Key Takeaways

• The Proposed Regulations, once finalized, will provide general rules applicable to domestic manufacturers of eligible components, including guidance regarding the term “produced.”

• The term “produced” is defined as a process conducted by the taxpayer that substantially transforms constituent elements, materials or subcomponents into a complete and distinct eligible component.

• Parties to a contract manufacturing arrangement (as defined in the Proposed Regulations) have flexibility in that they may contractually agree on which party should be treated as the producer. Thus, parties to contract manufacturing arrangements should carefully review the Proposed Regulations to (a) confirm their arrangement meets the definition of a contract manufacturing arrangement and (b) determine which party should be designated the producer.

• The Proposed Regulations also state that the domestic production requirements under Section 45X do not apply to constituent elements, materials and subcomponents.

Introduction

As covered in our prior alerts, the Inflation Reduction Act[1] enacted new renewable energy credits, including an advanced manufacturing production credit under Section 45X that provides tax credits to domestic producers and sellers of certain eligible components related to renewable energy and battery storage. The IRS and Treasury Department issued Notice 2022-47 on November 21, 2022, requesting general and specific comments on questions pertaining to the administration of Section 45X.[2] The IRS and Treasury Department followed up on Notice 2022-47 by publishing in the Federal Register on December 15 a notice of proposed rulemaking under Section 45X (the Proposed Regulations).[3] The preamble states that comments must be submitted by February 13 and that a hearing on the Proposed Regulations is scheduled for February 22. What follows is an overview of the Proposed Regulations.

Definition of ‘Produced’

The advanced manufacturing credit under Section 45X is available to taxpayers that domestically produce and sell eligible components to an unrelated taxpayer. The statute, however, does not define the term “produce.” The Proposed Regulations provide that “produced” means a process conducted by the taxpayer that substantially transforms constituent elements, materials or subcomponents into a complete and distinct eligible component. The Proposed Regulations further clarify that mere assembly or superficial modifications to elements, materials or subcomponents does not satisfy the definition of produced. Specifically for solar grade polysilicon, electrode active materials and applicable critical minerals, the term “produced” means processing, conversion, refinement or purification of source materials such as brines, ores or waste streams to derive a distinct eligible component.

The Proposed Regulations further clarify that an eligible component, the production of which began before December 31, 2022, and is completed and sold after December 31, 2022, is eligible for a credit under Section 45X. In addition, the Proposed Regulations address integrated components and provide that a taxpayer is treated as having produced and sold an eligible component if such component is integrated, incorporated or assembled into another eligible component that is eventually sold to an unrelated party. Similar to the definition of “produced,” “integrated, incorporated or assembled” requires a substantial transformation of the first eligible component into another complete and distinct eligible component and does not include mere assembly or superficial modifications. As an example of an incorporated eligible component, the Proposed Regulations reference the sale of an electric vehicle that contains a battery module with incorporated battery cells and electrode active materials. The Proposed Regulations provide that the taxpayer may claim a Section 45X credit for the electrode active materials, the battery cells and the battery modules when the electric vehicle is sold to an unrelated party.

Observations

• The definition of “produced” aligns with long-standing IRS guidance and precedent that mere assembly does not constitute manufacturing.
• The clarifications for incorporated eligible components will be welcomed by taxpayers. Certain issues could use additional clarity; the IRS and Treasury should consider additional examples beyond electric vehicles and their batteries.

Application to Contract Manufacturers

There are additional rules for contract manufacturers. The Proposed Regulations broadly define the term “contract manufacturing arrangement” as any agreement providing for the production of an eligible component if the agreement is entered into before the production of the eligible component. Routine purchase orders for off-the-shelf property or a contract that only requires de minimis modifications to property to tailor it to a customer’s needs are not considered contract manufacturing arrangements. Also excluded are arrangements where the contractor knows or has reason to know that it can satisfy the production out of existing stocks or the normal production of existing goods. In general, the Proposed Regulations provide that the party to a contract manufacturing arrangement that performs the actual production activities that bring about a substantial transformation resulting in the eligible component is the taxpayer that may claim a credit under Section 45X.

A special rule applies, however, where parties to a contract manufacturing arrangement agree to and certify which party to the contract may claim the credit under Section 45X for eligible components produced under the contract. The Proposed Regulations provide as an example a contract that is a “tolling arrangement” (i.e., a customer supplies the designs, specifications, materials and subcomponents to the manufacturer) for the production of solar modules to be sold by the customer and where the parties agree that the customer is the producer for purposes of claiming a credit under Section 45X. The Proposed Regulations provide an additional example of a tolling arrangement where the customer does not sell the solar module but instead uses it in their business. Under this latter example, neither party can claim a credit under Section 45X since there is no sale of the solar module.

Observations

• The Proposed Regulations adopt a broad definition of “contract manufacturing.” Taxpayers should carefully analyze whether their contract manufacturing arrangements might be viewed by the IRS upon audit as falling into the limiting categories of routine purchase orders for off-the-shelf property, de minimis modifications or the normal production of existing goods. Parties that have arrangements that fall into these limiting categories will be treated by the IRS as not engaged in the production of eligible components.

Subcomponents Produced in the United States

The Proposed Regulations reaffirm that only eligible components produced within the U.S. or a U.S. territory qualify for credits under Section 45X. A more favorable rule, however, is proposed for constituent elements, materials and subcomponents used in the production of eligible components. Such items would not be subject to the same domestic production requirements under the Proposed Regulations.

Observations

• The Proposed Regulations do not themselves provide examples of what constitutes a subcomponent. Separate IRS guidance under the domestic content rules relating to investment tax credits under Section 48 states that items such as nuts, bolts, screws, washers, cabinets, covers, shelves, clamps, fittings, sleeves, adapters, tie wires, spacers, door hinges and similar items constitute subcomponents. While it would be helpful if the Proposed Regulations were adjusted to make this same point, taxpayers may feel comfortable looking to related guidance for various definitions.

Related-Party Sales

The statute under Section 45X provides that a taxpayer may treat a sale of components to a related person as a sale to an unrelated person by making an election in the form and manner prescribed by the Secretary of the Treasury. The Proposed Regulations provide that future guidance published in the Federal Register, Internal Revenue Bulletin or forms and instructions published by the IRS will provide the form and manner for making the election. The election must be made annually and filed with the taxpayer’s timely filed original federal income tax return (including extensions). The election is applicable to all sales of eligible components to related persons. The election must be made for each eligible trade or business of the taxpayer.

Observations

• Taxpayers that make and then sell eligible components to related parties should carefully analyze the Proposed Regulations to make sure the sales qualify the taxpayer for the credit. Additional analysis may be required if the eligible component is integrated into another eligible component by a related taxpayer.

Anti-Abuse Rule

The Proposed Regulations adopt an anti-abuse rule that targets the unnecessary production and sale of eligible components where the eligible components are not intended to be used and the primary purpose of their production and sale is to obtain the benefits of a credit under Section 45X. Examples that may result in the application of the anti-abuse rule include situations in which an eligible component is discarded, disposed of or destroyed prior to being put to productive use.

[1] P.L. 117-169.

[2] Unless otherwise stated herein, “Section” references are to the Internal Revenue Code of 1986, as amended.

[3] REG-107423-23 and referred to herein as the “Proposed Regulations.”

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