What are tax advantaged financing structures?
Tax-advantaged financing structures support private investment in designated activities by reducing the effective tax rate applied to realized profits. Examples in the U.S. tax code include support for low-income housing, natural resource extraction, or sewage treatment. Extending these provisions to investments such as greenhouse gas (GHG) reduction and carbon removal, which would allow greater access to capital and lower tax rates on income from such projects.
Three tax advantaged financing structures are particularly helpful for decarbonization projects. These do not represent a comprehensive list of all tax advantaged financing structures, but rather a few prominent examples.
- Master Limited Partnerships: MLPs are investment vehicles that combine the benefit of being able to raise capital as a publicly traded entity with the tax benefit of a private partnership. Most MLPs are concentrated in the oil and gas sector.
- Real Estate Investment Trusts: REITs are companies that own or operate income-generating real estate including apartment complexes, hotels, office buildings, timberland, or infrastructure like cell towers and energy pipelines. They avoid “double taxation” – i.e., are only taxed at the individual (not corporate) level – and are traded like stocks.
- Private Activity Bonds: Tax-exempt PABs are bonds issued by state or local governments to support private investment in qualifying activities. The Internal Revenue Code allows for use of PABs to raise funds for otherwise private activities that have significant public benefit, like low-income housing, airports or hazardous waste facilities.
How do tax-advantaged financing structures work?
- Master Limited Partnerships: MLPs trade on public exchanges, so they are able to raise capital in public equity markets, like corporations, but unlike corporations, they are only taxed at the individual level rather than at both the corporate and individual levels. Unit holders, similar to shareholders, contribute capital and receive a share of the MLP’s income, which depends on the project’s cash flow volume. MLPs have one general partner that manages the MLP and the rest are limited partners (unit holders).
- Real Estate Investment Trusts: REITs are similar to MLPs in terms of ability to raise capital and their ability to only be taxed at the individual level. REITs lease space and collect rent on that space, which they then distribute to shareholders as dividends. Carbon removal infrastructure is not currently REIT- accessible, but guidelines allow renewable energy REITs in some cases. Timberland is also eligible as a REIT. To qualify as a REIT, 75% of assets and gross income must come from qualifying “real property” and 90% of taxable income must be distributed to shareholders.
- Private Activity Bonds: Tax-exempt PABs function like municipal bonds, but the proceeds are used by private entities for development of certain types of qualifying infrastructure. The income generated on these bonds is not subject to federal income taxation, and because of this, borrowing rates are lower than conventional borrowing rates and projects can be more profitable for developers. These types of tax-free bonds, which are generally only accessible by government-owned projects, can be used by municipalities to attract investment and encourage economic development: municipalities are able to essentially borrow on behalf of private companies that will carry out the project and take advantage of the tax exemption benefit.
Key design considerations
These tax-advantaged financing structures exist already in the tax code, so policymakers may consider extending their applicability to include carbon removal and clean energy infrastructure, or designing new policies specifically tailored for carbon removal or clean energy. A key consideration across all structures is what types of clean energy or carbon removal projects would be eligible to take advantage of these financing structures. These financial structures are likely most applicable to carbon removal approaches or technologies that require upfront infrastructure investments, which could include technological options like direct air capture and associated CO2 pipelines, or natural pathways like forest restoration that uses machinery like sawmills. Given that they are financing structures dependent on investors committing capital upfront and receiving regular dividend payments in return, MLPs, PABs, and REITs would also only be applicable to projects where there is sufficient and predictable income, for example through the sale of captured CO2 or timber.
Structure-specific design considerations include:
- How should project income be distributed to unit holders (how frequently and what proportion of income)? Would a minimum quarterly distribution or variable distributions make sense?
- What is an optimal required level of income from qualifying sources? Should it be revised from the current level of 90% given the different revenue structure of decarbonization projects as compared to projects that currently qualify for MLPs?
- What are appropriate asset, income, and cash distribution thresholds? Should they be revised from the current 75%, 75%, and 90% thresholds, respectively?
- Should a minimum number of shareholders be required? And should there be any restrictions on the number of shares owned by any one individual?
- Should volume or size limitations on bond issuance be included? If so, should they be based on the type of project, on a state-by-state basis, or some other metric?
- What is an appropriate duration of financing?
MLPs were created in 1981 and restricted in 1987 to the real estate and natural resource sectors over concerns of too much lost corporate tax. A few attempts to expand the eligibility for MLPs to clean energy generation have received bipartisan support – first in 2012 with the introduction of the MLP Parity Act, which was reintroduced a few times after, and later renamed the Financing Our Energy Future Act and reintroduced in 2019. Calls have also been made to expand MLP access to carbon capture and storage technology, provisions for which are included in the 2020 Moving Forward Act introduced in the House.
MLPs have allowed oil and gas companies to raise capital on public markets, to which renewable energy (and carbon removal) projects have not had the same access. Access to MLPs for renewable energy and carbon removal would allow for greater access to public capital and avoidance of double taxation for corporations. MLPs could theoretically be used for both technological carbon removal projects, like direct air capture, as well as infrastructure investment needed for natural pathways, like forest restoration.
While there have been numerous proposals to expand access to MLPs to the renewable energy sector, some concerns exist as well. The most prominent seems to be that if the idea is to level the playing field between oil and gas and renewables, it would be more effective to eliminate the loophole of oil and gas being designated “passive income” that allows them access to MLPs. Additionally, expanding access to MLPs could open it up for other industries to try and join and could erode the corporate tax base.
Real Estate Investment Trust
REITs were created in 1960 to allow wider access to investment in real estate. Since then the IRS has slowly expanded assets that can qualify for REITs, but that definition still includes mostly traditional assets like buildings, railroads, cell towers, and others; due to asset and income limitations, REITs cannot own a significant amount of clean energy (or carbon removal) infrastructure. In 2016, the IRS clarified that some renewable energy assets associated with buildings may be REIT-eligible, but large utility-scale assets are not. Companies can request the IRS to make a judgment as to whether they are acceptable as a REIT – the first of these requests came in 2013, with a renewable and energy efficiency company (since IRS considers energy efficiency to be a building component). Timberland is already eligible as a REIT and could be leveraged to also focus on carbon removal.
Expanding REIT accessibility would entail the IRS expanding its definition of “real property” to include clean energy or carbon removal infrastructure.
Private Activity Bonds: Formerly known as Industrial Development Bonds, tax-exempt Private Activity Bonds have been used to finance many types of infrastructure including roads, airports, and mass transit systems in the U.S., however, the Internal Revenue Code does not include clean energy or carbon removal pathways as qualifying projects. Other types of tax-advantaged bonds exist for clean energy, but do not allow the same access to private investment. Forest resilience bonds exist to incentivize private investment in forests, but are not tax free.
- Intro and legislative summary: https://nawindpower.com/is-it-time-for-renewable-energy-mlps
- Issue brief on the case for MLP parity: https://acore.org/wp-content/uploads/2018/03/ACORE_MLP_IssueBrief_March-2018.pdf
- Legal perspective on MLP fundamentals and structuring: https://www.kslaw.com/blog-posts/master-limited-partnerships-fundamentals-and-related-structuring-and-formation-considerations
- Arguments against MLP parity: https://digitalcommons.wcl.american.edu/cgi/viewcontent.cgi?article=1586&context=sdlp
Private Activity Bonds
- Legal overview of PABs: https://www.sgrlaw.com/briefings/overview-of-private-activity-bond-financing-and-incentives/
- C2ES webinar on using PABs for decarbonization infrastructure: https://www.youtube.com/watch?v=iOzKG0MwfzA
Real Estate Investment Trusts