were previously ineligible, ARRA also enhances the ITC by repealing the provision, under prior law, that had excluded amounts allocable to "subsidized energy financing" or the proceeds of tax-exempt "private activity bonds" from the credit base. This change allows projects that are financially assisted by state and local governments to take full advantage of federal subsidies through the ITC. The tax basis of energy property is reduced by only 50 percent of the amount of the ITC allowable with respect to the property. Therefore, ARRA's extension of first-year bonus depreciation for physical property placed in service by the end of 2009 is a significant benefit to the owners of clean energy projects, in addition to the ITC. ARRA gave its strongest boost to the clean energy sector by creating a 30 percent grant available for new clean energy generation facilities that are eligible for the ITC (Grant). The Grant is a direct subsidy payable in cash by the U.S. Treasury Department. The Grant provisions were added to ARRA in recognition that the financial crisis had generated enormous losses for many potential renewable energy investors, putting them in a current and future tax loss position and unable to utilize the ITC. The legislative history of ARRA indicates that the Grant is intended to mimic the ITC. 4 Unlimited funds have been appropriated to fund the Grant program so that all qualifying projects that meet the deadlines construction must begin in 2010 and the applications must be received by Oct. 1, 2011 will receive the subsidy. Taxexempt organizations, governmental agencies and instrumentalities, certain co-ops, and partnerships, any partner of which is one of the foregoing, are generally not eligible to receive the Grant. Qualifying renewable projects generally may select either the PTC, the ITC, or the Grant. ARRA also provides an ITC equal to 30 percent of the cost basis of qualifying property of a new or refurbished facility for the manufacture of property such as electric car batteries and smart-grid electricity transmission equipment that is designed to reduce greenhouse gas emissions. To be eligible to claim the ITC, the owners of such facilities must obtain a certification from the Treasury Department. Tax expenditures for this special ITC are capped at $2.3 billion. New tax legislation will often require taxpayer guidance to be issued by the Treasury Department and/or the IRS to help taxpayers apply the new rules in a real world context. The process for issuing guidance can be quite time consuming, in many cases taking years. In situations where Congress is trying to quickly stimulate economic activity, the lack of guidance can significantly slow taxpayer response and the intended stimulative effect. The ITC, however, does not require significant new guidance. A general investment tax credit was first added to the Internal Revenue Code by the Kennedy Administration in It was a prominent feature of the tax law for many years
3 until it was repealed (except for a limited category of investments) in 1986, as part of a major tax law reform. Over the course of those years, regulations, rulings and court cases interpreted its application in a variety of circumstances. 5 The ITC, resurrected by ARRA for a broad array of renewable energy projects, carries with it that entire body of law and IRS interpretation, providing investors with guidance on many, but not all, the issues arising in a renewable energy investment. While the Grant was designed by Congress to "mimic" the ITC, because it is a direct cash payment it has economic characteristics that are fundamentally different than a tax credit. As investors began to analyze potential renewable energy transactions, issues and questions concerning application of the Grant provisions began to develop. Grant Guidance from the Treasury and DOE In response to questions and comments by industry participants, 6 the Treasury Department and DOE jointly issued guidance (Guidance) on many Grant-related issues in July of this year. 7 The speed with which the Guidance was issued, and the broad interpretations adopted on many issues, indicates an intent to encourage investments using the Grant. The Guidance made clear that the Grant program will not be administered by the IRS. Thus, qualification and recapture issues will not fall under IRS audit jurisdiction. Any liabilities to the federal government arising from the Grant program will not be treated as tax liabilities, but will be treated as debt obligations owed to the federal government. From a substantive perspective, the Guidance confirmed that generally only the "first user" of a qualified project is entitled to the Grant, although the Grant may be passed to an investor through a sale and leaseback transaction undertaken within three months of "first use." 8 Further flexibility is provided by permitting a lessor/owner to pass the Grant to a lessee/operator of a qualified facility. 9 ARRA imposes significant restrictions on Grant availability when tax exempt organizations are involved in a renewable energy project. Thus, participation by certain cooperative organizations, tax exempt entities (such as schools and hospitals) and state and local government entities (such as public power districts) could preclude Grant availability. In recognition of the important role that many tax exempt entities may play in a renewable energy project, the Guidance permits a tax exempt entity to participate in a renewable energy project through the use of a so called "corporate blocker," a taxable corporation owned by the participating tax exempt entity, without losing Grant eligibility. 10 Also, in recognition of one of the logistical difficulties in financing a wind energy project utilizing many stand-alone wind energy turbines, the Guidance permits elective aggregation of multiple turbines located on the same site for determining the beginning of construction and the first use rule. 11 Perhaps the most significant provision of the Guidance addresses "recapture." The Grant, like the ITC, is designed to vest over a five-year period. If a project receiving a Grant ceases to qualify for the Grant, or ceases to be owned by a person qualifying
4 for receipt of the Grant, it is "recaptured" at a rate of 20 percent per year and must be repaid to the Treasury. Unlike ITC recapture, which generally occurs upon a sale or other disposition of a project, a project receiving a Grant may be sold or transferred to a new owner without triggering recapture so long as the new owner could have qualified for the Grant and the old and new owners agree in writing to pay any recapture that occurs in the future. 12 This relaxation of the recapture rule will provide investors with the flexibility to sell projects at a later time without the burden of a recapture obligation. Also, the recapture obligation is personal to the Grant recipient and does not result in a government lien on the project, eliminating a concern for potential secured project lenders. 13 The Guidance provided fast and welcome information on the issues described above and many other significant issues concerning the Grants. Many of the issues were addressed in a manner designed to encourage investments utilizing the Grant. Nevertheless, many questions remain unanswered. Perhaps the most significant is the issue of economic substance. A threshold question underlying every transaction designed to achieve a tax objective is whether it has adequate economic substance, often measured by pre-tax profit, apart from its tax consequences. If a transaction lacks sufficient economic substance, the investor may lose the expected tax benefits. The obvious catch-22 in a transaction that would not be economical without a federal subsidy, such as the targeted renewable energy projects benefited by ARRA, is how the economic substance rule is satisfied. The investor marketplace is applying a commonsense approach to this issue, even though the Treasury/IRS has yet to make a definitive statement regarding application of the economic substance doctrine to the Grant or the ITC. Explicit guidance on this issue might persuade those investors who worry that common sense does not always carry the day in the world of taxes. Notwithstanding open questions and technical issues regarding the Grant, it appears that the Guidance has provided investors and their advisors with enough clarity to get back into the market. As of the date of this writing, over $500,000,000 in grants have been issued and the market indications are that use of the grant is being worked into more traditional deal structures which have been used for monetizing other tax incentives such as the PTC. DOE Innovative Technologies Program In contrast to the recent passage of ARRA, the DOE Program was originally passed under Title XVII of the Energy Policy Act of (Title XVII). A primary purpose was to support the debt financing of, among certain other projects, energy efficiency and renewable energy technologies that constitute "New or Significantly Improved Technology," as defined in final regulations developed for Title XVII (Final Regulations). 15 New or Significantly Improved Technology cannot be "Commercial Technology," which is defined in the Final Regulations as "a technology in general use in the commercial marketplace in the United States at the time" a term sheet is issued by the DOE in respect of a guarantee. 16 The Final Regulations explain further that a technology "is in general use if it has been installed in and is being used in three or more commercial projects in the United States in the same general application as in the proposed project, and has been in operation in each such commercial project for a period of at least five years." 17 The original requirements for
5 eligible projects were specified in Section 1703 of Title XVII, as well as the Final Regulations. While Title XVII had a stated goal of promoting renewable energy, there were no guarantee commitments issued under the DOE Program until March 2009, 18 after the passage of ARRA, and the program had been criticized for its management and speed. ARRA amended Title XVII to create a new Section 1705 authorizing a new program for renewable energy projects that commence construction no later than September 30, 2011, 19 and also provided that $5.965 billion is to be made available to pay credit subsidy costs of loan guarantees issued. 20 The first solicitation for loan guarantee applications under Section 1705 was issued by the DOE on July 29, 2009 (July Solicitation) and up to $8.5 billion in loan guarantee authority was made available. Additionally, the July Solicitation made available up to $2.5 billion to pay the credit subsidy costs of 1705 projects. Given that the introduction to Section 1705 provides that it is "notwithstanding section 1703," 21 and the categories of projects do not include the New or Significantly Improved Technology standard, it was expected by many market participants that the July Solicitation would cover commercially viable projects not necessarily using innovative technology. However, this was not the case and the requirements for 1705 projects under the July Solicitation were primarily the same as for 1703 projects, with the main difference being that 1705 projects could qualify for credit subsidy cost coverage. At the time of this writing, a new solicitation for commercially viable 1705 projects is expected by early October. 22 Recent statements and actions by the DOE appear to evidence a push to increase the effectiveness of the DOE Program. For example, on August 7, 2009, the DOE published a request for public comments for a proposed rulemaking amending the intercreditor and collateral sharing provisions in the final regulations for Title XVII. 23 These provisions have been, and continue to be, one of the sources of confusion with market participants who feel that the existing Final Regulations do not adequately reflect current deal structures used for renewable energy project financing. The language in the request for comments reflects the guidance the DOE sought from market participants, explaining that part of the background for the proposed amendments arose from "information received from industry indicating the wide variety of ownership structures which participants would like to employ in implementing projects seeking loan guarantees...." 24 The proposed amendments would allow for more flexibility in collateral sharing and intercreditor arrangements between the DOE and other project financing parties. The public comments received to the DOE's request are also an example of the eagerness of the market to make the DOE program more effective, with suggestions including the switch from a limited solicitation process to more of a rolling application process, and providing more flexibility for the terms of non-guaranteed loans and equity investments. While it remains to be seen whether all of the issues raised by the market will be addressed in revised regulations, there at least is a recognized willingness on the part of the DOE to listen to what the perceived issues are. Conclusion The ability of ARRA to stimulate activity in the financing market for green energy projects has, at least in part, resulted from the Treasury's responsiveness to the
6 realties of the market. Through their recent actions, the DOE appears to be similarly interested in responding to market participants and will hopefully act in a manner similar to the Treasury. Given the increased push for development at a time when the financing markets remain tenuous, it will likely take continued interaction and dialogue between the government and private sector to develop the programs that could provide the optimal jolt to the green energy sector. Patricia G. Hammes is a partner in the Project Development & Finance Group at Shearman & Sterling and head of the firm's Sustainable Development Group, and can be contacted at phammes@shearman.com. Mitchell E. Menaker is a partner in the Tax Group at Shearman & Sterling and is a member of the Equipment Leasing and Finance Association's (ELFA) Federal Tax Committee, and can be contacted at mitchell.menaker@shearman.com. Robert N. Freedman is a counsel in the Project Development & Finance Group at Shearman & Sterling and a member of the firm's Sustainable Development Group. He is listed in the 2009 Guide to the World's Leading Project Finance Lawyers, and can be contacted at robert.freedman@shearman.com. Derek Kershaw is an associate in the Tax Group at Shearman & Sterling with experience on issues relating to renewable energy, and can be contacted at derek.kershaw@shearman.com. You can visit Shearman & Sterling on the web at or call at Crude Oil Windfall Profit Tax Act of 1980, Pub. L. No , 221(a) (codified at IRC 46(a)(2)(C)). 2 American Recovery and Reinvestment Act of 2009 (ARRA), Pub. L. No (2009). 3 Press Release, Solyndra Inc., Solyndra Offered $535 Million Loan Guarantee by the U.S. Department of Energy (Mar. 20, 2009), Release H.R. Rep. No , at 621 (2009). 5 See, e.g., Treas. Regs., 26 C.F.R through ; Rev. Rul , C.B. 16 (regarding failure of lessee to use investment credit property in a trade or business); Xerox Corp. v. U.S., 656 F.2d 659 (Ct. Cl. 1981) (distinguishing use of investment credit property by tax-exempt from use of investment credit property to serve tax-exempt). 6 See, e.g., Equipment Leasing and Finance Association, Proposed Treasury Guidance Relating to Investments in Renewable Energy Projects (June 22, 2009) (on file with authors). 7 U.S. Treasury Dept., Office of the Fiscal Ass't Sec'y, Payments for Specified Energy Property in Lieu of Tax Credits under the American Recovery and Reinvestment Act of 2009 (July 9, 2009), available at
7 8 American Recovery and Reinvestment Act of 2009 (ARRA), Pub. L. No , Div. B 1603(f), 123 Stat. 115, 365 (2009); Internal Revenue Code (IRC) 50(d)(4). 9 ARRA, Div. B, 1603(f), 123 Stat. 115, 365; IRC 50(d)(5). 10 U.S. Treasury Dept., supra note 5, at Id. at Id. at Id. 14 Pub. L. No , 1701 et seq., 42 U.S.C C.F.R through C.F.R Id. 18 This loan guaranty, for Solyndra, Inc., has now also been finalized. 19 ARRA, Div. A, 406, 123 Stat. 115, ARRA, Div. A, Title IV, 123 Stat. 115, 140. ARRA specifies that $6 billion be appropriated, and of that $25 million is to be used for administrative expenses and $10 million is to be transferred to the Advanced Technology Vehicles Manufacturing Program. 21 ARRA, Div. A 406, 123 Stat. 115, Department of Energy, Webinar, Loan Guarantee Program, Suggestions for a Strong Application (Sept. 8, 2009), available at 23 Loan Guarantees for Projects That Employ Innovative Technologies, 74 Fed. Reg. 39,569 (proposed Aug. 7, 2009) (to be codified at 10 C.F.R. pt. 609). 24 Id.
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