II. Rev. Proc. 2007-65
More than a year after the release of Notice 2006, the IRS issued Rev. Proc. 2007-65. In the latter, the IRS provided that it would treat allocations in a partnership flip transaction as having a substantial economic effect as long as the arrangement was structured in the manner provided for in the revenue procedure.
A. Safe Harbor
Rev. Proc. 2007-65 established a safe harbor for partnership allocations of the PTC with respect to wind energy. The revenue procedure also stated that any allocations of the PTC that did not meet the safe harbor requirements would be ‘‘closely scrutinized’’ by the IRS. The safe harbor requirements as set forth in the revenue procedure are as follows:
• The project developer must maintain a minimum 1 percent interest in ‘‘each material item of partnership income, gain, loss, deduction and credit’’ during the life of the development project. An investor must maintain, at all times during which it holds a partnership interest, an interest in each material item of the partnership’s income and gain that is at least 5 percent of the investor’s percentage interest in the partnership’s income and gain in the year that the investor held its largest percentage interest.
• An investor must make a minimum unconditional investment by the time the wind energy production facility is placed in service equal to ‘‘at least 20 percent of the sum of the fixed capital contributions plus reasonably anticipated contingent capital contributions required to be made by the investor under the partnership agreement.’’ Although the investor must
maintain the minimum unconditional investment as long as it is a partner in the partnership, the amount may be reduced in some circumstances. The minimum investment amount does not take into account future required investments until the investments actually are made. The safe harbor prohibits an investor from arranging with the developer or another party related to the wind energy project for protection against the loss of any portion of its minimum investment.
• At least 75 percent of the sum of an investor’s fixed capital contributions and reasonably anticipated contingent capital contributions must be fixed and determinable and not contingent
in amount or certainty of payment.
• None of the developers, investors, or any related parties may have a contractual right to purchase any assets of the wind energy development project or an interest in the partnership ‘‘at a price less than its fair market value determined at the time of exercise of the contractual right to purchase.’’ Moreover, the project developer is prohibited from purchasing the production facility or an interest in the partnership until five years after the facility has been placed in service.
• The partnership is prohibited from having a contractual right to cause any party to purchase the wind energy production facility or any assets of the partnership, excluding electricity, from the partnership. Further, an investor is prohibited from having a contractual right to cause any party to purchase its partnership interest.
• No guarantee or insurance of an investor’s right to a PTC allocation is permitted. Thus, the partnership and the investors are required to bear the risk that the wind energy production facility would fail to generate any PTC. However, a guarantee regarding wind resource availability may be provided by an unrelated third party if the partnership or the investor
directly pays the cost of or premium for that guarantee.
• The allocation of the PTC must be in accordance with the partners’ interests in the partnership, as provided by reg. section 1.704-
1(b)(4)(ii). In addition to providing the safe harbor, Rev. Proc. 2007-65 also restated the IRS’s position in Notice 2006-88, providing that it would not rule on any issues relating to partnerships claiming the PTC.
B. Industry Reaction
The purpose of Rev. Proc. 2007-65 was to ensure that a partner in a wind energy partnership would be treated as a partner and not as a mere purchaser of PTCs. The safe harbor provided by Rev. Proc. 2007-65 was intended to ‘‘simplify the application of [section 45] to partners and partnerships that own and produced electricity from qualified wind
While some commentators welcomed the certainty provided by Rev. Proc. 2007-65, many in the wind industry were concerned about the rigid guidelines that had to be met in order to qualify for
the safe harbor. Two particular concerns were raised. First, the prohibition on fixed price purchase options was inconsistent with industry practice.
Second, practitioners questioned the IRS’s promised ‘‘close scrutiny’’ of transactions that did not conform to the safe harbor limited flexibility in negotiating the terms of partnership flip transactions.
Several industry participants submitted comment letters, arguing that the ‘‘close scrutiny’’ language rendered the safe harbor completely inflexible and therefore contrary to the purpose and spirit of a revenue procedure.93 In the comment letters, commentators pointed out that the safe harbor in Rev. Proc. 2007-65 sharply contrasted the approaches taken in other safe harbors provided by the Treasury and the IRS because they do not normally define matters of law and are not designed to be tools for tax enforcement. One letter even suggested that because the revenue procedure was more akin to a regulation project in its tone and purpose, it should be subject to revision after public comment. The commentators concluded that the revenue procedure would not provide comfort and encouragement to the industry and that its strenuous requirements instead would hinder wind energy farm development.
Many writers also expressed concern about the restriction on the use of buyout options in a wind energy partnership. The safe harbor requires that if one partner has a buyout option, the purchase price cannot be lower than the fair market value ‘‘determined at the time of exercise.’’ Although the IRS’s rationale for this restriction was not stated,95 it seems the agency was concerned about an investor divesting itself of the risk of holding an interest in a wind energy partnership by arranging an exit at a predetermined price. This theory is consistent with the prohibition in the safe harbor against the investor having the ability to put its interest to another party. However, unlike the investor’s put option, the investor’s buyout option does not give the investor direct control over whether the option is exercised. Rather, that power rests with the option holder, and whether the buyout option is exercised depends on the value of the investor’s interest at the expiration of the option. Thus, the investor still bears the risk of loss of its capital contributions and the investor’s return is subject to the performance of the wind energy project. In fact, a buyout option in favor of the developer or a related party guarantees the investor nothing.
In their letters, commentators argued that parties in a partnership flip structure need to be able to determine their potential risks and returns at the time the transaction is entered into. Thus, the buyout price must be set at the closing of the transaction, not when the buyout option is exercised. On this point, commentators noted that in the typical
wind energy partnership, the cash flows are determined by independent appraisal before the parties’ entry into the agreement, so setting a buyout price when the transaction is entered into is reasonable and generally based on reliable and mutually agreed on information.
In one letter, an energy company claimed that the buyout option limits the ability of partners in a wind energy partnership to efficiently plan an exit strategy and would therefore discourage investment in new renewable energy projects. The company laid out a detailed argument against the buyout option restriction, contending that the IRS has never issued a similar restriction on other partnerships — even in the context of tax credits — and that the restriction is inconsistent with many areas of tax law in which a taxpayer maintains a valid equity interest even though it enters into financial arrangements to reduce risk. In fact, both the IRS and the courts have confirmed the validity of partnerships in which one partner has the option to purchase another partner’s interest at a price below FMV. For example, in a sale-leaseback, in which the seller transfers property to a buyer who has income with which to offset tax credits and deductions and then leases back the property, courts have held that the buyer owned the leased property even though the seller held a fixed-price call option.