IRS Safe Harbor Provisions for Flip Projects
By: DANIEL A. YARANO & CHRISTINA K. BRUSVEN
January 2008
On November 5, 2007, the IRS published Revenue Procedure 2007-65, providing guidance to wind project developers and investors using a “partnership flip” tax structure to make special allocations of income, gain, loss deduction, and production tax credits (PTCs) under §45 of the Internal Revenue Code.
The partnership flip structure is an industry-recognized business model to finance the development of wind projects. This structure allows limited liability companies (LLCs) to allocate income, gain loss deductions, and PTCs to the limited liability company members. Investors who can utilize PTCs provide the bulk of the equity capital to the project in consideration for income, gain, loss deductions, and PTCs. The investor often receives these allocations until it has achieved a specified internal rate of return. At that point, the LLC membership percentage interest is adjusted to direct the allocated income, loss, and tax credits to the developer.
However, complying with the special allocation requirements of the partnership flip structure (Subchapter K, particularly §704(b) of the Code) can be complex, and wind developers had sought IRS private letter rulings. In Notice 2006-88, the IRS announced it would no longer rule on any issues under Subchapter K as it related to partnerships seeking federal tax credit under §45. The wind industry has been awaiting the additional guidance provided by the IRS in Revenue Procedure 2007-65.
Scope of Revenue Procedure 2007-65
The Revenue Ruling is directed at wind energy developers and investors who own and operate wind projects that qualify for tax credits under §45 of the Internal Revenue Code. The Revenue Procedure replaces all future requests for private letter rulings related to the allocation of PTCs for wind projects. In place of the private letter rulings, the IRS established a safe harbor consisting of specific requirements (a “Safe Harbor”) that must be satisfied by wind projects using the flip model to avoid IRS challenges.
The Revenue Procedure describes three parties to the wind development projects. The “Developer” is the project developer, the “Investor” is the party whose investment return is expected to come from both PTCs and operating cash flow from the project, and the “Project Company” is the partnership formed between the Developer and Investor to own and operate the wind farm.
The parties must comply with all of the requirements to qualify for the Safe Harbor. Since the allocation of tax credits is described and directed by the Project Company’s limited liability agreement, this agreement must clearly demonstrate compliance with these requirements. The IRS stated that it will “closely scrutinize” the Project Company as a partnership and the Investor as a partner if the partnership agreement does not satisfy each requirement of the Safe Harbor.
IRS Safe Harbor Provisions
The partnership flip model structure and agreement must comply with each of the following requirements:
- Developer’s Minimum Interest. Developers must maintain a minimum partnership interest of at least 1 percent of the income, gain, loss deductions, and tax credits at all times. The ruling does not require the Developer to contribute at least 1 percent of the capital to the company.
- Investor’s Minimum Interest. In addition, Investors must maintain a minimum partnership interest equal to at least 5 percent of the Investor’s percentage of partnership interest in the year in which the Investor’s percentage of partnership interest is the largest. For example, an equity investor owning 99 percent during the front end of a project must be allocated at least 5 percent of the partnership income, gain, loss deductions, and tax credits after the flip.
- Investor’s Minimum Investment. The Investor is required to make and maintain a minimum investment of at least 20 percent of the sum of the fixed capital contributions and reasonably anticipated contingent capital contributions on or before the later of these two dates: (a) when the wind project achieves commercial operation or (b) when the Investor acquires its membership interest. The Investor cannot be protected against loss of any portion of its minimum investment by the Developer, other investors, the turbine supplier, or a power purchaser.
- Purchase Rights. The Developer, Investor, or any related party may not be given a right to purchase any property in the wind farm or interest in the partnership for less than fair market value at the time the option is exercised. In determining fair market value, the parties may consider (a) contracts entered into in the ordinary course of the wind project’s business and negotiated at arm’s length with a party not related to the Project Company or the Investor and (b) a long-term power purchase agreement, if it was entered into with a party unrelated to the Project Company.
- Five-Year Requirement. A Developer or related party may not be given the right to purchase the wind farm or an interest in the partnership earlier than five years after the wind project’s commercial operation date.
- Put Rights. The Project Company may not have contractual rights to cause any party to purchase the project or any of its assets, except electricity from the company. In addition, the Investor may not have a contractual right to cause any party to purchase its partnership interest.
- No Guarantee of PTCs. No person may guarantee the Investor the right to any allocation of PTCs.
- Risks Related to Wind Resource. The Project Company must bear the risk that the wind resource is not as great as anticipated. This requirement does not prohibit a weather-derivative contract with an insurance company as long as the Investor or Project Company directly pays a premium for the contract. Similarly, a long-term power purchase agreement with an unrelated party is allowed. However, a take-or-pay contract between related parties is strictly prohibited. In take-or-pay contracts, the buyer pays for the electricity regardless of whether the electricity is delivered.
- No Loans. The Developer or a related party may not lend any Investor funds to acquire any part of the Investor’s interest in the Project Company or guarantee indebtedness incurred in connection with the acquisition of the Investor’s interest in the Project Company.
- Allocation of the PTC. The PTCs must be allocated in a manner that complies with Code §1.704-1(b)(4)(ii). This means the PTCs must be allocated in the same manner as sales of electricity from the wind farm.
- Separate Activity for Purpose of §469. Under the passive activity loss rules, each wind tower will be treated as a separate activity and may only be grouped with other qualifying wind facilities. Thus, as a general rule, only entities subject to §469, not individuals, will be able to offset non-project income with the PTCs.
As shown in the examples the Revenue Procedure provides, these requirements allow a traditional flip model that allocates 99 percent of the interest in the partnership to the Investor in the first ten years. They also allow cash to be allocated differently than income. However, the IRS will closely scrutinize an agreement that allocates less than 1 percent of the interest in the partnership to the Developer. In addition, if the Investor was allocated a 99 percent interest in the first ten years of the project, after the project has reached its flip date, the Investor must retain at least a 5 percent ongoing interest in the project’s income and losses.
Impact on Existing and Future Projects
The Safe Harbor provisions apply to all transactions entered into on or after November 5, 2007. Existing projects that signed agreements prior to the IRS Revenue Procedure do not need to reform their agreements to comply with these regulations. However, if prior agreements comply with the Safe Harbor provisions, the IRS will not challenge their PTCs allocation as long as the allocations also follow the special allocation provisions in §704(b).
Takeaway
Given the strong language in the Revenue Procedure noting that the IRS will “closely scrutinize” flip projects that do not comply with the Safe Harbor provisions, stakeholders in all future projects, including those already in early stages of development, should take steps to make sure their partnership agreements meet all the Safe Harbor requirements.