Lecture on Tax Equity

• Deficit Restoration Obligation (DRO)

• Suspended Loss
• Outside Basis Capital Account
• 731 (a) Adjustments
• Stop Loss Reductions in Taxable
Benefit
• Absorption
Crazy Arcane • Excess Cash Distribution
Terms • Hypothetical Liquidation at Book
Value
• Stop-Loss Reallocations
• Minimum Gain
• Deemed cash distribution
• 704(b) Capital Account

2
 • I am a student and not a teacher
• I am not a tax accountant
• I am not a lawyer
• I am trying to show you a few ideas
Standard about complex cash flow waterfalls and
how to make models flexible
Warnings • I use references including actual models
and quotations from documents. When
things are my opinion, I try to specify.
• If this video is torture or you are falling
asleep, then turn it off (unless you are
using it as a way to get to sleep)
 Lawyers Love it

Some
People Investment bankers who like
complex things love it too
Really
Like Harvard Students like it because it
Complexit makes them look smart

y
Few people step back and ask
about who is receiving economic
benefits and why
 • Turn off the video
• Demonstrates efficient waterfall
What if techniques and how people make
models un-necessarily difficult
you are • Set up of account to monitor the
return on the project
not • Incorporate constraints using
accounting data
interested • Real question on constraints is the

in the US reduction in tax benefits from

“Suspended Loss” and how these affect
the timing of the flip in a yield based
flip.
 Objectives of Video
• Demonstrate more complex modelling of tax
equity with yield-based flip and with constraints
on being able to use tax benefits by one party.
• Focus on the tax aspects that affect the IRR on the
tax equity investor and not on the book income or
other measures. Philosophical issue relating what
is really appropriate in financial models and the
desire of some to make things look complex.
• Concentrate on capital accounts of tax equity
investor and not of the partnership or the sponsor
equity
Sources

Articles on Tax Allocation

Actual financial models

Accounting and finance theory

 Modelling Ideas
• Before any modelling, understand the
economics of the transaction and, in
particular, how the constraints on taxable
income apply.
• Put in complex accounts with all of the tax
code items
• Then, simplify the complexities and
demonstrate efficient models.
 Introduction to Structure of Tax Equity
with Yield-based Flip and Time based Flip
 Creating a Partnership with Tax Equity Investor and
Sponsor/Developer

• The project company does not exist for tax purposes until
the Tax Equity Investor provides funds. Until then, it is
usually a limited liability company with only one owner:
the developer. I refer to the developer as the Developer
or the Sponsor.
• A partnership flip typically raises 40% to 70% of the
project value from the Tax Equity Investor. This depends
on the partnership sharing ratios and other factors.
• The Tax Equity Investor usually waits to buy into the deal
after it is already in service, except in solar deals where
the Tax Equity Investor will not be able to claim a 30%
investment tax credit on the project unless he is a part
owner before the project is in service.
 Tax Equity Partnership Structure

Off-taker
Tax Equity Sponsor
Investor Investor

Investment Partnership Investment

that does not
pay tax

Cash Allocation of
Distribution Taxable Income
Tax Equity Tax Equity
Investor Investor

Sponsor
Sponsor
Investor
Investor
 Basic Yield Flip
• Partnership diagram
 General Idea of Flip Structure
• Most renewable energy projects are funded by
a “flipping” partnership structure.
• The general form of such a partnership is an
arrangement between a tax equity partner and a
sponsor partner wherein the tax equity provides
much, if not the majority of the equity.
• A yield flip structure provides for a tax-free
cash sweep to the sponsor returning some or all
of the sponsor’s equity contribution in the
initial years of the project operations.
 • The US government offers tax
benefits on solar projects that are
worth roughly 56¢ per dollar of
capital cost (ITC or PTC plus PV of
Tax Depreciation).
Value of • Most developers have a hard time
Tax using the tax benefits. Therefore
developers use “tax equity” where
Benefits in the benefits are effectively
Renewable bartered for capital to build the
project.
Projects • Some tax equity investors price by
quoting an amount per dollar of
investment tax credit. The
amounts range from $1.10 to
$1.32 per dollar of tax credit. 14
 • The cash generated by the
partnership (EBITDA) can be
distributed to the partners in a
completely different ratio than the
profit or loss for tax purposes (after
depreciation). 
• For example, the Tax Equity Investor
Profit Share Does Not may get 99% of the taxable profit or
Equal Cash Share loss before the flip (usually a loss).
from EBITDA of The tax loss reduces net corporate
tax payments.
Partnership
• But the Tax Equity Investor gets a
minority of the cash generated –
EBITDA of the partnership. 
• Most of the operating cash (i.e.
without tax benefits) goes to the
Sponsor/Developer Investor and not
the Tax Equity Investor.
 • The partnerships are organized as
limited liability companies.
• No income taxes at the partnership
level.
• Taxes are paid by the investors on their
Organisation own corporate tax returns. 
of • A Tax Equity Investor receives the vast
majority of the profits, losses, and
Partnerships investment tax credits or production tax
credits from the partnership. (Usually,
but not always, 99%)
• Later, a flip occurs. The Sponsor Investor
gets the majority of them (usually, but
not always, 95%).
 Partnership Sharing Ratios
• In a yield based structure, the partnership
allocates taxable income and loss 99% to the
Tax Equity Investor until the investor reaches
a target yield (target IRR).
• After this, the Tax Investor’s share of income
and loss drops to 5%. The sponsor has an option
to buy the investor’s interest.
• In some transactions, the post-flip sharing ratio
has been 6% to 7%. Cash may be distributed in a
different ratio before the flip.

17
 Amazingly Bad Government Policy
• Cash Flow Sweep is the Safest Kind of Loan
• Interest Rates on Loans are 2-4%
• Banks have to pay taxes on loan interest, but tax equity investors
receive after tax interest
• “Target returns in the US tax equity market had dipped below 6%
unleveraged and after taxes. They are headed back up and are
currently in the mid-6% to low 7% range for one off wind and solar
photovoltaic projects.”
• “As of this writing, tax equity investors require 7.5-9.5% for
unleveraged projects.  This is the after-tax return to the tax equity
investor, net of its tax benefits.  The cash return to the tax investor and
cost of capital seen by the developer are lower.”
• “Utility-scale solar PV yields are 7.25% to 8% unleveraged for the
least risky deals involving the most experienced sponsors. Residential
rooftop solar for brand name developers is a little below 9%.”

18
The only explanation for Explanation
the high yields is
monopoly power of Tax
for Yields
Investors Above
Interest
Implies that the Value of
Rates by
Tax Deductions Accrues Such a
to Tax Equity Investors Wide
and Not to Consumers or Margin
Developers
Modelling Issue – Treatment of Real Tax Losses
when the Total Tax Allocations Cannot Be Used

The central tension in partnership flip

transactions is whether the tax equity
investor is truly a partner or is a bare
purchaser of tax benefits in substance.

If the equity capital falls below zero (named the outside

basis) then if the partnership is sold, the proceeds to the
investor would be zero. The investor has no money at risk
and cannot receive tax benefits. Here with zero capital, the
investor is a bare purchaser of tax benefits
Structure of Model without Tax
Limitations
 Modelling Time-based Flip and Yield-based Flip

• Time Based Flip is Pretty Easy

• Set-up switches for flip
• Understand tax deductions and cash flows
• Incorporating tax constraints involves working
through the tax rules
• Yield Based Flip is Not Too Difficult if:
• Set-up a tracking account like debt balance on sub-
debt with capitalised interest
• Set-up a cash flow waterfall that distinguishes
between pre-flip cash flows and post-flip cash flows
• Concentrate on the Tax Equity pre-flip cash flow to
determine the timing of the flip.
 Waterfall and Tax Equity – Assume 100% to Tax Equity Before
Flip and 0% After Flip

• Exercise with Basic Waterfall – Min Function

with Opening Balance Plus Capitalised Yield
at Flip Rate.
 Adjustments When Allocation Changes
• Need to compute the percent of period pre-flip. Use the Tax
Equity pre-flip dividends divided by the total basis to compute the
percent of the period.
 Modelling Yield Flip with Multiple Cash Flows

• There are at least two cash flows that occur to each partner:
• The first is a portion of the cash flow generated from the
partnership EBITDA
• The second is a portion of the tax benefits including the negative
taxable income and the ITC or the PTC.
• When there are more than two cash flows, then you cannot
use the MIN function on both of the cash flows at the same
time.
• Instead, you can make a waterfall and compute the MIN
adjusting for the previous distribution
• (e.g. compute the tax distribution with standard MIN function –
MIN(cash flow, opening balance + accrued capital charges)
• then, compute the operating cash flow with MIN(cash flow,
opening balance + accrued capital charges – distributions from tax)
 Demonstration of Multiple Flows and Computing Flip

• Set-up the capital account with multiple flows and

then adjust the MIN functions

26
 Fixed Flip
• In a fixed-flip transaction, the investor
receives annual cash distributions from the
partnership, equal to 2% of the tax equity
investment, ahead of all other cash
distributions.
• There is then a “waterfall” list of instructions
for how remaining cash is shared between the
sponsor and tax equity investor.

27
 Time Based Flip and Preferred Distribution
• Modelling the flip is easy – just use a switch. Note that cannot
model time flip and yield flip at the same time.
• The stated yield is misleading.
• Assume 30% ITC
• Assume a contribution ratio of 1.28
• Assume a 2% Yield
• The ITC is not really contributed so with a cost of 100 and the
contribution is 30 x 1.28 or 38.4. The real contribution is 8.4.
• A preferred distribution of 2% on 38.4 or .768 is the same as
9.14% yield.
 Illustration of Time Based Flip
• Time based flip involves beginning with time
switch.
 General Constraints from Negative
Capital and No Investment in Partnership
 Financial Modelling Theme
• You can show the cost of every pencil purchased
in a financial model.
• This may be ok, but then people understanding the
transaction may be confused with all of the pages that
are used to derive EBITDA and Capital Expenditures.
• Make sure you do not lose sight of what is important
for negotiating and for evaluating risks
• The same issue exists for tax equity – you can
show a whole bunch of accounts that just confuse
things. You need to find things that that really
matter and make sure users understand how the
things that matter really work.
 Items In the Capital Accounts
• Here is what one person on the internet said about financial models:
“Financial models should have monthly 704(b) capital accounts and
tax bases for each partner from financial close through project end that
incorporate the following key components:”
• Contributions / distributions
• Taxable income / (loss)
• Remedial depreciation 704(c)
• Minimum Gain
• Stop loss reallocation
• Excess distributions
• Deficit Restoration Obligation (“DRO”)
• Suspended losses
• Many of these things have nothing to do with like minimum gain, stop
loss reallocation and DRO may not affect cash flow and may just
create confusion.
 Calculation of Capital Accounts
• Capital accounts (equity balances) change in each
period. They go up and down each year to reflect
partnership results.
• After calculating the capital accounts, the model
should show the balance at year end in each partner’s
capital account. If you include both investors you can
balance the balance sheet – it is like minority and
majority interest.
• The next line should show the balance in the
“adjusted capital account.” It is the adjusted capital
account that cannot go into deficit unless the partner
has agreed to a deficit restoration obligation.
 Absorption, Capital Account, Outside Basis
• According to one commentator, “Almost all
partnership flip transactions have “tax absorption”
issues.”
• Each partner has two equity accounts:
• a “capital account” also known as 704 (b) and,
• an “outside basis” that uses tax depreciation
• These are two ways of measuring equity capital or
what the partner put into the deal and what it is
allowed to take out in benefits.
• Most tax equity investors run out of the tax based
outside capital account before they are able to absorb
99% of the depreciation.
 Capital Account and Outside Basis
• Each partner in a partnership flip transaction is
supposed to track two different equity capital accounts
related to its equity capital. These include the “capital
account” referred to as 704 (b) and “outside basis”
which uses tax depreciation.
• These equity capital accounts are different ways of
measuring what each partner invested and took out of
the deal in dividends and allocated income.
• If either capital account becomes negative, then it is a
sign that the partner took out more than the fair share.
• The capital accounts represent a limit on the capacity
of the investor to absorb tax benefits.
 Limitation on Both Capital Accounts
• Note that in the statement, the term “capital
accounts” is used in the quote below. This
implies that the capital account must be
positive for both accounts.
 Implications and Opinions about Capital Accounts

• Understand the difference between equity capital

accounts – book capital account called 704 (b) and
outside basis that uses tax depreciation in
computing income and capital.
• The only account that really matters is the tax equity
account – these accounts fall fast because of the tax
depreciation allocated to tax equity investors for this
account.
• The only thing that is important is the outside basis tax
equity capital account because (1) you cannot make
adjustments to change the account and (2) tax
depreciation makes that account fall down much faster.
 704 (b) and Outside Capital Accounts
• A partner’s capital account represents its relative
financial ownership of the partnership.
• Any equity capital account for a partner (investor)
starts with the cash paid to buy into the deal (i.e.
contributed to the partnership).
• Modelling the capital account is like modelling any
equity capital account – capital is increased by paid-in
capital and by income and it is reduced by dividends.
• For the partnership, pre-tax income after depreciation
must be computed to determine income. The income is
then allocated to the different partners in order to
compute alternative capital accounts.
Difference Between Capital Account and Outside Basis

• Outside basis is tax basis – it uses the taxable

income and accelerated tax depreciation.
• It does not have re-allocations.
• It uses tax depreciation
• No dividends recorded for tax value
• Includes ITC adjustment
• Capital account is book basis using fair value and
it may be adjusted by the DRO (explained later).
• Adjusted for ITC
• Uses FMV and Book Value not Tax Depreciation
• Includes re-allocation
 Focus on the Capital Account for the Tax Equity Investor

• Can compute the capital balance for all of the

investors, but it is really only the tax investor equity
balance that matters.
• The accelerated depreciation will cause losses for
the first few years of operation even though the
project generates positive cash flow. These losses,
plus reductions from distributions of cash, generally
drive tax equity’s capital account negative.
• It is the outside basis or the equity account for the
tax equity investor with tax depreciation where the
negative capital is most pronounced.
 Capital Account and Book versus Tax Income

• Uncertainty with respect to computing capital account

(the 704 (b) account).
• According to one source: “The income and loss that
are reflected in 704 (b) capital accounts are “book”
income and loss.” However, in various financial
models the 704 (b) the tax depreciation is used.
• According to the same source, “The “book” amounts
are not the same as what is reported on financial
statements. They are not the taxable income and loss
that get reported on tax returns, either.”
• Models I have seen use tax depreciation rather than
book depreciation.
 Capital Account Tracking for Outside or Tax Basis

• Accurate accounting for partnerships requires that

partners keep track of their capital accounts (704
(b)) and outside bases which is from the tax basis.
• A partner’s outside basis is the tax basis and uses
tax depreciation in computing income.
• To demonstrate the outside or tax basis, assume
that a partner has an outside basis of $350.
• Assume the partner sold its share of a partnership for
$500.
• In this case the partner would pay taxes on 500-350.
The capital gains tax would be on $150.
 Outside Basis
• A partner’s outside basis is a potential limit
on the ability of an investor to absorb tax
subsidies.
• Outside basis goes up and down each year in
the same way as capital accounts. Add
income. Subtract cash distributions and
losses allocated to the partner. However,
instead of using the “book” income and loss,
use taxable income and loss.
 Adjustment for ITC and PTC
• Taking a step away from partnerships,
IRC §50(c) says that an asset owner must
reduce the depreciable basis of any asset that
uses an energy credit (such as the ITC) by ½
the amount of the credit.
Illustration of Both Capital Accounts
Note that there is a re-
allocation in the first
case and not in the
second case.

In this case the

income is the
same in both
cases
 Example of 704(b) Account in Model
• In this model, there are many pages with
accounts like this. It is torture to work
through.
In this case, the income is
computed from tax
depreciation
 Example of Outside Basis
• In this case the outside basis includes a stop-
loss re-allocation. Imagine how many
accounts if this is for all
investors and inside basis
too.
 Illustration of 704 (b) Capital Account
• Note in this case the capital account uses
book depreciation and has capital re-
allocation.
Note use of book loss
and book income
 Illustration of Both Capital Accounts
• Note that in this case, there is no re-allocation
in the outside basis and the account is
computed on an annual basis. Account cannot
go negative
 Other Model
• Please do not do this
Modelling Outside Basis Capital
Accounts
There Must Be Meaningful Risks and Rewards to the Tax Equity
Investor

• The 5% of EBITDA and preferred dividend –

are risks and rewards.

52
 Suspended Losses
• Cannot allocate of losses in the outside basis.
Cannot drag the partner’s tax basis – the outside
basis -- below zero.
• Unlike for 704(b) (book basis) capital accounts,
these suspended losses are not reallocated to the
other partner. Instead they reduce the negative
taxable allocation.
• These tax losses are suspended and can be used
to offset future profits. You have to wait until
tax equity outside basis is positive – this can
have a big effect on the tax investor IRR.
 Suspended Loss and Carry Forward
• These suspended losses are carried forward
and can be used to offset future income when
the partner’s outside basis is positive.
• This is of course very costly to the tax investor.
• One question is whether this should modelled
at the partnership.
• For a time-based flip you do not even need to
model tax cash flow – only the taxable income.
• The reason for modelling tax cash flows in a
yield based transaction is for the flip timing.
 Problem of Suspended Loss
• The partners’ outside bases increase and decrease
in much the same way as their capital accounts.
• Unlike capital accounts, however, outside bases
cannot go below zero.
• Losses that would drive a partner’s outside basis
negative are suspended.
• Even if the tax equity investor does not care about the
size of its DRO and does not require the partnership
to reallocate any losses to the sponsor, its losses often
end up being suspended at some point due to this
limit.
 Implications of Limits on Outside Basis
• Only real concern is the tax equity account.
Other accounts – the developer equity
account and the partnership account do not
cause a constraint on cash flow from taxable
income.
• In a model, compute the suspended loss from
the outside or tax capital base for the tax
equity account.
• Don’t mess up the model with a whole bunch
of other accounts.
 • Alternative Calculations of
Flip Timing:
• Should the suspended loss
affect the computation of
Issue of
the yield flip (by putting
Suspend
the cash flow from the
Loss and
suspended loss in the
Timing of
capital tracking account)
Flip
Calculation • Or, should the suspended
loss be independent of the
yield flip calculation and
the adjustment for the
yield flip be computed
separately from the yield
flip calculation.
 Effects of Tax Rate Change
• Tax rate change and one-time adjustment
 Modelling Outside Basis
• Include a basic capital account
 Notes on Suspended Loss
• Constraint driven by tax depreciation and not
PTC
• Once negative, income above dividends
required to reverse the suspended loss.
• No tax calculations required to compute the
suspended loss – only taxable income.
 • Whether the suspended loss affects timing
of the flip is a matter for negotiation.
• If the suspended loss affects the timing of
the flip, then the flip is delayed which
benefits the Tax Equity Investor and harms
the Developer/Sponsor Investor.
• If the suspended loss affects the timing of
Implications of the flip, then there can be a difficult circular
reference because the timing of the yield
Suspended Loss affects the distributions and the distributions
Issue affect the suspended loss.
• Other issues are similar and could affect the
tax flow including:
• Changes in the tax rate
• NOL carryforwards of the tax investor
• Treating some dividends as taxable (731
capital gains) rather than excluding the
dividends from taxable income.
 Outside Basis and Suspended Loss
• Stepping up to such an obligation may
prevent losses from being shifted to another
partner, but it does not ensure the investor
will be able to use the losses fully.
• Even if he can keep the losses, his use of
them may be suspended if he does not have
enough “outside basis” to absorb them fully.
 Outside Basis and Excess Cash Distribution
• If the partner still has a negative outside basis
after converting all of the cash he was
distributed into an excess cash distribution,
then the model should suspend the use of any
losses the partner was allocated that year to
close the remaining gap.
• The partner keeps the losses, but he cannot
use them until a later year when his outside
basis goes back up.
Capital Gains, Section 731 and
Outside basis
 Negative Outside Basis Before Adjustment
• If the outside basis goes to zero:
• The model should treat the cash the partner was
distributed that year — to the extent needed to get
the outside basis back to zero — as an “excess
cash distribution.”
• This means the partner must report the distribution
as a capital gain.
• It is costly to be in such a position from a tax
perspective.
• When cash is later distributed to partners, it is not
normally taxed again. An excess cash distribution
is a form of double taxation.
 Section 731 Capital Gains
• Note that dividends are not generally taxable, but there
is an exception named Section 731 gains. Here, the tax
investor still receives dividends, but the tax investor
must pay taxes on these dividends.
• Cash distributions also decrease outside basis.
• Distributions that would drive outside basis below zero
create a form of income known as Section 731 gains.
• “Gain shall not be recognized to such partner, except to
the extent that any money distributed exceeds the
adjusted basis of such partner’s interest in the
partnership immediately before the distribution.”
• IRC §731
 Excess Distribution
• Excess Distribution - Whenever a partner
receives a distribution that would exceed its
outside basis or tax basis.
• In this case, the book basis or 704(b) capital
accounts are increased for the tax investor.
 Excess Cash Distribution
• If there is an excess cash distribution, then the model
should increase the “inside basis” — or basis that the
partnership has in the project— by the amount of the
excess cash distribution.
• The partners’ capital accounts should also be increased
by the same amount. However, the investor’s capital
account will usually increase by 99% of the excess
cash distribution if it occurs before the flip, and the
developer’s capital account will increase by only 1%
of it. The increase must bump up partner capital
accounts in the same ratio that a gain in the same
amount would have been reported by the partners.
 Capital Account for Tax Equity
Investor on Book Basis (704(b))
 Modelling Ideas
• Understand which capital account will really
cause the problem
• If book depreciation rather than tax
depreciation is used, the 704 (b) account
constraint will be much less important than
the outside basis account.
 Standard Book Capital Account or 704 (b)
• To compute: add to each partner’s capital account at
year end his share of income earned by the partnership.
• Subtract the losses he is allocated and cash he is
distributed.
• In other words, increase the capital account each year
as the partner suffers detriment;
• having to report income is a detriment (because taxes
will have to be paid on that income). Reduce the capital
account by the benefits the partner receives;
• being distributed cash or allocated losses is a benefit.

71
Capital Account Illustration
Illustration of 704(b) Capital Account
Transfer

Tax Income Used

 Stop Loss Reallocations
• This applies to the regular (i.e. not the
outside basis or tax basis) 704(b) capital
account balance. If the capital account shows
a deficit in excess of any deficit restoration
obligation, that loss would be ‘‘reallocated’’
to the other partner.
• The reallocated losses are also taken into
account in determining each partner’s share
of taxable income, which flows through the
calculation of the partners’ tax bases.
 Shift in Losses
• If losses shift in a year because of inadequate capital
account, then the shift will drag production tax credits
with it.
• Say net losses are supposed to be shared in a 99-1
ratio in favor of the investor. But the investor has too
little capital account in a year to absorb the full net
loss in that ratio.
• The result is that part of the loss shifts back to the
developer. Here the production tax credits will end
up being allocated that year in the actual ratio that
losses were shared (i.e., not 99-1).
• This is all harmful to the Tax Equity Investor
Deficit Restoration Obligation
 DRO Overview
• The main way to deal with absorption is for the tax
equity investor to agree to make a capital contribution
to the partnership when the partnership liquidates in
the amount of any deficit in its capital account.
• This is called a deficit restoration obligation or
“DRO.”
• However, a DRO does not help if the other measure
of what the partner has put in and is allowed to take
out — its “outside basis” — has also hit zero.
• Any losses (depreciation) shift to the sponsor once
the tax equity investor runs out of capital account.
 Re-allocation in Capital Account
• Say the Tax Equity partner has a deficit in the
adjusted capital account (704 (b)). And this
deficit in the account exceeds the deficit that
has agreed to be restored with the DRO.
• Then the standard partnership agreement
shifts any losses in the Tax Equity Investor
capital account that was allocated that year to
the other partners to prevent a deficit.
• Note that if the Sponsor has an NOL
carryforward anyway, this is not costly to the
 DRO and 704 (b) versus Outside Basis
• DRO does not apply to outside basis
 Deficit Restoration Obligation
• After expiration of tax depreciation, the
partners receive both cash and taxable
income.
• With a DRO, an agreement is made only to
contribute up to a fixed amount. The amount
is the amount of deficit that the model
suggests will reverse itself on its own under
reasonably conservative assumptions about
how the project will perform.

80
 DRO and Negative Capital Account
• DRO - One way of dealing with a negative
balance in 704(b) capital account is for the
partners to agree to a ‘‘deficit restoration
obligation,’’ or DRO.
• A partner that agrees to a DRO will have to
contribute cash to the partnership, if it has a
negative capital account when the partnership
liquidates.
• This is because a partner (the Tax Equity
Investor) that dips below the line essentially
‘‘borrows’’ equity from the other partner.
 Is the DRO a Phony Obligation
• A DRO is a real obligation, but it will not require
the partner to post any collateral.
• The capital account deficit represents the amount
of cash that the partner would be obligated to
contribute to the partnership upon liquidation.
• An investor typically caps the DRO it is willing
to step into at a fixed dollar amount, generally no
greater than 10 percent to 20 percent of its total
investment, although some developer investors
refuse to agree to any DRO.
 DRO Kicks in if Liquidated
• A DRO requires any partner with a negative
capital account to restore it to zero (via a capital
contribution) if the partnership is liquidated.
• Even though capital contribution is only made if
the partnership liquidates, tax equity investors
generally do not want any DRO to exceed 25-
50% of their initial investment.
• Therefore, tax equity will often require the
partnership to reallocate losses to the sponsor
once its capital account drops below a certain
level. This affects real tax payments.
 Deficit Reduction Obligation Example
• Note that DRO is equal to distributions
Stop loss allocations
are the thing that are
really costly

84
Hypothetical Liquidation at Book
Value
 Hypothetical Book Value
• Under HLBV, the partners assume the partnership is
liquidated at GAAP book value at the end of each
period. Then, they allocate the difference between the
sum of partners’ tax capital accounts and the amount
received from the liquidation to the partners’ individual
tax capital accounts according to a liquidation
preference waterfall that is part of the partnership
agreement.
• The result is the ending GAAP capital account for each
partner. Once the parties have their GAAP capital
accounts, they can use the change between periods,
with adjustments for cash distributions, to determine
their GAAP income for each period.
 Hypothetical Liquidation at Book Value
• Investors typically use a method called
Hypothetical Liquidation at Book Value
(HLBV) to determine book (GAAP) income
allocations for partnership flips.
• The traditional equity method of accounting
is not appropriate when shares of ownership,
income, and cash are different and vary over
time, as they do in partnership flips.
Debt at Project Level
 Debt at Project Level
• Having debt at the project level makes it
possible for the investor to absorb more
depreciation by allowing part of the
depreciation to be claimed even though the
investor has run out of capital account, and
the project-level debt causes the investor’s
outside basis to increase.
 Minimum Gain
• “Minimum gain” is a fancy term for a simple
concept
 Project Level Debt
• Project-level debt is unusual in the current
market. Most debt is back-levered debt at the
sponsor level that sits behind the tax equity in
priority of payment.
• In deals where debt is ahead of the tax equity
investors, the tax equity investors will insist
that the lenders agree to forbear from
foreclosing on the project after a default long
enough to give time for the tax equity
investors to reach their target yield.
Lease Methods
 Three Tax Equity Structures
• There are three main tax equity structures for
transferring tax benefits, with two significant
variations. The three are partnership flips,
sale-leasebacks and inverted leases.
• Yield-based flips in the solar market usually
price to reach yield in six to eight years.
Fixed-flip deals usually flip at five to six
years.
 Sale-Leaseback
• In a sale-leaseback, the solar company sells the
project to a tax equity investor and leases it back.
Unlike a partnership flip where the investor gets at
most 99% of the tax benefits and has to work
through complicated partnership accounting rules
to determine whether it gets even that much, all the
tax benefits are transferred to the tax equity
investor.
• The investor calculates them on the fair market
purchase price that it pays for the project. The solar
company has a gain on sale to the extent the project
is worth more than it cost to build.
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 Leases and Rent Prepayment
• A sale-leaseback raises 100% of the fair market
value of the project in theory.
• In practice, the solar company is usually required
to prepay something like 15% to 20% of the
purchase price as prepaid rent.
• The rent prepayment is treated as a loan by the
lessee to the lessor that is offset over the lease
term, but that accrues interest in the meantime.
• The market calls such a loan a “section 467 loan”
after the section in the US tax code that governs
the tax treatment.
 Lease
• Lease
 Inverted Lease
• Inverted leases are used mainly in the rooftop
market. Think of a yo-yo.
• The solar company assigns customer
agreements and leases rooftop solar systems in
tranches to a tax equity investor who collects
the customer revenue and pays most of it to the
solar company as rent. The solar company
passes through the investment tax credit to the
tax equity investor. It keeps the depreciation.
The solar company takes the asset back at the
end of the lease.
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Inverted Lease
 Basic Yield Flip
• Partnership diagram
 Effects of Tax Rate Change
• Tax rate change and one-time adjustment
Hypothetical Liquidation at Book
Value
 Hypothetical Liquidation at Book Value
• The HLBV methodology follows three basic
steps:
• sell the business,
• follow-the-cash, and
• calculate book earnings.
 HLBV Method
• The first step in the HLBV methodology is to
liquidate the business – hypothetically– at book value
and calculate any taxable gain on the sale.
• By definition, liquidation at book accounting value
does not create any additional book accounting gain
or loss. In other words, if the business were to be sold
in the market at its current value on the accounting
books of the partnership, the gain would be net zero.
• Thus, the aggregate net earnings of the business to
date are the same in the case of the hypothetical
liquidation scenario as it is in the base real-world
scenario to date.
 Liquidation
• Contrary to book accounting earnings,
however, the liquidation typically creates a
taxable gain. Most deals use accelerated
depreciation (e.g., five-year modified
accelerated cost-recovery system) and bonus
depreciation methods that lower tax basis
faster than book value –accounting books.
• This difference creates a hypothetical taxable
gain per the liquidation scenario, which is
especially large in the early years.
Example of Sale