While many column inches have been filled extolling the broad benefits of the Inflation Reduction Act of 2022 (IRA), the power sector has been impatiently waiting for guidance from the US Treasury for greater clarity on some tax equity fine print — most notably, the concept of transferability.
Succinctly, with transferability, instead of tax equity needing to invest in the actual renewables project — which is why it can be so complicated and only a limited number of investors are willing to do so — you can sell the IRA’s tax credits.
The wait is now over with the Treasury having issued this highly anticipated proposed regulations for the transfer of certain income tax credits under Section 6418 of the tax code on June 14.
The tax credit sale market should now ramp up quickly – and some tax credit sale transactions where documents have already been signed, but not yet funded, will need revisiting – although careful diligence is required as the sector unpacks the guidance.
With the guidance addressing various aspects like definitions, transfer procedures, and pre-filing registration, one crucial question has also been answered: ‘who bears the recapture risk?’
Under the recapture provisions, investment tax credits (ITC) can be recaptured if there is a "disposition" of the project within five years of its placement in service. The ITC vests incrementally over the course of five years. For example, if a project is sold, or experiences a casualty event in year two, then 80% of the tax credit amount that remains unvested must be repaid to the Treasury.
Buyers are left on the hook to repay the Treasury both in cases where ITCs are recaptured due to a casualty or a sale of the project and credits for capturing carbon dioxide emissions are recaptured due to the carbon dioxide escaping from the sequestration arrangement. This can be frustrating for buyers as they may end up paying both the seller for the tax credit and the Treasury, despite having no control over the project and the events that trigger recapture.
David Burton, a partner with Norton Rose Fulbright, explained that the proposed regulations confirmed that the buyer of the tax credit can be indemnified by the seller for recapture. Burton noted that tax credit buyers insist on an indemnity from a creditworthy seller or tax credit insurance, and that the market has yet to see an ITC transfer deal with project level debt as the ITC buyer does not want the risk of recapture from a foreclosure by the lender on the project.
Burton further explained that Treasury did listen to industry concerns about ITC recapture from a sale of an interest in a partnership that owns the project. For instance, a sponsor and a financial investor own a project through a partnership. The partnership sells the ITC associated with the project. The sponsor during the first five years opts to exit the project by selling its partnership interest. He said: “The proposed regs have the selling partner suffer that ITC recapture, rather than the buyer of the ITC.”
Tax equity investors speaking to PFR have said they have been more focused on production tax credits (PTC) transactions so far in the transferability space due to the recapture risk associated with ITCs.
For PTC sales buyers must pay year-by-year and developers making forward sales – who want the full purchase price of the tax credit at inception of the project – would have to borrow bridge debt against the future revenue stream from a bank or other lender, including by structuring any payment by the tax credit buyer for future tax credits as a loan.
Despite the power sector having to navigate these new regulations and their fine print, transferability will increase liquidity in the tax equity market. Burton said: “Transferability creates a market entry point both for both novice and veteran tax investors.”
The novices like transferability as it allows them to reduce their taxes and align with their ESG goals without tangling with complicated financial accounting or becoming project finance experts. While some banks, that are veterans of tax equity transactions, like transferability as the purchase of tax credits, unlike a traditional tax equity investment, does not attract a capital weighting charge and requires less time from underwriting teams.
For more on tax equity and the impact of the Inflation Reduction Act keep an eye out for PFR's forthcoming roundtable