Participants in the initial wave of tax credit transfer transactions filed their returns reflecting those deals on October 15, marking another milestone for the Inflation Reduction Act’s experiment in tax credit transfers. At least for some credit buyers, the tax system is inching closer to the inevitable: audits.
In the due diligence they performed before the transfers, participants began preparing for examinations. The diligence process for tax credit transfers will likely always be at least partly customized to the parties because different entities have different concerns, but a more standardized roadmap has emerged over the past year or so as advisers and tax credit buyers and sellers gained experience.
Doing Your Homework
The basic outlines of the diligence process were informed in part by the precursor to transfers — tax equity. But the IRA clearly conceived of a transfer as a far simpler transaction, and accordingly they require less diligence. Consensus among buyers and sellers about how much less has evolved over time. The natural processes of maturation and acceptance of common diligence practices have made negotiations over due diligence more streamlined, said David Burton of Norton Rose Fulbright US LLP. “Now there are typically only a handful of issues to negotiate,” he said, adding that some buyers still do more due diligence than they need to out of an abundance of caution.
The due diligence required for a transfer is focused on ensuring that the project can continue to operate economically in order to avoid a recapture event or a disallowance of credits, said Billy Lee of Reunion, an energy tax credit marketplace. Unlike in tax equity and secured financing deals, investor returns aren’t dependent on cash flows of the project in transfers, hence less diligence. The relative simplicity of transfers is a large part of their appeal. “Transferees want to buy credits and never think about them again — that’s an ideal outcome of a tax credit purchase,” Lee noted. However, there are several areas where the tax credit buyer is exposed to some operational risk: avoiding recapture and complying with the prevailing wage and apprenticeship requirements.
Some deals require the seller to provide an annual compliance certificate to the buyer, but avoiding recapture and complying with the labor requirements are largely the project developer’s purview. Recapture, a scary possibility for transferees because it has high consequence, is very unlikely to happen, Lee said. If it does, the developer must notify the buyer so they can reflect that on their tax return and seek indemnification or make an insurance claim. Typical transfer agreements require transferors to comply with the prevailing wage and apprenticeship rules for alterations and repairs.
Prospective credit buyers and sellers increasingly try to ensure that the information they need for due diligence is prepared and vetted as they go into negotiations, said Anand Chaturvedi of Dili. Chaturvedi’s company automates the data and file processing that has traditionally been done manually in the due diligence stage of transactions and provides diligence reports that are based on complete data, rather than sampling, to identify risks. Chaturvedi added that collecting and processing diligence information before negotiations not only makes them go more smoothly but also helps to ensure that the data is available for a later examination by the IRS. “Part of our involvement in these deals is to make all of the documentation as robust as possible for audit,” he said.
Market Maturation
Due diligence may never be fully uniform for all transactions, but as the number of completed deals climbs, the process has become more efficient. “There is now a better appreciation for the scope of diligence on both sides. Buyers understand that they don’t need everything, and sellers understand that they can’t get away with providing nothing, or even the bare minimum,” Lee said. As a result, there are fewer disagreements in investment tax credit transfer negotiations over the scope of due diligence because it’s generally accepted what buyers and sellers need to be confident about the transaction, he said. Debate is more likely regarding due diligence for newer credits that have fewer precedent transactions, such as the section 45X advanced manufacturing production credit.
A handful of areas remain where buyers and sellers don’t always see eye to eye. Buyers sometimes ask for an independent engineer’s report. Sellers tend to argue that those reports are unnecessary for transfers, because the purchase takes place after the credits have accrued, Burton explained. Some buyers also seek corporate enforceability opinions. In addition, tax opinions are not part of every deal. Burton said that over half of his firm’s transfer deals through mid-October had no tax opinion condition precedent. The market appears to consider a good indemnity agreement a sufficient precaution.
The Required Minimum Is Not Enough
The final transfer regulations (T.D. 9993) outline the required minimum documentation that an eligible taxpayer must provide to a transferee, and some sellers initially sought to provide transferees with only that minimum. Advisers quickly pointed out that “minimum” was not equivalent to “recommended.” The preamble to the final rules notes:
In providing for the required minimum documentation that an eligible taxpayer must provide to a transferee taxpayer, the intention was to require a baseline of information that is necessary for validating an eligible taxpayer’s claim of eligibility to an eligible credit, while not overburdening the eligible taxpayer with production requirements or altering the arm’s length arrangement between the parties.
But the preamble also explains that an objective of the rules was to allow “sufficient flexibility for market participants to determine if more information is necessary in a particular transaction,” and it suggests that agreements between taxpayers might go beyond the minimum requirements.
The final transfer regs also include in reg. section 1.6418-5(a)(4) a list of circumstances that may indicate reasonable cause for avoiding an excessive credit transfer tax. Those include review of the seller’s records regarding the determination of the eligible credit, reasonable reliance on third-party expert reports, reasonable reliance on representations from the seller, and review of audited financial statements. The list also helped to frame the standard scope of diligence.
Standard diligence for ITC transfers includes the cost segregation report, placed in service substantiation, appropriate insurance coverage, seller credit analysis, prevailing wage compliance, and basic parameters indicating that the project has the right and ability to operate. The validity of any bonus credits must also be covered. If there is a step-up transaction, an appraisal is needed, Lee said. “Our due diligence effort is comprehensive, but efficient — we try to hit all the points that are salient to make sure that credit buyers have everything they need to get comfortable and defend their position if there is a challenge down the line,” he said.
Looking Ahead to Audits
Planning ahead for an audit means anticipating the questions that the IRS will ask on information document requests and collecting that information in advance.
“Typically the purchasers want to do enough diligence that they feel comfortable that even if there is an audit, there’s a complete and substantive file they can point to,” Lee said. Buyers typically also agree with the seller stating that the seller can be involved and allowed to participate in an audit, Lee said. Similarly, if there’s indemnity, the seller is given the right to consent to any settlements, and where insurance policies exist the buyer also provides the insurer with audit participation and settlement consent rights. “An audit is going to be a collaborative exercise,” particularly because there is not typically a way to allow the buyer to transfer an audit to the seller,” Lee said.
One way to reduce the risks that worry buyers and insurers is for sellers to show that they have a strong program for ongoing compliance or reporting, Chaturvedi said. “For alterations and repairs, the project developer needs to continue to pay prevailing wages and also give confidence to their insurer or credit buyer that those compliance rules are being met,” he said.