At a time when traditional financing is difficult to attract - especially for riskier projects - developers are forced to think outside of the norm to obtain project financing. One strategy implemented in select renewable energy transactions over the past few years has been to fold New Markets Tax Credits (NMTCs) into the financing stack.
Introducing NMTCs to a transaction may account for approximately 20% of the capital structure. This additional capital could be the distinguishing factor between a project being financially viable and a project not achieving a financial closing.
Although the NMTCs are a useful tool in financing a project, the necessary structure can be quite complex, and the ongoing compliance may influence the project owner’s or operator’s decision-making and behavior during the seven years following the financial closing.
Generally, in order to use a tax credit, a taxpayer is required to be the owner or lessee of the tax-credit-generating asset. One unique aspect of the NMTC program is that the credit-generating asset is not the energy facility or other piece of property for which the credit-generating investment will be used. Instead, the credit-generating asset is an investment in an investor or lender - not just any investor or lender, but rather a community development entity (CDE).
Because the developer does not have to share in the control or the ownership of the project in order to participate in a NMTC transaction, the NMTC has become an interesting source of additional financing for projects located in areas of the country that qualify for NMTC investing.
The NMTC was codified in 2000 as Section 45D of the Internal Revenue Code and is administered through the U.S. Treasury Department’s Community Development Financial Institutions Fund (CDFI Fund). The general purpose of the NMTC program is to encourage investment in poorer communities throughout the U.S. The NMTC is awarded pursuant to a competitive application process in accordance with certain annual caps.
The NMTC is a 39% tax credit that is claimed over six years and one day with respect to a qualified equity investment (QEI) in a CDE. In general, assuming no event of recapture has occurred, on the date the QEI is made and on each of the first two anniversaries of such date, the holder of the QEI on each such anniversary date is entitled to claim a tax credit equal to 5% of the QEI amount, and on each of the subsequent four anniversaries of such QEI date, the holder of the QEI on each such anniversary date is entitled to claim a tax credit equal to 6% of the QEI amount.
The CDEs are able to make below-market loans/investments, because the NMTC investor is earning a substantial part of its return from the tax credits it is claiming on its QEI. For example, in a situation where an investor makes a QEI of $10 million, it will claim $3.9 million in tax credits over seven years. As a result, it does not need to earn a market rate of return on its $10 million investment in the CDE and is willing to permit the CDE to be more flexible with its investment.
A majority of the QEIs are leveraged, where the tax credit investor will make, for example, a $10 million QEI that comprises $3 million equity and $7 million debt. The tax credit investor will still be able to claim $3.9 million of tax credits, because the QEI is $10 million. As a result, the tax credit investor is not nearly as concerned about the strength of the CDE’s investment as it would be if it were contributing $10 million of equity.
In this leveraged structure, the QEI debt provider is very concerned with the CDE’s investment, however, as its $7 million loan is generally secured only by the investor’s interest in the CDE.
As a result, the CDE is required to loan or invest the $10 million to a special, qualifying business (QALICB) on terms sufficient to permit the CDE to earn and distribute to the tax credit investor income sufficient to pay the requisite debt service on the QEI debt. In most transactions, the CDE will structure its loan/investment to the QALICB such that the CDE will earn enough money annually to pay its operating expenses, including asset management fees and tax and audit expenses, and to make distributions to the tax credit investor for its debt service.
Using the above example, assume the QEI debt costs $490,000 (7%) annually, and the CDE’s operating expenses are $80,000 annually. Also assume that the CDE only invested $9.5 million of the QEI into the QALICB. The result is that the QALICB borrows $9.5 million and will be charged $570,000 annually, which represents an interest rate of 6%.
In addition to this savings of 1% annually, the QALICB typically will enjoy the benefits of paying interest only for the first seven years of the loan term and the ability to borrow other money senior to all or a portion of the CDE’s loan.
However, the NMTC is not applicable in all cases, as its structure has a few areas of concern that developers should be aware of as they decide whether the NMTC can help a project get financed.
Failure to address the details of the structure of a NMTC transaction early on can cause significant delays in achieving a financial closing, as well as result in increased legal and accounting fees. In fact, the consequences of failing to set aside time and resources for structuring a NMTC transaction could be the loss of one or both incentives.
These complex structures can be quite costly, so it is critical that developers account for these additional costs their your initial budget.
Not all areas of the country that qualify for NMTC financing have CDEs dedicated to investing in such areas. In addition to finding a CDE with NMTC allocation authority capable of being used to finance projects in a selected area, developers also need to find both an investor and leverage lender who understand the NMTC program and want to purchase the credits.