In President Obama’s 2014 State of the Union address, he said: “Every four minutes, another American home or business goes solar; every panel pounded into place by a worker whose job can’t be outsourced. Let’s continue that progress with a smarter tax policy that stops giving $4 billion a year to fossil fuel industries that don’t need it, so that we can invest more in fuels of the future that do.”
With such an endorsement, the solar industry thought its tax priorities were in a prime position in the executive branch, but five weeks later the administration’s fiscal year 2015 budget proposal was released and included a proposal to completely repeal the solar investment tax credit after 2016.1
How could the President go from singing the praises of the growth of the solar industry to five weeks later proposing the repeal of the very tax incentive that drove that growth? Unfortunately, the legislative history included with the president’s budget proposal is silent as to the rationale.2
One could speculate that the Treasury’s experience administering the cash grant program that was enacted in 2009 in the American Recovery and Reinvestment Act and “mimics” the investment tax credit could be the reason for the assault on the solar investment tax credit. Possibly, Treasury has been surprised by the size of the cash grant awards requested and the structuring techniques deployed to maximize them and decided the issue was best addressed by removing the solar investment tax credit from the Internal Revenue Code.
It has become the ordinary course for Treasury to haircut cash grant awards based on its conclusion that the eligible basis of solar projects is overstated. These haircuts have led to litigation in the Court of Federal Claims. My blog post discussing one of the more prominent disputes is available here.
Treasury may be concerned that as investment tax credits are merely claimed on a tax return, and unlike the cash grant program are not subject to an application process, taxpayers will run amuck in their investment tax credit tax reporting. If this is the rationale for the assault on the solar investment tax credit, it would be consistent with a Treasury Inspector General’s report that found purported errors in a sampling of tax returns and expressed concerns about structuring techniques an IRS attorney apparently learned about at a solar conference. My blog post critiquing the Inspector General’s report is available here.
To be fair, the President’s budget proposal is not intended to leave the solar industry high and dry. Rather, it proposes to shift the industry to a production tax credit of 2.3¢ per KWh of electricity generated. In recent years, this tax credit has been available to the wind industry which has used it successfully.3 The production tax credit has currently lapsed, and the President proposes to make it permanent and refundable (i.e., making a cash refund from the IRS available to taxpayers that have tax liabilities that are less than the production tax credits they are entitled to). A permanent tax credit would provide stability to the renewable energy industry and eliminate the boom/bust cycle caused by temporary tax credits. A refundable tax credit would reduce the industry’s reliance on tax equity investors who right now have an upper hand in negotiating pricing and terms and conditions of renewable energy financings. However, the administration may not have fully considered the ramifications of shifting the solar industry to the production tax credit.
What distinguishes solar from other forms of renewable energy is that it is relatively easy to install on homes. Much of the solar equipment installed on homes is financed through leases to homeowners in which the lessor receives a significant portion of its return from the investment tax credit. However, the production tax credit rules require the electricity be “sold by the taxpayer to an unrelated person,”4 which prohibits leasing as in a lease the taxpayer/lessor is being paid for allowing the lessee to use its property (rather, than being paid for the sale of electricity).
There is no explanation in the 1992 legislative history for the leasing prohibition, but apparently the exclusion of production tax credits from lease transactions was the result of a policy judgment by the Conference Committee that abuses could arise if production tax credits were available to lessors.5 Does the administration plan to make an exception to that policy concern for solar? Alternatively, is it the administration’s intent to prohibit leases as a means of financing all the solar panels that have led to the thousands of “job[s] that can’t be outsourced”? Leasing has become so ingrained in residential solar that such a prohibition would be similar to telling General Motors that it cannot lease cars.
Open-loop biomass facilities have garnered an exception to the production tax credit leasing prohibition.6 However, the biomass exception works in the wrong direction: permitting the lessee to claim the production tax credit. The lessee in the residential solar lease is the homeowner who would not be able to claim a tax credit for equipment used for its personal (rather than business) use.
If the production tax credit rules were amended to permit a solar lessor to claim the investment tax credit, it would also create an administrative burden for the lessor for the ten-year production tax credit period. For that period for each project in its portfolio, the lessor would have to track and then report on its tax return the energy production of numerous residential solar projects. Residential solar is already the renewable energy segment with the highest demand for and least supply of tax equity. The ten year administrative burden of tracking and reporting production for numerous residential solar projects is not going to encourage more tax equity investors to enter that market.
The production tax credit as the single credit available for all renewable energy technologies has the appeal of simplification; however, the Administration needs to carefully consider if the production tax credit is the appropriate incentive for solar. The production tax credit has been successful in wind; however, wind has lower upfront costs and higher on-going maintenance costs than solar; therefore, a ten-year credit better matches the expense pattern of wind. Thus, the production tax credit may not be as suited for solar as it is for wind.
What Should the Administration Do?
Although I believe Treasury’s apparent concerns regarding taxpayer’s application of the investment tax credit rules is significantly overstated, it seems questionable as to whether the solar industry will be able to persuade Treasury of that. Rather than eliminating the solar investment tax credit, I suggest that Treasury take other steps to clarify and drive consistency in the application of the investment tax credit rules.
First, Treasury should follow through on its June 30, 2011, memorandum that discussed determining the basis of solar projects.7 That memorandum included dollar-per-watt guidance for solar projects that the industry generally followed. That memorandum provided that the market values “are continuously updated,” however, the values in that memorandum have not been updated since it was published almost three years ago. Treasury and the IRS could publish updated values and require taxpayers claiming solar investment tax credits in excess of those values to file a special disclosure on their tax returns to flag the return for audit. That would discourage taxpayers from claiming amounts in excess of the published values without a good explanation.
Second, the Solar Energy Industry Association has published a thoughtful paper principally authored by the accounting firm CohnReznick that discusses the determination of the fair market value for income tax purposes of solar projects. My post on the white paper (including a link to the white paper) is available here. Treasury or the IRS could review that paper and communicate with the industry as to what aspects it concurs with and what aspects give it pause. Such a candid discussion would provide valuable information to the industry that I suspect most taxpayers would abide by.
Finally, Treasury could propose a repeal of the investment tax credit pass-through election in Section 50(d)(5). I know some in the solar industry would be displeased with the loss of that election, but it seems a worthwhile sacrifice if it results in retention of the solar investment tax credit. This election permits a lessee to claim the investment tax credit. In the first instance, it is contrary to the fundamental tax principle that tax benefits accrue to the owner of the property.8 Second, it permits the lessee to claim the investment tax credit based on the notional fair market value of the property. This amount neither corresponds to what the lessor paid for the property nor to what the lessee pays in rent; thus, the election invites confusion and possibly abuse. Finally, it adds complexity to the Code.
It is worth noting that individuals at Treasury who appear concerned about structuring practices associated with the investment tax credit do not appear to be speaking with the team of IRS and Treasury tax practitioners that worked on Revenue Procedure 2014-12, which is discussed in my blog post here. Revenue Procedure 2014-12 promulgated a complicated safe harbor for historic rehabilitation investment tax credits under Section 47 that is based on the pass-through election in Section 50(d)(5), discussed above.
The solar and rehabilitation investment tax credit rules are fundamentally the same in terms of calculating basis, special elections, etc. It is unclear to me as to how Treasury could have simultaneously (i) approved that complicated safe harbor for rehabilitation investment tax credit structures in Revenue Procedure 2014-12 while (ii) drafting a repeal of the solar investment tax credit apparently due to concerns about taxpayer’s application of those same investment tax credit structuring principles.
1 The President’s fiscal year 2014 budget proposal did not propose extending the 30% investment tax credit for solar. http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2014.pdf at 20.The solar industry thought that was merely because as the solar investment tax credit applied to projects placed in service through 2016 that the President was merely prioritizing making the expiring production tax permanent. Thus, the 2014 budget proposal was not perceived as an assault on the solar investment tax credit. Unlike the 2015 budget proposal, the 2014 proposal did not include a repeal of the 10 percent investment tax credit that applies to solar projects placed in service after 2016. http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2015.pdf at 17.
3 Since 2009 wind projects have had the option of claiming either the production tax credit or the investment tax credit (or as applicable a cash grant equal to the investment tax credit). Since the lapse of the cash grant for wind in 2012, the production tax credit has been the more common choice for wind projects; however, a material number have opted for the investment tax credit.
4 § 45(a)(2)(B). The statute does not refer to ownership of the facility; however, the legislative history confirms that ownership and operation must be by the same taxpayer: the conference agreement makes two clarifications. First, in order to claim the credit, a taxpayer must own the facility and sell the electricity produced by that facility to an unrelated party.” Conf. Rept. ¶ 451.15, Energy Policy Act of 1992, P.L. 102-486.
5 See Conf. Rept. ¶ 451.15, Energy Policy Act of 1992, P.L. 102-486.
6 § 45(d)(2)(C).
8 Nonetheless, the election is absolutely legal as it is provided for in a statutory provision. See § 50(d)(5).