IRA energy related credits may benefit certain asset managers: PwC

In brief

The “Inflation Reduction Act” (the Act), enacted August 16, marks one of the country’s largest investments in infrastructure in recent memory and may offer substantial opportunities for infrastructure asset managers. One primary highlight of the legislation is the estimated $370 billion of new energy-related tax credits over the next 10 years, examined in our Insight, Reconciliation bill includes numerous energy incentive tax proposals.

While there are numerous takeaways from the Act, the following discussion addresses two key opportunities that may benefit asset managers that focus on infrastructure and real estate, including private equity funds and hedge fund managers:

The extension, expansion, and flexibility of the current renewable energy tax credit regime provides needed certainty for asset managers and developers with respect to the impact and availability of these credits on future deals, and
The monetization of tax credits through the Act’s establishment of refundability and transferability of certain credits.

Action item: These benefits, as well as the opportunity to ‘supercharge’ certain credits and layer in ‘kickers,’ provide additional incentives for asset managers to examine these credits when analyzing current and future deals.

In addition to the tax benefits these credits may provide, infrastructure asset managers should consider implementation costs, limitations on the ability to monetize these credits, and the impact on the traditional ‘tax equity’ financing structures previously used to monetize tax credits.

In detail

The Act reinstates and significantly expands current incentives that may provide significant tax benefits to infrastructure asset managers. The following discussion examines the benefits and highlights certain costs these two key opportunities may provide.

Extension, expansion, and flexibility of current renewable energy tax credit regime

The current tax credit regime is built around specific credits for specific technologies. The Act refreshes and extends the current tax credit regime through the end of 2024, but then pivots to a “technology neutral” tax credit regime through the end of 2032. The Act also allows the election of either the investment tax credit (ITC) or production tax credit (PTC) for certain technologies. In some situations, a single project may be able to elect the PTC on some assets and the ITC on other assets.

Prior to the Act, tax credits for renewable energy were renewed by Congress on an almost annual basis, which created uncertainty in the market. Having the tax credits established for a minimum of 10 years can provide clarity to asset managers and developers for planning future deals, greenfield activity, and platform development investments. This allows asset managers to plan much farther in advance and potentially to invest in less-established technology and structures.

Monetization of tax credits

For tax years beginning after December 31, 2022, the Act allows for the refundability or transferability of certain clean energy tax credits.

Refundability: Under new Section 6417, the Act allows for certain clean energy credits to be refundable for applicable entities ‒ limited to tax-exempt entities, state and local governments and subdivisions thereof, tribal governments, the Tennessee Valley Authority, and certain rural electric cooperatives. This refundability is often referred to as ‘direct pay.’

The “applicable entity” limitation does not apply for purposes of the Section 45Q carbon capture and sequestration credit, the Section 45V clean hydrogen production credit, or the new Section 45X advanced manufacturing production credit. However, non-tax-exempt entities can only elect to receive direct pay for these credits for the tax year in which the equipment is placed in service and the four subsequent tax years. Additionally, certain credits provide that the ability to elect direct pay is tied to the satisfaction of the domestic content requirements.

Transferability: Section 6418 provides that non-tax-exempt entities can sell to unrelated parties certain credits, including Section 30C alternative fuel refueling property credit, Section 45 renewable electricity production credit, and Section 48 energy investment tax credit. Section 6418 restricts a credit from being sold more than once. The income and expense related to the tax credit transaction are excluded from the seller’s and buyer’s taxable income, respectively.

What the Act means for infrastructure asset managers

Supercharged tax credits

The new legislation not only revives and refreshes the legacy renewable energy tax credit regime, but also offers opportunities to ‘supercharge’ those credits. While this ability to supercharge the credit is a positive for those that can benefit from the credit, the complexity and nuanced requirements mean that it will not be a simple task to calculate and document the potential benefits of available tax credits.

Under the Act, the tax credits have two-tiers: a “base rate” and a “bonus rate,” where the bonus rate is five times that of the base rate. To qualify for the bonus rate, a taxpayer must satisfy certain prevailing wage and apprenticeship requirements.

The Act also includes “kickers,” which are stackable and can increase the base and bonus rates for both ITC and PTC in certain circumstances. For example, under the new law the ITC can be as much as 60% or more of the cost of qualified property if certain requirements are met.

The “kickers” include:

10% bonus if a facility meets domestic content requirements
10% bonus if placed in service in an “energy community”
10% bonus for solar and wind facilities with a maximum net output of less than five megawatt (a/c) if located in a low-income community
20% bonus if the project is part of a “qualified low-income residential building project” or a “qualified low-income economic benefit project.”

Observation: The flexible incentives and kickers offered in the Act may influence operational and development decisions in several ways:

Current modeling suggests that in certain circumstances the ability to elect PTC for solar may be more profitable than the previous ITC election. Thus, solar developers will need to determine which credit could be the most beneficial for their project based on a combination of factors, including capital expenditure and net capacity factor.
Electing PTC on solar can avoid burdensome basis adjustment and recapture rules.
There may be opportunities to more efficiently claim credits on functionally interdependent systems under the new rules. For example, it may be possible to elect the PTC for solar while carving out an attached battery energy storage system and claiming the ITC on that system’s cost. The substantial tax credits in the Act may attract significant scrutiny from the IRS.
The domestic production kicker paired with the new Section 45X advanced manufacturing credit may influence operational changes to the supply chain in the coming years by encouraging onshoring of factories to the United States.
Census tracts must be examined for potential qualification for the energy community and low-income incentives, as the benefits could be meaningful enough to influence the development decisions for new facilities.

Targeted benefits…. hidden costs

The Act’s monetization of tax credits through refundability and transferability could limit the need of taxpayers to implement financing structures designed to monetize the credits known as ‘tax equity.’ Tax equity structures historically have been the primary way to monetize tax credits; however, they can have high costs due to their complexity. The potential to monetize tax credits without tax equity (and its associated costs) may allow for the entrance of small- to mid-market players in an industry that has been dominated by a relatively small number of tax equity investors.

Refundability and transferability also allow fund managers to consider opportunities to utilize tax credits to increase pre-tax cash realizations. This could make tax credit investments more appealing to a wider body of investors. Previously, tax credits often had limited value in a fund context since their value depends entirely on the specific tax position of each taxpayer.

Observation: Despite these potential benefits, there are also potential risks and veiled costs:

The refundability and transferability provisions do not apply to all tax credits or all taxpayers. As previously mentioned, refundability generally is limited to tax-exempts except for the carbon capture, clean hydrogen, and advanced manufacturing credits. Transferability, on the other hand, generally is limited to non-tax-exempt entities.
Another consideration is the implementation cost of transferability. Typical contract legal costs may balloon as the nuanced rules and risks of tax credits could add additional layers of legal and diligence expense. For example, buyers of tax credits likely will seek an indemnity that they are buying qualified tax credits to protect them from loss if the IRS were to disallow the credits.
Another complicating factor is that currently it is unclear how the ITC recapture rules will work under the new transferability legislation. The ITC vests over a five-year period and if the property generating the credit is disposed of within that five-year window, all or a portion of the credit must be recaptured. Future guidance is required from Treasury and the IRS to understand who suffers the recapture if an ITC is sold under Section 6418 transferability rules. This could result in transferability contracts requiring complicated restrictions on the sale of ITC-generating property when that ITC is transferred.

The elephant in the room: tax equity

One noteworthy question arising under the Act is its potential impact on tax equity. Tax equity’s purpose is to monetize tax credits and other tax attributes generated in the construction of renewable energy property. If the tax credits can be monetized through transferability, will tax equity still be needed?

Observation: While analysis and modeling are still ongoing, it appears that tax equity will remain one of the primary methods of renewable energy financing. Although transferability allows for credits to be monetized, it does not allow for the monetization of depreciation or other deductions, which are critical value propositions of tax equity partnerships.

Observation: It will be important to consider structuring when the intent is to implement transferability. The new legislation appears to provide that a taxpayer that is eligible for Section 6417 refundability is ineligible for Section 6418 transferability and vice versa (except for Section 45Q, 45V, and 45X credits). Since an election for either is made at the partnership rather than partner level, it is possible (absent effective structuring) that a partnership with both tax-exempt and taxable partners may be considered ineligible for refundability and transferability.

Impact on fund structures

Infrastructure fund managers also need to consider new ways to increase returns under the Act’s new tax credit regime. Funds with tax-exempt investors could be especially impacted. For example, will refundability mean that such structures can eschew the taxation of blocker corporations in certain circumstances? The aforementioned potential mutual exclusivity of refundability and transferability also could trigger complicated structuring considerations.

Observation: While numerous factors come into play and further clarification is required, in looking at the US renewable investment space, it may be prudent to separately structure tax-exempt and taxable investors in seeking the desired outcomes of refundability or transferability.

To build or not to build

The Act provides numerous opportunities for infrastructure asset managers. Whether exploring market opportunities as valuations of renewable portfolios increase or investigating development opportunities taking advantage of the new incentives, asset managers need to engage in appropriate diligence.

Observation: One decision point will be whether to delay projects until 2023 in order to take advantage of the new transferability and refundability incentives, which become effective for tax years beginning after December 31, 2022. Projects placed in service in 2022 typically won’t be eligible for refundability or transferability, but may be able to benefit from the new tax credits and are exempt from the wage and apprenticeship requirements necessary to receive the bonus rate if construction begins before the date that is 60 days after the date official guidance is published regarding those requirements. Whether to delay or accelerate construction may depend heavily on the specific incentives under consideration, and it will be important to document when construction begins.

Additional resources: For a broader discussion of the changes made by the Act, access our Insights: Senate passes “Inflation Reduction Act” reconciliation bill; Reconciliation bill includes numerous energy incentive tax proposals; Corporate book minimum tax to be effective for 2023.