1. Lecture on Tax Equity

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

3. Standard Warnings 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 about complex cash flow waterfalls and how to make models flexible
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)

4. Some People Really Like Complexity
Lawyers Love it
Investment bankers who like complex things love it too
Harvard Students like it because it makes them look smart
Few people step back and ask about who is receiving economic benefits and why
Some People Really Like Complexity

5. What if you are not interested in the US
Turn off the video
Demonstrates efficient waterfall techniques and how people make models un-necessarily difficult
Set up of account to monitor the return on the project
Incorporate constraints using accounting data
Real question on constraints is the reduction in tax benefits from “Suspended Loss” and how these affect the timing of the flip in a yield based flip.

6. 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

7. Articles on Tax Allocation
Sources
Articles on Tax Allocation
Actual financial models
Accounting and finance theory

8. 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.

9. Introduction to Structure of Tax Equity with Yield-based Flip and Time based Flip

10. 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.

11. Tax Equity Partnership Structure
Off-taker
Tax Equity Investor
Sponsor Investor
Investment
Partnership that does not pay tax
Investment
Cash Distribution
Allocation of Taxable Income
Tax Equity Investor
Tax Equity Investor
Sponsor Investor
Sponsor Investor

12. Basic Yield Flip
Partnership diagram

13. 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.

14. Value of Tax Benefits in Renewable Projects
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).
Most developers have a hard time using the tax benefits. Therefore developers use “tax equity” where the benefits are effectively bartered for capital to build the project.
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.

15. Profit Share Does Not Equal Cash Share from EBITDA of Partnership
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 may get 99% of the taxable profit or loss before the flip (usually a loss). The tax loss reduces net corporate tax payments.
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.
Profit Share Does Not Equal Cash Share from EBITDA of Partnership

16. Organisation of Partnerships
The partnerships are organized as limited liability companies.
No income taxes at the partnership level.
Taxes are paid by the investors on their own corporate tax returns. 
A Tax Equity Investor receives the vast majority of the profits, losses, and 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%).

17. 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.

18. 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 % 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%.”

19. Explanation for Yields Above Interest Rates by Such a Wide Margin
The only explanation for the high yields is monopoly power of Tax Investors
Implies that the Value of Tax Deductions Accrues to Tax Equity Investors and Not to Consumers or Developers
Explanation for Yields Above Interest Rates by Such a Wide Margin

20. 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

21. Structure of Model without Tax Limitations

22. 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.

23. 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.

24. 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.

25. 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)

26. Demonstration of Multiple Flows and Computing Flip
Set-up the capital account with multiple flows and then adjust the MIN functions

27. 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.

28. 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 or The real contribution is 8.4.
A preferred distribution of 2% on 38.4 or .768 is the same as 9.14% yield.

29. Illustration of Time Based Flip
Time based flip involves beginning with time switch.

30. General Constraints from Negative Capital and No Investment in Partnership

31. 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.

32. 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.

33. 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.

34. 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.

35. 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.

36. 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.

37. 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.

38. 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.

39. 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

40. 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.

41. 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.

42. 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 The capital gains tax would be on $150.

43. 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.

44. 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.

45. 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

46. 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

47. 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.

48. 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

49. 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

50. Other Model
Please do not do this

51. Modelling Outside Basis Capital Accounts

52. There Must Be Meaningful Risks and Rewards to the Tax Equity Investor
The 5% of EBITDA and preferred dividend – are risks and rewards.

53. 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.

54. 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.

55. 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.

56. 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.

57. Issue of Suspend Loss and Timing of Flip Calculation
Alternative Calculations of Flip Timing:
Should the suspended loss affect the computation of the yield flip (by putting the cash flow from the suspended loss in the capital tracking account)
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.
Issue of Suspend Loss and Timing of Flip Calculation

58. Effects of Tax Rate Change
Tax rate change and one-time adjustment

59. Modelling Outside Basis
Include a basic capital account

60. 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.

61. Implications of Suspended Loss Issue
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 the flip, then there can be a difficult circular reference because the timing of the yield affects the distributions and the distributions 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.
Implications of Suspended Loss Issue

62. 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.

63. 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.

64. Capital Gains, Section 731 and Outside basis

65. 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.

66. 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

67. 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.

68. 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.

69. Capital Account for Tax Equity Investor on Book Basis (704(b))

70. 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.

71. 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.

72. Capital Account Illustration

73. Illustration of 704(b) Capital Account
Transfer
Tax Income Used

74. 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.

75. 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 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

76. Deficit Restoration Obligation

77. 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.

78. 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

79. DRO and 704 (b) versus Outside Basis
DRO does not apply to outside basis

80. 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.

81. 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.

82. 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.

83. 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 % 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.

84. Deficit Reduction Obligation Example
Note that DRO is equal to distributions
Stop loss allocations are the thing that are really costly

85. Hypothetical Liquidation at Book Value

86. 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.

87. 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.

88. Debt at Project Level

89. 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.

90. Minimum Gain
“Minimum gain” is a fancy term for a simple concept

91. 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.

92. Lease Methods

93. 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.

94. 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.

95. 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.

96. Lease
Lease

97. 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.

98. Inverted Lease

99. Basic Yield Flip
Partnership diagram

100. Effects of Tax Rate Change
Tax rate change and one-time adjustment

101. Hypothetical Liquidation at Book Value

102. Hypothetical Liquidation at Book Value
The HLBV methodology follows three basic steps:
sell the business,
follow-the-cash, and
calculate book earnings.

103. 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.

104. 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.

105. Example of Sale