On February 19, 2020, the Internal Revenue Service (IRS) issued two highly anticipated items of guidance under section 45Q, which provides a tax credit for carbon capture and sequestration (CCS) projects. IRS Notice 2020-12 addresses the beginning of construction requirement for CCS projects. Revenue Procedure 2020-12 addresses allocations of section 45Q credits in partnership flip structures. Notably:
- The section 45Q beginning of construction guidance largely follows the beginning of construction guidance previously issued for wind, solar and other renewable energy projects.
- The section 45Q guidance for partnership flip structures largely follows similar guidance issued for wind energy partnerships (and often used for solar and other renewable energy projects).
- Additional guidance is expected in the near-term that will include proposed rules regarding certain section 45Q credit requirements and recapture.
Background
Congress originally enacted section 45Q in 2008 to provide a tax credit to taxpayers that capture and sequester carbon dioxide. However, due to certain shortcomings in the statute, the credit as originally enacted did not have the anticipated effect of spurring substantial investment in CCS projects. In 2018, significant changes were made by the Bipartisan Budget Act of 2018 to address many of the shortcomings of section 45Q, including:
- Increasing the credit amount;
- Attributing the credit to the owner of the carbon capture equipment;
- Providing for transferability of credits;
- Expanding the credit to include carbon oxides, as well as carbon dioxide;
- Decreasing the minimum carbon capture thresholds to qualify for the credit;
- Permitting the credit for a 12-year credit period, and replacing an industry-wide cap on the credit; and
- Allowing the credit for a broader range of sequestration methods.
As amended, section 45Q generally provides a tax credit to taxpayers that capture qualified carbon oxide using carbon capture equipment at a qualified facility and that (i) dispose of it in secure geological storage, (ii) use it as a tertiary injectant in a qualified enhanced oil or natural gas recovery project and dispose of it in secure geological storage, or (iii) utilize it for certain other purposes as permitted by statute or regulation.
To qualify for the credit, before January 1, 2024, either (i) construction of the carbon capture equipment must begin or (ii) construction of a qualified facility (i.e., an industrial facility or direct air capture facility) that has as part of its original planning and design the installation of carbon capture equipment must begin. (Notice 2020-12 provides definitions of the terms “carbon capture equipment”, "qualified facility”, “industrial facility” and “direct air capture facility.”)
On May 2, 2019, the IRS released Notice 2019-32, requesting comments on anticipated section 45Q guidance. The IRS received about 110 comment letters in response that Notice.
Beginning of construction guidance - Notice 2020-12
Although section 45Q includes a January 1, 2024 deadline for beginning construction for entitlement to the section 45Q credit, Congress did not define when construction would be treated as having begun, instead leaving that to the IRS to define. Notice 2020-12 provides that guidance.
Highlights of Notice 2020-12 include the following:
- Provides two alternative methods for taxpayers to establish the beginning of construction: (1) starting physical work of a significant nature or (2) paying or incurring 5% or more of the total project cost.
- Includes a continuity requirement (also referred to as a continuous construction or continuous efforts requirement). Unlike guidance for wind and solar energy property, there is a 6-year safe harbor instead of a 4-year safe harbor; beyond 6 years, a facts and circumstances analysis must be undertaken.
- Provides specific examples of physical work that may be used to satisfy the physical work test for qualified facilities or carbon capture equipment.
- Includes rules for transferring section 45Q CCS credit-eligible facilities for which the beginning of construction requirement had been satisfied.
- States that no private letter rulings will be issued regarding the Notice or the beginning of construction requirement.
| Eversheds Sutherland Observation: Notice 2020-12 is, in large part, consistent with the beginning of construction notice issued for solar and other renewable energy facilities – Notice 2018-59, as well as with six prior beginning of construction notices issued for wind facilities – Notice 2013-29, Notice 2013-60, Notice 2014-46, Notice 2015-25, Notice 2016-31, and Notice 2017-4. |
Two methods for establishing beginning of construction
Notice 2020-12 provides two methods to establish that construction of a qualified facility or carbon capture equipment has begun for section 45Q purposes – starting physical work of a significant nature (Physical Work Test) or paying or incurring 5% or more of the total cost of the qualified facility or carbon capture equipment (5% Safe Harbor). Construction will be deemed to begin on the first date that either method is satisfied, and both methods require continuous progress towards completion of construction (Continuity Requirement).
Physical Work Test
The Notice states that construction has begun when the taxpayer begins physical work of a significant nature. The determination of whether physical work of a significant nature has begun is a facts and circumstances analysis. The Physical Work Test focuses on the nature of the work performed rather than the amount of work or the cost thereof, and the Notice confirms that there is “no fixed minimum amount of work or monetary or percentage threshold required to satisfy the Physical Work Test.” Physical work can either be performed by the taxpayer directly or by other persons under a binding, written contract, and the work may be performed on-site or off-site.
The Notice provides as examples of off-site work of a significant nature the manufacture of:
- mounting equipment and support structures such as racks, skids, and rails;
- components necessary for carbon capture processes such as membranes, sorbent vessels, adsorbers, compressors, engines, motors, power generators and regenerators, reboilers, turbines, pressure vessels and other vessels, piping and pipelines, pumps, heat exchangers, solvent pumps, filters, recycling units, electrostatic filtration, water wash equipment, lube oil systems, dehydration systems, glycol contractors, specially designed flue gas ducts, conditioners, cooling towers, absorber units, and other types of gas separation, liquification, or processing equipment;
- components necessary for disposal of qualified carbon oxide in secure geological storage such as valves, specialized casing, or other components of a wellhead or well; and
- equipment necessary for disposal of qualified carbon oxide in secure geological storage such as wellhead equipment, booster compressors, and monitoring equipment for a storage site.
The Notice also provides the following examples of on-site physical work of a significant nature:
- the excavation for and installation of foundations (for the project as well as for buildings to house equipment necessary to the project) including the setting of anchor bolts into the ground and the pouring of the concrete pads of the foundation;
- the installation of a system of gathering lines necessary to connect the industrial facility to the carbon capture equipment or other equipment necessary to the qualified facility before transportation away from the qualified facility for disposal, utilization, or use as a tertiary injectant;
- the installation of components necessary for carbon capture processes such as membranes, sorbent vessels, adsorbers, compressors, engines, motors, power generators and regenerators, reboilers, turbines, pressure vessels and other vessels, piping and pipelines, pumps, heat exchangers, solvent pumps, filters, recycling units, electrostatic filtration, water wash equipment, lube oil systems, dehydration systems, glycol contractors, specially designed flue gas ducts, conditioners, cooling towers, absorber units, and other types of gas separation, liquification, or processing equipment; and
- the installation of equipment and other work necessary for the disposal of qualified carbon oxide in secure geological storage at the geological storage site, which may be at a different location than the qualified facility or carbon capture equipment.
| Eversheds Sutherland Observation: We would expect, based on experience in the renewables industry, that most taxpayers seeking to qualify under the Physical Work Test will undertake physical work on an item specifically described in the Notice (and listed above). |
Notice 2020-12 identifies two categories of activities that do not qualify as physical work of a significant nature: preliminary activities and inventory activities. The guidance provides examples of preliminary activities that would not qualify, including securing financing, exploring, researching, obtaining permits and licenses, conducting test drilling to determine soil condition (including to test the strength of a foundation), excavating to change the contour of land, clearing a site, and removing existing foundations or any components that will not be used in the project. The guidance also states that physical work of a significant nature does not include work performed, either by the taxpayer or by another person under contract, to produce components of a qualified facility or carbon capture equipment that are in existing inventory or are normally held in inventory.
| Eversheds Sutherland Observation: In both Notice 2020-12 and the analogous renewable energy guidance, preliminary activities do not qualify as physical work of a significant nature. However, the list of preliminary activities in the two notices are different -- the renewable energy guidance includes planning or designing, conducting mapping or modeling to assess a resource, conducting geophysical, gravity, magnetic, seismic and resistivity surveys, and conducting environmental and engineering studies as preliminary activities, while these activities are not listed as preliminary activities in Notice 2020-12. Although both the section 45Q and the renewables notices state that the respective lists of preliminary activities are not exhaustive, it would be helpful to understand from the IRS whether the differences are intended to signal that the excluded items (which generally are more significant in CCS projects as compared to many renewable energy projects) would be treated differently under the Physical Work Test. |
5% Safe Harbor
Construction of a qualified facility or carbon capture equipment will be considered to have begun if the taxpayer pays or incurs (depending on the taxpayer’s method of accounting) 5% or more of the total cost of the qualified facility or carbon capture equipment. The total cost of the qualified facility or carbon capture equipment includes all costs included in the depreciable basis of the qualified facility or carbon capture equipment. Costs associated with Front-End Engineering and Design (FEED) activities or other approaches for front-end planning may be considered to determine whether the 5% Safe Harbor has been met. A taxpayer may look through to costs paid or incurred by another person with whom the taxpayer has entered into a binding, written contract with respect to the project construction.
Notice 2020-12 provides clarity on how cost overruns shall be treated for the purposes of the 5% Safe Harbor. For a single project comprised of multiple qualified facilities or units of carbon capture equipment, if the total cost exceeds the anticipated cost such that the amount a taxpayer paid or incurred is less than 5% of the actual total cost of the project when placed in service, the 5% Safe Harbor can be satisfied with respect to some, but not all, of the qualified facilities or units of carbon capture equipment comprising the project, as long as the total aggregate cost of those qualified facilities or units of carbon capture equipment is not more than 20 times greater than the amount paid or incurred. For a single qualified facility or unit of carbon capture equipment that cannot be separated into multiple properties, however, if the amount paid or incurred in a given year ultimately is less than 5% of the total cost when the qualified facility or unit of carbon capture equipment is placed in service, the 5% Safe Harbor will not be satisfied.
| Eversheds Sutherland Observation: The inclusion of front-end planning costs in meeting the 5% Safe Harbor reflects the expectation of increased activity and expense that will be necessary in the planning and design stages of construction of a qualified facility or carbon capture equipment. However, these expenses alone are unlikely to meet the 5% threshold. |
Continuity Requirement
Both the Physical Work Test and the 5% Safe Harbor have a Continuity Requirement. The Continuity Requirement is deemed satisfied if a taxpayer places a qualified facility or carbon capture equipment in service by the end of the calendar year that is no more than six calendar years after the calendar year during which construction of the qualified facility or carbon capture equipment began (Continuity Safe Harbor Deadline). A taxpayer will be treated as having begun construction no earlier than 2020. If the qualified facility or carbon capture equipment is not placed in service before the Continuity Safe Harbor Deadline, whether the Continuity Requirement of either the Physical Work Test or the 5% Safe Harbor is satisfied will be determined based on the facts and circumstances.
| Eversheds Sutherland Observation: The inclusion of a 6-year period for the Continuity Safe Harbor, rather than the 4-year period provided for the renewable energy industry, has been well received by the carbon capture industry, particularly those that will be seeking tax equity financing, which generally requires that the Continuity Requirement be satisfied through the Continuity Safe Harbor rather than through a facts and circumstances analysis. |
If a facts and circumstances analysis, rather than the Continuity Safe Harbor is used, the guidance lists certain facts and circumstances that indicate continuous efforts, including:
- paying or incurring additional amounts included in the total cost of qualified facility or carbon capture equipment,
- entering into binding written contracts for manufacture of components of the qualified facility or carbon capture equipment or for future work to construct the qualified facility or carbon capture equipment,
- obtaining necessary permits, and
- performing physical work of a significant nature.
Notice 2020-12 provides a non-exclusive list of certain excusable disruptions that will not be considered as indicating a taxpayer has failed to satisfy the Continuity Requirement under a facts and circumstances analysis. That list includes:
- severe weather delays,
- delays due to natural disasters,
- delays in obtaining governmental permits or licenses,
- delays at the request of a governmental entity for public safety, security or similar concerns,
- interconnection-related delays (such as delays relating to the completion of construction on a new carbon dioxide pipeline or necessary upgrades to resolve capacity or congestion issues associated with a project’s planned interconnection),
- delays in the manufacture of custom components,
- delays due to labor stoppages,
- delays due to the inability to obtain specialized equipment of limited availability,
- delays due to the presence of endangered species,
- financing delays, and
- delays due to supply shortages.
For a single project with a single qualified facility or carbon capture equipment, whether an excusable disruption has occurred is determined in the calendar year when the qualified facility or carbon capture equipment is placed in service. For a single project comprising multiple qualified facilities or units of carbon capture equipment, whether an excusable disruption has occurred is determined in the calendar year when the last qualified facility or unit of carbon capture equipment is placed in service.
Transfer of qualified facility or carbon capture equipment
There is no statutory requirement that the taxpayer that places a qualified facility in service also be the taxpayer that begins construction on the facility. As such, a transfer of a fully- or partially-developed facility does not necessarily disqualify the facility under the Physical Work Test or the 5% Safe Harbor. However, a transfer solely consisting of tangible personal property between unrelated parties does disqualify the property such that any work performed or amounts paid or incurred by the transferor with respect to the transferred property will not be taken into account in determining whether the transferee meets the Physical Work Test or the 5% Safe Harbor.
Partnership allocation guidance - Revenue Procedure 2020-12
Section 45Q provides that the credit generally is available to the person that owns the carbon capture equipment and physically or contractually ensures the capture and disposal, utilization or use of the qualified carbon oxide. Revenue Procedure 2020-12 provides a safe harbor under which an investor will be respected as a partner/owner in (rather than a lender to) a partnership that owns carbon capture equipment and thus will be entitled to an allocation of available section 45Q tax credits. The section 45Q credit also may be transferred to the person that disposes of the qualified carbon oxide.
| Eversheds Sutherland Observation: Many renewable energy projects utilize a partnership flip structure under which the tax credits and depreciation benefits are primarily allocated to an investor that has the tax appetite to use those tax benefits, often referred to as a tax equity investor. (The other partner in the project company partnership is generally referred to as the sponsor or developer.) To be entitled to that allocation, the tax equity investor must be treated as an equity owner and partner, rather than a lender, with respect to the project company partnership. The IRS previously issued Revenue Procedure 2007-65, which provides a safe harbor for wind projects for which a section 45 production tax credit is sought that, if satisfied, will allow the tax equity investor to be treated as a partner. That guidance also has been used for solar and other renewable energy projects. Revenue Procedure 2020-12 was issued because it is anticipated that the partnership flip structure will be used for CCS projects for which the section 45Q project will be claimed, and to provide similar certainty to tax equity investors in those projects that they will be treated as partners to whom tax credits and depreciation can properly be allocated. Presumably similar rules apply where the credit is transferred to the person that disposes of the qualified carbon oxide, but confirmation from the IRS would be helpful. |
Under Revenue Procedure 2020-12, an investor, together with the developer, will be respected as a partner of a project company partnership that owns the carbon capture equipment if all of the requirements described below are satisfied:
Project developer’s minimum partnership interest
The developer must have a minimum 1% interest in each material item of partnership income, gain, loss, deduction, and credit at all times during the existence of the partnership.
Investor’s partnership interest
Each investor must have an interest in each material item of partnership income, gain, loss, deduction, and credit at all times that is at least 5% of its largest interest percentage. In addition, the investor’s partnership interest in the partnership must be a “bona fide equity investment”.
With regard to the bona fide equity investment requirement, the Revenue Procedure states:
The Investor’s Partnership Interest must constitute a bona fide equity investment with a reasonably anticipated value commensurate with the Investor’s overall percentage interest in the Project Company, separate from any federal, state, and local tax deductions, allowances, credits, and other tax attributes to be allocated by the Project Company to the Investor. An Investor’s Partnership Interest is a bona fide equity investment only if that reasonably anticipated value is contingent upon the Project Company’s net income, gain, and loss, and is not substantially fixed in amount. Likewise, the Investor must not be substantially protected from losses from the Project Company’s activities. The Investor’s return from its investment in the Project Company must not be limited in a manner comparable to a preferred return representing a payment for capital.
The investor also may not receive payments in the form of fees that are unreasonable and that would result in a reduction of the value of the investor’s investment in the partnership.
| Eversheds Sutherland Observation: Further clarification may be required regarding how the bona fide equity requirement applies in the context of a CCS project that does not generate sequestration or disposal revenue. There is no analogue to this requirement in Revenue Procedure 2007-65. |
Investor’s minimum unconditional investment
At all times, an investor’s minimum investment must be at least 20% of the fixed capital investment plus any reasonably anticipated contingent investment required to be made by the investor. The investment amount may be reduced through cash distributions from the operation of the project. The investor must not be protected from loss of the minimum investment by the developer, other investors or certain other persons.
Contingent consideration
More than 50% of an investor’s investment must be fixed and determinable, meaning that contingent consideration is limited to 50% of an investor’s investment. For this purpose, contributions for ongoing project expenses will not be treated as contingent payments by the investor.
| Eversheds Sutherland Observation: As compared to the 25% contingent contribution limit in Revenue Procedure 2007-65, this guidance provides a higher 50% contingent contribution limit, and carves-out ongoing project expenses. Such differences are needed due to the differences in the technologies involved in these two revenue procedures. |
Purchase rights
Neither project developers nor investors may have a call option to purchase the carbon capture equipment or a partnership interest at a future date.
Sale rights
An investor may not hold a put option to require any person to purchase the partner’s partnership interest at a future date at a price that is more than its fair market value.
| Eversheds Sutherland Observation: This guidance varies from the guidance in Revenue Procedure 2007-65 which allows call options, but not put options. From a tax equity investor perspective, a put option is preferable to allow it more control over the exercise of the option. |
Guarantees and loans
No party involved in the project company may directly or indirectly guarantee the investor’s ability to claim section 45Q tax credits or a repayment of tax credits if challenged by the IRS, or distributions or other consideration (other than through a put option). The developer may not lend any funds to the investor to acquire the investor’s interest in the project company or guarantee any indebtedness incurred in connection with that acquisition.
The following guarantees may be provided to the investor or the project company:
- guarantees for the performance of any acts necessary to claim the section 45Q credit (including ensuring proper secure geological storage of the qualified carbon oxide through disposal, or use as a tertiary injectant, or utilization); and
- guarantees for the avoidance of any act (or omissions) that would cause the Project Company to fail to qualify for the section 45Q credit or that would result in a recapture of the Section 45Q Credit. Examples of guarantees permitted under this section include completion guarantees, operating deficit guarantees, environmental indemnities, and financial covenants.
A long-term carbon oxide purchase agreement entered into on arm’s-length terms between the project company and an emitter, between the project company and an offtaker, or between an emitter and an offtaker, does not constitute a guarantee even if the emitter or the offtaker is related to the project company, and even if such contracts contain “supply all,” “supply-or-pay,” “take all,” “take-or-pay,” or “securely store-or-pay” provisions. A long-term contract between the project company and the emitter or the offtaker pursuant to which the project company leases the equipment to the emitter or the offtaker or agrees to use the equipment to perform services for the emitter or the offtaker also does not constitute a guarantee even if the emitter or the offtaker is related to the project company.
Allocation of the section 45Q credit
Allocations under the partnership agreement must satisfy requirements under section 704(b). Tax credits and any recapture must be allocated in accordance with Treas. Reg. § 1.704-1(b)(4)(ii).
If the project company generates receipts from its sequestration activities, an allocation of the section 45Q credit in the same proportion as their respective distributive share of income is treated as being made in accordance with the partner’s interest in the partnership. If the project company does not receive payments from its sequestration activities, an allocation of the section 45Q credit in the same proportion as the partners’ loss or deduction associated with the cost of capture and disposal will be treated as in accordance with the partners’ interest in the partnership.
| Eversheds Sutherland Observation: Section 45Q, as amended in 2018, left many unanswered questions. Notice 2020-12 and Revenue Procedure 2020-12 help fill in many of those gaps and, overall, provides guidance that is highly responsive to the public comments submitted. The similarities between the new guidance and prior guidance for wind, solar and other renewable projects, provide much needed certainty for tax equity investors and developers, and the differences between the new guidance and the prior renewable energy guidance reflect the differences in those technologies. In order for the new section 45Q to avoid the fate of the old section 45Q, the remaining unanswered questions will require additional guidance from the IRS and Treasury, which we understand is forthcoming, that similarly is responsive to the public comments submitted by the industry. |
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1 For additional coverage of Notice 2019-32, see Eversheds Sutherland Legal Alert: IRS requests comments on section 45Q carbon sequestration credit in Notice 2019-32. For additional Eversheds Sutherland coverage of section 45Q, see also Legal Alert: IRS releases 2019 inflation adjustment for section 45Q carbon oxide sequestration credit.
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