With the background I provided in part one of this article on safe harbors and tax credits — Solar Partnership Flip – Alive and Well in 2016: Part I — we can now look at the partnership flip and its relationship with the Internal Revenue Code (IRC).
The partnership flip is a business arrangement where the allocations of profits and losses are shared among the partners on a certain percentage basis for a period of time, and then shared on a different percentage basis after that period ends. These business arrangements have been used for decades in real estate partnerships.
For example, the most common arrangement in partnerships investing in low-income housing is for the primary capital investor to receive 99 percent of the profits and losses for a 15-year period and then for that investor to flip down to only 10 percent of profits and losses thereafter. Although, there is no section of the tax code that specifically mandates or even acknowledges a partnership flip structure, the IRS has acknowledged through Revenue Procedures, CCA Memoranda and the like that a properly-structured partnership flip works to shift most economic benefits, including tax benefits, to one designated investor (often called a tax equity investor), and post-flip to shift the economics back to favor the other investor (often called a cash equity investor or sponsor). In addition, there is support in the regulations under IRC §704(b) where the initial allocation lasts at least five years.
We know from Rev. Proc. 2007-65 that in a partnership flip involving a wind energy PTC, the tax equity investor may before the flip be allocated up to 99 percent of the income and deductions, with the cash equity investor receiving the remaining 1 percent or more. After a date certain (a “time-based flip”) or after the tax equity investor has achieved a target return on its investment (a “yield-based flip”), the allocations “flip” so that the tax equity investor receives 5 percent of the income and deductions with the balance allocated to the cash equity investor.
Under the safe harbor of Rev. Proc. 2007-65, the percentage allocations may vary provided that before the flip the cash equity investor does not receive less than a 1-percent allocation of the income and deductions, and after the flip not more than 95 percent of the allocation of income and deductions. That broad outline of the safe harbor rule set forth in Rev. Proc. 2007-65 is mirrored in Rev. Proc. 2014-12 for investment in historic property rehabilitations.
So, through Revenue Procedures, the IRS has acknowledged that a properly structured partnership flip works under the IRC to shift economic benefits, including tax benefits, to one designated investor, and post-flip to shift the economics back to favor the other investor; provided, however, that the cash equity investor has at least 1 percent pre-flip and not more than 95 percent post flip. If the percentage allocations give cash equity investors less than 1 percent pre-flip, then the taxpayer is no longer in the safe harbor and must argue the less certain position that it still fits within the legal requirements of §48 of the IRC to qualify for the Investment Tax Credit (ITC).
Revisiting Rev. Proc. 2007-65
The IRS stated in CCA 201524042 that Rev. Proc. 2007-65 “does not apply to partners or partnerships with § 48 energy credits.” Rev. Proc. 2007-65 dealt with a partnership flip structure in a wind project looking to benefit from the §45 Production Tax Credit (PTC). Viewed in the proper context, it is clear that the IRS is noting that Rev. Proc. 2007-65 addressed tax credits that fundamentally differ in their requirements from the ITC.
Its comment did not address the partnership flip structure, per se, but rather addressed the obvious fact that the Rev. Proc. 2007-65 dealt with a PTC under §45 of the IRC, and not the ITC favored by solar projects and found under §48 of the IRC. In other words, because certain technical aspects of the two tax credits differ in material ways, the IRS was alerting taxpayers that they cannot mechanically apply the requirements of one to the other — a critical warning given that IRS went on to conclude in CCA 201524042 that the taxpayer did not properly apply the requirements of the safe harbor outlined in Rev. Proc. 2007-65 to the solar transaction.
This finding is consistent with our earlier observation that those charged with interpreting or enforcing legal requirements, such as the IRS, approach precedent and other official interpretations of law cautiously. That is, legal conclusions are only valid for the specific facts analyzed, and any extension of those conclusions in other cases must be done so thoughtfully and carefully.
This reading of CCA 201524042 also explains why, after noting that Rev. Proc. 2007-65 “does not apply to partners or partnerships with §48 energy credits,” the IRS nonetheless went on to apply the fundamental principles of the partnership flip safe harbor requirements to the solar transaction in the CCA memo. Incidentally, those same safe harbor requirements are also the same ones applied by the IRS in Rev. Proc. 2014-12 for tax credits involving investments in the rehabilitation of historic properties, another tax credit found under §48 of the IRC. Unfortunately, the CCA Memo dealt with a complex solar transaction that clearly failed the requirements of the safe harbor, and so it does not offer the clarity and certainty that a case in which the IRS approved the taxpayer’s transaction structure would have.
Sophisticated and experienced tax counsel and tax equity investors have always understood CCA 201524042 in its context. At the Cost of Capital — 2016 Outlook Roundtable, hosted by Chadbourne & Parke in January, the Managing Director and Head of Renewable Energy at JP Morgan, John Eber, estimated that transaction parties invested over $5 billion in solar financings in 2015. At the same event, Jack Cargas, Managing Director of Renewable Energy at Bank of America, estimated that the leading finance structure of choice for 2015 was the partnership flip structure.
For these reasons, it seems safe to conclude that a solar partnership flip transaction involving energy investment tax credits under §48 of the IRC remains alive and well. That said, the real lesson from CCA 201524042 is that an investor must always look closely at the factual and legal basis underlying any precedent on which it relies, and consult experienced tax practitioners when faced with any uncertainty.