On July 9, 2009, the Treasury Department issued much-anticipated guidance (the “Guidance”) governing the cash grant program for renewable energy projects that was enacted as part of the American Recovery and Reinvestment Tax Act of 2009 (the “Recovery Act”). Of particular interest to many project sponsors, investors and lenders are the provisions in the Guidance for sale-leaseback transactions.
In the Recovery Act, Congress enacted energy provisions that introduced new choices and considerations for investment in renewable energy projects. It (1) extended the production tax credits (“PTC”) under Code Section 45, (2) provided an option to elect an investment tax credit (“ITC”) equal to 30% of qualifying costs in lieu of the PTC, thus significantly expanding the scope of the Code Section 48 energy credit, and (3) created a new program, administered by the Treasury, to provide cash grants in lieu of both the ITC and the PTC.
The renewable energy business historically has been dependent on tax incentives to be economically viable. Renewable energy projects such as wind facilities have relied heavily on “tax equity” financing, typically provided by institutions such as banks and insurance companies having significant tax capacity. The economic crisis has caused the tax equity markets to freeze, in part because investors having tax capacity has dwindled, and in part because the risk premium demanded by investors has dramatically increased.
The new cash grant program is intended to dissolve these obstacles and unfreeze the financing of renewable energy projects. Nevertheless, the program will not completely eliminate the “inefficiency” caused by the fact that project sponsors often will not generate taxable income in the early years, during which period the project will generate a significant amount of depreciation on an accelerated basis. The sale-leaseback transaction may allow a project sponsor to transfer the tax depreciation to an investor who can derive current benefits from the depreciation deductions.
A sale-leaseback structure is generally incompatible with the objective to monetize PTCs because section 45 requires that the owner of a qualifying facility also be the operator of the facility. Thus, tax equity financing has historically been structured in the form of partnerships in which the PTCs and other tax benefits are specially allocated (over a 10-year period for PTCs) to the investors. As a result of the cash grant program, however, sale-leaseback transactions are expected to become an important part of the financing techniques available for renewable energy projects.
Overview of Program
Generally, Code Section 1603 of the Recovery Act directs the Treasury to make payments to persons who place in service “specified energy property” during 2009 or 2010, applying rules similar to the rules of Code Section 50 applicable to the ITC. Property placed in service after 2010 may be eligible if construction began in 2009 or 2010 and the property is placed in service by a specified date.
An applicant must be the owner or, under certain conditions described below, the lessee of the property and must have originally placed the property in service. Specified energy properties include qualified facilities as defined in sections 45 and 48. For most types of property, including wind, solar and biomass, the amount of the grant is 30% of the eligible cost basis of the specified energy property. The applicable percentage is 10% for certain other types of property.
Generally, except in the case of an election permitted in the context of leases, (1) a grant is not includible in the gross income of the recipient, and (2) the tax basis of the property is reduced by an amount equal to 50% of the grant. This basis reduction follows the rule for energy credit property under section 50(c)(3).
Sale-Leaseback Transactions
The Guidance provides specific rules for leasing and sale-leaseback transactions. Many of these rules follow the existing rules applicable to the pass-through of energy tax credits to lessees. Notably, the Guidance allows a lessor and lessee to elect that the lessee rather than the lessor shall be entitled to the grant. The election is generally permitted in a sale-leaseback transaction if (1) the lessee originally places the property in service and (2) the lessee sells the property to the lessor and leases it back within three months of the date it was originally placed in service (the “Three-Month Rule”).
If a sale-leaseback satisfies the Three-Month Rule and the election is not made, the lessor will be considered the original user of the property even though the lessee places the property in service. In that event, the property is considered to be placed in service not earlier than when it is used under the leaseback.
Where an election is made for the lessee to obtain the grant, three special rules apply. First, for purposes of the grant program, the lessee is treated as having acquired the property for an amount equal to the independently assessed fair market value of the property on the date the property is transferred to the lessee. Thus, if the fair market value of the property as independently valued is greater than its basis, the project sponsor/lessee may be eligible for a grant amount that is higher than the amount the sponsor would obtain based on the its cost basis in the property in the absence of the sale-leaseback. Further, the grant amount to the lessee could theoretically be different from the grant amount that the lessor could receive based on its purchase price in the transaction if the lessor were to place the property in service.
Second, the basis of the property is not reduced as it would be (by 50% of the grant amount) if the lessor does not elect to have the lessee obtain the grant. Thus, the lessor is able to claim depreciation deductions based on its purchase price.
Third, the lessee must include ratably in gross income over a five year period an amount equal to 50% of the amount of the grant. The income inclusion is the flip side of the preservation of full basis to the lessor. Overall the income inclusion may result in net gain to the fisc because depreciation of at least a portion of the preserved basis (equal to 50% of the grant amount) is likely to be claimed over a period greater than five years.
Accordingly, the effect of an election for the lessee to apply for the grant generally would be to preserve the depreciable basis to the lessor and to cause income recognition of 50% of the grant amount to the sponsor/lessee over a five year period. If the election were not made and the benefit of the grant were to be transferred to the lessee, for example as an increase in the purchase price, the full value of that transfer may constitute taxable income to the sponsor. The sponsor and prospective owner/lessor will need to weigh these considerations in structuring a sale-leaseback transaction for qualified energy facilities.
This article is one of several that appear in
North America Tax News and Developments, August 2009.