Tax equity financing is a way to contribute financial resources to a project or company while receiving certain tax benefits. Some of the methods include asset contribution, allocation, flipping, and reallocation. The practice of tax equity financing is more prevalent in some industries, such as renewable energy. Tax benefits from equity financing reduce the amount of an investor's true income and liability, while encouraging business expansion.
When an investor decides to financially back a company or one of its capital projects, he may contribute certain assets at fair market value. This value may be higher than the cost of the assets, which often results in an investor being able to delay a capital gains tax. Anytime a person sells an asset for an amount that is greater than its cost, the profit is considered taxable income. If an investor decides to sell his assets to a firm at fair market value, he does not delay his potential tax liability.
Another way of deferring tax liability is the idea of remedial allocation. For example, a firm may issue new shares to existing stockholders who can only receive dividend payments if the firm produces a certain amount of profit or once a specific point in time has passed. Even though investors still hold an ownership claim in the company, any income received from their financial contributions is put off and potentially allowed to grow. In remedial allocation, the gain on the contributed asset is recognized over time rather than upfront.
Flipping is a tax equity financing method that changes the amount of equity an investor has in a project or company throughout its useful life. When the flip technique is used, an investor tends to receive the majority of his tax benefits at the beginning of the project and his income at the end of its life. For example, one investor may invest more resources in the beginning and then sell his stake in the project until his percentage of ownership dwindles to an insignificant amount. Another investor may contribute a smaller amount prior to the project's commencement and end up with a higher percentage of ownership at the end.
Tax equity financing can also employ the method of reallocation. With this technique, a financial contributor may receive an amount of income from his investment that is significantly lower than his original contribution. Under the tax equity financing method of reallocation, the investor creates a deficit that reduces or eliminates his tax liability when his investment share is sold.