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Where Does Taxation of a Building Component End and a Utility Begin?
As solar prices become more affordable and utility and tax subsidies continue, it has become economical for even the northern regions of our Country to install solar PV arrays.
Companies, commonly referred to as Energy Services Companies (ESC) who where once relegated to the southern tiers, are now popping up in northern New England promising "free" commercial installations.
This technical taxation brief describes from the ESC's view point, how commercial installations using investor funds would be taxed on ESC owned solar infrastructure installation.
The primary issue, yet to be resolved, is where does the taxation of a building component end and that of "utility" begin. The two classifications render material and opposite results significantly altering transaction structuring economics.
Solar Panels and Connecting Infrastructure - Classified as Rental Real Estate or Equipment?
From a taxation perspective, owners and their investors wish to depreciation their capital investment in each commercial installation as quickly as possible. The classification between equipment, generally with 5 year lives, versus real estate, which is 27.5 or 39 year, is very material. For passive real estate investors who are rental real estate professionals, any losses would be deductible if classified as rental real estate under IRC Section 469(c)(7) assuming an aggregation election is in place.
From the taxation perspective of the owner-builder, their primary concern is to match cash out flows to repay principal with depreciation so that such payments are all pre-tax.
From a building component view point (rather than that of a utility) and due to the finalization of the so-called "repair regulations," this issue must be analyzed in terms of "unit of property." Interesting, the regulation discussed below used a different term, rather it used "distinct asset" rather then the new nomenclature.
Investors Who Are Rental Real Estate Professionals and REITs
The classification of solar infrastructure as rental real estate would create all sorts of problems and opportunities for both the ESC, its members and the ESC investors.
The US Treasury weighed in on this matter with proposed regulation (REG-150760-13; 79 F.R. 27508-27516 issued May 14, 2014) as it effects REITs. The classification is material to REITs because non-real estate assets could easily cause a REIT to loose its pass through taxation status.
Th IRS concluded in that proposed regulation that "The PV Modules, mounts, and exit wire are each distinct assets." Under example 8 of the regulation which addresses land based mounts, and using a 5 factors permanency test, the IRS concluded that the mounts for the solar panels are inherently permanent and are real property; the panels themselves are machinery or equipment, not real property; and the exit wire is real property. Consequently, in application to such installations the portion of the lease attributable to the PV panels would be an equipment, not rental real estate.
However, in example 9, the exact same installation (at least from our view point) but directly associated with a building's electrical usage, was deemed to be all real estate. Here lies the basis upon which the classification of an entire PV array system may be classified as real estate.
Keep in mind that these proposed regulations (not yet permanent at the time of this article) have little legal authority as they are not enforceable.
We believe the IRS' proposed regulation and its decisions in examples 8 and 9 are flawed in that they substitute a "distinct asset" test for what should have been a "unit of property" analysis. That leads us to believe that this proposed regulation was not reviewed, or not reviewed very thoroughly, or may be caught up in turf battles in the National Office, between the staffs who created this proposal and whose who that composed the Repair Regulations that require the latter analysis. It is not clear to us why they so materially departed from the finalized Repair Regulations. It is certainly possible that these proposes will be re-proposed rather than simply issued.
Our personal believe, subject to additional research is that under the final Repair Regulations a solar array permanently affixed to a building's roof and designed and installed primarily for its electrical needs, yet owned by an ESC rather then the building's owner, would constitute a separate "Unit of Property" that would constitute "real estate" because it is a component of the building's electrical system as defined in those final regulations.
We would lament that there certainly exists risks that in the final case law opinions occurring decades from now, the courts may opine that any system generating electricity, regardless of its association with a specific structure, is machinery and equipment. Those decision would need to grapple with the fact that all buildings include systems that generate products, the nature of which may also be produced by a utility, for example, hot water, heat, a/c and sewer to water. We suspect that the law will determine that the aspects of "production" when they are available for, and sold to a public utility, are machinery and equipment which is akin to most of these installation. In the interim, we recommend that commercial installations wishing to classify their solar array installation as equipment distinguish their tax attributes by structuring a substantial portion of the output for 3rd party use and then convert as needed to their own use. Likewise, those commercial installation wishing to classify the entire installation as real estate should enter into agreements with neighbors to provide private power in a consortium fashion.
Another important related logistical issue in terms of the above tax positions, is whether the ESC's revenue stream should be structured in its contracts as rental income, determined in terms of electrical usage, or revenue from the sale of electricity. Such carefully crafted structures tied to real world economics would be difficult for the IRS to reclassify.
Those with the most to gain or loose should consider requesting a private letter ruling and its likely industries, such as REITs which are far out in front on this issue, may win this key classification battle. ESC have much catching up to accomplish their general classification goals.
Conclusion
The professionals at Dana S. Beane & Company, PLLC have extensive working knowledge in the many renewable energy industries. In order to help assure favorable out comes, we recommend you integrate our tailored creative transaction structures, taxation and accounting system design and implementation capabilities at the beginning of your project . Our gold is to work to implement transaction taxation strategies with accounting systems that work as designed and anticipated wherein accounting and tax work products become "routine" and thus, affordable. That is, proper planning will avoid exception based accounting and tax reporting which is never pretty and is always expensive. Having a grasp of cash flow economics, tax consequences of structuring alternatives and implement methods will assure your that project does not experience surprises or worse. Renewable energy is an excite new field with much promise to save our world from human induced climate change, however, avoid being a "cow boy or girl pioneer with an arrow in the back" by employing our expertise and experience in your projects.
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