On January 6, 2021, the U.S. Treasury Department and the Internal Revenue Service ("IRS") issued much anticipated final regulations with respect to Section 45Q of the Internal Revenue Code. As explained below, the regulations liberalize a number of concepts and provisions which should make the financing of carbon capture and sequestration ("CCS") projects more attractive to tax equity investors.
As a brief overview, Section 45Q provides a tax credit to U.S. taxpayers who capture qualified carbon oxide and either properly store or use the captured carbon oxide in certain ways. The policy purpose of the credit is to incentivize investment in CCS to reduce the amount of carbon oxide emitted into the atmosphere, in particular by coal-fired power plants, which is broadly consistent with policies aimed at combating climate change and furthermore aligns with requirements of the Paris Agreement just re-accepted by President Biden.
The Bipartisan Budget Act of 2018 overhauled Section 45Q by greatly expanding the credit, in particular by: (i) making it applicable not just to carbon dioxide, but to carbon oxide generally, which includes both carbon dioxide and carbon monoxide, and (ii) eliminating certain caps. These expansions of the existing credit are designed to increase the financial viability of CCS project developments of existing carbon emitting assets. Following the changes, the IRS issued Rev. Pro. 2020-12 and Notice 2020-12, and the Treasury released proposed regulations in May, 2020. The IRS guidance and proposed regulations left a number of important issues with respect to the credit unresolved. Accordingly, the final regulations provide much needed clarity to CCS projects seeking to claim Section 45Q credits. This article discusses four of the major developments from the final regulations.
First, the final regulations clarify how and when a taxpayer can make an election to transfer Section 45Q credits. This is important because any disposer, injector, or utilizer who enters into a "binding written contract" with the original taxpayer can qualify as a credit claimant. The party receiving the credit by transfer must be in direct contractual privity with the taxpayer and cannot turn around and transfer the credit to a subcontractor. However, the final regulations do permit the original taxpayer to transfer credits to multiple eligible claimants—i.e., a taxpayer can elect to transfer a partial amount of the Section 45Q credits to both a disposer and a utilizer who are separate entities. The final regulations also define what qualifies as a "binding written contract" and permit taxpayers to amend their existing contracts to meet these requirements. These changes allow taxpayers to structure deals and projects to fit their needs and should encourage more third-party involvement in CCS projects.
Second, the final regulations reduce the "recapture period" from five years to three years—a much requested change from commenters to the proposed regulations. As is the case with other tax credits, the "recapture period" refers to the time frame during which a project must comply with the policy goals of the credit; failure to comply with those goals causes a "recapture" of the credits and the taxpayer who claimed them is required to add the recapture amount to the tax owed in the year of the recapture event. Recapture with respect to Section 45Q credits occurs when previously captured carbon oxide leaks out of secure geological storage or ceases to be properly utilized. The reduction to a three-year recapture period is a departure from the typical five-year period used for solar and wind tax credits. The Treasury determined that a three-year period was sufficient because risk of leakage is greatest in the year of injection and thereafter significantly decreases as the carbon oxide becomes stable. This change is a significant win for taxpayers as it notably reduces both the taxpayer’s risk and compliance burden.
Third, the final regulations permit taxpayers to aggregate multiple carbon capture facilities into one project. Notice 2020-12 allows taxpayers to aggregate facilities solely for purposes of determining whether construction has begun. The final regulations extend this rule by allowing taxpayers to aggregate facilities for the purpose of meeting the minimum capture requirements of Section 45Q(d). The final regulations permit taxpayers to use the factors from Notice 2020-12 to determine whether multiple facilities can be aggregated to operate as a single project, such as common ownership, location, and disposal. These aggregation rules are favorable because not only do they permit the taxpayer to pool risk and increase administrative ease, but also they allow smaller industry players to achieve the minimum capture requirements necessary to claim the credit. This increases the viability of carbon capture projects for businesses of all sizes.
Lastly, the final regulations provide a definition for "carbon capture equipment," a term not defined by the statute itself. The proposed regulations provided a broad, general definition, but notably also provided two lists—a list of included components and a list of excluded components. Many commenters argued for the removal of the two lists, citing the confusion they caused. Others argued for the inclusion of additional components on the lists. Ultimately, the final regulations remove both lists and keep only a "functionality-based definition." In our view this change likely achieves the policy goals of the statute.
Beyond the major developments discussed above, the final regulations provide taxpayers clarification on numerous other issues that were previously unresolved. With limited exceptions, the final regulations are taxpayer friendly, which will likely spur increased interest in investments in CCS projects. The extent to which these projects are able to have a meaningful impact on carbon oxide levels in the atmosphere remains to be seen.