If you’ve been following our renewable energy client alerts, you know that we’re always looking for the larger implications of IRS announcements in the field. After the leading revenue procedure on production tax credits for wind, Rev. Proc. 2007-65, was announced, we speculated that many of its features, particularly the ability to “flip” an investor’s interest from 99 percent down to about 5 percent, would quickly spread to other kinds of tax credit transactions, even though, by its terms, the revenue procedure only applied to wind. Indeed, flips to 5 percent have become routine practice in many partnerships used in tax credit and grant transactions.

This brings us to the latest publication on the topic from Treasury, Announcement 2009-69. It updates and modifies Rev. Proc. 2007-65 in four ways, and we expect at least one of the rules of this announcement to spread to a broad range of transactions.

The four parts of Announcement 2009-69:

• It makes clear that 2007-65 is a “safe harbor” and not an “audit guideline.”
• It provides the ability to set a fair market value purchase price for the facility before the time of exercise.
• It assures that individuals with passive income from other sources can use wind credits to reduce their tax liability from those other sources.
• It makes clear that non-compliance with 2007-65 will not subject a transaction to “close scrutiny.”

The new rule about fair market value should get your special attention. In this announcement, Treasury has greatly eased the burden on structuring exit strategies for wind transactions, and, if our prior experience with wind rulings continues to apply, this may ultimately result in modified exit strategies for most other tax credit transactions as well.

What does the Announcement say about fair market value?

The announcement provides that the developer, the investor, or any related party may have a “contractual right” to purchase the wind farm, any property included in the wind farm, or an interest in the project company (i.e., the partnership or limited liability company that owns the wind farm) if the following requirements are met:

1. The contractual right must be negotiated for valid non-tax business reasons.
2. The negotiation must be at arm’s length by parties with material adverse interests.
3. The purchase price must be not less than “fair market value,” which is determined either:
   1. at the time of exercise, or
   2. at an earlier time, provided the parties reasonably believe, based on all facts and circumstances at the time the price is determined, that the price will be not less than fair market value at the time the right may be exercised.

In addition, the announcement keeps the rule from Rev. Proc. 2007-65 that does not allow the developer or a related party to have such a contractual right earlier than five years after the facility is placed in service.

Thinking about Announcement 2009-69

I intentionally parsed the fair market value test into several pieces to help us consider its implications.

First, there’s the requirement that the contractual right must be negotiated for valid non-tax business reasons. This requirement should be easy enough to meet. It’s hard to imagine a renewable transaction where, at the very least, the developer or the host would not like to regain sole control of the facility. From the investor’s end, having the ability to convert an illiquid partnership interest into cash also seems a valid non-tax business objective.

Second, the negotiation must be at arm’s length by parties with material adverse interests. If the negotiation were between the owner partnership and the host-user, this requirement should be easily met. The developer would be accepting a single payment (or an installment payout) in lieu of payments for the sale of energy, and the host-user would be seeking the opposite. Thus, the two have “material adverse interests.. However, by its terms, the announcement applies to a different group of people, i.e., the developer, the investor, and their related parties. When a buyout of the investor is involved, the argument may be a bit harder to maintain—the typical investor desires a set of tax benefits, and is then willing to withdraw. Indeed, it’s often the tax advisor who insists on “profit motive” or a minimum 5-percent interest based on Rev. Proc. 2007-65. Still, the investor does have an adverse interest—if it stays in the transaction, it should get a string of payments, and the IRS has already determined that a 5-percent interest is “sufficient.” So, even between the developer and the investor, negotiating a buyout for this right should be a negotiation between parties with material adverse interests.

Third, and here’s the most important part of the announcement, the parties can set the price in advance, if they reasonably believe it will be the future fair market value. Note that the announcement does not provide guidance as to “reasonable belief”—in particular, it doesn’t require a professional valuation. That’s not to say that a professional valuation isn’t a good idea, especially when a lot of money or tax credits are at stake, but it does indicate that the parties should be able to run a set of projections, showing a range of values of the purchaser’s future rights or obligations and then negotiate a price based on that analysis. For example, the projections might show what a host could expect to pay for electricity, or an investor might expect to get in distributions, determine an appropriate rate of return, and then present value the stream of projected payments or distributions to come up with a value, or at least the starting place for an “arm’s length negotiation.”

What are the implications of the announcement?

We should expect the announcement to lead to some important changes in how business deals are done. In particular:

1. Ability to set the price in advance. Of course, this is the key implication of the ruling, and the question is how far this rule might extend. While there continue to be places in the regulations and legislative history that refer to “fair market value at the time of exercise,” the announcement has changed the timing significantly, at least for transactions within its scope, i.e., wind production tax credit deals where a purchase right is held by a developer or investor.  Now, as noted earlier, the collateral question is whether this standard will migrate to other tax credit transactions, and to other parties. For example, if fair market value “reasonably” determined in advance works for wind PTC deals, then shouldn’t it also work for wind ITC deals (where the tax credit is 30 percent of the cost of the facility)? If it works for wind, shouldn’t it work for solar, biomass, or geothermal? If it works for a developer or investor, shouldn’t it work for a host of the project or purchaser of the electricity? After all, shouldn’t the definition of “fair market value” be the same, regardless of the kind of energy or the person exercising the purchase right?  Accordingly, we’ll be watching to see whether this safe harbor becomes a more universal standard.
2. Tax exempts and governments. If you’ve been a regular reader of our alerts or seen us speak at conferences, you’ve heard about the implications of Section 7701(e)(4) of the Code. That’s the section that distinguishes between leases and service contracts, and effectively provides a safe harbor from the “tax-exempt use” rules of the Code if four tests are passed, one of which is that the service recipient not have an option to purchase, or be required to purchase, all or part of a facility “at a fixed and determinable price (other than for fair market value).” This is a special area of interest under the “Set the Price in Advance” heading. If the rules of the new announcement apply to a Section 7701(e)(4) determination, then a tax-exempt user or a governmental user could have a pre-set option price, provided that price is determined in accordance with the rules described above. Obviously, this would be a major boon to the structuring of tax-exempt and governmental projects.
3. “Not less than” pricing. The announcement provides that the purchase price must be “not less than” fair market value. Because several tax rules require that the price be fair market value, tax advisors and their clients have worried about whether the seller can set a “minimum price” (e.g., one that guarantees a certain rate of return) that might be higher than fair market value. While many transactions are already using such prices, the announcement plainly allows them.

4. Calls vs. other purchase rights.[1] By virtue of amending Rev. Proc. 2007-65, the announcement only applies to “calls” held by developers and investors. But it’s hard to see why a call couldn’t also run to a service recipient. Furthermore, tax advisors have sometimes extended “put” rights to other people, provided the right is tied to fair market value.  In view of the announcement, should it be possible for a service recipient to have a call to acquire the facility, and the owner of the facility to have a similar put, each at a reasonable, pre-determined fair market value?

   Perhaps not. Because Rev. Proc. 2007-65 expressly doesn’t allow puts, this line of reasoning merits more thought. But it is hard to see why a fair market value methodology should be okay for calls, but not for other kinds of transactions.

   Of course, there are larger implications if the parties can assure a purchase and sale of the facility for a purchase price set in advance. This would go beyond mere puts and calls. For example, tax advisors have worried about whether providing a definite obligation to acquire property turns a service relationship into an installment sale. In other words, if the host buys electricity from the owner of the facility for five years, followed by a definite obligation to purchase the facility for a known price in year six, is this arrangement really a sale of the facility in the first year, with contingent payments in the first five years, followed by the final payment in year six? Similarly, if an investor is admitted to a partnership for five years, with a fixed exit price in year six, is this still a partnership relationship that entitles the investor to be allocated tax credits for the years when it’s a partner? Even under the announcement, these kinds of transactions appear problematic.

Now, as previously noted, it must be remembered that the Revenue Procedure and, therefore, the announcement are expressly limited to Section 45 production tax credits for wind facilities. This means that you should work with your tax advisor to determine whether a particular non-wind-PTC transaction should be structured in reliance on the announcement. Still, you have to wonder how the IRS will be able to provide a compelling argument as to why fair market value can be set in advance for these kinds of facilities and credits, but not others. Of course, the production tax credit, which is based on sales of electricity, has the potential to vary over the 10-year period of the credit, but that shouldn’t affect whether fair market value can be set in advance. Finally, each transaction should be structured and documented with care, to assure that the parties really are negotiating at arm’s length for non-tax reasons, and that their fair market value price is “reasonable.” We wouldn’t rule out using professional valuations, or at least valuation guidelines (for determining internal rate of return, and similar components of a valuation analysis), as the situation warrants.

1. To refresh the reader’s memory, a “call” is the right of a buyer to force the owner to sell, and a “put” is the right of an owner to force a buyer to buy.

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