Practitioners of US project finance in the late 1980s wistfully recall when corporations queued up to invest in leveraged leases of nuclear power plants, accepting much of their return in the form of tax benefits. Some transactions required a dozen lessors – which have more recently come to be known as tax equity investors – to fund a large deal. Indeed, if one corporate lessor demanded more favourable terms and conditions, others were prepared to take its place. Yet today corporate tax appetite is scarce.

By July 2011, a renewables industry group estimated there were only 15 tax equity investors active in the market. The number of investors increased in the year after that, but it remains under 30, and financial institutions predominate. And the market is fragmented, such that some invest in wind but not solar; within wind and solar, investors often prefer specific manufacturers. Similarly, players each have specific structures: some prefer leases, others prefer partnerships; and few want to be subordinated to a secured lender. The result: demand outpaces supply. The industry trade group estimates that in 2012, the demand for tax equity would be $7-10 billion, at least double the available supply of $3.6 billion.

At least seven factors have combined to squeeze the US corporate tax bas base: globalisation, employee stock options, the domestic manufacturing deduction, the mortgage crisis, check-the box regulations, the growth of master limited partnerships and bonus depreciation.

Public corporations are the primary candidates for tax equity investments, thanks to the Tax Reform Act of 1986. That act limited the ability of individuals and closely held corporations to use tax credits and other tax deductions to offset income from their occupations, businesses or their investment portfolios. Entities taxed as partnerships pass their tax attributes through to their partners. If those partners are individuals or closely held corporations, the same limitations apply. Thus under current law, public corporations, in most instances, are the only viable tax equity providers.

Globalisation

Increased global commerce has led to a reduced US corporate tax base for at least three reasons. First, if a corporation’s global operations meet a set of complex tax rules, then no US tax is due on the earnings of such operations until the cash associated with those earnings is repatriated to the US. In the last 25 years, these rules have become more flexible, particularly in terms of financial services activity. This flexibility expanded the opportunities for corporations to generate foreign earnings for financial statement purposes without US tax. Since 2006, US corporations have accumulated $1.2 trillion of earnings that have been left abroad without triggering US tax, according to an estimate from Goldman Sachs.

Second, there has been an increase in the use of foreign tax credits. When US corporations do bring their foreign earnings to the US, those earnings typically have been subject to tax in the foreign country in which they arose. In order to avoid double taxation, the US provides a foreign tax credit, generally equal to the taxes paid abroad. For instance, $100 of profit earned in Indiana generates $35 of federal tax liability, whereas $100 of profit earned in Ireland generates just $22.50 of US federal tax liability (which includes a 12.5% Irish tax rate).

The third reason is transfer pricing. The US has a relatively high corporate income tax rate; therefore, in transactions between a US corporation and a foreign affiliate, the logical tendency is to shift expenses (i.e., tax deductions) to the US corporation, which will enjoy a deduction at 35% and shift profit (i.e., taxable income) to the foreign entity taxed at a rate that is almost certainly less than 35%, such as the 12.5% in Ireland. The transfer pricing rules in the Internal Revenue Code require transactions between a US entity and its foreign affiliates to be at arm’s length, but there is enough variation in length of the arms of tax planners to still allow for some tax optimisation, which generally means less tax revenue for the US.

An economics professor estimates that the execution of these three strategies in 2008 saved corporations $90 billion – money that otherwise would have reached the US Treasury. That $90 billion translated to 30% of corporate tax revenue in the US. This is reportedly up from a mere $60 billion in 2004.

Stock options

In the 1980s, employee stock options were relatively exotic and enjoyed by a precious few. But since then, stock options have become ubiquitous. Several forces coalesced to expand the use of stock options. First, in the early 1990s, stock options became a mainstream compensation technique: executives were expected to have their interests align with shareholders by receiving a substantial portion of their compensation through stock options. Second, in 1993, Congress capped the deduction for executives’ compensation but provided an exception for stock options. Further, the financial statement treatment of employee stock options has produced a valuable benefit relative to the tax treatment of stock options. The corporation/employer has a GAAP expense equal only to the stock options’ fair value at the time of issuance, which is generally determined by applying the Black-Scholes formula; if the option is issued at the then-share price, the fair value of the option is often minimal. In contrast, the corporation/employer is entitled to a tax deduction when the employee exercises the option, and the tax deduction is equal to the economic value of the option to the employee.

The overall tax deduction may therefore be many times the overall GAAP expenses, a benefit that chief financial officers prize extremely highly. According to The New York Times, Apple reported that options had cut its federal income tax bill by more than $1.6 billion from 2005 to 2008, while Goldman Sachs and Hewlett-Packard reduced their federal tax bills by $1.8 billion and nearly $850 million, respectively, over that same period.

After the Facebook initial public offering in May 2012, ambitious tax equity arrangers planned trips to Menlo Park, California, to pitch its chief executive officer, Mark Zuckerberg. After consulting Facebook’s financial statements, they reportedly discovered that it already had claimed a $16 billion tax deduction for employee stock options, entitling it to a $500 million tax refund related to 2010 and 2011 and reducing its taxes to zero in 2012 and in an unspecified number of future years.

Domestic manufacturing deduction

The domestic manufacturing deduction (DMD) was enacted in 2004 to replace an earlier tax benefit for exports that the World Trade Organization found to be an impermissible export subsidy. DMD is not limited to exports and provides a deduction generally equal to 9% of eligible taxable income. This is equivalent to reducing the corporate tax rate from 35% to less than 32% for eligible taxable income.

Eligible taxable income is broadly (but at times oddly) defined. For instance, Starbucks is eligible to claim the benefit on roasting coffee but not on its retail sales. Further, if you think the citizens in Hollywood have little in common with the citizens of Detroit, you would be mistaken; Congress has deemed making movies to be manufacturing for DMD purposes, so long as they are not pornographic. Most corporations qualify for DMD to some extent, other than corporations in the services industry or those that provide consulting or financial services. Not coincidentally, the leading remaining players in tax equity are banks.

The mortgage crisis

But the financial services industry’s rise to dominance in the market has not been completely smooth. Up until 2008, the industry was a reliable provider of tax equity. But the mortgage crisis substantially eroded the tax appetite of the financial services industry. Lehman Brothers disappeared. AIG has carryforward tax losses that have no clear end.

JP Morgan, Bank of America and Wells Fargo each acquired troubled institutions that carried large tax losses, while Citigroup’s books were laden with homemade mortgage and derivative losses. They have each re-entered the tax equity market, but with less fervour than they had in 2007.

Check-the-box

The 1997 check-the-box tax regulations provided taxpayers with the gift of being able to form a company that shields its owners from personal liability, but without the corporate income tax that had previously generally been the price of a corporate veil. Since 1997, the only reason to have a US entity taxed as a corporation is to have its shares publicly traded.

Master limited partnerships

Even many publicly traded entities are spared the imposition of corporate income tax. The growth of master limited partnerships means that many types of businesses can be publicly traded without being subject to corporate income tax. To qualify for this corporate income tax exception, 90% of the gross income must derive from one of the following: exploration, production, refining or transportation of: oil, gas or coal; real estate; or interest, dividends or capital gains. Thus, entities as diverse as oil and gas developers like Andarko and private equity managers like Och-Ziff are publicly traded but not subject to corporate income tax.

Bonus depreciation

Congress, for most of the period from 2001 to 2012, has allowed taxpayers to take bonus depreciation for new equipment purchases. The bonus percentage has varied from 100% of the cost (essentially expensing for all new equipment) to 30%. It was first intended to stimulate the economy after the terrorist attacks of 11 September 2001.

Under bonus depreciation, taxpayers can exploit their capital expenditure to substantially – and easily – reduce their taxes in the year of that expenditure. Further, some state public utility commissions require their utilities to claim bonus depreciation and pass the benefit to their customers, even if the utilities prefer different ways of monetising their tax base. Accordingly, it has decreased the appetite for tax-advantaged corporate investments.

In addition to bonus depreciation, utilities have left the tax equity market for other reasons. First, utilities like MidAmerican, Duke Energy and Exelon have decided that it is better to use their tax appetite on their own investments. They buy wind and solar projects outright and claim the tax credits and depreciation themselves. Utilities like NextEra (formerly known as Florida Power & Light) invested so much in renewable energy that it is carrying forward tax credits that it cannot use currently; thus, NextEra has become a customer of tax equity providers.

Boosting supply

A collection of corporate tax incentives has shrunk the number of public corporations that pay substantial tax, which in turn has shrunk the number of potential tax equity investors. Indeed, the scale of these corporate tax incentives has hindered efforts in Congress to boost stated policy initiatives, including advancing renewables.

The principles of supply and demand dictate that the few investors in the market are able to drive up after-tax yields, which increases the cost of capital for renewables developers. That expense – cost of capital – is the most critical in the development and construction of renewables projects. A higher cost of capital for developers means fewer renewable energy projects are completed for every dollar of tax benefit legislated by Congress. Congress would spur greater investment in clean energy for each corporate tax dollar foregone, if fewer corporations could reduce their tax liability through other means.

These tax benefits, combined with greater investment in the quality and quantity of in-house tax departments, have led to a significant erosion of the corporate tax base in the US. There are three strategies for the renewable energy industry to decrease cost of capital and thus develop more generating projects.

First, identify new entrants, in the form of established public companies with primarily US operations – those that have not seen a spike in their share price that resulted in a large tax stock option deduction. Second, with looming tax reform, convince Congress to increase taxes on foreign earnings, reduce the deduction for stock options and eliminate the DMD, whilst continuing accelerated depreciation as well as the tax production tax credit for wind generation projects and the investment tax credit for solar projects. Third, push Congress to expand MLP rules to include renewable energy and widen the pool of tax equity investors to individual investors, creating a retail market for tax equity in the US, like there is in Germany. Individual investors would widen the supply of tax equity and drive the cost of capital for renewables projects.