Tax Law Update
On January 6, 2021, the IRS issued final regulations relating to section 45Q. This is the fourth piece of guidance from the IRS relating to section 45Q, following IRS Notice 2020-12, Revenue Procedure 2020-12, the Proposed Regulations and now the final regulations. With the regulatory structure in place, implementation of most carbon capture, use and sequestration (“CCUS”) structures can proceed with confidence about the tax effects.
Section 45Q allows a production type credit for taxpayers that capture carbon oxide. The most common form of carbon oxide that will be captured is carbon dioxide (CO2), but the poisonous gas carbon monoxide is also contemplated by section 45Q. The amount of the credit varies depending on the usage. For carbon that is sequestered but not otherwise used, the credit amount reaches $50 per metric ton in 2026. For carbon oxide that is used for enhanced oil recovery or other permitted uses, the credit amount reaches $35 per ton in 2026. The increased amount for carbon oxide sequestered but not otherwise used reflects an approximation of the value for which the carbon oxide might be sold to an enhanced oil or gas recovery project. The credit is available for a 12-year period beginning on the date that the carbon capture equipment is originally placed in service. Like other renewable credit programs, the credit is only available if construction of the facility which uses the carbon capture equipment begins prior to a certain date. Following the enactment of the Consolidated Appropriations Act, 2021 (the “Act”), that date is January 1, 2026 (extended from January 1, 2024). The Act also included generous funding for the expanded use of CCUS by authorizing billions of dollars for federal programs supporting research, development and demonstration of CCUS technology. One of the technologies that is specifically encouraged is “direct air capture,” in which the carbon dioxide is removed from the general atmosphere directly, rather than being separated from an industrial facility.
One of the unique features of section 45Q is that the party that captures the carbon oxide has the right to assign the credit to the party that uses, utilizes or disposes of the carbon oxide.
Prior to the issuance of the final regulations, the IRS had provided three specific forms of guidance. In February 2020, the IRS issued Notice 2020-12 and Rev. Proc. 2020-12. Notice 2020-12 provided guidance on how to establish construction has begun on a qualified facility or carbon capture equipment. Rev. Proc. 2020-12 provides a safe harbor for flip partnerships using special allocations that shift after a tax equity investor achieves a certain return on their investment. Finally, in June, the IRS published proposed regulations regarding many of the operative and definitional provisions of section 45Q.
The final regulations make a number of changes:
The principal changes made in the final regulations are discussed below.
Definition of Carbon Capture Equipment
With the exception of carbon dioxide that is captured using direct air capture, carbon oxide must be captured by the use of carbon capture equipment that is installed at an industrial source. The proposed regulations contained an expansive definition of “carbon capture equipment,” greatly complicating the analysis of whether the taxpayer would be eligible for the credit where multiple parties are in the production chain. The final regulations eliminate the equipment list and add a functional definition.
Notice 2020-12 and the proposed regulations allow existing carbon capture equipment (as well as qualified facilities) to be treated as newly placed in service and qualify for a new 12-year period of 45Q credit eligibility, if the “80/20 Rule” is satisfied. The 80/20 Rule allows carbon capture equipment to be treated as newly placed in service if the cost of the refurbishment and retrofitting of the equipment is equal to 80% of the fair market value of the existing equipment plus the costs of the refurbishment and retrofitting. Prior to the final regulations, it was unclear what the boundaries of the carbon capture equipment were for purposes of determining the fair market value of the existing equipment. The final regulations introduce the concept of an “independently” functioning process train, defined to include all components that make up an independently functioning process train capable of capturing, processing and preparing carbon oxide for transport. The final regulations do not provide a definition of a “process train” and the preamble does not provide additional context. Although the definition is somewhat circular, the final regulations provide clarity of the quantum of equipment that must be modified.
Revision to Recapture Period
Section 45Q provides that the Secretary of the Treasury shall provide guidance on the extent to which credits shall be recaptured. The proposed regulations provided guidance on the recapture of credits where there was leakage of carbon oxide into the atmosphere. Under the proposed regulations, credits could be recaptured up to five years after the credit was claimed. The final regulations reduce the recapture period to three years. The final regulations also clarify application of the recapture provisions where a partnership is involved and there is a partnership termination, for example, if the tax equity investor exercises a put right under the partnership’s operating agreement.
Specific Rules Relating to Contracts and Subcontracts
Both the proposed regulations and the final regulations contemplate that certain functions can be contracted out to third parties. The proposed regulations and final regulations provide standards for the contractual provisions that should or may be in the contract. Contracts that do not meet the standard will not invalidate eligibility for the seeking the credit. A question arose as to whether a contractual provision would be valid if it limits damages. The final regulations allow a contract to have a liquidated damages provision as long as the liquidated damages are equal to at least 5% of the total contract price.
The proposed regulations and final regulations allow the taxpayer claiming the credit to enter into a contract with a third party to dispose of, inject or utilize the carbon oxide. The final regulations go further and allow that third party to then enter into a subcontract with another third party to dispose of, inject or utilize the carbon oxide, however, this subcontractor may not be a credit claimant. This is relevant to the rule under section 45Q(f)(3)(B) that allows the owner of the carbon capture equipment to make an election to allow the third party disposing of, injecting or utilizing the carbon oxide to claim the credit instead of the carbon capture equipment owner. The final regulations preclude further transfers (such as to a subcontractor) of the credit to the subcontractor.
Regarding the assignment of the credit, the final regulations add a specific requirement that the (f)(3)(B) election (assignment of the credit) may only be made on an original return. No explanation is provided in the preamble to the final regulations, but given the generous nature of the election, it is not surprising.
Clarification Regarding the “Placed-in-Service” Election
An election is available under Section 45Q to treat facilities which are placed in service prior to February 9, 2018, as having been placed in service on February 9, 2018. This would allow taxpayers who had placed carbon capture equipment in service prior to February 9, 2018, to qualify for the increased credit amounts under the amendments to section 45Q in 2018. This is commonly referred to as the Petra Nova provision as it was drafted to allow the owners of the Petra Nova plant to claim the higher credit amount. One requirement of this election is that the facility capture at least 500,000 metric tons of qualified carbon oxide in the year in which the election is made. The final regulations make two clarifying changes: (1) the election must be made each year and (2) multiple facilities may be aggregated in making the determination as to whether the 500,000 metric ton threshold is met.
Guidance Relating to the Lifecycle Analysis
A taxpayer that “utilizes” carbon oxide may be eligible for the $35 per ton credit. Unlike carbon oxide that is used in enhanced oil recovery or which is disposed of in secure geological story, to be eligible for the credit, the taxpayer must conduct a life cycle analysis (“LCA”) of the carbon oxide captured and utilized. The proposed regulations did not address the requirements of a qualifying life cycle analysis.
Section 45Q(f)(5)(B) provides that an LCA must be used for purposes of determining the amount of qualified carbon oxide utilized by the taxpayer. However, an LCA does not yield a result in metric tons of qualified carbon oxide that is utilized. An LCA provides the result in CO2-e. The final regulations reconcile this by requiring the use of an LCA to measure CO2-e, but limiting the section 45Q credit to the amount of qualified carbon oxide measured at the source of capture. This allows taxpayers to continue to use the current industry-standard LCA process, ensuring an overall decrease in greenhouse gases, while also preventing taxpayers from claiming the section 45Q credit for a reduction in greenhouse gases other than carbon oxides (measured in CO2-e) that exceeds the amount of carbon oxides that are captured.
The LCA must be prepared in conformity with ISO 14040:2006 and ISO 14044:2006. In addition, taxpayers must use the NETL’s CO2 Utilization Guidance Toolkit, including the guidance and data available on DOE’s website at https://www.netl.doe.gov/LCA/CO2U, until such time as additional guidance is developed by the DOE or another federal agency. This in effect requires the use of the DOE template. The results of the LCA must be documented in a written LCA report. The taxpayer must receive approval of its LCA prior to claiming the section 45Q credits for such taxable year on any federal income tax return.
Commercial Market Determination
Under section 45Q, a taxpayer may obtain the credit for carbon oxide that is used in a commercial market. The proposed regulations did not address the meaning of a commercial market. Under the final regulations, a commercial market is defined broadly as a market in which a product, process or service that utilizes carbon oxide is sold or transacted on commercial terms. A taxpayer must submit a statement attached to its Form 8933 substantiating that a commercial market exists for its particular product, process or service.
Additional Carbon Capture Equipment – Definition of Carbon Capture Capacity
For facilities that are placed in service prior to February 9, 2018, and do not make the election discussed above to treat the equipment placed in service on February 9, 2018, the credit available is limited to the carbon oxide captured by “additional carbon capture equipment.” February 9, 2018, is the date the Bipartisan Budget Act of 2018 (the “BBA”) was enacted. The amount of credit available is then divided between the lower, pre-BBA credit amounts and the higher, post-BBA credit amounts. First, the taxpayer receives the pre-BBA credit equal to the annual “carbon capture capacity” of the facility as of February 8, 2018, or, if a lesser amount is captured, the total amount of carbon oxide captured by the taxpayer during the taxable year. The excess over this amount is eligible for the post-BBA credit amounts. The term “carbon dioxide capture capacity” means capture design capacity.
Qualified Facilities – Annualization
In order to qualify for the credit, facilities must satisfy certain emission and capture thresholds. Facilities, other than direct- air capture facilities, that emit 500,000 or less metric tons of carbon oxide and “utilize” the carbon oxide must capture at least 25,000 metric tons of carbon oxide. Electricity-generating facilities must capture not less than 500,000 metric tons of carbon oxide. All other facilities, including direct-air capture facilities, that do not “utilize” the carbon oxide must capture at least 100,000 metric tons of carbon oxide.
The proposed regulations provided for the annualization of the amount of carbon oxide emitted and captured during the first taxable year in which carbon capture equipment is placed in service at the facility. The final regulations extend this to the year in which the 12-year period ends. This provides relief for facilities that would meet the thresholds for a full taxable year but may not if the first and last taxable year is less than a 12-month period.
The final regulations provide important guidance to potential developers and financers of CCUS projects and provides a level of certainty for planning and structuring projects. The final regulations, along with the extra time to begin construction of these projects provided by recent legislation, will allow for first-of-their-kind projects and financing structures to be put into place and capitalize on the generous credits provided under section 45Q.