IRS Releases Proposed Regulations for Carbon Sequestration Tax Credit

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The proposed regulations, released on May 28 and on which taxpayers may currently rely pending finalization, build on prior guidance for carbon capture and sequestration tax credits under Section 45Q of the Internal Revenue Code. This guidance provides a framework for certainty in allowing developers, investors, and even service providers to benefit from the Section 45Q credit in a manner similar to that employed for other industries. The benefits will hopefully speed the expansion of the carbon capture industry and the reduced carbon release that it promises, similar to how tax credits have helped spur the renewable energy industry.

The US Department of the Treasury and the Internal Revenue Service (IRS) released a set of proposed regulations under the Section 45Q carbon sequestration tax credit, which expands on the IRS’s recent guidance under Notice 2020-12 and Revenue Procedure 2020-12 released on February 12. As we reported in a previous LawFlash, Notice 2020-12 provided standards for a project to “begin construction” to qualify for the Section 45Q credit. And, Revenue Procedure 2020-12 provided a safe harbor for “tax equity” investments using a “flip” partnership structure. We viewed this guidance as providing added certainty for investments in carbon capture and sequestration projects as tax equity investors look for new investment opportunities, particularly when similar credits in other industries (namely, the renewable energy industry) begin to sunset under current law.

Certain key provisions of the proposed regulations pertaining to the technical mechanical and associated measurement, reporting and certification requirements for the Section 45Q credit are discussed below. A forthcoming LawFlash will address the additional tax-related eligibility and administrative compliance requirements set forth in the proposed regulations.

THE SECTION 45Q TAX CREDIT FOR CARBON CAPTURE PROPERTY

By way of background, Section 45Q provides a performance-based tax credit in a specified dollar amount per metric ton of carbon oxide stored or utilized depending on the project type. Specifically, the amount of the Section 45Q credit depends on whether the captured qualified carbon oxide is disposed solely through secure geological storage (disposal), used for tertiary injection and disposal through secure geological storage (injection), or utilized by fixing it through photosynthesis or chemosynthesis, converting it to a material or chemical compound in which it is securely stored, or using it for any other purpose for which a commercial market exists (utilization).

For currently in-development and future projects, the Section 45Q credit applies for the 12 years following the project’s placed in service date. The amount of the tax credit escalates every year until 2026 when it reaches either $35 or $50 per metric ton of carbon oxide stored (depending on the type of project). The credit may then increase in later years if adjusted for inflation. Only eligible qualified facilities the construction of which beings before January 1, 2024, and related carbon capture equipment that has either similarly begun construction before January 1, 2024, or the original planning and design for the applicable qualified facility includes installation of the carbon capture equipment, are eligible for the credit.

The credit is flexible because it is not limited to a particular industry and generally applies to industries that produce large quantities of carbon dioxide or other carbon oxides. Thus, the Section 45Q credit is relevant not only to the electric power generation industry (for fossil-fired power plants), but also to various heavy production industries that emit large quantities of carbon oxides. In addition, the amount of tax credit involved can be significant. For example, a power plant that emits and captures 5 million tons of carbon dioxide a year could generate $250 million worth of tax credits.

Certain different rules and credit amounts apply to carbon capture equipment originally placed in service at a qualified facility before the enactment date of the Bipartisan Budget Act of 2018 (February 9, 2018).

DISOPSAL AND INJECTION – SECURE GEOLOGIC STORAGE AND MEASUREMENT

One method of qualifying for the Section 45Q credit is to dispose of captured carbon oxide in secure geologic storage. To qualify, the carbon oxide must be stored—and not used as a tertiary injectant for enhanced oil and gas recovery—and comply with the requirements of 40 CFR Part 98, subpart RR or the applicable Underground Injection Control regulations.

Geologic storage also includes the use of carbon oxide as a tertiary injection for enhanced oil and gas recovery. If the carbon oxide is used as a tertiary injectant, to qualify for the credit, the proposed regulations require the carbon oxide to be stored in an underground formation in compliance with the requirements of either 40 CFR Part 98, subpart RR, “Geologic Sequestration of Carbon Dioxide,” or the International Organization for Standardization (ISO) standards endorsed by the American National Standards Institute (ANSI) under CSA/ANSI ISO 27916:19, “Carbon dioxide capture, transportation and geological storage – Carbon dioxide storage using enhanced oil recovery (CO2-EOR).”

The taxpayer must certify the volume of carbon oxide disposed of by tertiary injection and claimed for the Section 45Q credit. If the taxpayer reported the volume to the US Environmental Protection Agency (EPA) under subpart RR, the taxpayer can self-certify the volume for the Section 45Q credit. If the taxpayer determined the volume under CSA/ANSI ISO 27916:19, they must prepare the documents outlined in the standard and supply them to a qualified independent engineer or geologist, who then must certify that the documentation provided, including the mass balance calculations and information on monitoring and containment assurance, is accurate and complete.

UTILIZATION – LIFECYCLE ANALYSIS FOR THE USE OF CARBON OXIDES

Another method of qualifying for the Section 45Q credit is through the utilization of carbon oxides. The uses allowed by Section 45Q are the fixation of carbon oxide through photosynthesis or chemosynthesis, the chemical conversion of carbon oxide to a material or compound that securely stores it, or by using it for any other purpose for which a commercial market exists as determined by the Secretary of the Treasury.

The amount of carbon oxide used—and thus qualifies for the credit—is equal to metric tons the taxpayer shows were captured and permanently isolated from the atmosphere or displaced from being emitted based on an analysis of lifecycle greenhouse gas emissions. The measurements of the amount of carbon oxide captured and the lifecycle analysis must be performed by an independent third party. The lifecycle analysis report must contain documentation consistent with ISO 14044:2006, “Environmental management — Life cycle assessment — Requirements and guidelines,” and documents showing the qualifications of the third party.

The taxpayer must submit the written lifecycle analysis report to the IRS and Department of Energy (DOE). The analysis will undergo a technical review by the DOE, and the IRS, in consultation with the EPA, will decide whether to approve it.

SECTION 45Q CREDIT RECAPTURE

The proposed regulations provide that a recapture of a Section 45Q credit occurs when subject carbon oxide is no longer captured, disposed of, or used as a tertiary injectant during the recapture period. The recapture period begins on the date of the first injection into secure geologic storage or use as a tertiary injectant. The period ends five years after the last taxable year the Section 45Q credits is claimed or the date of monitoring ends (under subpart RR requirements or the CSA/ANSI ISO 27916:19 standard). For released carbon oxide not deliberately removed from storage (leaked carbon oxide), a recapture event may be determined by a taxpayer, operator, or regulatory agency, in which case the taxpayer must quantify the amount of leaked carbon oxide under the applicable regulatory or other standard. The IRS must consider all available facts and may consult with the relevant regulatory agency in verifying the amount of leaked carbon oxide. Carbon oxide deliberately removed from a secure storage site constitutes a recapture event in the year of removal.

Any recapture event will be accounted for in the taxable year that it is identified and reported. The leaked carbon oxide amount for the year first effectively offsets against the amount of any eligible qualified carbon oxide otherwise subject to disposal or injection for the year (that is, so that the Section 45Q credit for the year would apply with respect to the net amount of qualified carbon oxide subject to disposal or injection). Any excess leaked carbon oxide amount is subject to recapture as additional taxes due for the year, calculated at the applicable statutory rate. The applicable rate is determined on a last-in-first-out basis (LIFO), with the excess leaked qualified carbon oxide deemed attributable first to the prior taxable year, then to the second preceding year, and then up to the fifth preceding year. The proposed regulations include a mechanism for allocating recapture among multiple Section 45Q claimants.

The proposed regulations do not include a recapture safe harbor. But, they do provide a limited exception to recapture if the leakage results from actions not related to the selection, operation, or maintenance of the storage facility, such as volcanic activity or a terrorist attack.

Helpfully, the preamble to the proposed regulations reaffirms the permissive provisions in Rev. Proc. 2020-12 allowing third-party-provided Section 45Q credit recapture insurance to not constitute an impermissible guarantee of a Section 45Q credit for purposes of a tax equity investment “flip” partnership structure. The preamble also solicits additional comments on how the recapture provisions should apply to Section 45Q credit carryforwards.

REQUEST FOR COMMENTS

The Treasury Department and IRS are seeking comments on the following specific issues:

  • How to achieve consistency in boundaries and baselines so that similarly situated taxpayers will be treated consistently
  • The definition of commercial markets and standards for Lifecycle Analysis
  • How to apply the recapture provisions to Section 45Q credits that are carried forward to future taxable years because of insufficient income tax liability in the current taxable year
  • All aspects of information collection burdens related to the proposed regulations

Comments are due 60 days after the proposed regulations are published in the Federal Register.

Morgan Lewis will continue to monitor this area for developments and will release a more comprehensive LawFlash on the specific tax provisions in the proposed regulations.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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