This page discusses the deficit reduction obligation which can reduce exposure from the inside capital becoming negative. The deficit restoration obligation (“the DRO”) is associated with this inside basis account and can potentially be used to eliminate deficits in the tax investor’s inside basis. As with the discussion of the outside basis, I discuss inside basis (account 704 (b)) in terms of how things associated with this account can affect the cash flow and IRR to the tax investor.
When the investment balance falls to zero without any mitigation (from the DRO), the taxable income increases and the after tax return goes down. Everything is in this page and the page about the inside basis and the minimum gain is about preventing the inside basis from being negative. The reason for limiting the inside capital is the notion of “Substantial Economic Effect.” If the inside capital falls below zero, the tax equity investor is not considered a real partner but is a “bare purchaser of tax benefits”
Two big questions about the inside basis in my opinion are: (1) how does the income allocation in the inside basis account affect the tax equity IRR by virtue of the DRO (e.g. if there is an income re-allocation from the sponsor to the tax investor, does this increase taxes for the tax investor or is it taken account elsewhere); and (2) is the inside basis used for computing the gain on sale for tax purposes or is the tax basis of the plant used when the tax investor exits the partnership SPV? I wish I could say that I know the absolute answer to this one, but have seen different models treat the gain on a sale from the by the tax investor to the sponsor/developer differently. The famous DRO or deficit reduction obligation raises its ugly head when working through the inside capital account or the 704(b) capital account. The DRO can limit the negative balance of the inside capital account, but this can be a bad thing for the tax investor IRR.
Here are some terms related to the Deficit Reduction Obligations
- Deficit Restoration Obligation
- Allows the tax investor to have a negative capital account and not have to increase taxable income (which is very bad for the tax investor). You do not want to re-allocate income to the sponsor
- With the DRO, the tax investor “borrows” equity from the sponsor to claim the negative income that would otherwise be re-allocated. Note that there must be equity to borrow.
- Could also borrow the tax free cash distributions
- DRO Effect in the case of Liquidation
- Not very likely
- Requires the partner borrowing or taking the DRO to contribute real cash capital
- This risk of the tax investor actually paying for the DRO is a credit risk for the tax investor and a benefit for the developer/sponsor
DRO, Suspended Loss and Exposure
Assume that because of a loss and the investment the capital goes to zero. Assume this happens for the inside and outside basis (there can often be not much difference between the two).
When the inside basis goes to below zero, there is an income re-allocation and the tax equity investor has higher income (which is bad for them) and the developer gets lower income (which they do not care about very much). After this re-allocation is made, there is no way to get the allocation back.
When the outside basis goes to below zero, there is a suspended loss. The tax investor still takes a hit and must pay higher taxes, but it is not as bad as the income allocation because the hit is eventually paid back in something like a NOL (net operating loss carryforward) that reverses when the tax equity capital is above zero.
So, you would rather have a suspended loss than an income re-allocation.
As the inside basis is book income, you can play around with it a bit. You could “borrow” capital from the developer to keep the capital account at zero. This is not real borrowing and has no cash implications unless something really bad happens to the project and taxes must really be paid. Here all the capital goes to zero. In this dramatic case, the developer, not the tax investor, has an actual liability. As this case is not generally modelled, the only effect of the DRO is to create a separate account that is not cash. This is the DRO. Too many people give you BS and get confused by this implying that it is real cash.
If you use the DRO, then you still will have a problem with the outside basis. This is because the equity capital account cannot be reallocated on the outside basis. So you will still have a suspended loss. But at least you can eventually recover the added taxes you pay (on a nominal undiscounted basis) and you have not lost the increased taxes forever.
The final difficult issue relates to a DRO and a sale of the interest in the project by the tax investor to the developer. If a DRO is used and the suspended loss arises, then does the partnership still have access to the remaining NOL type suspended loss or alternatively is it lost. This is outside of my tax expertise, but if two investors own a corporation, and the corporation pays taxes, then the NOL is not lost just because the investor make up changes. On the other hand, if there is an M&A transaction, it is generally not allowed to buy a corporation to get the NOL.