The Need for California Conformity with Federal Tax Law for Direct Pay and Transferability

California is one of the top states for clean energy generation, and tax equity finance has been an essential tool for attracting private investment into the state’s clean energy sector. To meet the state’s goal of 100% clean energy by 2045, California will need to build 148,000 megawatts (MW) of new clean capacity.1 Continuing to attract private investment is essential to maintaining this progress while also creating economic activity across the state. The federal Inflation Reduction Act (IRA) created additional tools—direct pay and transferability—that seek to expand investment options in the clean energy sector. Many state tax codes allow for “rolling” conformity with federal tax laws; however, an update to California’s tax code is necessary to ensure that the state can take full advantage of these new financing options.

This fact sheet provides a brief introduction on the central role tax equity finance has played in clean energy projects, describes the new direct pay and transferability financing options, explains the difference between the state and federal tax code, and discusses why state-federal conformity is important to unlocking these new investment tools for sustaining California’s climate and economic progress.

Tax equity finance is essential for clean energy project development

Tax equity provides a critical financing source for clean energy projects. In a typical tax equity transaction, an investor funds a large portion of a wind, solar, storage, or other clean energy project’s overall financing in exchange for a share of the project’s tax credits (i.e., the Production Tax Credit (PTC) and Investment Tax Credit (ITC)), other tax benefits, and cash flows. Tax equity investments have several key benefits for renewable energy projects:2

  1. Enabling Project Financing: The tax equity investor provides between one-third to two-thirds of the total capital of a clean energy project, injecting essential upfront capital into its development.
  2. Fully Utilizing Tax Incentives: Project sponsors often lack sufficient tax capacity to take full advantage of the federal tax incentives (the PTC and ITC) available for clean energy projects. Tax equity transactions allow the project sponsor to monetize the federal tax credits and other tax benefits for clean energy by allocating them to a tax equity investor in exchange for their up-front capital.
  3. Enhancing Financial Stability: Tax equity provides additional value to project sponsors in the form of long-term advance commitments to fund projects, which the sponsors can use to raise construction finance.

Investors view tax equity as a low-risk asset class with attractive risk- adjusted returns. Clean energy projects are often held in limited liability corporations (LLC) and taxed as partnerships. In a typical transaction, the project sponsor will form a partnership with a tax equity investor to own the project LLC jointly. The tax equity investor acts as a passive owner and sizes its investment based on a pre-negotiated rate of return, which comes from tax credits and other tax-related benefits, like the ability to claim all the depreciation of the project’s qualified assets in the first five years of the project; the rest of the return comes from the cash distributions from the project’s cash flows. The most common tax equity arrangement is referred to as a “partnership flip” transaction, illustrated below:

Figure 1: Basic Partnership Flip Transaction

U.S. banks represent approximately 80% of the annual clean energy tax equity market, which has ranged from $18-23 billion annually over the past three years.3 The tax equity market is estimated to grow to over $50 billion this decade.4

Transferability and direct pay diversify and expand sector investment options

To enhance the accessibility and effectiveness of the PTC and ITC, the IRA introduced provisions for direct pay and transferability, offering greater flexibility for investors for financing renewable energy projects.

Direct pay allows tax-exempt and governmental entities to invest in clean energy projects and claim the equivalent amount of the tax credit in the form of a direct payment from the Internal Revenue Service (IRS). Direct pay is also available for taxable entities that would receive credits for carbon capture, clean hydrogen, and the manufacturing of renewable energy components.

Transferability enables project owners to monetize tax credits by transferring them to other taxpayers with sufficient tax liabilities. Exercising transferability can help reduce the complexity of tax equity transactions by simplifying the relationship between a project developer and tax credit purchaser. Instead of entering into a multi-year partnership, the investor can provide the capital necessary in exchange for tax credits and exit involvement in the project. This simplified relationship opens the door for increased investment in the sector, the participation of non-traditional investors, and more significant project development. Transferability is expected to supplement traditional tax equity and attract $10 billion in 2024, and much of this will be deployed through hybrid structures that continue to utilize tax equity.5

Description of Current Law

According to the Federation of Tax Administrators, conforming state tax laws with the federal tax code helps simplify individual taxpayers’ compliance by creating standard definitions and rules within state and federal tax administration.6

However, California does not have “rolling” conformity with current federal tax laws, meaning that to conform with specific changes on the federal level, the state legislature needs to act.7 Currently, California tax law conforms to federal law as of January 1, 2015.8 Notably, because of previous legislation that created conformity with federal tax law for traditional tax equity investments, transferability and direct pay would be treated differently than traditional tax equity despite their status as alternative methods to monetize the federal tax credits:

  • Direct pay: If a taxpayer elects to use the direct pay option under the IRA, the Internal Revenue Service (IRS) treats such an election as an overpayment of tax and refunds the taxpayer for the appropriate amount. Without a change to California’s tax laws, these payments could be considered income for state tax purposes, exposing entities traditionally exempt from income tax to state tax liability.9 Failing to change this provision risks shutting California’s state, local, and tribal governments, and other traditionally exempt taxpayers from accessing the IRA’s benefits.
  • Transferability: If a taxpayer elects to use the transferability option under the IRA, the IRA provides that the proceeds of the sale of tax credits under the transferability provisions are excluded from taxable income. Absent a change to state law to conform with the federal requirements, the proceeds of the sale of federal clean energy tax credits by California project developers will be considered income for state tax purposes. In addition, purchasers could not claim a business deduction for the cost of acquiring the credit.10

Why conformity between California state and federal tax laws is important

While California is one of the top states for clean energy generation, the state will need to build 148,000 MW of new clean power to meet its goal of 100% clean energy by 2045. Since 2021, investments in California’s clean energy economy have been substantial, with private sector announcements totaling approximately $18 billion in clean power generation projects, $7 billion in clean energy and manufacturing and infrastructure, and $6 billion in electric vehicles and batteries.11

According to the U.S. Energy and Employment Report from the U.S. Department of Energy (DOE), California is the top state in the nation for clean energy job growth,12 and according to projections, the state’s clean energy sector – specifically solar, wind, battery storage, and energy efficiency – stands to produce approximately 243,000-380,000 new jobs by 2030.13

It is clear that the clean technology sector is a core engine for economic opportunity, new job creation, and attendant tax revenues. However, it is unlikely that clean energy projects in California will be able to take advantage of either the direct pay or transferability provisions of the IRA. This could impact the cost of projects, likely dampening overall economic activity tied to the clean technology sector and revenue generated from that increased economic activity.

Failure to revise California’s tax code to fully take advantage of the IRA’s transferability and direct pay provisions risks disrupting the important progress of California’s clean energy economy.

  • Dampen Economic Activity: For example, without conformity, projects could incur tax costs of 8.85 cents for every dollar invested in transferability and direct pay. This could make California projects prohibitively more expensive to complete when compared to other neighboring states (Arizona, Nevada, Oregon) that have implemented federal conformity. If California does not conform its tax code, it risks less economic activity in the sector overall and therefore less wage, property, and other tax revenue impact for the state.
  • Equity concerns: Any nonconforming state that does not act to align its definitions of taxable income with the changes made under the IRA risks locking out communities, investors, and individuals from fully accessing the historic federal resources for creating jobs and economic opportunities, advancing clean energy deployment, and meeting climate change objectives.
  • Impact to tribal and local governments: California’s state, local, and tribal governments, and other traditionally exempt taxpayers would have to pay more for clean energy and could be shut out from accessing a federal benefit (direct pay) that was specifically created for them in the IRA.
  • Higher cost of power: If California does not conform its tax code to enable the use of direct pay and transferability, projects in California could instead be limited to using traditional tax equity only. There will be fewer available financing partners under this model, and financing costs may be higher compared to projects that can also take advantage of direct pay and transferability. These financing costs could be passed on to ratepayers through higher power prices, like any other project costs.
  • Slower path to decarbonization: Limiting California clean energy projects to using traditional tax equity only could slow the pace of clean energy deployment in the state, and result in project developers and investors moving business elsewhere. This could result in the loss of billions of investments and thousands of jobs in California’s clean energy economy – threatening the attainment of the state’s climate objectives.
  • Burdens on taxpayers: Failure to conform could lead to confusion and additional burdens on taxpayers, inadvertent tax consequences, and unnecessarily raising the cost and complexity of project development and deployment.

1 Governor Newsom Updates the Roadmap to California’s Clean Energy Future | Governor of California

2 The Risk Profile of Tax Equity Investments

3 Tax Equity: Enabling Clean Energy and Growing the American Economy – ACORE

4 Tax Equity: Enabling Clean Energy and Growing the American Economy – ACORE

5 ACORE interviews with investors

6 “Hearing with IRS Commissioner Rettig on the 2022 Filing Season” – U.S. House of Representatives

7 How do state individual income taxes conform with federal income taxes? | Tax Policy Center

8 Bill Analysis – SB-1191 Personal Income Tax Law and Corporation Tax Law: exclusions: environmental credits. (ca.gov)

9 Ibid.

10 Ibid.

11 Investing In America | The White House