E.7 | DART – Deloitte Accounting Research Tool

E.7.1 Overview

In the United States, federal, state, and local governmental agencies often subsidize certain activities and investments with tax credits and other incentives. Many of these incentives are claimed directly by the party engaged in the subsidized activity; however, there are several incentives (some of which are described in this discussion) for which the project sponsor (the “sponsor” or “developer”) cannot use the incentives generated. When the sponsor cannot use tax credits (and other incentives such as accelerated tax depreciation deductions), it often partners with companies that have tax capacity so that it can more efficiently monetize these tax benefits. These companies are referred to as tax equity investors (TEIs).

In a typical tax equity financing transaction, there are two parties: the sponsor (or developer) and the TEI. Typically, the sponsor is tax-inefficient (i.e., it cannot use the tax benefits generated by the project). As a result, the sponsor enters into a financing arrangement with a TEI to monetize the tax benefits. These projects are common in the renewable energy industry in which, for example, production tax credits (PTCs), investment tax credits (ITCs), and tax credits for carbon oxide sequestration under IRC Section 45Q are generated.

Because the TEI generally has sufficient tax capacity to use tax benefits generated by a project or projects, the TEI contributes capital to the tax equity financing structure in return for the majority of the tax benefits generated by the project(s). Tax equity commonly accounts for about 30 percent to 70 percent of a project’s capital stack (depending on the credit, transaction structure, TEI target rate of return, etc.). While many TEIs have entered the market over the past several years as part of their sustainability strategy, other major reasons that companies make tax equity investments are to earn economic returns and reduce their effective tax rate.

The sections below discuss various forms of tax equity structures that have evolved in practice, including partnership flips, sale-and-leasebacks, and inverted leases.

E.7.2 Partnership Flip Structures

In a typical partnership flip structure, a partnership is formed to own and operate a project (or projects) in which federal tax credits and other tax benefits are generated (e.g., accelerated depreciation deductions). The partnership between the sponsor and the TEI is generally organized as a limited liability company, which represents a flow-through entity for tax purposes (i.e., there are no income taxes at the partnership level, and the sponsor and TEI factor in the tax benefits [expenses] on their respective tax returns). The partnership is generally structured with two classes of equity:

Equity held by the TEI (often referred to as a “Class A member”).
Equity held by the sponsor (often referred to as a “Class B member”).

There are two types of partnership flip structures:

Yield-based partnership flip — The TEI earns a certain target yield before the “flip” in tax allocations and cash distribution percentages.
Fixed-date partnership flip — The TEI receives up to 99 percent of the tax allocations from the partnership but the flip date occurs on a predetermined date, regardless of the returns earned by the TEI before the flip date.

The sponsor and the TEI negotiate a target after-tax rate of return (i.e., a “target IRR”) for the TEI. The TEI’s up-front cash investment is determined on the basis of the sponsor’s and TEI’s estimate of the net present value of cash flows to be received by the TEI over the life of the investment. Once the net present value of future cash flows is determined, the TEI’s capital contribution is calculated by determining the contribution value required to achieve the target IRR by a certain date, typically referred to as the “target flip date.”

Equity financing received by a project entity is used to pay for the construction or purchase of the project(s). During the first taxable year of the partnership after a project is placed in service, taxable income or loss and other tax benefits (e.g., tax credits) are generally allocated to disproportionately favor the TEI, while cash distributions are generally allocated to disproportionately favor the sponsor. Typically, once the TEI achieves its target IRR or a predetermined date is reached (the “flip date”), the sponsor can choose, but is not obligated, to purchase the TEI’s residual interest after the flip at fair value. This option allows the sponsor to reacquire complete ownership of the project(s) after the TEI has used the majority of the tax benefits generated by the project(s). In addition, as discussed in further detail below, upon this flip date, the economics of the arrangement between the sponsor and the TEI reflect both the sponsor’s and the TEI’s achievement of positive returns over the life of the entity.

E.7.2.1 Put Options

Certain TEIs are subject to regulatory requirements under which they must demonstrate their ability to exit certain investment categories (e.g., the structures described herein) at a specified time (e.g., 10 years after the inception of the arrangement). One way for TEIs to demonstrate such an ability is to hold a put option in the structure. The exercise price of the put option typically (1) is the lower of a fixed amount or the fair value of the TEI’s partnership interest as of the exercise date and (2) does not provide an economic incentive for the TEI to exercise the option.

E.7.2.2 Withdrawal Rights

A variation on a put option in structures is the presence of withdrawal rights, which are based on traditional common law or state law and represent a TEI’s right to withdraw from a partnership. The features of the exercise price for withdrawal rights are like those for put options. Withdrawal rights, however, are different from put options in that (1) withdrawal rights are not based on a regulatory requirement and (2) the only recourse for TEIs holding withdrawal rights is to the project assets (i.e., renewable energy projects), not to other partners (e.g., the sponsor) or other third parties.

E.7.3 Sale-and-Leaseback Structures

Sale-and-leaseback structures involve the sale of an asset by a sponsor (the “seller-lessee”) to a TEI (the “buyer-lessor”), which is then leased back to the seller-lessee (i.e., the original owner) for a term of no more than 80 percent of the life of the asset. Through its ownership of the asset as the buyer-lessor, the TEI receives the tax credits and tax depreciation benefits, along with rent payments in accordance with the lease with the seller-lessee. Meanwhile, the sponsor receives the net operating income from the asset (after paying rent to the lessor). At the end of the lease term, the seller-lessee typically has an option to buy the project back from the buyer-lessor at its current fair market value. Effectively, the structure is established in such a way that the sponsor receives financing for the project; accordingly, a capital outlay is required from the TEI, which is then secured by the tax benefits and project revenues.

E.7.4 Inverted Leases

There are two varieties of lease pass-through structures, which are more commonly referred to as “inverted leases”:

“Basic” inverted lease — In a basic inverted lease structure, the sponsor owns the project through the lessor and makes a “lease pass-through” election to pass the credit from the lessor to the lessee, which is owned by the TEI (the lessee is usually structured as a fixed-date partnership flip between the sponsor and the TEI). This structure effectively constitutes a bifurcation of (1) the tax depreciation (i.e., tax losses), which remains with the sponsor, from (2) the tax credits, which are passed through to the TEI.
Inverted lease with cross-ownership — In this structure, in addition to the lessor-lessee relationship between the sponsor and the TEI, the lessee also owns up to 49 percent of the lessor partnership, allowing the TEI to share in the tax losses generated by the lessor partnership. As with the basic inverted lease structure, the lessee is typically structured as a fixed-date partnership flip between the sponsor and the TEI.

The TEI generally earns its return by (1) receiving distributable cash and (2) being allocated most of the tax credits (e.g., 99 percent) and taxable income or loss (e.g., 49 percent). Typically, the TEI exits the partnership when the sponsor exercises a purchase option (that it often holds) on the TEI’s residual interest in the lessee.

E.7.5 Identification of Variable Interests

Tax equity structures are common in renewable energy projects, and the guidance in Section E.5 generally applies to projects underlying such structures. The determination of whether an interest is a variable interest is often complicated and should focus on the purpose and design of the legal entity being evaluated and the risks to which the legal entity was designed to be exposed. For more information about identifying variable interests, see Chapter 4.

Partnership flip structures (see Section E.7.2) may present unique variable interests. Accordingly, reporting entities should carefully evaluate organizational documents for the presence of any derivative instruments, guarantees, puts, or similar arrangements that may give rise to such interests.

E.7.6 Determining Whether a Legal Entity Is a VIE

As discussed in Chapter 5, when assessing whether a legal entity is a VIE, a reporting entity must determine whether the following conditions apply; if any one of them is met, the reporting entity would conclude that the legal entity is a VIE:

The legal entity has insufficient equity at risk to finance its activities.
The equity holders (as a group) lack any of the three characteristics of a controlling financial interest.
Members of the equity group have nonsubstantive voting rights.

For partnership flip structures, which focus heavily on the determination of whether a legal entity is a VIE, there can be additional complexity. When evaluating these types of structures under ASC 810, reporting entities should assess whether they are limited partnerships (or similar structures) and, if so, whether the holders of equity at risk (typically, the limited partners) have substantive kick-out or participating rights. If such rights do not exist, the partnership would be considered a VIE. See Section 5.3.1.2 for further discussion of whether a limited partnership (or similar entity) is a VIE.

E.7.6.1 Sufficiency of Equity at Risk

Determining the sufficiency of equity investment at risk often requires the use of significant judgment. This applies particularly to tax equity structure companies that are in the development stage, because equity funding may occur in phases or the company’s development may be primarily financed with temporary lending arrangements that are expected to be repaid with equity upon the achievement of certain operational milestones.

A legal entity is considered a VIE if it does not have sufficient equity investment at risk to permit it to finance its activities without additional subordinated financial support. A reporting entity would determine the sufficiency of this equity investment by performing the following steps:

Step 1 — Identify whether the interest in the legal entity is considered GAAP equity.
Step 2 — Determine whether the equity investment is “at risk” on the basis of the equity investment population.
Step 3 — Determine whether the identified equity investment at risk is sufficient to finance the legal entity’s operations without additional subordinated financial support.

When performing step 3, a reporting entity must consider the design of a development-stage entity to determine whether its equity investment at risk is sufficient. That is, in certain circumstances, it may be appropriate for the reporting entity to consider only the legal entity’s current stage of development. Specifically, if a legal entity is in the development stage and there is substantial uncertainty about whether it will proceed to the next stage, it may be appropriate for the reporting entity to consider only the current stage in the sufficiency assessment. This approach is consistent with the assessment of power for a multiple-stage entity (i.e., the power to direct the most significant activities of the legal entity). For additional discussion of (1) the sufficiency of equity at risk and (2) whether there is a substantive contingency related to proceeding to the next stage of development, see Sections 5.2.4 and 7.2.10.2, respectively.

Example E-11

Sufficiency of Equity

Company C maintains an investment in Entity B, a legal entity that is a tax equity structure. Entity B consists of and consolidates Project Company P, which owns and operates assets under construction. Entity B has admitted to the partnership a third-party TEI. Further, B is capitalized with a combination of equity and commercial debt that is not investment-grade, which suggests that the lenders may not view B as having sufficient capitalization. In addition, B will need additional funding for its operations, including construction. The purpose and design of B are to construct and operate the assets for P.

In this example, there is not substantial uncertainty related to the completion of development; therefore, B is not a phased entity. The equity is not sufficient to finance B’s current operations (which include construction) in the absence of subordinated financial support. Accordingly, B exhibits the characteristics of a VIE under the criterion in ASC 810-10-15-14(a) because of insufficient equity at risk.

Note that B’s status as a VIE would need to be reconsidered upon each additional equity funding in accordance with the guidance in ASC 810-10-35-4(d).

Questions have arisen related to whether tax equity qualifies as equity at risk. A reporting entity’s conclusion can substantially affect its VIE analysis. Tax equity will generally qualify as “at risk” unless the return of the TEI is somehow guaranteed by the structure. Making disproportionate distributions of equity until the flip date generally would not, in isolation, constitute a guarantee. In practice, we commonly observe that partnership flip structures have insufficient equity at risk and thus are evaluated under the VIE model.

E.7.6.2 Equity Investors at Risk, as a Group, Lack the Characteristics of a Controlling Financial Interest

A legal entity is considered a VIE if the at-risk equity holders as a group, through their equity investment at risk, lack any of the following three qualities, which are the “typical” characteristics of an equity investment:

The power to direct the most significant activities of the legal entity.
The obligation to absorb the expected losses of the legal entity.
The right to receive the expected residual returns of the legal entity.

For many tax equity structures that are VIEs, the determination of whether the at-risk equity holders lack the characteristics of a controlling financial interest is based on the first characteristic above (i.e., the power to direct the most significant activities of the legal entity). Many tax equity structures are legally established as limited liability companies but have governance structures that are similar to limited partnerships. Generally, these entities have a managing member, which is the functional equivalent of a general partner, and a nonmanaging member or members, which are the functional equivalent of a limited partner or partners. ASC 810-10 contains specific criteria related to limited partnerships and similar entities in the determination whether such entities are VIEs. For more information about this assessment, see Section 5.3.

E.7.6.3 Nonsubstantive Voting Rights

The final condition in the VIE analysis is often referred to as the “anti-abuse provision” since it aims to prevent legal entities from being structured in a manner in which a party does not have voting control but in substance should be consolidated by a reporting entity that meets the “substantially all” criterion described in step 2 below. Although intended to address abuse, this provision may apply to many legal entities established with valid business purposes that qualify as VIEs.

In assessing whether a legal entity is a VIE under this provision, a reporting entity must perform the following steps:

Step 1 — Determine whether one investor has disproportionately few voting rights relative to that investor’s economic exposure to a legal entity.
Step 2 — Assess whether substantially all of the activities of a legal entity either involve or are conducted on behalf of the investor identified in step 1, including that investor’s related parties and some de facto agents.

If a legal entity satisfies the criteria in both steps 1 and 2, its voting rights are considered nonsubstantive and the legal entity is therefore a VIE. Given the unique circumstances that may occur with respect to voting rights, particularly in partnership flip structures, reporting entities should continually assess the relationship between each investor’s voting rights and their economic exposure.

E.7.7 Identifying the Primary Beneficiary of a VIE

As discussed in Chapter 7, the evaluation of whether to consolidate a VIE focuses on whether the power criterion and the economics criterion have been met. However, the determination is often based on which variable interest holder satisfies the power criterion since generally more than one such holder can meet the economics criterion.

In a tax equity structure, it may be difficult to identify the significant activities of the legal entity. Further, the significant activities are likely to differ in each stage of the legal entity’s life cycle, from the initial development of the underlying project through the ultimate sale or decommissioning of the facility. These significant activities may include financing, construction, operating and maintenance, dispatch, and other activities. We would expect it to be rare that no significant activities are identified for tax equity structures, particularly those with substantive renewable energy projects underlying the entity.

As indicated in Section E.7.2.2, it is not uncommon for partnership flip structures to include withdrawal rights for the TEI. Note that withdrawal rights that do not require the dissolution or liquidation of the entire entity do not represent liquidation rights and therefore should not be considered kick-out rights (and thus do not affect the primary-beneficiary assessment). Furthermore, when the exercise of a withdrawal right does require the dissolution or liquidation of the entire entity, the right should only affect the determination of the primary beneficiary if the right (1) is substantive and (2) gives a single reporting entity (including its related parties and de facto agents) the unilateral ability to liquidate a legal entity.

To the extent that withdrawal rights held by the TEI are only exercisable in the future, they should be considered in the same manner as other forward starting rights. See Section 7.2.10.1 for a discussion of forward starting rights in the context of the primary-beneficiary assessment.

E.7 Tax Equity Structures