PRODUCTION TAX CREDIT BASICSPRODUCTION TAX CREDIT BASICS

James F. Duffy, EsquireNixon Peabody LLP100 Summer StreetBoston, MA 02110-2131(617) 345-1129(866) 947-1697 (fax)jduffy@nixonpeabody.com

IPED

Financing Wind Power: The future of Energy

May 7-9, 2008

Scottsdale, Arizona

The Production Tax Credit

• The production tax credit (the “PTC”) under Section 45 of the Internal Revenue Code remains the principal federal incentive for wind production

• The following is a brief summary of the PTC, together with interpretations thereof, and Revenue Procedure 2007-65 (November 5, 2007) in particular

• Dollar-for-Dollar reduction in Federal income tax liability

• Under current law, the wind facility must have been placed in service prior to January 1, 2009 in order to be eligible for PTCs

Using the Production Tax Credit

• The PTC is currently (for 2007) 2.0 cents per kilowatt hour of electricity produced by the taxpayer and sold to an unrelated person, for a 10-year period beginning on the date the facility was originally placed in service

• So, the amount of tax credits depends upon the

amount of electricity generated

• The “Produced by the Taxpayer” requirement means that the owner of the wind project receives the PTCs

• So, you can’t just sell PTCs; you have to make the purchaser of the PTCs an owner of the wind project

• Most developers of community wind projects either: (i) do not anticipate having Federal income tax liability for the next 10 years such that they will be able to take advantage of the PTCs themselves, or (ii) need to monetize the PTCs up front in order to help pay for the costs of developing their project

• One option is that at or just before the date when a wind project is placed in service, the developer will sell the entire wind project to a purchaser who will then own the project and receive the PTCs

• Under this scenario, the value of the PTCs is one component of the total purchase price paid for the project

• Also, under this typical structure, the original developer generally gives up control of the project

• Particularly in a community project, the original developer may not want to give up control of the project, as the original developer is generally a part of the local community

• Section 45(e)(3) of the Internal Revenue Code anticipates that the owner of a project may have more than one owner

• Section 45(e)(3) provides that if a project has more than one owner, the PTCs will generally be shared by the owners in proportion to their respective ownership interests in the “gross sales” from the facility

Syndicating the Production Tax Credits

• The way to structure a transaction so that there is more than one owner for tax purposes is generally to use a limited partnership or a limited liability company

• For tax purposes, a partnership (which includes a limited liability company) is not recognized as an entity, so that the partners are treated as owners as to their allocable interests in the partnership

• The original developer can structure the legal owner of the project as a limited partnership or an LLC, and the investor who is interested in the PTCs can be a limited partner or member thereof and thus an owner for tax purposes

• The owner can then allocate almost all (up to 99%) of the PTCs to the investor

• The original developer can remain in control of the wind project by being the general partner of the partnership (or the managing member of an LLC)

• But, remember that the PTCs are shared between the owners in proportion to their shares of “gross sales”

• So, in my example the investor would have to have a 99% interest in the gross sales of the facility

• However, the developer could also receive a reasonable development fee for developing the project, and to the extent that there were insufficient sources of funds to pay that fee up front, some of it could be deferred and paid out of operating revenues

• In addition, the original developer, in its capacity as the general partner of the limited partnership, can receive a reasonable annual fee for managing the project

• Debt on the project could be paid prior to reaching the 99-to-1 sharing ratio

• Where the developer has contributed capital to the limited partnership to fund the gap between the total development costs and the amount of the investor’s capital contribution, under Rev. Proc. 2007-65 the developer’s capital contribution can be returned as a priority cash flow item prior to the 99-to-1 sharing ratio

• The developer could borrow outside the partnership to obtain this capital, generally pledging to the lender as collateral the developer’s interest in the partnership

• The investor’s payments can be characterized entirely as capital contributions to the owner limited partnership or they can be characterized partially or entirely as a purchase price for the investor’s interest in the owner limited partnership

• A simple syndication structure for a wind project is as set forth on the following slide

99%99%Limited Limited Partner Partner

(Investor)(Investor)

99%99%Limited Limited Partner Partner

(Investor)(Investor)

1%1%General General Partner Partner

(Developer)(Developer)

1%1%General General Partner Partner

(Developer)(Developer)

Limited Limited Partnership Partnership

(Owner)(Owner)

Limited Limited Partnership Partnership

(Owner)(Owner)

Wind ProjectWind ProjectWind ProjectWind Project

• Also, at some point after the end of the 10-year PTC period, there could be a ”flip” to give the general partner (the developer) a greater percentage interest (up to 95%) in the project’s cash flow

• And at some point after the 10-year PTC period (or after the investor has achieved a targeted IRR yield), the general partner/developer could have an option to buy out the limited partner/investor’s interest at its fair market value

• The investor’s payment can be made up-front, so that it can be used as owner’s equity in the development process, or to pay off development period financing

• The investor could pay most (up to 80%) of its funds on a pay-in schedule of up to 10 years, as PTCs are delivered (a “pay-as-you-go” plan), but at least 75% of the investor’s reasonably expected investment must be fixed and determinable and not contingent

• These are just general concepts. The terms of the syndication of the Production Tax Credits from each wind project will vary, based in part upon the economics of the particular transaction.

• Because of the sophisticated tax structuring involved, there will be not insignificant legal and accounting costs in each of these transactions, so it may not be as cost-efficient to syndicate the PTCs in this manner for smaller community wind projects, unless either (i) the investor is a community-oriented company willing to make a relatively small investment or (ii) a community wind project can be pooled with other similar community wind projects to provide a larger investment to cover the transaction costs

Wind Farm

D

Wind Farm

D

Wind Farm

C

Wind Farm

C

Wind Farm

A

Wind Farm

A

99%Limited

Partner(s)(Investor(s))

99%Limited

Partner(s)(Investor(s))

1%General Partner

(Investment Banker)

1%General Partner

(Investment Banker)

99%Limited

Partner(s)(Investment

Fund)

99%Limited

Partner(s)(Investment

Fund)1%

General Partner

A(Develope

r)

1%General Partner

A(Develope

r)

1%General Partner

B(Develope

r)

1%General Partner

B(Develope

r)

1%General Partner

C(Develope

r)

1%General Partner

C(Develope

r)

1%General Partner

D(Develope

r)

1%General Partner

D(Develope

r)Limited

Partnership A

(Owner)

Limited Partnership

A(Owner)

Limited Partnership

B(Owner)

Limited Partnership

B(Owner)

Limited Partnership

C(Owner)

Limited Partnership

C(Owner)

Limited Partnership

D(Owner)

Limited Partnership

D(Owner)

Wind Farm

A

Wind Farm

A

• In the model shown on the chart on the previous slide, each community wind project can be structured based upon its own economics and can negotiate its own business deal with the investment fund

• The investor does benefit from diversification of sponsor and wind regime, and perhaps off-taker, compared to an investment in one large project

• To keep down transaction costs, the same base documentation can be used as the starting point for each project

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• Facilitating these structures is an area where the states and public advocacy groups could be very helpful

• States and institutional non-profits have done this in the housing tax credit area

PTC POINTERS

• The PTC is reduced by up to 50% to the extent that project costs are funded by (i) federal, state or local government grants for use in connection with the project, (ii) the proceeds of state or local tax-exempt obligations, (iii) subsidized energy financing provided directly or indirectly by federal, state or local programs or (iv) other credits allowable with respect to any property which is part of the project

• For the first 4 years of the 10-year PTC tax credit period, PTCs can be applied to reduce the investor’s Alternative Minimum Tax

• Facilities are generally depreciated over 5 years (5-year MACRS)

• PTCs are received by the taxpayer as they are earned, so there is no recapture risk to an investor if the investor sells its PTC investment during the 10-year PTC period (this is an advantage over many other tax credits where there is a tax credit recapture risk if the investment is disposed of during the tax credit period)

• The amount of the PTC, currently 2.0 cents per kilowatt hour of electricity generated, is re-calculated by the IRS for each year of the PTC period of a facility (it was 1.9 cents per kilowatt hour for 2006)

Revenue Procedure 2007-65

• Revenue Procedure 2007-65 (effective November 5, 2007) gives guidance in structuring wind energy transactions

• By its terms, Rev. Proc. 2007-65 does not apply to geothermal, biomass and the other facilities eligible for PTCs

• This is a “safe harbor”, but be very wary of not following it

• In order to comply with Rev. Proc. 2007-65, the developer must have a minimum 1% interest in each item of partnership income, gain, loss, deduction, and credit throughout the term of the partnership

• Also, an investor’s interest cannot “flip” down to less than 5% of its initial interest

• Under Rev. Proc. 2007-65, there are no calls (developer’s rights to buy out the investor’s interest) in the first 5 years, and no puts (investor’s rights to require the developer to buy out the investor’s interest) at all

• Any calls must be for not less than the fair market value of the interest involved

• In order to comply with the Rev. Proc., as of the later of the project’s placed in service date or the investor admission date, the investor must have at least 20% of its total anticipated capital invested in the partnership

• Also, at least 75% of the investor’s capital must be not subject to adjusters

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