IRS Ruling Creates Tax Opportunity for American Indian Tribes to Own Solar Projects

The IRS on March 8, 2013, released Private Letter Ruling 201310001 addressing the tax treatment of solar projects owned by American Indian tribes.¹ The ruling holds that for purposes of the investment tax credit, an American Indian tribe is neither a foreign government, an instrumentality of the federal or a state government nor a tax-exempt organization and, therefore, can elect to “pass through” the 30 percent credit associated with a solar project to a third party investor (as lessee).

This is a significant (and surprising) outcome given that American Indian tribes are not subject to federal income tax.² Accordingly, the IRS might have deemed an American Indian tribe to be a tax-exempt entity, a foreign government or an instrumentality of the federal government or a state for purposes of the tax credit rules. As such, it would not have been eligible to make such an election: the investment tax credit would have been foregone.³

In the “pass through lease” structure referenced in the private letter ruling, the “lessee” is often a financial institution (known in industry parlance as a “tax equity” investor). The lessee “shares” the economic benefit of the tax credit with the lessor (i.e., the American Indian tribe) through the rents it pays. Often substantial rents are due at closing, so that the lessor can benefit indirectly in the short term from the tax credit.

As the lessee does not “purchase” the solar project, it does not have a tax basis in it.⁴ Normally, the investment tax credit is 30 percent of the solar project owner’s tax basis in the project. However, in this arrangement, the investment tax credit is 30 percent of the “notional” fair market value of the solar project (even though, neither party actually paid fair market value for the property). Typically, the parties will have an independent appraiser determine such fair market value.

If the lease is terminated in the first five years of the transaction, the lessee is required to “recapture” the investment tax credit by including certain amounts in taxable income. The amount to be included starts at 100 percent of the investment tax credit claimed and declines 20 percent a year.

In theory, the transaction could have been reversed: the American Indian tribe could have sold the solar project to the financial institution and leased it back.⁵ However, under that structure, the lessor (i.e., the financial institution) would have been subject to slow depreciation rules for recovering the cost of the asset: straight-line over the greater of 12 years and 125 percent of the lease term.⁶ It is likely that the parties selected the lease pass through structure because they were able to optimize the rents in a way that resulted in better tax economics.

Many American Indian tribes are considering various forms of solar investment. To date, these have typically been leasing land for projects to be developed on. This private letter ruling expands the available solar energy investment opportunities available to American Indian tribes. Being able to share the tax benefits associated with the investment tax credit with tax motivated investors is a significant economic benefit and one that American Indian Tribes should be aware of when considering investments in solar projects.

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¹ A private letter ruling is only legally binding for the taxpayer it is issued to. When such rulings are released to the public, the names and identifying information are redacted.

² Rev. Rul. 67-284, 1967-2 C.B. 55, 58, modified on another issue, Rev. Rul. 74-13, 1974-1 C.B. 14.

³ I.R.C. § 50(b)(4)(A).

⁴ Because the lessee does not have a tax basis in the project, and thus cannot reduce its tax basis by half of the credit (i.e., 15 percent) as is generally required, it is required to include taxable income equal to 3 percent of the notional fair market value of the asset in each of the first five years of the lease (i.e., 15 percent total). Treas. Reg. §1.48-4(n).

⁵ Under either scenario, the American Indian Tribe’s ultimate goals of using the solar energy generated by the project, deriving income from third party sales of the energy and realizing a share of the tax benefits associated with the project could be achieved.

⁶ I.R.C. § 168(g)(3)(A), (h)(2)(A)(iv).