The Inflation Reduction Act of 2022 opened up many energy credit opportunities for tax-exempt organizations. The Internal Revenue Service (IRS) and US Treasury Department released on June 14, 2023 proposed regulations on the direct payment regime, which guidance should help organizations evaluate whether to engage in clean energy projects.
The Inflation Reduction Act created new chances for tax-exempt organizations to participate in the benefits of various energy credits. As we have previously discussed, Section 6417 of the Internal Revenue Code (the Code) now permits tax-exempt organizations to effectively receive cash payments from the government in lieu of claiming one of the 12 specified energy tax credits.
Code Section 6418, on which we recently wrote, further creates a market for these clean energy credits by permitting tax-exempt organizations to transfer these credits to nonexempt taxpayers in exchange for cash, and treats those payments as nontaxable to the exempt organization.
WHO CAN BENEFIT (THE GOOD AND THE BAD)
Section 6417 is built around the concept of an “applicable entity.” In general, an applicable entity is (1) any tax-exempt organization, (2) any state or political subdivision thereof, (3) the Tennessee Valley Authority, (4) any Indian tribal government, (5) any Alaska Native Corporation, or (6) any corporation operating on a cooperative basis that is engaged in furnishing electric energy to persons in rural areas.
In addition, there are “electing taxpayers,” which are taxpayers other than applicable entities that elect to take advantage of Section 6417 for three of the applicable credits: the Section 45V clean hydrogen credit, Section 45Q carbon oxide sequestration credit, and Section 45X advanced manufacturing production credit.
The tax law has traditionally acknowledged a distinction between a political subdivision and an instrumentality. An instrumentality is generally understood to be an organization created by or pursuant to a state statute that is operated for public purposes but does not have the full powers of a government.
The statutory language created uncertainty about whether instrumentalities such as a state university or a port authority could be considered an “applicable entity.” Fortunately, the regulations specifically extend “applicable entity” status to agencies and instrumentalities. This is a welcome clarification and the good news of the proposed guidance.
The bad news of the proposed guidance is the treatment of partnerships and S corporations. Section 6417 specifically contemplates the possibility of a partnership or S corporation electing direct payment for any applicable credit. The statutory language appeared to allow for the possibility of exempt organizations creating partnerships with taxable entities for the purposes of pursuing energy projects. Exempt organizations have sought clarity on this issue as many such organizations choose to partner with for-profit organizations in investment and development of credit generating projects in other sectors such as affordable housing and are interested in doing so here as well.
The ability to partner with for-profit organizations was seen as vital to meaningful participation of exempt organizations in the clean energy space. However, the proposed regulations take the position that partnerships and S corporations can never be “applicable entities” (no matter how many partners or shareholders satisfy the statutory definition) and the statutory references only apply to partnerships and S corporations as “electing taxpayers” (i.e., it is only relevant for the three specific energy credits mentioned above).
As a result of this view, two or more “applicable entities” cannot form a partnership to pursue an activity that would produce the other nine specified energy credits. This is a surprising result, and will most likely discourage applicable entities from pooling resources to participate in a clean energy project. The proposed guidance holds out the possibility that applicable entities could pool resources with other entities, including for-profit organizations, by operating a project as co-tenants and not partners for tax purposes.
In other words, the proposed guidance would require an applicable entity to own an undivided interest in or share of the underlying credit property. This type of arrangement is common in the oil and gas industry, but normally co-owners of an operating project have a high possibility of being treated as partners for tax purposes. It remains to be seen whether a co-tenant arrangement is a viable approach for clean energy projects.
The IRS and Treasury Department have requested comments on whether any additional rules are needed. We expect that the government will receive numerous public comments asking for reconsideration of the rules for partnerships and S corporations.
REGISTRATION PROCESS
As anticipated, the proposed guidance provides for a mandatory prefiling registration process aimed at preventing fraud. An applicable entity or electing taxpayer will be required to use the prefiling registration process to register itself as intending to make the elective payment election. The process will also require a list of all applicable credits intended to be claimed and a list of each applicable credit property that contributed to the determination of such credits.
An applicable entity or electing taxpayer that does not obtain a registration number for the applicable tax year and report the registration number on its annual tax return would be ineligible to make an elective payment election. However, the proposed guidance provides that completion of the prefiling registration process and receipt of a registration number does not alone entitle the applicable entity or electing taxpayer to a direct payment with respect to the applicable credits determined.
The registration process will require applicable entities and electing taxpayers to submit required information through an online portal. In addition to some very specific and detailed requests (e.g., deeds/leases for the property where the project is located), there is also a catch-all for any other information that the applicable entity or electing taxpayer believes will help the IRS evaluate the registration request. While this may seem like a burdensome exercise, most of this information will presumably have been compiled as part of the due diligence prior to engaging in the project.
Because the online portal for registration is not yet available, we do not know what the exact process will involve. In addition, it is unclear what level of review of the submitted materials the IRS will engage in before issuing a registration number. The proposed guidance on registration were issued as temporary regulations. The temporary regulations apply to taxable years ending on or after June 21, 2023. As such, while there are still details to be worked out, the rules requiring registration have the force of law. The temporary regulations will expire on June 12, 2026.
As a potential trap for the unwary, the registration number is only valid for one taxable year, while certain of the applicable credits based on production provide for credit generation for multiple years. The registration process appears to contemplate a streamlined renewal, but this should not be viewed as a ministerial act. Failure to renew the registration would preclude the opportunity to receive the direct payment in a subsequent year.
NO DIRECT PAY FOR TRANSFERRED CREDITS
The companion to Section 6417 is Section 6418, which allows a taxpayer other than an applicable entity to sell applicable energy credits. All applicable credits under Section 6417 are also credits that can be sold under Section 6418. This appeared to allow for the possibility that an applicable entity could buy a credit under Section 6418 and then make a direct-pay election under Section 6417.
Because credits are sold at a discount relevant to the amount of the potential credit, this could have led to opportunities for tax-exempt organizations to benefit from the difference between the transfer price and the direct pay amount. Unfortunately, the proposed guidance precludes this possibility, and a Section 6417 direct-pay election will not be allowed for credits that are purchased under Section 6418.
REDUCTION OF DIRECT PAYMENT BENEFIT FOR THIRD-PARTY SUPPORT
If an applicable entity receives a grant, forgivable loan, or other tax-exempt income for the specific purpose of purchasing, constructing, reconstructing, erecting, or otherwise acquiring an investment-related credit property (a Restricted Tax Exempt Amount), and the Restricted Tax Exempt Amount plus the applicable credit exceeds the cost of the underlying project, then the amount of the applicable credit is reduced so that the total amount of applicable credit plus the amount of any Restricted Tax Exempt Amount equals the cost of the underlying project.
Once all the various credit incentives and enhancements are layered on, the applicable credit could be as much as 70% of the cost of the underlying project. This means that the reduction starts to become a real economic consideration if 30% of the project is being financed with a Restricted Tax Exempt Amount.
This rule only applies to the applicable credits that are based on the cost of the underlying credit (e.g., the Section 48 or Section 48E investment tax credit); it does not apply to the applicable credits that are based on production (e.g., the Section 45 or 45Y production tax credit).
While a rule that provides for the reduction of a benefit may seem undesirable, this rule indirectly confirms that the credit base for a project can include amounts paid through grants.
NEXT STEPS
The proposed guidance should help tax-exempt organizations focus on implementing an energy credit strategy. As of now, there is a very high hurdle for an applicable entity to partner with another applicable entity or a for-profit taxpayer. However, the clarification that instrumentalities and agencies are treated as applicable entities greatly expands the universe of potential beneficiaries of the direct pay election.
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