May 29, 2024 | By Dorian Hunt, Head of Renewables

What is a federal tax credit? I like to think of it as a gift card that you can only use to pay your federal taxes or get souvenirs at the IRS gift shop (note from editor: does not exist). Prior to the Inflation Reduction Act (“IRA”), there were only two ways to “monetize” tax credits (i.e. turn them into cash): 1) use them to pay your tax bill or 2) allocate them within the context of a tax equity structure in exchange for an infusion of cash from a tax equity investor. Since the IRA, we now have a third option: Code section 6418 allows for the sale of certain federal general business credits generated in connection with the nation’s energy expansion. There are a couple of different flavors of credit, broadly: 1) the investment tax credit (“ITC”) and 2) the production tax credit (“PTC”). The former is based on the eligible cost to build a certain type of asset (think solar or battery storage as a couple of common examples). The latter is based on the volume of a certain attribute produced, such as electricity from renewable resources. In this discussion, I will focus on the ITC and some ways to think about the various decision points a project owner might face when trying to monetize those ITCs.  

As mentioned, ITCs are based on the eligible costs of an asset. How much of an asset’s cost is ITC eligible? That’s outside of our scope here, but let’s just assume that you’re confident in your cost to build because you’ve correctly applied your accrual and capitalization policies and appropriately applied the energy property rules from the Code section 48 regulations (current and proposed). Let’s also further assume that you have done all the things you need to get a 30% ITC (e.g. fulfilling prevailing wage and apprenticeship requirements or starting construction before a certain date). Let’s further assume that your cost to build was $100 and 100% of that is ITC eligible. The amount of ITC you might generate in this instance is $30. 

You have a $30 ITC, so use it against your federal taxes payable. What if you don’t have federal taxes payable? Well, that $30 ITC isn’t of much use to you. Even if you may have had federal tax liability before placing this asset in service, you may not have it now on account of the accelerated tax depreciation you may have claimed on the asset. You could wait to use it by carrying it forward in accordance with the guidelines of Code section 39, but if you don’t want to wait, you’ll want to find an alternative solution. This exact situation was the impetus for the creation of the tax equity market: developers of projects that couldn’t make timely use of the credits that were meant to incentivize their behaviors had to participate in an alternate and often very complex monetization channel known as tax equity finance. However, as mentioned above, with the IRA that ITC can likely be sold to an unrelated party (probably at a discount) in accordance with Code section 6418 and the accompanying Treasury Regulations. So, let’s assume that you sell the ITC for 90 cents on the dollar and you are able to turn that $30 ITC into $27 of cash. The IRA has allowed you to turn lemons into lemonade.  

What if that project that cost $100 to build had a fair market value (“FMV”) of $120? If one were able to claim the ITC based on the project’s FMV then the resulting credit would have been $120 x 30% = $36. However, ITC eligible basis is determined through cost not FMV (notwithstanding the exception under Treas. Reg. 1.48-4 often used in inverted lease tax equity monetization structures). So, unless there is a taxable transaction whereby an owner of a project is able to establish a cost equal to FMV, the incremental ITC is elusive. The tactic du jour to establish a cost basis equal to FMV is for the developer to sell the project to an affiliated entity, such as a tax equity partnership (“TEP”) formed jointly with a tax equity investor (“TEI”).    

Putting 6418 to the side for a moment and using our facts so far, if the sale were respected in all aspects for federal tax purposes (and there were no conditions such as tax exempt ownership or nonqualified nonrecourse finance that could reduce the eligible basis), the TEP would have a cost basis of $120 in the asset. Let’s assume that the TEP is what is known as a traditional time-based partnership flip such that we could plausibly say that a developer might raise approximately $1.15 of tax equity from the TEI for each $1 of ITC generated (there are a lot of levers to pull here, your mileage may vary, consult your tax advisor). If that were the case, the incremental basis enabled by that sale would be $120 FMV less $100 cost to build = $20. The incremental ITC on that incremental basis would therefore be $20 x 30% = $6. The additional ITC proceeds from the TEI in our facts would be $1.15 x $6 = $6.9. If we stop our analysis there, we can spend the rest of the day sitting quietly in appreciation of our own cleverness. However, we need to keep working, there’s more to it. Those additional ITC proceeds come with costs. Let’s unpack some of those costs. 

First, depending on your tax rate, the gain on the sale of the asset might introduce some level of tax drag. If we assume a 21% tax rate, that $20 gain could result in $20 x 21% = $4.2 in incremental taxes. If we compare that against our incremental proceeds from TEI, we’re still in a net positive position of $6.9 of additional ITC proceeds less $4.2 taxes payable = $2.7. Let’s call this Case 1. What if our tax rate were instead 40%?   Well, in that case the math does not work out in our favor as our taxes payable on that transaction would be $20 x 40% = $8 in incremental taxes. If we compare that against our incremental TEI proceeds of $6.9, we’ve lost $1.1. What if we didn’t have a 30% ITC, however, and instead had 40% ITC (because we were able to demonstrate fulfillment of an “adder” requirement, such as the one available for placing an asset in service in a so-called “energy community”)? Then, the transaction might flip back to being accretive with additional ITC proceeds of $9.2 ($20 x 40% x $1.15) and the same $8 in taxes (again, using a 40% tax rate for the seller). Don’t stop here though, keep reading. What other costs do we need to consider? 

Stepping back, you may be wondering why a TEI would contribute $1.15 and only receive a $1 in ITCs. It’s a great question, because it typically would not. The TEI is getting more than the ITCs from this arrangement. If you consider this a closed system, everything that the TEI is getting represents an item relinquished by the developer. The other prominent value streams typically attendant to the operation of a project apart from the ITC are the tax accelerated depreciation and the net cash flows from, say, selling electricity. How much of each of those does the TEI expect to receive? Well, the TEI will typically try to get as much accelerated depreciation as would be allowed by the machinations of Code section 704(b) (and the Treasury Regulations thereunder) and the TEI’s tax outside basis. If the TEI contributed $120 x 30% x $1.15 = $41.40 in our example, it might be able to absorb accelerated depreciation deductions equal to $41.40 less its share of the basis reduction described in 50(c)(3) which in this case might be $36 x 99% x ½ = $17.82, or $41.40 less $17.82 = $23.58. If the developer were tax efficient, it might consider that as lost value. From the TEI perspective, however, in order to breakeven on a nominal basis it would need an additional $41.40 less $36 x 99% less $23.58 x 21% = $0.81. We’ve used up the depreciation, the ITC – so in our closed system all that remains is the cash flow from operating the asset. Again, on a nominal basis to breakeven, that would imply that over the tenor of the TEI’s investment, the developer would have to allocate an additional $0.81 of cash flow value to TEI. Going back to modify Case 1 (developer has a 21% tax rate, ITC is 30% of eligible costs, TEI provides $1.15 per credit), this would reduce the developer’s net benefit to $2.70 of incremental ITC proceeds net of taxes less $0.81 of additional leakage = $1.89.   

However, TEI likely isn’t trying to breakeven on a nominal basis but instead trying to achieve a certain positive IRR or MOIC greater than 1 on its investment. Let’s assume then, in the context of Case 1, that the TEI is entitled to a 7.5% after-tax IRR at a point that is 7 years after the asset is placed in service. The moving variable in our example then is the $0.81 in nominal leakage to break even. If we need to instead calculate a leakage that achieves a 7.5% after-tax IRR at the end of year 7, that equates to approximately $1.25 (we derive this by running a net present value (“NPV”) calculation at a discount rate equal to the TEI flip target yield and then future-valuing any NPV deficit by that same TEI flip target yield, then NPV that value by an assumed developer cost of capital of 8%). So, that changes Case 1 to $2.70 of incremental ITC proceeds net of taxes less $1.25 of additional cash leakage = $1.45.  However, once the flip is achieved, the story is not over. A TEP typically has an arrangement whereby the TEI might exit through executing its put option or the developer might force him to exit by issuing a call option. For the sake of this discussion, let’s assume then further that the TEP is able to achieve a 10% after-tax yield after exit. In that case, we can replace the $1.25 assumed leakage above with $1.63. So, that changes Case 1 to $2.70 of incremental ITC proceeds net of taxes less $1.63 of additional cash leakage = $1.07.  

We started this journey talking about the ability to sell ITCs under Code section 6418. How does that fit in here? Well, there may still be incentive even in the case of a 6418 transaction to establish an ITC basis equal to FMV. In the case of what is known as a hybrid tax equity structure, you might have an otherwise typical partnership flip that retains the option to sell ITCs at a potential discount under Code section 6418. Or, you might have a synthetic tax equity partnership where the premise is to set up a partnership for the purpose of selling all the ITCs under 6418, along with a bespoke sharing of cash and deductions. In those cases, we’d anticipate that the net benefit (or detriment) of entering into a transaction to establish an eligible cost basis equal to FMV would correlate (though not 1:1) with price per credit at which the ITC might be sold under Code section 6418.  

What about transaction costs? Yes, any of these structures might imply transaction costs or insurance products which might be significant, and the amount of those costs should be factored into the overall FMV step up cost/benefit thought process, similar to what I’ve outlined above. In summary, when considering the additional benefits that might come with fair market value step ups on ITC assets, it’s prudent to consider the whole picture. Developers need to think about their tax rates, cost of capital, fair market values in excess of cost, ITC applicable percentages, monetization structures, counterparty expectations, insurance costs, and transaction costs.  


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