Tax flaw in U.S. stimulus hurts renewables

A major goal of the American Recovery and Reinvestment Act of 2009 is to spur activity in the renewable energy sector. However, a technical tax flaw in the legislation is preventing it from accomplishing its objective in the marketplace.

This issue is serious and must be rectified before activity in the renewable sector can increase to the level contemplated by the president. Here's the problem:

In order for a renewable energy project to be economically viable, investors must be able to take advantage of certain tax incentives, primarily depreciation and tax credits. Depending on the type of project, the present value of these tax incentives can be as high as 60 percent of the initial cost of a renewable energy project. Approximately half of that value is attributable to tax credits, and the other half is attributable to depreciation.

However, and this point is crucial, in order to benefit from these tax incentives, an investor has to have taxable income.

Unfortunately, as you know, many of the banks, insurance companies and other large financial institutions that have previously financed renewable energy projects have incurred large losses. Consequently, these entities are not able to use the tax benefits that are required for a renewable energy project to be economically viable, and many of them have left the market.

The recovery act attempts to solve this problem by allowing taxpayers to elect to receive cash in lieu of tax credits. However, investors do not have the ability to convert depreciation into cash. Because depreciation represents approximately half the tax incentive by value, and investors have to be able to use the depreciation for a renewable energy project to be viable, the market remains frozen.

We think that the best solution to this problem is to expand the investor pool beyond the banks, insurance companies and other financial institutions that have previously participated. This will require amending the Internal Revenue Code to provide an exemption for renewable energy projects from the passive loss rules contained in Section 469.

Under current “passive loss” rules, individuals and certain other types of taxpayers are not able to utilize losses and tax credits from so-called “passive activities” to offset wages, income from active businesses, dividends, or most types of capital gain. Because individuals investing in renewable energy projects are generally passive investors, they are subject to the passive activity rules and, therefore, are not able to utilize losses and credits from renewable energy projects to offset wages, active business income, dividends, or most types of capital gain. Although some wealthy individuals may have a sufficient amount of passive income from other sources to benefit from tax incentives for renewable projects notwithstanding the passive loss rules, the definition of passive activity income is very narrow, and very few individuals qualify. 

Consequently, a large number of wealthy individuals have been effectively excluded from the pool of potential investors. The only reason that banks, insurance companies and other financial institutions are able to invest in renewable energy projects is that these taxpayers are already exempt from the passive loss rules. Thus, exempting renewable energy projects from these rules would simply serve to level the playing field.

There is precedent under Section 469 for exempting income from other types of businesses from the passive loss rules. For example, exemptions are available for certain types of real estate investments, and for working interests in oil and gas properties.

Providing an exemption from the passive rules for investments in renewable energy projects would permit wealthy individuals to pool their resources through partnerships and other investment vehicles to provide financing in an economically viable manner, and thereby provide the capital required to expand the renewable energy market. As a matter of policy, given that the law already contains an exemption for working interests in oil and gas properties, an exemption for investment in clean renewable energy is particularly appropriate.

We’ve had preliminary discussions on this issue with Treasury Department officials, various legislators, staff people and members of the Obama administration. Lobbying efforts are ongoing, but it is unclear whether they will succeed. Various members of the private equity and venture capital community have been made aware of the problem and are reaching out to their contacts. Industry groups are aware of the issue and are working on it as well. Hopefully, lobbying efforts will succeed and this flaw in the tax code will be fixed in upcoming energy legislation.

Arnold Grant is a partner in the Chicago office of Reed Smith and a member of the firm’s renewable energy practice group, which recently submitted a proposal to the Obama administration for increasing the pool of potential tax equity investors in renewable energy projects.

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