1. Background

On November 17, 2023, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations (Proposed Regulations) relating to eligible energy property that qualifies for the section 48 energy investment tax credit. The notice of proposed rulemaking consists of several proposed amendments to the existing Income Tax Regulations under section 48 of the Internal Revenue Code (Code). In addition, the Proposed Regulations (i) update the types of energy properties eligible for the section 48 investment tax credit (ITC), reflecting changes in the energy industry, technological advances, and updates from the Inflation Reduction Act of 2022 (IRA), (ii) address the prevailing wage and apprenticeship requirements (PWA), and (iii) discuss additional rules applicable to energy properties. Some advances addressed include technologies the IRA added to the definition of ITC energy property, such as electrochromic glass, energy storage technology, microgrid controllers, and biogas property.

2. Defining Energy Property

Code section 48(a)(3)(B)(i) defines energy property as property that is constructed, reconstructed, or erected by the taxpayer. Existing Treas. Reg. section 1.48-2(b)(1) provides that property is considered constructed, reconstructed, or erected if the work is performed for the taxpayer in accordance with the taxpayer’s specifications. The Proposed Regulations would largely adopt the definition of the term “constructed, reconstructed, or erected” from existing Treas. Reg. section 1.48-2(b)(1) while modifying it to address energy property. Specifically, the Proposed Regulation section 1.48-9(b)(1) provides that the term construction, reconstruction, or erection of energy property means work performed to construct, reconstruct, or erect energy property either by the taxpayer or for the taxpayer in accordance with the taxpayer’s specifications.

Code section 48(a)(3)(B)(ii) alternatively provides that energy property can include property which the taxpayer acquires if the original use of such property commences with the taxpayer. The Proposed Regulations would define this as a transaction by which a taxpayer obtains rights and obligations with respect to energy property, including title to the energy property under the law of the jurisdiction in which the energy property is placed in service, unless the property is possessed or controlled by the taxpayer as a lessee, and physical possession or control of the energy property.

Section 48(a)(3)(C) provides that to be eligible as energy property, depreciation (or amortization in lieu of depreciation) must be allowable for the property. Section 48(a)(3)(D) provides that to be eligible as energy property, the property must also meet any performance and quality standards that have been prescribed by the Secretary of the Treasury.

Notably, energy property generally would not include equipment that is an addition or modification to an existing energy property unless the rules regarding retrofitted energy property apply. Under section 48, all of the components of energy property that meet the statutory requirements are considered “energy property.” Components of an energy property are those that would be included in a unit of energy property because they are functionally interdependent, as well as property owned by the same taxpayer that is an integral part of such energy property. The Proposed Regulations would adopt these concepts of functional interdependence and property that is an integral part of an energy property. Functional interdependence is found for components if the placing in service of each component is dependent upon the placing in service of each of the other components in order to generate or to store electricity, thermal energy, or hydrogen, or otherwise perform its intended function. To be an integral part of energy property, such property must be used directly for the intended function of the energy property as provided by section 48(c) and as described in §1.48-9(e) and be essential to the completeness of the intended function. The Proposed Regulations provide an example that the integral part rule includes power conditioning and transfer equipment as part of a qualified offshore wind facility, but excludes transmission and distribution equipment from being part of the qualified offshore wind facility. Onsite roads that are used for equipment to operate and maintain the energy property are another example of integral property. However, roads primarily for access to the site, or roads used primarily for employee or visitor vehicles, are not integral parts of an energy property.

1. Types of Energy Property

The Proposed Regulations would expand the definitions of energy property provided in existing regulations to account for new technology and also include notable changes that affect existing types of energy property, including qualified biogas property.

1. Qualified Biogas Property

The current definition of qualified biogas property is under Code section 48(c)(7), which provides that "qualified biogas property" is property comprising a system that converts biomass (any organic material other than oil and natural gas, and coal) into a gas that consists of not less than 52 percent methane by volume, or is concentrated by such system into a gas that consists of not less than 52 percent methane, and captures such gas for sale or productive use, and not for disposal via combustion. Qualified biogas property also includes any property that is part of a system that cleans or conditions such gas.

Although the Proposed Regulations would adopt this statutory definition, the Proposed Regulations also provide notable changes to what is determined to be qualified biogas property. Components of property are considered qualified biogas property if they are functionally interdependent, that is, if the placing in service of each component is dependent upon the placing in service of each of the other components in order to perform the intended function of the qualified biogas property. Examples of functionally interdependent components of the qualified biogas property include, among others, a waste feedstock collection system, a landfill gas collection system, mixing or pumping equipment, and an anaerobic digester. However, upgrading equipment is not a functionally interdependent component of qualified biogas property since it is not necessary to satisfy the statutory requirements that the biogas converted from biomass contain not less than 52 percent methane, and that it be captured for sale or productive use.

2. Proposed Definitions of Other Types of Energy Property

3. Rules Relating to the Increased Credit Amount for Prevailing Wages and Apprenticeship

On August 29, 2023, Treasury and the IRS issued proposed regulations on the clean energy PWA requirements instituted under the IRA (See our legal alert on the proposed regulations). Satisfying the PWA requirements entitles a taxpayer to claim five times the base amount of the credits otherwise available under several of the clean energy credit provisions. The credits eligible for PWA bonuses include, but are not limited to, production tax credits under sections 45 and 45Y, investment tax credits under sections 48 and 48E, and carbon capture and sequestration credits under section 45Q.

With respect to the section 48 credit, the basis of the energy property placed in service during the taxable year is multiplied by five if the project satisfies the PWA requirements.

If the project does not satisfy the PWA requirements, the bonus credit amount may still be available under certain sections of the Code, including section 48, with respect to energy projects with a maximum net output of less than one megawatt (One-Megawatt Exception). Additionally, this same bonus credit amount is available under certain sections of the Code including section 48 if beginning of installation or beginning of construction (BOC) occurred before January 29, 2023 (BOC Exception).

The current notice of proposed rulemaking withdraws certain portions of the previous proposed regulations and re-proposes regulations providing additional guidance on the PWA requirements, with respect to the definition of an energy project, guidance concerning the One-Megawatt Exception, and guidance on the recapture rules applicable to failures to satisfy the PWA requirements.

1. Recapture Rules

Section 48(a)(10)(C) provides a recapture rule for failure to satisfy the PWA requirements for alterations or repairs that occur during the five-year period after the energy project is placed in service. Previous proposed regulations included guidance that required taxpayers to ensure that any laborer and mechanic employed by the taxpayer, or any contractor or subcontractor in the construction or alteration of an energy project are paid wages not less than the prevailing rates for such activities in accordance with the Davis-Bacon Act. In addition to potential recapture, the failure to satisfy the PWA requirements remains subject to the correction and penalty provisions proposed in Treas. Reg. section 1.45-7(c)(1).

The new Proposed Regulations clarify that a taxpayer that fails to satisfy the prevailing wage requirements with respect to any period during the five-year period beginning on the date the project is placed in service is subject to recapture under section 48(a)(10)(C) of a portion (up to 100 percent) of the increased credit amount. The failure to satisfy the PWA requirements remains subject to the correction and penalty provisions proposed in Treas. Reg. section 1.45-7(c)(1).

Consistent with the recapture rules of section 50(a), the five year recapture period under section 48(a)(10)(C) begins on the day an energy property is placed in service and ends on the day that is five full years after the placed-in-service date, and each year within such recapture period is treated as a separate recapture year. The recapture percentages in section 50(a) apply based on the year in which the section 48(a)(10)(C) recapture event occurs.

Under the Proposed Regulations, taxpayers determine whether a recapture event has occurred at the end of the taxable year that begins or ends within the five-year recapture period. Further, the Proposed Regulations provide that verifying compliance with the prevailing wage requirements is required via annual information reporting. The IRS anticipates the annual reporting obligation will be made with the annual income tax or other annual return following the close of each recapture year.

The Proposed Regulations clarify that the section 48(a)(10)(C) recapture event remains applicable to credits transferred under section 6418. Proposed 1.6418-5 explains notification requirements for an eligible transferor taxpayer and that a transferee taxpayer is responsible for any amount of tax increase under section 48(a)(10)(C).

2. Energy Project Definition

With respect to the increased credit amounts for the PWA requirements, domestic content bonus credit, and increase in credit rate for energy communities, the term “energy project” means one or more energy properties that are operated as part of a single project. Multiple energy properties are considered as one energy project if at any point during the construction of the multiple energy properties they are owned by a single taxpayer and any two or more of the following factors are present:

1. The energy properties are constructed on contiguous pieces of land;
2. The energy properties are described in a common power purchase, thermal energy, or other off-take agreement or agreements;
3. The energy properties have a common intertie;
4. The energy properties share a common substation, or thermal energy off-take point;
5. The energy properties are described in one or more common environmental or other regulatory permits;
6. The energy properties are financed pursuant to the same loan agreement.

The Proposed Regulations do not address whether cross collateralization might impact this determination.

If multiple energy properties are treated as a single project for BOC purposes with respect to the section 48 credit, the multiple energy properties would also be treated as one energy project for purposes of the PWA requirements, the domestic content bonus credit amount, and the increased credit for energy communities.

3. One-Megawatt Exception

The Proposed Regulations address the determination of the One-Megawatt Exception nameplate capacity in relation to specific technologies. The nameplate capacity of electricity-generating projects is determined by megawatts of electrical (alternating current) or thermal energy that the unit is capable of producing on a steady state basis and during continuous operations under standard conditions.

Projects such as electrochromic glass property, fiber-optic solar, and microgrid controllers do not generate electricity or thermal energy, and are therefore not eligible for the One-Megawatt Exception.

4. Rules Applicable to Energy Property

Proposed Regulation Section 1.48-14 clarifies and adds several rules pertaining to energy properties, including (i) application of the 80/20 rule to retrofitted properties, (ii) dual use properties, (iii) properties eligible for multiple credits, (iv) treatment of incremental costs, (v) election of the ITC, and (vi) the treatment of qualified interconnection costs associated with low-output energy properties.

1. Retrofitted Properties

Prop. Reg. 1.48-14(a) would apply the 80/20 rule to retrofitted energy properties. Thus, a retrofitted energy property may be deemed originally placed in service if the fair market value of its used components does not exceed 20 percent of the total value of the energy property. Taxpayers may include the new costs paid or incurred for components that are an integral part of the energy property (as defined in section 1.48-9(f)(3)(i)) in the basis of the energy property for purposes of calculating the ITC. In the case of an energy project, under section 1.48-13(d), taxpayers must apply the 80/20 rule to each unit of energy property included in the energy project.

2. Dual Use Rule

Dual use property refers to property that utilizes energy from both a qualifying source under section 1.48-9(a) (solar energy property, wind energy property, or geothermal equipment), and a non-qualifying source. Prior regulations required the use of a minimum of 75 percent of energy from a qualified source in order to include a proportionate amount of the eligible basis in the energy property in calculating the ITC, and precluded an energy property from receiving and aggregating energy from multiple qualifying sources. Prop. Reg. 1.48-14(b)(2) lowers the threshold to 50 percent, and permits the aggregation of energy inputs from more than one energy property. If less than 50 percent of energy is derived from qualifying sources, then the energy property’s eligible basis is zero and it is not eligible for the ITC.

3. Energy Property Eligible for Multiple Federal Income Tax Credits

Under the Proposed Regulations taxpayers would be able to use an energy property’s basis to calculate both the ITC and another available Federal tax credit, but only to the extent that the other Federal income tax credit was not claimed with respect to the taxpayer’s eligible basis in the energy property.

4. Incremental Cost Rule

The Proposed Regulations adopt the current incremental cost rule, which provides that only the incremental cost of energy property may be included in the calculation of its eligible basis. Incremental cost is defined as the excess total cost of equipment over the amount that would have been expended for the equipment if it were not used for a qualifying purpose under the ITC.

5. Special Rules Concerning Ownership

Prop. Reg. 1.48-14(e) states that a taxpayer owning an energy property is eligible for the ITC only to the extent of its eligible basis in the energy property. This extends to multiple taxpayers holding a direct ownership interest in particular energy property, with their eligible basis limited to their fractional ownership interest in the energy property. Related taxpayers, those that are members of a group of trades or businesses that are under common control, are treated as one taxpayer in determining ITC eligibility.

6. Coordination with Other Code Provisions

Prop. Reg. 1.48-14(f) adopts the procedures in Notice 2009-52 describing how taxpayers owning a qualified facility may elect to claim the ITC in lieu of the production tax credits available under Code section 45. This is an irrevocable election the taxpayer must make on a completed Form 3468, filed with its Federal income tax return in the year the qualified investment credit facility (as defined below) is placed in service. A separate election must be made for each qualified facility and the election is binding on all taxpayers that directly or indirectly own an interest in the qualified facility. In the case of a qualified facility owned by a partnership or S corporation, the election is made by the entity and is binding on all section 48 credit claimants.

The Proposed Regulations include several pertinent definitions in determining the eligible basis:

• Qualified Property – (i) tangible personal property or other tangible property (excluding a building or its structural components), only if the latter is used as an integral part of qualified investment credit facility, (ii) which is depreciable (or amortizable), and (iii) that is constructed, reconstructed, erected, or acquired by the taxpayer and the original use commences with the taxpayer.
• Tangible Personal Property – any tangible property except land and improvements such as buildings or inherently permanent structures. Local law is not controlling in determining what qualifies as tangible personal property under the ITC.
• Integral Part – property used directly in the intended function of the qualified investment credit facility and is essential to the completeness of the intended function of the facility. This includes:
  • Power conditioning equipment - transformers, inverters, and converters, which modify the characteristics of electricity or thermal energy into a form suitable for use or transmission or distribution, and parts related to the functioning or protection of power conditioning equipment (i.e., switches, circuit breakers, arrestors, and hardware and software used to monitor, operate, and protect power conditioning equipment).
  • Transfer equipment - equipment that permits the aggregation of energy generated by components of energy properties and equipment that alters voltage in order to permit transfer to a transmission or distribution line (i.e., wires, cables, and combiner boxes that conduct electricity), parts related to the functioning or protection of transfer (i.e., current transformers used for metering, electrical interrupters, circuit breakers, fuses, and other switches), and hardware and software used to monitor, operate, and protect transfer equipment. Transfer equipment does not include transmission or distribution lines.
  • Roads – those that are an integral part of a qualified investment credit facility and integral to the activity performed, such as roads used for equipment to operate and maintain the facility. This does not include general access roads.
  • Buildings – generally buildings are not integral, except:
    • A structure that is essentially an item of machinery or equipment, and
    • A structure that houses property integral to the activity of a qualified investment credit facility if the use of the structure is so closely tied to the use of the facility that the structure clearly can be expected to be replaced when the facility is replaced.
• Qualified Investment Credit Facility – wind facility, closed-loop biomass facility, open-loop biomass facility, geothermal or solar energy facility, landfill gas facility, trash facility, qualified hydropower facility, and marine and hydrokinetic renewable energy facilities:
  • That satisfies any applicable placed in service and beginning of construction requirements;
  • For which no Code section 45 credit has been allowed; and
  • For which taxpayer has made an irrevocable election to treat the qualified facility as energy property.

7. Rules for Certain Lower-Output Energy Properties to include Qualified Interconnection Costs in the Basis of Associated Energy Property

The Proposed Regulations clarify treatment of costs associated with qualified interconnection property under the IRA. Section 48(a)(8)(A) of the Code generally provides that energy property shall include amounts paid or incurred by the taxpayer for qualified interconnection property, which has a maximum net output of 5 megawatts or less, to provide for the transmission or distribution of the electricity produced or stored by such property. Qualified interconnection property means, with respect to an energy project (excluding microgrid controllers) tangible property (i) which is part of an addition, modification or upgrade to a transmission or distribution system that is required at or beyond the point at which the energy project connects to the transmission or distribution system, (ii) which is constructed, reconstructed, or erected by the taxpayer or the cost or which is incurred by the taxpayer, and (iii) the original use of which begins with a utility, pursuant to an interconnection agreement.

The Proposed Regulations further provide:

• Only amounts paid or incurred by the taxpayer will be included in the basis of the related energy property. A taxpayer may not include reimbursed costs in the basis.
• The 5 megawatt limitation is measured only by the nameplate generating capacity of the energy property at the time it is placed in service;
• Qualified interconnection property is not taken into account when determining whether an energy property satisfies the requirements for the domestic content bonus credit or the increase in energy community credit rates (as qualified interconnection property is not energy property since it is neither functionally interdependent, nor an integral part of, such property).

5. Effective Date

The Proposed Regulations generally apply to property that is placed in service after December 31, 2022, and during the taxable year beginning after the date the final regulations are published in the Federal Register, with two exceptions: (i) Proposed Regulation section 1.6418-5, which provides for recapture determinations with respect to transferred credits relating to section 48(a)(10(C), will apply to taxable years after the date the final regulations are published in the Federal Register, and (ii) Proposed Regulation section 1.48-13, pertaining to prevailing wage and apprenticeship requirements, applies to projects placed in service in the taxable years ending after the date the final regulations are published in the Federal Register and the construction of which begins after the publication date.

Taxpayers may rely on Proposed Regulation sections 1.48-9, 1.48-14 and 1.6418-5(f) with respect to property that is placed in service after December 31, 2022, and during a taxable year beginning on or before the date the final regulations are published in the Federal Register. Taxpayers may rely on Proposed Regulation section 1.48-13 with respect to construction of a property or project beginning on or after January 29, 2023, and on or before the date the regulations are published as final regulations in the Federal Register.

Comments to the Proposed Regulations are due by January 21, 2024, with a public hearing scheduled for February 20, 2024.

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