Energy entrepreneurs are acquainted with the economic importance of Federal income tax incentives that promote the development of energy resources and infrastructure. Tax incentives include tax credits, bonus depreciation allowances[i] and favorable expensing rules for intangible drilling costs.
Energy-related tax incentives offered by the Government target a variety of goals. Our nation has focused, albeit sporadically, on becoming more energy self-sufficient since the oil cartel-created shortages of the 1970s. People alive at that time recall waiting in long lines for gasoline. Conservation measures included neither running public fountains nor lighting Christmas lights. As a new employee in a gas pipeline in the 1970s, I heard Denver-based consultants paint a picture of ever increasing natural gas prices related to projected natural gas supply shortages. Natural gas was trading at very high prices (about $5 per MCF in Canada) in the early 1980s, and as a result plans were being made to construct an Alaska to Continental U. S natural gas line. That project ultimately was cancelled as tight natural gas supply conditions abated.
In large measure past tax incentives arguably have been successful in stimulating a favorable supply response. One poignant example is the effectiveness of the Internal Revenue Code §29 credit related to coal seam gas[ii] that stimulated a new technology of production. As a result of this and other factors, natural gas surpluses arose for most of the ensuing years. Other important changes included the impacts of gas and electricity deregulation, changes in demand for gas powered electric generation and technological improvements such as horizontal drilling and fracturing formations that provided the ability to produce natural gas from shale gas plays.
Political events and the cycles of economic growth and recession have driven the emergence of new economic stimulus and environmental laws. Recently, climate change goals and a financial meltdown have taken the forefront of policy debates. In spite of the partial success of past energy initiatives, as we begin the Obama years our nation finds itself in a quandary: How do we meet today’s environmental objectives and simultaneously promote economic development during a time of financial insecurity and slackening demand? An important consideration is that, although many of us would like to see “green power” technologies succeed, the fact is that today only roughly 3 percent of electricity (excluding hydro power from total resources) is generated from renewable power contributors.[iii] In addition, many well known technological and logistical challenges remain, such as a shortage of transmission infrastructure for wind power and the present status of nascent carbon capture technology. In such an environment policy makers strive to be creative. As far as tax policy is concerned, the government’s most recent economic stimulus package evinced creativity to promote “green energy” beyond past measures.
This article provides a summary of and comments on an important tax program that is targeted to both stimulate new near term “green energy” resources and the economy. The program involves cutting a check to energy project developers, rather than the alternative of permitting tax credits on their income tax returns. The program permits developers tax depreciation amounts over the life of these projects that exceeds out-of-pocket investments as discussed below, thus providing both a cash flow benefit and governmental financial subsidy. The incentives are intended to fill the gap temporarily created by diminished investor demand for the purchase of syndicated income tax credits.
What is “The Deal” and Who is Eligible?
Section 1603 of the American Recovery and Reinvestment Tax Act of 2009 provides for optional cash payments, instead of tax credits, for eligible “green energy” property used in a trade or business or for the production of income. The payments apply to certain property placed in service during 2009 or 2010, or under some conditions in later years. The payments are equal to either 10% or 30% of the tax basis of the property, depending on the type of property. Payments will be made within 60 days of the later of the date the property is placed in service or a complete application claiming a payment is filed. Those who elect to receive the cash payments as a result also elect to forego otherwise available tax credits (production or investment credits) under Sections 45 and 48 of the Internal Revenue Code (Code). They also must agree to the terms and conditions of the Section 1603 program. To be eligible to receive payments, an application must be filed as described below.
To be eligible to receive cash payments, any applicant must be the owner or lessee of the property and must have placed the property in service. The cash payments don’t apply to non-business energy property and to residential energy efficient property as set forth in Sections 25C and 25D of the Code. The payments can’t be claimed by governments, charitable organizations, clean energy bondholders, or cooperative electric companies. The payments also can’t be claimed by any direct or indirect partner (or other holder of an equity or profits interest) which is an organization described in the preceding sentence, unless this person only owns an interest in the applicant through a taxable C corporation. Real estate investment trusts and Code §1381 (a) cooperatives are not pass-thru entities for this purpose.
What Property Qualifies for Cash Payments?
Regardless of when construction begins, the property must be placed in service between January 1, 2009 and December 31, 2010, or alternatively construction must have begun in 2009 or 2010 and the property must be in service before a credit termination date (either January 1 of 2013, 2014 or 2017, depending on the type of property). Thirty percent payments apply to large wind, biomass facility, geothermal under Code §45, landfill gas, trash facility, hydropower facility, marine & hydrokinetic facility, solar facility, fuel cells and small wind projects. Ten percent payments apply to geothermal under Code §48, microturbine, combined heat & power and geothermal heat pump projects. For fuel cells the maximum payment can’t exceed $1,500 for each KW of capacity, and for microturbines the maximum is $200 for each KW of capacity. Under this program expansions of existing eligible property may qualify for the cash payments.
Regarding the eligibility requirement that construction must have begun in 2009 or 2010 and if the facilities are to be completed later, the standard may be met only by conducting actual physical construction work of a significant nature on the project. The standard is not met by preliminary activities such as planning, designing, securing financing, exploring, clearing a site, test drilling to determine soil condition or excavation to change the contour of land. However, if the facilities involve modular construction at an off-site location the standard is met based on applying the principles referred to previously at the off-site location. If the project is to be constructed by a third party under a contract, the contract must be binding and enforceable under State law as defined by several conditions of the program. The rules provide a safe harbor permitting the construction-must-have-begun standard to be met if the applicant has incurred or paid more than 5 percent of the cost of the property, excluding the cost of the preliminary activities described above.
Where the facility includes multiple units of property, such as a wind turbine farm, the owner of the multiple units may elect to treat the units and any control system that serves all units as a single unit property for purposes of determining the beginning of construction and the date the property is placed in service. In such a case, failure to complete the entire project will not preclude receipt of payments for those components of the project that were completed within the deadlines of the Section 1603 payment program.
Where property, such as solar energy or fuel cell property, is installed on other property like a building or truck only the property described in Code §48 is eligible for the payment. Property used predominately outside the United States is not eligible. The original use of the property must begin with the applicant, but construction consisting of not more than 20 percent of used parts will not disqualify the eligibility of the property.
How Can I Apply?
Applications are available at www.treasury.gov/recovery. You must wait to submit an application until the property is in service if construction is completed in 2009 or 2010, but you may submit an application if the property is under construction in 2009 or 2010 and the project will be placed in service in later years. All applications must be received no later than October 1, 2011. For applications related to property under construction, supplemental information to verify completion must be submitted within 90 days after the property is placed in service.
Other application requirements include the applicant’s Data Universal Numbering System (DUNS) number which may be requested at no cost at 1-866-705-5711. You must also register with the Central Contractor Registration Service at www.ccr.gov/startregistration.aspx.
Applicants for the payments must submit required documentation demonstrating the eligibility of the property, that it has been placed in service, or if placed in service after 2010 that construction began in 2009 or 2010. Examples of the documentation required to demonstrate eligibility include final engineering design documents certified by a professional engineer, documentation of nameplate capacity that meets required minimums or maximums, documentation of meeting efficiency requirements, and for hydropower projects evidence of a Federal Energy Regulatory Commission certification and license.
Documentation to demonstrate that the property has been placed in service includes a commissioning report by the project engineer, equipment vendor or independent third party certifying that the equipment has been installed, tested and is ready and capable of its intended use. If the property is connected to a utility the documents must demonstrate that the interconnection agreement is in effect. Documentation of the project being under construction but not yet in service must include paid invoices or other financial documents demonstrating that significant physical work has begun or the project meets the safe harbor test.
Other Requirements
The income tax basis of the property upon which the cash payments are calculated is determined under the general rules for determining the basis of property for depreciation purposes under the Code and IRS regulations. No payments will be made related to property expensed all at once under Code §179, or if intangible drilling and development expenses (IDD) will be deducted currently by the applicant. However, IDD costs that will be depreciated or amortized are eligible. Applicants must submit documentation supporting the claimed cost basis of the property, including a detailed breakdown of all costs and, for properties with a cost of over $500,000, an independent accountant’s certification attesting to the accuracy of the claimed costs.
While these cash payments are not taxable income in the gross income of the applicant, the basis of the property is reduced by only 50 percent of the payment. This means that available tax depreciation allowances will be reduced only partially (either by 15 percent or by 5 percent, depending on the type of property) as a result of the cash payments (either 30 percent or 10 percent, depending on the type of property); thus, the depreciation permitted on the property will exceed the investor’s actual net cost of the facilities. This is a very favorable provision considering that the property may also be eligible for 50 percent bonus income tax depreciation. The cash payments must be normalized under the provisions of former Code §46(f) applicable to the computation of accumulated deferred income taxes for utilities.
Leasing transfers from a lessor to a lessee do not annul eligibility for the cash payments as long as several requirements are met. First, both the lessor and lessee must be eligible parties to receive the payments. Second, the lessor must agree to transfer its rights to the lessee by waiving its right to the payments and to production or investment tax credits. Third, the basis for computation of the payments must use an independently assessed fair market value of the property on the date of transfer under the Code and the regulations governing elections to allow lessees to receive energy tax credits. Fourth, the lessee must agree to include ratably in its gross taxable income 50 percent of the payments as a recapture of income over a five year period.
Sale and leaseback transactions are permitted. In that case, the lessee must be the person who originally put the property in service, and the transaction must occur within three months after the project in service date.
If an applicant disposes of the property to an unqualified entity, or if the property ceases to be eligible for the cash payment, or permanent cessation of production occurs during the first five years of service, the cash payments are recaptured (required to be put into gross taxable income) ratably over that time. In other words, 80 percent of the credit amount would be recaptured if the property is sold during the second year of service, 60 percent if this occurs during the third year of service and so forth.
Conclusion
Project developers likely will be attracted to this new government program because significant energy tax incentives can be monetized early in the project life without having to “syndicate” the transaction, such as was done by the Williams Coal Seam Gas Royalty Trust, as is discussed herein in the endnotes. The cash payments will reduce the effective cost of the eligible “green energy” projects, though the concept potentially tends to encourage less efficient projects. Project developers should seek to understand these rules thoroughly and to plan carefully to meet the requirements of the law. If the requirements aren’t met, the anticipated incentive payments may not be received, or may be recaptured into income after the fact. The program includes significant, and to some extent costly, administrative requirements that will affect project plans and execution strategies.
Project developers should focus now on making projects eligible for these cash incentives prior to the end of 2010. One of the most significant requirements is the necessity of beginning real construction activities by the end of that year.
NOTES
i For example, the Tax Relief Act of 2003, the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009 all included 50 percent bonus tax depreciation provisions, i.e. the ability to elect to deduct against income (for qualified property) half of the cost of property in the first year of service. Under the most recent Act the 50 percent bonus depreciation election is available for qualified property whose use starts during 2008 or 2009 (2010 for certain longer-lived property).
In 2004 Calvin H. Johnson in a University of Texas Austin School of Law paper argued that 50 percent bonus depreciation is bad public policy because “investments in equipment that returns only 70 percent of the prevailing fair market value interest rates can go forward.” See Johnson, Calvin H., Depreciation Policy During Carnival: The New 50 Percent Bonus Depreciation, Tax Notes, Forthcoming.
Available at SSRN: http://ssrn.com/abstract=432161
ii For an example of the “monetization” of Internal Revenue Code (Code) §29 tax credits to raise capital examine the history of the Williams Coal Seam Gas Royalty Trust (NWSE:WTU) that was formed to provide investors with quarterly cash distributions and tax credits under §29 of the Code. The concept of “monetization” involves an owner of a property who is not able to use a tax credit to be able to sell an economic interest in the property to a tax oriented investor who is able to use the credit. Further information on the process of monetization of coal seam gas tax credits is available in a September 30, 1998 white paper, “Update on Application of §29 Tax Credit to Coal Seam Gas,” by Greg A. Sanderson and Lesley W. Berggren of Gomel & Davis, LLP under Work Assignment No. 4-1 of U. S. Environmental Protection Agency Contract 68-W5-0017.
See http://www.epa.gov/cmop/docs/pol003.pdf.
iii See Karlgaard, Rich, “Waxman-Markey Flunks Math,” Fortune Magazine, August 3, 2009, p. 23.
ivFor additional information on the requirements of this economic stimulus program see: http://www.treas.gov/recovery/docs/guidance.pdf