Who Invited HLBV to the Party? (and can someone please kick them out!)
How the Hypothetical Liquidation at Book Value methodology has become a challenge for public corporations seeking to support renewable energy and other ESG initiatives
By Matt Davis
Corporations Aggressively Pursuing ESG Profiles
Today more than ever, public corporations are actively seeking to improve their ESG profiles. There are multiple ways to forward this agenda, from reducing their carbon footprints to diversifying their workforces and boards to improving their transparency for their investors and actively improving the communities in which they operate.
One powerful tool that corporations can utilize to further this agenda is investment in renewable energy tax credit partnerships. This allows a company to direct capital earmarked for Federal tax liabilities towards investment in a partnership that develops and operates renewable energy projects. A $25mm tax equity investment would facilitate solar installations with the capacity of adding 66,000 KWdc of clean, renewable energy to the power grid. Over the lifetime of such a project, this is the equivalent of 350,000 homes’ electricity use per year or removing 465,000 passenger cars from the road annually.
Accounting Approach is Hindering ESG Investments
The Federal government is encouraging investment in renewable energy through tax credit programs, and corporations are looking for ways to move in greener directions, creating a powerful alignment of interests. In the last decade alone, solar has experienced an average annual growth rate of 49 percent, according to data from the Solar Energy Industries Association. There are now more than 89 gigawatts (GW) of solar capacity installed nationwide, enough to power 16 million homes. Given the huge positive impact these projects create for corporate investors and their communities, one might expect broad institutional participation in these investments. Why is this not the case? The answer, certainly in part, lies in accounting treatment. Accounting firms, particularly the traditional big four, are requiring that their clients utilize a highly inefficient and complex approach to account for these investments. This accounting treatment results in reporting which inaccurately reflects the economics of the investment and in some instances may result in investment losses reported above the line, adversely and artificially impacting operating earnings. This adverse accounting treatment is materially hampering investment at this critically important moment. The Financial Accounting Standards Board (FASB) should take note and remove a significant roadblock to investment.
In November 2000, the American Institute of Certified Public Accountants (AICPA) released an Exposure Draft Proposed Statement of Position (SOP) entitled Accounting for Investors’ Interests in Unconsolidated Real Estate Investments. The purpose of the SOP was to offer a framework where partners in real estate and private equity deals could determine the valuation of their stake in the event of a liquidation of the partnership. One of the concerns the authors sought to address was how to deal with variable interest investments. The backdrop at the time were the Enron generated accounting issues which emerged with difficult valuations of complicated partnership interests. The mechanism introduced was called Hypothetical Liquidation at Book Value (HLBV). HLBV’s goal is to value variable interests (ownership interests that change over time) in partnerships during the life of the partnership. As its name would suggest, it does so by assuming the partnership liquidates at its book value at the end of each reporting period and the interests are valued based on what they would receive under such hypothetical liquidation under the terms of the partnership agreement. This is a sensible approach to more accurately reflect the value of interests in partnership investments where the underlying partnership interests and value of partnership assets change.
The modern-day solar ITC partnership flip transaction, which is the typical ITC partnership structure, was developed many years ago, pre-dating the HLBV SOP. Nevertheless, HLBV is ill-suited for use with tax equity ITC partnerships. In the typical tax equity ITC investment, the vast majority of the investor’s return is the receipt of federal ITCs. In the case of solar ITC, it’s all received in the initial year of the investment. The tax equity investor may receive additional cash distributions over the following years, but they are modest compared to the ITC. In the case of solar ITC, recapture is so rare as to be statistically insignificant but would occur if the partnership was liquidated prior to the expiration of the five-year recapture period. After the expiration of the five-year recapture period, the tax equity’s investor interest in the partnership “flips” from 99% to 5% and typically is redeemed from the entity shortly thereafter. The tax equity partner’s retention of a 99% interest for the first five years of the partnership is to avoid recapture of ITC received in the first year, not because of some expectation of significant economic benefit from the underlying project.
Applying HLBV methodology to tax equity ITC investments illogically skews income recognition and results in a distortion of the economic reporting of the investment for GAAP reporting purposes. Under a hypothetical liquidation of the investment, ITC recapture would result, and the tax equity investor would receive the bulk of the value of the partnership’s book valued assets to compensate for the loss of the ITC under most partnership agreements. Under both the deferral and the pass-through method of equity accounting, the partnership’s investment would be written down to a very small number upon the receipt of the ITC. This would be an appropriate result given the limited remaining economic return expected by the tax equity investor. However, HLBV would write the investment back up close to its original value based on its use of a hypothetical liquidation to determine the value of the underlying partnership interests. This would result in grossly overstated income and assets in the initial year and overstated above-the-line losses in the succeeding five years. In any ITC partnership, early liquidation is not an option. While partners may have good reason, economic or otherwise, to dissolve a real estate partnership, there is never a reason justifying a liquidation that would trigger ITC recapture.
Public corporations who seek to participate in solar ITC partnerships are often compelled to apply HLBV and the harmful GAAP losses that frequently accompany its use. HLBV creates EPS volatility that can be prohibitive for meaningful investment in solar ITC. Accounting firms are challenged to find a more appropriate methodology to address this partnership issue and, for their part, are actively working with their clients to minimize the adverse impacts that can result from HLBV implementation. Companies are forced to choose between opportunities that support ESG and green initiatives, and the price stability of their shareholder’s stock.
Is there a better way?
The partnership flip structure that governs the majority of solar ITC partnerships could be better served by an accounting methodology already used in another corner of the tax credit universe. The Low Income Housing Tax Credit (LIHTC) program utilizes proportional amortization. FASB issued guidance on LIHTC in January 2014, enabling investors to account for the income statement effects of their investments entirely through income tax expense. FASB made these adjustments, in part, to encourage investors to support these low income housing projects, which may lack capital otherwise. This is a viable roadmap that could be followed for the solar ITC.
While this path warrants exploration, it will also likely take FASB a long time to provide investors and accounting firms with better guidance.
In the meantime, accounting firms are working with their audit clients and solar ITC developers and syndicators to structure transactions that can minimize the negative impacts of HLBV application. Often, the investment and the investment reporting are so small relative to the operations of the company that HLBV accounting can be ignored. In situations where the investment is intended to be significant, solutions are now being proposed by a number of the Big 4 firms through use of the flow-through method of equity accounting to smooth out the above-the-line impact of these investments. This requires careful consultations with consultants to formulate specific company accounting policies to better reflect the impact of these investments. The goal would be to recognize the income from these investments either over the underlying asset’s useful life or the ITC recapture period. A standardized, widely available disseminated solution would be in everyone’s economic interests.
Tax equity ITC investments serve our national interests. Corporations are highly motivated to make these investments in furthering their own impact initiatives and are frustrated by the complications created by HLBV accounting. FASB should be actively looking to modernize methodologies that will encourage investment. The accounting industry can help investors achieve their goal to support renewable energy and properly navigate the imperfect accounting methodologies that lie in their path.
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