Tax Equity Structures in U.S. – DRO’s, Stop Loss, Outside Capital Account …

This second page of the tax equity analysis addresses issues associated with the tax code that may limit the amount of the tax benefits.  Issues like the DRO (deficit restoration obligation), the outside capital account, suspended losses, depreciation adjustments, qualified income offset, hypothetical liquidation at book value    .  I attempt to present focused examples that demonstrate the mechanics of how the tax rules work and how the tax constraints affect the ultimate cash flow and IRR of partners. I label these things potential tax constraints. When attempting to understand these tax constraints I have tried three things.  First, I have tried to read through slides prepared by lawyers (yuck).  Second, I have tried to work through models created by other people and replicated the details of different formulas. Third, I have tried to create focused examples which eliminate a lot of the junk that illustrate exactly how these things can affect cash flow before liquidation and during the liquidation period.  On this page I focus on the third method and provide some focused examples. For me, the ultimate question of all of this stuff is the risk for a tax equity partner that will ultimately result in not being available to use the tax benefits. expensive lawyers seem to love to confuse.

In the discussion below I refer to various articles that explain the various tax rules and the constraints.  I have put the articles in the resource library. If you want access to the library send me an e-mail at edwardbodmer@gmail.com.

 

Capital Accounts — What Are They and Which one Matters

Tax equity models often include four capital accounts — two capital accounts for the tax investor and two for the sponsor (I sometimes call the sponsor the developer, sorry for the confusion).  Balances in these capital accounts drive many of the potential tax constraints like suspended loss and the deficit restoration obligation. Therefore, the first section of this page addresses various issues associated with the inside capital account and the outside capital account. The first issue to address is what exactly is a capital account.  The second issue is what is the fundamental difference between the outside and inside capital account (in contrast to less important details between the outside basis and the non outside basis). The third issue is which account really matters in terms of cash flow to the tax investor and the sponsor.

Issue 1: A capital account (inside or outside) is just like any equity account

Let’s address the first issue.  A capital account is just like any equity account that includes paid in capital and retained earnings.  Both the inside capital account and the outside capital accounts are essentially equity accounts. Like any equity account, you can start with an opening balance, add net income, add capital contributions and deduct dividends. Both the outside and the inside capital increase via capital contributions and (positive) income allocations.  Both decrease via cash distributions and losses (negative income) allocated.

If there is no debt for the partnership, the sum of capital accounts should be the same as the tax basis. If you think of a really simple case with no current assets and no cash and no debt, then the total assets are the net plant.  As the balance balances, the net plant equals the total equity.  Therefore in a simple case, the capital account is the same as the net plant of the project or the tax basis.

Sometimes the inside capital account is vaguely thought of a book basis and the outside capital account is though of as a tax equity account.  One article I read referred to the inside basis as “inside basis / book basis – fair market value (FMV).”  The outside basis was referred to as “Tax basis / outside basis – cost basis.” For either the inside capital account or the outside capital account the depreciation expense is measured at the tax depreciation rates when computing income. This is illustrated by one of the legal presentations I read stated that “book depreciation each year will bear the same ratio to the book basis as the tax depreciation each year bears to the tax basis.”  This confusing language just means that you use tax depreciation rates.  To illustrate how the capital accounts work I have put a couple of examples below. Note that in the screenshot below the book income is the same as the income for income tax purposes.  The only difference is that in the book income calculation the depreciation can include remedial depreciation.  Further, it is possible that an account named 704(b) additional book basis amortisation may be included. In the case to the tax income, the remedial depreciation is not included but something called 734(b) additional tax depreciation is included.  For purposes of understanding the fundamentals of the inside capital account or the book capital account versus the outside capital account, these added depreciation amounts are not included and we just need one income calculation.  I am trying not to muck up thing with all of these horrible accounts and focus on how the constraints can affect the IRR to investors.

Issue 2: What is the fundamental difference between the different capital accounts

I have included a couple of screenshots that illustrate the two capital accounts below these paragraphs. When you look at the screenshots below, you can see different titles in the accounts. The main difference in the capital accounts is that outside capital account that may be called the tax basis cannot fall to a negative amount. If there was one investor (and no debt) or if both investors had the same ratio of income to equity investment (e.g. if both investors put in 50% and they both get 50% of the income and dividends) then the account could not be negative.  This is just because the balance sheet must balance.  On the asset side, the net assets are positive as long as there are not big write-offs or negative residual value.  This means that if the only account on the liabilities and capital side is equity, the equity cannot be negative.  The way a capital account can be negative is if the tax investor takes more of the losses relative to the amount of his investment.

One of the articles I read suggested that  “most tax equity investors run out of the capital account before they are able to absorb 99% of the depreciation.” In very simple terms if the tax equity only receives the tax losses from depreciation as negative income and the tax investor only invests 50% of the asset, then the balance must become negative.  Consider a case where the total capital expenditure is 1,000 and the tax depreciation is 250 per year.  Further assume that the tax rate is 21% and allocation of the tax loss is 100% to the tax investor.  The income allocation would bring the investment to zero after year 2. On top of this, the dividends received by the investor (to the extent that they are above the income, which they are) will further reduce the equity balance.

In the screenshots below, the first illustrates an inside or book basis for the capital account.  The second screenshot illustrates the outside capital account or the tax basis.  Note that the accounts are the same until the fourth year. As shown in the second screenshot below, the outside basis has a potential adjustment at the end for stop losses and cannot be negative.

 

 

 

 

Issue 3: Which of the capital accounts really matter

Maybe I have no business saying this as I have not seen this point in the articles (that you can get by sending me an e-mail), but the suspended loss and the outside tax basis is a lot more important than the book basis and all of the painful discussion about deficit reduction obligations. In a time-based flip the suspended losses will directly affect the tax investor IRR.  With a yield-based flip, the developer/sponsor IRR is more affected as the time to the flip is extended.  In contrast, Losses allocated to a partner are only allowed to the extent of the partner’s “outside” tax basis in its partnership interest. Excess losses are suspended and carried forward until the partner has sufficient tax basis.

But this does not work with the outside capital account goes negative.  If the outside capital account is negative, there are cash flow effects on the tax investor because tax depreciation is transferred from the tax investor to the sponsor.

  • Account behavior – what happens if cap account or tax basis goes negative?
  • Cap Account: one or both partner cap accounts allowed to go negative
  • Negative cap account does not automatically result in a Deficit Restoration Obligation (“DRO”)
  • DRO results when one partner’s capital account is negative while the other partner’s capital account is positive (or, if debt, one partner’s capital account is disproportionately negative)
  • Tax basis or the outside is NEVER allowed to go negative
  • Suspended losses – correction for when tax losses would drive tax basis negative
  • Excess distributions – adjustment for when cash distributions would push tax basis negative

 

Suspended Loss — Does the Suspended Loss Affect Cash Flow of the Tax Equity Investor

  • Results when taxable losses (after adjusting for excess distributions) cause a partner’s tax basis to go negative
  • Partner is unable to utilize the loss (it is “suspended”) and must carry it forward until they have a sufficiently positive tax basis to absorb the losses
  • Suspended losses still count as an income allocation for overall income allocation percentage and subsequent PTC allocations
  • Loss reallocation (stop losses)
  • Maintains a partner’s capital account balance at zero or prevents it from becoming disproportionately negative (i.e. prevents DRO)

 

  • Inefficiencies for PTC deals
  • In the early years of a project, stop losses steer taxable loss away from tax equity investor
  • Provides sponsor with taxable losses it may not be able to utilize
  • PTCs also transferred to sponsor in same ratio as the final income allocation!
  • Suspended Losses
  • Results when taxable losses (after adjusting for excess distributions) cause a partner’s tax basis to go negative
  • Partner is unable to utilize the loss (it is “suspended”) and must carry it forward until they have a sufficiently positive tax basis to absorb the losses
  • Suspended losses still count as an income allocation for overall income allocation percentage and subsequent PTC allocations

 

 

Exercise – Model with Outside Capital (or Tax Basis)

 

Does the Deficit Restoration Obligation Only Matter at Liquidation and Only Apply to One of the Capital Accounts

The DRO applies to the capital account (the inside capital account) and not the outside the capital account.

One way to deal with the problem for the inside capital account (not the outside capital account) is for the tax equity investor (not the sponsor) to make a capital contribution to the partnership when it liquidates.  This contribution is the DRO.  Note that the contribution does not occur until the tax investor exits the investment.

This is the kind of confusing  language that you get “In lieu of a qualified income offset, a partner with a negative capital account (this would be the tax investor) may sign up for a DRO so that losses continue to be allocated to the partner even though its capital account is negative.”

  • Allows tax losses or cash distributions to drive a partner’s cap account below zero instead of reallocating income
  • One partner essentially “borrows” equity from the other to claim tax loss or tax free cash distributions
  • Requires the partner taking the DRO to contribute capital in the event of a liquidation
  • Unlikely scenario but real credit risk nonetheless
  • Relative risk profile of DROs created by tax losses as opposed to cash distributions

How does the DRO work during the liquidation period.

  • DRO – Deficit Restoration Obligation (“Impermissible Negative”)
  • Allows tax losses or cash distributions to drive a partner’s cap account below zero instead of reallocating income
  • One partner essentially “borrows” equity from the other to claim tax loss or tax free cash distributions
  • Requires the partner taking the DRO to contribute capital in the event of a liquidation
  • Unlikely scenario but real credit risk nonetheless
  • Relative risk profile of DROs created by tax losses as opposed to cash distributions

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.

A partner’s capital account is the partner contributions, increased or decreased by the partner’s share of income or loss and decreased by partner distributions. For this purpose, income and loss refers to the  book definitions.

If the partnership liquidates in accordance with capital accounts, the book allocations drive the economics of the deal.

Taxes paid by the partnership on behalf of a partner are typically treated as a deemed distribution.

The agreement likely intends to follow the safe harbors if, after paying creditors and setting up reserves, the agreement distributes the remaining proceeds according to the partners’ §704(b) capital accounts.

In lieu of a qualified income offset, a partner with a negative capital account may sign up for a DRO
(typically a limited DRO) so that losses continue to be allocated to the partner even though its capital
account is negative

 

Does Qualified Income Offset Affect Cash Flow to the Tax Equity Investor

If the capital account of any partner is negative after the initial allocations of cash and taxable
income/losses, there may be a reallocation of income between partners, referred to as a
“qualified income offset” or “QIO” in an amount necessary to eliminate any negative capital
account balances.

 

 

Excess Distributions

(a.k.a Distributions in Excess of Tax Basis a.k.a 731(a) Excess Distributions)

  • Results when cash distributions (before tax losses) pushes a partner’s tax basis below zero
  • Deemed to be a sale of part of the interest and requires partner to recognize a gain
  • Cash distributions to a partner are tax free to the extent they do not exceed the partner’s tax basis
  • Wind Energy models assume capital gains taxes of 20% for distributions to Wind Energy
  • C-corp excess distributions are taxed at ordinary income (35%)

 

Post-target flip allocations

Tax equity will often want higher allocations of cash in the event they don’t reach their target flip IRR on time. This can cause some serious concerns for backleverage and cash equity investors.

  • Capital account & tax basis impacts of excess distributions
  • Tax basis – a gain (income) is recognized which brings tax basis back to zero
  • Cap account – excess distribution gives rise to an intangible asset that increases the capital accounts (ignoring built-in gain / deemed value)
  • Sharing of new asset between partners subject to negotiation
  • New intangible asset is depreciated via 15 year SL
  • Depreciation deductions from these new assets can be specially allocated (some ambiguity to this provision, safer to allocate in same ratios as gross income)

Hypothetical Liquidation at Book Value

This is the risk that when the inside capital account is negative the tax investor may have to repay taxes.  A way to layout this amount is shown below.  The issue is whether the hypothetical book value should affect the cash flow and the IRR to the tax investor.

 

 

Issue: If You Hit a Capital Constraint (Where the Capital Falls Below Zero), How Exactly Will This Affect The Tax Equity Investor

Proceeds in liquidation must be distributed according to the positive capital account balances of the partners;

Partners with deficit balances in their capital accounts upon liquidation are unconditionally required to restore such deficit balance to the partnership.

Relatively meaningless item: Partners’ capital accounts are maintained in accordance with the rules found in the Regulations (i.e., the allocation is reflected in the partners’ capital accounts for book purposes);

 

provisions to avoid the partner having a negative adjusted capital account

 

The partnership cannot allocate losses to cause the partner’s capital account to be lower than what the partner is actually or deemed obligated to repay (an Adjusted Capital Account deficit);

Definitions

Minimum gain is the amount by which the nonrecourse debt exceeds the Section 704(b) basis in the property secured by the debt.

Issue: What Happens When Inside Or Outside Capital Accounts Fall Below Zero

 

 

Issue: What is the Business With PAYGO

 

 

 

 

 

 

 

Power Point Slides that Work Through Modelling and Accounting Issues Associated with Tax Equity Financing