The Bipartisan Budget Act of 2018 passed by Congress on February 9, 2018 included an extension through January 1, 2022 of the 10 percent federal tax credit for the owner of combined heat and power (CHP) plants, also known as cogeneration.
The 10 percent tax credit for CHP originally expired at the end of 2016. For many organizations contemplating energy-efficient upgrades to their physical plants (such as hotels, healthcare facilities or manufacturing facilities), the extension of the federal tax credit could make CHP more attractive.
Anecdotally, many organizations are unaware that the boiler units or heat recovery systems they buy for their physical plants could be eligible for a federal tax credit. In some organizations, this may be because the employees in charge of upgrading the physical plant may not be in contact with the organization’s accountants. Even if they are aware of the existence of the tax credit, they may incorrectly assume that only completely new CHP systems, as opposed to capital improvements to existing eligible systems, are eligible for the credits or that the size limitation in the CHP rules applies to an entire facility rather than to each separate CHP system inside the facility.
If the organization where the CHP unit is installed is unable or unwilling to own the CHP system or take the tax credits, the developer of the CHP system can retain ownership of the system and claim the tax credits or otherwise form a joint venture with a tax equity investor in a similar partnership structure as is used for solar investment tax credits.
This article provides a broad overview of the rules and eligibility requirements for the federal CHP tax credit and highlights pitfalls for the unwary, both relating to the understanding of the tax rules and the potential cost savings for such organizations.
What is CHP?
CHP systems use a single fuel source to produce both electricity and useful thermal energy. A prototypical example is a large industrial boiler that burns natural gas to produce steam, which then can be used for a number of applications with no additional fuel consumption. The heat that would normally be lost in the power production process is reclaimed and used to provide necessary heating, cooling or other industrial processes. This process can be very energy-efficient and can also provide backup power during grid outages.
CHP technology is not new and is fairly widespread across many types of industries. However, there has been an increased interest in investments in CHP systems in the United States, both for new systems and upgrades to existing systems, due to advances in technology, a renewed focused on energy efficiency and now the extension of the federal tax credit.
Incentives for CHP systems— Federal tax credits and depreciation:
The Internal Revenue Code (IRC) Section 48 federal investment tax credit (ITC) provides a 10 percent energy credit on the eligible basis (or cost) of CHP system property that a taxpayer owner places in service. CHP equipment is also eligible for 100 percent bonus depreciation in the first year it is placed into service.
Eligibility requirements for the ITC:
CHP is defined in IRC Section 48 as property “comprising a system which uses the same energy source for the simultaneous or sequential generation of electrical power, mechanical shaft power, or both, in combination with the generation of steam or other forms of useful thermal energy (including heating and cooling applications).”
In addition to meeting the definition above, a CHP system must:
· produce at least 20 percent of its total useful energy in the form of thermal energy which is not used to produce electrical or mechanical power (or combination thereof),
· produce at least 20 percent of its total useful energy in the form of electrical or mechanical power (or combination thereof),
· have an energy efficiency percentage that exceeds 60 percent (except for systems that use biomass), and
· begin construction before January 1, 2022.
o Generally, under guidance issued by the IRS in 2018, projects can begin construction by either performing physical work of a “significant nature” or by incurring at least 5 percent of total ITC eligible costs in the relevant tax year.
o CHP projects are not subject to ITC phasedown provisions applicable to wind and solar projects. Thus, the 10 percent CHP ITC is available for projects beginning construction before January 1, 2022.
The ITC is limited for CHP systems that have an electrical capacity in excess of 15 MW or a mechanical energy capacity of more than 20,000 horsepower or an equivalent combination of electrical and mechanical energy capacities. It is fully denied for CHP systems with a capacity in excess of 50 MW or a mechanical energy capacity in excess of 67,000 horsepower or an equivalent combination of electrical and mechanical energy capacities.
Recapture rules applicable to the ITC are designed to prevent taxpayers from investing in an ITC-eligible project, claiming the ITC and then exiting that investment shortly thereafter. These rules generally require that a taxpayer retain its investment in the CHP project for 5 years from the project’s placed in service date. If a recapture event occurs during that 5-year period, the ITC is recaptured in an amount that is reduced by 20 percent during each year of the 5-year period.
Recapture events can include the following:
· CHP system permanently ceasing to operate;
· the taxpayer selling the CHP system or an interest in the entity owning the CHP system; and
· the CHP system being owned or used by tax-exempts such as governmental agencies (though careful tax planning and the use of certain structures may prevent this particular recapture event from occurring).
Developers retaining ownership:
In many situations, the owner of the facility in which the CHP is installed may not want to retain long-term ownership of the CHP itself. In those scenarios, the developer of the CHP unit can retain ownership and can either take advantage of the tax credits itself if it has U.S. taxable income or enter into a joint venture with a third-party tax equity investor that may be able to take advantage of the tax credits and depreciation benefits and would receive a cash stream from the service contracts relating to the projects. The structure of this sort of joint venture would be similar to those that take advantage of solar investment tax credits. These structures vary, but the most typical one is a “partnership flip”, whereby a developer finds an investor who can use the tax benefits and the two partners own the project (or many similar projects) in a joint venture partnership. The partnership allocates 99 percent of the income, loss and tax credits relating to the project(s) to the tax equity investor until it reaches a target return or until a fixed date occurs. Cash is distributed to the tax equity investor in a percentage to be negotiated. Once the investor’s target return is achieved or the fixed date occurs, the investor’s share of allocations and distributions drops down to 5 percent and the developer typically has the option to buy out the investor’s interest.
Incentives for CHP systems—select state and local incentives:
Although a full survey of the state and local-level incentives available for CHP is beyond the scope of this paper, there are a number of CHP incentives available at the state and local level as well. Many are modeled after the federal ITC. One of the more generous state incentives that was modeled in part after the federal ITC was the 35 percent North Carolina Renewable Energy Credit, which spurred investment in CHP and other renewable energy systems in that state before it was phased out. If your organization is contemplating an investment in CHP, consult your accountants or tax counsel to make sure no potential source of incentive money is left on the table.
Many boiler and/or heat recovery systems that organizations install could be eligible for the federal tax credit for CHP. If the organization buys the CHP unit once installed, it may be able to take advantage of this tax credit and the tax credit may be factored into the pricing for the unit.
Similarly, CHP developers that retain ownership of the CHP unit can either take advantage of the tax credit themselves or try to monetize them through a joint venture arrangement with third party investors. Organizations that are contemplating these investments and CHP developers should be sure to discuss them with their tax counsel and accountants to see whether they qualify and what incentives might be available to them.
About the authors: Joel Hugenberger is a partner in McDermott Will & Emery’s New York office. He advises developers, sponsors, lenders, and investors on project development and financing transactions, primarily in the renewable energy sector.
Heather Cooper is a partner in McDermott Will & Emery’s Miami office, where she works on federal income tax matters, with a focus on energy tax issues. She represents clients in restructurings, mergers and acquisitions, and other transactional energy related matters.
Philip Tingle is partner in McDermott Will & Emery’s Miami office. As global head of the Firm’s Energy Advisory Practice Group, he represents energy companies such as utilities, independent power producers and financial institutions on a wide range of energy tax-related matters.