This page explains modelling of inverted leases that can be used for financing solar projects with investment tax credit in the U.S. The inverted lease seems counter intuitive were financier — the tax investor — makes payments to the developer/sponsor and not the other way around. But when you do this, you can do two things. First, the tax law allows you to transfer the ITC to the tax investor. Second, the tax investor can make a big payment to the sponsor/developer that covers the transfer of the ITC meaning that the developer gets paid for the ITC. As with other pages that become very arcane and confusing, I try and explain this inverted lease with a simple example. I start with a regular lease so you can see how rental payments should be structured. First, understand that a key difference between leases and loans is that leases involve tax depreciation. If there was no tax depreciation transfer to the lessor (like the lender or the tax equity), then the lessor would be just like a lender. Second, in order to try and understand an inverted lease, I begin with a more standard prepayment lease of the entire project.
Prepayment Lease – Entire Project
For a prepayment lease, the tax equity is a lessor (lendor or tax investor) who buys the entire project from the developer. The lessor then owns the asset and can use all of the tax benefits. This was used to sell and leaseback nuclear plants. When, the lessor develops a rent payment it should include the value it receives as tax benefits in the effective rental payment. The developer pays some of the rentals up-front using the proceeds from the sale. This is like paying off debt to reduce future payments. The lease payments can then be structured so that cash flows are sufficient to repay the rental payments.
The problem with this structure is that the original developer of the project does not have any ownership in the asset. In theory, when the asset is sold, it is at the fair market value and can be expensive. This is the problem with the developer not having ownership of the project. If the rental payments are high the sponsor may not have an incentive.
This is a standard lease. You can begin by using the PMT formula to find a flat payment that re-pays a loan. Then you can add the tax benefits to the lessor and re-compute the lease payment. You can also compute the IRR to the developer by assuming that the developer makes the initial payment during construction. To illustrate the standard lease, you can start with the cash flows and the computation of the net present value of cash flow. The value of the tax benefits will be part of the the lease payment
Once you have made the initial calculations, you can compute some lease payments. If you were to compute a simple loan without considering the tax benefits and make it into a lease payment, it may be the case that the lease payment is higher than the cash flow. In the first case I use an interest rate of 4.5% and the payment is more than the cash flow. This case with the lease rate without considering taxes or residual value, the lease rate is 93.
Even though the lessor is much like a lender, they would probably not be generous enough to give you an interest rate of 4.5%. If the interest rate increases to 7%, the lease payment increases to 109 as shown in the screenshot below.
These simple examples did not account for residual value or the tax benefits that are retained by the lessor. When you include these, you can make a little goal seek to compute the level payment that will give you a lease payment. If you do not assume an up front payment by the developer (now the lessee), then the payment is lower. With the 15 year assumption and no residual value, the lease rate is 64.43 as shown in the screenshot below.
In this case the rental rate is higher than the cash flow. If you assume increasing cash flow from something like merchant cash flows, then the deficit in cash flow is worse. Think about it. Then the original developer does not have an incentive to operate the asset. He just wants to take his money an run away. Further, by assuming that the developer sells the asset at cost, he does not make any money.
Now assume increasing cash flow that leads to a somewhat lower IRR of 3%. You can also assume a valuation with a high discount rate. Then the deficit in cash flow is more even if you assume a residual value. You can see that in this case the initial cash flow is only 30
The screenshot below shows the lease payment without an initial repayment. In this case with a residual value, the lease payment is again higher than that cash flow.
In the final case I assume that money is paid back in an initial payment. This allows the lessor to make a lower payment.
Inverted Lease (Lease Pass-Through)
In this case the tax equity investor acts as a lessee (paying the rental payment) rather than the lessor. This seems very confusing because it is as if the tax investor is the borrower and user of money rather than the lender. The tax investor pays rent to the sponsor/developer rather than just receiving cash distributions as with the typical partnership structure. But the tax investor receives revenue from selling electricity. The key is that the sponsor/developer is allowed to transfer the ITC to the tax investor who is not a lessee. This means that the tax investor is allowed to keep the ITC benefits and also the rental income. But the tax investor (lessee) makes a really big rental payment up-front. The developer/sponsor owns 100% of the asset.In this structure the tax investor never owns the asset. The real problem with this method is that the tax investor does not get the accelerated depreciation. Unlike the normal leveraged lease, the sponsor/developer keeps a controlling interest in the project.
I summarize the inverted lease with bullet points below so you can better understand the modelling:
- The tax equity investor acts as a Lessee. He pays rental payments to the sponsor/developer who is now the lessor (like lending money).
- The tax investor pays rent to the sponsor/developer rather than receiving cash distributions.
- The tax investor receives revenue from selling electricity.
- The sponsor/developer is allowed to transfer the ITC to the tax investor who is not a lessee.
- Tax investor (lessee) makes a really big rental payment up-front to the developer — this is like buying the project.
- The developer/sponsor owns 100% of the asset.
- The tax investor does not get the accelerated depreciation. Unlike the normal leveraged lease, the sponsor/developer keeps a controlling interest in the project.
I have made a simple model that illustrates how an inverted lease could work. I begin with cash flows that generate a 3% pre-tax IRR with inflating cash flows as in the leveraged lease case. These cash flows that begin the analysis are repeated in the screenshot below.
In the first case I assume that the up-front payment is equal to the ITC. I also assume that the lease term is 10 years and the tax investor lessee must pay a residual value. In this case I use the goal seek to obtain a NPV as with the other case. If you assume a different discount rate than the 9%, then the economics change to the developer.
Now lets take the tax investor lessee and look at the developer/lessor. In this case the cash is received for the lease but the developer does not receive the operating cash flow. Recall that the developer/sponsor does get to deduct the accelerated depreciation. This developer perspective is illustrated in the screenshot below.
Now lets change a couple of things. The first screen shot is for a case with 20 year lease. In this case the lease rate is higher and close to the operating cash flow.
The final case is for 6 years and has no residual value.
The inverted lease is illustrated in confusing diagrams. In the diagram remember that the developer/sponsor is the lessor. The developer receives money from the tax investor as rental payments. Note that the ITC is passed from the developer to the lessor.
Note below that there is a safe harbor for the inverted lease transactions (I don’t know what section 47 credits are). The last point can be re-written that the IRS will not challenge allocations of ITC by a partnership LLC to the tax investor.
ITC based on the FMV of the project rather than the cost
Lessor (the developer/sponsor) using the FMV to capture the ITC
Some people believe the B.S. — one quote a publication called “North American Clean Energy”. A number of large corporate investors with tax appetite, known as “tax equity”, have consistently reduce the cost of project development by monetizing tax benefits that developers (“cash equity”) are unable to initially utilize. By passing on some of this benefit to the cash equity and by receiving some of the pre-tax cash from operations, tax equity can provide a project with much more favorable financing than traditional borrowing.
