Clean energy sector tax incentives in the US and UK

Both the US & UK governments want to incentivise alternative energy through the use of tax breaks Source: Bloomberg

At today's equipment costs and energy prices, the development of renewable or green energy requires government subsidies to compete with fossil fuel alternatives.

In the US, the American Recovery and Reinvestment Act of 2009 (ARRA) and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (collectively, the stimulus legislation) established a high water mark for renewable energy subsidies. While a number of these provisions have expired or are set to expire in 2012, renewable energy is generally still favoured under the tax law. Meanwhile, the UK has traditionally proceeded with a mix of market-oriented measures and a few specific tax incentives, and further measures are in the course of being introduced. The UK government came in with an announcement that it would be the "greenest government ever", but there have been some bumps along the way (most recently, at the time of writing, in the Court of Appeal over its proposals to scale back the Feed-in Tariff scheme).

The tax provisions of the stimulus legislation subsidised investments in projects, such as wind, solar and biomass electricity generation facilities, by: extending the availability of per-unit-of-production tax credits for electricity sold by such facilities; greatly expanding eligibility of clean energy projects for the Investment Tax Credit (ITC); and (iii) creating a 30% grant for facilities eligible for the ITC (the grant). First-year "bonus" depreciation, which applied not only to energy-production property but to most business property, was also extended by the stimulus legislation. Additionally, federal income tax credits for electric vehicles, hybrid-electric vehicles and hydrogen-fuelled vehicles were increased and extended by the stimulus legislation. All of these tax subsidies were available only for energy produced and property used predominantly within the US.

Several important incentives have recently expired, including: the grant (subject to grandfather rules), which was designed as a temporary substitute for the 30% ITC for investors and developers that could not use the ITC because of tax base erosion; 100% bonus depreciation, which has been replaced by 50% bonus depreciation; ITCs for factories that produce property designed to reduce greenhouse gas emissions; and some of the credits for alternative fuel vehicles and related property.

Many significant tax benefits remain available for US renewable energy projects. While the grant has expired, numerous grandfathered projects are likely to proceed. Additionally, the ITC remains in effect for many types of renewable energy projects.

The ITC, which is equal to either 10% or 30% of the cost basis of a qualifying renewable energy project (energy property), offsets an investor's US federal income tax liability in the year the energy property is first placed in service. Progress expenditure credits are available before the project is placed in service in the case of projects that take two years or longer to construct. The depreciable tax basis of property is reduced by only 15% as a result of the investor claiming the ITC, meaning that significant depreciation deductions arise from the use of such property, in addition to ITCs. The ITC is available for qualifying biomass, landfill gas, hydropower, marine hydrokinetic, and larger wind energy projects, as well as solar and geothermal energy property. The ITC is not a refundable credit and therefore requires an investor with a federal income tax liability to effectively utilise the ITC. The cash grant was enacted because many investors were unable to use the ITC because of losses arising during the financial crisis, but as noted, the grant expired in 2011. Typically, investors who can use the ITC invest through lease and flip partnership structures. In the case of most types of clean energy facilities, the ITC expires within the next few years. ITCs are available for wind projects placed in service by December 31 2012; biomass, landfill gas, hydropower, and marine hydrokinetic projects placed in service by December 31 2013; and solar and geothermal projects placed in service by December 31 2016.

Investors in certain qualifying green energy project may claim production tax credits (PTCs) which also offset federal income tax liability for a project as an alternative to the ITC. Often the choice between ITC and PTC will depend on a comparison of capital cost to expected energy output. PTCs can be claimed by the operator(s) of a qualifying energy production facility for each kilowatt-hour of electricity produced and sold to unrelated parties in each of the first 10 years after the facility is first placed in service. Generally, flip partnership structures are utilised for PTC investments. To qualify for PTCs, a qualified facility must be placed in service by December 31 2012 (for wind facilities) or December 31 2013 (for closed-loop biomass, open-loop biomass, geothermal, municipal solid waste, qualified hydropower, and marine and hydrokinetic renewable energy facilities). The amount of the PTC credit is different for different types of energy resources: in 2011 the credit for wind, closed-loop biomass, and geothermal energy facilities was 2.2 cents per kilowatt hour while for open-loop biomass, municipal solid waste, qualified hydropower, and marine and hydrokinetic renewable energy facilities it was 1.1 cents per kilowatt hour. The credit rates are adjusted for inflation every year.

Both ITCs and PTCs may be carried back for one year and forward for twenty years if they are not usable in the tax year in which they arise.

In 2012, owners of qualifying equipment generally may deduct as a bonus first-year depreciation allowance 50% of the depreciable basis of renewable energy property they place in original service. If an investor takes the ITC for property, only 85% of the cost basis of that property remains depreciable. After claiming the bonus depreciation, the remaining basis is depreciated at generally accelerated rates, typically over a 5½ year schedule.

A US federal income tax credit is allowable for each "new qualified plug-in electric drive motor vehicle" and "new qualified fuel cell motor vehicle" for the year in which the vehicle is first placed in service. The credit for each qualified plug-in vehicle is between $2,500 and $7,500, depending on the capacity of the vehicle's battery. The plug-in vehicle credit is to be phased out on a manufacturer-by-manufacturer basis. The credit for each qualified fuel cell vehicle is between $8,000 and $40,000; this credit is available for vehicles purchased on or before December 31 2014. Both the electric vehicle credit and the fuel cell vehicle credit are available to taxpaying individuals or businesses that purchase qualifying vehicles for personal or business use, as well as to sellers of qualifying vehicles to tax-exempt and governmental of entities.

The expired grant and bonus depreciation are caught up in what seems to have become Congress' annual Business Tax Extenders exercise. Each year a group of expiring business tax benefits including the research and development tax credit, the active financing exception to subpart F and numerous others often including renewable energy benefits, are the subject of last minute (or after the fact) legislation that provides for a single year extension. Many of these provisions were allowed to expire at the end of 2011. While Congress is expected to take up the Business Tax Extenders this year, it is unclear that 100% bonus depreciation and the grant will be included.

In previous years, Business Tax Extenders enjoyed a level of bipartisan support for extension of these benefits without revenue offsets. The environment this year is markedly different. The Ways and Means Committee of the House of Representatives, which this year is controlled by Republicans, appears interested in an individual review of each of the Business Tax Extenders to determine which among them are worthy of renewal. This approach is consistent with an election year focus on deficit reduction and comprehensive tax reform.

Additionally, the renewable energy industry has suffered a number of public relations set-backs caused by events like the Solyndra bankruptcy and well-publicised electric car battery problems.

While the House of Representatives may not be sympathetic to renewable energy, the Finance Committee of the Senate, which is controlled by Democrats, generally has a more sympathetic view, with many Democratic Senators supporting extension of the grant and bonus depreciation.

Unfortunately, between the Congressional gridlock that has characterised 2011 and 2012 election year jockeying, there is little reason to be optimistic that common ground will be achieved on Business Tax Extenders that include expired renewable energy provisions. Nevertheless, between the many tax benefits that remain available for renewable energy investments and grandfathered Grant transactions, we are likely to see continuing investment in US renewable energy projects.

Two of the main fiscal levers to encourage renewables in the UK have been the enhanced capital allowances (ECA) system and the climate change levy (CCL). ECAs have offered immediate 100% tax depreciation for expenditure on certain ranges of environmentally beneficial or energy saving equipment – for instance solar thermal systems, rainwater harvesting systems, "clean cars" and equipment for gas refuelling stations. At the other end of the scale, energy suppliers subject to CCL can claim an exemption to the extent that energy is supplied from renewable sources, and otherwise can access a CCL rate reduced by 65% where targets for energy efficiency or carbon reduction targets are met.

Alongside this, there have been market-oriented initiatives. These include the Renewables Obligation system, enabling trade in Renewables Obligations Certificates between electricity suppliers so that overperformers are paid by underperformers; the similar Renewable Transport Fuel Obligation system; the EU-wide Emissions Trading Scheme (which had unintended consequences that required surgery to combat missing trader intra-community VAT fraud); and, for emissions outside the EU scheme, the CRC Energy Efficiency Scheme which ranks large organisations by their reported carbon emissions and, starting from 2012, allows them to trade in emissions allowances.

The sun will soon be setting on a number of tax incentives Source: Cornell Solar

Over the course of the last year, further measures have been announced which build over a landscape that was already somewhat confusing. Most strikingly, the Feed-in Tariff (FiT) saga has involved restrictions announced in March 2011 affecting tax-privileged vehicles receiving FiTs, followed by court battles from October over proposals to scale back the FiT scheme itself – not the most stable environment to encourage investors.

The FiT scheme involves financial incentives to accredited small-scale generators of electricity using a low-carbon energy source. A fixed payment is provided for electricity that is generated on-site and for any unused electricity that is exported to the national grid. Households that use renewable technology to generate electricity mainly for their own use should not be subject to income tax on payments under the scheme.

Since the scheme's introduction in 2010, there has been a boom in the installation of domestic solar panels, to the extent that the government felt this element of the tariff was not sustainable. In March 2011, restrictions were imposed on certain vehicles (EIS and VCTs, which are intended to encourage investment in small entrepreneurs through shareholder tax benefits) from being involved in businesses further subsidised through the FiT scheme. Separately, the government announced a consultation in October 2011 on halving the FiT for solar panels installed on or after December 12 2011. As this was before the closing date for the consultation process, the High Court ruled that the introduction of the change in this way was flawed, and the government lost again at the Court of Appeal. The government has announced that leave will be sought for an appeal before the Supreme Court, leaving considerable confusion for both consumers and industry. In the meantime, draft legislation has been published to remove the benefit of ECAs from equipment attracting payments under the FiT scheme or the similar Renewable Heat Incentive, and to reduce the annual capital allowances rate for solar panels outside the FiT scheme from 100% to 10%.

Another key policy, confirmed at the 2011 budget, is the introduction of a carbon price floor from April 1 2013. This will effectively provide for a governmentset price floor for fossil fuels used in electricity generation (initially £16 ($25) per tonne of CO2 emissions, rising to £30 by 2020) by adjusting applicable rates of CCL and fuel duty, and is intended to encourage investment in low-carbon power generation. It is worth noting that the floor potentially privileges nuclear power as well as renewable energy sources, and has recently been criticised by a Parliamentary committee for the effect on UK consumers and industry.

It can be seen that in the US, despite the expiry of several important incentives for renewable energy, many significant tax benefits remain available, though the future political environment is uncertain. In the UK, there is a plethora of (perhaps overly complex) reliefs and initiatives, which are generally intended to encourage alternative energy as a matter of policy; although, against a background of sharpened political debate over energy subsidies, it remains to be seen whether recent developments have assisted this cause.

Mitchell Menaker, partner, New York (mitchell.menaker@shearman.com), Derek Kershaw, associate, New York (derek.kershaw@shearman.com), Simon Letherman, counsel, London (simon.letheman@shearman.com), Iain Scoon, partner, London (iscoon@shearman.com) and Gabriel Ng, trainee, London (gabriel.ng@shearman.com) of Shearman & Sterling.