There has been a lot of talk recently about how expanding the use of publicly traded partnerships (PTPs) – or, more colloquially, master limited partnerships (MLPs) – to wind and other renewables could increase their financing options. MLPs have been a key investment tool in the oil and gas industries since the 1980s. However, expanding the availability of PTPs to renewable energy projects, by itself, will not be enough. Other, more technical changes are necessary in order for PTPs to even come close to fulfilling the wind energy industry’s expectations.
First, it is helpful to understand the environment in which the original PTP provisions were established. Congress enacted Internal Revenue Code (IRC) Section 7704 as part of the Omnibus Budget Reconciliation Act (OBRA) of 1987. OBRA was largely a compromise bill that contained both spending cuts and revenue increases intended to address budget deficits.
Beginning in 1981, the oil, gas and real estate industries, which historically had used partnerships as their preferred structure, began to take those partnerships public. Partnerships offer the advantages of a single level of tax and far greater flexibility in the allocation of profits and losses and the distribution of cash. Their disadvantage, however, had been the lack of limited liability (at least for the general partner) and the inability of partnership units to be publicly traded.
That began to change with Apache Oil in 1981. The trend developed in the oil, gas and real estate industries, but eventually expanded to include amusement parks, restaurants, hotels, casinos and even the Boston Celtics of the National Basketball Association.
The growing trend toward PTPs coincided with, and likely was accelerated by, the reduction in individual tax rates. Prior to 1981, the highest marginal tax rate on an individual’s unearned income was 70% – significantly higher than the top corporate tax rate of 46%. With the passage of the Economic Recovery Tax Act of 1981, that top rate for individuals was reduced to 50%. Five years later, with the enactment of the Tax Reform Act of 1986, the top marginal rate for individuals was reduced to 28%, while the maximum rate for corporations was reduced to 34%.
Therefore, the maximum rates for individuals and corporations were inverted compared to their rates prior to 1981. This made pass-through entities, with their single level of tax, far more beneficial.
By 1987, lawmakers had grown concerned that the inversion of individual and corporate rates, coupled with the expansion of PTPs, could spell the practical end of the corporate tax base. Section 7704 was the result.
Section 7704 provides a general rule that PTPs will be taxed as corporations, unless specific requirements are met. One of these requirements is that at least 90% of the PTP’s gross income be “qualifying income,” which is defined generally as income from the exploration, development, mining, production, processing, refining, transportation (including pipelines) or marketing of any mineral or natural resource (including fertilizer, geothermal energy or timber), or the transportation or storage of certain alcohol fuels and biofuels.
Unless they fell into one of the categories of “exempt” PTPs, existing PTPs were only excused from the application of Section 7704 for 10 years from the date of enactment. It is important to note that the 1987 legislation’s purpose was not to incentivize certain industries to take advantage of the PTP structure, although it eventually had that effect. Instead, Section 7704 was designed to prevent erosion of the corporate tax base by stopping the migration of entities to PTP status before that migration became a stampede.
MLP Parity Act
In 2012, Sens. Chris Coons, D-Del., and Jerry Moran, R-Kan., introduced the MLP Parity Act. The legislation expands the list of what can constitute “qualifying income” under IRC Section 7704 to include the income derived from “the generation, storage or transmission to the electrical grid of electric power exclusively utilizing any resource described in Section 45(c)(1) or energy property described in Section 48.”
In essence, income from any resource currently eligible for the production tax credit (PTC) or investment tax credit (ITC) would be qualifying income for the purposes of the PTP rules. According to Coons’ website, the legislation is intended to provide liquidity, fundraising advantages, limited liability and dividends in ways similar to corporations.
More technical changes are necessary in order for MLPs to even come close to fulfilling the wind energy industry’s expectations.
Coons also says the act would “level the playing field between traditional and new energy businesses” and could “unleash significant private capital into the energy market.”
Indeed, the legislation could have those results. Raising equity for renewable energy projects, many of which are small, is often like chasing rabbits without a net.
Equity for renewables comes in two buckets: real equity and tax equity. Real equity typically involves the investment in a straight-up ownership interest and competes in the marketplace against a myriad of different investment options. Tax equity, on the other hand, is a special type of investment that is generally limited to a few large corporate investors seeking to obtain tax benefits, such as credits and deductions, as the primary source of their investment return.
If renewable energy developers could raise capital in the marketplace via a PTP structure, investors – leery of investing in single projects or locking themselves into investments for lengthy periods – could view renewables in a very different light. Indeed, to certain investors, investments in PTPs provide advantages over traditional stocks.
PTPs typically attract investors seeking returns based on yield and cashflow rather than appreciation. Because of that perception in the marketplace, investors seek out PTPs because they are valued and trade more like a debt instrument than an equity, which can provide stability and value in an otherwise low-yield world.
For these reasons, the MLP Parity Act might be welcomed by investors and those seeking to raise capital. However, the legislation fails to address certain tax issues that could make the PTP mechanism cumbersome at best.
Not so simple
There are several existing tax provisions that would make renewable energy PTPs unattractive to certain types of investors and unwieldy for everyone else. Merely allowing renewables to take advantage of the PTP mechanism, as the MLP Parity Act does, would not resolve those issues.
To some extent, the renewable energy industry is dependent on government subsidies, such as tax credits and hyper-accelerated depreciation.
The tax-equity market has developed to permit renewable energy developers to take maximum advantage of those subsidies, even though the developers are unable to use the subsidies themselves or may derive less value from them than could be obtained through outside investors.
If the current tax incentives stay in place, investors seeking a yield or income-based investment may not be willing to pay a premium for such tax subsidies. To such investors, cash is king, and tax incentives are likely of secondary importance, if not irrelevant. Thus, the value of such incentives would not be maximized unless tax-equity investing were to continue. That would be problematic under the current partnership tax rules because tax credits generally must be allocated in a manner consistent with the way in which income (or loss) is allocated.
Moreover, the technical tax obstacles to a fully liquid investment in a tax subsidized industry could be staggering. PTPs are, by definition, partnerships, so the tax rules in Subchapter K of the IRC would impose many requirements that could have interesting effects on the market.
For example, assume a solar PTP is about to place in service a large solar facility qualifying for the ITC. IRC Section 706 would limit the credit to only those PTP unit holders who owned their units on the placed-in-service date, likely causing unit values to fluctuate markedly before and after. In addition, IRC Section 50 would impose a recapture tax if any of those unit holders were to sell their units within five years after the facility were placed in service. These issues would have a severe effect on liquidity and maximizing the value of the tax incentives.
Another impediment to making PTPs viable tools for renewable energy arises from the current limitations on the use of tax benefits by individual investors. The Deficit Reduction Act of 1984 provided the “at risk” rules under IRC Section 465, while the Tax Reform Act of 1986 enacted the infamous “passive loss rules” in IRC Section 469.
These statutes present significant hurdles for individuals (and closely held corporations) attempting to benefit from tax incentives such as the PTC, ITC or extremely fast depreciation. In the absence of an explicit exception in these rules for losses (and credits) derived from renewable energy projects, the pool of capital potentially opened through the MLP Parity Act would still be limited generally to corporate investors.
Coons and Moran have taken the first step: From a tax policy standpoint, the movement away from a classic corporate tax, in which a corporation is taxed separately from its owners, to an integrated system could be considered a positive development.
However, it is important to keep in mind that the MLP Parity Act is just a first step. Much more needs to be done to realize the full value of PTPs for renewables. w
Viewpoint: Project Finance
Master Limited Partnerships: Setting The Expectation
By Gregory F. Jenner
Is the growing chorus trumpeting MLPs as an investment vehicle for wind energy justified or does more work need to be done?
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