Under current law, there are significant tax benefits for renewable energy projects in the United States. These benefits include nonrefundable ITC and PTC tax credits and depreciation deductions. From the perspective of a renewable energy developer, however, such tax benefits may be difficult to use effectively. Currently, ITC and PTC tax credits are nonrefundable, meaning that developers with tax liability lower such credit will face difficulties effectively utilizing such excess credit. Developers face a similar problem with depreciation deductions, as these will only operate to reduce taxable income. If a developer does not have enough taxable income to utilize these depreciation deductions, it will be difficult to effectively utilize such excess.
The difficulties developers face in effectively utilizing nonrefundable credits and depreciation deductions explain the prevalence of tax equity financing. Tax equity investors, which typically have much larger tax liabilities and taxable income, don’t face the same difficulties as developers in effectively utilizing nonrefundable credits and depreciation deductions. The IRS has provided helpful guidance on “partnership flip” structures that form the basis for tax equity investors to be able to claim and utilize such nonrefundable credits and depreciation deductions – which effectively allows developers to monetize such tax benefits even if they would not be in a position to effectively utilize them themselves absent a tax equity financing.
The direct pay proposal in the Build Back Better Act seems to promise to make it easier for a renewable energy developer to effectively utilize ITCs and PTCs. This has led some to wonder what effect the enactment of the direct pay proposal would have on the tax equity market. The remainder of this post will broadly sketch out such direct pay proposal and will recount some thoughts on the effect direct pay could have on the tax equity market recently published in an article by Brian R. Murphy, tax partner, and Dorian Hunt, managing director, at EY LLP.
The direct pay proposal would allow a renewable energy developer to elect to treat an ITC or PTC as a refundable credit. This would allow a developer with even no tax liability to treat the amount of credit as an overpayment of tax which would result a cash payment refund in the amount of such overpayment being made to the developer.
What effect will the direct pay proposal have on the tax equity market? Murphy and Hunt observe that many tax equity investors prefer to invest in large projects utilizing established technologies such as onshore wind and solar. This suggests that projects in which tax equity investors may have tepid interest (such as small projects or projects utilizing newer technologies) will certainly be good candidates for utilizing the direct pay election.
Murphy and Hunt also argue that certain types of credit may be easier to replace with direct pay than others. They explore the example of a PTC partnership flip structure. There, a tax equity investor would commonly provide significant capital upfront in exchange for a 10-year credit stream. They compare this to a PTC project that elects the direct pay option. Here the developer would not receive cash upfront, and Murphy and Hunt argue that this may not be a great fit for developers who are accustomed to paying off construction debt with tax equity proceeds early in a project’s life cycle.
Another limitation of the direct pay option analyzed by Murphy and Hunt, here compared to a traditional tax equity ITC structure, is that in such a traditional structure the project is often sold into the tax equity structure. This will lead to a step up in basis for the project and accordingly an increase in the ITC, which is based on the basis of such project. Murphy and Hunt point out that an ITC project electing the direct pay option may not benefit from this step-up in basis and thus will result in smaller credits.
Ultimately, Murphy and Hunt conclude that it is not clear what the impact of the direct pay option on the tax equity market will be and offer the possibility that it may not eliminate the tax equity market, but rather serve as an additional tool for developers to consider. Of course, the direct pay proposal has an unclear path to enactment and could change, perhaps significantly.
Stay tuned to the Emerging Energy Insights blog updates on any such changes. Contact Doug Jones or another member of Husch Blackwell’s State and Local Tax Team, Wind Team, or Solar Team for any tax-related questions you have.
 See Revenue Procedure 2007-65, 2007-50 IRB 967. This revenue procedure was issued in the context of wind projects and the PTC, but the guidance has been widely used by the renewable energy industry to apply the principals of such guidance to other technologies.
 See Tax Equity in a Direct Pay World, Brian R. Murphy and Dorian Hunt, Tax Notes Today, February 16, 2022.