The guidance issued on February 19 by the Internal Revenue Service is the type that the carbon capture and storage industry had sought, and will hopefully open up the market for investment by eliminating tax-related uncertainties for financial investors.
The Internal Revenue Service (IRS) released Notice 2020-12 (the Notice) and Revenue Procedure 2020-12 (the Revenue Procedure), which together provide needed guidance on the federal income tax credit for carbon capture projects under Section 45Q of the Internal Revenue Code of 1986, as amended. Specifically, the Notice and the Revenue Procedure provide guidelines and helpful bright-line “safe harbors” for Section 45Q credit qualification and financing structures modeled on prior guidance for other tax credits, principally credits for renewable energy projects.
The carbon capture and storage industry had been seeking this sort of guidance for the Section 45Q credit to spur the market for financial investors to invest in eligible projects, which had largely been sidelined due to uncertainty surrounding tax related issues for investors. The hope is that this new guidance and associated certainty will open up the market for investment in these types of projects in a manner similar to the way analogous prior guidance did for other tax advantaged projects, especially as some of the tax benefits underlying current “tax equity” investment structures in other industries begin to sunset under current law.
The Section 45Q Tax Credit for Carbon Capture Property
Section 45Q provides a performance-based tax credit for carbon capture property. The Section 45Q credit is flexible in that it is not limited to a particular industry; it generally may apply to industries involving the production of large quantities of carbon dioxide or monoxide. Accordingly, the Section 45Q credit is relevant not only to the electric power generation industry (for example, coal, oil and gas fired power plants), but also to various heavy production industries (for example, ethanol and fertilizer production, natural gas processing, refining, chemicals production, and the manufacture of steel and cement). In addition, the amount of the tax credit involved can be quite significant. For example, a power plant that emits and captures 5 million tons of carbon dioxide a year could generate $250 million worth of tax credits.
Congress originally enacted the Section 45Q credit in 2008, but recently extended and expanded the credit under the Bipartisan Budget Act of 2018, PL 115-123. Broadly, Section 45Q currently provides a tax credit in a specified dollar amount per metric ton of carbon oxide stored, depending on the applicable project type. For currently in-development and future projects, the Section 45Q tax credit applies for the 12-year period following the project’s placed in service date. The tax credit dollar amount during this period escalates on a yearly basis until 2026 when it reaches either $35 or $50 per metric ton of carbon oxide stored (depending on the type of project), and for subsequent years may increase based on an adjustment for inflation. Only eligible carbon capture property that has begun construction before January 1, 2024, is eligible for the credit (the Start Construction Rule).
The Notice – Start Construction Rule Guidance
The Notice provides guidelines and helpful safe harbors pertaining to when taxpayers are considered to satisfy the Start Construction Rule for eligible property, which is an essential element for Section 45Q tax credit qualification. The Notice is largely patterned after similar IRS guidance for the Section 45 production tax credit (PTC) and Section 48 investment tax credit (ITC) for renewable energy projects, but updated to take into account the different technologies and tax credit eligibility standards under Section 45Q.
As with the prior PTC/ITC guidance, the Notice provides two methods to satisfy the Start Construction Rule for purposes of qualifying an otherwise eligible project for the Section 45Q credit: either (1) beginning “physical work of a significant nature,” or (2) incurring 5% or more of the cost of the qualifying project. Both methods also require that a taxpayer make continuous progress towards completion once construction has begun. This continuous progress requirement is a facts and circumstances determination based on certain enumerated factors; but, the Notice provides a safe harbor that deems this standard to be met if the project is placed in service prior to the end of the 6th calendar year following the calendar year the project satisfied the Start Construction Rule (which is favorable compared to the four-year continuous progress safe harbor under the PTC/ITC guidance).
Also like the prior PTC/ITC guidance, the Notice provides standards for determining the permissible breadth of a single project for purposes of the Start Construction Rule, rules determining the scope and timing of onsite and offsite work conducted or costs expended by the taxpayer or by a third-party contractor that are taken into account under the Start Construction Rule, rules pertaining to retrofitted equipment qualifying for the credit, and restrictions on transfer of equipment.
The Revenue Procedure – Safe Harbor for Tax Equity “Flip” Partnerships
The Revenue Procedure provides a helpful safe harbor for a “tax equity” financing investment in the form of a “flip” partnership structure. For background, many developers of property eligible for tax benefits (for example, tax credits and accelerated depreciation deductions) or “sponsors” seek out “tax equity investors” to provide a portion of the equity financing for the project that can more efficiently utilize the tax benefits and disproportionally share in these tax benefits as a part of the financial return on their equity investment. For tax and other reasons, a prevalent form of tax equity financing is a “flip partnership” or a project entity taxed as a partnership for federal income tax purposes that disproportionally (as compared to capital investment ratios) allocates initial period profits and losses to a tax equity investor (which carry tax benefits) with a later period “flip” to much lower allocation of profits and losses to the tax equity investor. The IRS has in prior guidance provided safe harbor standards for wind power PTC partnerships and Section 47 rehabilitation credit partnerships.
The Revenue Procedure amalgamates and largely reiterates the safe harbor standards set forth in this prior guidance as applied to the Section 45Q credit. For example, the Safe Harbor sets forth limits for minimum partner interests in partnership taxable items (5% for investors and 1% for developers), minimum partner investment, impermissible sponsor guarantees, and purchase options. Helpfully, the Revenue Procedure liberalizes a standard in the prior guidance by allowing up to 50% of the investor’s capital investment to be contingent (which allows so-called “PAYGO” commercial structures in which post-investment transaction additional investments are made based on the ongoing productivity of the project).
Further, and most crucially, the Revenue Procedure relaxes certain related party restrictions that account for the unique nature of carbon capture projects as compared to the wind power and rehabilitation projects addressed by the prior guidance. A long-term oxide purchase agreement entered into on arm’s-length terms among any combination of the partnership owning the project (the Project Company) and the carbon oxide emitter (the Emitter) or qualified carbon oxide purchaser (the Offtaker) does not constitute an impermissible guarantee, even if between related parties. Additionally, long-term lease or services contracts with respect to the project between the Project Company and the Emitter or Offtaker, even if they are related, do not constitute an impermissible guarantee.
These deviations from the more stringent related party standards under the prior IRS guidance for PTC and Section 47 rehabilitation credit partnerships are particularly welcome as they recognize the likelihood that, in the market, one or both of the Emitter and the Offtaker will often be related to the Project Company. Accordingly, the Revenue Procedure falls back on the requirement that the commercial arrangement between the parties be on arm’s-length terms.
