INTRODUCTION

Tax-exempt entities (such as non-profits, schools, and municipalities) frequently ask what financing options they have when purchasing solar systems given their inability to use the available tax incentives (ITC) and accelerated depreciation (MACRS).  It is important to thoroughly explore each of their options before choosing the financing model so that an option with the most favorable economics, risks and deal terms is chosen.  Legal and tax advice should be sought early in the process to understand all of the options available to them.

OPTIONS

Three main financing options exist for tax-exempt entities desiring to purchase solar and a fourth option is available to public entities.

1. Create Your Own Power Purchase Entity

A tax-exempt entity (or its donors) can create a for-profit Special Purpose Entity (“SPE”) that will own the solar system and sell the electricity produced from it to the tax-exempt entity in order for the solar tax benefits to be utilized.  To accomplish this model of financing, individual investors who want to help the tax-exempt entity join in a business enterprise to develop the SPE for the solar project, and thus, financing is achieved by member investments, grants and tax incentives.  Under this model, the SPE enters into a site lease agreement to keep its solar system on the tax-exempt entity’s roof or adjacent property.  Although the SPE must make a profit – for e.g., all electricity sold to the tax-exempt entity must be sold at a fair market value (“FMV”) – the tax-exempt entity can likely achieve better electricity pricing and overall terms than if dealing with a third-party developer.  For example, deal terms can include a minimum amount of profits, liability and risks, and optimum options to purchase and other terms can be included.

To make this type of financing model work, the SPE just needs one or more tax equity investors to meet the passive income rules – for e.g., the investors need a tax appetite from passive income (not salaries, etc.).  Conversely, the SPE can partner with a tax motivated investor to accomplish the financing if insufficient financial resources and tax appetites of the members exist via a flip structure or sale/leaseback.  In a flip, the SPE partners with the tax motivated investor in a new special purpose entity that owns and operates the project.  Most of the benefit flows to and equity comes from the tax equity investor until fully monetized (reaches agreed upon rate of return).  Then, the allocation of benefits and majority ownership flips to the SPE (minimum 5 years).  After the flip, the SPE can buy out the tax equity investor.  In a sale/leaseback, the SPE installs the solar system, and then sells it to a tax investor that leases it back to the SPE as a lessee.  The SPE is responsible for operating and maintaining the solar system and making lease payments to the tax investor (lessor).  The SPE might have the option to buy back the project (at FMV) after the tax benefits are exhausted.  These later two flip and sales/leaseback options are more complicated than if the SPE has sufficient member tax appetite, but important to consider.

This method of financing requires legal and financial savvy to set up as numerous legal, financial and tax issues must be navigated.  For instance, the tax-exempt entity needs to arrange for setting up and running the SPE (a business), raising capital, and negotiating contracts, such as between owners, site host, utility and shared benefits and management of the SPE.  Additionally, the tax-exempt entity should be prepared to spend time crafting the legal and financial aspects of the chosen business model.  An in depth discussion of every issue related to this financing model is not possible in this newsletter (or at least not attempted), however, a few of the main considerations are reviewed in the paragraph below.

Most of the financial issues that must be navigated for this type of financing model relate to the solar Investment Tax Credit (ITC).  For instance, to make use of tax credits or losses (from depreciation) requires taxpayers with significant taxable income.  Additionally, passive income investors can only apply the ITC to passive income.  The “passive activity rules” limit investors who do not “materially” participate in the business activities.  “At risk limitations” also apply as investors can only claim losses equivalent to their amount of risk in the activity.  Therefore, unless borrowers are personally liable for loans, “at risk limitations” will prohibit their ability to claim losses from the business activity.  Securities regulations also must be navigated.  To reduce the burden of securities compliance a private placement exemption to registration requirements is often sought, however, among other things this limits who can invest and how much such an offering can be conducted. Active and passive investor participation is okay.  For instance, the SPE can pass the benefits of the ITC through to participants, but only if participants have a tax appetite for passive income offsets or to the extent that they materially participate in the business.  Although the structure appears complicated, once successfully set up, the tax-exempt entity can have predicable discounted pricing, go-green and have the option to purchase the solar system before the PPA ends.

2.  Non-Profit “Donor” Model

Another financing option available to tax-exempt entities desiring to finance their solar system is the non-profit “donor” model.  Under this model, a separate non-profit is created to purchase and own the system.  Financing of this non-profit can be comprised of donor contributions, and the non-profit will subsequently donate the system to the tax-exempt entity.  Thus, supporters help finance the solar system through tax-deductible donations to the non-profit.  The non-profit created to own the system will also probably be eligible for grants and/or other sources of foundation funding even though it is not eligible for the associated tax benefits such as the ITC.  The non-profit can also obtain revenue from selling any Solar Renewable Energy Credits (RECs) either up front or over the life of the system.  A primary disadvantage to this model is that the tax advantages are less favorable than under a model that utilizes the ITC; for example, a $1,000 donation would only reduce taxes by $300 for a donor in the 30% tax bracket.

3.  Contract with an Existing Developer (PPA Company)

A third financing option available to the tax-exempt entity is to work with a third-party PPA company (“developer”) already established to make a profit on the applicable sale of electricity to its customers.  Several types of companies provide this service, including independent PPA companies as well as solar contractors with their own in-house PPA portfolios.  Under this model, an advantage is that the SPE entity structure is already set up and established.  Tax-exempt entity (and solar EPC contractor if not also the developer), however, must execute the applicable contracts on the developer’s terms.  These are often less favorable terms as compared to the above options, especially with respect to pricing, risks, and liabilities.  Additionally, the developer may or may not take the deal.  Another potential risk is the developer’s viability over time, and terms related thereto, although security agreements can be executed to protect the parties.  It is also important to consider that both the contractor and tax-exempt entity will have less control over items such as system component parts and system design and significant liability.

Although this model allows for a low initial investment, a commercial size solar system will still require significant legal fees negotiating the agreements.  The EPC and PPA negotiation can be long and costly, which is unfortunate given the tax-exempt entities’ limited control over project design, operations, risks, and suboptimal PPA pricing.  On the positive side, no operations and maintenance responsibilities are required, and this model usually provides a path to ownership per the terms of the contract with the developer.

4.  Municipal Bond – Power Purchase Agreement

A fourth financing option is available if the tax-exempt entity is a municipality.  This model is a hybrid PPA called the “Morris model” after the first county in New Jersey that utilized the approach.  Under this option, a municipality issues taxable bonds to finance a municipal PPA project.  After an RFP is issued, the public entity sells bonds to finance the development.  Subsequently, the public entity executes a lease-purchase agreement (making the developer the solar system owner for federal income tax purposes and the lessee for state law purposes) and a PPA for the purchase of electricity.  Since the public entity issues government bonds at a low interest rate, it can bargain for a better solar PPA deal than the developer would otherwise provide due to transferring low-cost capital to the solar developer.   The combination of PPA and bond financing is deemed by some as the break through to creating a workable financing model for solar projects. Although multiple factors affect whether this model can be adopted in certain states, California contains the necessary requisites for it to work.

Like a third-party PPA, the hybrid model enables the public entity to benefit through savings passed on from federal tax incentives, receive fixed electricity costs for a long-term contract, and have no operating and maintenance responsibilities for the solar system. By providing capital and assuming financial risk, the public entity has leverage to bargain for a better PPA price. While the public entity may not have full control over project details as in the other ownership models, the hybrid model allows public entities to negotiate project specifics and contract terms.

The disadvantages to this financing model include that transaction costs may be higher than under the other models. The state or local government must issue a bond and negotiate a PPA. That said, the public entity can include the legal fees and bond issuance costs in the development costs in the RFP.  Another factor to be considered is that the program development time can be lengthy from 4-5 months to over two years and the public entity needs “deep pockets,” meaning that its credit rating is strong and that it can assume additional debt. A strong credit rating (A–AAA) is needed to attract bond investors at a return that would enable the model. Finally, the deal structure adds an extra layer of liability for the public entity since it is liable to bond holders for bond repayment as well as the third-party developer for PPA payments. It is possible to negotiate specific terms with the developer to mitigate this additional risk.  For tax-exempt entities wanting to use the Morris model, the process takes the willingness to form partnerships across a range of agencies and experts in municipal bonds and contract law.

CONCLUSION

Thus, multiple financing options exist for tax-exempt entities that want to purchase solar and not miss out on the opportunity to benefit from the available tax incentives. Although a direct purchase of the solar system allows full control over the project, design, operations, and risks, and the ability to choose what to do with renewable energy attributes generated by the project (retain or monetize), the inability to take full advantage of all the potential tax advantages greatly increases project costs.  It is important to carefully consider all options before making a decision on the best financing model for tax-exempt entities.  Fortunately, through the creativity and dedication of people in the solar industry the array of financing options now existing for tax-exempt entities enables flexibility and choices.

The descriptions above are relatively simplified versions of the ownership/financing structures and may not include all options available to tax-exempt entities wanting to purchase solar.  None of the analysis presented here should be construed or relied upon as legal advice.

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