Developers Turn to Tax Opinion Insurance to Solve the “Starting Physical Work of a Significant Nature” PTC Eligibility Issue
Industry reports suggest that three developers have purchased tax opinion insurance to provide financial assurance to tax equity investors that their projects will be production tax credit (“PTC”) eligible. Use of this insurance product appears to be how the developers are bridging the gap between what their law firms are prepared to opine constituted “starting physical work of a significant nature” 1 in 2013 and the PTC eligibility risk certain cautious tax equity investors are prepared to bear.
Below is a description of tax opinion insurance generally followed by background with respect to the PTC eligibility issue in question.
Tax Opinion Insurance
Tax opinion insurance has been offered for years. Typically, it had been used to insure that a spinoff or merger was tax-free. Now, it is becoming more common in tax credit transactions.
For the insurance policy to be issued, the insurance underwriter requires a “should” opinion from a law firm with a national reputation for tax expertise or a major accounting firm. Rather than engaging its own counsel to render this opinion, the insurer will typically accept an opinion from the insured’s tax advisor. The insurer will typically engage its own counsel to review the opinion. For the PTC start of construction issue, the insurer will also review the independent engineer’s report that documents what work was completed in 2013.
The conventional wisdom is that although the tax opinion is shared with the insurer (i.e., a party who is not the law firm’s client) which is an apparent waiver of the attorney-client privilege, the opinion is still protected from disclosure to the IRS by the work-product doctrine.
The typical tax opinion insurance policy size is $100 to $400 million; however, insurers will consider polices under $100 million. For policies over $400 million, the premiums increase materially due to difficulties in forming an underwriting syndicate of sufficient size. Market observers estimate the total appetite for insurance companies with respect to PTC start of construction risk is $3 billion. Last year, over $1 billion of various types of tax equity transactions were insured for various tax issues.
If the transaction is audited, the taxpayer/insured controls the audit. The insurance policy contains certain safeguards to prevent the taxpayer from “horse trading” an IRS settlement of an insured issue in exchange for leniency from the IRS with respect to an uninsured issue.
Generally, the tax opinion insurance policy’s only exclusion from coverage is if the insured did not believe one or more of the representations in the tax opinion to be true at the time the opinion was rendered.
The policy will cover lost (i) PTCs, (ii) a tax gross-up due to the fact the insurance proceeds are taxable while the PTCs they replace would not have been subject to tax, (iii) IRS interest and penalties, and (iv) out-of-pocket audit defense costs. However, in all events the total payment is subject to cap provided for in the policy.
Premiums are negotiable and vary based on a number of factors, such as the size of the deductible and the coverage amount. However, the premiums are relatively high, so it is an infrequent issue for which tax opinion insurance is the solution.
Insurance policies are available for tax issues unrelated to income taxes, such as real estate transfer taxes and sales tax. Industry estimates are that with many billions in policies written there has only been approximately $50 million in payouts.
Start of Construction PTC Eligibility Issue
To be eligible for PTCs, a project developer prior to the end of 2013 either had to (i) “incur” 5 percent of the ultimate cost of the project for eligible costs or (ii) undertake “physical work” of a “significant nature.”2 Many project owners lacked the capital to incur the 5 percent in 2013, so they were left with the physical work route.
An IRS notice (prior client alerts discussing the notice and subsequent clarification of other issues available here: April 16 and here: April 26) provides that starting excavations of sites for turbine foundation in 2013 was sufficient to achieve PTC eligibility.3 Thus, starting excavation of a turbine site in 2013 should be sufficient; however, the only example with respect to this issue in the notice provided that PTC eligibility was achieved by completing excavation of the foundations for 20 percent of turbine sites, pouring the concrete pads for those turbine sites and installing bolts for the sites in 2013.4 The meaning of the rules was further clouded by reports of conflicting informal conversations with lawyers at the IRS’s National Office regarding the appropriate interpretation of these rules.5
When developers who did less than the notice’s example suggested sought to raise tax equity, they in some instances found the tax equity investor unwilling to take risk millions of dollars of PTCs risk with respect to to how the IRS would apply the notice in audits that would not arise for a number of years. Often, the developer would then inquire to the IRS about the possibility of a private letter ruling; this path was foreclosed when IRS lawyers suggested the question was too factual for such a ruling.
Some developer would then offer the potential tax equity investor 100 percent of the project’s distributable cash flow, if IRS determined the project not to be PTC eligible. However, certain tax equity investors concluded that even that would not provide an acceptable after-tax return over a reasonable period of time, if PTCs were not available.
At this point in the negotiations, the developers that have opted for insurance either did not (i) have a sufficient balance sheet to provide a meaningful indemnity for this issue or (ii) want to expose their balance sheets to this size of risk. Thus, tax opinion insurance was the only means to induce the tax equity investor to commit to invest in the project. Fortunately for the wind industry, insurance companies are prepared to bridge the gap between what the developers’ law firms are prepared to render “should” opinion with respect to and the cautious investing criteria imposed by tax equity providers.
1 See IRS Notice 2013-29.
2 IRS Notice 2013-29.
3 Id. at § 4.02 (“For example, in the case of a facility for the production of electricity from a wind turbine, on-site physical work of a significant nature begins with the beginning of the excavation for the foundation, the setting of anchor bolts into the ground, or the pouring of the concrete pads of the foundation.” This sentence is a little odd as it item of work is couched as “or;” however, from a practical perspective setting of anchor bolts requires the pouring concrete pads of the foundation which requires excavation of the foundation. It is an unanswered question as to why the sentence did not merely provide that the excavation for the foundation was sufficient.)
4 Id. at § 4.04(3).