Takeaways

• As of the date of this alert, the IRS and Treasury have not issued guidance addressing the one-time sale or transfer of certain applicable renewable energy credits. There is uncertainty regarding the procedures and documentation that will be required to effectuate a transfer and uncertainty regarding whether a buyer’s ability to utilize the transferred credit may be limited by application of the passive activity rules.
• Taxpayers considering buying or selling eligible credits should carefully consider the diligence they undertake to document the seller’s initial eligibility for the transferred credits.
• Taxpayers buying credits may face penalties if transferred credits taken are in excess of the allowable amount with respect to the applicable facility or property. Taxpayers buying credits should additionally consider appropriate representations, warranties, covenants and indemnities related to the purchase of credits, including whether it is appropriate to support an indemnity obligation with cash to be held in escrow. 

Introduction[1]

As covered in our prior alert, the Inflation Reduction Act[2] (IRA) modified and reinstated existing renewable energy credits and enacted new renewable energy credits. The IRA also enacted two novel alternatives to tax equity structures for monetizing renewable energy credits: (1) sale and transfer of applicable credits for cash (§ 6418) and (2) a “direct pay”/refundable credit approach (§ 6417). For certain credits, some taxpayers will have a choice between these two alternatives; however, for other credits, some or all types of taxpayers will not have a choice. We consider only the sale and transfer alternative in this alert.

Background

The newly enacted one-time transfer provision allows certain eligible taxpayers to elect to transfer all or a portion of certain eligible credits to an unrelated taxpayer in return for cash. The cash payments are not includible in the gross income of the seller and are not deductible by the buyer. Eligible credits may be transferred for less than the amount of the credit without resulting in any income to the seller.[3]

Taxpayers that are eligible to elect to make transfers include all entities other than tax-exempt entities, state and local governments, Indigenous tribal governments, Alaska Native corporations, and certain cooperatives engaged in furnishing electricity to persons in rural areas. The tax credits eligible for transfer include those under § 30C (alternative fuel refueling property), § 45 (renewable electricity production credit), § 45Q (carbon oxide sequestration credit), § 45U (zero-emission nuclear power production credit), § 45V (clean hydrogen production credit), § 45X (advanced manufacturing production credit), § 45Y (clean electricity production credit), § 45Z (clean fuel production credit), § 48 (energy investment tax credit), § 48C (qualifying advanced energy project credit) and § 48E (clean electricity investment credit) of the Code.

The election to transfer any portion of an eligible credit must be made no later than the due date (including extensions of time) of the tax return for the taxable year in which the credit is determined.  Once a transfer election is made, it is irrevocable.

Observation #1 – What Is Considered Cash?

The statute provides that payments made for eligible credits must be made in cash. The statute, however, does not provide a definition of cash. Thus, taxpayers looking to purchase credits need clarity regarding what forms of consideration may be used to purchase credits. For example, there are other sections of the Code that include in the definition of cash or money an account receivable, commercial paper or short-term obligations.[4] It is not clear, however, that a buyer could rely on these expanded definitions of cash and money for purposes of transferring a credit.

Treasury and the IRS will accordingly need to clarify whether the definition of “cash” will be constrained to physical cash, wires, checks or some other form of cash transfer that is immediately available, or whether it will be more expansive, including things such as a note, debenture or something else entirely. In addition, Treasury and the IRS will need to clarify whether there are any issues with prepayments for credits. For example, it is not clear whether a buyer may purchase credits with a purchase contract entered into in advance of the actual transfer of cash.

Treasury and the IRS also should provide examples of what constitutes a sale of a tax credit. Many taxpayers believe that product sale prices that take into account availability of a credit (for example, a seller may sell a product to a buyer at a lower price, taking into account that the tax credit available to the seller makes the manufacture and sale profitable to the seller even at the lower sale price) do not constitute the sale of a tax credit.

Observation #2 – What Documentation Is Required for Transfers?

The statute does not provide guidance on what types of documentation a taxpayer must maintain in order to substantiate and support any credits that it receives via a transfer. The statute grants broad authority to the IRS to determine what information or registration is necessary in order to prevent fraudulent, duplicative or improper payments and transfers of eligible credits. To date, the IRS has not issued any guidance regarding documentation or a registration process, but it is anticipated that initial guidance will be issued this spring and that the IRS will create a registration portal this year that will require buyers and sellers of credits to supply the IRS with information related to a transfer of credits. Taxpayers should anticipate that the registration portal will require robust and contemporaneous documentation that is produced by a party unrelated to the taxpayer. Notwithstanding, taxpayers should not expect the registration process to replace any diligence that the taxpayer would otherwise perform to ensure the validity or existence of credits.

Given the risk of fraud associated with tax credits, buyers should conduct due diligence regarding the production or construction of the property or facility that gave rise to a credit, including any bonus or add-on amounts (i.e., the wage and apprenticeship requirements). Buyers should additionally consider requiring sellers to create or maintain appropriate documentation supporting the validity or existence of credits and any bonus or add-on amounts that would sufficiently withstand an IRS audit.

Observation #3 – What Contractual Protections Should Buyers of Credits Consider?

Buyers of credits also need to consider the consequences of buying a credit that is later determined by the IRS to be invalid or overstated. Under the one-time transfer rules, the buyer would suffer an increase to its tax liability and a 20 percent penalty if a claimed credit turns out, for whatever reason, to not exist or to be overstated. The penalty may be waived or abated if a buyer is able to demonstrate that it acted with reasonable cause.

Buyers should accordingly consider appropriate representations, warranties, covenants and indemnities related to the purchase of credits, including whether it is appropriate to support an indemnity obligation with cash to be held in escrow. In addition, buyers will want to perform robust due diligence regarding the production, construction or property that gives rise to credits and bonus credits (i.e., increased credits due to satisfaction of wage and apprenticeship requirements). Buyers may additionally consider obtaining a tax credit insurance policy.

Observation #4 – What Is the Impact of the Passive Activity Rules?

One of the most discussed points relating to transfers of credits is whether the passive activity rules will apply to the buyer of a credit. A taxpayer’s ability to utilize eligible credits is initially limited to the taxpayer’s net income. However, certain rules disallow certain business credits that arise in connection with the conduct of “passive activities” where the tax credits exceed a taxpayer’s tax liability allocable to its passive activity. In general, a passive activity is an activity that involves a trade or business in which the taxpayer does not materially participate.

The statute does not directly state whether the passive activity rules apply to transferred credits. To date, the IRS has not issued guidance addressing the issue. While arguments may be made that the passive activity rules should not apply, taxpayers should approach any transfers with caution and consider that future guidance may take the position that the passive activity rules apply to purchased credits.

Observation #5 – How Will the IRS Audit Transfers?

How the IRS will audit eligible credits acquired via a one-time transfer is also open for debate. Logically, the IRS would first need to audit the producer of the property or the owner of the project that gave rise to the credit. Secondarily, the IRS would need to make sure that all valid credits claimed by a transferee were not claimed by others and that the seller did not make a direct pay election. Buyers should consider contractual protections allowing participation in an IRS audit of the seller in addition to indemnities in the event purchased credits are determined to be invalid or unavailable to the buyer. 

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