The Problem with Tax Credits
Ever since the first 7% Federal investment tax credit was enacted by Congress in 1962, a recurring problem has been the issue of how to make this benefit available to companies that are not currently taxable or are unable to carry back the credit against prior years’ tax liability. Many of the companies for which these credits are intended are not profitable, have no tax liability and therefore are unable to use the tax credit. Companies that fall into this category are those experiencing financial difficulties due to depressed business opportunities and/or late-venture stage companies that have not yet reach breakeven cash flow and profitability.
Monetizing Tax Credits with Equipment Leases
There has for a long time been a recognition of the limitations attendant to the use of tax credits to stimulate desired types of investment. There have been a number of different attempts, some described below, to facilitate the monetization of Federal investment tax credits in the past.
The usual remedy for this situation until the enactment of the Section 1603 grants in 2009 was the use of true lease transactions. Title to the eligible equipment would be acquired by a taxable financial institution, acting as lessor, which claimed the investment tax credit and passed through its benefit in the form of reduced rental payments payable by the user of the equipment, acting a lessee.
The problems with using equipment lease transaction to monetize investment tax credits are (a) transaction costs reduce the benefit realized by the equipment user (the lessee), and (b) the amount of tax base available in the market for these types of equipment lease transactions ebbs and flows depending on general economic conditions and therefore affects the ability of equipment users to realize the benefits intended by Congress in enacting the tax credits in the first place.
Tax Benefit Transfers – September through December 1981
One of the most notorious schemes to facilitate monetization of the Federal investment tax credit were the tax benefit transfer (TBT) transactions authorized by the Economic Recovery and Tax Act of 1981. The TBT transactions were basically “wash” lease transactions that had no economic substance but were instead solely intended to transfer the investment tax credit and depreciation benefits associated with ownership of equipment from a non-taxpayer to a taxable corporation—usually a financial institution or a highly profitable service company—in return for a cash payment at closing. When word reached the press in late 1981 that General Electric Company had zeroed out its entire 1981 tax liability and additionally received tax refunds for a number of prior tax years, the resulting public outcry was so loud that Congress eliminated the TBTs by the end of 1981.
Enter the Section 1603 Grant Program in 2008
The Section 1603 program was created as part of the American Recovery and Reinvestment Tax Act of 2009 to increase investment in domestic clean energy production. Under Section 1603 the Department of the Treasury made payments in lieu of investment tax credits to eligible applicants for specified energy property used in a trade or business or for the production of income. The §1603 Program expired on December 31, 2011, although projects that started construction prior to that date were eligible to receive the award subject to certain conditions.
The Only Game in Town
Since the expiration of the Section 1603 grants, a true lease transaction is the only “game in town” for companies to benefit from the now 26% investment tax credit for renewable energy equipment but are unable to do so because they have no tax liability. These leases can be done on direct basis—a lease between a financial institution as lessor, and the user of the equipment, as lessee—or in the form of a tax equity partnership which acts as lessor. Suffice it to say that direct leases are the only structure available for small-scale projects, i.e., under $5-10 million, while the tax equity partnership deals are usually employed for very large, utility-scale projects running $50-100 million+.
What Does the Future Hold for Federal Government Investment Incentives?
The Biden Administration is currently considering the implementation of “direct pay” options to remove the impediment of requiring a tax liability to use the traditional investment tax credits. These options are included in President Biden’s $2 trillion American Jobs Plan announced March 31, 2021, and included in the Growing Energy and Efficiency Now Act (GREEN Act) and section 45Q carbon capture legislation (ACCESS 45Q). Passage of these provisions is tied to the enactment of the additional Federal government stimulus in addition to the $5 trillion already appropriated in past 12 months—hence the probability of its enactment is unpredictable at best and far from guaranteed.
A significant feature of the GREEN Act is its inclusion of a provision allowing taxpayers to elect to have 85% of the ITC refundable. In other words, taxpayers could take the credit as a refund even if they do not have the taxable income to offset the credits.
About Fairfield Capital
Fairfield Capital stands on decades of financing experience with major commercial and investment banks, private equipment funds, and commercial finance and leasing companies.
We help public and private companies navigate the complexities involved in the accounting and tax considerations associated with the lease financing of renewable energy equipment.