© 2011 Winston & Strawn LLP
Cash Grant and Renewables: The Latest Developments Brought to you by Winston & Strawn’s Tax Practice Group.
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Today’s eLunch Presenters
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John Lorentzen
Andrew Ratts
Tax Chicago
Tax Chicago
[email protected]
[email protected]
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Cash Grant Overview
Section 1603 of the American Recovery and Reinvestment Act of 2009 (the "ARRA"), as amended, authorizes Treasury to pay a "Cash Grant" equal to either 30% or 10% of the "eligible basis" of "specified energy property" placed in service during 2011 or whose construction "begins" after 2008 and before the end of 2011.
"Specified energy property" that is eligible for a Cash Grant generally includes only tangible property (excluding buildings) that is an integral part of the activity performed by the renewable energy facility and for which depreciation is allowable.
Property is an integral part of a facility if it is used directly in the facility, is essential to the completeness of the activity performed at the facility, and is located at the site of the facility.
Eligible basis generally includes all items properly included in the depreciable basis of the eligible property.
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Cash Grant Overview
Since the enactment of the ARRA, the financing of renewable energy projects has almost universally been built around the Cash Grant.
Exception is recent wind projects with high capacity factors and reduced capital costs for which the PTC is proving to be more valuable.
To receive a Cash Grant, new projects must be placed in service or must "begin" construction this year.
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Cash Grant Overview
Qualified renewable energy facilities eligible for the Cash Grant (and the percentage of Cash Grant payment for which the "specified energy property" they comprise) are the following:
Wind (30%)
Solar (30%) Closed-loop and open-loop biomass (30%) Geothermal (30%)
Includes "large" wind and "small wind" facilities.
Geothermal facilities that qualify for PTCs under I.R.C. § 45 are eligible for a 30% Cash Grant payment but facilities that only qualify for an ITC under I.R.C. § 48 are only eligible for a 10% Cash Grant payment.
Landfill gas (30%) Trash to power (30%) Hydropower (30%) Marine and hydrokinetic (30%) Fuel cells (30%) Microturbines (10%) Combined heat and power (10%) Geothermal heat pumps (10%)
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Cash Grant Overview
Published Cash Grant authorities include the following (linked for your convenience):
ARRA § 1603. Statute extending Cash Grant for 2011. Guidance document published by Treasury. Cash Grant terms and conditions. Cash Grant sample application form. Accountant certification requirements. Requirements for assignment of Cash Grant payment. General FAQs for Cash Grant program. FAQs relating to "beginning of construction." Guidance regarding evaluating the eligible basis of solar PV projects.
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Prospects for Extension
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Prospects for Extension
The renewable industry is focusing its resources on an extension of the PTC for wind beyond the end of next year. As noted, given today's capital cost and capacity factors, the PTC is more valuable for wind projects than the Cash Grant.
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Prospects for Extension
The most likely reason for the Cash Grant program not being extended is that the liberality of the grandfathering rules as being administered by Treasury makes its extension unnecessary.
As a practical matter, all wind projects qualifying for tax credits (i.e., that are placed in service this year or next year) can be grandfathered. Also, many solar projects can be effectively grandfathered.
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Grandfathering Projects
Projects can be grandfathered either by:
Beginning physical construction of the project this year and continuing construction without unnecessary interruption (a "continuous program of construction") until the project is placed in service. Complying with a safe harbor by incurring 5% of the cost of the project this year (the "5% Safe Harbor").
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5% Safe Harbor
An applicant can grandfather a project for the Cash Grant if the applicant demonstrates that 5% of the cost of the "specified energy property" was incurred before the end of 2011. The applicant can rely on costs incurred by the applicant itself or on costs of components incurred by a third party.
If the applicant relies on costs incurred by a contractor, the costs must be incurred after executing a "written binding contract" for specific property, entered into before the manufacture of the components. If the applicant relies on its own incurred costs of purchasing property, the property can come from the seller's existing inventory.
There is also no "continuous program of construction" requirement if the applicant uses the 5% Safe Harbor to grandfather a project.
Therefore, once the safe harbor is met, there is no need to begin actual construction.
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5% Safe Harbor
An applicant incurs the cost of property when the property is "provided" to the applicant.
When property is provided depends on the applicant's method of accrual accounting, but generally occurs when property is delivered to the applicant. Property is treated as delivered to the applicant when title and risk of loss pass to the applicant, even if the property remains in storage at the manufacturer's warehouse or elsewhere.
If the applicant pays for property in advance and reasonably expects the property to be provided within 3½ months, the applicant incurs the cost of the property on the payment date.
This special rule especially benefits developers of solar projects, the components of which can easily be delivered within 3½ months. Developers can prepay for components before the end of this year and receive delivery in 2012 yet still qualify the cost of these components under the 5% Safe Harbor.
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5% Safe Harbor
Once the cost of property has been incurred under the 5% Safe Harbor, developer can use the property to qualify any number of projects for the Cash Grant.
It does not matter if the projects that will ultimately qualify have yet to be identified. The developer must submit a preliminary application by October 1, 2012, but can later move property to a different project site.
After the end of 2011, equipment that qualifies under the 5% Safe Harbor can also be assigned to wholly-owned "special purpose entities," which will then construct the project and apply for the Cash Grant.
The cost of property that was incurred by the developer-parent will be deemed to have been incurred by the subsidiary-applicant for purposes of the 5% Safe Harbor.
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5% Safe Harbor
Once property is grandfathered under the 5% Safe Harbor, the project that will ultimately qualify for the Cash Grant can be placed in service anytime through the end of the currently applicable tax credit period. The end of the currently applicable tax credit period for each Cash Grant-eligible renewable energy resource is the following:
January 1, 2013: "large" wind. January 1, 2014: closed-loop and open-loop biomass, geothermal qualifying for PTCs under I.R.C. § 45 (and for a 30% Cash Grant), landfill gas, trash to power, hydropower, marine, and hydrokinetic. January 1, 2017: solar, "small" wind, geothermal qualifying for an ITC under I.R.C. § 48 (and for a 10% Cash Grant), fuel cells, microturbines, combined heat and power, geothermal heat pumps.
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Structures Unique to the Cash Grant
With the advent of the Cash Grant, some traditional financing structures used by developers of renewable energy projects have been modified to take advantage of the flexibility offered by the Cash Grant. We will discuss the following structures:
Two modifications to the traditional partnership flip structure.
Partnership flip with a "pre-tax" investor. "Net-of-Cash Grant" partnership flip structure.
Two modifications to traditional leasing structures.
"Pre-tax" lease pass-through structure. Current monetization of 15% of the project's initial basis through a sale and leaseback.
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Modified Partnership Flip Structures Equity Investor
Developer
Investor earns return through allocations of some combination of cash and/or depreciation until flip point and is given a residual share in project cash and taxable income thereafter.
Electricity Market
Project Company Sale of Power
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"Pre-Tax" Investor
The investor in the partnership is allocated 99% of all income (including Cash Grant non-taxable income) and loss (including depreciation) from the project and is distributed 99% of operating cash flow until the investor earns a specified pretax cash return on its investment. Thereafter, the investor is allocated 5% of taxable income from the project and distributed 5% of operating cash flow. Basic structure complies with the "wind safe harbor" and passes the economic substance test because the investor is by definition earning a positive cash-on-cash return.
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"Net-of-Cash Grant" Structure
Pre-flip period (until the end of the taxable year in which the fiveyear anniversary of the placed-in-service date occurs):
The investor is allocated 99% of all income (including Cash Grant nontaxable income) and loss (including depreciation) from the project. The investor receives a priority cash dividend equal to a percentage of its invested capital. The pre-flip period covers the Cash Grant recapture period and the five-year accelerated depreciation recovery period.
Post-flip residual period:
The investor is allocated 5% of taxable income from the project. The investor's share of operating cash flow is the share that shows the investor receiving total cash distributions (in both the pre- and post-flip periods) that exceed its cash investment by a small amount.
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"Net-of-Cash Grant" Structure
Allocations of income and loss comply with the "wind safe harbor." The allocation of non-taxable Cash Grant income increases the investor's basis in the partnership and allows the investor to be allocated more depreciation deductions.
Some depreciation may nevertheless be reallocated to the developer if they exceed the investor's basis in the partnership.
Structure should pass economic substance test.
The post-flip cash sharing ratios are set so that the investor is expected to realize a small cash-on-cash positive return. The basis increase resulting from the allocation of non-taxable Cash Grant income and the resulting additional depreciation that can be allocated to the investor (equal to 15% of the project's basis) should be viewed as a targeted tax benefit equivalent to the ITC or Cash Grant.
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Features Common to Both Structures
The Cash Grant can be used to repay construction financing and debt financing can be used to limit the amount of equity financing required from the investor. The investor can defer its investment until after the project is placed in service.
An initial investment equal to the lesser of $500,000 and 1% of the expected total equity of the project should be made before the project is placed in service by the partnership. The investor can wait until the project is placed in service, permanent financing is obtained, and the Cash Grant application is filed to complete its investment.
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Call Option and Withdrawal Right
The developer can have a call option to purchase the investor's interest on the expected flip date.
The call option price can be the fair market value of the interest at the time of exercise or a fixed price equal to the expected fair market value of the interest on the call option date and still be compliant with the "wind safe harbor." The call option price can have a floor that provides a "pre-tax investor" with a specified pre-tax return or that provides the investor with a small positive cash-on-cash return in the "net-of-Cash Grant" structure.
The traditional common law/state law right to "withdraw" from the partnership may be made available to the investor.
The exercise price may be the lower of a fixed amount or the fair market value of the investor's interest on the date of withdrawal. There would be no expected economic incentive for the investor to exercise this right. This right is not a put because the only recourse is to the project assets, not the other partners or any other third party.
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"Pre-Tax" Lease Pass-Through Structure Equity Investor Investor earns cash return through Cash Grant and cash flow from operations.
Developer Rent Prepayment Lease of Project Pass Through of Cash Grant
Electricity Market
Project Company Sale of Power
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"Pre-Tax" Lease Pass-Through Structure
The investor makes a cash contribution to the project company that is then paid to the developer as a prepayment of rent for the project. The lease term and rental payments are structured so that the investor earns a specified pre-tax cash return on its investment.
The developer makes an election to pass-through the Cash Grant to the investor who applies for and receives it.
The lease should still comply with the "leasing safe harbor" published by the IRS.
The project must be leased before it is placed in service in order for the passthrough to be effective.
If, at the end of the lease term, the investor has not earned its expected pre-tax cash return, then the investor can extend the lease at fair market value rents until the specified return is achieved.
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"Pre-Tax" Lease Pass-Through Structure
The developer can be the manager of the project company. The amount of the Cash Grant is based on the fair market value of the project.
Therefore, the basis upon which the Cash Grant is calculated can include a markup over the project's cost that the developer would have charged a third party had it sold the project outright. However, the developer would not be required to currently recognize income on this markup as it would for an outright sale.
The developer remains the owner of the project and retains the depreciation benefit.
The developer can use the depreciation deductions to shelter the income from rent. The project's depreciable basis is based on the cost of the project to the developer and does not include a markup, but there is not currently taxable income from a markup.
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"Pre-Tax" Lease Pass-Through Structure
The developer can use the rules of Code Section 467 to defer and optimize the income recognition pattern from the rent prepayment. The developer can have an option to terminate the lease early by paying the lessee the greater of:
The fair market value of the cash flows that the investor is expected to realize for the remainder of the lease. The amount of money that would cause the investor to achieve its expected pre-tax cash return.
The investor must include one-half of the Cash Grant in income over five years in a level pattern.
This has less present value detriment than the loss of five-year MACRS deductions.
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Current Monetization of 15% of Basis
Sale of Project
Project company obtains the Cash Grant and then sells the project to a lessor, who in turn leases the project back to the developer. Lessor earns after-tax return through cash rent payments, and depreciation deductions. Project company can monetize a current loss equal to 15% of the project's original basis.
Lessor
Project Company
Lease of Project
Developer
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Rent
Current Monetization of 15% of Basis
The project company can sell the project to a lessor, who will in turn lease the project to the developer, who continues to operate the project.
The lessor will earn an after-tax return through cash rent payments and depreciation deductions as is typical for equipment lessors.
The project company can retain the proceeds of the Cash Grant and depreciation deductions equal to 70% of the project's initial basis will be moved to the lessor.
The sale of the project to the lessor will not cause a recapture of the Cash Grant as long as the project continues to be operated for its intended purpose. The project company will realize a current tax loss equal to 15% of the project's initial basis.
If the project has an initial basis of $100 and is eligible for a $30 Cash Grant that is claimed by the project company, its appraised value (i.e., the value for which it will be sold to the lessor) will be $70. Meanwhile, the project's adjusted tax basis will be $85 (its $100 initial basis minus one-half of the Cash Grant amount), resulting in a $15 ordinary loss to the project company upon the sale to the lessor.
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Current Monetization of 15% of Basis
An equity investor can invest in the project company before the project is placed-in-service and earn a return by monetizing the Cash Grant payment and the $15 current loss.
This structure can therefore enhance the timing benefit from monetizing part of the project's depreciable basis, especially after the expiration of 100% bonus depreciation. If the lessor is an affiliate of the equity investor at the project company, however, the tax loss equal to 15% of the project's initial basis may be disallowed and deferred until the lessor disposes of the project.
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New Basis Guidance
Treasury recently released a new guidance document entitled "Evaluating Cost Basis for Solar Photovoltaic Properties."*
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The guidance outlines the process used by Treasury to evaluate the amount of a project's basis that is eligible for the Cash Grant. Although the guidance applies specifically to solar PV property, the methods it describes, and the underlying principles, apply to all types of property eligible for the Cash Grant.
"Treasury Releases New Guidance on Evaluating Cash Grant Eligible Basis," Winston & Strawn's briefing on the new guidance, is linked for your convenience.
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New Basis Guidance
Eligible basis generally consists of the direct "hard" costs of the eligible property, and other direct and indirect "soft" costs related to buying or producing the property that are properly capitalized into tax basis. However, the guidance states that in certain circumstances where the stated cost does not reflect the "true economic cost," Treasury may ignore the cost basis stated on the application.
Cases where the stated cost is determined by related parties not acting at arm's length. Other circumstances, where parties presumably acting at arm's length nevertheless have an incentive to inflate the purchase price of property above its fair market value (e.g., sale-leaseback transactions).
The guidance recognizes that each system is different and that the cost basis of eligible property may therefore vary based upon its specific characteristics.
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New Basis Guidance
Treasury's first step in its evaluation is to compare the stated cost basis to a set of standardized, "benchmark" turnkey prices per watt.
These benchmark prices vary solely upon market (e.g., residential vs. commercial) and MW size. The benchmark prices are continuously updated. According to the guidance, they reflect a "high quality of equipment" and "include profit."
If the claimed eligible basis is consistent with the benchmarks, the review focuses on the cost breakdown to ensure that only eligible cost items have been included. Applications that claim an eligible basis that is materially higher than the relevant benchmark receive closer scrutiny, focusing not only on eligible versus non-eligible cost items, but also on related party consideration and other "unusual" circumstances.
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New Basis Guidance
An applicant can submit a third-party appraisal demonstrating that its claimed eligible basis is consistent with a market transaction between unrelated parties. Treasury tends to favor the cost approach as a valuation method.
Cost data for PV systems is widely available and increasingly timely. Treasury will accept a cost approach that includes a markup over the cost of eligible property as long as it is consistent with industry standard and the scope of work for which it is received. Treasury has found that appropriate markups typically fall in the range of 10% to 20%. The valuation should explicitly address the appropriateness of the markup.
Treasury views the income approach as the least reliable valuation method.
Too many assumptions have to be made. Treasury will carefully review appraisals in cases where the income approach yields a fair market value that exceeds the cost to build the property by a "significant" margin. In those instances, a portion of the claimed value may need to be allocated to other assets, rights, or contracts that are ineligible for a Cash Grant.
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Questions?
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Thank You.
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Contact Information
John Lorentzen
Andrew Ratts
Tax Chicago 1 (312) 558-5282
[email protected]
Tax Chicago 1 (312) 558-5991
[email protected]
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