- Under the IRA, select renewable energy credits are transferrable, including to individuals and pass-through entities.
- The transferees of these credits are subject to the passive activity rules of Section 469 of the Internal Revenue Code, limiting who might benefit from these credits on transfer.
- The risk of the credits being disallowed, perhaps due to project failure, falls on the transferee and not the transferor, making appropriate indemnities and assurances as to the credit quality of the transferor paramount.
On June 14, 2023, the Department of the Treasury and the Internal Revenue Service (IRS) released guidance on Internal Revenue Code (IRC) Section 6418, added as part of the Inflation Reduction Act of 2022 (P.L. 117-169)(IRA), granting taxpayers a new way to monetize certain tax credits. The guidance included proposed regulations relating to the transferability of tax credits under IRC Section 6418 (Transferability Guidance), temporary regulations regarding information and registration requirements (Pre-Filing Registration Guidance) and a series of frequently asked questions. (For a more general summary of this guidance, refer to our prior alert.) Notably, despite the hopes of tax practitioners and industry groups to the contrary, the new proposed regulations apply the passive activity rules of IRC Section 469 to transferees of tax credits under IRC Section 6418, which impacts the ability of individuals (and estates, trusts and certain corporations) to benefit from the credits. Additionally, the proposed regulations provide that transferees will bear the risk of certain events that result in a recapture of previously claimed tax credits.
Transferability in General
Prior to the enactment of IRC Section 6418, investors most typically accessed renewable energy tax credits by investing in so-called “tax equity” partnerships, which owned renewable energy facilities and disproportionately allocated profits, and associated tax credits, to investors with the tax capacity to utilize the credits. Investors in such partnerships, however, necessarily assumed the risks inherent in an operating energy production business. As a result, these types of investors typically were larger and more sophisticated, and thus able to handle the diligence burden, legal and accounting costs and risks involved in such partnership arrangements. Now, with the allowance of transferability under IRC Section 6418, the monetization of renewable energy tax credits has been made both easier and more accessible to a broader range of investors.
As a general matter, IRC Section 6418 allows for the sale of tax credits solely for cash to unrelated taxpayers. The payment of cash does not constitute taxable income to the transferor and is not deductible by the transferee. The proposed regulations make clear that any non-cash consideration included in a credit transfer will invalidate the transaction.
Application of Passive Activity Rules
Under IRC Section 469, a tax credit is subject to limitation if associated with a “passive activity.” Such limitation generally equals the amount by which credits from all passive activities allowable for the tax year, including various renewable energy tax credits, exceed the regular tax liability of the taxpayer for the tax year allocable to all passive activities. Any credit disallowed for a taxable year as result of the passive activity limitation generally can be carried forward to later taxable years, subject to the same limitation.
Under the relevant IRC provisions, a passive activity is any trade or business in which the taxpayer does not materially participate and rental activity beyond certain limits. Material participation is defined as when a taxpayer’s involvement in the business or trade is substantial, and is also regular and continuous. Treasury regulations provide detailed guidance as to the requirements for material participation.
The passive activity rules apply to individuals, trusts and estates, but do not apply to corporations, except for personal service corporations and closely held corporations. For pass-through entities, the passive activity rules apply at the level of the shareholder or partner.
Passive income and losses can include the following activities:
- Equipment leasing,
- Rental real estate (with some exceptions, including if someone is a real estate professional),
- Limited partnerships (with some exceptions),
- Partnerships, S corporations and limited liability companies in which the taxpayer has no material participation, including profit distributions, and
- Certain royalties.
Since typical tax equity investors do not materially participate in the tax equity partnership’s underlying energy production business, the passive activity rules would apply unless the investors are corporations (other than personal service corporations and closely held corporations). With the application of these rules, IRC Section 6418 limits what sort of individuals or members of a pass-through entity are able to use purchased credits under IRC Section 6418.
Whether Congress intended for the passive activity rules to apply to purchasers of renewable energy tax credits under IRC Section 6418 is unclear. The proposed regulations resolve any question on this front for the time being. More specifically, the proposed regulations do not allow the transferee to “step in the shoes” of the transferor for purposes of determining material participation in the credit-generating activity for purposes of IRC Section 469. As a result, a transferee subject to IRC Section 469 would only be able to utilize purchased tax credits against tax liabilities associated with passive income generated from other sources.
Transferees Subject to Recapture Rules
An area of concern arising from the transfer of credits has been clarity around tax credit recapture. For example, investment tax credits under IRC Section 48 are potentially subject to recapture if the underlying assets are disposed of, or permanently taken out of service, during the five-year period following their placed-in-service dates. Other types of credits can be recaptured as well under rules applicable to the relevant credit type.
Nevertheless, some relief of risk is provided to the transferee. IRC Section 6418 requires that the transferor must give notice of a recapture event to the transferee, and the transferee must take that recapture event into account and repay the IRS accordingly. No guidance existed in the IRC as to how such a process should work in practice, and the proposed regulations provide certain clarity on important aspects of how recapture would apply. The proposed regulations also provide relief for certain recapture events for a partnership that otherwise would have been expected to cause recapture to the transferee; specifically changes in the ownership interests in the partnership. Such relief generally pertains to changes in the ownership of interests in the partnership by partners that were entitled to the credits when claimed. The proposed regulations apply an entity-based approach to applicable partnerships for purposes of tax credit recapture, so only transfers or dispositions of assets at the partnership level would cause a loss of the tax credit to the transferee.
The proposed regulations also permit the transferor to indemnify the transferee for any recapture.
The allowance for transfers of renewable energy tax credits under the IRA is a major change and opens up the purchase of such credits to new categories of transferees. As discussed above, many individuals (as well as estates, trusts, personal service corporations and closely held corporations) still may not be able to utilize these credits due to the passive activity limitations of IRC Section 469. For those with passive income from other sources, however, the transferability of credits could prove attractive.
Additionally, less than favorable is the risk that disallowance of transferred credits falls on the transferee, not the transferor, in the event of certain recapture events. Such risk will require a transferee to negotiate appropriate indemnity protections with the transferor, and satisfy itself with the ability of the transferor to satisfy its indemnity obligations if a recapture event arises.
Renewable energy tax credits already are trading through quickly developing marketplaces. For the right taxpayer, these transferrable credits could provide a low-risk way to get an income tax benefit, assuming diligence is exercised, and appropriate protections are negotiated. The pool of purchasers might be limited, but there may be a substantial number of those who can benefit.