How Early Investors are Approaching IRA's New Tax Credit Regime: Additional Tax Credits Drawing Broad Interest
Inflation Reduction Act IRA transferable tax credits bring significant optionality to tax credit buyers.
Reprinted from the Novogradac Journal of Tax Credits
January 2024 – Volume XV – Issue I
Corporate income tax revenue was $425B in 2022, suggesting that if IRA tax credits reach $100B annually, monetizing these credits will require over 20% of annual corporate federal income tax to redirect into clean energy projects. Attracting new sources of tax-related capital into the market remains one of the major hurdles facing the renewable energy sector.
Congress attempted to lower the barriers to entry for attracting tax credit capital by introducing transferability – a transaction mechanism that allows for the purchase and sale of credits, rather than the more complex tax equity partnership structure.
So far, this solution appears to be attractive to corporate taxpayers. In 2023, the range of buyers interested in IRA tax credits has grown beyond the traditional appetite from banks, insurance companies, and some specialized financial services firms.
IRA credits bring significant optionality to tax credit buyers
There are many different types of tax credits from which to choose. For example, there are two credit types – Internal Revenue Code (IRC) Section 48 investment tax credits (ITC) or IRC Section 45 production tax credits (PTC) – and 11 sub-credits spanning electricity generating technology, low carbon fuels, carbon capture and sequestration, and advanced manufacturing.
There is also a range of pricing discounts available that reflect the risk profile of a specific project. Buyers now have far more optionality around the attributes of the credits they are buying, and the transaction process itself.
Buyers can also choose from two different tax credit structures – a single-year ITC or a ten-year stream of PTCs. Single-year ITCs apply to the tax year in which the project was placed in service. This gives tax teams the ability to buy credits year-by-year to offset fluctuating or unpredictable tax liabilities. PTCs are generated alongside the physical output of the project (e.g., electricity, sequestered carbon, manufacturing components, etc.). This allows tax credit buyers to contract for either a spot purchase – i.e., the credits from a single period of output (usually one year) – or a forward commitment to a stream of credits. For taxpayers with a predictable amount of tax over a multiyear period, committing to a forward PTC, or “strip,” purchase can improve the economics of the transaction versus a single-year purchase.
In the current market, spot PTC purchases offer the smallest discount to face value, since they carry less risk compared to ITCs which have a recapture provision, whereas PTCs do not. Single-year ITCs typically offer the median discount and PTC strips offer the largest discount.
Optionality also comes in the form of purchase timing. There are two considerations here – first, most transferable credits are not paid for until a project is placed in service. This approach gives buyers the ability to require key conditions precedent to be met before funding and greatly reduces construction risk to the buyer while isolating the buyer’s exposure to pure tax credit-related risks. Second, buyers can still contract for credits prior to payment. Treasury guidance released in June 2023 formally allowed taxpayers to apply their “intent to purchase” credits to quarterly estimated payment, creating an opportunity to save on quarterly payments prior to laying out cash for a tax credit purchase.
Structuring purchases or payments around quarterly estimated payment days can deliver the best internal rate of return and cash management value. Contracting early in the year can often help buyers secure the best economics, even for credits that aren’t generated until later in the year. Ultimately, buyers should consider the timing of credit purchases as an additional benefit of transferability and plan accordingly for their own tax position.
Transferable IRA credits carry discrete, manageable risks
For early investors in IRA tax credits, risk mitigation should be the primary focus of a transaction process. In general, IRA credits carry the same risks as investing in pre-IRA wind or solar PTCs or ITCs. When investors buy these credits using transferability, however, they eliminate the structure risk associated with tax equity partnerships. This results in cleaner transactions, where buyers need to primarily focus on de-risking the credit itself, rather than the operating profile of the underlying asset.
For a transferable tax credit purchase, buyers must focus on two core risks:
- Qualification: Was the tax credit properly claimed?
- Recapture: Applicable only to Section 48 ITCs and Section 45Q PTCs (not applicable to other PTCs)
A Section 48 ITC is calculated on the cost basis of the energy property placed in service during the tax year. The IRS may challenge the cost basis of the energy property, and if this amount is ultimately reduced, the amount of ITCs from the project will be reduced as well, resulting in an excessive credit transfer tax to the transferee. Buyers will want to review detailed documentation that records the project’s cost basis, verified by a reputable third party accounting or legal firm. In addition, prevailing wage and apprenticeship requirements and any bonus credit adders will need to be verified.
To qualify for a Section 45 PTC, a project needs to generate electricity from a qualified energy resource during the ten-year period beginning on the date the facility was placed in service. Because the PTC is tied to production, the primary risk associated with PTCs is accurate production accounting. This risk is considered easily manageable because production is quantifiable and readily verified.
Recapture on a Section 48 ITC requires that (1) the property remains a qualified energy facility for five years, and (2) there is no change in ownership of the property for five years. In practice, there are three key risks that can be investigated with respect to recapture:
- Proper site control: ensure that the energy project will not be forced from the property by a current or new landlord, triggering a recapture
- Adequate property and casualty insurance: ensure that there is sufficient coverage such that the energy property will be rebuilt in the event of a casualty event
- Mitigate risk of recapture due to debt foreclosure: ensure that lender has agreed to forbearance agreement, or debt is structured in a way that does not trigger recapture in the event of a default
In addition, the seller will need to contractually assure the buyer that there will not be a change in ownership during the five-year recapture period, which the indemnity agreement will help ensure.
To protect against these risks, buyers will negotiate indemnifications from the seller, and may seek tax credit insurance as a backstop to protect the value of the credits. Working with experienced transaction partners familiar with renewable energy tax credits can ensure that risks have been properly diligenced and risk mitigation is in place in the event of a challenge from the IRS.
Common points of negotiation in tax credit transfer agreement
Unlike a tax equity investment where control rights are an inherent part of the negotiated partnership structure between a project developer and tax credit investor, transferable tax credits sold via a purchase-and-sale agreement don’t carry the same level of ongoing rights for a buyer. This means that buyers should identify the key points of negotiation they will want to include in a tax credit transfer agreement (TCTA).
Some common points of negotiation beyond price include:
- Timing of payments
- Audit participation rights
- Scope of buyer indemnification
- Tax credit insurance and who bears the associated costs
- Representations and warranties, and pre-close/post-close conditions precedent
Several of these are closely related to risk management and warrant additional explanation – namely, the scope of buyer indemnification and tax credit insurance.
Buyers will typically secure a broad indemnity that shifts most risks (and their associated costs) from the buyer to the seller. In a tax credit transfer transaction relating to a Section 48 ITC, the primary risks to which a buyer is subject are qualification and recapture. The price of the credit can vary depending on the strength of this indemnity – if a creditworthy guarantor or very large balance sheet (in comparison to the size of the credit) is providing the indemnity, tax credit insurance may not be required.
For instances where a buyer does want tax credit insurance, this cost is typically paid by the seller or the price of the credit is adjusted accordingly when the buyer is procuring insurance directly. Tax credit insurance can be a double-trigger policy that backstops the seller indemnity. So, if the seller fails to perform on the contractual obligations around a recapture or disallowance event, for example, the insurance policy steps in to make the buyer whole. Tax credit insurance is usually quite comprehensive and costs several pennies per dollar of credit.
Conclusion: discrete, manageable risks
The IRA created an attractive tax credit regime for corporate taxpayers to participate in the energy transition while managing their own federal tax liability over an extended period. While these credits are not certificated in the same manner as some state tax credits, they do bear the benefit of being transferable – vastly lowering the barrier to participation when compared with legacy tax equity investments.
The risks to these credits are not zero, but they are discrete and manageable through due diligence, seller indemnification, and products like tax credit insurance. Buyers can generally find ways to substantially de-risk these credits while still preserving sufficient value.