Energy Transition and ESG – tax incentives powering change in global real estate

Energy transition and the focus on ESG are clearly here to stay: albeit with varying degrees of speed and scale of implementation across different real estate asset classes and jurisdictions.

A recurring global theme is the significant disconnect in the promises being made to real estate investors (e.g. at a “Fund” or “PLC” level) versus what is happening “on the ground” at a real estate “asset” level.

That is translating into a degree of head scratching about how to fulfil at an “asset” level the promises which have been made to investors, including how this is going to be funded (e.g. additional equity or “green” capex loans).

However a slightly different but equally fundamental question is “what is this really going to cost?”

What is the “real” cost?

An essential but often overlooked concept is the “gross to net” cost of capital expenditure (“capex”) needed to meet ESG and energy transition goals.

In “non-Tax” speak, this is the importance of establishing the actual cost of the capex works, taking into account any tax or other government incentives, which can reduce the net cost of the works in question.

Further complexity arises because the true “net” cost can differ depending on which party (e.g. a landlord or a tenant) is legally responsible for the capex works.

We consider these questions in the context of different jurisdictions below.

A) UK – tax incentives

In the UK, significant tax incentives exist and indeed have been augmented in recent UK Budgets.

These incentives frequently arise in the form of “capital allowances”: the UK’s form of tax deductible depreciation (as accounting depreciation is non-deductible for UK corporation tax purposes).

Examples include “enhanced capital allowances” (generally available in respect of a broad range of qualifying expenditure including many forms of energy saving plant and machinery) and “structures and buildings allowances” (available in respect of the cost of, broadly, “bricks and mortar”). Both forms of allowance effectively offer the opportunity for tax relief i.e. cash tax savings on particular types of capex.

In the UK Spring Budget 2023, the “full expensing” of capital expenditure was introduced as an incentive to promote capital expenditure.

In respect of qualifying expenditure this full expensing provides up to:

(a) 100% “first year” tax relief to companies which would otherwise only be entitled to claim allowances at a rate of 18% per annum on a reducing balance basis; and

(b) 50% “first year” tax relief to companies which would otherwise only be entitled to claim allowances at a rate of 6% per annum on a reducing balance basis.

This significantly accelerates the amount of UK tax relief available for qualifying expenditure to the year in which the expenditure is actually incurred (rather than the benefit of the tax relief being spread over a number of accounting periods).

Accelerated tax relief can provide significant cash flow benefits particularly in a high inflationary environment which creates and exacerbates other cash flow pressures on businesses.

In economic terms, this form of UK tax incentive can substantially reduce the “real” cost of capex works in “real time”, providing tax relief in the year in which much of the capex is incurred.

To date, these forms of UK tax incentive are frequently overlooked, potentially because:

(a) previously such incentives were generally spread over time and therefore difficult to value; and

(b) it is difficult to keep track of the incentives available in a world where the names, form and type of such incentives change so frequently.

B) Australia

The Australian Tax code currently contains a less extensive range of tax based incentives in respect of capex of this nature than in the UK.

However, that position is beginning to change, with the Government introducing legislation into Parliament to enact a clean energy incentive which is available (at this stage) for certain small businesses. Specifically, the legislation proposes to provide entities with annual turnover of less than $50 million with bonus deductions of 20% of the cost of qualifying assets, or improvements to existing assets, which support electrification or more efficient energy use.

In order to qualify for the bonus deduction, eligible small business expenditure must be incurred, or the asset must be first installed and ready for use, between 1 July 2023 and 30 June 2024. Expenditure is not eligible where it involves assets which are capable of being powered directly by fossil fuels (as opposed to assets only capable of being powered by electricity regardless of the source of the electricity), even if in practice the asset is predominantly or solely powered by electricity.

The bonus deduction will apply to eligible expenditure up to $100,000, with a maximum bonus deduction of $20,000. Although this measure is only temporary and is limited in a number of other respects (in respect of the relevant size of entities, timing of installation, with a cap on expenditure eligibility), historically it has been common for similar measures to be extended and expanded over time.

In addition, Australia operates a withholding tax concession for certain foreign residents investing in “clean building managed investment trusts”. Where a relevant foreign investor invests in such a vehicle, the withholding tax rate on distributions of income and capital gains is reduced to 10%. The Government announced in Budget 2023-24 that the list of buildings that are eligible to be clean buildings (where the relevant energy rating criteria are satisfied) is to be extended beyond office buildings, hotels, and shopping centres, to also include data centres and warehouses.

These recent announcements indicate the Australian Government is actively considering how to use the tax system to encourage investment in energy transition. Accordingly, investors should continue to watch this space for developments.

C) Pan-European initiatives

The EU’s so-called “REPowerEU Plan” dated May 2022, encouraged Member States “to consider additional tax measures such as reductions and exemptions from vehicle taxation for both the purchase and use of electric and hydrogen vehicles, tax deductions linked to energy savings and the phase-out of environmentally harmful subsidies”.

This is a highly topical and developing area of European legislation which should be kept under review as Member States wrestle with the combined challenges of (i) how to respond to the impact of the US Inflation Reduction Act and (ii) how to incentivise ESG and Energy Transition improvements at a domestic level.

In particular:

(a) the introduction of future EU based tax incentives in light of the REPowerEU Plan cannot be ruled out;

(b) Member Status are introducing, ever evolving, forms of local tax based incentives; and

(c) Member States are wrestling with the challenges of incentivising capex designed to accelerate energy transition while at the same time considering the impact of the proposed so-called “Pillar II” principles, which are expected to introduce a minimum domestic level of taxation in each jurisdiction.

We have highlighted examples of such incentives below in Spain, Italy, France and Germany.

(i) Spain

In Spain these incentives include:

(a) Introducing a new tax depreciation allowance in respect of expenditure on energy efficient electricity and thermal installations costing up to EUR 500,000 in FY 2023 which are intended for “self-consumption” by the entity incurring the expenditure; and

(b) Applying double the general Spanish “depreciation coefficient” on electric vehicles and their charging infrastructures, provided that they are used in a business activity.

In addition, local Spanish municipalities are entitled to approve tax rebates in respect of their local taxes (Property Tax, Constructions Tax and Local Business Tax) for expenditure incurred in connection with certain energy efficient thermal and solar installations.

From a practical perspective, when capex programmes are being considered these potential tax savings should be kept under review in the context of modelling the potential net cost of the works in question.

(ii) Italy

In the context of the broader REPowerEU Plan, Italy has introduced various new incentives. These are designed to incentivise individuals and, in certain circumstances, companies, to adopt environmentally friendly measures. Two key measures are:

(a) the “Ecobonus”; and

(b) the “Superbonus”.

The “Ecobonus” is a form of tax deduction, with rates ranging from 50% to 85% depending on the precise nature of the relevant qualifying expenditure in question which is incurred in respect of certain types of thermal insulation, energy efficient air conditioning systems and photovoltaic installations. The regime requires the person or company entitled to benefit from the incentive to file with the Italian tax authorities an attestation by a qualified professional in respect of the capex works in question. The attestation must confirm the relevant energy efficient enhancements to the relevant building have been achieved.

The “Superbonus” is another form of tax incentive which is available predominantly to individuals but can also be used in certain circumstances by companies. This incentive broadly provides an Italian tax deduction up to 110% of the cost of qualifying capex works incurred in 2022, 90% for 2023, 70% for 2024 and 65% for 2025.

Both forms of tax incentives can generate tax credits which, in limited circumstances, may be transferred to a contractor and used in partial satisfaction of the consideration payable for the qualifying capex works in question or sold to a third party.

(iii) France

In France, relatively limited tax incentives in connection with energy transition have been enacted to date. The measures enacted in France predominantly apply to small and medium sized enterprises (“SMEs”) which own or lease premises and carry out energy related improvements to buildings used in the course of the relevant SME’s business.

However, the draft French Finance Bill 2024, released on 27 September 2023, includes significant new tax incentives to support and incentivise energy transition related expenditure in France.

The proposed reforms include the introduction of a tax credit for investments in connection with sustainable energy (referred to as “C3IV”).

Under the new C3IV regime, eligible companies would be able to obtain a tax credit in respect of investment expenditure incurred in France in connection with the production or acquisition of tangible or intangible assets enabling the production of sustainable energy which are approved by the (i) French Tax Administration and (ii) the ADEME (Agence de l’Environnement et de la Maîtrise de l’Energie).

The new tax incentive would only be available to companies operating in the battery, solar panel, wind turbine and heat pump production sectors provided they meet the prescribed eligibility conditions of the regime and depending on their location and size. The amount of the tax credit would be set at a rate between 20% and 60% of the cost price (plus taxes and charges) of applicable investment expenditure, up to a limit of EUR 150,000,000.

(iv) Germany

The German tax system includes a number of tax based incentives designed to incentivise capital expenditure which is intended to increase energy efficiency and to limit the impact of climate change.

For example, relatively recent legislative changes now ensure that:

(a) non-German owners of German real estate (e.g. Luxembourg “Propcos”) can benefit from an exemption from German trade tax in circumstances where such a property owner sells electricity to tenants from photovoltaic systems or from “e-charging” stations located on the German real estate in question. Prior to this change, the sale of such “self-generated” electricity risked bringing such property owners within the scope of German trade tax; and

(b) German tax privileged “special investment” funds would be able to generate up to 10% (increased from 5% with effect from 1 January 2023) of their income from “commercial activities” which for these purposes includes income from the generation of electricity from renewable energy and from the operation of “e-charging” stations.

Furthermore, the German federal government published a draft bill in July 2023, which includes an incentive scheme for investments designed to limit the impact of climate change (“Klimaschutz-Investitionsprämiengesetz – Klimaschutz-InvPG”). The draft bill is currently at the earliest stage of the legislative process and remains subject to amendment.

However, at this stage it provides that, subject to the satisfaction of a number of conditions, the German federal government will subsidise investments that support increased energy efficiency or reduce energy consumption. The draft bill provides that the incentive will be in an amount up to 15% of the cost of the qualifying capital investment expenditure (capped at €30,000,000 per company). The progress of this draft bill through the remainder of the legislative process should be kept under review.

Summary and practical action points

Where are the opportunities?

As the law in this area continues to develop, there are real opportunities to increase returns and “free cash” in structures, particularly where assets require significant capex to keep pace with Energy transition and ESG requirements.

Action point

It would be prudent for investors and real estate asset managers to avoid leaving “value on the table” by considering at a Heads of Terms/Term Sheet stage the extent to which (i) tax based incentives could alter the net cost of the capex works in question; and (ii) whether practical agreement and “buy in” from different parties is required to maximise the availability of such incentives.