16 minute read | July.20.2023
On June 14, 2023, the IRS and Treasury issued proposed regulations (the “Proposed Regulations”) under two novel provisions of the Inflation Reduction Act of 2022 (the “IRA”) designed to promote capital investment in renewable energy: (1) “direct pay,” allowing certain tax-exempt, taxable and government entities to elect to receive cash payments from the federal government in lieu of energy tax credits and (2) “transferability,” allowing the transfer of energy tax credits to unrelated parties in exchange for cash payments. Important details in the Proposed Regulations are summarized below. The Proposed Regulations are of interest to anyone thinking about developing or financing a renewable project or anyone interested in acquiring tax credits from another renewable energy project. The IRS and Treasury also issued temporary regulations (“Temporary Regulations”) with an immediate effective date.
The direct pay rules permit certain entities to receive a direct payment of certain tax credits. Eligible entities include tax-exempt organizations, states, and political subdivisions such as local governments, Indian tribal governments, Alaska Native Corporations, the Tennessee Valley Authority, rural electric co-operatives, U.S. territories and their political subdivisions. The Proposed Regulations clarify that agencies and instrumentalities are also eligible for direct pay. These entities will find direct pay to be a particularly attractive financing mechanism.
The following twelve credits are eligible for direct pay:
In addition, certain electing taxpayers other than applicable entities may receive direct payment of certain tax credits over five years. The credits which they are allowed to receive are limited to (1) the Section 45Q credit (credit for carbon oxide sequestration), (2) the Section 45V credit (credit for production of clean hydrogen), or (3) the Section 45X credit (advanced manufacturing production credit). These are referred to as “electing taxpayers.” Electing taxpayers may include regular C corporations.
The Proposed Regulations
The Proposed Regulations address many issues that were not addressed by the statute and will be important in implementing direct payment structures.
Consistent with the statute, the election, by either an applicable entity or an electing taxpayer, is treated as the payment of estimated tax.
The Proposed Regulations also confirm that an applicable entity that wholly owns a disregarded entity may make an election with respect to the applicable credit property held directly by the disregarded entity.
The Proposed Regulations also specifically address the treatment of partnerships where one of the members of the partnership is an applicable entity. In this regard, the Proposed Regulations state that the election must be made at the partnership level, thereby precluding members of a partnership that is an applicable entity from making the election. This means that tax-exempt entities cannot take advantage of direct pay if participating in a project through a partnership. Some commentators had asked whether a C corporation owned by an applicable entity could make the election. The preamble to the Proposed Regulations states that an applicable entity would not include a C corporation, even if its owner is an applicable entity. The preamble to the Proposed Regulations states that an applicable entity may engage with other entities, such as for-profit partners, in an ownership arrangement that has properly elected out of partnership treatment for federal income tax purposes.
Timing of Election
The Proposed Regulations provide that the election must be on the “annual tax return” filed not later than the due date (including extensions of time) for the original return for the taxable year for which the applicable credit is determined. This will be the year in which the property giving rise to the credit is placed in service. The annual tax return is a term that is introduced in the Proposed Regulations. If the entity is normally required to file an annual return with the IRS, the election should be made on such annual return. For applicable entities not normally required to file returns, such as state, local, territorial, and tribal governments, the election is claimed on a Form 990-T. Any electing taxpayers claiming the direct payment that do not ordinarily file an annual tax return with the IRS (such as taxpayers located in U.S. territories) are required to claim the direct payment on the form that they would be required to file if they were located in the United States. In each case, the election must be made by the due date of the original return for the year for which the election is made (including extensions of time).
In general, this means that the direct pay credit may not be claimed until the filing of the annual tax return in the tax year after the year the qualifying project is placed in service.
The return must be on an original return and no Section 9100 relief is available. This is a particularly harsh rule and is likely to be the subject of comments. An elective payment election generally is irrevocable and applies with respect to any applicable credit for the taxable year for which the election is made. For applicable entities, the election applies for the full period during which the credit is available. The election applies to the year of the election and the four subsequent years. The rule is more lenient for electing taxpayers who make an elective payment election, since while the election applies for one five-year period per applicable credit property, such election may be revoked. Any revocation, if made, applies to the taxable year in which the revocation is made and each subsequent taxable year within the election period. Any such revocation may not be subsequently revoked.
The Registration Requirement
Under the Proposed Regulations, in order to make an election for a direct payment, both applicable entities and electing taxpayers must register on an IRS portal. An entity must obtain a registration number prior to filing its tax return in which an elective payment is to be claimed. The IRS, in turn, will issue a registration number. The registration number is only valid for one year. The information needed as part of the return is extensive and is designed to allow the IRS to validate the claim for the direct payment. The Temporary Regulations implement the registration requirements, effective for taxable years ending on or after the date of publication in the Federal Registrar.
Limitation on Credits for Qualifying Property Acquired with Grants, Forgivable Loans, and Other Tax-Exempt Income
A special rule applies to limit the amount of the direct pay tax credit when the qualifying property is acquired using grants, forgivable loans, or other income exempt from taxation. Entities that receive grants, forgivable loans, or other tax-exempt income and use such amounts for the specific purpose of purchasing, constructing, reconstructing, erecting, or otherwise acquiring property eligible for the tax credits (“Restricted Tax-Exempt Amounts”) may be limited in the amount of credits they may receive. The Proposed Regulations allow those Restricted Tax-Exempt Amounts to be included in basis for purposes of the direct pay provisions, but they require a reduction of the credit if the Restricted Tax-Exempt Amount plus the credit exceeds the total cost basis of the tax credit property. This rule may become a trap for the unwary.
This is illustrated in the Proposed Regulations by a number of examples. In one example, School district A receives a tax-exempt grant in the amount of $400,000 from the Environmental Protection Agency to purchase electric school bus B. A purchases B for $400,000. A’s basis in B is $400,000. B qualifies for the maximum Section 45W credit, $40,000. However, because the amount of the grant (the Restricted Tax-Exempt Amount) plus the amount of the Section 45W credit exceeds the cost of B, A’s Section 45W credit is reduced by the amount necessary so that the total amount of the Section 45W credit plus the Restricted Tax-Exempt amount equals the cost of B. Thus, A’s Section 45W credit is reduced by $40,000 to zero.
In order to discourage abuse, taxpayers who claim a direct payment greater than the amount of credits otherwise allowable are subject to a 20% penalty on the excessive payment, unless there is reasonable cause for the excessive payment. Taxpayers taking positions regarding tax basis that are questionable may run the risk of being subject to the excess payment penalty.
The transferability rules allow “eligible taxpayers” (generally, taxpayers other than tax-exempt parties) to elect to transfer eligible credits to unrelated taxpayers rather than using the credits against their U.S. federal income tax liabilities. Transferability applies to the same credits eligible for direct pay other than the commercial clean vehicle credit (Section 45W).
The eligible credits noted above can be “transferred” (i.e., sold or assigned) once by a taxpayer, but may not be sold again by the buyer who acquires them. An arrangement where tax ownership is transferred first to a dealer or intermediary and then to the ultimate buyer violates the “no second transfer” rule. However, an arrangement using a broker to match eligible taxpayers and buyers should not violate the “no second transfer” rule, assuming the arrangement at no point transfers the U.S. federal income tax ownership of a specified credit portion to the broker or any taxpayer other than the buyer. The Proposed Regulations also specify that allocations of purchased credits by a passthrough buyer, such as a partnership or S corporation, to its direct or indirect owners does not violate the “no second transfer” rule.
Notably, a facility or project owner can transfer tax credits but cannot transfer depreciation benefits in a transferability transaction. The inability to transfer depreciation benefits can be significant in tax equity financings, which may make tax credit sales for certain projects less attractive overall.
The Proposed Regulations also provide that the passive activity loss rules will apply to transferred credits. Therefore, individual taxpayers are less likely to purchase such tax credits.
Cash Payment Requirement
Cash payments received for a transfer are not considered income for the person transferring the credit and cannot be deducted by the person receiving the credit. The rules also clarify that a buyer does not have to include in gross income the amount by which the credit amount allowed exceeds the amount that the taxpayer paid for the transferred credit. This clarification is important since buyers are expected to pay discounted amounts for purchased tax credits. The Proposed Regulations define “paid in cash” to limit the payment to U.S. dollars, which can be made by cash, check, cashier’s check, money order, wire transfer, ACH transfer, or other bank transfer of immediately available funds. They also provide a safe harbor timing rule that validates a payment if made within the period beginning on the first day of the eligible taxpayer’s taxable year during which a specified credit portion is determined and ending on the due date for making a transfer election (described below). A contract to purchase all credits by transfer meets the paid-in-cash requirement if the payments are completed within this timing.
To transfer credits, an eligible taxpayer must make a transfer election. A transfer election must be made on an original return not later than the due date (including extensions of time) for the original return of the eligible taxpayer for the taxable year for which the eligible credit is determined. If a valid transfer election is made by an eligible taxpayer for any taxable year, the buyer specified in such election (and not the eligible taxpayer) is treated as the taxpayer for purposes of the Code with respect to the specified credit portion. An eligible taxpayer may make multiple transfer elections to transfer one or more specified credit portion(s) to multiple buyers, provided that the aggregate amount of specified credit portions transferred with respect to any single eligible credit property does not exceed the amount of the eligible credit determined with respect to the eligible credit property. A partnership or S corporation that determines an eligible credit with respect to any eligible credit property held directly by such partnership or S corporation may make a transfer election with respect to eligible credits determined with respect to such eligible credit property. An eligible taxpayer must make a transfer election to transfer a specified credit portion of an eligible credit on the basis of a single eligible credit property. For example, an eligible taxpayer that determines eligible credits with respect to two eligible credit properties would need to make a separate transfer election with respect to any specified credit portion of the eligible credit determined with respect to each eligible credit property.
Recapture Rules for Transferred Investment Tax Credits
If applicable investment credit property is disposed of, or otherwise ceases to be investment credit property with respect to the seller, before the close of the relevant recapture period, notification requirements apply. The seller must notify the buyer of a recapture event and the recapture amount, if any, in such form and manner as guidance may provide.
Generally, the buyer bears the financial responsibility for a recapture event and is required to recapture an amount of previously claimed tax credits based on the timing and amount of the recapture event.
Transfers by partners or S corporation shareholders can give rise to indirect transfers. If an indirect transfer by a partner or an S corporation shareholder causes a recapture event with respect to applicable property, the property ceases to be investment credit property with respect to the individual partner or shareholder of the seller, rather than the seller (the passthrough entity). Thus, the individual partner or shareholder retains the recapture cost in those events.
Bonus Credit Amounts
Bonus credit amounts (i.e., domestic content and energy community additions to the base credit) cannot be transferred separately from the base credit. The base credit and bonus credit must be transferred proportionately to a buyer.
Excessive Payment Penalty
As in the case of a direct payment, if the IRS determines that a transfer election results in a transfer of credits in excess of the amount of credits that would be allowed to the relevant seller, the IRS will impose a penalty equal to 20% of the excessive transfer amount, unless there is reasonable cause for the excessive transfer.
A transfer of any specified portion of a credit to a buyer may be disallowed, or the U.S. federal income tax consequences of any transaction effecting the transfer may be recharacterized, in circumstances where the parties to the transaction have engaged in the transaction or a series of transactions with the principal purpose of avoiding any U.S. federal tax liability beyond the intent of the transferability rules. The Proposed Regulations provide an example where a fee for services is improperly characterized as purchase price for a tax credit rather than a fee for services to take advantage of the rule that provides that such purchase price is not includible in the income of the seller for tax purposes. Other regulations have taken a broader approach, applying an anti-abuse rule when a principal purpose of the transaction is to avoid U.S. federal income tax.
Pre-Filing Registration for Transfers
Transfer eligibility is contingent upon the seller completing the specified filing process, obtaining a registration number from the government, and reporting the registration number on the entity’s annual tax return. Completion of the pre-filing registration requirements and receipt of a registration number does not, by itself, mean that the taxpayer is eligible for a valid transfer. Ultimately, eligibility is determined under the substantive technical rules granting the specific energy credit.
Transfers and Estimated Taxes
The IRS clarified that a buyer may take into account a credit that it has purchased, or intends to purchase, when calculating its estimated tax payments, though the buyer remains liable for any additions to tax to the extent the buyer has an underpayment of estimated tax. This is important because being able to reduce estimated tax payments increases the present value of a purchased credit as compared to a situation where buyers would need to wait until a tax return is actually filed to obtain a benefit from the credit.
Interplay of Direct Pay Rules with Transferability Rules
Several commentators raised the question of whether a taxpayer could transfer credits to an applicable entity which in turn would make the direct pay election. That approach could have mitigated situations where there was a limited market appetite for tax credits. The Proposed Regulations address this in the negative. The Proposed Regulations state that any credits for which an election is made under the direct pay rules must have been determined with respect to the applicable entity or electing taxpayer, meaning that the applicable entity or electing taxpayer owns the underlying eligible credit property or, if ownership is not required, otherwise conducts the activities giving rise to the underlying eligible credit. However, the Proposed Regulations solicit comments as to any limited situations where it may be appropriate to allow such transfers.
Effective Date of the Proposed Regulations
The regulations are proposed to apply to taxable years ending on or after the date the Treasury decision adopting the Proposed Regulations as final regulations is published in the Federal Register. Taxpayers may rely on the Proposed Regulations, in taxable years ending before the date the Treasury decision adopting the regulations are published, provided they follow the Proposed Regulations in their entirety and in a consistent manner. As noted above, the Treasury and IRS also issued Temporary Regulations. The Temporary Regulations apply to taxable years ending on or after the date of publication in the Federal Registrar. Taxpayers will need to apply the Temporary Regulations until the Proposed Regulations are finalized.
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In sum, the Proposed and Temporary Regulations provide helpful guidance to taxpayers seeking to take advantage of the direct pay and transferability provisions. While questions remain, they are a step in the right direction.
 The IRS and Treasury also issued a series of frequently asked questions and answers. Elective Pay and Transferability Frequently Asked Questions: Overview | Internal Revenue Service (irs.gov).
 The IRS recently released a series of questions and answers on direct pay for State &* Local Governments. Q&A on Elective Pay for State & Local Governments | Internal Revenue Service (irs.gov).