Tax Issues

The tax system often is used to provide incentives for investments in certain types of projects the government wants to encourage, including wind power projects. These incentives raise tax planning issues that go well beyond those involved in general structuring, choice-of-entity, and other financing considerations, and create the potential for significant economic benefit. The available incentives also have been subject to frequent changes as federal and state energy policies have evolved. The following discussion is only a general summary and is current as of the date hereof. Please contact one of the attorneys listed above for answers to your specific legal questions and to check on any changes that may have occurred since the date of this publication.

FEDERAL INCOME TAX ISSUES

I. The Production Tax Credit. Section 45 of the Internal Revenue Code of 1986, as amended (“Code”), provides a credit against federal income tax for producing electricity from certain renewable resources, including wind. This credit is known as the “production tax credit” (“PTC”).

A. Requirements for Claiming the Credit. The PTC for wind power applies to electricity that is (1) produced at a qualified facility during the 10-year period that begins on the date the facility was originally placed in service and (2) sold to an unrelated person. Each of the following requirements must be satisfied for a taxpayer to qualify for the PTC:

1. Produced by the Taxpayer. The electricity must be produced by the taxpayer seeking to claim the PTC. If more than one person has an ownership interest in a facility, production from the facility is allocated among the owners in proportion to their respective ownership interests in gross sales from the facility. A partnership (including a limited liability company (“LLC”) that is treated as a partnership for federal income tax purposes) is treated as one person for purposes of this rule, which means that individual partners are not treated as owning separate, undivided portions of a facility that is owned by a partnership.
2. Qualified Energy Resources. The electricity must be produced from wind or another qualifying renewable resource.
3. Qualified Facility. The electricity must be produced by a facility located in the United States that is owned by the taxpayer claiming the PTC, is originally placed in service after December 31, 1993, and the construction of which began before January 1, 2022. A wind facility generally is considered to be “placed in service” for purposes of this rule when the facility is placed in a condition or state of readiness and is available to produce electricity. Each wind turbine that is capable of being separately operated and metered, together with its tower and supporting pad, is considered a separate “facility” for purposes of this placed-in-service rule. The Internal Revenue Service (“IRS”) has issued a number of notices—Notice 2013-29, Notice 2013-60, Notice 2014-46, Notice 2015-25, Notice 2016-31, Notice 2017-4, Notice 2020-41, and Notice 2021-41 (collectively, “Notices”)—that describe two alternative methods for a taxpayer to be treated as having begun construction in a particular taxable year. Under the first method, a taxpayer must have performed physical work of a significant nature during the taxable year and must maintain a continuous program of construction thereafter. Alternatively, under the second method, the IRS will consider construction as having begun if the taxpayer paid or incurred 5 percent or more of the total cost of the facility in a particular taxable year, and thereafter made continuous efforts to advance towards completion of the facility. The Notices also contain special rules describing circumstances under which the continuous construction and continuous efforts requirements will be deemed satisfied. Generally, the continuous construction and continuous efforts requirements will be deemed satisfied if a facility is placed in service (1) in the case of a facility the construction of which began in 2016, 2017, 2018, or 2019, by the calendar year that is no more than six calendar years after the calendar year during which construction of the facility began, (2) in the case of a facility the construction of which began in 2020, the calendar year that is no more than five calendar years after the calendar year during which construction of the facility began, or (3) in the case of a facility the construction of which began in 2021, the calendar year that is no more than four calendar years after the calendar year during which construction of the facility began.
4. Sold by the Taxpayer. The electricity must be sold by the taxpayer claiming the PTC to an unrelated person during the taxable year.
5. No Advance Approval Required. There is no advance approval requirement for claiming the PTC. A taxpayer that is entitled to the credit simply reports it on the appropriate form attached to the taxpayer’s federal income tax return.

B. Calculation of the PTC. The PTC for any taxable year during the credit period generally is equal to 1.5 cents, adjusted for inflation, multiplied by the number of qualified kilowatt-hours (“kWh”) of electricity produced and sold by the taxpayer during the year. For electricity produced and sold during 2021, the inflation-adjusted PTC amount was 2.5 cents per kWh.

C. Phase-out of Credit for Wind Facilities. The amount of the PTC calculated for each year is reduced by 20 percent in the case of any facility the construction of which began after December 31, 2016 and before January 1, 2018, 40 percent in the case of any facility the construction of which began after December 31, 2017 and before January 1, 2019, 60 percent in the case of any facility the construction of which began after December 31, 2018 and before January 1, 2020, and 40 percent in the case of any facility the construction of which began after December 31, 2019 and before January 1, 2022. Facilities with respect to which construction began on or after January 1, 2022 currently are not eligible for the PTC.

D. Disqualified Wind-Generated Electricity. Disqualified wind-generated electricity is not taken into account in computing the PTC. With certain exceptions, disqualified wind-generated electricity generally is electricity that is (1) produced at a wind facility that is placed in service by the taxpayer after June 30, 1999 and (2) sold to a utility pursuant to a contract originally entered into before January 1, 1987, whether or not the contract was amended or restated after that date.

E. Cutback for Government Financing. The amount of the PTC is reduced for facilities financed in whole or in part with certain government grants, proceeds of tax-exempt bonds, subsidized energy financing (financing provided under a federal, state, or local program designed to provide subsidized financing for energy conservation projects), or other tax credits. The IRS has ruled that certain state tax credits do not reduce the PTC.

F. Nonrefundable Credit. The PTC is a “nonrefundable” credit. If a taxpayer entitled to the PTC does not have sufficient income tax liability to use the entire credit for a particular year, the taxpayer is not entitled to a refund of federal income tax on account of any excess credit. Any unused portion of the credit generally may first be carried back one tax year and then be carried forward 20 tax years from the year the credit arose.

G. Sunset Date. As described above, to qualify for the PTC a taxpayer must have begun construction on the facility before January 1, 2022. The sunset date has been extended a number of times since Section 45 was first added to the Code (once retroactively after the PTC had expired for a number of months). Proposals to extend the sunset date are a matter of frequent discussion, and it is possible that the sunset date could be extended beyond the current deadline by future legislation.

II. The Investment Tax Credit. Sections 46 and 48 of the Code allow the owner of a qualified wind facility that is placed in service on or after January 1, 2009 and construction of which begins before January 1, 2022 to elect to claim the investment tax credit (the “ITC”) in lieu of the PTC. The ITC is a one-time credit against income tax that is based on the amount invested in a facility, rather than on the amount of electricity produced and sold. For facilities on which construction began before January 1, 2017, the amount of the ITC for a qualified wind facility is 30 percent of the tax basis (generally the cost) of the qualifying property that is placed in service during a taxable year. The amount of the ITC is reduced by 20 percent in the case of any facility the construction of which began after December 31, 2016 and before January 1, 2018, 40 percent in the case of any facility the construction of which began after December 31, 2017 and before January 1, 2019, 60 percent in the case of any facility the construction of which began after December 31, 2018 and before January 1, 2020, and 40 percent in the case of any facility the construction of which began after December 31, 2019 and before January 1, 2022. Facilities on which construction began on or after January 1, 2022 currently are not eligible for the ITC.

A. Requirements for Claiming the ITC. The ITC applies only to “energy property,” which is defined for purposes of a wind facility to include property that meets the following requirements:

1. Wind Equipment. The property must be equipment that is used to produce electricity from wind. The property must be (1) tangible personal property or (2) other tangible property (not including a building or its structural components) that is an integral part of the wind facility.
2. Depreciable or Amortizable. The property must be eligible for depreciation or amortization deductions for federal income tax purposes.
3. Qualified Facility. The property must be part of a qualified facility that is located in the United States, is owned by the taxpayer seeking to claim the ITC, and the construction of which began before January 1, 2022.
4. No PTC Allowed. The property cannot be part of a facility for which the PTC has been allowed.
5. Irrevocable Election. The owner of the property must make an irrevocable election to claim the ITC rather than the PTC.

B. Basis Reduction. The tax basis of property with respect to which the ITC is claimed is reduced for all tax purposes (including depreciation and calculating gain from a sale) by one-half of the amount of the ITC. Thus, for facilities the construction of which began before January 1, 2017, the initial tax basis of the qualifying components of a wind facility with respect to which the ITC is claimed generally will be 85 percent of the cost of those components.

C. Recapture of the Credit. The ITC is subject to recapture if, within five years after a facility is placed in service, the taxpayer sells or otherwise disposes of the energy property or stops using it in a manner that qualifies for the credit. The amount of recapture depends on when during the five-year period the property is disposed of or ceases to be used in a qualifying manner.

D. No Cutback for Government Financing. The ITC, unlike the PTC, generally is not reduced with respect to facilities that are financed in whole or in part with the proceeds of tax-exempt bonds, subsidized energy financing, or other forms of government-supported financing.

E. Nonrefundable Credit. The ITC, like the PTC, is a nonrefundable credit. If a taxpayer entitled to the ITC does not have sufficient income tax liability to use the entire credit in the year in which the project is placed in service, the taxpayer is not entitled to a refund of federal income tax on account of the credit. Any unused portion of the credit generally may first be carried back one tax year and then be carried forward 20 tax years from the year the credit arose.

F. Sunset Date. To qualify for the ITC, a taxpayer must have begun construction on a facility before January 1, 2022. See Section II above for an explanation of the “beginning of construction” requirements.

III. Depreciation. In addition to tax credits or grant payments, wind facilities also can generate significant tax losses that can be valuable to owners with other sources of taxable income that can be offset by the losses.

A. MACRS Depreciation. Qualifying components of a wind farm are eligible for greatly accelerated depreciation deductions under the Modified Accelerated Cost Recovery System (“MACRS”), typically over a five-year period based on the double declining balance method of depreciation.

B. Bonus Depreciation. An owner of qualifying property that is acquired and placed in service after September 27, 2017 and before January 1, 2023 generally is entitled to deduct 100 percent of the adjusted basis of the property in that year. For qualifying property acquired after September 27, 2017, an owner of qualifying property is entitled to 80 percent bonus depreciation for property placed in service in 2023, 60 percent bonus depreciation for property placed in service in 2024, 40 percent bonus depreciation for property placed in service in 2025, and 20 percent bonus depreciation for property placed in service in 2026. Bonus depreciation provisions expire for property placed in service beginning January 1, 2027. To qualify for bonus depreciation, property generally must have a recovery period of 20 years or less. Thus, property that otherwise would qualify for five-year MACRS depreciation, for example, generally will qualify for bonus depreciation.

IV. Monetizing Federal Income Tax Benefits; Ownership Structuring Issues. A taxpayer that has little or no need for tax credits or losses (e.g., because it has little or no taxable income) may nevertheless be able to benefit from various tax incentives by entering into an arrangement with an investor that can use credits, losses, or both. For example, a taxpayer could enter into a partnership with an investor that is willing to contribute cash to help finance a wind power facility. The partnership could then operate the facility and, within certain limits, the tax credits and losses could be allocated to the partner that can use them. In 2007, the IRS published guidance (Revenue Procedure 2007-65) establishing a safe harbor for structuring these partnership transactions. A number of specific requirements must be satisfied to qualify for the safe harbor. In the alternative, a taxpayer could develop a facility, place it in service, sell it to an investor, and then lease it back from the investor. This second alternative, known as a “sale-leaseback,” is available with respect to the ITC, but generally is not available with respect to the PTC. These and other potential techniques for “monetizing” tax credits and losses involve risk and require careful tax planning. These considerations should be taken into account in the very early stages of project development, including when choosing the type of entity that will own a facility and the various financing alternatives available. A comparison of the economic benefits of the PTC and the ITC requires, among other considerations, careful financial modeling of the projected costs and output of each specific project and of the full array of potential tax and financing implications. This should include careful consideration of any limitations that may apply to a particular owner’s ability to claim the available tax benefits, such as alternative minimum tax liability, at-risk limitations, and passive activity limitations.

STATE AND LOCAL TAX ISSUES

In addition to federal income tax issues, construction and operation of wind facilities also raise numerous state and local tax issues that should be carefully examined. Following is a general description of the types of issues that may arise, with selected examples. Developers and investors should be careful to obtain very current information about state tax in general, and state tax incentives in particular. States are generally narrowing their tax-based direct development incentives, either by interpreting existing law narrowly or by legislative change, sometimes with retroactive effect.

I. Net Income Tax States. The vast majority of states impose a net income tax. States generally base their income tax system on the federal system, and many states have adopted relatively uniform rules governing division of the tax base and computation of taxable income. Despite these similarities, however, each state’s tax system is different and must be separately analyzed.

A. Nexus, Business Structure, and Apportionment. Siting a wind project in a state generally will create “nexus” with the state and generally will allow the state to tax the income of the company that owns or operates the project. Less substantial activities, such as consulting, may create nexus with a state as well.

One of the most important decisions affecting state taxation is the type of legal entity used when starting a new project. Choices may include corporations (including S corporations and C corporations), LLCs, and limited partnerships. The decision can affect:

• Whether tax is imposed directly on the project company or on its owners; and
• Whether taxable income (or loss) is determined on a stand-alone basis or whether state tax will be measured by combining or consolidating the income of affiliates, including the parent company.

States generally measure the taxable income of a company by apportioning a percentage of overall taxable income to the state. The percentage is determined by a formula that relies primarily on gross receipts attributable to the state divided by gross receipts everywhere. An increasing number of states, including California, Oregon, and Minnesota, generally rely exclusively on gross receipts (“single-factor apportionment”), but additional factors such as property or payroll in the state may apply in some circumstances and are the norm in some states, including Montana. For purposes of attributing sales of electricity among different states, some states follow the traditional approach of sourcing the sale based on where the greatest proportion of income-producing activity related to the sale occurs. Other states may use different sourcing rules. For example, for Oregon apportionment purposes, sales of electricity by public utilities are sourced to the state where delivery occurs, as indicated by the parties’ documented agreement, while sales by nonutilities are sourced to the state of ultimate destination regardless of the place of delivery.

The choice-of-entity and apportionment rules can sometimes produce surprising results: if the company or group as a whole has taxable income, the company may owe tax to a state even if the activities in that state are not profitable on a stand-alone basis.

B. Income Tax Incentives. Some income tax states offer incentives to promote the development of wind power and other alternative energy projects. It is important to understand the nature of each incentive, as there is considerable variation among the states. Also, as noted above, some state incentives may reduce the amount of the federal incentives available for the project.

Hawaii, for example, offers an income tax credit for certain alternative energy systems, including wind systems. Hawaii provides a tax credit equal to the lesser of 20 percent of the cost of a wind system or $500,000 where the system is installed on commercial property for commercial use. The credit applies to the tax year in which the system is placed in service and it may be carried forward until exhausted.

Oregon formerly offered a similar investment-based credit, known as the Business Energy Tax Credit (“BETC”), for development of wind and other renewable energy generation projects. While legacy projects will continue to benefit from the BETC for several years to come, the program has been severely curtailed for new generation projects.

II. Sales and Use Taxes. Nearly all states impose a sales tax. In most states, the tax is imposed only on sales of tangible personal property. Some states also impose use tax on sales of certain kinds of services. In addition, some states impose a transfer tax on the sale (and sometimes the lease) of real property.

A. Purchase or Use of Equipment. Most states’ sales and use taxes will apply to the purchase or use of equipment within those states.

B. Generally No Sales or Use Tax on Sales of Power. Most states that impose sales and use taxes do not impose those taxes on sales or use of electricity.

C. Sales Tax Incentives. A number of states, including Washington, Colorado, and Nevada, have adopted an exemption or partial abatement from sales tax for machinery and equipment used in wind facilities. As noted above, some of these exemptions have recently been narrowed or are subject to sunset dates.

III. Property Tax. Virtually all states impose property tax that is assessed annually and is measured, in some fashion, by the value of real property. Most states also tax tangible personal property that is used for business purposes. Intangible property is taxable in some states if the owner is centrally assessed, as discussed below:

A. “Central” or “State” Assessment Likely. In many western states, such as Oregon, a company that produces electricity is “centrally assessed” for property tax purposes. Central assessment means that the taxable value of the property is determined by the state revenue authority rather than by the county assessor’s office. In Washington, central or local assessment depends in part on whether the company’s property crosses county lines. In California, a facility with a generating capacity of 50 MW or more may be subject to central assessment.

B. Valuation. States generally accept the three traditional valuation methods for valuing electricity generation property (cost approach, income approach, and comparable sales approach). However, if the property is centrally assessed, the state taxing authority may also be authorized to determine value by combining the property with other facilities owned or used by the same company. In that case, the taxing authority may aggregate property within and without the state, determine the value of the entire “unit,” and allocate some portion of the unit value to the taxing state by means of a formula. Determining the correct value of a particular project is a matter of frequent controversy. Industry efforts to obtain special valuation rules that take into account the unique aspects of wind power have been successful in some states, such as Colorado.

C. Property Tax Reporting. States typically require owners of centrally assessed property to file annual returns reporting the value of their property. It is good practice to consult a valuation expert before filing the first return with respect to the property, in order to accurately communicate on the return items that could result in tax savings in future years.

D. Rollback Penalties in Farm and Timber Use Areas. Many states impose property tax penalties when land that is used for farming or timber is dedicated to a different use. In addition to those penalties, property taxes may increase prospectively after the change of use. This issue typically arises when land leases are negotiated. It is best to address this issue as part of financial modeling.

E. Property Tax Incentives. As part of due diligence in constructing or acquiring a wind facility, it is worthwhile to inquire whether any property tax incentives are available. Property tax incentives can be particularly advantageous because property tax liability typically applies throughout the life of the project, and, in contrast to income tax, property tax is often highest in the early years before the project is profitable. For example, in Oregon it may be possible to obtain a temporary property tax exemption under the state Enterprise Zone Program or the Strategic Investment Program. The Enterprise Zone Program typically offers an exemption for three to five years, but in rural areas the exemption period may be as long as 15 years. To qualify, state law requires that the company increase its permanent, full-time employment within the zone by at least 10 percent. (Note that one employee may satisfy the minimum hiring requirement if the company has not previously operated within the zone.) Other requirements, such as minimum capital investment size, may apply. The Strategic Investment Program statutes offer a partial exemption for 15 years, with a fee payable to the county and other potential conditions. Negotiations for benefits under both the Enterprise Zone and Strategic Investment Programs generally occur at the county level, sometimes with participation of cities.

F. Taxes in Lieu of Property Tax. States may impose taxes in lieu of property tax. Minnesota, for example, imposes a wind energy production tax in lieu of property tax on wind facilities. The owner of a wind energy conversion system must report the annual production (in kWh) of the facility to the Minnesota Department of Revenue by January 15 of the calendar year following production. The Department of Revenue determines the production tax due and notifies the owner and county or counties where the facility is located. The owner of the facility must then remit the tax to the appropriate county or counties. The tax rate varies based on the nameplate capacity of the facility. In addition, a developer of a new or existing facility may be able to negotiate with the applicable county to establish a payment in lieu of the wind energy production tax based on production capacity, historical production, or other agreed-upon factors. Similar to Minnesota, Idaho imposes a wind energy production tax in lieu of property tax on wind facilities equal to 3 percent of the gross wind energy earnings, which are defined as the gross receipts of a wind energy generator from the distribution, delivery, and sale of electrical energy generated, manufactured, or produced by means of wind energy within Idaho to a customer for direct use or resale.

IV. Excise Taxes. When considering operation of a wind facility, state and local excise taxes also should be taken into account.

A. Washington Public Utility Tax. The state of Washington and a number of municipalities within Washington impose a public utility tax (“PUT”) on the privilege of engaging in certain utility businesses within the state and those localities. The state PUT is imposed at a rate of 3.8734 percent of gross income derived from certain enumerated public service businesses, including the “light and power business.” The “light and power business” is defined for purposes of the state PUT as “the business of operating a plant or system for the generation, production or distribution of electrical energy for hire or sale and/or the wheeling of electricity for others.” The state PUT is intended to apply only to revenues derived from the retail sale of electricity to consumers. Accordingly, deductions in computing gross revenues may be allowed for revenues derived from the sale of electricity for resale, among other deductions. The Washington business and occupation tax may also apply, depending on the specific activities that the business conducts. Cities and towns also may impose a local PUT or a local business and occupation tax, or, in some circumstances, both. Local rates can be substantial.

B. Other State and Local Excise Taxes. Other states and localities may impose other kinds of excise taxes. For example, California imposes a fee based on California-sourced gross receipts for the privilege of doing business as an LLC. Similarly, Nevada imposes a commerce tax based on gross revenue for the privilege of engaging in business in Nevada. In addition, some Nevada and California cities impose gross receipts taxes for the privilege of doing business in the locality. All potentially applicable taxes, including state and local excise taxes, should be carefully analyzed in determining the costs and benefits of operating a wind facility.