PRODUCTION TAX CREDIT BASICS

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PRODUCTION TAX CREDIT BASICS

• James F. Duffy, Esquire
• Nixon Peabody LLP
• 100 Summer Street
• Boston, MA 02110-2131
• [phone]
• [phone] (fax)
• jduffy_at_nixonpeabody.com

IPED Financing Wind Power The future of
Energy May 7-9, 2008 Scottsdale, Arizona
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The Production Tax Credit

• The production tax credit (the PTC) under
  Section 45 of the Internal Revenue Code remains
  the principal federal incentive for wind
  production
• The following is a brief summary of the PTC,
  together with interpretations thereof, and
  Revenue Procedure 2007-65 (November 5, 2007) in
  particular

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Using the Production Tax Credit

• Dollar-for-Dollar reduction in Federal income tax
  liability
• Under current law, the wind facility must have
  been placed in service prior to January 1, 2009
  in order to be eligible for PTCs

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• The PTC is currently (for 2007) 2.0 cents per
  kilowatt hour of electricity produced by the
  taxpayer and sold to an unrelated person, for a
  10-year period beginning on the date the facility
  was originally placed in service
• So, the amount of tax credits depends upon the
  amount of electricity generated

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• The Produced by the Taxpayer requirement means
  that the owner of the wind project receives the
  PTCs
• So, you cant just sell PTCs you have to make
  the purchaser of the PTCs an owner of the wind
  project

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• Most developers of community wind projects
  either (i) do not anticipate having Federal
  income tax liability for the next 10 years such
  that they will be able to take advantage of the
  PTCs themselves, or (ii) need to monetize the
  PTCs up front in order to help pay for the costs
  of developing their project

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• One option is that at or just before the date
  when a wind project is placed in service, the
  developer will sell the entire wind project to a
  purchaser who will then own the project and
  receive the PTCs
• Under this scenario, the value of the PTCs is one
  component of the total purchase price paid for
  the project

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• Also, under this typical structure, the original
  developer generally gives up control of the
  project
• Particularly in a community project, the original
  developer may not want to give up control of the
  project, as the original developer is generally a
  part of the local community

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Syndicating the Production Tax Credits

• Section 45(e)(3) of the Internal Revenue Code
  anticipates that the owner of a project may have
  more than one owner
• Section 45(e)(3) provides that if a project has
  more than one owner, the PTCs will generally be
  shared by the owners in proportion to their
  respective ownership interests in the gross
  sales from the facility

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• The way to structure a transaction so that there
  is more than one owner for tax purposes is
  generally to use a limited partnership or a
  limited liability company
• For tax purposes, a partnership (which includes a
  limited liability company) is not recognized as
  an entity, so that the partners are treated as
  owners as to their allocable interests in the
  partnership

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• The original developer can structure the legal
  owner of the project as a limited partnership or
  an LLC, and the investor who is interested in the
  PTCs can be a limited partner or member thereof
  and thus an owner for tax purposes
• The owner can then allocate almost all (up to
  99) of the PTCs to the investor

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• The original developer can remain in control of
  the wind project by being the general partner of
  the partnership (or the managing member of an
  LLC)
• But, remember that the PTCs are shared between
  the owners in proportion to their shares of
  gross sales
• So, in my example the investor would have to have
  a 99 interest in the gross sales of the facility

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• However, the developer could also receive a
  reasonable development fee for developing the
  project, and to the extent that there were
  insufficient sources of funds to pay that fee up
  front, some of it could be deferred and paid out
  of operating revenues
• In addition, the original developer, in its
  capacity as the general partner of the limited
  partnership, can receive a reasonable annual fee
  for managing the project

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• Debt on the project could be paid prior to
  reaching the 99-to-1 sharing ratio
• Where the developer has contributed capital to
  the limited partnership to fund the gap between
  the total development costs and the amount of the
  investors capital contribution, under Rev. Proc.
  2007-65 the developers capital contribution can
  be returned as a priority cash flow item prior to
  the 99-to-1 sharing ratio

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• The developer could borrow outside the
  partnership to obtain this capital, generally
  pledging to the lender as collateral the
  developers interest in the partnership
• The investors payments can be characterized
  entirely as capital contributions to the owner
  limited partnership or they can be characterized
  partially or entirely as a purchase price for the
  investors interest in the owner limited
  partnership

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• A simple syndication structure for a wind project
  is as set forth on the following slide

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99 Limited Partner (Investor)
1 General Partner (Developer)
Limited Partnership (Owner)
Wind Project
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• Also, at some point after the end of the 10-year
  PTC period, there could be a flip to give the
  general partner (the developer) a greater
  percentage interest (up to 95) in the projects
  cash flow
• And at some point after the 10-year PTC period
  (or after the investor has achieved a targeted
  IRR yield), the general partner/developer could
  have an option to buy out the limited
  partner/investors interest at its fair market
  value

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• The investors payment can be made up-front, so
  that it can be used as owners equity in the
  development process, or to pay off development
  period financing
• The investor could pay most (up to 80) of its
  funds on a pay-in schedule of up to 10 years, as
  PTCs are delivered (a pay-as-you-go plan), but
  at least 75 of the investors reasonably
  expected investment must be fixed and
  determinable and not contingent

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• These are just general concepts. The terms of
  the syndication of the Production Tax Credits
  from each wind project will vary, based in part
  upon the economics of the particular transaction.

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• Because of the sophisticated tax structuring
  involved, there will be not insignificant legal
  and accounting costs in each of these
  transactions, so it may not be as cost-efficient
  to syndicate the PTCs in this manner for smaller
  community wind projects, unless either (i) the
  investor is a community-oriented company willing
  to make a relatively small investment or (ii) a
  community wind project can be pooled with other
  similar community wind projects to provide a
  larger investment to cover the transaction costs

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• In the model shown on the chart on the previous
  slide, each community wind project can be
  structured based upon its own economics and can
  negotiate its own business deal with the
  investment fund

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• The investor does benefit from diversification of
  sponsor and wind regime, and perhaps off-taker,
  compared to an investment in one large project
• To keep down transaction costs, the same base
  documentation can be used as the starting point
  for each project

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• Facilitating these structures is an area where
  the states and public advocacy groups could be
  very helpful
• States and institutional non-profits have done
  this in the housing tax credit area

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PTC POINTERS

• The PTC is reduced by up to 50 to the extent
  that project costs are funded by (i) federal,
  state or local government grants for use in
  connection with the project, (ii) the proceeds of
  state or local tax-exempt obligations, (iii)
  subsidized energy financing provided directly or
  indirectly by federal, state or local programs or
  (iv) other credits allowable with respect to any
  property which is part of the project

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• For the first 4 years of the 10-year PTC tax
  credit period, PTCs can be applied to reduce the
  investors Alternative Minimum Tax
• Facilities are generally depreciated over 5 years
  (5-year MACRS)

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• PTCs are received by the taxpayer as they are
  earned, so there is no recapture risk to an
  investor if the investor sells its PTC investment
  during the 10-year PTC period (this is an
  advantage over many other tax credits where there
  is a tax credit recapture risk if the investment
  is disposed of during the tax credit period)

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• The amount of the PTC, currently 2.0 cents per
  kilowatt hour of electricity generated, is
  re-calculated by the IRS for each year of the PTC
  period of a facility (it was 1.9 cents per
  kilowatt hour for 2006)

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Revenue Procedure 2007-65

• Revenue Procedure 2007-65 (effective November 5,
  2007) gives guidance in structuring wind energy
  transactions
• By its terms, Rev. Proc. 2007-65 does not apply
  to geothermal, biomass and the other facilities
  eligible for PTCs
• This is a safe harbor, but be very wary of not
  following it

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• In order to comply with Rev. Proc. 2007-65, the
  developer must have a minimum 1 interest in each
  item of partnership income, gain, loss,
  deduction, and credit throughout the term of the
  partnership
• Also, an investors interest cannot flip down
  to less than 5 of its initial interest

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• Under Rev. Proc. 2007-65, there are no calls
  (developers rights to buy out the investors
  interest) in the first 5 years, and no puts
  (investors rights to require the developer to
  buy out the investors interest) at all
• Any calls must be for not less than the fair
  market value of the interest involved

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• In order to comply with the Rev. Proc., as of the
  later of the projects placed in service date or
  the investor admission date, the investor must
  have at least 20 of its total anticipated
  capital invested in the partnership
• Also, at least 75 of the investors capital must
  be not subject to adjusters

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