Many American Indian tribes have been considering business opportunities in connection with solar projects. To date, most of the focus has been with respect to the siting of utility scale solar projects on tribal land in the desert. For instance, the Moapa Band of Paiute Indians have leased land on their Nevada reservation for a 250 MW solar project being developed by kRoad Solar.
A March private letter ruling from the IRS [available here] is likely to prompt American Indian tribes to consider owning solar projects and leasing them to tax equity investors, such as banks, that can claim a 30 percent federal investment tax credit and then return possession of the solar project to the Indian tribe at the end of the lease.
The primary tool of federal policy to promote solar renewable energy is tax incentives. In the case of solar projects, the incentives are a 30 percent investment tax credit and accelerated depreciation over five years. United States tax policy generally provides that entities that enjoy tax exemptions should not be able to benefit directly or indirectly from these types of tax incentives. In parlance of tax practitioners, this rule is known as the “Pickle Rule”; it is named after the sponsor of the provision, J.R. Pickle who was chairman of the Ways & Means Committee in 1982 when the rule was enacted.
America Indian tribes, unlike charities, do not enjoy tax-exemptions. Further, unlike state and local governments, there is no constitutional prohibition with respect to the federal government taxing them. Nonetheless, a series of long-standing IRS revenue ruling hold that federal income tax is not to be imposed on Indian tribes.
In light of the policy of the Pickle Rule and the fact that federal income tax is not imposed on American Indian tribes, no tax practitioner is known to have opined that investment tax credits were available to a tax equity investor that executed a renewable energy transaction with an Indian tribe. The recent IRS private letter ruling suggests that tax practitioners were too pessimistic in rendering advice to Indian tribes.
The Indian Tribe Private Letter Ruling
The private letter ruling holds that, for purposes of the investment tax credit, an American Indian tribe is neither a foreign government, an instrumentality of the federal or a state government nor a tax-exempt organization and, therefore, can elect to “pass through” the 30 percent credit associated with a solar project to a third party investor (as lessee). After this ruling, American Indian tribes are the only entities that are not subject to federal income tax that may do so. Therefore, they have a unique advantage as solar developers: they are not subject to federal income tax but may pass through tax credits to tax equity investors.
In the “pass through lease” structure referenced in the private letter ruling, the “lessee” is the tax equity investor (typically a financial institution). The lessee “shares” the economic benefit of the tax credit with the lessor (i.e., the American Indian tribe) through the rents it pays. Often substantial rents are due at closing, so that the lessor can benefit indirectly in the short term from the tax credit. Further, when the American Indian tribe accrues rent as the lessor, it does not have to pay income tax on it (in contrast to all other developers).
Normally, the investment tax credit is 30 percent of the solar project owner’s tax basis in the project. However, in the type of structure addressed in the ruling, the investment tax credit is 30 percent of the “notional” fair market value of the solar project (even though, neither party actually paid fair market value for the property). Typically, the parties will have an independent appraiser determine such fair market value.
If the lease is terminated in the first five years of the transaction, the lessee is required to “recapture” the investment tax credit by including certain amounts in taxable income. The amount to be included starts at 100 percent of the investment tax credit claimed and declines 20 percent a year.
In light of the recapture rule, the lease of a solar project needs to be at least five years, and some tax practitioners prefer longer to give the lessee a greater stake in the asset to justify the investment tax credit its claims. However, questions as to the validity of the arrangement as a lease for federal income tax purposes could arise in light of certain IRS ruling guidelines for leases, if the lease term exceeded 80 percent of the useful life of the project. Therefore, the lease term must be somewhere between five years and 80 percent of the project’s useful life.
Usually, the investment tax credit results in the basis of the solar project being reduced by half of the tax credit. However, in a transaction in which the lessee claims the investment tax credit, the lessee does not have a basis in the project to be reduced. Therefore, the Internal Revenue Code provides that the lessee must include in its taxable income 10% of the investment tax credit amount for each of the first five years of the transaction.
In theory, the transaction could have been reversed: the American Indian tribe could have sold the solar project to the tax equity investor and leased it back. However, under that structure, the lessor (i.e., the tax equity investor) would have been subject to slow depreciation rules for recovering the cost of the asset: straight-line over the greater of 12 years and 125 percent of the lease term. The depreciation rules reference property leased to Indian tribes as being ineligible for accelerated depreciation, but that concept is omitted from the investment tax credit rules. It is likely that the parties selected the lease pass through structure because they were able to optimize the rents in a way that resulted in better tax economics.
Implications for Subsequent American Indian Tribe Solar Transactions
As the March IRS ruling is only a private letter ruling (as opposed to a revenue ruling), it technically only applies to the taxpayer that requested it. For instance, an IRS agent is not precluded from auditing other taxpayers on the same issue addressed by the private letter ruling.
Tax equity investors are unlikely to be prepared to take the risk as to the transaction’s eligibility for the investment tax credit without the benefit of either their own private letter ruling or an indemnity, because the investment tax credit is too large a portion of their economic return to make an all or nothing bet with respect to eligibility for it. Therefore, Indian tribes considering transactions similar to that discussed in the private letter ruling will need to wrestle with the question of whether, without a private letter ruling, are they prepared to indemnify their tax equity investor? More cautious tribes may want to request private letter rulings for their transactions. The only drawback is that even a relatively simple private letter ruling can take the IRS a number of months to process.
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