The U.S. Department of the Treasury (Treasury) issued Notice 2023-38 (the Notice) on May 12, 2023, which contains the first rules concerning the domestic content bonus credits for renewable electricity, renewable natural gas, energy storage, hydrogen storage, and some hydrogen facilities pursuant to Code[1] Sections 45, 48, 45Y, and 48E.[2] These bonus credits were created by the Inflation Reduction Act (IRA), which was enacted in August 2022. While the Notice includes several big wins for the renewable energy industry, it also raises several big questions. This Update highlights key aspects of the Notice and discusses its potential implications for investors, developers, manufacturers, and suppliers.

Domestic Content Bonus Credits

Why do domestic content bonus credits matter? The IRA revitalized U.S. federal income tax credits for renewable energy, fuels (including hydrogen and renewable natural gas), and carbon capture. It also created a few “bonus” credits in addition to the base investment and production tax credits. One of these credits is available for projects that (1) use only U.S.-produced steel and iron and (2) use a threshold amount of U.S.-produced “manufactured products” and “components.” This is called the domestic content bonus or adder. The domestic content rules also inform (but do not apply to) the new manufacturing facility tax credits under Code Sections 48C and 45X and should be considered alongside many of the U.S. Department of Energy and U.S. Department of Transportation grant programs.

The Notice

What is the Notice? The Notice is an announcement that Treasury and the Internal Revenue Service (IRS) intend to issue proposed Treasury Regulations. The proposed Treasury Regulations that are eventually published will likely be drafted differently than the Notice and may vary substantively. Taxpayers will have an opportunity to influence the domestic content rules by submitting comments during the public notice period that is always used after proposed Treasury Regulations are released. Taxpayers should also consider providing comments to the IRS or Treasury on the Notice itself.

Can we rely on the Notice? Yes. Taxpayers are expressly permitted to rely on the rules in sections 3 through 6 of Notice 2023-38 (i.e., the substance of the Notice) for projects that begin construction before the day that is 90 days after the day on which Treasury publishes the proposed Treasury Regulations in the Federal Register. While it is unclear when Treasury will publish the proposed regulations, the Notice is fairly well developed.

Domestic Content Rules

What is domestic content? That’s complicated. Here are the highlights:

1. The domestic content requirements for steel and iron apply to construction materials that are structural steel and iron and not to items such as fasteners, covers, and cabinets. The steel and iron rules also do not apply to manufactured products or components and subcomponents of manufactured products. Whether domestic steel and iron rules cover items such as steel tanks used to manufacture and store renewable fuels and hydrogen is not clearly answered in the Notice.
2. The manufactured products rule is very complex. Key requirements include the following:
   • Under Code Sections 45, 48, and 48E, at least 40% (or 20% for offshore wind) of the manufactured products and components must be manufactured in the United States to obtain the bonus. This percentage applies for as long as the production or investment tax credits are available. (This was murky in the statutes, but Treasury clearly states this in the Notice.) In contrast, the applicable percentage under Code Section 45Y starts at 40% (or 20% for offshore wind) and increases over the first few years that the production tax credit is available to 55%.
   • The applicable percentage is measured across a project that qualifies for the relevant credit. It is measured by reference to both manufactured products and manufactured product components.
   • When all the manufactured products in a project are manufactured in the United States, and all the components of the manufactured product are manufactured in the United States, the process is very simple. But let’s be real—those projects are unicorns. In most cases, project developers and investors will have to look to one or more manufactured products or components to achieve the applicable percentage. They will do this by referencing the direct labor and materials costs to manufacture those manufactured products and manufactured product components. Put another way, the applicable percentage rule requires determining the direct labor and materials costs that a manufacturer pays or incurs to produce manufactured product components and the manufactured products themselves, then calculating how many of those costs are attributable to U.S. activities versus activities abroad. At a high level, this means it will be important for manufacturers all over the world to keep excellent records of their materials costs and the amounts they pay laborers. Moreover, these manufacturers may need to be willing to provide this information to customers, either directly or through an intellectual property escrow arrangement that can be accessed only in case of an audit.
   • The Notice raises at least two key practical questions regarding what costs count under the applicable percentage rule. First, the cost of automated manufacturing lines is considered an “indirect” cost and therefore does not count toward the applicable percentage. The question then becomes whether the American manufacturing industry finds value in stepping away from or limiting automation so that investors can obtain these bonus credits. Second, labor costs are based only on employee compensation, with no consideration of employee benefits, which are a significant cost for employers. This aspect of the guidance presents a clear tension with the IRS’s signal to use employees rather than automation. It will be up to the American manufacturing industry to determine whether these are good choices for it in the long term.
   • The Notice provides some guidance distinguishing between a manufactured product and a component, but there is room for doubt. The Notice indicates that manufacturing is a process to alter the form or function of materials or other elements of a product in a manner that both increases the value and transforms the material or elements. In other words, manufacturing is not merely assembly. A component is a material, article, or supply incorporated into a manufactured product. Confusingly, a component could also be manufactured under the definition in the Notice.
   • There are safe harbors that apply to solar, onshore wind, offshore wind, and battery energy storage:
     • Manufactured products include solar trackers, solar panels, wind turbines, battery modules, battery enclosures, monopiles, inter-array cables, and offshore substations. Steel and iron include solar racking, piers or ground screws for solar, wind towers, and the rebar that is incorporated into concrete pads and foundations. This level of granularity provides important clarity for the solar, wind, and battery industries.
     • Several of the more complex manufactured product categories (solar panels, wind turbines, battery modules) call out specific types of manufactured product components. Classifying specific items as manufactured product components is important because it is necessary to evaluate only where manufactured product components were manufactured (or, if the item is not manufactured, then where they were mined) and not subcomponents.
   • Subcomponents do not matter for purposes of evaluating compliance with the domestic content rules. However, Treasury did not clearly describe where a subcomponent stops and a component begins. Unless proposed Treasury Regulations distinguish components and subcomponents, taxpayers likely must rely on inferences from the list of safe harbor classifications and historic Federal Transit Administration guidance interpreting the Buy America Act.

How do taxpayers prove they qualify for the domestic content bonus? Taxpayers must certify the availability of the bonus in a statement attached to the typical U.S. federal income tax credit form for their project (e.g., Form 3468 for the investment tax credit). There is no form for this statement yet, but the Notice implies that one will be issued. The Notice is thin on details for this certification, but it is possible that taxpayers will have to attest to the direct costs used to determine that the project meets the manufactured products rules. Until more guidance is released, developers would be wise to obtain as much documentation and specific information about cost and place of manufacture from suppliers as possible.

Next Steps

Manufacturers may want to revisit their domestic content projections and refine them to account for the distinctions drawn in the Notice. They may also consider whether there may be another way to achieve sufficient domestic content to satisfy their customers. Developers should consider the level of detail required in procurement contracts and whether additional information or assurances in existing contracts are needed. Investors should carefully consider the level and type of assurances they require before paying for domestic content bonus credits. And everyone ough to think hard about whether additional or different guidance is needed and, therefore, whether it is in their interest to comment on the Notice or the proposed Treasury Regulations as soon as they are released.

Endnotes

[1] All references to the “Code” herein are to the U.S. Internal Revenue Code, as amended and restated.

[2] Code Section 45 concerns the traditional production tax credit for renewable electricity. Code Section 48 concerns the traditional investment tax credit for renewable electricity and post-IRA, renewable natural gas, energy storage, and some hydrogen production facilities. Code Section 45Y concerns the new production tax credit for renewable electricity (i.e., the Clean Electricity Production Credit). Code Section 48E concerns the new investment tax credit for renewable electricity (i.e., the Clean Electricity Investment Credit).