Question from Seminar Participant: The tax equity investor invests to own only a portion of the production tax credits (PTCs) up front, since there is an unknown of the actual production levels of the wind farm. What does the project company do with the portion of the PTCs not sold up front? Are they generally sold to the same tax equity investor year after year, or is there some other way for the project to receive value for them?
Answer: In a typical wind tax equity partnership that follows the safe harbor in Revenue Procedure 2007-65, the tax equity investor is allocated 99 percent of the profit and loss (which is different from its right to distributable cash), determined using tax principles until the later of (a) when it achieves after-tax flip rate and (b) five years. That allocation of profit and loss brings with it the right to 99 percent of the PTCs. PTCs are generated for 10 years from the project’s placed-in-service date (i.e., when it starts operating). If the tax equity investor achieves its flip rate before that 10-year period is over, the tax equity investor’s allocation declines. The minimum revenue procedure permits the investor’s allocation can decline to 4.95% (i.e., 5 percent of 99 percent), but the exact level to which it declines is negotiated up front in the limited liability company agreement (LLCA).
After the flip occurs, then a much larger percentage (up to 95.05%) of profit and loss (and PTCs) is allocated to the developer based on how the LLCA was originally drafted. The developer has three choices: (i) it can use the PTCs to reduce its own federal income tax liability (but few developers have sufficient tax liability to do that in an efficient manner); (ii) it can contribute its interest in the project company (e.g., its right to 95.05 percent of the PTCs) to another limited liability company and have this new tax equity investor purchase an interest in this new limited liability company in exchange for an allocation of 99 percent of the 95.05 percent of the PTCs (i.e., a profit and loss allocation) that remains for the 10-year period from the project’s original placed-in-service date; or (iii) it can approach the original tax equity investor and propose amending the original LLCA to provide that the tax equity investor’s allocation is restored to 99 percent for the remainder of the 10-year period in exchange for a contribution to the project company that is distributed to the developer. Option (iii) is the most likely scenario.
Some developers decide to address option (iii) in advance by stipulating in the original LLCA that any PTCs that are available after the flip date will be allocated to the tax equity investor, but the tax equity investor will have to make an additional contribution to the project company of an agreed amount for each dollar of PTCs that it is allocated, and that contribution will be distributed by the project company to the developer. This is known as “pay go” and is permitted by Revenue Procedure 2007-65, provided that, at the outset of the transaction, the reasonably projected pay go payment is 25 percent or less of the tax equity investor’s total projected capital contributions. Some developers find that they are able to negotiate a higher contribution for each dollar of additional PTCs, if they address this post-flip pay go arrangement in the original LLCA. Such developers find this approach to be more favorable than having to negotiate an amendment to the LLCA after the flip is achieved, when the tax equity investor knows that the time and transaction expenses associated with negotiating a transaction with a new tax equity investor along the lines of option (ii) in the preceding paragraph are likely prohibitive, resulting in the developer being a “captive audience,” effectively subject to the tax equity investor’s pricing demands.