On May 2, 2019, the Internal Revenue Service ( the “IRS”) released Notice 2019-32 (the “Notice”) which requested comments for Carbon Oxide Sequestration Section 45Q of the Internal Revenue Code
Orrick submitted comments in response to the Notice. Our comments addressed a number of points: (1) application of the requirements relating to recapture of the credit where leakage occurs: (2) determination of when the start of construction occurs; (3) clarification of the election to transfer the credit (the “Section 45Q(f)(3)(B) Election”); and (4) issuance of a revenue procedure similar to Revenue Procedure 2007-65.
The following summarizes our comments.
We have suggested that the IRS consider implementing a safe harbor using the EPA’s Mandatory Greenhouse Gas Reporting Standard, 40 CFR Part 98 (“Subpart RR”), or an equivalent program approved by the EPA to provide that so long as taxpayer can demonstrate that carbon dioxide is sequestered or stored in secure geologic storage using the Subpart RR standard which is filed in the year following the taxable year that tax credits were claimed, then there will be no recapture for such taxable year. There could be recapture if leakage is discovered in the following year, but that would be only where there was negative storage and it would be limited to the credits generated in the prior year. Using the Subpart RR standard will ensure that investors are at most exposed to recapture of one year of credits if no leakage is found when the site is tested in the following year.
Start of Construction
Under the solar and wind guidance, the IRS included a requirement that taxpayers that start construction must satisfy a continuity requirement, “continuous efforts” in the case of the 5% safe harbor and “continuous construction” in the case of the physical work test. When this guidance was initially issued for wind projects, the tax equity market was concerned that there was not enough certainty in satisfying these tests, which are based on all the facts and circumstances. The IRS responded by providing a safe harbor that taxpayers that begin construction and complete the project by the 4th anniversary from the end of the year that construction began will be deemed to satisfy the continuity requirement. We believe this safe harbor should be adopted for carbon sequestration, but that the 4-year window should be extended to 6 years because this technology is more complex and the typical time frame for developing and constructing carbon capture equipment is longer than for wind and solar projects. It is our understanding that projects (for example, a thermal retrofit) will take two years longer to complete than comparable renewable projects.
The Section 45Q(f)(3)(B) Election
For projects that are constructed after the Bipartisan Budget Act of 2018, taxpayers must own the carbon capture equipment and physically or contractually ensure the capture and disposal, utilization, or use of tertiary injectant of such carbon oxide. As enacted in 2008, Section 45Q did not have an ownership requirement. Section 45Q(f)(3)(B) provides that a taxpayer may elect to transfer the credit to a person that disposes of the qualified carbon oxide, utilizes the qualified carbon oxide or uses the qualified carbon oxide as a tertiary injectant. Some advisors have suggested the only tax equity financing structure available to these transactions is the “partnership flip” (which is described in Revenue Procedure 2007-65) because of the requirement that the taxpayer must own the carbon capture equipment and physically or contractually ensure the capture. We believe it would be beneficial to broaden the scope of available transactions by making the election flexible enough to permit the owner in a lease structure to require the lessee contractually to provide sequestration of the carbon. If that clarification were provided, then the owner would be eligible for the credit and, therefore, the sale lease-back structure and inverted lease structure would be available financing options for these projects. Further, similar to the case for solar projects, the election could be used to pass the credit through to the lessee in the inverted lease structure.
Application of the Principles of Revenue Procedure 2007-65
The renewable energy market relies heavily on Revenue Procedure 2007-65 which provides a safe harbor for structuring partnership flip transactions for wind projects. One question often raised by tax equity investors is whether there is a certain amount of operating cash flow that must be distributed to the tax equity investor as part of their return. We believe it would be very beneficial if the guidance includes confirmation that a tax equity investor’s return may be solely from tax credits and depreciation, at least in cases where there is limited income at the project company level. See Sachs v. Comm’r., 277 F. 2d 879 (8th Cir. 1960), affirming 32 T.C. 815 (1959). Revenue Procedure 2007-65 also provides that only 25% of a tax equity investor’s capital contribution may be contingent. As a result, wind deals that use a “pay as you go” structure, typically tie up to 25% of the tax equity investor’s contribution to the receipt of production tax credits in the future. We understand that it is difficult to satisfy the 25% requirement in carbon sequestration deals primarily because tax equity’s entire investment is tied to the credits, which results because there is very little cash flow. We would recommend raising the portion of tax equity’s investment that may be contingent to 60% to make carbon sequestration deals more viable. In revising the safe harbor, we would also recommend excluding capital contributions for operating expenses from the capital contributions that are considered contingent. Finally, it would be helpful to issue guidance that is specific to carbon sequestration or at least confirm that the principles established in Revenue Procedure 2007-65 also apply to Section 45Q.
To read the full text of Orrick’s comments to the Internal Revenue Service click here.