Tax-exempt investment in partnerships holding energy properties

Editor: Christine M. Turgeon, CPA

The Inflation Reduction Act of 2022, P.L. 117–169, significantly amended and expanded the investment tax credit (ITC) under Sec. 48, including making additional types of energy property eligible for the ITC, and providing increased credit amounts for energy projects that satisfy prevailing wage and apprenticeship requirements and domestic content requirements, or are located in energy communities. The Inflation Reduction Act also established the technology–neutral zero greenhouse gas (GHG) emission electricity investment credit under Sec. 48E, which replaces Sec. 48 as the primary tax incentive for investment in clean–energy facilities placed in service after 2024.

The amount of the ITC under these provisions generally is calculated as (1) the applicable percentage of the basis of the Sec. 48 credit–eligible energy property or (2) the applicable percentage of the Sec. 48E credit–qualified investment with respect to any qualified facility and energy–storage technology.

Approaches to sharing the ITC and other tax benefits

Investments in energy projects offer two primary tax benefits: the ITC and accelerated depreciation. Some developers cannot use these tax benefits themselves but can use them to incentivize tax equity investors that provide bridge financing until the projects receive cash payments.

The most common traditional tax equity structure for monetizing ITCs and depreciation is the partnership flip structure. Under this arrangement, the partnership that owns the project allocates a tax equity investor a large portion of the tax benefits (e.g., 99%) and a lower share of cash for an agreed–upon period — generally five years, to avoid ITC recapture under Sec. 50. After this period, the allocation to the investor “flips” down to a lower percentage (e.g., 5%), and the sponsor typically has an option to purchase the tax equity investor’s interest.

The Inflation Reduction Act introduced two additional avenues to monetize ITCs by allowing (1) applicable entities, including tax–exempt entities, that directly hold the energy projects to elect direct payments under Sec. 6417, and (2) eligible taxpayers — excluding applicable entities — to transfer ITCs to third parties under Sec. 6418. However, these options do not facilitate the monetization of depreciation, which can be claimed only by the tax owner of the project, and typically require sponsors to sell the ITCs at a discount to reflect substantiation and recapture risks for the transferee.

Hybrid structures are now emerging that allow a tax equity investor to direct the partnership to sell tax credits that would otherwise be allocable to them, while retaining the corresponding depreciation — thereby combining the benefits of the traditional partnership flip structure with the direct–transfer option.

Limitation of tax benefits for tax-exempt organizations

A notable limitation of both traditional and hybrid tax equity structures arises when energy property, which is otherwise eligible for the ITC and accelerated depreciation, is held by a partnership that has indirect tax–exempt partners. This is because the tax–exempt partner’s indirect proportionate share of the property is treated as tax–exempt–use property that is ineligible for these tax benefits.

Under Secs. 50(b)(3) and (4), property used by certain tax–exempt organizations, governmental units, or foreign persons or entities is — subject to specific exceptions — ineligible for the ITC under Secs. 48 and 48E. If the property is held by a partnership, then under Sec. 50(b)(4)(D), rules similar to Secs. 168(h)(5) and (6) apply. These rules deny accelerated cost recovery on tax–exempt–use property and require the taxpayer to apply the applicable alternative depreciation system (ADS) method instead.

For purposes of Secs. 50 and 168, tax–exempt entities generally include the United States (including any state or political subdivision thereof), organizations exempt from tax (other than cooperatives described in Sec. 521), and foreign persons or entities (with exceptions for certain property subject to U.S. taxation). A tax–exempt controlled entity— generally, any corporation if 50% or more of the value of its stock is held, directly or indirectly (taking into account the attribution rules of Sec. 318), by one or more tax–exempt entities (other than a foreign person or entity) — is also treated as a tax–exempt entity for this purpose (Sec. 168(h)(6)(F)(iii)).

A reading of the statute suggests that for purposes of applying Sec. 50, the ownership of a U.S. corporation by a foreign person or entity is not considered when determining whether the U.S. corporation is a tax–exempt controlled entity. If the corporation’s stock is publicly traded, only 5% shareholders are taken into account.

A tax–exempt controlled entity can elect out of tax–exempt treatment under Sec. 168(h)(6)(F)(ii), thereby enabling the entity to claim the ITC and accelerated depreciation tax benefits. This election requires both the tax–exempt controlled entity and its shareholders to recognize income and gain from its interest in a partnership (and any dividend or interest received or accrued by the tax–exempt controlled entity from such partnership). That income is treated as unrelated business taxable income (UBTI) to the tax–exempt controlled entity for purposes of Sec. 511. This election is irrevocable and binding on all tax–exempt entities holding interests in a tax–exempt controlled entity. It is unclear whether the election is valid if the U.S. corporate blocker is owned by a super tax–exempt entity that is never subject to UBTI, although a literal interpretation of the statute may support the election in that case.

Tax-exempt-use property held by partnerships

As a general rule, if property is owned by a partnership that has both a tax–exempt entity and an individual or non–tax–exempt entity as partners, and any allocation to the tax–exempt entity of partnership items is not a qualified allocation, then the tax–exempt entity’s proportionate share of that property is treated as tax–exempt–use property under Sec. 168(h)(6)(A) (and thus ineligible for the ITC and accelerated depreciation).

Under Sec. 168(h)(6)(B), an allocation to a tax–exempt entity is qualified if it (1) is consistent with that entity’s allocation of each item of income, gain, loss, deduction, credit, and basis throughout the entire period during which the entity is a partner in the partnership, and (2) has substantial economic effect within the meaning of Sec. 704(b)(2).

There is limited guidance under Sec. 168(h)(6)(B) (and the temporary regulations issued under the predecessor to Sec. 168(h) in 1985 and amended in 1992) describing qualified allocations, so common partnership allocation provisions such as targeted allocations, preferred returns, fill–up allocations, and tracking allocations may not be qualified allocations. Allocations made under Sec. 704(c) are not taken into account when determining whether the partnership has made qualified allocations. Allocations that are not governed by the substantial–economic–effect rules (e.g., an allocation of basis of an oil and gas property, which generally is governed by Sec. 613A(c)(7)(D)) and allocations that cannot have substantial economic effect (e.g., nonrecourse deductions) also must comply with provisions governing those items.

These rules apply in the case of any passthrough entity and in the case of tiered partnerships and other entities under Sec. 168(h)(6)(E). As a result, if a tax–exempt entity owns an interest in a lower–tier partnership through one or more upper–tier passthrough entities, its indirect ownership could result in the property being treated as tax–exempt–use property — unless qualified allocations are made.

Sec. 168(h)(1)(D) provides that tax–exempt–use property does not include any portion of the property that is predominantly used by a tax–exempt entity (directly or through a partnership) in an unrelated trade or business subject to tax under Sec. 511 (i.e., UBTI). However, super tax–exempt entities (e.g., state and local governments or state pension funds) do not have UBTI, and thus partnerships with these partners may need to classify the portion of partnership property deemed owned indirectly by super tax–exempt investors as tax–exempt–use property, absent a rule that the interest is excluded from the tax–exempt–use property classification.

Consequences of investments in partnerships without qualified allocations

If a partnership with tax–exempt partners does not make qualified allocations, the indirect tax–exempt owner’s proportionate share in property will be treated as tax–exempt–use property that is not eligible for the ITC. Additionally, that share of the otherwise eligible property must be depreciated using the ADS under Sec. 168(g)(1)(B) instead of the general depreciation system (GDS), denying accelerated recovery.

Generally, a tax–exempt entity’s proportionate share of any property owned by a partnership is determined under Sec. 168(h)(6)(C)(i) on the basis of that entity’s share of partnership taxable income or gain (excluding gain allocated under Sec. 704(c)), whichever results in the largest proportionate share. If the entity’s share of partnership items of income or gain varies during the period that entity is a partner in the partnership, that share would be the highest share that entity may receive. For example, in a partnership flip structure, the sponsor typically has a 95% share of income after the end of the flip period, so a sponsor indirectly held by a tax–exempt entity would be required to exclude 95% of the indirect tax–exempt investor’s share from qualification for the ITC and accelerated depreciation.

If the property is held through a tiered partnership structure, then the share of partnership items of income or gain must be determined with respect to each tier to ultimately determine the extent to which the tax–exempt entity’s investment in the top–tier partnership results in a portion of the otherwise eligible property held by the lowest–tier partnership being treated as tax–exempt–use property, rendering that portion of the property ineligible for the ITC or accelerated depreciation. It should be noted that it is often difficult to determine the total interest held by tax–exempt entities and super tax–exempts in open–end–type partnership investments and publicly traded partnerships.

Partnership allocations are critical

If tax–exempt entities invest in energy projects through partnerships, careful consideration should be given to allocations under the respective partnership arrangements to avoid any detrimental impact on the eligibility of the energy property’s basis for ITC and accelerated depreciation. Proper qualified allocations of partnership items to the direct and indirect tax–exempt partners could allow the partnership to continue to claim ITCs and accelerated depreciation. Given the limited guidance and the complexity of tiered–ownership structures, it can be challenging to determine whether specific allocations should be treated as qualified.

Editor

Christine M. Turgeon, CPA, is a partner with PwC US Tax LLP, Washington National Tax Services, in New York City.

For additional information about these items, contact Turgeon at christine.turgeon@pwc.com.

Contributors are members of or associated with PwC US Tax LLP.