Essential Terms and Negotiation Strategies for Tax Credit Transfer Agreements
An overview of the principal agreement between a buyer and seller of transferable tax credits.
Introduction: Why buying tax credits is preferred by many corporate taxpayers
By allowing corporate taxpayers to purchase tax credits from renewable energy projects through the Inflation Reduction Act, Congress created a streamlined incentive to allow companies to put their tax payments to work financing the energy transition.
At the heart of this program, referred to as “transferability” or “transferable tax credits,” is a simple concept. Instead of requiring a partnership to allocate credits to a corporate taxpayer, that taxpayer can now use a tax credit transfer agreement (TCTA) to simply buy the credits from the generating source. By using a TCTA to purchase tax credits, corporations no longer must use complicated partnership structures that may generate negative accounting results.
For tax, treasury, and corporate finance professionals, this is a welcome development. In order to identify and manage all the risks of a tax credit transaction, a thorough understanding of the purchase documents is critical – starting with the TCTA itself.
In its simplest form, the TCTA is the contract that legally obligates a buyer to buy and a seller to sell the transferable tax credits generated from one or more projects. This article covers the key commercial and legal terms of the TCTA, as well as the allocation of risk between the parties.
Key components of a tax credit transfer agreement
A TCTA can be structured in two ways, principally depending on whether tax credits have already been generated. Spot transactions may use a simultaneous sign and close structure or a sign and subsequent close structure, while forward transactions will generally use a sign and subsequent close structure.
For transactions where a project has already generated tax credits and all closing conditions precedent will be achieved upon signing, a TCTA should be structured for a simultaneous sign and close. In this structure, payment happens upon execution of the contract.
For transactions where transferable tax credits will be generated in the future or where credits have been generated but have conditions that have not yet been fulfilled – for instance, a cost segregation is outstanding – the TCTA can be structured for sign and subsequent close. In either case, a sign and subsequent close ensures the buyer, seller, and project meet certain conditions before closing.
Pricing is the obvious commercial term that the transacting parties must negotiate. It is typically reflected as a price per $1.00 of tax credit. However, there are other commercial terms that need to be considered – ideally, early in the negotiation process – and reflected in the TCTA, including:
- Maximum credits acquired: A buyer will often put a cap on the amount of credits it acquires.
- Percent of credits acquired: If there is more than one purchaser of credits from a specific project, the TCTA may specify the pro rata amount of credits allocated to a particular buyer.
- Different pricing for different credit years: To the extent a buyer is acquiring credits from multiple credit years, or there is uncertainty as to the tax year in which a credit may be generated, the parties may negotiate pricing specific to each credit year. (We wrote about the rush to get projects placed in service in December here).
- Payment terms: To the extent that a buyer desires to pay the seller that is not immediately after all closing conditions have been met, the TCTA should specify these payment terms.
- Transaction costs: To the extent that each party does not bear its own legal and transaction costs (which we think makes the most sense), the parties should agree upon cost sharing.
Representations and warranties
At a basic level, the seller will represent that it owns the project, the project is qualified to generate transferable tax credits, they are eligible to claim and transfer the credits from the project, and such tax credits have not been previously sold, carried back or carried forward.
The seller will also need to make representations around the project itself – for instance, the project has been placed in service as of the closing date (for §48 ITCs); that the electricity was generated and sold to a third party (for §45 PTCs); whether the project qualifies for any bonus credit adders (energy community, domestic content, or low income); and whether the project has complied with or is exempt from prevailing wage and apprenticeship requirements.
There are also customary and non-controversial representations that both parties typically make, including around legal organization, due authorization, enforceability, no litigation, and no material adverse effect.
Pre-closing covenants and conditions
Pre-closing covenants govern the conduct of the parties between signing and closing. Pre-closing covenants are generally non-controversial, representing best practices to ensure that the seller does not do anything to impair the value of the credits and continues to advance the project in a commercially reasonable way. If any material changes do occur, a seller should be obligated to inform the buyer promptly.
Closing conditions precedent
Both the buyer and seller will need to meet conditions precedent (CPs) that are required to obligate the other party to close on the transaction, although most CPs in TCTAs are obligations of the seller.
The closing conditions validate that the credits have been generated and can be transferred as contractually envisioned; furthermore, they stipulate the specific deliverables that the buyer and seller must furnish prior to closing. Some common CPs include the following:
- Restatement of representations and warranties: This “bring down” confirms that all of the previous representations made by both parties remain accurate.
- Evidence that the project has been placed in service for tax purposes by a certain date.
- Completion of a pre-filing registration with the IRS along with a transfer election statement.
- Procurement of tax credit insurance (if agreed to by the parties).
- Evidence that the project has complied with the prevailing wage requirements and the project qualifies for any bonus credits available.
- For §48 ITCs, provision due diligence reports, including a cost segregation analysis and appraisal by agreed upon consultants. An appraisal is not required in many transactions but is typically warranted where there is a fair market value step-up transaction.
- For §45 PTCs, evidence that the electricity has been generated and sold to a third party; if the PTCs were subject to a wind repower, a report that establishes the 80/20 test has been met.
- No changes of tax law.
The buyer, importantly, is confirming within the closing conditions that they have conducted a thorough due diligence process. Demonstration of a thorough due diligence process can help buyers avoid a 20% “excessive credit” penalty in the event of a disallowance.
The IRS transferability guidance includes a “reasonable cause” provision that can absolve buyers of the 20% penalty (but not their pro-rata share of the excessive credit itself). The most important factor to establish reasonable cause is “the extent of the transferee taxpayer’s efforts to determine” that the credit transferred was appropriate. Specific examples provided by the IRS that establish reasonable cause include review of seller’s records, reliance on third party expert reports, and reliance on seller representations.
Although transferability does not require a buyer and seller to enter into an equity partnership, both parties still have legal obligations to one another for a period of time following the transaction. The post-closing covenants detail these obligations and ensure ongoing compliance and cooperation.
Most importantly, the post-closing covenants require the parties to file their tax returns and properly reflect the tax credit transfer. This includes attaching the transfer statement with registration numbers to both the seller and buyer’s tax returns.
For §48 ITCs, recapture risk allocation is addressed in the post-closing covenants. The seller agrees to not take any action that would lead to recapture (such as sale or abandonment of the project) and, failing that, to notify the buyer if there has been a recapture event. Both parties agree to take any actions required of them if recapture occurs. Furthermore, during the recapture period1, the seller is required to meet the prevailing wage and apprenticeship requirements for any alterations or repairs on the project (although this requirement does not apply to routine operations and maintenance). To the extent the IRS determines that the seller violated wage and apprenticeship requirements, the seller has the ability to remediate such violations within 180 days of identification of such failure through cure payments. The requirement to make such cure payments should be a specific covenant in the TCTA.
In any tax credit transaction, whether a tax equity transaction or a tax credit transfer, the risk of loss often manifests itself in the form of an IRS audit. Given that a buyer has received the benefit of a tax credit, the IRS generally looks to the buyer if it challenges the amount of credit that was claimed. However, the buyer has an indemnification from the seller (and potentially tax credit insurance), so the seller will want visibility into any future tax proceedings that relate to the transferred credits.
Proceedings with the IRS can be governed in one of two ways. First, the buyer can control any proceedings with the IRS, with the right of the seller to be informed of the progress of the proceedings and the right to participate in such proceedings. Alternatively, the seller can control any proceedings with the IRS, with the buyer having participation rights. Control and participation rights should be negotiated between the parties as a commercial matter.
A TCTA should include 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 §48 ITC, the primary risks to which a buyer is subject are qualification and recapture.
- Qualification risk: Pertains to whether the tax credits will be allowed in full by the IRS. Disallowance could result from several factors, including challenges to the qualified tax basis of the asset, the date the asset was placed in service, prevailing wage and apprenticeship labor, and the claim of bonus credit adders.
- Recapture risk: Occurs if the asset no longer remains energy property owned by the seller during the recapture period. This can occur in numerous circumstances, most notably if there is a default on a loan that results in a foreclosure2, or a sale of the energy property by the seller3. However, there are other instances that can cause recapture, such as a casualty event where the asset is not or cannot be rebuilt or a loss of site control where the project loses its ability to remain commercially operational. While these scenarios are remote, buyers should nonetheless remain aware that they exist.
There are fewer risks in a §45 PTC transaction. Generally, though, for any TCTA, the seller should expect to indemnify the buyer for any credit losses (other than from losses that were a direct result of a buyer action).
Unlike a traditional tax equity partnership, the buyer of tax credits has no control or governance rights over the project and, therefore, should not expect to assume the risk associated with credit losses.
In most cases, indemnity payments made by a seller to a buyer will be taxable transactions. Therefore, indemnity provisions will include a tax gross-up to ensure the buyer is able to cover any losses on an after-tax basis. Also, it is typical that a seller will indemnify for interest and penalties that may be assessed against the buyer.
As is common in purchase and sale transactions, indemnification will include breaches of representations, warranties, and covenants. As discussed previously, post-closing covenants are important for tax credit transfer transactions, given that the filing of both parties’ tax returns is required for the legal transfer of the credit from seller to buyer.
The transferor of a tax credit is the first regarded entity that owns the project generating the credit. For instance, if a project is owned by a single member LLC project company (which is a very common structure for energy projects), which is in turned owned by a partnership, the transferor of the tax credit is the partnership, as opposed to the project company, as that project company is a disregarded entity.
Given that the transferor may be a company of limited financial wherewithal, a guarantor is needed to backstop the indemnity obligations of the transferor. The guarantor is typically the parent company of the developer. In order to evaluate the creditworthiness of the guarantor, a buyer will want financial statements – preferably audited – of the guarantor. A buyer should undertake a credit analysis to understand the likelihood of repayment by the guarantor, should a recapture or disallowance condition occur. This analysis should take into consideration that the IRS can recapture tax credits over a 5-year period, with the amount of potential recapture stepping down by 20% each year. In determining the duration of the guarantee, the buyer should also consider the IRS audit statute of limitations, which typically runs three years.
Tax credit insurance
To the extent that the creditworthiness of the transferor and guarantor is insufficient for the buyer, tax credit insurance may be required. Whether tax credit insurance is required is typically negotiated up front, as the insurance premium is meaningful and will reduce the seller’s net economics.
Tax credit insurance can cover qualification, recapture, and structure4 risk. Not all risks need to be covered in each transaction, so all parties will need to agree on the covered tax provisions and understand the specific exclusions to each coverage.
To bind an insurance policy, the transacting parties must prepare a comprehensive due diligence package to submit to insurance providers. Once the submission is made, it usually takes several weeks to bind a policy. Parties should consider the insurance timeline during the TCTA negotiating process.
The insurer typically does not have contractual privity to the TCTA.
For any TCTA that is structured with a non-simultaneous signing and close, a termination provision is included that would provide an outside date to complete the transaction. Some typical reasons for termination would be if a project is delayed beyond a certain date, or if the project was not placed in service in a particular tax year.
How Reunion helps
Our founding team has been at the forefront of renewable energy tax credit financing and innovation for the last twenty years. With our marketplace of over $2 billion of near-term transferable tax credits, we can help identify tax credit opportunities that meet the needs of corporate tax teams. Additionally, we will guide buyers through transactions in a detailed and comprehensive manner, with a focus on properly identifying and managing risk.
To learn more about how we can help your company, please contact us.
1 The recapture period is the first five years from the date the project is placed in service.
2 A buyer may require a seller to negotiate a forbearance agreement with its lenders, where lenders agree to “forbear” against a direct foreclosure on the asset that would cause an ITC recapture.
3 A change in the upstream ownership of a partnership or S-corp does not cause recapture for the buyer of the credit, although this may trigger recapture to the shareholder or partner who sold their interests.
4 Whether the IRS will respect the transaction and the eligibility of the transferor to sell and the transferee to purchase the credits.