Private Equity

The Inflation Reduction Act of 2022 (the “IRA”) includes two new monetization opportunities – (i) the ability to receive cash payments from the government in lieu of claiming certain tax credits (“Direct Pay”) and (ii) the ability to sell certain tax credits to third parties for cash (“Transferability”). These provisions were intended to increase the pool of capital for clean energy projects by expanding potential sources of funding based on tax credits. Although this expanded pool picks up tax-exempt and governmental investors, proposed guidance from Treasury and the IRS would meaningfully limit the ability of such entities to utilize these provisions if they invest through a tax partnership.      

Historically, most clean energy developers had limited options to maximize the value of tax credits and deductions from their projects. If, as was often the case, the developers could not efficiently utilize the tax benefits, they generally looked to bring in an investor that could. These “tax equity” investors were generally limited to a small pool of large corporations such as banks and insurance companies with substantial recurring tax liability sufficient to utilize the tax benefits. Notably, tax-exempt and governmental entities, lacking the requisite tax liability, were relegated to the sidelines. The limited pool of investors (as well as the degree of cost and complexity in implementing tax equity structures) created challenges for clean energy developers seeking funding. Direct Pay and Transferability were intended, at least in part, to help alleviate these challenges.

Briefly stated, Direct Pay allows certain tax-exempt and governmental entities to receive a cash payment from the government (structured as a tax refund) for applicable credits even if the entity would not otherwise have any federal income tax liability.[1] Transferability, on the other hand, permits taxable entities to sell certain tax credits to unrelated purchasers for cash.    

In June 2023, Treasury and the IRS issued proposed regulations on Direct Pay and Transferability.  In addition to imposing various other requirements (e.g., pre-filing registration, transfer or elective payment elections, etc.), the proposed regulations contain limitations that would often render both Direct Pay and Transferability unavailable for many tax-exempt and governmental entities that invest through partnerships. Specifically, a tax-exempt or governmental entity, though eligible to claim Direct Pay for a project it holds directly, cannot claim Direct Pay if it instead holds the project through a partnership. This is the case even if all partners in the partnership are tax-exempts or governmental entities otherwise eligible for Direct Pay.  In addition, the presence of certain tax-exempt or governmental entities as partners proportionately limits the partnership’s ability to utilize Transferability with respect to investment credits and certain other credits. Although certain exceptions may be available for organizations subject to UBIT, these limitations are particularly harsh as applied to state and local governmental investors (e.g., state pension funds). These investors, typically referred to as “super” tax-exempts, are common investors in private equity funds and often prefer to invest “unblocked” through partnerships. Absent alternative structures, such unblocked investments could reduce the partnership’s ability to monetize clean energy credits to the extent of the “super” tax-exempts’ share of ownership.

These limitations are seemingly inconsistent with the IRA’s goal to expand the pool of capital for clean energy projects. In light of this inconsistency, some have called for Treasury and the IRS to reconsider their position when they finalize the proposed regulations. For example, Treasury and the IRS could permit the partnership to elect Direct Pay on behalf of its tax-exempt or governmental partners for their share of the credit, or perhaps allow the partnership to transfer its credits without reduction for such entities’ proportionate ownership. If adopted, these alternatives would provide greater flexibility to tax-exempt and governmental entities (and private equity funds in which they invest) seeking to invest in clean energy.

Absent changes in the proposed regulations, alternative measures may be necessary to preserve both the project’s eligibility for tax credits and the parties’ desired economic arrangement. To explore two alternatives, these measures might take the form of alternative structures or claiming a different type of tax credit (e.g., a production tax credit) that is not subject to the limitations discussed above.

Alternative structures. Although the proposed regulations permit a tax-exempt or governmental entity to claim Direct Pay if it owns a direct interest in the project for tax purposes (as opposed to through a partnership), this is unlikely to be a feasible alternative for most private equity funds and their investors given, among other things, the limited flexibility to implement common economic arrangements (e.g., profits interests). Instead, many funds otherwise subject to the restrictions discussed above may consider having such entities (including “super” tax-exempts) invest on a blocked basis through a taxable US corporation. A fund could either (i) block only the relevant tax-exempt or governmental investors (a “partially blocked” structure) or (ii) block all the fund’s investors by holding the investment entirely through a taxable US corporation (a “fully blocked” structure). While a partially blocked structure would preserve the benefits of a flow-through structure for US taxable investors, it would be inconsistent with typical structures for “super” tax-exempts and would subject their investment to a layer of corporate tax that would not normally exist (thereby potentially changing their economic return). On the other hand, a fully blocked structure, though placing all investors on the same footing, would subject an even larger proportion of the investment to an additional layer of corporate tax and limit flexibility on exit.[2]

Utilizing a different type of credit. Alternatively, because the limitations on tax-exempt ownership generally only apply to investment tax credits, the project may be eligible for a different type of tax credit to which such limitations do not apply. For example, an entity’s solar project placed in service in 2025 could be eligible for an investment tax credit (to which the restrictions on tax-exempt ownership apply) or a production tax credit (to which such restrictions do not apply). Other factors, however, may make the production tax credit unattractive as compared to the investment tax credit, depending on, among other things, the need for significant upfront funding and the projections for the project’s operations.[3] In all cases, the structure of the fund’s investment and the type of credit ultimately utilized should be carefully considered.

[1] Other entities (i.e., “taxable” entities) are also eligible for Direct Pay for three specific tax credits (carbon capture & sequestration, clean hydrogen and advanced manufacturing) for five years.

[2] The availability of any strategy involving a “blocker” would also depend on whether the fund’s investor base was sufficiently diverse to avoid the blocker being a “tax-exempt controlled entity” (generally, any corporation if tax-exempt or governmental entities own 50% or more of the value of its stock).

[3] Note that not all clean energy projects will be eligible to elect to claim either a production tax credit or an investment tax credit.