Safe harbor for structuring wind PTC deals

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Merryl Gilmore
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DECEMBER 10, 2007 Safe harbor for structuring wind PTC deals By Forrest Milder and Michael Goldman The energy community has long awaited IRS guidance on the use of flip structures, i.e., partnerships or LLCs in which the parties interests change significantly, as forecast approximately one year ago when the IRS issued Notice 2006-88, 2006-42 I.

1 DECEMBER 10, 2007 Safe harbor for structuring wind PTC deals By Forrest Milder and Michael Goldman The energy community has long awaited IRS guidance on the use of flip structures, i.e., partnerships or LLCs in which the parties interests change significantly, as forecast approximately one year ago when the IRS issued Notice , I.R.B Typically a flip occurs once the equity investor has achieved its desired yield through the allocation of substantially all the tax credits, other tax benefits, and cash distributions. On October 19, 2007, the IRS released Revenue Procedure , announcing a safe harbor for audit (not advance ruling) purposes with respect to flips and certain other deal terms. The IRS subsequently modified the revenue procedure in Ann , issued in December, This article will refer to the revenue procedure, as modified, as the Revenue Procedure. In particular, the Revenue Procedure establishes the requirements (the Safe Harbor) under which the [IRS] will respect the allocation of Section 45 wind energy production tax credits by partnerships in accordance with Section 704(b). Interestingly, the revenue procedure only applies to the wind production tax credit (PTC) provided in Section 45 of the Internal Revenue Code. In particular, it does not apply to geothermal or biomass, which generally have the same rules for allocations, nor to solar, which is a more traditional investment tax credit. Still, we think it is useful to be familiar with the views of the IRS with respect to this one kind of energy credit. Based on our experience with a wide range of credits, we expect that both tax professionals and IRS agents will use the rules of the Revenue Procedure as a guide when working with other credits, even when it does not truly apply to the particular transaction or credit under consideration. The Rules. The Revenue Procedure provides about a dozen tests, all of which must be passed for the Revenue Procedure s safe harbor to apply. If a transaction fails one or more of these tests, the Revenue Procedure provides that the IRS will closely scrutinize the transaction. 1. Minimum 1 percent interest for developer. The developer must have a minimum of 1 percent interest in each material item of partnership income, gain, loss, deduction, and credit

2 throughout the existence of the project company.[1] 2. Minimum 5 percent interest for each investor. Each investor must have a minimum interest in each material item of partnership income and gain for every year, equal to 5 percent of its largest interest in income and gain for any year. 3. Minimum investment. The investor must have a minimum investment at all times equal to 20 percent of the sum of (i) its fixed investment plus (ii) its reasonably anticipated contingent investment, provided that cash distributions from company operations can reduce the amount of its investment. This minimum investment rule becomes effective with respect to an investor s investment as of the later of the date the wind project is placed in service or the date the investor acquires its interest in the project company. 4. Minimum non-contingent investment. At least 75 percent of the sum of (i) the investor s fixed investment plus (ii) the investor s reasonably anticipated contingent investment must be a fixed and determinable obligation that is not contingent or uncertain. 5. Call rights. Rights held by the developer, the investors, or related parties to purchase all or a part of the facility or an interest in the project company must be at a fair market value price or higher. 6. Contracts considered in computing fair market value. In computing fair market value, the valuation may take into account: (i) power purchase agreements with persons unrelated to the project company and (ii) all other contracts entered into in the ordinary course of business with unrelated parties. 7. No call right in first five years. The developer and related parties cannot have a contractual right to purchase the facility or any interests in the company (even at fair market value) before five years after the facility is first placed in service. 8. No put rights. Neither the project company nor the investor can have a contractual right to cause anyone to purchase the facility or their interest in the company, respectively. 9. No guarantees of credit allocations. No person may guarantee or otherwise insure the investor the right to any allocation of credit under Section Guarantees from insiders. The project company must bear the risk that wind resource is less than projected. None of the developer, the turbine supplier, nor any power purchaser can provide a guarantee of the wind. Others can provide such a guarantee if the project company or the investor directly pays the premium. A take or pay power purchase agreement (i.e., a contract in which the buyer pays even if the electricity is not delivered) with a related

3 company will be considered an impermissible guarantee. Of course, under Section 45, a sale of electricity to a related party will not qualify for the credit. 11. Limits on loans from insiders. The developer and related persons cannot lend the investor any of the funds to acquire its interest or guarantee any debt incurred by the investor in connection with the acquisition of its interest. 12. Allocations in accordance with regulations. The credit must be allocated in accordance with the Section 704 tax credit rules found at (b)(4)(ii). Thus, the wind PTC must be allocated the same as the electricity sale that gave rise to the credit. 13. What is a related party? The revenue procedure uses two different related party tests. The tests in item 6(i) (relating to power purchase agreements) and 10 (relating to guarantees, including take-or-pay contracts) apply the trades or businesses under common control test of Section 52, while all other references to related parties apply the tests of Sections 267(b) and 707(b), which typically consider whether the parties have more than 50 percent common ownership or are members of the same family. Examples. The revenue procedure provides two illustrations, and, in each, the transaction is divided into three phases. The first example reaches a favorable conclusion where the three phases are as follows: In the first phase, the developer gets 100 percent of the cash until it has gotten its capital back, with the developer also getting 1 percent of the company s gross income, loss, and PTCs, and the investor getting the remaining 99 percent. In the second phase, the investor gets 100 percent of the cash until it has gotten its minimum return (including 99 percent of the income, loss, and PTCs) with the developer still getting 1 percent of the tax items. In the final phase, the developer gets 95 percent of everything and the investor gets 5 percent. The second example reaches an unfavorable conclusion where everything is the same as the first example, except that, in phase 1, the developer only gets 0.5 percent of the company s gross income, loss, and PTCs. Note that the revenue procedure only applies to transactions entered into on or after its date of publication in the Internal Revenue Bulletin expected to be November 5, It also provides that the service will not challenge agreements entered into before that date if all of the above tests are met. Observations. A few thoughts about the Revenue Procedure: 1 Put rights. The drafters of the revenue procedure appear to dislike puts. This isn t as important in Section 45 transactions, since puts are seldom used. In some other areas, however, the aversion toward puts should be noted, e.g., state tax credit deals, where the investor has a large capital account and wants to take the resulting taxable loss as soon as possible by putting its interest for a small price.

4 2 Minimum investment. The Revenue Procedure requires a substantial minimum upfront investment 20 percent at closing, and, over time, a non-contingent investment of 75 percent. Investors in non-ptc transactions should take note of this requirement, as, in situations where placement in service is imminent and an investor needs to be in the transaction before that happens, the investor typically invests a modest amount to be a partner, with the balance to be paid/contributed when the details are fully negotiated. In PTC deals, however, this is generally less important, since only one or two months credits may be at risk. Still, we may be faced with a higher threshold to become an investor due to the Revenue Procedure. 3 Adjusters. The Revenue Procedure explicitly rejects most any adjuster or variation unless it is limited to 25 percent of the investor s total anticipated contributions. Most wind PTC transactions do not provide for significant adjustments to the capital contributed, though, again, adjusters frequently play a role in transactions related to other tax credits. It should also be noted that it is not clear how the Revenue Procedure would treat transactions in which a non-tax contingency (e.g., a last-minute title defect, left to be fixed after closing, might lead to a partial unwind of the transaction if not corrected) is intended to be handled. Discussions with the authors of the Revenue Procedure indicated that they did not envision such contingencies in their drafting. However, unless and until the IRS clarifies this rule, it makes sense to keep such partial unwinds to under the 25% permitted by the Revenue Procedure. 4 Flips. The IRS is being quite permissive in its view of flips. The first example, described above, allows a flip from 99 percent of the tax benefits all the way down to 5 percent. Since 1989, when an IRS ruling indicated that it didn t like flips in an historic tax credit transaction, the tax community has been concerned that the IRS might reject them altogether. The Revenue Procedure blesses a flip from 99 percent down to 5 percent, at least in wind deals. We have seen some deals done prior to the publication of the Revenue Procedure where the investor s interest is flipped to below 1 percent, and, as set forth in Example 2, the IRS may consider such a flip too aggressive when reviewing transactions entered into after publication of the Revenue Procedure. 5 Effect of the Revenue Procedure. Originally, the Revenue Procedure provided an audit safe harbor that would be binding on the IRS whenever the partnership and the investment satisfy all of its requirements. However, Announcement made it clear that the IRS would respect transactions which complied with its provisions, providing a higher level of comfort than having to wait for a possible audit. The Revenue Procedure specifically provides that the IRS will not provide private letter rulings on any issues under the partnership tax rules for any partnership claiming the PTC for wind. 6 Developer-friendly. Finally, it s worth noting that this safe harbor generally favors the developer side the Revenue Procedure permits the developer to receive all the cash at the beginning, requires almost all of the investor s cash obligation to not be contingent, and prohibits the developer and affiliates from guaranteeing or giving an adjuster with respect to business or tax credit problems. On

5 the other hand, developers of community-scale projects may find it more difficult to meet certain requirements of the revenue procedure, and therefore, more difficult to attract tax equity. Of course, the particular facts of each transaction should be reviewed closely. Please feel free to call Nixon Peabody with your thoughts and questions. To ensure compliance with IRS requirements, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. 1. The Revenue Procedure defines a project company to be a partnership between a project developer and one or more investors. An investor is defined as a partner in the project company whose investment return is reasonably anticipated to be derived from both Section 45 credits and participation in operating cash flow.

26 CFR : Examination of returns and claims for refund, credit or abatement; determination of correct tax liability. (Also: 45, 704, 1.

26 CFR : Examination of returns and claims for refund, credit or abatement; determination of correct tax liability. (Also: 45, 704, 1. Part III Administrative, Procedural, and Miscellaneous 26 CFR 601.105: Examination of returns and claims for refund, credit or abatement; determination of correct tax liability. (Also: 45, 704, 1.704-1)