New Clean Energy Tax Credit Rules Transfer Deal Risks to Buyers

In light of the Treasury Department’s final rules for transferring clean energy tax credits, companies should be aware that such transfers have potential for project-related risks. They should understand and take steps to mitigate these risks if they want to purchase clean energy tax credits.

Under the final rules, companies that buy (and thus claim) clean energy tax credits will bear all the risk of losing the credits if there are qualification deficiencies or tax credit overstatements by the seller. And when the transfer is of investment tax credits, known as ITCs, purchasers bear all risk of liability to repay all or part of the tax credit to the government if certain project-related events occur.

In its final rules, the Treasury rejected the idea that tax credit sellers should be allowed to divide the tax credits from a particular project into higher-risk and lower-risk tranches to accommodate buyers with different risk tolerances.

Companies can, and are, addressing these challenges through deal structuring and terms. Sellers of credits should anticipate these issues and proactively consider structural and transactional means to reduce a buyer’s risk to help ease transactions, reduce price discounts, and improve cost efficiencies.

Risks Involved

Clean energy tax credit risks generally fall into two buckets. The first is risk of disallowance for claiming credits to which the applicable project wasn’t entitled, either because the project didn’t meet applicable qualification requirements or because the amount was otherwise overstated.

The final rules call this an “excessive transfer” but place the risk on the purchaser. The rules also impose a 20% penalty on the purchaser unless the purchaser can show that it performed a reasonable level of due diligence.

The second bucket is “recapture” liability and applies only to ITC projects. Specifically, all or a portion of the ITC must be repaid if there’s a change of ownership of a ITC project—or the project is permanently taken out of service—during a specified period (generally five years).

The recapture amount is 100% during the first year and steps down annually in equal increments to 0% in the first year following the recapture period. Except for an indirect change of ownership of a project owned by a partnership, the rules again place recapture liability on the purchaser.

Diligence Needed

Market participants should expect to perform detailed due diligence about the underlying project’s tax credit qualifications and amounts to avoid additional penalties under the final rules.

Sellers should be prepared to provide documentation and third-party verification of critical facts, including compliance with prevailing wage and apprenticeship requirements, third-party verification of the nature and amount of costs or production, and an appraisal supporting any ITC basis step-up.

Most tax credit purchasers don’t insist on full-blown diligence about the project itself, because their return is based on the tax credit purchase price discount rather than on the project’s performance.

However, because ITC purchasers are exposed to recapture liability upon a shut-down or transfer of the project (due to bankruptcy, foreclosure, or any other reason), ITC sellers can expect buyers to conduct some level of diligence on the project’s viability, insurance, and financing arrangements.

Contractual Obligations

Buyers should require, and sellers should expect to make, strong representations regarding the project’s tax credit qualification and claimed amounts, backed by indemnification.

Many tax credit purchasers don’t have much experience with clean energy tax credits. The new prevailing wage and apprenticeship requirements raise novel issues, as do the qualification requirements for new and “bonus” credits. In addition, unlike traditional tax equity investors, tax credit purchasers have no project ownership interest through which to access project cash-flows and recover their expected return.

Due to the forward-looking nature of recapture events, ITC buyers should require—and ITC sellers should expect to commit to—strong negative covenants prohibiting actions that constitute or increase the risk of a recapture event. Both sides also should prioritize affirmative covenants, including obligations to maintain insurance that will enable the project to continue operation following a material liability or casualty event.

Support and Insurance

Indemnities are only as strong as the entity standing behind them. A tax credit seller often is a single-purpose entity with no assets other than the project, and the project itself may be highly leveraged with senior debt. Sellers therefore should expect purchasers to seek guarantees or similar support from a creditworthy entity to support the seller’s indemnification obligations.

Purchasers may require tax credit insurance, the premium of which is often paid by the seller, in lieu of or in addition to upstream credit support. However, the coverages and exclusions of these policies may differ significantly.

Both parties should carefully consider the policy’s coverage. Nearly all policies will cover tax credit qualification and amounts, but coverage for forward-looking recapture risks isn’t universal. Exclusions based on the accuracy of representations to the insurer by the seller, without a non-imputation rider, would undermine the policy’s value to a tax credit purchaser.

Additional Protections

If material credit support isn’t practical, prospective ITC sellers should proactively consider pre-sale structuring to mitigate a buyer’s recapture risk.

This could include structuring ownership of the project through a bankruptcy-remote special purpose vehicle (and related protections) and loss-payee casualty insurance endorsements. It also could include working with project financing parties up front to agree on acceptable foreclosure forbearance terms or to establish, where feasible, a financing structure that permits foreclosure without triggering recapture liability for the tax credit purchaser.

Although the allocation of project-related risk to a purchaser of clean energy tax credits presents challenges, they aren’t insurmountable. Understanding and proactively addressing the risks in deal structuring and terms allows both sellers and buyers the opportunity to get these deals done.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Martha “Marty” Pugh is a corporate tax partner in K&L Gates’ power practice group, focusing on renewable energy incentives related to wind, solar, and energy storage projects.

Jim Goettsch is a mergers and acquisitions and finance partner in K&L Gates’ power practice group.

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