Tax Issues of “Greening Up” U.S. Energy Infrastructure
In the first issue, we examined how to use a partnership flip structure to utilize the renewable energy electricity production credit. In this second issue, we dive a little deeper into the credit itself.
What Is the Production Tax Credit?
The renewable energy electricity production tax credit (PTC), Section 45 of the Internal Revenue Code, is a tax credit of 2.1 cents per kilowatt hour for electricity sold from certain renewable energy projects. The statutory rate of 1.5 cents has been inflation adjusted since its enactment in 1992 and is currently at 2.1 cents for sales of electricity in 2009, although it’s just 1.1 cents for certain types of renewable technologies. (See Notice 2009-40, 2009-19 in Internal Revenue Bulletin 931, May 8, 2009.) We won’t know for a while what the 2010 amount will be. Since its enactment in 1992, the PTC has undergone a series of short-term extensions, and actually lapsed in three years (1999, 2001 and 2003). In 2009, Congress provided a three-year extension of the PTC through December 31, 2012, as part of the American Recovery and Reinvestment Act. In its current form, the PTC can be a significant financial aspect of a renewable energy project and cannot be overlooked.
Who Can Use the PTC?
Financers and developers (including utility companies) can use the PTC to reduce the costs of building and operating a renewable energy project. In the , we examined the use of a partnership flip structure to share and use PTCs efficiently.
In addition, traditional fossil fuel companies making significant amounts of taxable income (and maybe even more in a tax world without the deduction for intangible drilling costs or percentage depletion) can benefit from PTCs for developing renewable energy sources to complement their fossil energy portfolio. Indeed, it is not only private equity funds and retirement funds that have the capital to finance these projects, but also the fossil fuel companies (that have made historical amounts of taxable income in the past few years) that have sufficient cash to fund the required investment to “green up” the U.S. energy infrastructure and use PTCs.
How Is the PTC Calculated?
The PTC for any taxable year is equal to the product of 2.1 cents multiplied by the kilowatt hours of electricity produced by the taxpayer from qualified resources at a qualified facility during the 10-year period beginning on the date the facility was originally placed in service and sold by the taxpayer during the taxable year. The amount of PTC so calculated is subject to phase-outs and other limitations that prevent the doubling of benefits for the project. Projects that receive Department of Energy (DOE) grants or are subsidized by other favored forms of financing (such as tax-exempt bonds) cannot receive the full benefits of the PTC — see IRC Section 45(b). In addition, there are other credits available for some renewable energy source projects that, if elected, preclude the project from qualifying for PTCs.
What Is a Qualified Resource?
For the PTC, qualified renewable resources include wind, closed- and open-loop biomass, geothermal, solar, small irrigation, municipal solid waste, hydropower, and marine and hydrokinetic power, according to IRC Section 45(c)(1):
- Wind resources used to produce electricity are obvious.
- Closed-loop biomass is organic material from a farm that is planted to be used exclusively at a qualified facility to produce electricity.
- Open-loop biomass is waste from agriculture livestock, solid wood waste (pallets, crates and other construction waste) and other agricultural resources that are not closed-loop biomass used to create electricity.
- Geothermal refers to reservoirs that consist of natural heat stored in rocks or in aqueous liquid or vapor. The geothermal heat is used to produce electricity.
- Solar resources used to produce electricity are obvious.
- Small irrigation cannot use dams or other impoundment of water through canals or ditches to generate electricity. In addition, the nameplate capacity of a small irrigation system cannot exceed 5 megawatts of power.
- Municipal solid waste produces energy as it biodegrades. The biodegradation creates methane gas that can be used at a “landfill gas facility” to produce electricity.
- Hydropower essentially is the use of dams to produce water flows that generate electricity.
- Marine and hydrokinetic projects rely on wave, tide and other free-flowing bodies of water (including temperature differentials in oceans) to produce electricity.
What Is a Qualified Facility?
The qualified facility rules under Section 45(d) deal with when a facility must be placed in service to qualify for PTCs. For example, a wind facility must be placed in service after December 31, 1993, and before January 1, 2013, for its electricity production to qualify for PTCs — see IRC Section 45(d)(1). The qualified facility rules can also address expansion of existing facilities. For example, Section 45(d)(2)(B) addresses the expansion of a closed-loop biomass facility. The qualified facility rules can also address the generation capacity of the facility — see Section 45(d)(3)(A)(i)(II). Each type of renewable resource under Section 45(c) has its own set of rules under Section 45(d) dealing with date placed in service, expansions, generation capacity and other relevant items in determining whether a particular project can be a “qualified facility.” Each set of rules needs to be reviewed for the particular source of energy for a particular project.
Other Rules Applicable to the PTC
Section 45(e) provides rules that deal with, among other things:
- The requirement that all production of electricity occur in the U.S. or in a U.S. possession;
- Relevant inflation adjustments;
- Exclusion of sales under certain contracts; and
- Coordination of the PTC with other credits and incentives for the same production in order to prevent duplication of benefits.
Be sure you address these rules if you are analyzing availability and deal value of credits under the PTC. As is the case with most financial analyses, if the tax benefits appear too good to be true, check again and again. And then again.
The PTC is allowed as a credit against tax under Section 38 as a general business credit — see Sections 38(a) and (b)(8). The general business credit allowed for any taxable year may not exceed the excess of the taxpayer’s net income tax over the greater of (1) the tentative minimum tax for the tax year, or (2) 25 percent of the taxpayer’s regular tax liability over $25,000. Under this section, the general business credit can be used to reduce a taxpayer’s regular tax liability down to the tentative minimum tax amount. For purposes of this calculation, the PTC is merely a component of the general business credit. This limitation essentially means that a taxpayer with general business credits can only reduce its tax liability to the amount of its tentative minimum tax liability.
However, under Section 38(c)(4), certain PTCs are specified credits — see Section 38(c)(4)(B)(iii). As such, the limitation discussed above is modified so that the first limit — the tentative minimum tax — is treated as being zero — see Section 38(c)(4)(A)(ii)(I). Thus, to the extent a taxpayer has PTCs for facilities placed in service after October 22, 2004 (the date of enactment of the specific credit provisions for PTCs), those PTCs can offset 100 percent of a taxpayer’s alternative minimum tax. Thus, the effective limitation for PTCs for facilities placed in service after October 22, 2004, is 25 percent of the taxpayer’s regular liability over $25,000. The specified PTCs could reduce a taxpayer’s effective tax rate to 25 percent of the statutory amount (or 8.75 percent compared to the U.S. statutory 35 percent rate). This is a significant benefit, as most other components of the general business credit can only reduce a taxpayer’s tax liability to the alternative minimum tax amount, which can greatly exceed 25 percent of the regular tax amount.
Coordination with the Investment Credit
The general business credit under Section 38(a) includes the investment credit under Section 46. The Section 46 investment credit includes the energy credit under Section 48. The energy credit is 30 percent of the basis of each energy property placed in service during the taxable year — see Sections 48(a)(1) and (a)(2)(A)(i). The credit applies to solar and wind projects, among others — see Sections 48(a)(3)(A)(i), (ii) and (vi). Under Section 48(a)(5), a taxpayer may elect to treat a qualified facility under Section 45 as qualified property, which is part of a qualified investment credit facility under Section 48. In such a case, the qualified facility will be treated as energy property under Section 48, the energy percentage will be 30 percent, and the PTC will not be available for any year in which the Section 48 energy credit is taken on that property.
Essentially, the decision whether to take PTCs or the energy credit will be based on the modeling of both the PTCs and the energy credit. Remember that PTCs have the added feature of being able to reduce tax liabilities below the tentative alternative minimum tax. The energy credit is not a specified credit under Section 38(c)(4), but merely a component of the overall general business credit under Section 38(a).
Alvarez & Marsal Taxand Says:
President Obama and the entire administration are searching for ways to stimulate the economy and add real and permanent jobs within the United States. Requiring a national portfolio of renewable-based energy is one tool the government will use to stimulate investment in green energy industries. Another tool will be the government’s ability to authorize tax credits, grants and other financial benefits for making investments in green energy industries. The required investment to convert from the current fossil-based energy infrastructure to a larger renewable-based energy infrastructure should create research, engineering, manufacturing, construction and service jobs in the U.S. in green energy industries. Taxes will continue to be a large and important part of the benefits that the government will use to stimulate and reward the appropriate economic growth in green energy industries.
The PTC is a significant factor in the financial modeling for a renewable energy project. As the U.S. continues to convert from a fossil-based energy infrastructure to one with a significant base in the renewable (green) sector, credits like the PTC will continue to play an important role in financing these projects. The PTC has the added feature of being a specified credit and able to reduce a tax liability below the alternative minimum tax — a feature that is rare in U.S. tax law and one reserved for very special projects and initiatives.
Projects that qualify for the PTC can also qualify for the energy credit. Therefore, significant upfront financial and tax modeling is necessary to make the best decisions about which credit to elect for a renewable energy project. Phase-out and limitation provisions that affect the PTC need to be understood and communicated to finance and other deal team members so the proper amount of PTC (and project return on investment) can be modeled.
Although other articles in this series will continue to address individual components of tax law that promote green energy initiatives, another point to keep in mind is the totality of how these provisions work together in combination or as mutually exclusive to each other. Another component is the conversion issues that will arise as we move from a fossil-based infrastructure to one based on a significant contribution from green energy resources. Yet another issue that will arise is the yet-unknown implications of taxing the use of fossil-based energy or the implementation of a cap and trade type of regime or of carbon taxes (or both) for dealing with dirty energy.
In the next issue in this series, we will address further issues related to various proposals in Congress concerning a clean and domestic energy agenda.
Managing Director, New York
For More Information on this Topic, Contact:
Managing Director, Washington, D.C.
Managing Director, Miami
Managing Director, Houston
Other Related Issues:
We would like to hear from you.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the U.S., and serves the U.K. from its base in London.
Alvarez & Marsal Taxand is a founding member of Taxand, the first global network of independent tax advisors that provides multinational companies with the premier alternative to Big Four audit firms. Formed in 2005 by a small group of highly respected tax firms, Taxand has grown to more than 2,000 tax professionals, including 300 international partners based in nearly 50 countries.
© Copyright 2010 Alvarez & Marsal Holdings, LLC. All Rights Reserved.
Alvarez & Marsal | 6th Floor | 600 Lexington Avenue | New York | NY | 10022