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Renewable Energy Project Tax Planning: Legal Strategies Maximizing Federal Tax Benefits and Incentives

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TUESDAY, FEBRUARY 14, 2012

Presenting a live 90-minute webinar with interactive Q&A

Andrew W. Ratts, Partner, Winston & Strawn, Chicago

Katherine Breaks, Director, KPMG, Washington, D.C.

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Renewable Energy Project Tax Planning: Legal Strategies: Maximizing Federal Tax Benefits and Incentives

OPTIONAL PROGRAM/CURRICULUM DESIGNATION

Katherine M. Breaks Director, Washington National Tax Practice Washington, D.C.


Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND

CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING

PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions,

memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through

consultation with your tax adviser.

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Agenda

Status update Best practices Special issues in “grandfathered” projects

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Grant Awards by Dollar Amount: Over $9.8 billion in grants awarded (as of January 1, 2012)

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Open Loop Biomass

Combined Heat & Power

Fuel Cell

Geothermal Electricity

Geothermal Heat Pump

Hydropower (incremental)

Landfill Gas

Marine

Microturbine

Small Wind

Solar Electricity

Solar Thermal

Trash Facility

Wind

Large Wind – 82%

Biomass – 2% Geothermal Electricity – 2%

Solar Electricity – 16%

Solar Thermal – 2%


Number of Grant Awards by Project Type: 4,375 grants awarded (as of January 1, 2012)

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Open Loop Biomass

Combined Heat & Power

Fuel Cell

Geothermal Electricity

Geothermal Heat Pump

Hydropower (incremental)

Landfill Gas

Marine

Microturbine

Small Wind

Solar Electricity

Solar Thermal

Trash Facility

Wind

Solar Electric – 82%

Solar Thermal – 5%Wind – 5% Biomass – 1%

Small Wind – 5%


Best Practices

Securing grant eligibility does not stop at the “begin construction” deadline- it is an ongoing process and applicants must be aware of all aspects of the eligibility and application process: • Duns # • AUP • Independent Engineer’s Report

• Documentation of continuous program of construction (photos, etc.) • Make sure appropriate legal entities are in place

• Assign contracts to appropriate legal entities? • Gather and organize all relevant documentation • File preliminary application as soon as possible • Continue to maintain record of all invoices, reports, etc. • Commissioning reports • Final cost segregation report • Attestation report • CCR • File final application

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“Grandfathering” issues

Grant applicants could satisfy the “begin construction” by requirement by commencing “physical work of a significant nature” or paying/incurring 5% of grant eligible costs. In 2 new FAQs released December 13, 2011, Treasury describes certain issues related to “grandfathered” eligibility under the 5% safe harbor:

• Q 23. For applicants relying on the 5% safe harbor, what happens if ownership of the energy property changes hands between the time the property is acquired for use in a project and the time the project is placed in service?

• A 23. If a person (the transferor) contributes, assigns, or transfers property to a second person (the transferee) and the transferee uses the property in a project, the transferee is treated for purposes of the 5% safe harbor as having pair or incurred, at the same time as the transferor, the costs that the transferor paid or incurred to acquire the property, but only if the transferor acquired the property for use in that project and is related to the transferee. A transferee and transferor that are related persons within the meaning of section 197(f)(9)(C) of the Internal Revenue Code immediately before or immediately after the contribution, assignment, or transfer of the property will be considered related for this purpose. However, if property is sold to an unrelated purchaser after December 31, 2011, the purchaser may not take the costs that the transferor incurred into account in determining whether the 5% safe harbor is met. This limitation does not apply in the case of a sale/leaseback arrangement. If an entity which met the 5% safe harbor with respect to a facility sells the facility to an unrelated entity and leases the facility back from that entity within 90 days of the placed in service date, the purchaser of the facility (assuming all other eligibility requirements are met) would be treated as satisfying the 5% safe harbor.

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FAQ #23 and potential issues:

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Developer forward purchases equipment (no project) prior to 12/31/11 and contributes to Project Entity after 12/31/11; Developer owns at least 20% of capital or profits of Project Entity

Tax Equity Investor Developer

Project Entity

§721 contribution of equipment

99% of profits

• Does this arrangement work under FAQ #23? • The FAQ states that transferor and transferee must be related “immediately before” or “immediately after” the transfer




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Developer forward purchases equipment (no project) prior to 12/31/11 and sells the equipment to Project Entity after 12/31/11. Project Entity takes cost basis in the equipment = amount paid to Developer. Developer owns at least 20% of capital or profits of Project Entity

Tax Equity Investor Developer

Project Entity

Sale of equipment

• Does this arrangement work under FAQ #23?




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Developer forward purchases equipment (no project) prior to 12/31/2011. Within 90 days of placed in service date Developer sells completed project to Unrelated Party and Unrelated Party leases the project back to Developer. Unrelated Party claims grant.

Unrelated Party Developer

Sells project

Leases project back Gain/loss on sale Rental deduction

Purchases equipment prior to 12/31/11…develops project

Grant (based on purchase price) Depreciation Rental Income

Straightforward sale-leaseback



FAQ #23 and potential issues

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Developer forward purchases equipment (no project) prior to 12/31/2011. After 12/31/2011 Developer contributes equipment to Project Entity. Developer owns at least 20% of capital or profits of Project Entity. Within 90 days of placed in service date Project Entity sells completed project to Unrelated Party and Unrelated Party leases the project back to Project Entity. Unrelated Party claims grant.

Unrelated Party Project Entity

Developer Contributes equipment

Sells project

Gain/loss on sale Rental deduction

Leases project back Grant (based on purchase price) Depreciation Rental income

Related party contribution with sale-leaseback: does this work under FAQ #23?



FAQ #23 and potential issues

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Developer forward purchases equipment (no project) prior to 12/31/11 and contributes to Project Entity after 12/31/11; Developer owns 20% of capital or profits of Project Entity. Project Entity leases project to Unrelated Party in an inverted lease arrangement. Tax equity invests in Project Entity.

Developer

Project Entity

(Lessor)

Unrelated Party

(Lessee)

Tax Equity Investor

Contributes equipment

Depreciation Rent

Leases project Grant (based on FMV)

Does this inverted lease arrangement work under FAQ #23?



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FAQ #24 describes an entity that purchases equipment in 2011 and changes ownership prior to placing the project in service • Q 24. For applicants relying on the 5% safe harbor, what happens if ownership of the entity that met the 5% safe harbor changes before the property is placed in service?

• A 24. If ownership of the entity that met the 5% safe harbor changes after December 31, 2011, and before the property is placed in service, eligibility is not affected if (1) the purchaser is an otherwise eligible 1603 applicant and (2) the entity being sold had commenced development of a project as evidenced by activity such as acquiring land, obtaining permits and licenses, entering into a power purchase agreement, entering into an interconnection agreement, and contracting with an Engineering, Procurement and Construction contractor. The purchaser of an entity which holds equipment only may not rely on costs paid or incurred to acquire that equipment. For example, a project company meets the safe harbor and commences development of a project by acquiring permits, a power purchase agreement, and an interconnection agreement. A partnership interest in the project company is sold to a tax equity investor (or the tax equity investor makes a capital contribution in exchange for a partnership interest) in a partnership flip transaction. The project company (with the tax equity investor as a partner) may rely on costs incurred by the project company to satisfy the 5% safe harbor. On the other hand, if a project company meets the safe harbor by purchasing and taking delivery of equipment but does no other activity, the purchaser of the project company may not rely on costs incurred by the project company to satisfy the 5% safe harbor.



FAQ #24 and potential issues − How does FAQ #24 apply to bankruptcies/liquidations? − FAQ #24 states that the entity being sold must commence

development of a project “as evidenced by activity such as” acquiring land, obtaining permits and licenses, entering into PPA, entering into an interconnection agreement, and contracting with an EPC contractor Are all of these steps necessary for development of a “project”? Many projects will not require all of these (e.g., PPA, interconnection) Will there be an advanced ruling process for determining when a

“project” begins?

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Katherine M. Breaks [email protected]

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© 2012 Winston & Strawn LLP

Best practices for tax structuring

Andrew W. Ratts


Best practices for tax structuring

How have financing structures evolve given cash grant and its recent rules?

Three years later, we have some good answers.

Questions linger.

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Best practices for tax structuring -- Some Answers

Evolutions in partnership flip model. Emergence of leasing. Other tax credit structures.

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Best practices for tax structuring -- More Questions

Will the leasing model continue to grow? The Sunset of the cash grant and the need to claim the ITC

The impending change in accounting rules

Will use of the tax-exempt bond market as a financing tool for renewable energy emerge?

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Best practices for tax structuring -- Planning

Size of Tax Equity Investment

• Extent to which Tax Equity is providing necessary funding

Term of Tax Equity Investment

• Anticipated Term 5-year? 15-year?

Pre-Tax Requirements of Tax Equity Investment

Upside Requirements of Tax Equity Investment

• Fixed priced call option available?

• Put option or ability to withdraw available?

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Best practices for tax structuring – Structural Tax Risk

Tax Ownership

"Sham Transaction"/IRC 7701(o)

Eligible Basis – ITC and Cash Grant

Income/Loss Recognition Pattern

• Timing of Tax Equity Investment

• Allocations for Partnership Flip

• IRC 467 for Leasing prepayments

• IRC 451 for Other prepayments

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Best practices for tax structuring – Rev. Proc. 2007-65 Partnership Flip

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Deep Pocket Taxpayer

Project Company

Allocated 1% of tax losses/income plus a varying percentage of pre-tax economics until target return achieved for taxpayer, then 95.05%

Allocated 99% of tax losses/income plus a varying percentage of pre-tax economics until target return achieved, then 4.95%

Sale of Power

Developer

Electricity Market


Best practices for tax structuring -- Rev. Proc. 2007-65 Partnership Flip

"Full" Compliance Issues. Enough ambiguities as to ever have "full" compliance"?

Any "pre-tax" profit required?

Vexing "DROs" (deficit restoration obligations)

Use of Price Protection Derivatives

PAYGO "fixed" versus "contingent" payments

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"Pre-tax" tax structure. Flip based upon pre-tax cash on reduced equity.

Tax depreciation, timing benefit of early losses and later recapture not relevant to flip.

Accounting treatment as debt?

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Application to other tax benefits. Capital based upon multiple of Cash grant/ITC

5-year Recapture Period

Flip based upon depreciation period, not after-tax return?

Tax depreciation relevant to flip?

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© 2012 Winston & Strawn LLP 29

Best practices for tax structuring –Prepaid PPA

Power Purchase

Project Company

Power Purchase Agreement

Prepayment for Power

Underlying Project financed with a Sale Leaseback or a

Special Allocation Partnership

Sale of Power as Produced


Tax-Exempt Debt ― Prepaid Electricity

The prepayment must be for the sale of a good as opposed to the provision of a service.

The current IRS position is that electricity is a good.

The taxpayer cannot recognize the prepayment as income any earlier for any other purpose, such as accounting for earnings.

The long-term deferral pattern is available with respect to all of the production from a specified facility because electricity is a non-storable "inventoriable good."

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If the prepayment is tied to the production of a specific facility, the PPA should be consistent with:

True lease ownership guidelines.

The requirements for a service agreement.

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A commodity sale contract may be recast as a lease for tax purposes.

All relevant factors are taken into account, but the following factors indicate a lease:

The commodity purchaser has physical possession of the facility.

The commodity purchaser controls the facility.

The commodity purchaser has a significant economic or possessory interest in the facility.

The commodity provider does not bear any risk of substantially diminished proceeds or increased expenditures from nonperformance.

The commodity provider does not use the facility concurrently to provide significant services to others.

The total contract price does not substantially exceed the rental value of the facility.

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Tax-Exempt Debt – Prepaid Electricity

A safe harbor applies to a facility producing electrical or thermal energy if the primary energy source for the facility is not oil, natural gas, coal, or nuclear power. The commodity purchaser cannot operate the facility.

The commodity purchaser cannot bear any significant financial burden from non-performance by the provider (other than for reasons beyond the control of the provider).

The commodity purchaser cannot receive any significant financial benefit from cost savings.

The commodity purchaser cannot have an option to acquire the facility except at its then fair market value.

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Tax-Exempt Debt – Local Furnishing of Electricity Subject to a plethora of special rules, tax-exempt private

activity bonds are permitted for the local furnishing of electric energy, defined as an area consisting of: A city and/contiguous county, or

Two contiguous counties.

However, such bonds are only available to furnishers of electricity who were in business on 01/01/1997, with respect to their service area on such date.

Query: How large is the universe of such privately owned utilities? Two examples are Con Edison and San Diego Gas & Electric.

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Best practices for tax structuring -- Leasing

Sale-leasebacks that previously applied almost exclusively to solar facilities have now been used with respect to wind generation facilities to capture the value of the depreciation.

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Developer Deep Pocket Taxpayer

Project Company

100% 100%

Sale of Project

Rent

Lease of Project

Electricity Market

Sale of Power

Special Purpose

Investment Entity



Sale-LeaseBacks are facing some issues.

First, upon the sunset of the cash grant, the sheer magnitude of ITCs on multiple hundred million dollar wind and solar projects may overwhelm market capacity.

Second, the accounting rules are expected to change such that the debt in leverage lease structures will be included on lessors' balance sheets.1

1 Winston & Strawn LLP is not an accountant and does not provide accounting advice. This discussion is simply intended to relay that accounting is an important issue for consideration as developers seek financing.

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Potential solution:

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Lessor (formerly

Project Co. LLC)

Lessee Newly Created

LLC

Tax Investor

<50%

Lease

Tax Investor Tax Investor

Debt

Sponsor

<50% <50%

100%

Loan Agreement



The tax investors can size their individual investment to take maximum advantage of the ITC (which they can use against their alternative minimum tax liability).

The tax investors will be required to use equity method accounting as minority investors.1

The lessor's net lease income will flow through to them.

The debt will not be included on the balance sheet of any of them; only the investment in the lessor will show up.

1 Winston & Strawn LLP is not an accountant and does not provide accounting advice. This discussion is simply intended to relay that accounting is an important issue for consideration as developers seek financing.

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Leasing -- How to transfer the assets? Sale of project company assuming it is an LLC taxed as a

disregarded entity – a “sale –leaseback”.

Project contract assignment.

Timing of Lease commencement

• Three month rule

• Unwinds

Reserves vs. letters of credit.

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Solar PV Guidance “Stated cost does not reflect …“true economic cost”

• Related parties not acting at arm’s length

• “Peculiar” circumstances” where parties have an incentive to inflate the purchase price above fair market value (sale-leaseback)

Benchmark Pricing

Submission of a “detailed and credible third-party appraisal”

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© 2012 Winston & Strawn LLP 41


“Lease PassThrough”/ “Inverted lease”

The ITC/cash grant (and some PTCs) may be passed through to a lessee by election permitting the separation of the cost recovery deductions from the tax credits or cash grant. The lessee can sublease or enter into a power purchase agreement so lessee can be further separated from user

Cost Recovery Deductions Electricity

Lease with ITC Pass Through Election

Sublease or Power Purchase Agreement

Available for all assets entitled to the investment tax credit including by way of election.

Tax Owner Lessee

User/ Power Buyer

ITC/some PTCs/ Cash Grant


Thank You.

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Andrew W. Ratts (312) 558-5991

Winston & Strawn LLP [email protected]

http://winston.com


Circular 230 Disclosure: These materials are intended for internal discussion purposes only. To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or any other state or local law, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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