The Wimpy Paradox
The Wimpy Paradox: Does Tax Reform Help or Hurt?
The Wimpy paradox is simple: how can a company pay today for the development and installation of energy efficiency projects with the savings and income from tomorrow -- or next year. Our new tax law will have an effect. Based on an excellent recent article, How The US Tax Changes Affect Transactions, by Keith Martin from the law firm Norton, Rose, Fulbright, this magazine is outlining our take on what kinds of changes we might expect. Mr. Martin's article can be viewed online or downloaded as a PDF.
Generally, energy efficiency and energy generation (renewable) projects are financed by:
- Tax equity and credits that provide tax relief in the future based on investments today;
- Capital expenditures by companies that have cash on hand when revenues exceed expenses,
- Loans issued to credit worthy borrowers, partly based on expected future savings/revenue, possibly supported with a power purchase agreement (PPA) from a large corporation or utility for future output;
- Prepaid power agreements, which pay the owner now, based on defraying future expenses for the use of solar or wind generated energy;
- For large solar installers, revenue from existing projects that pay for new installations.
- And, for large investors, so called 'warehouses' and securitization.
Tax Equity: Build Now, Pay Less Taxes Later
Briefly, the lower the tax rate, the less demand there is likely to be for tax credits. As Mr. Martin puts it:
The depreciation will be worth less at a 21% corporate tax rate than at 35%. Tax equity accounts currently for 50% to 60% of the capital stack for a typical wind farm and 40% to 50% for a typical solar project. These percentages will be lower in the future. Developers may try to fill in the gap with more debt.
He goes on to note that some existing tax equity will be affected by a complicated formula under BEAT, the base erosion anti-abuse tax, that makes returns for equity investors uncertain until end of year calculations on the gap between 10% of taxable income and total tax liability. Some investors could find their equity 'clawed back' if such gaps are too wide in one direction. (Read our full description of BEAT here.)
Capital Expenditures: Pay Now
The bill allows the full cost of equipment to be written off immediately rather than depreciated over time. This has several implications:
- Expensing is essentially a 100% depreciation bonus. There is currently a 50% depreciation bonus, but it only applies to new equipment. The 100% bonus can be claimed on used equipment.
- Owners can opt-out, spreading their depreciation over time.
While the implications for an individual business must be reviewed by tax attorneys and accountants, it is possible that such a deduction could be an attractive piece of project, combined with financing from additional sources.
Loans: Build Now, Pay Later
There is a limit on interest deductions, although it does not apply to any business with average gross receipts of $25 million or less, or regulated public utilities. It is elective for real estate businesses. Congress estimated that 95% of businesses will not be affected through 2021.
Prepaid Power Agreements: Build Now, Get Paid Now, Deliver Later
The bill will probably prevent future use of power purchase agreements that are paid in advance of actual generation because they must be reported immediately as income or, at best, partly in the year the prepayment is received and the balance in the year after. Mr. Martin added that the income hit can be offset by taking the 100% depreciation bonus in the first year, but that would reduce the amount of tax equity that can be raised to finance such a project.
Revenue From Existing Projects: Pay Now From a Portfolio of Projects
This is a more murky area. The new law could help some partnerships and S Corporations, where individuals pay the business tax. Under the new law, tax payers will only have to report roughly 80% of income they receive from partnerships, S corporations and other pass-through entities. This could make revenue from renewable projects more attractive, both for any company that is in the business of using current income from projects for future projects, or for borrowers who might be able to use such benefits as part of their loan paperwork. However, there are many restrictions on what exactly is a taxpayer under this provision: lawyers, doctors and other professionals are generally not able to use this provision.
'Warehouses' or Securitization: Invest
A 'warehouse' is a term for bundling several smaller projects together until there is enough size to create an investment vehicle that can be sold on the open market. Since the benefit of such products is generally income, rather than growth, the law's reduction in the tax rate could be an advantage for corporate investors. NREL, the National Renewable Energy Laboratory, has been working for several years to create transparent financing vehicles that standardize things such as technical terms, contracts and vendor criteria so that investors can compare various products to each other. However, scrutinization is still growing, and so is generally suitable for large, experienced investors.
All in all, the new law could shift the financing of future project toward loans and capital expenses and, at least for the next few years, away from tax equity, including tax credits such the Investment Tax Credit (ITC) for solar and the Production Tax Credit (PTC) for wind. While the tax law has implications, it is the opinion of this magazine that market demand in this accelerating industry will lead to products that help corporations efficiently finance renewable generation. Such products could include "Green Banks', which currently generally fund new energy enterprises, expanding to include project financing. The growth of the industry, combined with the assured future revenue, will likely continue to be an attractive to investors and financial institutions.