August 19, 2024 | By Dorian Hunt, Head of Renewables
If you’re a renewable energy developer and you’re trying to figure out how much investment tax credit (“ITC”) your project might be able to generate, it’s sensible to look into Section 48. You read it top to bottom and you internalize it. You read it and re-read it and after the 10th time through, you’re so confident in your ITC abilities that you toss your copy of the tax code out the window (as I picture this scenario the developer is driving and the bulky tax code causes brief chaos on the road, but nobody is harmed).
But wait! You should have kept reading to the next section: Section 49. Section 49 is what “The Two Jakes” is to “Chinatown”. It’s there and it’s a sequel, but nobody really likes it. Section 49 limits the amount of ITC that might be available in certain ownership structures and is a cousin to the at-risk rules contained in Section 465.
Individuals and closely held C-corporations (“CHCCs”) that invest in partnerships may be aware of the Section 465 at-risk rules and their ability to limit the use of losses and deductions flowing from a partnership. However, they may be less mindful of the possibility that similar rules could apply to limit the ITCs generated by that same partnership. These limitations have increasingly become a trap for the unwary as novel ITC monetization channels develop alongside traditional tax equity flip structures. The ramifications of Section 49 are particularly relevant in the context of ITC sales under code Section 6418 introduced under the Inflation Reduction Act. Before we talk about monetization, however, let’s refamiliarize ourselves with the foundations and basics.
Give Me Shelter
Like many great tales, this one begins with loss (we need to start here before we get into ITCs). Section 465 was enacted at the height of the tax shelter era. At that time, wealthy investors commonly entered into partnerships that engaged in a variety of businesses, often with no expectation of ever being allocated a net profit from the activity; instead, the taxpayer’s “return” on its investment would come in the form of federal income tax deductions used by the investor to offset other taxable income. For example, a doctor that earned significant ordinary income from his practice might invest money in a cattle ranch that he otherwise had no involvement in running (and frankly, probably would never visit). The cattle ranch gave rise to tax losses allocated to the doctor, who used the losses to offset income from his practice. In many cases, the operations that gave rise to the doctor’s share of losses could be debt-funded, with significant nonrecourse borrowing from a bank. Congress did not like it, so enter Section 465.
Congress enacted the at-risk rules of Section 465 to ensure that a taxpayer bears the economic risk of loss reflected by federal income tax deductions used by the taxpayer to offset other sources of income.i To do so, Section 465 provides that, in the case of an individual or a CHCC engaged in certain listed activities or a trade or business not specially described, any loss for the tax year is allowed only to the extent of the aggregate amount with respect to which the taxpayer is at risk for the activity at the close of the tax year; if property is owned by a partnership, Section 465 is applied at the partner level. Thus, if property owned by a partnership gives rise to allowable losses allocated to a partner that is an individual or a CHCC, the partner must run a gauntlet of loss limitation rules that begins with Section 704(d), progresses to Section 465, then Section 469, and finally Section 461(l) before that loss can actually be utilized by the partner.
Section 465(b) provides that a taxpayer is considered “at risk” for an activity with respect to amounts including – (i) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity; and (ii) certain amounts borrowed with respect to the activity. For this purpose, borrowed amounts generally only include loans for which the taxpayer – (i) is personally liable for repayment (i.e., recourse loans); or has pledged property (other than property used in the activity) as security for the borrowing (but only to the extent of the fair market value of the pledged property). However, a taxpayer generally is not treated as “at risk” for amounts borrowed from a person that has a financial interest in the activity (other than an interest as a creditor) or someone related to a person (other than the taxpayer) that has an interest in the activity. Notwithstanding the above, a taxpayer may be treated as “at risk” with regard to a nonrecourse loan if that loan meets the definition of “qualified nonrecourse financing” (which requires, at a minimum that the borrowing be in connection with holding real property).
Under the rules described above, if a taxpayer funds the acquisition of a $1 million asset with cash, the taxpayer is fully at risk with respect to the property. Thus, the taxpayer (subject to other loss limitation rules) would be entitled to report $1 million of losses with respect to the property (subject to other potential loss limitations). In contrast, if the taxpayer funds the acquisition with $200,000 of cash and an $800,000 nonrecourse loan that is not qualified nonrecourse financing, the taxpayer would be entitled to just $200,000 in losses (again subject to other possible limitations).
If a taxpayer initially is at risk with regard to an activity, recapture of any losses may be required if the situation changes. For example, if the taxpayer described above borrowed the $800,000 on a recourse (rather than nonrecourse) basis, the taxpayer initially would be at risk with regard to the full $1 million acquisition. But what happens if, after all $1 million of losses are reported, the taxpayer refinances the entire $800,000 debt with a nonrecourse loan? In that case, Section 465(e) requires the taxpayer to recapture losses attributable to the financing by including in gross income the excess of those losses over the taxpayer’s redetermined amount at risk. Thus, the taxpayer would recapture $800,000 (assuming no other income related increases in the at-risk amount) in reported losses by including that same amount in income for the year of the recapture.
The 49th Parallel (to Section 465)
Losses are all well and good, but aren’t we more concerned with ITCs? Well, let’s flip to Section 49 which provides rules for credits that are similar to Section 465’s rules for losses. Specifically, certain nonrecourse financing is excluded from the ITC eligible basis (what Section 49(a)(1)(C) calls the “credit base”) owned by taxpayers subject to Section 465. This limitation applies to a handful of credits (e.g., the Section 47 historic rehabilitation credit) but for this discussion we’re going to focus on the Section 48 ITC for energy property.
Under this rule, if a taxpayer that funds the construction of energy property that otherwise would have a credit base of $1 million with $200,000 in cash and an $800,000 nonrecourse loan, the credit basis of the property would be $200,000 if the loan is nonqualified nonrecourse financing.
Nonqualified nonrecourse (“NQNR”) financing is defined by what it’s not. That is, NQNR financing refers to any nonrecourse financing (i.e., nonrecourse debt or debt borrowed from a person who has a non-creditor interest in the relevant activity or a lender related to such a person) that is not qualified commercial financing. Essentially qualified commercial financing is any financing with respect to property if (note that the following list is conjunctive, if you don’t meet all of these you have NQNR financing, which is potentially bad for ITCs) – (i) the property is acquired by the taxpayer from a person that is not related to the taxpayer; (ii) the amount of the nonrecourse financing with respect to the property does not exceed 80 percent of its credit base (there’s a special rule for energy property discussed more below which caps this ratio at 75 percent, but we’re starting here with the general rules); AND (iii) the financing is either borrowed from a qualified person or is a loan from (or guarantee by) any federal, state, or local government.
A “qualified person” means any person that is actively and regularly engaged in the business of lending money that is not (disjunctive NOT – meaning a qualified person can’t be any one of these things) – (i) related to the taxpayer; (ii) a person the taxpayer acquired the property from (or someone related to that person); or (iii) a person that receives a fee with respect to the taxpayer’s investment in the property (or someone related to such a person). However, in no case does qualified commercial financing include any convertible debt. The determination of whether nonrecourse financing obtained by a partnership or S corporation is qualified nonrecourse financing generally is made at the partner level for property owned by a partnership.
Looking back to the example above, assume that the $800,000 nonrecourse loan is borrowed from a bank that – (i) actively and regularly lends money; (ii) is not related to the taxpayer; (iii) that did not sell the property to the taxpayer; (iv) does not receive a fee (other than interest on the loan) with respect to taxpayer’s investment in the property; and (v) the loan is not convertible into equity in the taxpayer. Under those facts, the nonrecourse debt appears to qualify as qualified nonrecourse financing. Thus, the entire $1 million credit base would be considered at risk under Section 49.
Just like the Section 465 rules, the Section 49 at risk rules provide for the recapture of credits if the circumstances change and the taxpayer’s amount at risk is reduced. So, for example, if a taxpayer that initially funded construction of a project with cash and a recourse liability refinances that liability with a NQNR financing, the taxpayer will have to recapture prior reported credits to the extent its amount at risk has been reduced. Continuing with the example above, if the qualified nonrecourse debt was refinanced with a loan from a person related to the taxpayer, the at-risk credit basis would be reduced to $200,000, which should result in credit recapture under Section 49.
Conversely, Section 49 allows a taxpayer to report additional credits if there is a decrease in NQNR financing with respect to the property. Specifically, if there is a net decrease in NQNR financing at the close of a taxable year, the net decrease generally increases the credit basis for the property. For purposes of determining the amount of any credit allowable as a result of the increase credit basis, the increase is taken into account as if it were property placed in service by the taxpayer in the year the property was initially placed in service. However, any credit allowable is treated as earned during the tax year of the decrease in NQNR financing. So, if a taxpayer refinances a NQNR loan with qualified nonrecourse financing, increased credits may be available. However, Treas. Reg. 1.6418-3(a)(6)(ii)(B) provides that any additional ITC that might otherwise be available by virtue of a reduction in NQNR financing cannot be “sold”. We’ll talk more about monetization a bit later in this article.
Section 48 Giveth and Section 49 Taketh Away
The ITC at-risk rules of Section 49 have existed for some time. However, following enactment of the law commonly referred to as the Inflation Reduction Act of 2022 (the “IRA”), it may be time to reassess their potential application, as they have become more relevant. ITCs are incentives that allow taxpayers to reduce their tax liability by a certain percentage of the cost of an investment.
Fortunately, some relief from the stress of determining whether Section 49 exists. Specifically, Section 49 does not apply to reduce the credit basis of “qualified energy property.” Property qualifies as qualified energy property if (another conjunctive list – DM me if you hate how I keep clarifying this, “like and share” if you love it. If you’re ambivalent roll your eyes and just keep reading):
- the property is energy property to which Section 49 would otherwise apply;
- the energy percentage (determine under former Section 46(b)(2)) with respect to the property is greater than zero when the property is placed in service;
- at the close of the tax year in which the property is place in service, not more than 75% of the basis in the property is attributable to nonqualified nonrecourse financing; and
- any nonqualified nonrecourse financing in connection with the property consists of a level payment loan.ii
The gist of this rule is that a maximum of 75% of the cost of qualified energy property may be financed by a nonrecourse loan (so long as that loan is a level payment loan). What if the loan amount is higher than 75%? Well, it may be worth exploring if some portion of that loan is attributable to some other aspects of a given project, such as land or a non-ITC eligible structure like a building. How has Section 49 impacted ITC monetization?
Section 49 in ITC Monetization Contexts
One of the most common ways to monetize ITCs historically has been through tax equity partnership flips. When energy property is owned by a partnership and placed into service in that partnership, Treasury Regulation 1.46-3 provides that each partner is allocated a share of ITC-eligible basis and then (assuming each partner is a taxable entity that would appropriately file a Form 3800 to claim an ITC) uses that eligible basis to determine its ITC amount. This “aggregate theory” view of the world (where a partner is conceptualized as owning a share of underlying assets in a partnership as opposed to a piece a distinct entity, the partnership itself) is also suggested by how ITCs manifest on K-1s. That is, you won’t see an ITC allocated on a K-1 but rather a basis amount which a partner then uses to calculate its ITC.
However, other views might indicate that credits, which lack substantial economic effect (“SEE”), should be allocated in the same proportion as related amounts that do have SEE. From Treas. Reg. 1.704-1(b)(4)(ii): “if a partnership expenditure (whether or not deductible) that gives rise to a tax credit in a partnership taxable year also gives rise to valid allocations of partnership loss or deduction (or other downward capital account adjustments) for such year, then the partners’ interests in the partnership with respect to such credit (or the cost giving rise thereto) shall be in the same proportion as such partners’ respective distributive shares of such loss or deduction (and adjustments).” Practically, in the context of ITCs, this is usually read as meaning that ITCs, which are determined through capitalized expenditures that are then depreciated, should be allocated in the same proportion as that depreciation. So, the language of Treas. Reg. 1.704-1(b)(4)(ii) might suggest an “entity theory” (again, as opposed to an aggregate theory) in which an ITC is generated at a partnership and then allocated to partners.
Taking an aggregate theory view, let’s think about both sides of the balance sheet. In the language of Section 49(a)(1)(E)(i), “Except as otherwise provided in this subparagraph, in the case of any partnership or S corporation, the determination of whether a partner’s or shareholder’s allocable share of any financing is NQNR financing shall be made at the partner or shareholder level.” In a partnership, a partner’s share of nonrecourse debt is established under the rules of Section 752. So, by being allocated a share of potential ITC basis from a lower tier project that is encumbered by nonrecourse debt, it’s prudent to consider at the partner level whether that debt, by the application of Section 49, could diminish the amount of ITC that might be available. That is, looking at the asset at the partnership level alone does not tell the whole story: what happens when you consider the allocation of the asset through chains of tiered ownership?
In traditional tax equity partnerships used to monetize ITCs, it has been historically uncommon for projects to be subject to project level debt. If debt is present, it is more common that it would manifest as “backleverage”, which implies a set of facts wherein a partner holds debt at an upper tier that is secured by the distributions of cash from the sponsor’s partnership interest in the lower tier tax equity partnership. The “allocable share” requirement of Section 49(a)(1)(E)(i) might suggest that nonrecourse backleverage instruments could not effect a reduction in ITC basis. That is, it may be difficult to say that a partner has an allocable share of something that is not within the partnership to allocate. Further, Section 49(a)(1)(C) provides that the “credit base” is “the basis of energy property” (again other things are listed as being “credit base” but those are for other credit types). Could a partnership interest in a partnership that only owns energy property be considered “energy property”? If we revisit the aggregate theory principles discussed above in the context of allocated basis, some practitioners might argue that such a backleverage amount could reduce ITC eligible basis (again, only if we’re talking on the sponsor side about entities that would also be subject to Section 465).1 Practitioners have come to varying conclusions for various specific facts, but in the tax equity world, historically the discussion was largely academic.iii That is, Section 49 issues were given little consideration by virtue of the typical allocations being 99% of ITC basis in favor of a tax equity counterparty very unlikely to be subject to at-risk limitations. The remaining 1% that would be allocated to the sponsor partner in those structures, while potentially diminished under Section 49 by a certain read of Section 49(a)(1)(E)(i), was typically not viewed as a material reduction in a project’s value. This comports with the foundational impetus for tax equity financing that sponsor partners are largely agnostic to tax attributes (hence the desire to monetize tax attributes through tax equity structures).
As theindustry explores more monetization opportunities, different structures have evolved. Treasury Regulation 1.6418-2(d)(2) has resurrected the often-forgotten Section 49 in the context of credit sales. Let’s consider therefore monetization structures that take advantage of Section 6418 credit sales in the context of a partnership. First is “hybrid” tax equity, where an otherwise traditional 99/1 partnership flip might have the option to sell ITCs. Let’s assume that partnership has an asset with $333.33 ITC eligible basis with a 30% applicable percentage, generating a $100 ITC. Then, let’s assume this “hybrid” partnership sells ITCs at a price of 90 cents for every dollar of ITC. The ITC seller would expect to receive $90 of proceeds from the sale of ITCs. However, let’s further assume that the 1% partner in that selling partnership had a Section 49 at-risk issue that reduces the total ITC to $99. While the diminishment may still be small as a function of the overall expected ITC, the ITC reduction would not likely have been priced into the structure.
For a more challenging example, consider a “synthetic” tax equity structure that might consist of two partners with more balanced ownership, let’s say income and loss is shared 60/40 in the year the property is placed in service. Further assume that the 60 percent partner is subject to the Section 49 at-risk rules and has a sufficient amount of NQNR attributable to his share of the allocated basis to suffer a reduction in ITC. In that situation, it’s no longer the 1% of the ITC but rather 60% subject to limitation which would likely be a much worse situation. Even for those with experience structuring tax equity deals, it can be easy to miss without giving careful consideration to how evolving monetization structures differ from traditional tax equity structures.
Conclusion
If any portion of an energy project is debt-funded, it is essential to review the at-risk rules of Section 49 when estimating the expected ITCs to be generated by the project. As the example illustrates, an early examination may allow for planning that maximizes the credits generated by the project. As with most issues related to ITCs, the capital stack funding and the ownership of the asset generating those ITCs is paramount. All ITC stakeholders should add to their toolkit the ability to assess the potential ramifications of Section 49.
Footnotes
[i] At the same time, Congress enacted Section 469 to address the taxpayer’s lack of participation in the tax shelter activity.
[ii] A loan is a level payment loan if each payment is substantially equal, a portion of each payment is repayment of principal, and the portion attributable to principal is commensurate with decreases in the portion of the payment attributable to interest.
[iii] The language of Section 49(a)(1)(A) discusses NQNR ”financing with respect to such credit base”, which is unclear. Does ”with respect to” mean debt secured solely by energy property? What if the debt is secured by energy property as well as non-energy property? If the debt is secured by a partnership interest, do you look through the partnership interest under aggregate theory? Views will differ amongst practitioners.