June 10, 2024 | By Dorian Hunt, Head of Renewables

It’s late and you’ve just finished building your tax equity model. Through modern alchemy, you turned a material chunk of your soul into a perfectly coordinated collection of formulae and macros. Now, the economic and tax outcomes of every deal variant can be understood to 9 decimals of precision. Do you want to know what tax equity’s yield looks like in year 3? 2.07%. Year 5? 6.92% Year 65? #REF! (note from editor: author tells me this is something he calls an “Excel joke”). OK, this still needs some work, but it works for most purposes.  

Then the phone rings: The CFO wants to know what the financial reporting looks like before this deal closes. Not one to shy away from a challenge, you promise to run the numbers, slam the receiver down, and get to work. Your journey through whatever guidance you can cobble together leads you to arcane symbols: H, L, B and V. As you learn more, your mind recoils as if you’ve stumbled through the veil into the realm of an eldritch horror. Then, you remember that you haven’t had a phone with a receiver you could slam down in nearly 20 years, so the day is consistently weird. To shake off the fear, you anchor yourself with the comforting mantra of “tax credit monetization.” 

Tax credit monetization can be complex. If monetization takes place through a tax equity partnership or some variant thereof, it can take a tremendous amount of effort to understand and project its expected economic and tax outcomes. Even after expending that effort, you may still question how such structures should be reported in the financials. Since time immemorial, the most popular method of accounting for tax equity investments has been the hypothetical liquidation at book value (the “HLBV Method”). HLBV Method typically is used when it is not obvious what portion of a partnership’s earnings should be included in the tax equity investor’s or sponsor’s financial statements, such as in the case of disproportionate shifting of P&L and cash distributions percentages.  

Under the HLBV Method, each member of a partnership calculates the amount it would receive if the partnership were liquidated at book value at the end of the relevant measurement period.  The partner then compares that number to the same number calculated at the end of the prior measurement period. Any change between the amounts (after adjustment for contributions and distributions) is the financial reporting income or loss allocated to that partner for the measurement period. I always describe it as “Sub K targeted capital accounts, but for GAAP.” To date, nobody has responded with “Thanks, Dorian. That makes perfect sense.” So, let’s explore a less pithy description. 

The HLBV Method (The Typical Aspects) 

Applying the HLBV Method may involve significant complexity. One of the primary drivers of that complexity is the typical expectation that liquidation in the context of a partnership requires consideration of each member’s § 704(b) capital account. From the first step, those responsible for financial reporting have to understand (probably more than they had ever hoped to) how to determine a partner’s § 704(b) capital account. For tax practitioners, this can mean having to get confidence in § 704(b) balances long before those balances are required for inclusion in the tax workpapers that support tax return filings (because of the different dates for financial reporting and tax return filings). Once the § 704(b) capital accounts are materially understood, the question remains:  What gain or loss might a partnership experience if it sold its assets at a price equal to the GAAP basis in the assets? First, we calculate gain on such a sale as the difference between the sale proceeds and the basis of the thing being sold. Under the HLBV Method, the sale proceeds equal the GAAP basis in the asset; the basis of thing being sold is that asset’s § 704(b) basis. To calculate the gain, then, we need the GAAP basis of the assets and the combined § 704(b) capital accounts of the partnership.  

The determination of GAAP basis is a rich topic in and of itself and requires a knowledge base beyond the comprehension of most tax practitioners. However, there are some things to think about in the context of GAAP basis determination that are seen in few places outside of accounting for investments in tax credits. Specifically, how are investment tax credits (“ITCs”) reflected in GAAP basis? Do they reduce the GAAP basis of the asset (i.e. the “deferral method”) or are they reflected in each allocatee’s income tax provision (i.e. the “flow through” method)? Further, does the cost basis of the asset contain any items like related party development fees that are often excluded from GAAP basis by virtue of being borne of transactions from entities under common control? Projects taking advantage of production tax credits (“PTCs”) typically don’t have to worry about these nuances.  

The determination of § 704(b) capital accounts arguably is more straightforward because it largely lacks the accounting policy optionality inherent in GAAP. To spell it out, let’s say that a tax equity investor’s § 704(b) capital account moves up and down through the contribution and distribution of cash, as well as through the allocation of § 704(b) “book” income and loss. If the investee generates an ITC, we’d expect the capital accounts to also be reduced by any basis reduction that comes along with the ITC in accordance with § 50, in proportion to the amount of ITC allocated. In practical terms, for a sponsor partner in a tax equity partnership, the difference in § 704(b) capital account determination as compared to a tax equity partner is that the sponsor partner might establish its capital account through the contribution of property, which for § 704(b) purposes would be typically reflected at fair value. 

Calculating an investor’s share of income under the HLBV Method often requires an analysis of the partners’ capital accounts in the partnership in light of the liquidation provisions in the partnership agreement. In case of a liquidation waterfall, we might proceed allocate liquidation gain – (i) first to partners with deficit capital accounts; (ii) then to the tax equity investor until its target internal rate of return is achieved; and (iii) finally, any remainder shared in proportion to residual sharing percentages (think 95/5 [sponsor/tax equity investor] in a typical partnership flip). 

To see the forest through the trees, it is important to understand two things: 1) the HLBV Method is only for financial statement purposes – it’s not relevant for the  purposes of determining cash flow or tax income/loss allocations; and 2) the HLBV Method can be viewed as simply a mechanism for amortizing an investment in a partnership because the machinations of hypothetical liquidation eventually erode an initial investment to $0, albeit in a sometimes surprising pattern.  

Let’s run some quick numbers using the following assumptions: project fair market value (“FMV”) of $100, 30% ITC, tax equity contribution of 40% of FMV (sponsor bears the cost of the balance), 25-year useful life for GAAP, 5 year class life for tax (straight line for this simple example), and allocations of 99% of P&L to tax equity, 1% to the sponsor. For this very simplified illustration, assume a project that doesn’t produce, or distribute, any cash flow. 

Financial Statement Presentation (Two choices) 

Let’s look at how HLBV might shake out when we use the flow through and deferral methods of accounting for ITCs. The § 704(b) and after-tax cash flow aspects of the transaction are held constant across these two methods. Therefore, for both deferral and flow accounting let’s assume that tax equity puts in $40 then receives ITCs of $29.70 = $30 ITC x 99% (typical pre-flip tax equity P&L allocation) and $17 of deductions from tax depreciation, which might be valued at $3.57 assuming a 21% tax rate. Further assume that tax equity wants a 7.5% after tax yield on his investment. At the end of the first year, we can estimate that the tax equity partner has received $33.27 = $29.70 of ITCs + $3.57 of tax-effected benefit from deductions, leaving him owed about $6.91 = $40 investment less $29.70 of ITCs less $3.57 of tax-effected depreciation plus $0.18 cents in yield (pre-tax). This quantity (often called the “flip price”) is sometimes part of a tax equity partnership’s liquidation waterfall. Let’s assume for the below “flow through” and “deferral” method examples that we are dealing with the liquidation waterfall as described above: (i) first to partners with deficit capital accounts; (ii) then to the tax equity investor until its IRR is achieved; and (iii) finally, any remainder shared in proportion to residual sharing percentages For all of the below we’re going to assume that GAAP basis is depreciated on a straight-line basis over a 25-year useful life.  

For the flow through method, where the GAAP basis is undiminished by any ITCs, the GAAP basis at the end of year 1 would be $96 = $100 less $100/25 years. The combined § 704(b) capital accounts would be $68 = $100 in combined contributions less $15 in basis reduction (1/2 of the ITC) less $17, which is 1 year of tax depreciation calculated as ($100 less $15)/5. Therefore, the gain on a hypothetical liquidation would be $28 = $96 in hypothetical liquidation proceeds less $68 in combined 704(b) capital.  Taking a look at the liquidation waterfall from the lens of tax equity, his so-called CV (“carrying value”) at the end of the waterfall is $16.29 = $8.32 of 704(b) capital account at the end of year 1, plus $7.97 in hypothetical liquidation gain (which is composed of the $6.91 “flip price” identified above plus 5% of whatever gain is leftover at the end of the waterfall). This means that in the first reporting period, tax equity’s CV went from his $40 investment to $16.29. How do we use the two CVs to calculate pre-tax earnings? Well, HLBV is a balance-sheet oriented approach to calculating earnings. So, take the ending CV and compare it against the beginning CV or $16.29 less $40, or a loss of $23.71. 

In the deferral method, we change two variables: 1) the GAAP basis of the asset is reduced by the $30 ITC; and 2) the combined deemed GAAP investment amounts drop by $30 (otherwise the balance sheet wouldn’t balance, which is the closest thing that financial reporting has to eldritch non-Euclidean geometry). So, our liquidation gain drops to a loss of $0.80. We don’t have anything to cure capital account deficits or achieve a “flip price,” so the calculation of tax equity’s CV gracefully degrades to $8.28 = $8.32 of § 704(b) capital account at the end of year 1 (same as the flow through method example) less 5% (the assumed post-flip/residual sharing percentage) of $0.80 of hypothetical liquidation loss. Using the same balance-sheet based approach as our deferral method, we’d calculate pre-tax earnings as $8.28 less $10.30 or a loss of $2.02 (compare that to the loss of $23.71 in the flow through method). 

Here’s a rough illustration of the comparative pre-tax earnings income signatures for the first 10 periods we might expect in with the above facts (note that we’re anchored in the $2.02 loss and the $23.71 loss described in the examples above): 


The difference between the two approaches is one of geography: whether the earnings appear pre-tax or in the income tax provision. Which method is preferable typically depends on how earnings are viewed within a particular enterprise. All this complexity (as well as the often-volatile income recognition under the HLBV Method) leaves many stakeholders frustrated.  

Avoidance (A way out of HLBV?) 

In March of 2023, the Financial Accounting Standards Board (“FASB”) issued guidance allowing tax equity investors (but generally not sponsors) to avoid the HLBV Method if certain requirements are met.i Specifically, tax equity investors may use the proportional amortization method (the “PAM Method”) with respect to eligible investments.   

Under the PAM Method, a tax equity investor amortizes its initial investment cost in proportion to the income tax credits and other income tax benefits received, and recognizes the net amortization, income tax credits, and other income tax benefits in its income tax statement as a component of income tax benefit or expense. At first glance, this appears to be an attractive alternative to the HLBV Method. However, the requirements for applying the PAM Method can limit its applicability.   

Under ASU 2023-02, a tax equity investor may use the PAM Method only if the following conditions are met with respect to a project: 

  1.  It is probable that the income tax credits allocable to the tax equity investor will be available.  
  2. The tax equity investor does not have the ability to exercise significant influence over the operating and financial policies of the underlying project.  
  3. Substantially all of the projected benefits are from income tax credits and other income tax benefits.ii
  4. The tax equity investor’s projected yield based solely on the cash flows from the income tax credits and other income tax benefits is positive.  
  5. The tax equity investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the tax equity investor’s liability is limited to its capital investment. 

PAM may very well provide welcome relief for some investors in the context of tax equity partnerships. However, the HLBV Method – with all of its complexity and potential volatility –  likely is here to stay for the foreseeable future. We’ll run the numbers on the PAM Method and explore its practical limitations another day.  

i See, Accounting Standards Update 2023-02 (March 29, 2023) (“ASU 2023-02”).

ii Projected benefits include income tax credits, other income tax benefits, and other non-income-tax-related benefits. The projected benefits are determined on a discounted basis, using a discount rate that is consistent with the cash flow assumptions used by the tax equity investor in making its decision to invest in the project.