Developers and some tax equity players in solar financing structures have recently raised the specter of securitizing their power-purchase agreements (PPAs) or lease receivables in order to free up funds for other projects or investments.
In this article, we'll provide a summary of the structures currently being used to finance solar energy projects. We'll look at what securitization is and why it may be beneficial; who is a candidate for securitization; what revenue streams can be securitized in a complex financing structure, such as a partnership; when the securitization can occur during the life of the project; and a solar securitization can be done when, in addition to the developer, a tax equity investor is involved.
Current solar financing structures
In order to make solar projects economically viable, Congress enacted energy tax credit and grant programs as well as favorable depreciation rules. For solar projects developed through 2016, the credit (or the grant for those projects eligible) is 30 percent of the eligible purchase price of the project. Five-year MACRS accelerated tax depreciation deductions are also allowed on that cost.
If the developer were to be the only investor in the project, the project might still not generate an after-tax profit for the developer since most developers do not have the tax capacity to utilize those tax benefits. Thus, in order to make full use of those tax benefits, developers in many cases have sold a portion of their interest in a project to banks and corporations that have the tax capacity to use those tax benefits (“tax equity investors”) under tax structures that permit an allocation of those benefits largely to the tax equity investors.
With those benefits fully utilized by a tax equity investor, the parties can allocate a greater share of the cash from the PPA or lease to the developer, resulting in a significant after-tax IRR for both the developer and the tax equity investor.
The structures that have been developed to permit investment by tax equity investors have included sale-leasebacks, partnership "flip" transactions and inverted leases. Here's how they work.
In a sale-leaseback transaction, the developer enters into a PPA or a lease with the offtaker, such as a utility, commercial building owner or residential customer, before the commercial operation date (COD). The developer then sells the entire project to the tax equity investor at COD. The tax equity investor then leases the property back to the developer so that the developer is then the lessee under the lease from the tax equity investor and is also the service provider under the PPA or the sublessor to the offtakers (a “head lease/sublease”).
The tax equity investor claims tax ownership and the entire 30 percent energy tax credit and all tax losses from the project. It receives rent from the developer lessee, some portion of which may be prepaid by the developer from its sale proceeds. Normally, the tax equity investor will have a security interest in the developer sublessor’s PPA or sublease in order to secure the performance by the lessee developer of its rent obligations under the head lease.
The lessor may have incurred nonrecourse debt secured by the project and the lease receivables to acquire its interest. Typically, the debt, if any, will represent anywhere from 30 percent to 50 percent of the cost of the project. Typically, the developer makes a small profit on the spread between its rent/PPA receivable and its rent obligation to the lessor, relying more heavily on the developer fee included in the pricing of the sale to the tax equity investor to make its return.
In a sale-leaseback, the lessee may have an option to purchase the property from the lessor at the end of the lease (typically fifteen to 25 years) or in some cases at an earlier point in the lease, such as after the point in time at which the lessor has achieved its target IRR. That option may bear a fixed price based on the estimate of future fair market value done at the beginning of the lease or may be determined at the time of exercise based on the then-fair market value (the “Residual Interest”).
Partnership “flip” transactions
In a partnership flip transaction, the developer forms an LLC to construct the project and enter into a PPA or lease to an offtaker. Just before COD, the developer typically sells an interest in the LLC project company to a tax equity investor or investors. Since the LLC then will have two owners and it is generally treated as a flow-through entity for tax purposes, the LLC becomes a tax partnership and the developer and the tax equity investor then become partners in a tax partnership.
Under special allocation tax rules set forth in IRS guidelines and/or regulations, most (in many cases as high as 99 percent) of the tax credit and tax losses of the partnership are allocated to the tax equity investor for the period during which the project generates tax losses, usually five years to seven years, after which the allocations “flip” with the majority of future taxable income allocated to the developer (the “flip date”). The developer typically receives the majority of the cash in the deal but the tax equity investor receives enough cash to meet its IRR target and to satisfy certain pretax profit and economic substance criteria for tax purposes. The timing and amount also vary depending on certain technical tax rules that can impose a tax when distributions exceed the partner’s tax basis in the partnership.
The developer often has an option to purchase the tax equity investor’s partnership interest at some point after the flip date at a fixed price determined at the commencement of the partnership based on estimated future fair market value or determined at the time of exercise. Typically, that value is determined based on a discounted cash flow analysis of the tax equity investor’s projected distributions and residual interest at the end of the term of the partnership.
In the simplest form of inverted lease, the developer or its affiliate will lease the project to a tax equity investor who then enters into a PPA or sublease with offtakers. Under special tax credit rules for leases, a lessor may elect to pass through the entire 30 percent energy tax credit (but not depreciation benefits) to the lessee. The developer lessor retains tax ownership and associated depreciation deductions. The tax equity investor usually makes a small pretax profit on the spread between the rent and the PPA payments and its rent obligation to the developer lessor. The investor may in some cases prepay a portion of its rent with borrowed funds.
In the more complex version of an inverted lease, the lessor and lessee often involve cross-ownership by the developer and tax equity investor, for example, the lessee LLC owned primarily by tax equity with a small percentage held by the developer and the lessor LLC owned 51 percent by the developer and 49 percent by the lessee LLC or tax equity.
Description and advantages of a securitization
In a typical securitization of a receivable such as rent, the holder of the receivable (“Originator”) will sell the receivable (but not the equipment generating the receivable) to a special-purpose bankruptcy remote vehicle known as the “Issuer” or “SPV.” The Issuer then issues equity (“pass-through structure”) or debt securities (“pay-through structure”) to investors (“Syndicate”). The proceeds from those debt securities then transfer from the Issuer to the Originator. In some cases, the Originator will service the collection of the receivables for the Issuer depending on the effect of that on the book treatment sought.
In many ways, a securitization is like back-leverage in a transaction such as a solar lease, except that the Syndicate that purchases the receivable becomes the title holder to the receivable and thus as a legal matter has more than the security interest that a pure lender would normally take in the receivable.
The reason why people do securitizations is often based on an ability to book the transfer of the receivable as a “true sale” that would produce book income for the Originator, in addition to cash flow. In addition, there is often a desire to avoid consolidation with the SPV that can arise from the degree of remaining control held by the Originator. Before the promulgation of FAS 166 and 167, that “true sale” could be structured in a way to result in loan treatment for the Originator for tax purposes, that is, with the transfer being treated as a transfer of a security interest only and the repayment of the loan coming from the receivable. That would not result in income for tax purposes. The Originator in that case would report the rent at the normal time of accrual under the lease/PPA.
That win-win scenario became much more difficult after the promulgation of FAS 166 and 167. Although a discussion of those rules is beyond the scope of this article, those rules generally limit true sale treatment and the ability to deconsolidate the underlying obligation of the Issuer to pay the Syndicate in many of the situations that were used previously to avoid taxable income. Yet, the Originator still can choose whether it wants the book advantage or the tax advantage if no combined result can be obtained, that is, if the tax rules for securitizations have not changed in any significant way.
Who can securitize and what can be securitized?
Typical lease securitization
In a typical securitization of lease receivables in a single-tier lease transaction, the lessor normally can do the securitization without the consent of other parties other than a lender. If the property is already leveraged, a portion of the proceeds received by the lessor would be used to pay off the existing debt, since there generally cannot be two significant first-lien security interests burdening the same income stream.
Securitization of a project by the developer without tax equity
If we assume that the developer does not have a tax equity player lined up before COD or if we are at the point at which the tax credits have been reduced significantly or eliminated legislatively, it may consider securitizing its receivable from the offtaker, much like the lessor in a typical lease securitization. It could be used to repay the construction loan (if there is one). In that sense, the securitization is similar to a takeout loan. It could also do the securitization after COD as a form of back-leverage. In some cases, the developer may be trying to achieve a book sale of the receivable.
In a solar securitization that takes the form of a head lease/sublease, the tax equity investor as head lessor could, without consent of the lessee, securitize its lease receivable. In that case, the securitization will be similar to those done for other types of property, as described above. The tax equity investor would have to ensure that the transfer of the lease receivable in the securitization did not result in a deemed tax sale of the underlying project. A deemed disposition of the assets would result in a pro-rata recapture of the tax credit during the first five years after the project is first placed in service.
Even after that five-year recapture period, the lessor typically would not want to trigger a deemed sale of the underlying property for tax purposes, since it would have a taxable gain in most cases. Generally, though the securitization can be structured in a way that does not result in such a deemed disposition by, for example, over-collateralizing the transfer to eliminate most of the downside default risk for the investors or agreeing to substitute additional receivables for ones that default. However, that could prevent true sale treatment for book purposes.
The developer, on the other hand, most likely cannot securitize its PPA/sublease receivable. First, the rent obligation may be partially or fully recourse and the head lessor typically would have a pledge from the lessee of its PPA/sublease receivable to secure the lessee’s rent obligation. Thus, the head lessor would have to consent and it likely would not do so, especially if the lessor still has debt service obligations secured by the lease receivables. Conceivably, if the leverage is limited in amount, the lessee could prepay enough rent to cover the debt of the lessor, but that could negatively impact the lessor’s IRR. The developer’s spread between the head lease rent obligation and its PPA/sublease receivable is typically not large enough to securitize separately. Thus, it would seem unlikely that the developer in such a sale-leaseback transaction could enter into a securitization or if it did that it would get much out of it.
On its face, a partnership between the tax equity investor and the developer as an entity could securitize its PPA/lease receivable. The partnership would sell its receivable to the SPV and receive the cash proceeds. However, that may not always be feasible. In such a case, the developer and tax equity investor would both have to agree to the securitization, since both parties are likely entitled to future distributions from the partnership. Assuming there is such an agreement, the securitization of the partnership receivables and the distribution of those proceeds by the partnership to the partners could be made in proportion to their expected share of future distributions.
However, a distribution to the tax equity investor of its share of the proceeds could create possible tax issues for the tax equity investor. The distribution of the cash proceeds could be taxable to the extent that it exceeds the partner’s tax basis in the partnership. If the transfer is not structured as a loan for tax purposes, there would be a taxable sale of the receivable.
In addition, if the developer actually or constructively contributed the receivables to the partnership upon formation, as in the usual case where the developer has entered into the PPA before the partnership is formed, and within a relatively short period of time receives the proceeds of the securitization as a distribution, the distribution might trigger gain for it with respect to that initial contribution to the partnership, even if the transfer of the receivable is otherwise treated as a loan for tax purposes under the disguised sale tax rules. As noted in Part II of this article relating to the timing of the securitization, that result might be avoidable depending on the timing of the securitization.
If the future distributions of the partnership from the PPA/lease receivable have been eliminated in the securitization (that is, if they have been monetized), it is unclear how the parties would determine any fair market value purchase option price to acquire the tax equity investor’s interest in the partnership. Typically, the fair market value of that interest would be determined by a discounted cash-flow analysis of those future distribution rights and any expected residual value allocable to the tax equity investor. If the distributions have already been made before the exercise of the purchase option, the purchase option price might be relatively small using that approach.
In the lease area, the courts have held that for tax purposes, parties must disregard any prepaid rent in determining a fair market value purchase price for the lessor’s interest. That case law would require that the purchase option price be set without regard to the terms of the lease, including prepayments, to avoid a compelling bargain or nominal purchase price for the interest being acquired. If it is not, the courts have found that the lessor was not the tax owner.
If that concept were to be applied to a securitized partnership transaction, the tax equity investor may be reluctant to participate in the securitization from a tax standpoint using that methodology, since it could put at risk its tax ownership. Instead of using a cash-flow analysis to determine the purchase option price, the purchase option price could be set at replacement cost, which would not take into account a discounted cash flow analysis of future rent payments, generally speaking. However, that could mean that the developer essentially is paying the tax equity investor twice for that portion of the value of the property equal to the net present value of the tax equity investor’s projected distributions.
If the developer does not want to agree to that calculation of the purchase option, the tax equity investor may not want to participate in the securitization. In that case, it may be difficult for the developer to proceed with the securitization of that portion of the receivables that would give rise to the developer’s future distribution rights. The tax equity investor may have preferential distribution rights that would prevent such a singular securitization. Even if the tax equity investor does not have preferred distribution rights, it may object to the developer securitization if the bank in essence has first priority to receivable receipts, thus essentially converting the developer’s distribution rights into preferred rights. It simply may not be viable to split the partnership receivable. Thus, in some cases, it may not be possible to do the securitization at the partnership level.
If it is not possible to do a securitization at the partnership level, the developer may consider trying to securitize its rights to distributions at the partner level; in other words, the receivable would be the developer’s share of partnership distributions. It is not clear in that case what if any concerns the Syndicate buying the receivable might have as a result of the fact that the seller does not own the underlying property of the partnership or the PPA/sublease. Conceivably, Syndicate legal counsel might raise concerns about the distance between the developer’s receivable and the source of the partnership income from a security interest standpoint.
In addition, if the securitization results in a transfer of full term rights of distribution, it may be necessary to consider what if any impact that might have on the status of that partner as a partner for tax purposes and what, if any, effect a loss of such status might have on the status of the partnership as a tax partnership and the associated tax allocations, for example, whether it could result in a termination of the partnership for tax purposes that could adversely affect the tax equity. Presumably, if the syndicating partner has a sufficient residual value interest that is not securitized (and in particular, if the syndication is treated simply as a borrowing for tax purposes by that partner), that issue can be overcome.
The tax equity investor likewise could securitize its partner-level rights of distribution, but in most cases, there may not be enough cash at stake for the tax equity investor for it to make sense to securitize it, given the limited rights to cash the tax equity investor typically has.
In a simple inverted lease without cross-ownership, the developer as head lessor should be able to securitize its rent receivable to the extent it has not been prepaid by the lessee tax equity investor. That would be very similar to a normal lease receivable securitization. It should not create any tax issues for the tax equity investor or require its consent. Even if that securitization were deemed by the IRS to result in a disposition of the tax ownership of the property by the head lessor, that should not result in any recapture of the tax credit passed through to the tax equity investor as lessee. The lessee tax equity investor most likely could not securitize its receivable from the offtakers given its obligation to pay most of its rent to the lessor.
In a more complex inverted lease, it may be possible for the developer as a partner in the lessee LLC that owns an interest in the head lessor could securitize that interest. However, that may not be easy since that lessee also has cash flow from the ultimate offtaker that is pledged to pay rent to the head lessor.
Thus, in summary, it may be possible for the tax equity investor to securitize a head lease receivable, and it may be possible for the developer to securitize its head lease receivable in an inverted lease or to securitize its partner level distribution rights in a partnership flip. Of course, a developer also could wait to securitize until it has purchased the tax equity investor’s interest, at which point it could securitize in the same way as other equipment owners with lease receivables. In the other situations, it may difficult for the parties to securitize their interests.
In Part 2, we will consider when to securitize and what issues the parties will face in determining how to securitize to avoid negative tax impact for tax equity investors still in the deal. It will also cover certain practical considerations in such securitizations.
This is part one of a two-part article series on solar securitization.
Richard Mull is a principal in the Washington National Tax Group of KPMG, LLP, resident in the Los Angeles office. He has previously served as an attorney on the Joint Committee on Taxation of the U.S. Congress, where he worked on energy credit, depreciation and leasing legislation, among other things.