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IRS Guidance on Domestic Content – What Renewable Energy Companies Need to Know


10 minute read | May.15.2023

New tax guidance explaining how renewable energy projects can qualify for “bonus credits” if they meet U.S. domestic content rules answers significant questions, but also creates a qualification framework that will be complicated for project developers to navigate. The guidance in Notice 2023-38 (the “Notice”) was released by the Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) on May 12, 2023. Treasury and the IRS signaled that they intend to issue proposed regulations on domestic content that will be effective for taxable years ending after May 12, 2023. In the meantime, taxpayers will be entitled to rely on the Notice for projects that begin construction before the date that is 90 days after the proposed regulations are published.

Highlights of the Notice include:

  • a framework for identifying steel, iron, and manufactured product, the critical pieces of the domestic content analysis;
  • a “safe harbor” table categorizing certain project components that the IRS will accept as steel, iron or manufactured product in the context of utility-scale solar, wind (both onshore and offshore) and battery storage projects;
  • confirmation that components of manufactured products must be of U.S. origin, a detail that will require developers to obtain tracking information from manufacturers down to the component level;
  • confirmation that testing for sufficient manufactured product in a project will require manufacturers to disclose their direct manufacturing costs and cost to produce or acquire components; and
  • details about how to certify on a tax return that a project qualifies for bonus credits.

BACKGROUND ON BONUS CREDIT AMOUNTS

  • The Inflation Reduction Act of 2022 (the “IRA”) introduced a two-tier “base” rate and “increased” rate structure for federal income tax credits for renewable energy projects. The “increased” rate is worth five times the value of the base rate and is available if a project meets, or is grandfathered from, prevailing wage and apprenticeship requirements.[1]
  • Projects qualifying for renewable energy tax credits under section 45 (production tax credit), 45Y (clean energy production tax credit), 48 (investment tax credit) or 48E (clean electricity investment tax credit) can also qualify for a “bonus credit amount” worth up to an additional 10% for the production tax credit (i.e., 110% of the “full” rate) or an additional 10% of qualifying costs for the investment tax credit if they have sufficient domestic content.

Observation:  Meeting the domestic content requirements can add significant value, especially for projects qualifying for the investment tax credit, where the investment tax credit amount can be increased from 30% of qualifying project costs to 40%. Projects qualifying for domestic content are eligible for additional bonus credits if they are located in an energy community, and sub-five megawatt solar and wind projects can apply for further additional bonus credits if they are located in certain low-income communities.[2]

DOMESTIC CONTENT FRAMEWORK

  • To qualify for the domestic content adder, the IRA requires that 100% of any steel, iron or manufactured product that is a component of a project upon completion of construction must be produced in the United States
  • The Notice creates a hierarchy of components where an applicable project is composed of (i) steel, (ii) iron and (iii) manufactured products, and, in turn manufactured products are composed of a sub-tier of (A) components and a further sub-tier of (B) subcomponents.
  • The first step in the analysis is to determine which project components are steel and iron. If the identified steel and iron components are not 100% produced in the U.S., then the project cannot qualify for the domestic content bonus.
  • If the project’s steel and iron meet the domestic content rules, the next step is to identify and assess whether the project’s U.S. manufactured products meet the “adjusted percentage” test. As described below, this requires analysis down to the component level.
  • All of the manufactured products in a project are deemed to be produced in the U.S. for purposes of this rule if the cost of the “adjusted percentage” of U.S.-produced manufactured product is at least the percentage of the total cost of the project’s manufactured product as illustrated in the table below.

Construction Begins

Adjusted Percentage Generally

Offshore Wind

Before 2025

40%

20%

2025

45%

27.5%

2026

50%

35%

2027

55%

45%

2028 or later

55%

55%

STEEL OR IRON RULES

  • Identifying Steel or Iron – Steel or iron refers to “construction materials made primarily of steel or iron and that are structural in function.”

    • The Notice provides “safe harbor” classifications of the following components as steel or iron:
      • Racking, pile or ground screws, and steel or iron rebar for solar projects;
      • Towers, steel or iron rebar for onshore wind projects;
      • Towers and jacket foundations for offshore wind projects; and
      • Steel or iron rebar for a storage project.
    • The Notice excludes any steel or iron used in components or subcomponents of manufactured products and gives examples of items such as nuts, bolts, screws, washers, cabinets, covers, shelves, clamps, fittings, sleeves, adapters, tie wire, spacers, door hinges and similar items that are made primarily of steel or iron if they are not structural in function.

Observation:  A concern in the industry has been whether the presence of a single nut, bolt, washer or screw of non-U.S. origin would mean that an entire renewable energy project would fail to qualify for the domestic content adder. The Notice is helpful from that perspective but requires an analysis of whether a nut, bolt, washer, screw or other similar part is “structural in function.”

  • Steel or Iron Requirement – Once identified, steel or iron will qualify as domestic content if all of its manufacturing processes take place in the U.S., except metallurgical processes involving refinement of steel additives.

Observation:  The 100% rule for steel or iron is embedded in the IRA and not likely something Treasury and the IRS could change by administrative guidance. Nevertheless, it can result in somewhat draconian consequences. As the safe harbor table illustrates, a single piece of non-U.S. rebar in a solar project or a non-U.S. tower in a wind farm could cause a project to fail the test.

MANUFACTURED PRODUCT RULES

  • Identifying Manufactured Products and Components – Manufactured product refers to project components that are produced as part of a process that alters the form or function of materials or elements in a manner that adds value and transforms them into a functionally new item. Components of a manufactured product include any article, material or supply, whether manufactured or unmanufactured, that is directly incorporated into a manufactured product. The Notice does not explain how to identify subcomponents. The safe harbor classifications in the Notice identify the following items as manufactured product:

    • Trackers, modules[3] and inverters for solar projects;
    • Wind turbines[4] and wind tower flanges for onshore wind projects;
    • Wind turbines, transitions pieces, monopiles, inter-array cables, offshore substations and export cables for offshore wind projects; and
    • Battery packs,[5] the battery container/housing and inverters for storage projects.

Observation:  Although the Notice’s safe harbor tables are incomplete in that they do not address the treatment of every single potential project component, they provide a much-needed starting point to analyze how the domestic content rules should apply to a renewable energy project. Prior to the Notice there had been significant market uncertainty regarding whether items like modules and inverters should be considered manufactured products or components.

  • Manufactured Product Requirement – As described above, at least the “applicable percentage” of a project’s manufactured product must be produced in the U.S. For manufactured product to be produced in the U.S., (i) all of the manufacturing processes for the manufactured product must take place in the U.S., and (ii) all of the components of the manufactured product must be of U.S. origin. Components are treated as being of U.S. origin if they are manufactured in the U.S., regardless of the origin of the subcomponents.

Observation:  The Notice’s confirmation that components must be of U.S. origin (a requirement which comes from the pre-IRA Department of Transportation regulations for “Buy America Requirements,” on which the domestic content rules are based) adds significant complexity to the domestic content analysis. It will require project developers to dig into the origin of components of equipment they are buying and also determine which portions of those components should be treated as subcomponents that do not need to be from the U.S.

  • Application of the Adjusted Percentage Rule – The adjusted percentage is determined by dividing (A) the “Domestic Manufactured Products and Components Cost” by (B) the “Total Manufactured Products Cost.”

    • “Domestic Manufactured Products and Components” include both (i) manufactured products produced in the U.S., and (ii) components of manufactured products that are not produced in the U.S. if the components of the non-U.S. manufactured product are nevertheless mined, produced, or manufactured in the U.S.
    • “Total Manufactured Products” includes all of the manufactured products in the project (i.e., both U.S. and non-U.S. produced). It does not look at individual components.
    • For example, if the cost of a U.S. manufactured product is $100 and the cost of a non-U.S. manufactured product is $200, but the non-U.S. manufactured product includes U.S.-sourced components that cost $80, the test would be applied by comparing $180 (i.e, the cost of U.S. manufactured product plus the $80 cost of the U.S. components of the non-U.S. manufactured product) and $300 (i.e, the combined total cost of the manufactured product).

Observation:  The inclusion of U.S.-produced components of non-U.S. manufactured product in the numerator of the adjusted percentage test is helpful in that it allows taxpayers to partially benefit from manufactured products with some U.S. components. The downside is that it further increases the test’s complexity because taxpayers who want to take advantage of the rule will need to track components of non-U.S. sourced manufactured products. It is unclear how easy it will be to obtain this information from manufacturers.

  • How to Determine “Cost” – Cost for purposes of both the numerator and denominator of the adjusted percentage test means the direct material and direct labor costs that are paid or incurred by the manufacturer to produce the manufactured product or produce or acquire the U.S. component. Costs (including labor costs) of incorporating the manufactured product into the actual project do not count.

Observation:  Proving that the domestic content test has been met will require information from manufacturers about their direct costs. This will likely be a source of tension between developers who are being asked to pay a premium for U.S.-produced equipment and manufacturers who are generally reluctant to provide details about their actual costs. This method appears intended to isolate true cost as much as possible without taking into account the increased value (or markup) associated with domestic content qualification.

OTHER REQUIREMENTS

  • Certification Requirement – A taxpayer claiming the domestic content adder will need to certify to the IRS that the domestic content requirement has been met, in an attachment to IRS Form 8835 or IRS Form 3468, or other applicable form.
  • Recordkeeping Requirements – A taxpayer claiming the domestic content adder must maintain and preserve “sufficient records” to establish that a project qualifies for the domestic content adder.

[1] For a detailed discussion of the prevailing wage and apprenticeship requirements and applicable grandfathering rules, please see our previous client alert [https://www.orrick.com/en/Insights/2022/12/Initial-Guidance-On-Prevailing-Wage-And-Apprenticeship-Requirements]. The same prevailing wage and apprenticeship and grandfathering rules apply to each of the tax credits that are eligible for the domestic content adder. For a detailed discussion of how for-profit entities, tax-exempt entities, state and local government entities and tribal government entities can take advantage of the “direct pay” feature associated with the tax credits and the domestic content adder, please see our previous client alert [https://www.orrick.com/en/Insights/2022/08/Inflation-Reduction-Act-Levels-Renewable-Energy-Playing-Field-for-Tax-Exempt-Entities.]

[2] For a detailed discussion of the energy community bonus credit, please see our previous client alert [https://www.orrick.com/en/Insights/2023/04/IRA-Energy-Communities-and-Brownfields-Tax-Guidance-What-Companies-Need-To-Know].

[3] Cells, mounting frame or backrail, glass, encapsulant, backsheet, junction box (including pigtails and connectors), edge seals, pottants, adhesives, bus ribbons and bypass diodes) are identified as components of modules for purposes of the manufactured product analysis.

[4] Nacelles, blades, rotor hub and power converters are identified as components of wind turbines for purposes of the manufactured product analysis.

[5] Cells, packaging, thermal management systems and battery management systems are identified as components of battery packs for purposes of the manufactured product analysis.