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The Bracewell Tax Report is a periodic publication focused on developments in federal

income tax law, including the recently enacted Tax Cuts and Jobs Act, with emphasis on
how such developments impact the energy, technology and finance industries. The
publication provides summaries of changes in tax law and its interpretation, as well as
related practical guidance critical to making strategic business decisions and negotiating
transactions.

WEEK OF NOVEMBER 5

Featured Articles
IRS and Treasury Department Release Proposed Regulations on Opportunity Zones
Coming out of the Dark: Energy Storage and Renewable Tax Credits
Additional Reading
Future Topics

FEATURED ARTICLES

IRS and Treasury Department Release Proposed Regulations on Opportunity Zones

By Liz McGinley and Steven Lorch

On October 19, 2018, the IRS and Treasury Department released highly-anticipated
proposed regulations (the Proposed Regulations) under Section 1400Z-2 of the Internal
Revenue Code of 1986, as amended (the OZ Statute). The OZ Statute, which was
enacted pursuant to the Tax Cuts and Jobs Act, offers tax incentives to encourage private
investment in qualified opportunity zones (QOZs), which are certain low-income
communities designated by the Treasury Department.
The OZ Statute initially was met with great enthusiasm from taxpayers that saw
opportunities to recognize gains without current tax liability, reinvest such gains, and
potentially be subject to a reduced effective rate of income tax on such gains when they
ultimately are recognized. The OZ Statute, however, was long on promise and short on
details. The Proposed Regulations, which provide clear and practical guidance on the
scope and application of the OZ Statute, have been well received by taxpayers,
practitioners and commentators alike. Although many questions remain, the Proposed
Regulations should provide most taxpayers with sufficient guidance to obtain the benefits
of the OZ Statute. Additional regulations with respect to the OZ Statute are anticipated by
year end.

Primary Tax Benefits under the OZ Statute

The OZ Statute provides three primary tax incentives to encourage taxpayers to reinvest
capital gains in qualified opportunity funds (QOFs). First, a taxpayer may elect to defer
U.S. federal income tax on capital gains, to the extent such capital gains are reinvested in
a QOF, until the earlier of the taxpayer’s disposition of the QOF investment or December
31, 2026.

Second, a taxpayer that elects to defer such capital gains may receive an increase in its
tax basis in the QOF investment equal to 10% of the gain initially deferred if the QOF
investment is held for 5 years prior to December 31, 2026, and an additional increase in
tax basis equal to 5% of such deferred gain if the QOF investment is held for 7 years prior
to December 31, 2026. A taxpayer therefore could eliminate up to 15% of the capital gain
that was deferred in connection with the initial QOF investment. Because the deferral
period ends on December 31, 2026, however, taxpayers must make investments in QOFs
no later than December 31, 2019 to be eligible for the full 15% exclusion.

Third, if a taxpayer holds the QOF investment for at least 10 years, the taxpayer may elect
to increase the tax basis in the QOF investment to its fair market value. As a result, any
appreciation in the QOF investment (that is, gain in excess of the initial deferred gain)
generally would never be subject to U.S. federal income tax.

Qualified Opportunity Funds

A QOF must be classified as a corporation or a partnership for U.S. federal income tax
purposes. It also must be organized in one of the 50 U.S. states, the District of Columbia
or one of the U.S. possessions. If an entity is organized in a U.S. possession, it will qualify
as a QOF only if it is organized for the purpose of investing in qualified opportunity zone
property (QOZ Property) that relates to a trade or business operated in the U.S.
possession in which such entity is organized.

In addition, at least 90% of a QOF’s assets must be comprised of QOZ Property (the “90%
Test”). For purposes of the 90% Test, the QOF must determine the fair market value of its
assets based upon financial statements filed with the SEC, or any federal agency other
than the IRS, or certified audited financial statements under certain circumstances.
Otherwise, the QOF must use the cost basis of its assets for purposes of the 90% Test.

The OZ Statute provides that QOZ Property includes three asset classes: qualified
opportunity zone business property (QOZ Business Property), qualified opportunity zone
stock (QOZ Stock), and qualified opportunity zone partnership interests (QOZ Partnership
Interests). The Proposed Regulations clarify and refine the scope of the three asset
classes, as follows:

QOZ Business Property: tangible property used in a trade or business of a QOF if (1)
the QOF purchases the property after December 31, 2017, from an unrelated person,
 (2) the original use of the property in the QOZ commences with the QOF, or the QOF
substantially improves the property, and (3) during substantially all of the QOF’s holding
period for such property, substantially all of the use of such property was in a QOZ. For
this purpose, property is treated as substantially improved only if, during any 30-month
period beginning after the date of acquisition, the new basis of the property attributable
to improvements made by the QOF, on the one hand, exceeds the initial adjusted basis
of the property in the hands of the QOF at the beginning of the 30-month period, on the
other hand. The Proposed Regulations add that basis attributable to land is disregarded
in the calculation of substantial improvement.

QOZ Stock: stock acquired by a QOF, solely for cash, from an entity classified as a
corporation for U.S. federal income tax purposes. The exchange must occur after
December 31, 2017 and, at the time of issuance, the corporation must conduct a QOZ
Business (as described below) or, in the case of a new corporation, be organized for
purposes of conducting a QOZ Business. During substantially all of the QOF’s holding
period for such stock, such corporation must qualify as a QOF Business.

QOZ Partnership Interests: partnership interests acquired by a QOF, solely for cash,
by an entity classified as a partnership for U.S. federal income tax purposes. The
exchange must occur after December 31, 2017 and, at the time of issuance, the
partnership must conduct a QOZ Business or, in the case of a new partnership, be
organized for purposes of conducting a QOZ Business. During substantially all of the
QOF’s holding period for such partnership interest, such partnership must qualify as a
QOF Business.

To be treated as conducting a QOF Business, substantially all of the tangible property

owned or leased by a corporate or partnership subsidiary of a QOF must be QOZ
Business Property. For this purpose, the Proposed Regulations provide that “substantially
all” means 70%. Accordingly, to the extent a QOF invests in a corporate or partnership
subsidiary, it would have more flexibility in its direct and indirect asset ownership than if it
held all of its assets in the form of QOZ Business Property. For purposes of this 70% test,
valuation rules similar to the 90% Test apply.

In addition, to be treated as conducting a QOF business, such a corporate or partnership

subsidiary must (1) derive at least 50% of its total gross income from the active conduct of
a trade or business in a QOZ, (2) use a substantial portion of its intangible assets in the
active conduct of a trade or business in a QOZ, and (3) hold less than 5% of its property
as nonqualified financial property, which includes debt, stock, partnership interest,
warrants, notional principal contracts and other similar property. For purposes of the
requirement regarding nonqualified financial property, the Proposed Regulations include a
safe harbor for reasonable working capital held in cash, cash equivalents or debt
instruments with a term of 18 months or less. Under the safe harbor, such working capital
assets are not treated as nonqualified financial property if (1) there is a written plan that
identifies such working capital assets as held for the acquisition, construction, or
substantial improvement of tangible property in a QOZ, (2) there is written schedule
consistent with the ordinary start-up of a trade or business for the expenditure of such
working capital assets within 31 months of the receipt by the business of the assets, and
(3) the trade or business substantially complies with such written schedule.

Finally, the Proposed Regulations provide that a corporation or partnership must self-
certify its status as a QOF on an IRS Form 8996, a draft of which was released with the
Proposed Regulations, and this form must be attached to the corporation or partnership’s
U.S. federal income tax return for each year that the QOF determination is made.

Qualifying for QOZ Tax Benefits under the Proposed Regulations

The OZ Statute, together with the Proposed Regulations, provide that, to qualify for QOZ
tax benefits, an Eligible Taxpayer must reinvest Eligible Gains from the sale or exchange
of an asset into an Eligible Investment within the Statutory Period, and file a Deferral
Election (each as described below). The Proposed Regulations clarify the meaning of
such terms, as follows:

Eligible Taxpayer: any taxpayer that recognizes capital gain for U.S. federal income
tax purposes, including individuals, corporations (including RICS and REITs), and
partnerships. The Proposed Regulations clarify that, if a partnership does not elect to
invest eligible gains in a QOZ, a partner may invest its share of such gains in a QOF,
and provide procedures for such partner to make the Deferral Election (as defined
below).

Eligible Gain: capital gain realized from an unrelated person that would be recognized
no later than December 31, 2016. The OZ Statute was unclear whether ordinary
income, including, for example, depreciation recapture, would be eligible for
reinvestment into a QOZ. The Proposed Regulations confirm that only capital gains,
either short term or long term, are so eligible.

Eligible Investment: any equity interest in a QOF, including preferred stock or a

partnership interest. An equity interest in a QOF will not fail to qualify as an Eligible
Investment if the interest is used as collateral for a loan, as long as the Eligible
Taxpayer is treated as owning the interest under U.S. federal income tax principles. The
Proposed Regulations clarify that neither a debt investment in a QOF nor a deemed
capital contribution under Code Section 752(a) will constitute an Eligible Investment for
this purpose.

Statutory Period: 180 days after the date when the Eligible Taxpayer would have
recognized the Eligible Gain, without regard to the Deferral Election.

Deferral Election: an election filed on IRS Form 8949 and attached to the taxpayer’s
U.S. federal income tax return for the taxable year when the Eligible Gain would have
been recognized, without regard to the application of any QOZ tax benefits.

Looking ahead
While the Proposed Regulations answer many questions raised by the OZ Statute,
additional guidance will be needed. Notably, further clarification is needed with respect to
the application of the OZ Statute to Eligible Investors and QOFs that are classified as
partnerships for U.S. federal income tax purposes, particularly pooled investment vehicles,
such as private equity funds, that seek to reinvest capital gains in QOFs. The IRS and
Treasury Department have promised additional guidance, including in the form of further
proposed regulations, in the near future.

Effective Date
The OZ Statute became effective on January 1, 2018. If finalized, the Proposed
Regulations would apply to transactions that occur on or after the date the Proposed
Regulations are finalized. Taxpayers may rely on the Proposed Regulations prior to the
date they are finalized, so long as taxpayers apply the Proposed Regulations in their
entirety and in a consistent manner.

Coming out of the Dark: Energy Storage and Renewable Tax Credits
By Michele Alexander, Ryan Davis and Catherine Engell

The increased demand for energy from renewable sources and the resulting growth of the
renewable energy industry has led to the development of an increasing body of law
designed to address issues specific to this sector. Recently, questions have come to the
forefront regarding the treatment of technology developed in order to store energy
produced from renewable sources.

Certain limitations still exist that inhibit the industry’s growth despite the advances made in
renewable energy technology and the best efforts of the sector’s governmental and non-
profit advocates. Primary among these limitations is the difficulty of storing the energy
produced through renewable sources for later use with the goal of providing a consistent
source of power that may be drawn on as demand requires. Development of and
advances in energy storage technology may help pave the way for renewable energy to
serve as the primary source of electricity for a population center, rather than merely
bolstering the supply produced through traditional power plants. As a result, energy
producers and lawmakers alike have taken a keen interest in the tax treatment of energy
storage devices, particularly with respect to their eligibility for certain benefits or subsidies
available in connection with property used in the actual generation of energy from
renewable sources (and not merely its storage). Increasingly, tax law, while initially behind
the times, is beginning to catch up with the technology. However, questions still remain.

Background
In general, renewable energy producers may choose between the Production Tax Credit
(PTC), which provides a tax credit based on the amount of energy produced, and the
Investment Tax Credit (ITC), which provides for a tax credit equal to 30% of the basis in an
energy property (defined here) in the year it is placed into service.1 An energy property is
deemed to be “placed into service” in the taxable year during which either (i) depreciation
begins or (ii) the property is in a state of readiness and availability for its function.2 In the
case of energy storage devices, where energy is stored rather than produced, taxpayers
historically have only claimed the ITC, the applicability of which is contemplated in the
regulations with respect to both wind and solar and subsequent Private Letter Rulings.3

As a result, the primary questions with respect to the availability of tax credits for batteries
and other energy storage property have not centered on eligibility or which credit to use,
but rather how the credits could be utilized with respect to functioning energy property that
is retrofitted with energy storage capabilities. Specifically, how do we reconcile the fact
that a battery is considered to be “qualified energy property,” and therefore eligible for the
ITC under the applicable Treasury Regulations, with the fact that it is not clearly integral to
the function, the production and transmission of energy, of said energy property. The
situation becomes even more unclear in cases where preexisting energy property that
already produces and transmits energy is retrofitted with energy storage devices. How
does one argue that the battery is “integral” to this energy property that was clearly
functioning without storage capabilities? Could a battery by itself be separately creditable
from the energy property to which it is attached, and, as a result, could a taxpayer take
advantage of the ITC with respect to a retrofitted battery even if already electing to utilize
the PTC with respect to the preexisting energy property? Fortunately, the IRS has
favorably ruled with respect to the first two questions, leading to optimism, but not
certainty, with respect to the third. In order to further consider that question, it is helpful to
review the rationale of the IRS in addressing the first two inquiries, particularly its detailed
consideration of the benefit provided by energy storage relative to the energy property.

What Has Been Illuminated

With respect to the first question, in PLR 201142005, a taxpayer who was in the process
of constructing a utility-scale wind project sought guidance from the IRS regarding the
eligibility of energy storage equipment which was to be included in the project for the ITC.
As described in PLR 201142005, the device would charge when wind speeds were high
and discharge when they fell. According to the IRS, the storing of electricity for use at a
later time is a classic use of a battery and therefore the energy storage device in question
fell directly under the applicable Treasury Regulations and was fully eligible for the ITC.
Perhaps tellingly, the IRS also discussed at some length the way in which the wind project
was being built in order to supply energy to an electric grid that served nearby
municipalities. In order to be selected to sell energy to this grid, the project needed not
only the ability to meet forecasted demand, but also the ability to respond to the real time
demand of an electric grid in a similar manner to nonrenewable energy power plants (an
capability for which it would be paid additional compensation). In other words, in order for
the wind project to fulfill this requirement, a battery was indeed necessary and, therefore,
the storage device could be considered integral to the energy project in the particular
instance. The IRS has mirrored this sentiment with respect to solar property. In PLR
201444025, the IRS similarly found that storage devices that were included in solar
energy property were necessary in order for the solar energy property in question to
optimally function.

How does this rationale apply in situations where existing renewable energy property,
which clearly was functioning in the absence of a battery, is retrofitted with a storage
device? In PLR 201208035, similar to the situation outlined above, a utility-scale wind
project was seeking to sell energy to an electric grid. Like other wind energy producers,
this project suffered from transmission constraints when there were low wind speeds,
which limited its ability to act as the electric supplier to nearby municipalities. The
developer retroactively added a storage facility to solve this issue. Not only would the
addition of the storage device solve the transmission problem, it also would allow the
producer to shift the time of the transmission from off-peak hours (when most of the wind
energy was produced) to peak hours when the grid would pay a higher price for the
electricity. Finally, it also would allow the wind farm to have more control over the flow of
its electricity, which the grid required of its producers. Using rationale identical to that
which it applied to the instances where batteries were included in the energy property from
the outset, the IRS found that the storage devices were fully eligible for the ITC in the year
such devices were included. Again, although the property was functioning prior to the
addition of the battery, it was not functioning optimally and its shortcomings could
decrease its earnings or result in it losing the opportunity to act as an energy supplier to
the grid. As a result, the battery was necessary for the energy property to be fully
functioning and to fulfill its intended purpose of supplying energy to the electric grid in
question.

PLR 201308005 dealt with this issue as it related to solar energy. The taxpayer in this
case was a large solar developer that leased constructed solar energy property to be
attached to residences and businesses. The developer wanted to start including batteries
on its solar energy projects so it could store energy that it produced during daylight hours
and provide it during peak usage, the nighttime hours when the sun is not shining. The
IRS specified four benefits the solar energy property would obtain from including batteries,
including that the battery would allow (i) the energy property to store electricity from
daylight that it then could then use during off-peak hours and then sell back any unused
electricity to the grid, (ii) renewable energy producers to decrease the amount of energy it
provides to the grid in situations where the amount produced fluctuates rapidly (as is
required by most electric grids) and store the excess energy for later use rather than
having it go to waste, (iii) for a stable flow of electricity to the grid (which is a particular
difficulty for wind and solar developers) by allowing the grids to pull electricity from the
battery when it needs and shed it to the battery when necessary, and (iv) the customer to
limit its peak usage by pulling stored electricity to use during those times when electricity
would cost more. Again, although the batteries were not included in the solar property
originally, and are therefore obviously not technically integral to the functioning of the
property, the IRS stressed the ways in which the addition of the battery would provide the
energy project with the ability to function optimally.

Where We Remain in the Dark

While the guidance issued by the IRS clarifies the eligibility of storage facilities with
respect to wind and solar projects which utilized the ITC, it remains unclear whether a
retrofitted battery could take advantage of the ITC, even if the preexisting energy property
is already utilizing the PTC. Specifically, is the energy storage device itself separately
creditable or is it deriving its ability to take the credit because of the energy property to
which it is attached? If the latter, would it then be possible for the battery to utilize the ITC
if the device to which it is attached is not utilizing (or not eligible for) that tax credit? This is
a particularly important issue for onshore wind producers who often derive a greater
benefit from the PTC than the ITC.

There is some reason to believe that this is the case. As discussed above, the IRS has
allowed a taxpayer to utilize the ITC with respect to a retrofitted battery in a later year
despite the fact that the taxpayer utilized the credit in connection with the existing energy
property in the year that the existing energy property was placed into service. This
treatment by the IRS lends credence to the idea that the battery itself is separately
creditable and not merely viewed as an extension of the preexisting energy property.
However, until the IRS issues guidance where this issue is explicitly dealt with, onshore
wind developers (and other energy producers that seek to utilize the PTC) will remain in
the dark on whether they can retroactively add batteries and other storage technology and
still be able to take advantage of the ITC with respect to that property.

1 IRC Section 48(a)

2 Treas. Reg. 1.46-3(d).

3 See Treas. Reg. 1.48-9(d)(3); 1.48-9(e)(1); PLR 201142005; PLR 201208035;

201308005; 201444025.

ADDITIONAL READING

New ‘Opportunity Zone’ Tax-Break Rules Offer Flexibility to Developers

Treasury Outlines Tax Breaks for Investing in Distressed Areas

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FUTURE TOPICS

The Bracewell Tax Report will be distributed on a regular basis. Upcoming topics will
include:

Application of Opportunity Zone regulations to partnerships

Application of Opportunity Zone regulations to foreign investors

If there are topics of interest that you would like us to cover, please click here.
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