Expect the Inflation Reduction Act to drive major changes in investor, developer behavior: “This will make a big change in the way people think about investing in clean energy”

Edison Energy recently sat down with Judy Kwok, a Partner at Troutman Pepper, to discuss key tax provisions in the recently passed Inflation Reduction Act (IRA). Kwok’s practice focuses on federal income tax aspects of investing in onshore and offshore wind, and solar, among other types of renewable energy, as well as general M&A tax issues for the energy industry.

Intimately familiar with the unique perspectives of both developers and tax equity investors, Kwok has a deep technical and commercial knowledge of the complex tax issues and structured arrangements arising from renewable energy investments, including investment tax credit and production tax credit qualification, flip partnerships, repowerings, sale-leasebacks, debt-equity, and depreciation. She has written and spoken extensively on regulatory and legislative developments in the renewable energy tax arena.

Part I

The Inflation Reduction Act’s support for the clean energy sector is being lauded as a game changer that will reduce carbon emissions by roughly 40 percent by 2030, bolster domestic manufacturing, and provide direct investments for underserved communities across the country.

Key provisions around tax incentives are expected to drive large-scale deployment of clean technologies while boosting innovation, workforce development, and the creation of a robust supply chain.

“The legislation will make a big change in the way people think about investing in clean energy,” said Judy Kwok, a Partner at Troutman Pepper. “Going forward, the investment tax credit (ITC) and production tax credit (PTC) will strongly incentivize taxpayers to develop and invest in projects that have specific characteristics, including meeting thresholds for U.S.-produced components and being located in certain low-income communities or communities that historically are economically dependent on the fossil fuel industry. These incentives can have a major effect on developer and investor behavior because the potential increases in the ITC and PTC are very large.”

Domestic wins big

The PTC will increase by 10 percent, while the ITC will grow by 33 percent if developers meet domestic content thresholds for iron, steel, and manufactured products. Add to that the fact that manufacturers will receive their own refundable credits just for making their products in the U.S. and then selling them – a significant show of support for domestic manufacturers.

Kwok notes the impact that this advanced manufacturing production credit will have on U.S. solar panel manufacturers, who have been unable to keep up with China, where most solar panels are currently made. And, even when solar modules are assembled in the U.S., many of the subcomponents like PV cells and wafers are actually produced in China.

While 100 percent of all steel and iron in a project (for the ITC) or a facility (for the PTC) must be U.S.-produced, the domestic content threshold for manufactured products is 20 percent for offshore wind projects and 40 percent for all other projects. The domestic content enhancement applies to projects placed in service after 2022.

“This new legislation solidly shows support for U.S. manufacturers,” Kwok said. “This is a very significant development in particular for wind and solar. Not only is the use of U.S. equipment in renewables projects being incentivized through enhanced tax credits, but the government is actually going to pay U.S. manufacturers in cash, and that is a major development.”

Direct pay

Kwok is referring to the direct-pay provision, which would allow refundability of ITCs and PTCs only for certain tax-exempt and governmental entities but permit refundability for taxpaying entities for a handful of other credits, including the clean hydrogen production credit, the Section 45Q carbon sequestration credit, and the advanced manufacturing production credit.

“The legislation singles out those few credits for special treatment,” she said. “Any taxpaying entity or person – not just tax-exempt organizations – can receive cash from the government for these credits. This is particularly important for taxpayers that may not have tax capacity to use their credits.”

Direct pay, however, may not always be the answer for developers.

“Even if you, as a developer, are eligible for direct pay, the government does not pay you as soon as your project places in service,” Kwok said. “You can only apply for direct pay when you file your tax return for the following year – with still-undetermined rules for entities that do not file returns – and then you wait for the government to issue you a refund, which could take at least a few months, and perhaps longer.”

In fact, says Kwok, there is no bright line rule stating when the government must issue direct payments for ITCs and PTCs. This uncertainty and possibility of delay can steer some taxpayers away from direct pay, depending on their specific circumstances, including cost of capital.

Transferability

Another game changer is the “transferability” provision, in which the clean energy-focused credits eligible for the direct-pay election can also be transferred to an unrelated taxpayer in exchange for cash. The credit must be transferred by the due date of the transferor’s tax return for the taxable year in which the credit is determined. In addition, a credit cannot be subsequently transferred.
The transferability of the tax credits means that some taxpayers could decide to forgo tax equity financing transactions and monetize the tax credits simply by selling them.

“While the new transferability rules make it possible to monetize tax credits, deciding whether to use those rules, or to go with traditional tax equity structures, is potentially complicated,” Kwok said. “First, buyers of tax credits typically will do so only if they get a discount, and the size of that discount remains to be seen as the market starts to develop. Multiple drivers will determine the discount, including tax capacity of potential tax credit buyers.”

Those drivers also include risk allocation, which will potentially be affected by each potential buyer’s individual risk appetite. In other words, who will be left holding the bag if, for example, the eligibility analysis for the tax credits goes awry or if there’s an ITC recapture event, among other potential issues? Adding to the risk calculation is the fact that the mechanics of real-life clean energy tax credit transfers have not yet been tried and tested before the IRS.

As with the direct-pay provision, a lot will also depend on how long it will take for developers to get paid.

Transferability currently presents significant timing uncertainties, says Kwok, “because it is not clear when we might have a liquid enough market that a developer can obtain cash in exchange for expected tax credits as soon as the project is placed in service. Will credit buyers be willing to commit to buying tax credits before the taxable year is over and they have definitively determined their tax capacities? In a PTC situation, will credit buyers commit to buying tax credits for a full 10 years in the future? There will be a diversity of approaches to these questions.”

Kwok also notes that while you can transfer clean energy tax credits or, in some cases, get direct pay for them, you cannot transfer depreciation benefits. Moreover, many traditional tax equity financing structures permit investors to receive ITC and depreciation benefits based on the full FMV of the qualifying parts of the project, as opposed to the cost basis of ITC-eligible equipment, which is frequently lower.

“The depreciation benefits continue to be a source of value that a sponsor cannot monetize on its own, unless it has tax capacity in its own right,” she said. “If a sponsor cannot use the depreciation, it still needs a financing party to take the depreciation benefits and give them economic value.

It’s potentially complex, says Kwok, “because you have these different drivers affecting the decision of whether to transfer credits or, in some cases, take advantage of direct pay—the value of the depreciation and the FMV step-up, the timing of the credit transfer, and the discount on the credits—and everyone in their own specific circumstances values these drivers differently. We will see a broad range of responses to these new options.”

Stay tuned for second part of our conversation with Judy, which will dive further into key tax provisions in the IRA, including those around American labor, environmental justice, and new technologies.

Explore previous installments in our Pulse on Policy series.