Q&A: Tax liability insurance
December 2024 | SPECIAL REPORT: CORPORATE TAX
Financier Worldwide Magazine
December 2024 Issue
FW discusses tax liability insurance with Josh Emmett at CAC Specialty.
FW: Could you explain how the US Inflation Reduction Act has expanded the universe of taxpayers who can utilise tax credits?
Emmett: The Inflation Reduction Act (IRA) of 2022 fundamentally changed the way developers of clean energy projects can finance their projects. Prior to the IRA, developers, who were unable to utilise the tax credits generated by their projects themselves, would have to enter into ‘tax equity’ transactions to monetise the tax credits. Tax equity investors, typically large banks, employ teams of professionals that specialise in underwriting tax equity transactions for projects generating tax credits. The tax equity investor receives the tax credits and other tax benefits generated by the project as well as cash generated by the sale of electricity. The IRA now allows the direct sale of tax credits to taxpayers that can use such credits to offset their tax bill on a dollar-for-dollar basis. This means that tax credit purchasers do not need to analyse the economics of a project as an operating asset.
FW: Within companies, who is typically driving efforts to purchase tax credits?
Emmett: We typically see interest in tax credit purchases coming from tax directors and chief financial officers. Tax credits typically trade for 90-95 cents on the dollar. This means that a large corporate could purchase tax credits to reduce its tax liability by $100m and pay $95m for tax credits. This is a significant reduction in taxes paid and is a massive tax planning opportunity. At the same time, if there is an audit by the Internal Revenue Service (IRS), and the tax credits are reduced or disallowed, there is not a large margin of error before the corporate is paying more in taxes, interest and penalties than if it paid the original $100m of taxes. Thus, tax insurance is an effective and efficient tool to mitigate this risk and facilitate the purchase and sale of tax credits.
FW: In what ways is tax insurance being used to facilitate the purchase and sale of tax credits?
Emmett: Although tax credit purchasers do not need to analyse the underlying economics of a project, there is still risk to purchasing tax credits. The risk is that the IRS audits either the corporate purchaser or the owner of the project that generated the purchased tax credits and reduces or disallows the tax credit, resulting in an underpayment of taxes by the tax credit purchaser. Most corporates that are interested in purchasing tax credits do not have in-house expertise to diligence the projects. One way to mitigate this risk is to hire outside legal counsel that has experience with renewable energy projects and transactions to monetise the tax credits they generate. However, even with experienced counsel, there is still risk that the IRS disagrees with their analysis or the tax credits are recaptured. Tax credit transfer agreements typically include an indemnity from the tax credit seller to the tax credit buyer for any loss or reduction of the purchased tax credits. However, corporates may not want to rely on the developer’s balance sheet to backstop the indemnity. Tax insurance allows tax credit buyers to look to the creditworthiness of the insurance companies writing the policies, which are typically at least A-rated by AM Best.
“Although tax credit purchasers do not need to analyse the underlying economics of a project, there is still risk to purchasing tax credits.”
FW: Could you outline the process of obtaining a tax insurance policy? How long does it usually take?
Emmett: A tax insurance broker will gather information about the underlying project generating tax credits, the tax credit transfer and the parties involved in the transaction. This information is packaged together to send a submission to the insurers that are interested in writing tax insurance policies. The insurers typically provide proposals to the broker within three to four business days after receiving the submission and the proposals are discussed with the client before an insurer is engaged. The tax insurance market operates on the timelines of the transactions that they facilitate. From the time an insurer is engaged until the policy coverage is bound can take as little as a week, but two to three weeks would be considered a reasonable pace. Underwriting consists of two workstreams. First, the tax insurance underwriter will request information and documentation to complete an underwriting process. Second, the tax insurance policy language is negotiated between the insurer and the insured. The broker’s role is to facilitate these two workstreams to make it a smooth process.
FW: What are the tax risks typically insured under a tax credit insurance policy?
Emmett: There are three buckets of tax risks that can be insured under a tax credit insurance policy. First, the tax structure risk. If the tax structure is not respected by the IRS, there may be a loss of some or all of the tax credits transferred to the tax credit buyer. Tax structure includes the requirements to transfer tax credits from the seller to the tax credit purchaser. There may be other tax structuring as well. For example, the project may be owned by a tax equity partnership or a partnership with a preferred equity investor. Tax insurance will also insure that the underlying tax structure will be respected. Second is qualification risk. This covers a broad range of tax risks and will depend on the underlying facts of the project and the type of tax credit being purchased. Examples of qualification risks include compliance with the prevailing wage and apprenticeship requirements and qualification for certain ‘adders’ to tax credits. Adders include the domestic content adder for projects using a certain threshold of US-produced products, the energy community adder for projects located in areas where fossil fuels were historically a driver of employment or a coal mine or coal-based power plant was closed, and the low and middle income adders for projects located in low or middle income communities. For the investment tax credit, tax insurance will also insure the fair market value of the project and the allocation of such value to ‘energy property’ for purposes of determining the amount of the tax credit. Third is ‘section 50 recapture’. At a very high level, section 50 recapture occurs if ownership of project assets changes or a project is permanently placed out of service. Section 50 recapture is only applicable for the five-year period after a project is placed in service and is phased down by 20 percent each year. For example, if a project is sold in year two, 60 percent of the investment tax credits will be recaptured. If a project is sold in year four, 20 percent of the investment tax credits will be recaptured. And if the project is sold in year six, there is no recapture of investment tax credits.
FW: Could you highlight some of the key terms to be found in a tax credit insurance policy?
Emmett: A tax insurance policy provides certain duties and obligations of the insured and the insurer. The insured is required to provide timely notice to the insurer of any claim under the tax insurance policy, which generally is triggered when a taxpayer receives some form of communication from the IRS that the IRS is examining the tax credits claimed by the insured. Although the insured always remains in the driver seat of the IRS audit, the insured must cooperate with the insurer and keep the insurer reasonably informed. However, the insured cannot settle with the IRS without the consent of the insurer. The insurer also has duties under the policy to cooperate with the insured. The goal is to have a collaborative process between the insured and the insurer throughout the audit process, without the insurer slowing down the efforts of the insured. Moreover, a tax credit insurance policy includes a clear process for the insurers to make payment under the policy. Policies cover contest costs, which will be paid on a periodic basis, such as monthly or quarterly, and within a certain number of days of the insured submitting evidence of such contest costs. The insurer must also pay within a certain number of days – typically 45 or 60 – after a final determination. The language in the tax insurance policy is drafted so that a taxpayer receives the insurance proceeds when payment is due to the IRS, so the insured does not need to pay out of pocket and wait for reimbursement.
Josh Emmett is a vice president in CAC Specialty’s tax insurance practice, specialising in providing insurance solutions for tax credit based transactions. Prior to joined CAC, he was a senior tax associate at Orrick, Herrington & Sutcliffe LLP, where he advised both the investors and sponsors who were constructing, buying and selling, and financing renewable energy projects that intended to qualify for federal tax credits. He can be contacted on +1 (860) 605 4240 or by email: josh.emmett@cacgroup.com.
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