Tax equity in a direct-pay world

Direct pay as described in the BBBA may ultimately prove a better fit for some projects than others. The most active tax equity investors demonstrate a preference for large projects that use increasingly established and proven technologies, such as onshore wind and solar. However, the universe of credit-eligible technologies is broader than onshore wind and solar; if the BBBA as proposed were to come to fruition, even more technologies could become credit-eligible.

Direct pay would allow for potentially easier monetization of credits, particularly for more nascent and less frequently used technologies, such as fuel cells or carbon capture systems. Even for those projects that continue to deploy more traditional technologies, scale and overall project cost are often limiting factors in the ability to raise tax equity (that is, it has historically been challenging to raise tax equity for projects that are smaller scale or relatively lower cost). For instance, it has proven difficult to widely structure tax equity partnerships for smaller onshore wind and solar projects, which is likely a consequence of the high fixed transaction costs typically incurred in the establishment of partnership flips and inverted leases.

Direct pay differs from other monetization programs that have historically been available to renewable energy, such as the section 1603 cash grant program.⁴ Instead of a payment being made to a developer after submission of a grant application, the direct-pay regime proposed in the BBBA is structured as a deemed payment of income tax (which is expected to also apply to the proposed alternative minimum tax on book income described in the BBBA).⁵ If an entity that makes that election has no taxes payable (or the respective tax credits available exceed the taxes payable), that cash payment would be refunded in the due course of the typical tax return filing-IRS refund cycle in place for taxpaying entities. Once made, the election to receive a direct payment under the system described in the BBBA would be irrevocable and apply to the entirety of a project’s potential credit, whether that’s a single-year investment tax credit or a multiyear PTC.

The language most recently included in the BBBA would preclude the election for direct pay from being made earlier than 270 days after enactment of the law. Further, while the annual reporting requirements for section 1603 grants required documentation of job creation, the BBBA includes significant and quantifiable requirements of its own that are focused on promoting economic growth and workforce development, including minimum domestic content provisions and prevailing wage and apprenticeship elements. We expect that Treasury and the IRS would develop the needed forms and guidance around these requirements during the 270 days after enactment.

Despite industry efforts, direct pay is limited only to section 38 general business credits and does not provide an alternative path to monetizing a project’s accelerated depreciation. For developers that are in a significant net operating loss carryforward position, accelerated tax depreciation will not provide an immediate cash benefit, even in the direct-pay context. Direct pay also carries with it a steep phaseout schedule for projects that begin construction after specific dates and do not meet domestic content requirements. Some technologies might have different standards of domestic content than others, but the qualitative premise is consistent: qualified facilities must be constructed with U.S. steel and iron and manufactured products that are part of those facilities contain specific percentages of domestic content, depending on the dates those projects started construction.

For projects that do not meet the prescribed domestic content requirements, the language contained in the BBBA provides a direct-pay reduction for projects that begin construction in 2024, 2025, and afterward, equal to 10 percent, 15 percent, and 100 percent, respectively. For example, if a project begins construction after 2025 and does not meet domestic content requirements, it is entitled to $0 of direct pay. This domestic-content-driven reduction does not apply to projects that instead use a traditional nonrefundable incentive. Therefore, the irrevocable nature of the election for direct pay could have significant unintended consequences for projects that incorrectly claim to have fulfilled direct content requirements yet are later proven not to have met those requirements.

Some credit types may prove to be more easily replaced with direct pay than others. For example, for a developer that monetizes PTCs in a partnership flip structure (under current law), it is common for a tax equity provider to provide significant capital upfront in exchange for a 10-year credit stream. However, a project that generates PTCs, opts for direct pay, and does not use tax equity (and is not able to borrow against a refundable credit stream) would have to wait up to 10 years to realize a similar cash value in PTCs compared with a partnership flip structure. This could create issues for developers that have become accustomed to paying off construction debt with tax equity proceeds early in a project’s life. Projects that elect for direct pay and eschew tax equity may anticipate using permanent debt financing as an alternative. However, the decision to use debt financing in a direct-pay scenario should not be made in isolation and should also consider interest deductibility limitations under section 163(j).

Some structuring implications may also need to be considered when comparing direct pay to traditional tax equity, particularly with ITCs. In a nonrefundable credit context, the basis for the ITC typically gets stepped up to fair market value in a tax equity transaction. To the extent that a developer builds and owns a project without a sale of that project to a tax equity structure, the asset would likely not experience that step-up in basis. This means, in a direct-pay scenario, ITCs will potentially be smaller in proportion to that foregone step-up.

The BBBA and the ultimate effect of any direct-pay provision should be examined in the context of the overall bill, including the introduction of an AMT on book income. Although the credits being discussed in this article can be applied against the current version of the book minimum tax, there is still uncertainty about how that minimum tax might affect investors and the availability of tax equity funds in the market going forward. More broadly, one must consider the intersection of all potential law changes in anticipating the impact those might have on tax equity and renewable energy development. Each stakeholder will have to independently consider its posture, tax and otherwise, when evaluating how to operate most effectively within the context of any new rules.

Direct pay for federal incentives is a feature that has persisted among the disparate legislative proposals that have come out over the last year focused on renewable energy development. Its ubiquity suggests that multiple stakeholders intend for it to become law, but how it may alter the development of renewable energy assets remains to be seen.

It’s not clear that direct pay will replace tax equity financing; rather, it may serve as an additional tool for various developers and provide added optionality for accelerated deployment of capital into renewable energy. Direct pay has its own specific array of potential challenges and limitations: tax depreciation is not monetized, realization of cash in a PTC is possibly delayed, there are substantial domestic content requirements, and so on. That said, the optionality that direct pay introduces for renewable energy developers will likely contribute to the accelerated deployment of nascent technologies and the installed base of low-carbon technologies on the nation’s electrical grid.

The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, legal or other professional advice. Please refer to your advisors for specific advice.

Summary

The optionality that direct pay introduces for renewable energy developers will likely contribute to the accelerated deployment of nascent technologies and the installed base of low-carbon technologies on the nation’s electrical grid.