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
General structure
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.
Commercial terms
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.
Post-closing covenants
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.
Indemnification
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.
Guarantee agreement
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.
Termination
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.
Footnotes
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.
Related Articles
In December 2023, the IRS issued Notice 2024-9, which details how "applicable entities" can satisfy the Inflation Reduction Act's domestic content requirements when using elective pay (which is often called "direct pay"). In particular, projects beginning construction on or after January 1, 2024 may have the value of their tax credit reduced if domestic content requirements are not met.
The IRS refers to the time-based credit reductions as the "statutory elective payment phaseouts."
Applicable credits
The required use of domestic content under elective pay applies to the following credits:
- §45: Electricity produced from certain renewable sources
- §45Y: Clean electricity production credit (technology-neutral PTC)
- §48: Energy credit
- §48E: Clean electricity investment credit (technology-neutral ITC)
Details for each credit can be found in our overview of IRA tax credits.
Applicable entities
Applicable entities subject to the statutory elective payment phaseouts include:
- Organizations exempt from income tax
- Any state or political subdivision thereof
- The Tennessee Valley Authority
- An Indian tribal government
- Rural energy cooperatives
- Alaska Native corporations
Credit reduction
The percentage of credit available to an applicable entity making a direct pay election is determined by multiplying the credit value by an "applicable percentage." Applicable percentages are as follows:
- 100%: Project meets domestic content requirements and/or has a net output of less than one megawatt (alternating current)
- 90%: Project begins construction on or after January 1, 2024 and doesn't meet either of the "100%" requirements
- 85%: Project begins construction on or after January 1, 2025 and doesn't meet either of the "100%" requirements
- 0%: Project begins construction on or after January 1, 2026 and doesn't meet either of the "100%" requirements
Exceptions
The IRS provided two exceptions to the domestic content requirement. If either exception applies, the applicable percentage is 100%.
- Increased cost exception: The inclusion of steel, iron, or manufactured products that are produced in the U.S. increases the project's overall costs of construction by more than 25%
- Non-availability exception: The relevant steel, iron, or manufactured products are not produced in the U.S. in sufficient and reasonably available quantities or of satisfactory quality
Attestation
Applicable entities can claim one of the above exceptions from the phaseout by attaching an attestation to the relevant tax form claiming the credit – form 8835 or form 3468.
The attestation must:
- Be signed by an individual with the power to bind the applicable entity in federal tax matters
- Be made under the penalties of perjury
- State that the entity has reviewed the requirements for each exception and has made a good faith determination that one or both apply
Treasury’s June 2023 guidance made clear that corporate taxpayers can offset their quarterly estimated tax payments using tax credits they “intend to purchase,” opening the door for tax credit buyers to realize most or all of the benefit of a tax credit prior to paying the tax credit seller.
An increasing number of corporate tax directors and treasurers are focused on these types of opportunities, which do not require the buyers to go “out of pocket” to invest in a tax credit. Instead, the buyer pays a clean energy company a discounted amount compared to what they would have paid the IRS; the payment is concurrent with, or in some cases even after their scheduled tax payment date.
In this article, we outline four scenarios where buyers can realize tax benefits prior to cash outlay. We assume the buyer is a corporation that pays $200M each year in federal tax, and is looking to purchase $50 to $100M in tax credits.
Structures that enable buyers to realize full tax benefit prior to cash outlay
Structure 1: §45 PTCs, paid quarterly in arrears
The buyer commits to purchasing $100M in tax credits in Q1, which allows the buyer to offset $25M in tax payments each quarter. Note that if the buyer commits to purchase $100M in Q2 instead of Q1, there is a similarly strong benefit; the buyer can offset $50M in tax payments in Q2, and $25M in both Q3 and Q4.
§45 PTC transactions are typically paid quarterly in arrears. Often, the payment schedule is organized such that the buyer pays concurrently or shortly after each quarterly estimated tax payment date, based on actual tax credits generated during the preceding period. In this example, the buyer pays a clean energy developer $23.75M on each estimated tax payment date, instead of paying the IRS $25M. This results in a $1.25M net benefit each quarter, without any out-of-pocket investment.
Both §45 PTCs, from electricity generated by qualified renewable energy resources such as solar or wind, and §45X AMPCs from advanced manufacturing facilities, can be structured in this way.
Structure 2: §48 ITC portfolio, paid quarterly in arrears
A portfolio of ITCs can be structured similarly to the previous example, where the buyer pays quarterly in arrears (and is therefore able to utilize the full tax benefit prior to cash outlay).
In this example, the seller has a portfolio of rooftop solar projects that will be placed in service throughout the year, generating a total of $100M in tax credits. The seller is offering an 8% discount for the credits. The buyer commits to the tax credit purchase in Q1, and reduces their estimated tax payments by $25M each quarter.
The buyer will pay for the actual credits generated at the end of each preceding quarter. In this example, we assume that $20M in credits are generated in Q1 and Q2, while $30M is generated in Q3 and Q4. As a result, a relatively lower volume of credits need to be paid for in Q1 and Q2 (while the reduction in estimated tax payments remains fixed at $25M each quarter), resulting in a strong net benefit in Q1 and Q2. Overall, the buyer saves $8M in taxes over the course of the year, without any out of pocket investment.
There is a risk that the seller does not generate as many credits as anticipated in a given tax year; if so, a make-whole provision can be negotiated, which obligates the seller to make the buyer whole for any difference between what they agreed to pay for the credits and what they would have to reasonably pay for any replacement credits. In the event of a shortfall of credits, Reunion will also work with the buyer to source replacement credits.
Structure 3: Commit to ITC early in the year, but pay late in the year
In this scenario, a buyer commits to purchasing ITCs that a developer will generate later in the year. While the IRS was clear that buyers can offset quarterly tax payments with tax credits they intend to purchase, it is up to buyers and their legal and tax advisors to decide what documentation is needed to establish intent.
Assume that the buyer and seller execute a tax credit transfer agreement in Q1, and the buyer uses this as a basis to start offsetting quarterly estimated tax payments. If the project is placed in service around or after the Q3 estimated tax payment date, the buyer will be able to offset taxes in Q1, Q2, and Q3 before having to pay the seller for the credits (see example below). This will free up $25M of additional cash each quarter for other corporate purposes, with the understanding that a lump sum will need to be paid to the tax credit seller at a later date.
Sellers typically prefer to receive payment as soon as the credits are generated, but it is possible to negotiate a delayed payment date. For example, if the payment date can be delayed to on or after the Q4 estimated payment date, the buyer will be able to take the full benefit of the tax credit before any cash outlay.
This strategy also applies if the buyer commits to the ITC in Q2 or Q3, and does not have to pay for the credit until later in the year.
Scenario 3 carries the risk that the project is not placed in service in 2024 tax year, which would require the buyer to source replacement credits. It is possible for the buyers to negotiate a make-whole provision, in the event that credits are not delivered as promised.
Structure 4: Buy tax credits to top up at the end of the year, resulting in a lower Q4 or final tax payment
The final scenario is a variation of Scenario 3. A company purchases tax credits at the end of the year, once they have a more concrete understanding of their total annual tax liability, and delays payment until their Q4 or final tax payment date.
Assume the buyer has paid $150M in taxes through the first 3 quarters, and has $50M due in taxes in Q4. The buyer can fully offset their remaining taxes due by committing to purchase $50M in credits in Q4. In this example, the buyer receives an 8% discount, paying $46M for the credits and achieving tax savings of $4M. The buyer can achieve the full benefit of the credit prior to cash outlay by arranging to pay the seller of the tax credit on or after the Q4 estimated tax payment date.
The same logic applies for credits purchased in time for the final tax filing (e.g., on April 15 for the prior tax year, for a calendar year filer). If a buyer has $20M in remaining payments due at final tax filing, they could offset the entire tax payment through purchase of a tax credit. Assuming they could identify and purchase a tax credit with an 8% discount, they would pay $18.4M to a tax credit seller, achieving $1.6M in tax savings. It is worth noting that if the buyer procures more than they end up owing in their final tax payment, the overpayment can be applied to the first estimated tax payment of the following year.
How Reunion works with corporate finance teams to purchase tax credits
Reunion partners with corporate tax and treasury teams to identify and purchase tax credits in a five-step process.
Download an Excel model with the four structures
To download the Excel model featured in this article, please visit our resources page.
Customize these scenarios to your company
Tax credit buyers have a variety of objectives when choosing to purchase a tax credit. Some are focused on maximizing the amount they can save on taxes by looking for the largest discount, while others want to minimize complexity and risk.
We have observed an increasing number of corporate tax and treasury professionals who are focused on transactions that preserve the timing of existing tax-related cashflows, or even improve corporate cash availability relative to the status quo.
Please reach out to the Reunion team if you’d like to examine the cash flow impact of tax credit purchases in further detail, and hear about specific project opportunities that can be structured to maximize economic benefits prior to cash payment.
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