Tax Law Alert: IRS Creates Safe Harbor for Wind Energy "Flip" Transactions

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The Internal Revenue Service has published a revenue procedure establishing a safe harbor with respect to allocation of production tax credits from wind energy facilities. Section 45 of the Internal Revenue Code (IRC) provides for a renewable electricity production credit for each kilowatt hour of electricity produced by the taxpayer from a qualified energy resource, including wind, at a qualified facility and sold to an unrelated person during the taxable year. The credit continues for 10 years from the time the facility was originally placed in service. Wind energy projects frequently are owned and operated by LLCs formed between a wind developer and one or more investors interested in earning returns from operating cash flow and IRC § 45 credits from the project. The IRS previously had announced that it would no longer rule on any issues for partnerships (LLCs generally are treated as partnerships for federal tax purposes) claiming the IRC § 45 production tax credit. The newly issued revenue procedure, Rev Proc 2007-65, establishes a safe harbor for the allocation of a partnership's IRC § 45 production tax credits from wind. It does not apply to any other tax credits, or to the allocation of a partnership's IRC § 45 credits from other qualified energy resources. If "each and every requirement" of the safe harbor is satisfied the IRS will respect the allocation of IRC § 45 credits in the operating agreement. In brief, the safe harbor sets forth eight primary requirements:

  1. Minimum Interest. The developer must have an interest of at least 1 percent in each material item of partnership income, gain, loss, deduction and credit at all times during the existence of the partnership. Each investor must have an interest in each material item of partnership income and gain, at all times while it owns an interest in the partnership, at least equal to 5 percent of the interest it will have in the year in which its interest is largest.
  2. Investor's Minimum Investment. Each investor must maintain, as long as it owns its partnership interest, an investment at least equal to 20 percent of the sum of its fixed capital contributions pursuant to the operating agreement, plus reasonably anticipated contingent capital contributions. The required minimum can be reduced by distributions of project cash flow or in connection with a sale pursuant to the exercise of an option as described in 4 below. Stop-loss arrangements are not permitted.
  3. 75% Fixed Obligation. At least 75 percent of an investor's total capital contributions must be fixed and determinable obligations that are not contingent either in amount or in certainty of payment.
  4. Only Fair Market Value Purchase Options. The exercise price of any call option held by the developer, an investor or any related party to purchase the project or any interest in the partnership must be at fair market value as determined on the date of exercise of the option. In the case of an option held by the developer or a related party, the option may not be exercisable earlier than five years after the qualified facility is placed in service. Special limitations are provided with respect to the effect of certain contractual arrangements on value for this purpose.
  5. No Put Rights. The partnership may not have a right to require any party to buy any or all of the project, and an investor may not have a right to require any party to buy its interest in the partnership.
  6. No Wind Guarantee. There can be no guarantee to an investor of any allocation of credit. Among other things, this means that the partnership must bear the risk that the wind does not blow as predicted. So long as the partnership or the investor pays the premium or cost, however, the partnership or the investor may acquire a weather derivative contract from an unrelated insurance company or other unrelated party. A long-term power purchase agreement with an unrelated party would not be a guarantee for this purpose.
  7. No Developer Loans or Loan Guarantees. Neither the developer nor a related party may loan any funds to an investor to invest in the partnership, or may guarantee any debt connected to that investment.
  8. Proper Allocation. The IRC § 45 credit must be allocated in accordance with Treasury Regulation § 1.704-1(b)(4)(ii). Among other requirements, this means that the credit must be allocated the same way gross income from sale of electricity is allocated.
The new revenue procedure includes two helpful examples. The examples appear to clarify several issues, including the fact that a 0 percent interest in cash distributions for a period of time does not violate the safe harbor, and the fact that flips in sharing ratios do not violate the safe harbor.


Key Contributors

Christopher K. Heuer
Kevin T. Pearson
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