[co-author: Michael Palmer*]
If there is to be rapid progress in limiting the increase of carbon dioxide (CO2) in the atmosphere, it will depend substantially on federal tax credits and state incentives for carbon capture and storage. For now, carbon capture and storage strategies are largely of three kinds: (1) biological removal (using photosynthesis to fix atmospheric CO2 in soils, grasses and trees), (2) direct air capture (DAC) (removing atmospheric CO2 and injecting it into geological formations), and (3) capture of CO2 before it is released. All three forms of capture may be the subject of a tax credit under Section 45Q of the U.S. Internal Revenue Code.
On July 1, 2021, the IRS released Revenue Ruling 2021-13 (Rev. Rul. 2021-13). In relevant part, that ruling held that an investor must own at least one component (and is not necessarily required to own all components) of carbon capture equipment in the “single process train” of carbon capture equipment at a facility in order to claim a Section 45Q tax credit.
Will the Ruling Make It Easier to Monetize the Section 45Q Tax Credit?
By allowing the Section 45Q tax credit to be divided among owners of the significant pieces of equipment used in capturing and storing the carbon oxide, the ruling gives more flexibility to project developers and investors.
The “partnership flip” is expected to be the preferred transactional structure in the Section 45Q tax equity market as the cost of industrial-scale carbon capture equipment falls.[1] Partnership flip structures allow developers to monetize the credit by allocating it to tax equity investors that have sufficient income to use the credits generated. Typically, a developer seeks out tax equity investors and forms a project company, usually in the form of a limited liability company, to own and operate a credit-generating asset. The project company is taxed as a partnership, allowing tax attributes and cash distributions to be allocated flexibly between the developer and investors. Initially, most of the taxable income, losses and Section 45Q tax credits are allocated to investors. But once investors hit a target rate of return, the tax and cash allocations “flip” and most of the taxable income, losses and remaining Section 45Q tax credits are allocated to the developer.
For the purposes of the Section 45Q tax credit, the credit-generating asset is the carbon capture equipment. For equipment placed in service on or after Feb. 9, 2018, the developer is the entity that owns the equipment and physically or contractually ensures the sequestration of the captured carbon oxide.[2] The “contractually ensures” language allows developers to contract or subcontract the disposal, injection or utilization of the carbon oxide and still claim the tax credit, provided certain conditions are met.[3] Developers also may make an election under Section 45Q(f)(3)(B) to allow a contractor that disposes, injects or utilizes the qualified carbon oxide to claim the credit, in effect transferring the credit. The flexibility and transferability of the credit ensures that developers and investors will be able to design flexible partnership structures or other arrangements to optimally allocate the Section 45Q tax credits to parties that can utilize them.
Under Rev. Rul. 2021-13, additional assistance to claim the credit was provided to developers and others by the IRS providing guidance that at least one component (and not all components) in a single process train must be owned by a single developer and providing helpful guidance as to how to calculate the placed-in-service date for purposes of the Section 45Q tax credit when a single process train includes multiple components, each of which are placed in service at different times.
*BakerHostetler thanks Michael Palmer, a second-year student attending the Northwestern University Pritzker School of Law, for research and drafting support.
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[1] To encourage hesitant investors, the IRS laid out a partnership flip transaction safe harbor in Revenue Procedure 2020-12. In this guidance, the IRS explains how tax partnerships used in connection with Section 45Q transactions can properly allocate the credit in compliance with applicable partnership tax rules and under what conditions investors will be considered bona fide partners. The procedure also provides an example of a permissible Section 45Q partnership structure, which is substantially similar to the typical partnership flip structure described above, with a 99 percent and 1 percent split on tax allocations for the investors and developer pre-flip, respectively, and a 5 percent and 95 percent split post-flip. Given its flexibility and the IRS’s guidance, the partnership flip structure is expected to be the common monetization structure of the Section 45Q tax credit.
[2] Treas. Reg. § 1.45Q-1(h)(1)(ii).
[3] Treas. Reg. §§ 1.45Q-1(h)(1)(ii), (h)(2).
