Essential Insights on Treasury's Transferability Guidelines
Our insights on important components of the Treasury's guidance on transferability, including the very positive, and somewhat less positive, announcements.
On June 14th, the US Treasury released guidance on the tax credit transferability mechanisms established by last year’s Inflation Reduction Act. This highly anticipated announcement provides proposed regulations for credit transfers under Section 6418. In this article, we will share initial insights and takeaways from the guidelines, and share thoughts on their effect on clean energy financing moving forward.
The overall industry reception to this week’s guidance appears positive, as it has largely followed expectations that market participants were anticipating. The guidance provided three key things to enable more investment into renewable energy projects:
- Certainty that corporate taxpayers can utilize the credits as intended, as well as clear guidelines that will allow transactions to move forward.
- A clear delineation of the risks and who will be responsible for them.
- A relatively low-burden process for registering, transferring, and claiming the credits.
Takeaways from Treasury guidance were largely positive
1. Clarity on transfer mechanics
Sellers electronically pre-register with the IRS, receiving a project identification number associated with each tax credit eligible property. Sellers and buyers must file a transfer election statement, which includes the registration number and is attached to the seller's and buyer's tax returns.
The transferee and transferor may file their returns in any order, as long as the transferee return is for the taxable year in which the eligible credit is taken into account under the rules of section 6418.
The IRS has released an FAQ with more details on the transfer process.
2. Narrows risk to buyer on tax credit recapture
As expected, recapture risk sit with the buyer; however, the risk to the buyer is narrowed through the following clauses:
- The Proposed Credit Transfer Rules expressly permit indemnification relating to recapture of the buyer by the seller
- A change in upstream ownership of a partnership or S corp does not cause recapture for the buyer of the credit, although this would trigger recapture to the shareholder or partner who sold their interests.
This is one of the most positive outcomes of the proposed regulations. Developers are often structured as partnerships, some with many different equity owners. Subjecting tax credit buyers to the risk of upstream changes of control that inadvertently cause recapture is a difficult risk to manage, and would likely not be covered by tax credit insurance. Additionally, sponsors may opt to continue using some form of backleverage (where a partner in the partnership that owns a project is the borrower, as opposed to the partnership itself), instead of negotiating forbearance agreements from lenders.
Unfortunately this does not change the risk profile to a developer, and they will still need to think carefully about structuring deals to avoid recapture.
3. Proceeds to buyer are tax-exempt
Another large positive for prospective buyers is that income made from a purchase of a tax credit is non-taxable. If a buyer pays $45M in cash for a $50M credit, they would not be taxed on the $5M proceeds. This is also beneficial for sellers, as it should create a market equilibrium that is closer to the true cost of the credit, and help them extract more value from their sales.
4. Supports activities of partnerships and intermediaries
The guidance confirms that partnerships or S corps may qualify as eligible taxpayers or transferee taxpayers. This opens up additional transaction structures, and seems to enable syndication mechanisms similar to those in existing tax equity transactions.
Guidance also confirmed that intermediaries can support transactions without violating the rule against second transfers, which is helpful clarification that should allow third party financial institutions and platforms, such as Reunion, to assist with facilitating transactions.
5. Credits can be purchased in advance
As expected, advanced purchases of eligible credits are permitted, as long as the cash payments are made within the specified period. In an industry that deals with a long timeframe and complex, large-scale projects, this is a welcome clarification that should narrow the timing gap, and allow sellers additional opportunity to find short-term financing from lenders and investors.
6. Credits can be factored into estimated taxes
In accordance with advanced purchases, buyers will be able to think ahead by tax planning credit acquisitions. “A transferee taxpayer may also take into account a specified credit portion that it has purchased, or intends to purchase, when calculating its estimated tax payments, though the transferee taxpayer remains liable for any additions to tax in accordance with sections 6654 and 6655 to the extent the transferee taxpayer has an underpayment of estimated tax.”
This is particularly meaningful, as a tax credit purchaser can calculate estimated tax payments in anticipation of future purchases of tax credits. From a time value of money standpoint, this accretes value to the purchaser in the context of forward purchases of tax credits.
7. Flexibility on 20% excess transfer fee
There is a 20% fee for excess credit transfer, but this “does not apply if the transferee taxpayer demonstrates to the satisfaction of the Secretary that the excessive credit transfer resulted from reasonable cause.” The guidance provided specific examples of what constitutes reasonable cause, and generally reflects standard due diligence efforts that Reunion would facilitate with respect to transactions on our platform.
8. Timeline for opening of registration portal
Lastly, the guidance confirms that the portal for registering and filing elections should open in late 2023. This should not be limiting, as most market participants expect that deals agreed upon in pre-registration will be able to be filed normally once registration opens later this year. The formal filings on the portal will provide for greater market transparency, and ensure that the same credits are not transacted twice.
Several takeaways from Treasury guidance were less positive
9. Lessees in lease pass through transactions are not allowed to transfer credits
This is one of the biggest surprises of the guidance, as most market participants had been expecting that such transfer would be allowed, and a number of transactions have closed based on this assumption. Given that a lessor is explicitly allowed to pass through an ITC at FMV (as opposed to cost), this could be the first indication that the IRS will be heavily scrutinizing transactions that step up basis.
In general, basis step up is a topic that is controversial, important, complicated and subject to interpretation. Most importantly, challenges to qualified basis are the most likely meaningful risk that a tax credit transferee assumes. We will be doing a deeper dive in this area in the near future; stay tuned.
10. Base and bonus credits must be sold in vertical slices
A seller has flexibility on the amount of credits they would like to sell, and can sell credits from one facility to multiple buyers. However, base and bonus credits cannot be sold separately; each buyer must receive a “vertical” tranche that includes a pro rata portion of base and bonus credits.
Said differently, all tax credit purchasers buying tax credits from a particular project are buying the same credit; if there is a reduction of credit, all purchasers will suffer a pro rata reduction. Sponsors were hoping to be able to sell different tranches of credits, at different pricing and risk profiles. While it is possible to synthetically allocate risk amongst a set of credit purchasers through contractual means, it remains unclear whether this will emerge as a common practice.
11. Passive loss rules continue to apply
While the guidance proposes that active/passive rules are expected to apply, they are requesting further comments. For the time being, we believe that it will remain challenging for individuals to participate in tax credit sales, other than to offset passive income.
Treasury Guidance was widely applauded by the clean energy industry for providing clarity on how project developers and investors can take advantage of transferable tax credits, a key financing tool of the Inflation Reduction Act. One goal of the IRA is to attract wider participation in clean energy financing through tax credits; Treasury guidance has provided the clarity that corporate investors will need to move forward with clean energy tax credit purchases. According to Treasury Secretary Janet Yellen, “More clean energy projects will be built quickly and affordably, and more communities will benefit from the growth of the clean energy economy."
Reunion is excited to play a part in accelerating the clean energy transaction. To learn more, please reach out to us at email@example.com.