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How to take advantage of tax credit transferability though the Inflation Reduction Act

Brandon Hill  Tax Principal / Federal Tax Strategies & Energy Services / CLA (Clifton Larson Allen LLP)

· 5 minute read

Brandon Hill  Tax Principal / Federal Tax Strategies & Energy Services / CLA (Clifton Larson Allen LLP)

· 5 minute read

The Inflation Reduction Act can expand potential participants in clean energy tax credits, and corporate tax professionals should take advantage of the new rules

The Inflation Reduction Act (IRA) has revolutionized the way federal clean energy tax credits are monetized and has transformed the way companies approach how they leverage investment and production tax credits for renewable energy projects. Traditionally, capitalizing on these credits involved a tax equity investment, binding an investor to a project for an extended period through various ownership configurations sanctioned by the Internal Revenue Service (IRS).

However, the IRA introduces a compelling alternative by permitting the buying and selling of these credits for cash. This creates a new avenue for companies seeking tax savings, offering them the option to engage in a growing tax credit market instead of committing to a long-term renewable energy investment with a sponsor.

Although developers and some investors still have compelling reasons to seek tax equity investments — such as depreciation deductions — the ability to transfer these credits introduces additional flexibility that allows investors to consider various options when aligning their investments with their tax objectives.

Overview of tax equity

The US tax code, notably with the addition of the IRA, incentivizes investments in specific sectors, particularly renewable energy. Often, developers of renewable energy projects cannot directly utilize these tax advantages, leading to the creation of a tax equity market. This market draws investment from corporations capable of funding these projects with available cash. Key roles and terms in a conventional tax equity framework include:

      • The project developer, referred to as the project sponsor, cannot fully leverage tax credits and depreciation benefits due to a limited tax liability.
      • A corporate taxpayer, acting as an investor, gives cash to achieve a desired return on investment or internal rate of return through tax benefits allocation.

For investors, the initial expenditure is the upfront investment in tax equity. The anticipated returns comprise three main components: i) a decrease in cash tax liability through acquiring tax credits and expedited tax depreciation benefits; ii) regular preferred cash distributions on a quarterly or annual basis; and iii) a final cash buy-out at the conclusion of the deal.

In a standard partnership flip deal, the partnership distributes 99% of the income, losses, and tax credits to the investor until a predetermined yield is achieved, although cash distributions follow a different proportion. Once this target yield is met, the share of benefits allocated to the investor diminishes, and the developer has the option to purchase the investor’s residual interest, an option that is commonly exercised.

Credit transfer provisions in the IRA

The IRA now allows for the sale of 11 specific tax credits, which were previously non-transferable or did not exist under US federal income tax regulations. This option is open to a broad range of eligible taxpayers, including for-profit corporations (S-corporations included), partnerships, individuals, and trusts. However, entities like tax-exempt organizations and local governments, which could opt for direct cash refunds, are not permitted to sell credits.

As this area of tax credit transferability continues to develop, the current market offers the advantage of acquiring credits at a discount, with a reduced investment timeframe and a more straightforward legal procedure compared to traditional tax equity dealings.

The cost of purchasing tax credits may differ or be influenced by factors such as the seller’s financial reliability, the project’s scope, the type of credit and its volume, and whether tax insurance is in place. Transactions must be conducted in cash between unrelated parties, and credits can be sold only once. The transfer is formalized through a purchase and sale agreement, accompanied by a transfer election statement included in both the seller’s and buyer’s tax returns for the relevant year. Considering the potential risks associated with these transactions, either the buyer or seller has the option to secure insurance to safeguard against possible recapture events.

To give an example, a recent client of ours was able to reduce their taxes by an estimated $2.2 million by purchasing discounted tax credits. The company’s C-corporations had the flexibility to acquire IRA credits to lower federal taxes for 2023 and 2024, including purchasing excess credits in 2023 and applying them retroactively for up to three years. What is remarkable is the manufacturer’s anticipated 8% savings off its total tax bill also will not be taxable for federal income tax purposes.

The company was particularly pleased to seize this opportunity early, given the finite availability of credits, the demand for which might drive up prices in the future. Moreover, the company’s exploration of IRA benefits extends further — now, the leaders of the company are collaborating with our firm to leverage another IRA opportunity that enables their nonprofit family foundation to access refundable credits for initiatives in green energy investment.

Deciding on the best approach

The market is expected to remain vibrant for both conventional tax equity investments and transactions involving the transferability of tax credits. Developers are likely to keep seeking tax equity investments in order to capitalize on tax depreciation benefits, which are absent in tax credit transfer scenarios. Also, tax equity investors are exploring strategies to engage in traditional tax equity frameworks while also considering separate transactions to transfer credits.

Investors in both avenues — tax equity and credit transferability — should implement thorough due diligence and secure tax insurance to minimize risks. The relatively simpler process of tax credit transferability is drawing a significant number of new investors to the field; and ultimately, each developer and investor will assess their unique circumstances to decide whether to opt for tax equity, credit transferability, or a combination of both strategies.

Whatever approach is decided upon, the key is that the transferability of tax credits is an innovation that opens the market for new investors in the tax credit investment space.

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