Navigating clean energy tax credits in climate tech venture lending
Changes to the tax code have made it easier to monetize renewable energy tax credits, attracting interest from emerging growth companies looking to bolster their balance sheets amid the slowdown in venture capital funding. These transactions are often viewed as credit-enhancing from a venture lender’s perspective, but the complexities of these structures can raise unique concerns.
This alert explores the intersection of innovative tax credit transactions and the venture lending market, highlighting key issues for venture lenders to consider.
ITCs and PTCs
The federal tax code has long provided two main forms of tax credits to encourage investment in renewable energy sources: (1) investment tax credits (ITCs) and (2) production tax credits (PTCs). Although both share the same goal, they differ in other respects.
ITCs are federal tax credits based on a percentage of the cost of installing renewable energy systems (ie, the basis of energy property placed in service by the taxpayer). PTCs are federal incentives that generally provide a tax credit based on the amount of, for example, energy, eligible components, or clean hydrogen produced by the taxpayer and sold to an unrelated party during the taxable year.
Changes enacted by the Inflation Reduction Act of 2022 (IRA) have enabled climate tech companies to more easily sell or transfer their ITCs and PTCs to unrelated parties that have no connection to the underlying renewable energy project, whether to a buyer seeking to reduce its own tax liability or a lender providing secured financing. This has been a boon to emerging growth companies that do not yet generate enough income to utilize the tax credits themselves, particularly during the recent period of sluggish venture capital activity.
As a result, tax credit transaction deal flow has surged under the IRA’s new rules. This trend is expected to continue with the amount of available tax credits predicted to grow to more than $30 billion annually.
Structuring issues
Climate tech companies are no longer reliant on complex “tax equity partnership” structures. They now have the leeway to use a broader range of structures to monetize their tax credits, with terms tailored to the needs and goals of the parties. Incumbent lenders would do well to understand these structures and consider any implications for their existing credit facilities.
For example, borrowers seeking to finance their tax credits – either through a bridge facility in anticipation of an outright sale or on a longer-term basis – commonly use structures akin to so-called “warehouse” facilities used in fintech lending transactions. Here, the clean energy project generating the tax credits is typically established as a bankruptcy-remote special purpose entity and disregarded entity for tax purposes (SPV). An intermediate holding company of this SPV then enters into a loan facility with a third party who advances funds at a discount to the tax credits’ value and takes a security interest in the tax credits as collateral.
Entities borrowing against the tax credits are often excluded as loan parties under the venture debt facility and thus do not pledge their assets as collateral to the venture lender. Nonetheless, lenders may choose to look out for any overlapping obligations of its loan parties. Such obligations can come in the form of limited “bad boy” guarantees covering only losses resulting from affirmative actions of the loan party guarantor, which are full-recourse guarantees of the non-loan party borrower’s obligations to a pledge by the loan party of its equity interest in the non-loan party borrower.
Lenders are encouraged to determine the scope of any competing obligations and consider whether they ought to be subordinated to the loan party’s obligations under the venture debt facility. Additionally, they may also want to ensure the continued functioning of the tax credit facility in the ordinary course.
To do so, they often require notice of any default or other adverse events under the tax credit facility and include a cross-default to the tax credit facility as well as certain other event-of-default triggers for failing to abide by certain terms of the tax credit facility. To the extent an SPV is used to generate the tax credits, many lenders will also include representations and covenants to ensure that the separateness provisions of such entities continue to be respected.
Outright sales of ITCs and PTCs by an existing borrower are often more straightforward from a venture lender’s perspective. Under the IRA, borrowers typically use M&A-style purchase documents containing customary representations and indemnification provisions (typically referred to as “tax credit transfer agreements”).
In order to understand the economic impact of the transaction, lenders may want to evaluate not only the amount and terms of payment, but also any material exposure (including recapture risk in the case of ITCs), as they would for a more-traditional corporate divestiture.
Regardless of the structure being used, existing lenders will also typically want to confirm that the transaction is permitted under the negative covenants and other terms of its loan agreement, and whether the tax credit transaction triggers a mandatory prepayment under the venture debt facility.
ITC recapture risk
In addition to any structuring issues, existing venture lenders may want to assess and address any potential risk of recapture in ITC related projects.
Specific to ITCs, recapture risk is the possibility that a renewable energy project loses its tax credit qualification status during the five-year vesting period, thereby increasing the credit holder’s tax liability. This might occur for several reasons, including the following:
- The project suffers a casualty event
- The project ceases operations, or
- The project’s assets or equity is disposed of (including a lender’s foreclosure of the assets generating the ITC).
Companies will often seek to minimize the risk of recapture by requesting that its lenders forbear against exercising remedies against the project’s assets during the vesting period, but some recapture events lie beyond the borrower’s control and thus cannot be eliminated.
This residual risk is typically negotiated and addressed in the indemnification provisions of the transaction documents, often with borrower-seller required to indemnify the buyer for any portion of the ITCs that are recaptured. This potentially sizable (but diminishing) outlay of cash can be difficult for lenders to accept from a credit perspective (and is a big reason why ITCs are rarely used as collateral in asset-backed credit facilities), but third-party insurance is available to protect against the possibility of recapture and other related indemnity claims.
Lenders are encouraged to review the purchase agreement to determine the ramifications of such recapture on the seller, including any indemnity obligations. The recapture risk of ITCs can make it difficult for lenders to include them in a borrowing base.
If you would like to discuss or have any questions regarding the topics outlined in this alert or related matters, please contact one of the authors or another member of DLA Piper’s Corporate or Venture and Growth Lending teams.