U.S. renewable investments have a specialised tax treatment that includes very rapid depreciation, production tax credits and investment tax credits. Because the tax benefits generally exceed the level of EBITDA by a wide margin, the tax benefits cannot be used by a standalone corporation. Instead, they result in a tax loss carryforward that dramatically reduces the value of the tax advantages to investors. The financial structures that have been developed to deal with the tax losses can involve a few issues that are difficult 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). 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.
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, a partner is not allowed to continue receiving tax benefits. 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.
Files associated with Lesson Set 7 – 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 firstname.lastname@example.org 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