The IRS issued guidance in February 2020 for the Section 45Q tax credit program, which is aimed at supporting carbon capture and sequestration. The guidance reflected comments received by the IRS in response to Notice 2019-32. The February guidance clarifies what it means to “begin construction” (“Notice 2020-12”) and provides a safe harbor for allocating carbon capture/sequestration tax credits among developers and tax equity investors in partnerships (“Revenue Procedure 2020-12”). The guidance regarding the commencement of construction largely mirrors previous guidance issued to the wind industry, and later adopted for the solar industry, defining when construction begins for purposes of qualifying for the production tax credit and investment tax credit (respectively, “PTCs” and “ITCs”). The safe harbor largely follows a safe harbor for allocating PTCs in wind projects, with some modifications stemming from a seperate safe harbor relating to the allocation of rehabilitation tax credits. The IRS has promised additional guidance in the “near future” on additional interpretive questions that are critical to implementing the Section 45Q program.
Overview of Section 45Q Tax Credits
The Section 45Q tax credit program provides a tax credit (the “45Q Credit”) associated with the sequestration or use of qualified carbon oxides (“COx”), including carbon dioxide. Section 45Q Credits may be sought for projects that commence construction prior to January 1, 2024. Section 45Q Credits are calculated on the basis of volumes of COx sequestered during the 12-year period after qualifying carbon capture equipment is placed in service and qualified COx is disposed of in secure geologic storage.[1] The source of the COx can either be from an industrial facility that produces COx or from a direct air capture facility, which captures COx directly from the ambient air.
The value of the 45Q Credit depends on whether the COx is sequestered in connection with use for enhanced oil or gas recovery. Starting in 2017, the credit was $22.66/ton for sequestered COx and $12.83/ton for COx that was used for enhanced oil or gas recovery. These amounts increase annually until 2026. From 2026 forward, the credit will be $50/ton for sequestered COx and $35/ton for COx that is used for enhanced oil or gas recovery (such amounts are increased annually by an inflation adjustment).
Notice 2020-12: Beginning of Construction Guidance
Carbon capture facilities must commence construction prior to January 1, 2024, to qualify for 45Q Credits. Notice 2020-12 identifies two ways to demonstrate that construction has begun—a physical work test and a five percent safe harbor test.
Physical Work Test
The physical work test requires the taxpayer to commence physical work of a significant nature or enter into a binding written contract with a 3rd party to commence such work. The focus is on the nature of the work not the amount or the costs.
This work can be on-site or off-site. On-site physical work of a significant nature includes installation of equipment for capture or sequestration of COx and excavation and/or installation of foundations. Off-site physical work of a significant nature includes manufacturing equipment and components necessary for the carbon capture or sequestration process. Such equipment and components may not be of the type typically held in inventory by a vendor. Notice 2020-12 includes additional examples of on-site and off-site physical work that qualifies as commencement of construction. It also provides a list of activities that normally precede physical work, such as securing financing and obtaining permits, that are explicitly excluded.
Five Percent Safe Harbor Test
Commencing construction can also be demonstrated by the five percent safe harbor test. This requires the taxpayer to pay or incur five percent or more of the total costs of the qualified facility or carbon capture equipment. Costs that are eligible for the five percent test include front-end engineering and design activities, which is an expansion of the eligible costs from the solar and wind guidance.
Continuity Requirement
Taxpayers relying on the physical work test must demonstrate a continuous program of construction after physical work commences. Taxpayers relying on the five percent safe harbor test must demonstrate continuous efforts to complete construction. Both continuity requirements are deemed satisfied if the qualified facility or carbon capture equipment is placed in service before the end of the calendar year that is six years from the date construction began. This is longer than the four-year continuity safe harbor under the wind and solar guidance and likely represents the IRS’s acknowledgement that there may be challenges associated with capture technology that is relatively new, as compared to the technologies in the wind and solar sector. Many commentators, including Orrick, recommended a six-year safe harbor to the IRS.
If a developer does not place the qualified facility or carbon capture equipment in service by the end of the sixth calendar year after the commencement of construction, the IRS will determine whether continuous construction or continuous effort has been satisfied based on the relevant facts and circumstances.
Revenue Procedure 2020-12: Partnership Allocation Safe Harbor
Many commentators also suggested that the IRS issue specific guidance to facilitate tax equity transactions in the form of a partnership flip for carbon capture projects based on the wind guidance. Revenue Procedure 2020-12 provides a safe harbor for allocating the 45Q Credit to tax equity investors that largely resembles the rules governing flip partnerships for wind projects claiming the PTC,[2] while looking to certain concepts from the rehabilitation tax credit safe harbor.[3]
The Revenue Procedure provides that the IRS will respect allocations of the 45Q Credit as agreed to in the operating agreement of the partnership if the requirements of the safe harbor are met, rather than allocating profits according to each partner’s interest in the partnership. An allocation based on each partner’s interest in a partnership requires an analysis based on a review of the facts and circumstances and could result in tax equity investors being allocated a smaller share of the 45Q Credit than the operative agreement would otherwise allocate (typically 99 percent). The key requirements of the safe harbor are provided below.
Minimum Partnership Interests
The developer must be allocated a minimum of one percent of each material item of partnership income, gain, loss, deduction and credit at all times during the existence of the project. The investor must be allocated a minimum of five percent of its largest percentage share of those same partnership items. This permits the tax equity investor to receive up to 99 percent of partnership income, gain, loss, deduction and the 45Q Credit.
Bona Fide Equity Investment
The investor’s interest in the partnership must have a reasonably anticipated value commensurate with the investor’s overall (not merely largest) percentage interest in the project, ignoring tax deductions, credits and allowances at the federal, state and local levels. In other words, the investor’s relationship to the partnership must be that of a partner, as opposed to a lender that is lending funds to a borrower or some other non-equity relationship. To show that the investor is a partner, it cannot be protected from losses and the potential upside cannot be limited, for example, in a manner similar to a preferred return representing a payment for capital. Further, the value of the investor’s partnership interest cannot be reduced artificially. The Revenue Procedure lists unreasonable developer, management, incentive or other fees, disproportionate rights to distributions or partnership interests issued to other partners for less than fair market value as examples of arrangements that are prohibited because they reduce the value of the investor’s partnership interest or economic return.
Minimum Unconditional Investment
Investors must make a minimum unconditional investment of at least 20 percent of its initial fixed commitment, plus any reasonably anticipated contingent investments required to be made by the investor under the partnership agreement. The investor must then maintain this “minimum investment” as long as it owns its partnership interest, except that it may be reduced for distributions of cash from the operations of the partnership.
Contingent Consideration
The ability of tax equity investors to use a “pay-as-you-go” structure (meaning that further investment will be contingent on the amount of carbon captured or otherwise be contingent in amount) for purposes of the Section 45Q program is expanded as compared to the PTC. For the 45Q Credit, up to 49.99 percent of a tax equity investor’s investment may be contingent. This is an increase from the 25 percent used under the PTC program.
This change in contingent consideration is beneficial in the 45Q Credit context because some projects may have little to no cash flow. The lack of cash flow from the project means that the 45Q Credit would account for nearly all of the tax equity investor’s return on investment. Tax equity investors under the Section 45Q program will likely want to maximize pay-as-you-go payments because, unlike the PTC program where cash could be swept to the tax equity investor if the partnership did not flip by the end of the PTC period, there will likely be much less cash available to sweep in carbon capture transactions.
Purchase and Sale Rights
Revenue Procedure 2020-12 introduced a prohibition on call options, but permits certain investor put options. This is consistent with historic tax credit guidance but is the exact opposite of the wind guidance, which prohibits puts but allows developer call options that are exercisable at fair market value. Put options must be exercisable at fair market value as determined at the time the put option is exercised.
Guarantees and Loans
A tax equity investor may not have guarantees from persons involved in the project with respect to its ability to claim 45Q Credits, the cash equivalent of the credits or the repayment of any portion of the tax equity investor’s contribution due to the inability to claim a 45Q Credit in the event that the IRS challenges all or part of the structure. Tax equity investors may obtain insurance, including recapture insurance, from persons not related to the developer, the tax equity investor or certain other parties related to the transaction. In addition, certain guarantees may be provided to the tax equity investor and the developer, including (i) guarantees for the performance of any acts necessary to claim the 45Q Credit (e.g., ensuring proper secure geological storage of the qualified COx through disposal, use or utilization) and (ii) guarantees for the avoidance of any act or omission that would cause the developer to fail to qualify for the 45Q Credit or that would result in a recapture of the 45Q Credit.
The developer may also enter into a “take-or-pay” arrangement with an offtaker—a qualified COx purchaser. Other permitted arrangements include contracts that contain “supply all,” “supply-or-pay,” “take all” or “securely-store-or-pay” provisions in agreements between the developer and an offtaker or between a COx emitter and an offtaker, even if those entities are related to the developer.
In addition, a developer, or any person related to it, may not lend funds to the tax equity investor to provide funding for the tax equity investor to acquire its interest in the partnership.
Permissible Methods of Allocating 45Q Credits
If the safe harbor is satisfied, the Revenue Procedure provides for the methodology for allocating the 45Q Credit under the rules for determining whether a special allocation of tax credits has substantial economic effect. The first applies to projects that generate income from activities related to COx; the second applies to projects that do not generate income from its activities related to COx. In the first scenario, the safe harbor requires the partnership to allocate the 45Q Credit in proportion with each partner’s share of income under the operating agreement. In the second scenario, the safe harbor requires the partnership to allocate the 45Q Credit in proportion to each partner’s share of losses or deductions associated with the costs of the capture, disposal, use or utilization of the COx.
Remaining Challenges to Implementation
The IRS provided much-needed guidance for developers and investors that addresses some, but not all, material uncertainties in the Section 45Q program. For example, until the IRS explains how permanent storage will be defined for purposes of sequestration, developers and investors will face significant uncertainty about the type of geological formations that will meet the 45Q Credit program requirements. Because the IRS can reclaim issued 45Q Credits for projects that fail to permanently secure COx, the absence of clarity concerning acceptable storage will be a significant risk for developers and investors.
The IRS currently intends to issue additional guidance as early as the second quarter of 2020. Treasury and IRS have been working on the guidance for quite some time. Any further delay in issuance of the guidance may push back projects in the pipeline that are seeking tax equity in the near future.
[1] This update focuses on sequestration of COx, but the “utilization” of COx is also eligible for the credit. “Utilization” for purposes of the credit includes (i) the fixation of COx through photosynthesis or chemosynthesis, such as through the growing of algae or bacteria, (ii) the chemical conversion of qualified COx to a material or chemical compound in which COx is securely stored or (iii) the use of such COx for any other purpose for which a commercial market exists (other than enhanced oil or natural gas recovery) approved by the IRS. The credit also includes the use of the captured COx as a tertiary injectant in certain enhanced oil or natural gas recovery projects that are disposed of by the taxpayer in secure geological storage.
[2] Revenue Procedure 2007-65 (the partnership-flip safe harbor for PTCs).
[3] Revenue Procedure 2014-12 (the partnership-flip safe harbor for Section 47 rehabilitation credits).
