This is the first of several webpages that describes how to model tax equity partnership structures and a cash flow flip used to achieve tax benefits from U.S. renewable energy investments. Many of the U.S. tax equity structures created to maximize tax benefits involve partnerships with a tax investor and the sponsor (sometimes called the developer). On this page I describe how to model flip structures, tax depreciation and distribution of partnership cash flow. I start with a simple case where income and cash flow are distributed in the same manner in the context of an annual model to explain the basics of computing cash flow flips. Then I move to situations in which the operating cash flow of the partnership (not including depreciation effects) is distributed in a different manner than income and where the analysis is developed on a periodic basis. On the next page I move to various complex tax rules such as stop loss accounts, deficit restoration obligations (at liquidation), qualified income offsets, excess depreciation, outside capital accounts and other horrible stuff. The principle question addressed on the next page is how do these things affect cash flow distributions to the partners.
Partnerships established for tax in the U.S. distribute cash flow in a different proportion than the proportion of income (income is just about always a big negative in early years). This is not all that different than when a corporation has different types of common stock with different characteristics. Because the tax benefits generally exceed the level of EBITDA at the patnership by a wide margin, the tax benefits could not be realised by a standalone SPV tax paying corporation. Instead, the tax benefits would result in a tax loss carry forward that dramatically reduces the value of the tax advantages to investors unless various strategies are implemented. The financial structures that have been developed to deal with the tax losses can involve a few issues from a modelling and/or finance theory perspective. The primary structure is to set up a partnership that does not pay taxes. This partnership is financed by two parties — a Developer/Sponsor Investor and a Tax Equity Investor. Each investor contributes to the partnership. The partnership distributes cash (it does not pay tax). In addition, the partnership also distributes taxable income. Distribution of taxable income and cash are on a different basis to the two investors and the distributions vary over time. The diagram below is supposed to illustrate this structure.
Simple Flip Case with One Cash Flow Item
The first exercise demonstrates the basic idea of structuring a flip structure with a hurdle rate. The key is to make a separation between four cash flows as follows:
- Senior Cash Flow before Flip — this is the cash flow that is used for assessing the flip rate
- Subordinated Cash Flow before Flip — this is a tricky cash flow to compute in the final flip year
- Senior Cash Flow After Flip — this is easy to compute from the cash flow subtotal
- Senior Cash Flow After Flip — this is easy to compute from the cash flow subtotal
The model that illustrates the simple case is available for downloading below. This first file is used to demonstrate how to make a basic capital tracking account. The second file includes construction funding and has similar methods for computing the distribution of cash flow with a cash flow flip.
The screenshot below illustrates how to set up the tracking account to evaluate when the cash flow flip occurs. The key is to set-up a tracking account for the senior tax equity investor who will continue to receive cash flow until a target IRR is met. This tracking account is something like a debt balance account where interest is capitalised instead of paid. Dividends received before the flip occurs are subtracted from the account and accrued cost of capital at the flip rate increase the balance of the account. The amount of capital invested is added to the account.
In the screenshot below, the tracking account is computed as a negative balance rather than a positive balance (I did this ages ago and I would suggest you apply positive balances). The only tricky item to compute in this simple example is cash flow received shown in line 38 below. This can be modelled like a cash flow sweep where it is the minimum of the amount of cash from the partnership (including tax benefits) or the amount of the opening balance plus the accrued cost of money in the tracking account. Note that it is the same as line 30 until column k. In column k the opening balance of 105.6 plus the accrued cost of money at the hurdle rate of 10.56 that sums to 116.5 is less than the partnership cash flow of 170. So in this period, the minimum is 116.5 rather than 170. After column K, the opening balance is zero and the accrued cost of capital is also zero. And zero is less than the partnership cash flow. So the dividends are also zero. This can be represented by the formula:
Distributions to Senior Tax Equity Before Flip =
MIN(Cash Flow to partnership, opening balance + accrued cost of capital)
The structure uses a flip structure where the Tax Equity Investor partner that can use the tax benefits receives much of the negative taxable income. After a target yield is met, the allocation changes and cash flow accrues to the second developer/sponsor investor. The flip can be designed with a fixed time flip or an IRR target (known as a yield) flip. This yield based flip structure can be modelled using a little trick with MAX and MIN where you set-up the tax equity investment in two pieces. The first piece is represented a lot like subordinated debt that does not receive cash interest but instead receives a cash sweep.
Periodic Cash Flows Rather than Annual Cash Flows
If a partnership is established, then taxes can be allocated in alternative ways to the partners where the amount of the income attributed to the partners must be tabulated along with the dividends that are not related to the tax benefits themselves.
More Complex Flip Case with Multiple Cash Flow Series
In this exercise, there are two different distributions to partners and two different allocations. The first allocation of income and therefore tax benefits is the standard 99%/1%. The second allocation is for the cash flow produced by the partnership. This ratio is assumed to be 35% to the tax investor and 65% to the sponsor/developer. This case is assumed to be a solar project with investment tax credit. The first screenshot below demonstrates that the tax investor puts in 55% of the investment, but that 29.1% of the investment is ITC which comes straight back to the investor.
The second screenshot demonstrates how you can structure a tracking account when there are two different distributions. In this case, the MIN should be in a cash flow waterfall rather than in the tracking account as I showed above for the simpler cases.
Tax Equity Structures in the U.S. and the Amazing way that Incentives for Renewable Energy Accrue to Large and Rich Companies with a Big Tax Bill
The structure uses a flip structure where the Tax Equity Investor partner that can use the tax benefits receives much of the negative taxable income. After a target yield is met, the allocation changes and cash flow accrues to the second developer/sponsor investor. The flip can be designed with a fixed time flip or an IRR target (known as a yield) flip. This yield based flip structure can be modelled using a little trick with MAX and MIN where you set-up the tax equity investment in two pieces.
The first piece is represented a lot like subordinated debt that does not receive cash interest but instead receives a cash sweep. The second issues involves esoteric issues associated with the tax code. If a partnership is established, then taxes can be allocated in alternative ways to the partners where the amount of the income attributed to the partners must be tabulated along with the dividends that are not related to the tax benefits themselves.
If capital that is computed using the pre-tax income (less depreciation deductions) and the non-tax related dividends falls to zero, the tax equity partner may have some problems. It is not surprising that the partner that is exposed to limits on tax is the tax equity investor. To compute the potential exposure, two different capital accounts can be be set-up and something called deficit reduction obligations may be used.
The complex finance structures and complex tax rules mask what I think is the most important and third issue. The tax equity investment has two characteristics that are particularly favourable to the Tax Investor. First, the repayment structure is often like a cash flow sweep or a senior debt with very low risk. Second, as much of the cash flow to the tax equity investor is after-tax the required returns should be less than the pre-tax returns. These two points suggest the return to the tax investors should be very low. But the returns to the tax equity investors have been surprisingly high, suggesting that the whole idea of the tax benefits to renewable energy which was supposed to reduce costs for consumers in fact primarily benefits a small group of very rich large companies.
Analysis of Tax Equity Investments
I have created a number of files that model tax equity transactions. The first file is associated with the videos and also has detailed capital accounts that evaluate constraints on the ability to use credits. Other files include sensitivity analysis without constraints and demonstrate the fundamental ideas.
Files in Resource Library Not Yet Uploaded with Explanation
I am in the process of uploading a number of files with a little explanation of how they work. This takes some time. In the meantime you can get the files in the resource library under the advanced project finance issues folder. If you send me an e-mail to email@example.com I will send you the files.
- Tax Equity Model and Exercises.xlsm
- Partnership Template Solar.xls
- Yield Flip Scenarios.xlsm
- IRR Flip with Mulitple Investors.xlsm
- Yield and Time w Documenation.xlsm
- Exercise 27 – Cash Flow Flip Exercise.xlsm
The basic point is that capital for the Tax Equity goes to zero using the first capital calculation (not the outside capital calculation)
Capital is computed with 50% of ITC
Capital is computed with only dividends from operations (it does not include tax distributions)
Net Income for capital computation is allocated using tax allocation factors
Compute a subtotal so you can see how much DRO is needed
DRO is capped at the level of dividends and does not help that much
Compute another sub-total after interim calculation
Stop loss is computed after DRO and constrains the use of tax benefits for tax equity partner
Final closing balance is after the stop loss and should be zero