Optimal Transaction Structuring under ARRA: The Use of Tax-Oriented Financing Structures to Step-Up the Basis of Self-Constructed Renewable Energy Projects and the Determination of Fair Market Value
Executive Summary – The tax incentives provided for qualifying renewable energy projects under the American Recovery and Reinvestment Act of 2009 include production tax credits, investment tax credits, and refundable cash grants. These incentives permit a range of transaction structuring options for qualifying projects, including the ability to step up the basis of a self-constructed project from construction cost to fair market value by entering into a sale/leaseback or partnership structure. This article addresses the mechanics of the step-up, considerations in the determination of optimal financial structure, and the determination of fair market value through the appraisal process.
The American Recovery and Reinvestment Act of 2009 (ARRA) provides a 30% investment tax credit, applicable against the cost of building or buying qualifying renewable energy projects. To maximize the access of investors and operators to this incentive, and in recognition of the fact that in the current environment many potential applicants do not have sufficient current tax liability to utilize the credit, the Treasury has permitted the credit to be converted to a cash grant with certain limitations.
It is important to note that, unlike volume-based production tax credits, the value of capital cost-based tax benefits – investment credits and depreciation expense – are a function of the cost basis of the project, and as such can vary depending on its transaction structure, to the extent that a transaction is elected that permits a step-up in basis.
Internal Revenue Code Sec. 48 refers to the cost of a qualifying renewable energy project
“(i) the construction, reconstruction, or erection of which is completed by the taxpayer, or
(ii) which is acquired by the taxpayer if the original use of such property commences with the taxpayer.”
The tax basis of projects that are purchased, or constructed under contract for the ultimate user, is the purchase price or acquisition cost; which, assuming an arm’s-length transaction, will be equal to fair market value, defined as:
“the estimated amount at which a property might be expected to exchange between a willing buyer and a willing seller, neither being under compulsion, each having reasonable knowledge of all relevant facts.”
Alternatively, self-constructed projects will have a basis equal to their cost to construct. Qualifying construction cost includes not only direct labor and materials, but a variety of soft costs including design and engineering, internally allocated salaries and expenses, insurance, construction period interest, professional fees, training costs, management costs, etc.
In both cases, only the tangible electrical generating equipment included in the qualified facility is eligible for ITC. Buildings and structural components are not eligible for ITC, but may be depreciated separately.
Ability to Step-Up Basis
The basis of self-constructed projects can be stepped up from construction cost to fair market value if they are financed on a tax-oriented basis through a sale/leaseback or partnership structure. In general, a project’s basis in a tax-oriented financing structure will be equal to:
(i) in the case of a sale/leaseback, the lessor’s acquisition cost of the project, or
(ii) in the case of a partnership investment by a tax equity investor, the sum of the developer’s and equity investor’s tax bases for their respective partnership interests.
For example, if a developer constructs a project with a qualifying cost of $100, and sells it to a lessor (not later than 90 days after it is initially placed in service) for a fair market value of $120 and leases it back, the basis of the project – for the purpose of determining investment tax credit and depreciation expense – will be $120. Under the provisions of ARRA, the ITC or equivalent cash grant can be passed back to the developer/lessee, essentially providing the developer with 100% financing and a 30% cash grant based on the $120 fair market value. (The grant is limited to 10% for certain project categories including qualified microturbine property, combined heat and power systems, and geothermal heat pump property.)
Alternatively, the developer may enter into a partnership structure with a tax equity investor. Under a typical flip structure, the investor’s partnership interest would be less than the value of an undivided interest in the project for the same initial percentage of ownership, as the partnership investor would receive a significantly lower proportion of the project’s back-end cash flows and residual value.
If the tax equity investor pays $90 for its partnership interest, assuming the same $120 fair market value of the project, and an initial 99/1 partnership allocation, the developer’s tax basis would be $25 [(1-$90/$120) x the $100 cost to construct] and the tax equity investor’s basis would be its $90 purchase price for its partnership interest. Assuming a 99/1% allocation ratio, the tax equity investor would be entitled to claim ITC equal to 99% of the partnership’s $115 tax basis in its assets (assuming all of its assets were ITC eligible.) Because of special rules applicable to property contributed to a partnership (which, in this structure, the developer would be treated as having done), the tax equity investor’s 99% share of partnership net income could be calculated assuming depreciation based on the full $120 FMV of the partnership’s assets. Please note that in all cases, total allowable depreciation expense would be reduced by half of the ITC claimed, or 15% of the project’s original basis.
In comparing the potential advantages of utilizing a lease or partnership structure to achieve a step-up in basis and tax benefits, a project owner or developer should consider the associated transaction expense, structural complexity, and after-tax financing costs of these alternatives compared with those of debt financing and a cash grant based on actual construction cost.
In this context, however, the important issue for developers is that a potentially significant increase in tax benefits associated with a qualifying renewable energy project may be realized through a sale/leaseback or partnership structure, vis-à-vis retaining ownership of a self-constructed project. The potential incremental tax benefits naturally depend on the difference between a project’s construction cost and its fair market value.
The determination of construction cost is conceptually straightforward, although in practice differences in construction management, financial reporting, and MIS systems may complicate the task of capturing all costs that may legitimately be included in the tax basis of a self-constructed project.
In general, “hard” costs would include land, land improvements, buildings, process construction materials, controls, the physical machinery and equipment located at the facility, and any additional support equipment. However, as noted above, under ARRA only electrical generating equipment integral to a qualified facility is eligible for ITC. Buildings and structural components are separately depreciable, but not as components of a qualifying project.
“Soft” costs can be broken down into three categories: direct, system, and facility. Direct soft costs are those that can be applied to a specific hard asset and would include any applicable taxes, freight, and installation. System soft costs are those that apply to assemblage of various subsystems within the facility and include system design and engineering, assemblage costs, and system integration costs. Finally, facility soft costs are those applicable to the entire project including project management, interest during construction, permitting costs, project design and engineering, training, debugging and commissioning, and acceptance costs. A reputable valuation consulting firm can assist in the determination and collection of these includable costs.
Determination of Fair Market Value
The determination of fair market value requires additional judgment and nuance. An appraisal performed under the Uniform Standards of Professional Appraisal Practice of the Appraisal Foundation requires that the three approaches to value – cost, income, and market – be considered.
The reality of the situation is that there will not always be sufficient information to develop values reflecting all three approaches. In addition, the values that can be developed under the different approaches will not always be deemed equally reliable. Finally, those values will rarely converge to exactly the same figure, and as such, will need to be reconciled. The reconciliation process consists of calculating the weighted average of the two or three values developed; it requires the valuer’s judgment regarding the quality of information available and the applicability of the results of each approach to the project under consideration. (If the available data are such that only one of the three approaches is deemed reliable, then no reconciliation is necessary.)
The Cost Approach
The foundation of the cost approach is the proposition that an informed purchaser would pay no more for property than the cost of producing a substitute property with the same utility. When this approach is applied, facts concerning the property in question are assembled in an appraisal inventory, and data regarding costs and price-governing factors are gathered. The accumulated data are then employed to develop the cost of reproduction new or the cost of replacement of the subject property.
In the case of a new renewable energy project, the hard and soft costs described above would provide a starting point. However, in considering the cost to a typical market participant, which in the power generation market would be an operator but not necessarily a constructor of such projects, one must also consider the entrepreneurial profit component of the purchase price of a generation asset. From the constructor’s perspective, without a profit margin there would be no incentive to build the project the operator wants to buy. From a buyer/operator’s perspective, purchasing a complete project means avoiding the risks of construction, the diversion of a management team whose skills may not include engineering and construction, and the opportunity cost (cost avoided by purchasing an existing facility rather than forgoing revenue during a potentially lengthy permitting and construction period.) In the cost approach, this concept is reflected by including entrepreneurial profit in the cost buildup. The percentage these potential costs could add beyond the initial cost will vary from project to project and will depend on such factors as demographics, permitting time, project construction period, and market demand.
The Income Approach
The income approach establishes the value of the property on the basis of the capitalization of the net earnings or cash flows expected from the property. These expected future cash flows are projected over an appropriate time frame and then converted to present value using a discount rate that reflects the risks inherent in ownership of the property. The sum of the discounted cash flows generated by the property provides an indication of its value.
The income approach to value provides a “ceiling” value (at least in non-speculative markets) in that a financial investor will not pay more for an asset than the present value of the income stream it will generate, discounted at the investor’s hurdle rate. The hurdle rate should reflect the investor’s cost of funds, the riskiness of the project and its forecast income stream. The income stream is typically analyzed on an unlevered basis – the project is valued as an operating business without consideration of financing.
In the case of renewable energy projects, while capital costs and operating costs may be known, revenues may depend on inherently variable volume inputs including sunshine and wind, as well as variable price inputs, to the extent that long-term, fixed-price power purchase agreements are not in place. Further, discount rates will vary not only with the investor’s underlying cost of capital, but the investor’s risk-adjusted return requirements; this may reflect factors ranging from the scarcity of investment capital, to commodity price volatility, and to the perceived riskiness of different generation technologies.
The relationship between the cost and income approaches is demonstrated in the capital budgeting process, in which the net present value of an income generating project is determined by subtracting the project’s acquisition cost from the present value of the income generated by its operation.
For clarification, it should be noted that in a sale/leaseback, lease rentals are not included in the valuation analysis; doing so would permit a circular process whereby a lessor would be willing to pay whatever purchase price would generate an acceptable return based on the rentals negotiated with the lessee, regardless of the underlying profitability of the leased project. While such an arrangement could make economic sense to the lessor if the lessee were considered creditworthy, it would not reflect the operating economics, or value, of the project itself, and as such would be an inappropriate determinant of the project’s tax basis.
The Market Approach
The market approach establishes value through analysis of recent sales of comparable property. An analysis is made of the differences between the properties and the subject, and the sales prices are correspondingly adjusted to arrive at indications of the subject’s value.
As a general rule of valuation, the most important determinant of value is actual market transactions. However, depending on the type of asset being valued, available market transactions for non-commodity assets may not necessarily be strictly comparable; they may not reliably indicate the value of the asset under consideration. Certainly anyone who has ever bought or sold a home is familiar with the concept of “comps” that are not really comparable to the subject property, and specialized assets such as renewable energy projects may have significant differences in size, technology, location, power contracts, weather conditions, available tax incentives, etc. While general comparisons of capital cost per kilowatt may provide useful rules of thumb, the unique features of generation assets are such that, more often than not, the market approach is not included in the reconciled fair market value determination of a renewable power project.
Reconciliation of Value
In determining the final opinion of the fair market value of a project, the indications of value produced by applying the cost approach, market approach, and the income approach must be considered.
These approaches to value have varying degrees of applicability depending on the specific situation. For example, the cost approach is usually relied upon primarily in situations where the assets are new or nearly new and fully utilized for their designed intent. The market approach is the most accurate approach for indicating fair market value as long as there are sufficient comparable sales of which all the specifics to the various transactions are known. The income approach would typically be given more weight if the appraised property had a proven income-generating history over a sufficient interval so that clear operating patterns, reflecting a mature operation, could be observed.
The applicability of each approach will vary for different valuations, and is subject to the appraiser’s level of comfort with the information provided by each approach, as well as the level of confidence and supportability in the conclusions derived there from. The final reconciliation may result in a single approach being selected and supported by the other two, an equal weighting of all approaches, or an infinite variety of combinations in between.
The American Recovery and Reinvestment Act of 2009 provides significant incentives for the development of renewable energy projects, and is expected to facilitate the financing of many projects that would not otherwise have been feasible in the current economic environment.
The alternatives offered under ARRA, such as investment credits vs. production credits, or the option to take cash grants in lieu of tax credits, support a broad range of potential financial structures for these projects. As such, a careful analysis of alternatives is required to determine the optimum financial structure for a specific project under a given set of market conditions.
One of the fundamental components of this analysis is the determination of potential tax benefits of entering into a lease or partnership structure as an alternative to retaining ownership of a self-constructed renewable energy project. The ability to achieve a step-up in basis, from cost of construction to fair market value, can offer significant economic incentives.
The determination of fair market value by an independent valuation consultant is frequently used to establish basis, set purchase options, and confirm compliance with revenue procedures applicable to tax-oriented financing vehicles. Professional valuation consultants must be knowledgeable about both asset classes and transaction structures, and must be able to communicate effectively with financiers, attorneys, and other professionals and transaction participants in order to assure not only a smooth appraisal process, but an optimally structured transaction.
Ken Kramer (shown left) and Rick Meyer (shown right) are the founding partners of Rushton Atlantic, LLC, a New York andChicago based valuation consulting practice focusing on the structured finance, collateral finance, and insurance markets. They had previously established and managed the Structured Finance Group at American Appraisal Associates, the leading practice in the valuation of power and energy, manufacturing, transportation, and infrastructure assets subject to cross-border tax structured financings. In addition, Rick Meyer has testified as both a fact and expert witness in Federal Court on tax-oriented financing matters.
Contact Mr. Kramer at firstname.lastname@example.org.
Contact Mr. Meyer at email@example.com.