As investors consider renewable energy and carbon reduction projects, tax incentives should be part of economic modeling and decision-making. Both operators and investors need to analyze the various factors regarding financial reporting and overall financing structure.
Separately, reducing carbon emissions from traditional energy sources is a front-and-center objective of leaders, policymakers, and citizens globally. Large multinational corporations spanning all industries, including the world’s largest oil and gas companies, are active participants in developing new technologies designed to achieve aggressive carbon reduction standards and targets. Business operating budgets are allocating increasing levels of capital to carbon initiatives.
With all of that said, the build-out of renewable energy sources, and carbon reduction progress, for that matter, is still dependent on tax incentives to make project economics viable. There may well be a time in the not-too-distant future where the economics of renewable energy projects and carbon reduction initiatives stand on their own, but that time hasn’t yet arrived.
There may well be a time in the not-too-distant future where the economics of renewable energy projects and carbon reduction initiatives stand on their own, but that time hasn’t yet arrived.
The focus of this article is one of the tax incentives available for renewable energy source projects.
Investment tax credit (ITC)
There are many tax incentives targeting production of and investment in various renewable energy sources. The incentives cover both industrial and residential applications, with many having been in existence for decades. One of the more common tax incentives is the investment tax credit (ITC).
The ITC is claimed against federal income taxes, and is based on a percentage up to 30% of the eligible cost of a facility placed in service during the tax year. While wind and solar are the most common renewable energy sources of the ITC, geothermal and biomass projects also qualify for the credit. The ITC generally starts at 30% of eligible costs but is subject to various phase-down rates depending on the renewable energy source involved. In the case of wind, the phase-down actually reversed in 2020, reducing from 60 to 40% for facilities in which construction begins in 2020.
Technological advancements have improved the basic economics of renewable energy projects; however, given the considerable attention being given the transition to renewable energy sources, one would expect tax incentives to continue to be part of the economic calculus into the foreseeable future.
Evaluating the use of the ITC
There are numerous project-specific factors that should be considered when evaluating eligibility for the ITC, including, among others, the type of project and its specific use, qualifying property expenditures, the date construction begins on the facility, and the date the facility is placed in service.
A common funding source in the renewable energy space involves capital providers referred to as tax equity investors. Many renewables companies are in the startup phase, and thus don’t generate enough taxable income to be able to utilize ITCs and other renewable energy tax incentives. Accordingly, renewable startups often partner with tax equity investors having tax profiles enabling them to utilize the credits. Effective deal structures are available to accommodate the routing of ITCs to tax equity investors in a manner acceptable to the Internal Revenue Service.
Financial reporting considerations for the ITC: Deferral and flow-through
The ITC falls within the scope of Accounting Standards Codification 740, Income Taxes, as it’s a credit for taxes based on income. There are two acceptable methods to account for the use of the ITC: the deferral method and the flow-through method, each with its own benefits.
The deferral method results in the credit being reflected in net income over the productive life of the related property and equipment because the credit is recorded as a decrease in the net book value of the related property and equipment balance or as a deferred credit, and results in decreased depreciation charges or recognition of income associated with the deferred credit over the productive life of the related property and equipment. An offsetting reduction to income taxes due (or payable) is also recorded, or if no income taxes are due (or payable), a deferred tax asset is created.
The flow-through method results in the credit’s immediate reduction in income taxes due (or payable) for the year in which the credit arose with an offsetting decrease to income tax expense. However, if the credit cannot be fully utilized and is carried forward, it results in the creation of a deferred tax asset.
If a deferred tax asset is created in either the deferral method or flow-through scenario, it’s subject to realizability analysis to determine if a valuation allowance is needed. Depending on the entity-specific positive and negative evidence, companies in the startup phase or are still working to achieve continued profitability may not meet the “more likely than not” threshold regarding realizability of the deferred tax asset in which case a valuation allowance is required. Therefore, when considering the appropriate recognition method for the ITC, it’s important to consider the potential impact of a valuation allowance.
Using the deferral method may, in effect, result in the write-down of the related property and equipment balance, as the property and equipment balance is reduced through a reclassification to a deferred tax asset for the ITC created, which is then reduced as a result of a valuation allowance, while the flow-through method may result in no net impact on the financial statements, given the offsetting impacts of the valuation allowance on the deferred tax asset that the ITC created.
There are many technical and project-specific considerations that need to be analyzed when considering the ITC and other renewable energy tax incentives. It’s important for renewable entities and investors to carefully navigate the various planning, qualification, filing, and financial reporting factors along with overall financing structures.
If you have any questions, please give our energy team a call.