The Mechanics of Tax Equity (Part Two)

Tax equity investing (also known as tax-oriented investing) originated as a means for financing low-income housing projects in the United States. The tax equity investor aims to extract tax credits and taxable depreciation losses from a project in order to reduce its own tax burden. In return, the project sponsor is able to effectively obtain a higher return on their investment by contributing less capital upfront. They do this by entering into a legal partnership which allows them to allocate tax benefits and income disproportionally between partners: an investor might put in only 30% of the equity but receive 99% of the tax benefits. The percent allocation of tax benefits and cash income to each partner is determined at the inception of the partnership.
This percent allocation may change through the life of the project. A common structure is to incorporate a yield-based flip, where the allocation of cash and tax benefits to the tax equity investor is substantially reduced once they have achieved a predetermined return on their investment.
It may not be desirable for either partner if the tax equity investor holds their stake in the project indefinitely. Projects often include a buyout option for the project sponsor to purchase the tax equity investor’s stake once tax equity has achieved their target return.
Anyone who has filed personal income taxes in the U.S. can appreciate that taxes are complicated. It’s fitting then that tax equity investing adds a significant amount of additional complexity to the traditional project finance model.  Mastering them begins with committing to the idea that all tax equity partnerships have to comply with federal tax laws. In order to ensure this compliance, a set of partnership capital tracking accounts is established.
Capital accounts keep track of how much value a partner has extracted from a partnership, and ensure that the total tax benefits do not exceed the threshold. The IRS wants to avoid situations where a partner invests a single dollar and in return receives millions of dollars of tax benefits.
There are two types of capital accounts: inside basis (also called 704(b)) capital accounts, and outside basis. At a high level, the inside accounts determine the allocation of tax benefits between partners, and the outside accounts determine how much of their allocated benefits a partner may use in a given year.
In a tax equity investment structure, the project produces cash benefits and tax benefits. These benefits are first filtered through the inside basis capital accounts to test for “over-allocation” of benefits to the tax equity investor. If found, some reallocations of benefits may occur. Next, the benefits are filtered through the outside basis capital accounts to determine the tax impact to the tax equity partner. Any excess losses are deferred to later years. To help visualize this “order of operations” in tax equity mechanics, we have included a simplified diagram. Note that both reallocations and loss deferrals reduce the return for tax equity – because they result in less efficient usage of tax benefits. Tax equity transactions are typically structured to minimize the likelihood or impact of these events occurring. 

Mechanically, the inside basis capital account starts as a positive number equaling the tax equity investor’s initial investment. This number declines over time as the investor extracts taxable depreciation losses and cash distributions from the project. Because the tax equity investor provides less than 100% of the capital t, and 100% of the project will be depreciated, eventually tax depreciation pushes the tax equity capital account to a negative number:  

From a tax standpoint, this would imply that the tax equity investor had extracted extra value from the partnership. This negative balance here would also require the tax equity investor to contribute additional capital if the partnership were liquidated. Under US tax code, this would result in some portion of tax losses and tax credits being taken away from the tax equity investor and given to the project sponsor. Shifting tax benefits to the project sponsor puts us in the same inefficient situation we started in – the project sponsor cannot use these tax credits effectively. To avoid this, tax equity implements a deficit restoration obligation (DRO).
The DRO is almost like a letter of credit or guarantee provided by tax equity. It is essentially a binding promise of additional capital available to cover any negative amount in their inside basis. Mechanically, it allows the inside capital account to go negative without reallocations, up to a point.
In practice, partnership liquidations are extremely rare, so the DRO’s practical purpose is to avoid reallocations of tax benefits to the project sponsor. DROs are usually sized such that no reallocation of benefits is projected to occur. Once tax benefits have been fully extracted from the project, the inside capital account balance is restored to positive through regular project income.
After any required reallocations are calculated, the outside basis capital account is used to calculate the actual tax benefits available to the tax equity investor. 
Mechanically, the outside basis capital account works similarly to the inside basis. It starts as a positive number that falls over time as the investor extracts taxable depreciation losses and cash distributions from the project. However, this account cannot go negative, and does not use a DRO. Instead, tax benefits that would drive the account negative are deferred to later periods when the project has income. 

These deferred benefits allow the tax equity investor to continue extracting benefits from the project for years after the project has stopped actually producing tax benefits.
This process of filtering project tax benefits through inside and outside capital accounts is then repeated in each subsequent period. Of course, only an accountant and lawyer know all the nuances in each deal, but this describes the mechanism. In part three, we’ll discuss some current challenges facing the US tax equity market.