Renewable Energy Leasing Opportunities

With the increased interest and emphasis on renewable and alternative sources of energy at the federal and state level and with increased consumer demand for “green” energy, opportunities abound for investments in renewable and alternative energy sources, including wind, solar, biomass, and geothermal among others. Congress, through the tax code, has encouraged investment in these energy sources. The best known tax incentives are the production tax credit provided with respect to electricity produced from certain renewable sources under Section 45 and the investment tax credit provided under Section 48 for certain energy property, including solar projects.

Lately there has been increased interest in the use of sale-leasebacks as a financing mechanism for solar projects. While most of the activity to date has involved solar projects, there is no reason that sale-leasebacks could not be used to finance other types of renewable energy or other energy projects eligible for investment tax credits under Section 48, such as fuel cells, geothermal or certain combined heat and power facilities, as well as integrated gasification combined cycle and other advanced coal-based generation projects under Section 48A or gasification projects under Section 48B.

A sale-leaseback, however, is not an efficient or effective means of financing most wind or other facilities where the investor is seeking to receive Section 45 production tax credits. Generally, in order to qualify for PTCs, the facility must be owned by and the production of the electricity must be attributable to the recipient of the credits. In a sale-leaseback transaction, there would be two different entities: One that owns the project (purchaser/lessor) and one to whom production of the electricity is attributable (seller/lessee operator). In such case, neither entity would be able to claim the credits. Thus, Section 45 transactions involving equity investors generally use a partnership flip or other structure.

There is, however, an exception to this rule for closed-loop or open-loop biomass facilities. Closed-loop biomass facilities generate electricity from plants that are planted exclusively for the purpose of producing electricity; Open-loop biomass facilities generate electricity from certain types of qualifying animal waste, wood waste, or agricultural wastes.

Section 45 provides that in the case of a facility which produces electricity from closed-loop or open-loop biomass, if the owner of the facility is not the producer of the electricity, the lessee or operator that is the producer of the electricity is the taxpayer that is entitled to the tax credit. Accordingly, so long as the lessee of a facility is responsible for the burdens and benefits associated with the production of electricity, it is entitled to the tax credits produced by the closed-loop or open-loop biomass facility.

By contrast, the investment tax credit is available to the person who owns the facility at the time the facility is first placed in service. There is no requirement that production of electricity be attributable to the person getting the credit. Under a special rule, if the facility is sold and leased back no later than three months after the placed-in-service date, the owner under the sale-leaseback will be entitled to the credit. Thus, unlike the production tax credits, a passive investor in a sale-leaseback can receive the investment tax credit associated with a facility provided it acquires its interest in a sale-leaseback within three months of the time the facility is placed in service.

The Most Common Sale-Leaseback Structure

The most common sale-leaseback structure currently seen in the market is one in which the developer of the project sells the facility to an equity investor and immediately leases it back. The lessee then enters into a long-term power purchase agreement, under which it agrees to provide the energy produced at the facility to a third party, often a tax-exempt entity such as a school or a state or local government, under a long-term power purchase agreement. The power purchase agreement serves as the credit support for the transaction. Due to the nature of the facilities, they are usually located on the property of the power purchaser, but are maintained and operated by the lessee.

Sale-leasebacks of solar facilities need to comply with the traditional leasing guidelines that equity investors have dealt with for years, but particularly when a power purchase agreement is involved, there are special issues.

In order for the investor in a sale-leaseback of solar equipment to be eligible for the investment tax credit, the sale-leaseback must occur no later than three months after the equipment is placed in service for federal income tax purposes. This poses potential pitfalls for transactions where the sale-leaseback is scheduled to occur close to the end of the three-month window. The determination of the placed-in-service date is a very factual one, and the placed-in-service date for federal income tax purposes may not be the same as the “commercial operations date” as defined in the power purchase agreement. In determining when an asset is placed in service, the Internal Revenue Service considers a five-factor test. Generally, those factors are: 1) whether all necessary permits for the construction and operation of the facility have been received, 2) whether all critical tests have been completed, 3) whether daily operations have begun, 4) whether the unit has been synchronized to the grid, and 5) whether the unit has been turned over to the taxpayer by the constructor. These are all very fact specific, and the investor and its counsel must be comfortable as to when the assets were placed in service in order to make sure the sale-leaseback falls within the three-month window.

Transfer Ownership

In order for the investor in a sale-leaseback transaction to be entitled to the investment tax credit, the sale-leaseback must transfer ownership of the assets to the investor for federal income tax purposes. In general, this requires that the sale-leaseback satisfy long-established leasing parameters. Satisfaction of many of these parameters will require input from an appraiser. The lease term, including any renewal terms with fixed rates, must not exceed 80% of the expected remaining useful life of the asset as of the closing date. In addition, the expected value of the asset at the end of the lease term must exceed 20% of its value as of the closing date, without taking inflation into account. Next, if the lessee has the option to purchase the asset during or at the end of the lease term, the purchase price should be set at fair market value or, if set at a fixed amount, it should be set at an amount equal to or greater than the appraiser's estimate of the fair market value of the asset at the time it can be exercised. Moreover, if there is a purchase option, that option should not be ongoing. In addition, there cannot be anything about the purchase price, the transaction, or the asset that would result in the lessee being expected to be compelled to exercise the purchase option. The asset itself must not be limited-use property. That is, it must be reasonable to assume that at the end of the lease term someone other than the lessee can use the asset in a commercially reasonable manner.

Economic Substance

In addition to the above requirements, the transaction must have economic substance. In sale-leasebacks this has traditionally meant that the transaction must provide a reasonable pre-tax profit to the investor. Traditionally, in sale-leaseback transactions, equity investors and their tax counsel have required that the transaction generate a pre-tax internal rate of return at or above the expected rate of inflation. This calculation can take into account the expected residual value of the asset at the end of the lease term. Some equity have taken the view that in
assessing whether a sale-leaseback involving renewable energy facilities has economic substance, the value of the investment tax credit can be taken into account as if it were cash. The theory behind this is that Congress provided the investment tax credit to promote investment in renewable energy assets, recognizing that without those credits such investments would not be profitable. As a result, those credits should be considered in determining whether or not such transactions have economic substance. While there are investors and tax counsel who apply this analysis to transactions involving solar equipment, the more conservative position is to apply traditional lease analysis and require a pre-tax profit without regard to the tax credits.

Purchase Option

Finally, in order to make sure that there is no recapture of the investment tax credits, the lease should not provide for a purchase option any earlier than six years after the placed-in-service date. While the recapture period for the investment tax credits is only five years after the placed-in-service date, an extra year should provide an additional “safety net” since the placed-in-service date is a facts and circumstances determination as discussed above, and opinions on the placed-in-service date may differ.

Sale-leasebacks in which the lessee has entered into a power purchase agreement with an off-taker present their own set of issues. The first set deal with ensuring that the power purchase agreement is respected as a service contract and not recharacterized as a lease. This is particularly important if the power purchaser is a tax-exempt entity. In that instance, if the power purchase agreement is recharacterized as a lease to a tax-exempt entity, the facility will be considered to be “tax-exempt use property,” and the investor will not be entitled to the investment tax credit and its depreciation deductions are likely to be substantially deferred. The second set of issues deal with making sure that the power purchase agreement does not create ownership problems in the lease above it.

The Internal Revenue Code provides a special safe harbor for determining if a power purchase agreement will be treated as a service contract and not as a lease if the contract is for power from an “alternative energy facility.” An alterative energy facility is a facility for producing electric or thermal energy if the primary energy source is not oil, natural gas, coal, or nuclear power. In the case of an alternative energy facility, as long as the contract purports to be a service agreement, it will be treated as such provided that: 1) the service recipient (customer) and the service provider (seller of the electricity) are not related, 2) the service recipient does not bear any significant financial benefit if there is non-performance under the contract, other than for reasons beyond the control of the service provider, 3) the service recipient does not receive any significant financial benefit if the operating costs are less than the standards of performance or operation under the contract, or 4) the service recipient has the right to purchase the facility at a price other than fair market value.

Often the power purchase agreement will have been negotiated between the lessee and the power purchaser prior to the time that discussions with an equity investor about a sale-leaseback have begun. As a result, unless counsel for the lessee and power purchaser were conversant with the types of issues that an investor in a sale-leaseback would be concerned about, the power purchase agreement may violate one or more of these restrictions. As a result, it is important that the power purchase agreement be carefully reviewed, and to the extent problems are found, the parties will need to amend it.

The second set of issues that can result from a poorly drafted power purchase agreement are factors that could affect the status of the lease as a true lease. For example, a power purchase agreement with a term longer than the lease term could result in the lessee being compelled to exercise a purchase option under the lease in order to fulfill its obligations under the power purchase agreement. This, in turn, could result in the lessor under the lease not being treated as the owner of the assets, and thus not entitled to the tax credit. The exercise of a purchase option prior to the fifth anniversary of the placed-in-service date could result in a recapture of the investment tax credits, if exercised, even at fair market value. Renewal options that would potentially extend the term of the power purchase agreement beyond the lease term are another potential issue. Finally, to the extent that the power purchase agreement contains one or more purchase options, it will be necessary to make sure that: 1) the exercise of those options is not in any way compelled, and 2) that there is a corresponding option in the lease that will enable the lessee to acquire the asset from the lessor if the power purchaser elects to exercise its purchase option under the power purchase agreement.

Conclusion

Sale-leasebacks are emerging as a popular form of financing for solar facilities. Although use of sale-leaseback financing to date has been primarily limited to solar facilities, sale-leasebacks can also be used to finance other types of renewable energy facilities, and there is no reason to think that they would not be so used in the future. The structure of these deals is one that is familiar to investors who have participated in leasing transactions before, and thus should be attractive to them.

Laura Ellen Jones is a partner in the Tax Practice Group at Hunton & Williams LLP (Richmond, VA), where she focuses her work on energy-related tax credits. She can be reached at [email protected] or 804-788-8746. David B. Weisblat is a partner with Hunton & Williams LLP (Washington, DC), whose practice focuses on federal and state tax issues associated with energy, project finance, leveraged lease transactions, and tax controversy. He can be reached at [email protected] or 202-955-1980.

With the increased interest and emphasis on renewable and alternative sources of energy at the federal and state level and with increased consumer demand for “green” energy, opportunities abound for investments in renewable and alternative energy sources, including wind, solar, biomass, and geothermal among others. Congress, through the tax code, has encouraged investment in these energy sources. The best known tax incentives are the production tax credit provided with respect to electricity produced from certain renewable sources under Section 45 and the investment tax credit provided under Section 48 for certain energy property, including solar projects.

Lately there has been increased interest in the use of sale-leasebacks as a financing mechanism for solar projects. While most of the activity to date has involved solar projects, there is no reason that sale-leasebacks could not be used to finance other types of renewable energy or other energy projects eligible for investment tax credits under Section 48, such as fuel cells, geothermal or certain combined heat and power facilities, as well as integrated gasification combined cycle and other advanced coal-based generation projects under Section 48A or gasification projects under Section 48B.

A sale-leaseback, however, is not an efficient or effective means of financing most wind or other facilities where the investor is seeking to receive Section 45 production tax credits. Generally, in order to qualify for PTCs, the facility must be owned by and the production of the electricity must be attributable to the recipient of the credits. In a sale-leaseback transaction, there would be two different entities: One that owns the project (purchaser/lessor) and one to whom production of the electricity is attributable (seller/lessee operator). In such case, neither entity would be able to claim the credits. Thus, Section 45 transactions involving equity investors generally use a partnership flip or other structure.

There is, however, an exception to this rule for closed-loop or open-loop biomass facilities. Closed-loop biomass facilities generate electricity from plants that are planted exclusively for the purpose of producing electricity; Open-loop biomass facilities generate electricity from certain types of qualifying animal waste, wood waste, or agricultural wastes.

Section 45 provides that in the case of a facility which produces electricity from closed-loop or open-loop biomass, if the owner of the facility is not the producer of the electricity, the lessee or operator that is the producer of the electricity is the taxpayer that is entitled to the tax credit. Accordingly, so long as the lessee of a facility is responsible for the burdens and benefits associated with the production of electricity, it is entitled to the tax credits produced by the closed-loop or open-loop biomass facility.

By contrast, the investment tax credit is available to the person who owns the facility at the time the facility is first placed in service. There is no requirement that production of electricity be attributable to the person getting the credit. Under a special rule, if the facility is sold and leased back no later than three months after the placed-in-service date, the owner under the sale-leaseback will be entitled to the credit. Thus, unlike the production tax credits, a passive investor in a sale-leaseback can receive the investment tax credit associated with a facility provided it acquires its interest in a sale-leaseback within three months of the time the facility is placed in service.

The Most Common Sale-Leaseback Structure

The most common sale-leaseback structure currently seen in the market is one in which the developer of the project sells the facility to an equity investor and immediately leases it back. The lessee then enters into a long-term power purchase agreement, under which it agrees to provide the energy produced at the facility to a third party, often a tax-exempt entity such as a school or a state or local government, under a long-term power purchase agreement. The power purchase agreement serves as the credit support for the transaction. Due to the nature of the facilities, they are usually located on the property of the power purchaser, but are maintained and operated by the lessee.

Sale-leasebacks of solar facilities need to comply with the traditional leasing guidelines that equity investors have dealt with for years, but particularly when a power purchase agreement is involved, there are special issues.

In order for the investor in a sale-leaseback of solar equipment to be eligible for the investment tax credit, the sale-leaseback must occur no later than three months after the equipment is placed in service for federal income tax purposes. This poses potential pitfalls for transactions where the sale-leaseback is scheduled to occur close to the end of the three-month window. The determination of the placed-in-service date is a very factual one, and the placed-in-service date for federal income tax purposes may not be the same as the “commercial operations date” as defined in the power purchase agreement. In determining when an asset is placed in service, the Internal Revenue Service considers a five-factor test. Generally, those factors are: 1) whether all necessary permits for the construction and operation of the facility have been received, 2) whether all critical tests have been completed, 3) whether daily operations have begun, 4) whether the unit has been synchronized to the grid, and 5) whether the unit has been turned over to the taxpayer by the constructor. These are all very fact specific, and the investor and its counsel must be comfortable as to when the assets were placed in service in order to make sure the sale-leaseback falls within the three-month window.

Transfer Ownership

In order for the investor in a sale-leaseback transaction to be entitled to the investment tax credit, the sale-leaseback must transfer ownership of the assets to the investor for federal income tax purposes. In general, this requires that the sale-leaseback satisfy long-established leasing parameters. Satisfaction of many of these parameters will require input from an appraiser. The lease term, including any renewal terms with fixed rates, must not exceed 80% of the expected remaining useful life of the asset as of the closing date. In addition, the expected value of the asset at the end of the lease term must exceed 20% of its value as of the closing date, without taking inflation into account. Next, if the lessee has the option to purchase the asset during or at the end of the lease term, the purchase price should be set at fair market value or, if set at a fixed amount, it should be set at an amount equal to or greater than the appraiser's estimate of the fair market value of the asset at the time it can be exercised. Moreover, if there is a purchase option, that option should not be ongoing. In addition, there cannot be anything about the purchase price, the transaction, or the asset that would result in the lessee being expected to be compelled to exercise the purchase option. The asset itself must not be limited-use property. That is, it must be reasonable to assume that at the end of the lease term someone other than the lessee can use the asset in a commercially reasonable manner.

Economic Substance

In addition to the above requirements, the transaction must have economic substance. In sale-leasebacks this has traditionally meant that the transaction must provide a reasonable pre-tax profit to the investor. Traditionally, in sale-leaseback transactions, equity investors and their tax counsel have required that the transaction generate a pre-tax internal rate of return at or above the expected rate of inflation. This calculation can take into account the expected residual value of the asset at the end of the lease term. Some equity have taken the view that in
assessing whether a sale-leaseback involving renewable energy facilities has economic substance, the value of the investment tax credit can be taken into account as if it were cash. The theory behind this is that Congress provided the investment tax credit to promote investment in renewable energy assets, recognizing that without those credits such investments would not be profitable. As a result, those credits should be considered in determining whether or not such transactions have economic substance. While there are investors and tax counsel who apply this analysis to transactions involving solar equipment, the more conservative position is to apply traditional lease analysis and require a pre-tax profit without regard to the tax credits.

Purchase Option

Finally, in order to make sure that there is no recapture of the investment tax credits, the lease should not provide for a purchase option any earlier than six years after the placed-in-service date. While the recapture period for the investment tax credits is only five years after the placed-in-service date, an extra year should provide an additional “safety net” since the placed-in-service date is a facts and circumstances determination as discussed above, and opinions on the placed-in-service date may differ.

Sale-leasebacks in which the lessee has entered into a power purchase agreement with an off-taker present their own set of issues. The first set deal with ensuring that the power purchase agreement is respected as a service contract and not recharacterized as a lease. This is particularly important if the power purchaser is a tax-exempt entity. In that instance, if the power purchase agreement is recharacterized as a lease to a tax-exempt entity, the facility will be considered to be “tax-exempt use property,” and the investor will not be entitled to the investment tax credit and its depreciation deductions are likely to be substantially deferred. The second set of issues deal with making sure that the power purchase agreement does not create ownership problems in the lease above it.

The Internal Revenue Code provides a special safe harbor for determining if a power purchase agreement will be treated as a service contract and not as a lease if the contract is for power from an “alternative energy facility.” An alterative energy facility is a facility for producing electric or thermal energy if the primary energy source is not oil, natural gas, coal, or nuclear power. In the case of an alternative energy facility, as long as the contract purports to be a service agreement, it will be treated as such provided that: 1) the service recipient (customer) and the service provider (seller of the electricity) are not related, 2) the service recipient does not bear any significant financial benefit if there is non-performance under the contract, other than for reasons beyond the control of the service provider, 3) the service recipient does not receive any significant financial benefit if the operating costs are less than the standards of performance or operation under the contract, or 4) the service recipient has the right to purchase the facility at a price other than fair market value.

Often the power purchase agreement will have been negotiated between the lessee and the power purchaser prior to the time that discussions with an equity investor about a sale-leaseback have begun. As a result, unless counsel for the lessee and power purchaser were conversant with the types of issues that an investor in a sale-leaseback would be concerned about, the power purchase agreement may violate one or more of these restrictions. As a result, it is important that the power purchase agreement be carefully reviewed, and to the extent problems are found, the parties will need to amend it.

The second set of issues that can result from a poorly drafted power purchase agreement are factors that could affect the status of the lease as a true lease. For example, a power purchase agreement with a term longer than the lease term could result in the lessee being compelled to exercise a purchase option under the lease in order to fulfill its obligations under the power purchase agreement. This, in turn, could result in the lessor under the lease not being treated as the owner of the assets, and thus not entitled to the tax credit. The exercise of a purchase option prior to the fifth anniversary of the placed-in-service date could result in a recapture of the investment tax credits, if exercised, even at fair market value. Renewal options that would potentially extend the term of the power purchase agreement beyond the lease term are another potential issue. Finally, to the extent that the power purchase agreement contains one or more purchase options, it will be necessary to make sure that: 1) the exercise of those options is not in any way compelled, and 2) that there is a corresponding option in the lease that will enable the lessee to acquire the asset from the lessor if the power purchaser elects to exercise its purchase option under the power purchase agreement.

Conclusion

Sale-leasebacks are emerging as a popular form of financing for solar facilities. Although use of sale-leaseback financing to date has been primarily limited to solar facilities, sale-leasebacks can also be used to finance other types of renewable energy facilities, and there is no reason to think that they would not be so used in the future. The structure of these deals is one that is familiar to investors who have participated in leasing transactions before, and thus should be attractive to them.

Laura Ellen Jones is a partner in the Tax Practice Group at Hunton & Williams LLP (Richmond, VA), where she focuses her work on energy-related tax credits. She can be reached at [email protected] or 804-788-8746. David B. Weisblat is a partner with Hunton & Williams LLP (Washington, DC), whose practice focuses on federal and state tax issues associated with energy, project finance, leveraged lease transactions, and tax controversy. He can be reached at [email protected] or 202-955-1980.