Below our questions asked by the audience during our webinar of
June 22 Capital Account Implications for Renewable Energy Tax
Credits with our answers and explanations. For reference, a PDF of
the presentation from the webinar is available here.
The questions are divided into the following five
categories:
DRO/Negative Capital Account
Questions
1. Question:
Could a “book-up” of a partnership’s capital
accounts due to a “reevaluation” of the project result in
the reduction or elimination of a partner’s deficit restoration
obligation (DRO)?
Answer: Yes, it could.
Explanation: The section 704(b)1
regulations permit a book-up of capital accounts when a new or
existing partner makes a capital contribution “(other than a
de minimis amount)” to the partnership in exchange for an
interest in the partnership. See Treas. Reg.
§1.704-1(b)(2)(iv)(f)(5). The contribution must be made for a
non-tax business purpose in order for the capital contribution to
qualify as a revaluation event. If such a contribution is made, the
partnership is permitted to revalue or “book-up” its
assets to fair market value. The “book-up” of the
partnership’s assets allows the partners to restate their
capital accounts to reflect the increased value of the
partnership’s property and can serve to eliminate or reduce a
DRO.
2. Question: In deals structured with a DRO,
the partnership agreement typically caps the applicable
partner’s DRO at a percentage of the partner’s capital
contributions. Do the tax rules provide for a limit on how large a
DRO may be?
Answer: The tax rules do not have an objective
limit on the size of a DRO.
Explanation: The concept of a DRO traces its
roots back to the principle that a general partner had unlimited
personal liability for the obligations of the partnership. Given
general partners had unlimited personal liability, the tax law does
not provide for an objective limit for how large a DRO may be.
We have seen tax equity deals in which 12-year straight-line
depreciation is elected and the tax equity investor’s DRO cap
is as little as 15% of its capital contributions. We have also seen
tax equity deals in which bonus depreciation is elected and the DRO
cap is more than 100% of the tax equity investor’s capital
contributions.
3. Question: What are the risks of sizing a DRO
cap with a large cushion to make sure the negative balance of the
tax equity investor’s capital account does not exceed the DRO
cap?
Explanation: There is not a tax risk with such
a strategy; however, there is a commercial risk: if the partnership
were to liquidate, the partner with the DRO would have to fund its
negative capital balance up to the cap with large cushion. Given
that commercial risk, partners generally opt to not provide DROs
larger than necessary to cover their reasonably projected negative
capital account balance (after adjustment for any “minimum
gain” attributable to any “partnership nonrecourse
debt”), which is what the section 704(b) regulations
require.
4. Question: What happens when an investor
exits a deal and has an outstanding DRO? Is there gain recognized
on the deficit capital account or does the investor need to
contribute cash at that point? If gain is recognized, are the
suspended losses released to cover the gain?
Answer: Assuming the exit is a sale of the
investor’s partnership interest, the buyer inherits the DRO.
The seller/investors recognizes gain for the difference between its
outside tax basis in its partnership interest and the purchase
price. However, the investor’s suspended losses are eliminated
and do not get transferred to the buyer, so the investor avoiding
the DRO is not as much as a windfall as it seems at first.
Explanation: If you are thinking of a typical
to partner partnership, the managing member and tax equity
investor, the result is that the partnership terminates. That does
not trigger the DRO as it is not a “liquidation.” In this
termination scenario, the buyer/managing member does not inherit
the DRO from the seller/investor because there is no longer a
partnership. The seller/investor does not recognize gain due to DRO
no longer applying, but the seller/investor does lose the benefit
of the suspended losses; in many deals, a partner’s suspended
losses are equal to its negative capital account balance, so this
is a wash. This is discussed further in the first question from Q&A for a prior
webinar.
Depreciation Questions
5. Question: Can depreciation that is
capitalized into inventory be specially allocated as a separable
line item? Or once depreciation is capitalized into the basis of
the inventoriable item, that depreciation deduction cannot be
allocated as a separable item and must be allocated in the same
ratio as all costs of goods sold.
Answer: It cannot be separately allocated. It
must be capitalized into cost of goods sold.
Explanation: In the power generation ,
depreciation is only separately allocable if the project is leased.
If power is sold pursuant to a power purchase agreement (or
scheduled directly into a power market), the IRS requires cost of
goods sold accounting, which means depreciation is capitalized into
cost of goods sold, which results in only a bottom-line profit or
loss to allocate. See GCM 38337 (Apr. 4, 1980); GCM 37352
(Dec. 21, 1977); Announcement 86-65, 1986-19 I.R.B. 19; TAM
200543050 (Oct. 28, 2005); PLR 200146009 (Nov. 19, 2001).
6. Question: To determine depreciation
schedules for wind and solar projects, do you look to section 168,
or are there more detailed rules for wind and solar?
Answer: Yes, the general depreciation rules
apply to wind and solar property.
Explanation: Section 168 and the regulations
thereunder provide rules for depreciation of all property,
including wind and solar projects. IRS Publication 946 is also
useful in determining depreciation schedules. The ITC regulations
(i.e., Treas. Reg. § 1.48-9) provide some guidance with
respect to depreciation. The U.S. Treasury’s section 1603 grant
guidance can be applied by analogy and may provide helpful
background. A number of PLRs have been issued over the years and
while not precedential, provide helpful guidance.
7. Question: If transmission equipment with a
15-year recovery period is placed in service in the same year as a
wind or solar power generation equipment with a 5-year recovery,
can the owner claim bonus depreciation on the 15-year recovery
period equipment and 12-year straight-line on the wind or solar
power generation equipment?
Answer: Yes.
Explanation: Depreciation elections apply
taxpayer-by-taxpayer, depreciation class-by-depreciation class and
placed in service year-by-placed in service year. I.R.C.
§§ 168(g)(7), (k)(7). Since 15-year transmission
equipment is a different deprecation class than 5-year renewable
energy generation equipment, a taxpayer can make different
depreciation elections, even if they are placed in service in the
same year.
Further, if one wind turbine (or solar project block) is placed
in service in year X and another wind turbine (or solar project
block) is placed in service in year Y, a taxpayer can make
different elections for the different placed in service years.
Further, the same corporation can be a partner in two separate
partnerships that each own separate solar projects, and one
partnership can elect bonus depreciation and the other partnership
can elect 5-year MACRS (or 12-year straight-line) depreciation.
These depreciation election rules are discussed further on page 4
of the article available at https://www.projectfinance.law/media/5552/2018-01-19-elfa-tax-reform-article-by-d-burton-and-a-levin-nussbaum.pdf
Suspended Loss Questions
8. Question: Consider an example in which a
partner contributes $100 and is allocated a $200 credit with $100
basis reduction and $150 loss, resulting in a negative $150 capital
account at year end. The partner has a negative outside basis.
Since the negative basis was created from a combination of both the
credit reduction and the losses, are both “suspended” in
proportion, or can the partner apply the ITC basis reduction FIRST
and attribute the entire negative capital account balance to the
loss only? That is does the ITC adjustment always come before the
loss?
Answer: There is no clear guidance directly on
point. However, the conventional wisdom in this area is that the
basis adjustment attributable to the ITC necessarily has to occur
first. It would have to occur first because the adjustment is
necessary to calculate the depreciation available with respect to
the project for the year in question. That is the project’s
basis is reduced by the ITC basis adjustment and the balance of the
basis is then subject to the depreciation rules of section 168.
Explanation: As there is no clear guidance on
point, it is rare to see reliance on this logical ordering
inference. Typically tax equity investors prefer a high degree of
comfort and would rather make an optional contribution than rely on
inference without direct guidance.
9. Question: Are a losses of a partner that are
suspended pursuant to section 704(d) subject to a limit on the
ability to use them in future years comparable to the 80% limit on
net operating losses (NOLs) that are carried forward?
Answer: No. There is not limit on the ability
to use losses that that are suspended under section 704(d) in
future years once the losses are released.
Explanation: In tax reform enacted in 2017,
section 172 was amended to allow only 80% of taxable income for any
year to be offset by the carry forward of net operating losses.
This rule is discussed on page 4 of the article available at https://www.projectfinance.law/media/5552/2018-01-19-elfa-tax-reform-article-by-d-burton-and-a-levin-nussbaum.pdf.
There is no comparable limit on the use of losses that are released
after being suspended pursuant to section 704(d).
Tax reform completely eliminated the ability to carryback NOLs.
However, it is still possible to carryback general business
credits, like the ITC and the PTC, one year. General business
credits can be carried forward 20 years.
PTC Questions
10. Question: Has the production tax credit
(PTC) for onshore wind expired?
Answer: Projects that “began
construction” prior to statutory deadlines can still claim
PTCs.
Explanation: The PTC has a 10-year credit
period, so operating projects can continue to claim PTCs.
Additionally, projects placed into service after the expiration of
the credit that “began construction” in earlier years can
still claim the credit (in later years at a reduced amount):
|
If Construction Begins: |
PTC Amount Reduced by |
|
During 2017 |
20% |
|
During 2018 |
40% |
|
During 2019 |
60% |
|
During 2020 or 2021 |
40% |
|
After 2021 |
No PTC Available |
The PTC rate is currently $26 a mWh. Accordingly, for an onshore
wind project to claim the full $26 a mWh, it must have begun
construction in 2016 or earlier. A wind project may opt for the
investment tax credit (ITC); however, the ITC amount would be
subject to the same level of reduction as the PTC. The begun
construction rules for wind are provided for in IRS Notice 2013-29
and its progeny.
11. Question: Why is there a basis reduction,
with a corresponding capital account and outside basis adjustments,
for 50% of the ITC but no corresponding adjustment for the PTC?
Answer: That is how Congress wrote the rules.
Specifically, section 50(c)(3)(A) provides for the basis reduction
of half of the ITC, and there is no corresponding basis adjustment
rule for the PTC. (Rehabilitated historic buildings also qualify
for an ITC, and that basis adjustment is 100% of the ITC.)
ITC Recapture Questions
12. Question: If ITC claimed on a partner’s
share of ITC eligible basis is recaptured, does the partnership
increase its basis in the energy property by 50% of the amount
recaptured by the partner?
Answer: Yes, it does.
Explanation: The partner will have an increased
tax liability in the year of the recapture by the amount of the
recapture, and the partnership will adjust its basis in the energy
property by 50% of the amount recaptured by the partner. I.R.C.
§ 50(c)(2).
13. Question: How does a project casualty
impact ITC recapture?
Answer: If the project is permanently removed
from service, the ITC would have to be recaptured. I.R.C. §
50(a)(1)(A).
Explanation: The amount of the ITC that must be
recaptured declines by 20% a year (i.e., if the casualty occurs
more than five years after the placed in service date, there is no
recapture).2
14. Question: What are the recapture rules for
qualified production expenditures (QPE), which allow ITC
to be claimed while a project is being constructed?
Answer: If the project is not ultimately placed
in service, the ITC claimed based on QPE must be recaptured.
Explanation: In general, ITC may not be claimed
until the project is placed in service. However, in some cases
taxpayers investing in projects that take more than two years to
construct need not wait until the property is in service to claim
the ITC. In the case of “progress expenditure property,”
a taxpayer can elect to claim ITC before as the project is being
constructed. See Treas. Reg. § 1.46-5(b).
Progress expenditure property is property being constructed by
or for the taxpayer that has an estimated normal construction
period of two years or more. In this context,
“construction” means building or manufacturing property
from materials and component parts. “Normal construction
period” starts on the day when the physical work begins or, if
later, on January 1 of the year in which the QPE election is made.
Treas. Reg. § 1.46-5(b).
If the project is never placed in service, the QPEs must be
recaptured. I.R.C. § 50(a)(2)(A).
A QPE election is rarely (if ever) made in practice. This is
because it entails construction risk. That is it requires owning
the project during construction and suffering recapture if the
project is not placed in service. The banks, insurance companies
and public corporations that are the efficient users of ITC
generally do not want to take construction risk. Therefore, they
will rarely entertain QPEs. In contrast, developers that are
comfortable with construction risk generally do not have sufficient
tax appetite to use QPEs efficiently.
Footnotes
1. All references to “section” or
“§” are to the Internal Revenue Code of 1986, as
amended, or the regulations thereunder.
2. I.R.C. § 50(a)(1)(B): “(i) One full year
after placed in service 100%
(ii) One full year after the close of the period
described in clause (i) 80%
(iii) One full year after the close of the period
described in clause (ii) 60%
(iv) One full year after the close of the period
described in clause (iii) 40%
(v) One full year after the close of the period described
in clause (iv) 20%”
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