Yesterday, the Internal Revenue Service issued two pieces of guidance related to carbon capture incentives. Revenue Procedure 2020-12 outlines a safe harbor as to how the credit may be allocated among developers and investors in a carbon capture partnership. Notice 2020-12 defines how carbon capture projects can demonstrate they have begun construction in order to qualify for the credit.

Background

Section 45Q, originally enacted in 2008, provides a tax credit for “qualified carbon oxide” that is captured using newly placed-in-service carbon capture equipment and disposed of in secure geological storage (including use as an injectant in enhanced oil or gas recovery). In 2018, Congress amended and expanded section 45Q, which made these projects more attractive to investors, but uncertainty as to its implementation has significantly limited investments in these projects.

The new guidance should alleviate concerns on some of the uncertainty and help jumpstart carbon capture projects, but key investor concerns remain, including: (i) the requirements for secure geological storage, and (ii) the circumstances in which the government can reclaim the 45Q credits if the projects aren’t ultimately successful in securely storing carbon. The IRS has stated it will issue further guidance on these issues “in the near future.”

Below are ten takeaways from yesterday’s carbon capture guidance, including how it compares to the IRS’s implementation of similar tax incentives.

Rev. Proc. 2020-12: Allocation Safe Harbor

1. How does the allocation safe harbor for the 45Q credit compare to safe harbors for other tax credits?

The guidance draws heavily from earlier safe-harbor guidance provided for investments in partnerships claiming tax credits for (i) the production and sale of electricity generated from wind energy and investments in wind projects (Revenue Procedure 2007-65), and (ii) the credit for rehabilitating certified historic structures and other qualified buildings (Revenue Procedure 2014-12).

2. Can project participants guarantee the 45Q credit for investors?

No person involved with the project company may guarantee or otherwise insure the investor’s ability to claim the credit, the cash equivalent of the credit, or the return of capital if the IRS challenges the credit.

However, guarantees may be provided for acts needed to claim the credit, such as ensuring proper secure geological storage, or avoiding anything that would cause failure to qualify for or the IRS recapturing the credit. For example, completion guarantees, operating deficit guarantees, and environmental indemnities are allowed.

The following are not guarantees: (i) a long-term carbon oxide purchase agreement, even if it contains take-or-pay, supply-or-pay or similar provisions; (ii) a lease of the capture equipment by the project company to a related emitter or carbon purchaser; and (iii) a tax credit insurance policy purchased from an unrelated insurer.

3. Can part of the investor’s contribution obligation be contingent?

Yes. As long as more than 50% of the investor’s obligations are fixed and determinable (i.e., not contingent in amount or certainty of payment), the investment will qualify. This is more generous than the guidance for investments in wind and rehabilitation projects, which requires 75% fixed payments. Contributions to pay ongoing operating expenses will not be treated as part of the investor’s contingent investment.

The exclusion of contributions to pay operating expenses is a welcome carveout, as carbon capture projects are expected to be costly and may generate little or no net revenue.

4. Are options on the project allowed?

Neither the developer nor the investor (nor any related person) may have a call option or other contractual right to purchase the carbon capture equipment at a future date.

Further, investors can’t have put options—that is, they can’t have a right to require any person to purchase or liquidate their partnership interest—at a future date at a price greater than fair market value determined at the time of exercise.

Determination of fair market value may take into account contracts or other arrangements creating rights or obligations only if negotiated and entered into at arm’s length and in the ordinary course of business. Unlike the rehabilitation credit safe harbor, however, the contracts may be with related parties.

5. Do allocations have to be consistent with receipts from carbon capture? What if the carbon capture does not generate any receipts?

If the partnership has income from carbon capture, allocations must be consistent with allocations of that income. If the partnership does not have income from carbon capture, allocations must be in the same proportion as the partners’ shares of losses or deductions from the costs associated with capture and disposal.

Notice 2020-12: Beginning Construction Requirement

6. Is guidance on beginning construction similar to that for other tax credits?

Yes. The guidance sets forth two methods—a physical work test and a 5% safe harbor—to satisfy the statutory requirement that construction of carbon capture equipment begin by December 31, 2023, drawing heavily from earlier safe-harbor guidance for investments in wind and solar projects.

7. Are there notable differences in the physical work test for carbon capture projects?

Methods of satisfying the physical work test are analogous to prior tax credit guidance, but two differences are worth highlighting: (i) installation of equipment and other work necessary for the disposal of qualified carbon oxide in secure geological storage at the storage site (which may be different than the location of the qualified facility or carbon capture equipment) qualifies, and (ii) installation of gathering lines connecting the industrial facility to the carbon capture equipment qualifies, but installation of equipment to transport the carbon oxide away from the facility does not qualify.

8. What activities do not satisfy the physical work test?

Preliminary activities in preparing the site are not considered physical work. Unlike the guidance on solar credits, the carbon capture guidance does not explicitly identify in its list of excluded preliminary activities (i) planning or designing work, or (ii) conducting environmental and engineering studies.

However, it’s unclear if a policy shift was intended regarding these activities because the list of excluded preliminary activities is not exclusive.

9. How does the 5% safe harbor for carbon capture projects compare to other tax credits?

The 5% safe harbor provides that construction of a qualified facility or carbon capture equipment will be considered as having begun when a taxpayer pays or incurs 5% or more of the total cost of the qualified facility or carbon capture equipment, and makes continuous efforts to advance towards completion of the project.
Costs counted towards satisfaction of the 5% safe harbor are analogous to prior tax credit guidance, but Notice 2020-12 explicitly includes costs associated with front-end engineering and design activities in the 5% safe harbor for carbon capture projects.

10. How long after construction begins does a taxpayer have for the carbon capture equipment to be placed in service?

A taxpayer has six years (instead of four for wind and solar projects) after the year construction begins to place carbon capture equipment in service. The additional time is consistent with the complexity of carbon capture projects compared to other tax-credit eligible projects.