Investors using the equity method of accounting for investments in renewable energy projects often run into challenges when applying traditional equity method accounting to renewable energy products with tax equity interests because income, losses, and cash distributions can shift over a project’s life.
Instead of the traditional equity method, the hypothetical liquidation at book value (HLBV) method may offer a solution for allocating GAAP equity, determining each investor’s share of earnings or losses, and improving reporting accuracy across the life of a project.
In this article, we explore how HLBV can be applied, consider alternative models such as the proportional amortization method (PAM), address potential challenges, and discuss related considerations for renewable energy partnerships.
Incentives and partnership structures in renewable energy projects
Project incentives
Renewable energy projects may generate value through:
Investment tax credits (ITC) including bonus credits available under the Inflation Reduction Act, which may be transferable
Production tax credits (PTC), including bonus credits available under the Inflation Reduction Act, which may also be transferable
Other incentives, such as renewable energy credits, property tax rebates or sales tax exemptions, and other state and local incentives
An investor’s ability to fully monetize the different economic incentives may be restricted, thereby decreasing the value of a project. In an effort to efficiently monetize these incentives and thereby increase the value of a project, investors will enter a partnership arrangement that provides for an allocation of these attributes to the investor that can most efficiently absorb the particular attribute. These “special allocations” allow the investors to segregate the attributes and allocate them separately to the investor who can most efficiently use them considering their own tax or financial profile. The allocations may also change over time, making it difficult to measure an investor’s interest in the project at any given point.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
The role of operating agreements
Renewable energy projects to deliver energy via solar, wind, hydro, or certain other sources are often structured as partnerships, with operating agreements that typically:
Guide allocations of taxable income, loss, and credits — including transferable credits
Provide terms that govern how cash distributions are allocated to different investor classes, and
Seek to allocate these items efficiently to meet investor and sponsor economic goals
These allocations often adjust over time, based on the project performance, which could lead to differences between hypothetical and actual liquidation outcomes. As a result, determining each investor’s financial interest for accounting purposes requires a method that reflects these changing economics rather than static ownership percentages.
HLBV method
To capture the dynamic nature of partnership allocations, many renewable energy investors apply the Hypothetical Liquidation at Book Value (HLBV) method. Rooted in the AICPA’s proposed Statement of Position:Accounting for Investors’ Interests in Unconsolidated Real Estate Investments (2000), HLBV allocates GAAP earnings by assuming liquidation at book value at each reporting date. Investors’ earnings equal the change in their claim on net assets under the liquidation waterfall in the operating agreement.
This methodology aligns directly with ASC 970-323, which requires equity method allocations to reflect liquidation outcomes rather than ownership percentages when the two diverge.
HLBV application
In an HLBV model, project GAAP equity is typically allocated based on partners’ capital balances as outlined in the operating agreement’s liquidation waterfall provisions. The process generally assumes:
Assets are sold at GAAP book value in a hypothetical scenario
Liabilities are settled
Remaining cash is distributed according to the liquidation provisions of the limited liability company agreement
The liquidation waterfall, as defined by the operating agreement, typically governs how cash would be distributed in a hypothetical liquidation. Transferable credits, such as those for ITC or PTC, may impact capital account balances depending on the accounting policy and the timing of the sale and subsequent distributions, potentially affecting HLBV calculations.
Hypothetical treatment
The proposed SOP provides limited guidance on renewable energy-specific issues, such as addressing ITC recapture or the treatment of transferable credits in a hypothetical premature liquidation. Operating agreements might include indemnification provisions or other consequences triggered by early asset sales or credit transfers, which could complicate HLBV calculations.
Alternative model: Proportional amortization method
FASB ASU 2023-02 broadened the proportional amortization method (PAM) beyond low-income housing tax credit structures to other qualifying tax credit investments. PAM simplifies reporting by recognizing the net benefit of tax credits and other tax attributes as a single yield, producing more predictable results.
PAM’s application may be limited by strict eligibility criteria. To qualify, substantially all the expected benefits must arise from income tax credits and other income tax benefits. Many renewable energy tax equity structures fail this test because investors often derive significant returns from operating cash flows, residual values, or other economic attributes.
As a result, while PAM may initially appear more straightforward, traditional renewable energy investments may not qualify and HLBV remains the predominant method of accounting.
This is a technical accounting matter that should be discussed with your accounting advisor with consideration given to particular facts and circumstances.
Measurable impacts
When applying HLBV during restricted periods, such as when tax credit recapture or transfer restrictions might apply, investors may need to consider measurable provisions in the operating agreement. For example, some agreements might restrict allocation flips during certain periods, which could conflict with general liquidation provisions that allow flips when a tax equity investor achieves a target internal rate of return (IRR). The SOP suggests that HLBV typically excludes consideration of economic impacts that could arise during an actual liquidation process, such as early termination fees, recapture costs, indemnification payments, or debt prepayment penalties, implying investors might focus only on GAAP-relevant impacts in hypothetical scenarios.
Accounting policy elections
Interpretations in HLBV calculations may be considered accounting policy elections. Investors might agree on how to handle specific provisions, such as indemnifications or recapture, in a hypothetical liquidation to avoid discrepancies with actual liquidation scenarios. Because HLBV interpretations may favor one investor over another, it is recommended that those interpretations be clarified between the investors where possible (including addressing them in the operating agreement).
Additional considerations
Benefits monetized outside the partnership, such as through Section 743(b) transactions, may affect an investor’s IRR in yield-based flips, potentially impacting HLBV equity calculations. Operating agreements might clarify how such benefits, including transferred ITC or PTC, are treated to reduce ambiguities.
Potential conflict areas
Ambiguities in operating agreements may lead to disputes in HLBV application. Key areas include:
IRR determination
Some agreements might assume all allocated attributes, including transferable credits, are monetized for IRR calculations but exclude partner-level transactions like Section 743(b) benefits. Clarity may be needed on whether suspended losses under Section 704(d) or transferred credits are included in IRR calculations, as ambiguity could lead to disagreements. For debt-funded projects, debt-funded losses and the impact on the IRR can vary.
Hypothetical liquidation as a discrete event
HLBV might treat liquidation as a discrete event or combine it with normal allocation year items. Treating it discretely may avoid conflicts with tax principles, such as claiming depreciation on disposed assets. The operating agreement might specify whether liquidation impacts, including those from transferable credits, are integrated with or separate from annual allocations.
Waterfall provisions
Liquidation waterfalls typically outline how income or proceeds are allocated. Many agreements follow Section 704(b) safe-harbor principles, distributing proceeds based on positive capital accounts. Gain from liquidation may be allocated to restore deficit accounts, satisfy minimum gain chargebacks, and achieve target IRRs, potentially triggering flips in distribution percentages. Some liquidation provisions specifically earmark or carve out proceeds from transferable credits instead of treating them as proceeds available for liquidating distributions under the usual provisions. Ambiguities in whether to allocate gain or proceeds might favor different investors, suggesting a need for clear provisions.
In many tax equity deals, base case models may include an HLBV schedule to address ambiguities. Including a provision to default to the base case model could clarify mechanics and reduce disputes.
