Solar Tax Equity Due Diligence Tips
Companies large and small are beginning to invest in solar tax credit deals as a smart tax strategy. Although these investments are smart and relatively straightforward, Greenzu’s team finds itself frequently educating new tax equity investors on a few key deal points. These are not tips in how to structure your investment, but rather how the underlying solar project deal with the customer should be structured.
Basic Solar Project Deal Structure
Most commercial solar projects are financed using a Power Purchase Agreement (PPA) or a Solar Service Agreement which is similar. In a PPA, developers like Greenzu install solar on a building’s rooftop at no cost to the building owner. The building owner, in turn, agrees to pay the developer for all the solar electricity generated over the next 20 years. At the end of the 20 years, the developer either removes the system or the building owner buys it for a residual buyout price. The developer retains ownership of the solar system throughout the term of the PPA. As the system owner, the solar developer is entitled to take all the tax incentives offered to people who go solar.
When you install a solar electricity system on a commercial rooftop, over 50% of the installation cost is repaid immediately through federal tax incentives. Unfortunately, many solar project developers lack the tax appetite to utilize those tax incentives. As a result, they form a joint venture with a company that has a large enough tax bill to use the tax credits. The way the joint venture works is the corporate partner buys an ownership stake in the solar project for an amount equivalent to the after tax value of the tax incentives, hence the name Tax Equity Investor. In return the Tax Equity Investor receives essentially all the tax credits and deductions given to the solar system, plus a share of the project cash flows.
Two Issues Worth The Tax Equity Investor’s Attention
Companies considering making a tax equity investment should evaluate the deal structure to confirm their tax incentives are safe. There are two common mistakes solar project developers can make when setting up the deal that put the tax incentives at risk: (1) Leasing to a Non-Profit; and (2) Fixing a Buyout Price. Fortunately, both are easy to spot before making the investment. Even better, the solution for both is explained in safe harbor rulings from the IRS.
Mistake 1: “Leasing” To A Non-Profit
A solar system that is sold or leased to a non-profit loses its federal tax incentives. Tax credits go to the solar system owner. If the owner is a non-profit, then the system is not eligible for the Federal Investment Tax Credit (ITC). (Instructions Form 3468) Similarly, equipment “leased” to a non-profit is not eligible for the ITC essentially because the IRS views the non-profit as the system owner. See IRS §7701(e).
A solar project installed on a non-profit rooftop can keep the tax incentives if the deal is a Power Purchase Agreement instead of a lease. Section 7701 outlines the criteria that makes one agreement a lease and another a PPA. Regardless of what you name the agreement, if you do not meet the Section 7701 criteria the IRS will disregard call it a lease to a non-profit, which is thereby ineligible for the Investment Tax Credit. Fortunately, the standard PPA deal structure naturally follows the Section 7701 criteria. Nevertheless, Greenzu often sees creative project developers propose two terms in particular that would run afoul of Section 7701, meaning the PPA to a non-profit would be deemed a lease. To avoid these two traps:
- Avoid fixed payments. If the non-profit customer pays a fixed amount each month, the project is a lease. If the amount owed varies each month based on energy production, then it is a service contract or power purchase agreement.
- Avoiding shifting maintenance to the customer. If the non-profit customer is required to maintain the solar system (or pay for normal maintenance), then the IRS says it is a lease because the lessor bears no risk for equipment failure, which makes it closer to a sale than a service. If the project owner pays for normal maintenance, it is closer to a PPA or Service Agreement.
Mistake 2: Fixed Buyout Price
The PPA should not promise the customer a sweetheart buyout price at the end of the PPA term. If you do, the IRS may treat it as a sale and say the tax credits go to the building owner not the Tax Equity Investor. Keep in mind, there is strong pressure to ignore this advice. Before they sign the PPA, customers will press to fix a buyout price as low as possible. Before making the investment, many investors will want to add a fixed buyout price into their investment model. Yet, all parties (developer, customer, and investor) must overcome this temptation. Any PPA that promises a fixed buyout price below fair market value may end up sending the Federal Tax Incentives to the customer and not the Tax Equity Investor.
As previously mentioned, the tax incentives go to the owner of the system. The IRS has the power to ignore the “form” of a contract and look at its true economic substance. If the IRS decides a PPA is in reality a sale, it will say the tax incentives go to the customer not the project developer/investor. The IRS issued a safe harbor ruling blessing certain PPA deal structures. (See Revenue Procedure 2007-65.) One requirement in the safe harbor involved the end-of-term buyout price. The IRS said the PPA cannot promise to sell the equipment for less than Fair Market Value (FMV).
The solution is to set the buyout price to “the greater of FMV or” a fixed amount. The economic reality is that before signing a PPA, customers want some idea what ballpark the buyout price will fall in. The Fair Market Value concept provides no clarity since the system will be 20 years old at that time. Yet, the IRS and your customer are judging this provision based on what your PPA says on Day 1. Therefore, to satisfy the IRS while also giving the customer some insight into your thinking, you can split the baby and say: the buyout price will be “the greater of Fair Market Value or a Fixed Price.” You then can include a declining buyout schedule in the PPA. If the IRS questions it, you can show the FMV price sets the floor, so you have met the safe harbor requirement.
About The Author
Brandon Conard is the CEO/General Counsel of Greenzu, specializing in financing commercial solar PPAs and solar leases. His expertise includes commercial energy analysis, solar fund structuring, and project finance. Previously, he led BlueMap’s energy research and engineering team providing advanced clean-tech purchase analytics to large commercial properties. As former Weil, Gotshal, & Manges attorney, Mr. Conard also understands the changing energy, tax, securities, construction, and environmental hurdles every solar project must clear. He’d love feedback on this article. Send it to [email protected]