Section 45Q offers a federal income tax credit for carbon capture and sequestration (“CCS”) to incentivize investment in projects that will reduce emission of greenhouse gases. Legislation in 2018 significantly enhanced the credit but delegated development of certain key rules to the Treasury and, pending release of such rules, many investment decisions in carbon capture projects have been tabled. Last week, Treasury Secretary Steven Mnuchin acknowledged delays and told the Senate Finance Committee that he was pressing his staff to release regulations soon. This week the IRS issued two pieces of guidance, IRS Notice 2020-12 and Rev. Proc. 2020-12 (described below), that address certain issues but, for guidance on the most critical and technically difficult aspects of the credit, taxpayers and investors must continue to wait for further IRS action.
Background on the Tax Credit
Section 45Q offers a credit against federal income tax liability in a specific dollar amount per metric ton of qualified carbon oxide (both carbon dioxide and carbon monoxide) that is captured and sequestered or used. The amount in tons must be measured and verified at both the point of capture and the point of sequestration or use. For purposes of section 45Q, CCS involves the capturing of molecules of carbon oxide, whether man-made or pulled directly from the ambient air, and then sequestering or storing the carbon by injecting it for secure permanent storage in underground geological formations or putting the captured carbon to a use for which a commercial market exists, including enhanced oil recovery (“EOR”). Captured carbon oxide that would otherwise be emitted as a by-product of an industrial production process, such as LNG, ethanol or fertilizer production, is also eligible for the credit.
The vast majority of captured carbon currently is used for EOR and it is expected that most companies that install carbon capture facilities will do so with the intention of selling the captured carbon to oil and gas producers who will use it for that purpose. The injection of carbon dioxide gas after traditional primary and secondary recovery methods have been completed pushes additional oil to the wellbore, by some estimates as much as an additional 25% of the original oil deposit. Once injected, the vast majority of the carbon oxide is trapped below ground in the geologic formation where the oil was located and thus has been removed from the atmosphere. A portion of the injected carbon oxide will return to the surface with the produced oil, but this returned carbon oxide is usually re-injected into the well and, in the process, the majority of the carbon oxide ends up left trapped in the underground formations.
Guidance on Beginning of Construction: IRS Notice 2020-12
Section 45Q provides that the credit is available for carbon oxide captured at a “qualified facility,” which is a facility that captures certain minimum amounts of carbon, “the construction of which begins before January 1, 2024” and either (i) construction of carbon capture equipment begins before such date or (ii) the original planning and design for such facility includes installation of carbon capture equipment.
Carbon capture facilities are generally large installations that constitute a multi-year construction project, sometimes taking as long as six years from conception to operation. Therefore, meeting a cut-off date for beginning of construction that is currently only four years away has been a point of anxiety for taxpayers planning projects otherwise eligible for the credit. The IRS has now released Notice 2020-12 to help to relieve that stress by adapting two alternative tests for determining when construction will be considered to have begun from prior guidance with respect to renewable energy (e.g., wind and solar) projects, the “Physical Work Test” and the “Five-Percent Safe Harbor.” Because of the statutory requirement that carbon capture equipment must either be part of the original planning and design for the facility or the construction of such equipment must have begun, if the equipment is not part of the original design and planning then the tests are applied and must be satisfied separately with respect to construction of the equipment as well as construction of the facility.
Under the Physical Work Test, taxpayers generally must show that physical work of a “significant” nature has begun on the facility, which is a facts and circumstances inquiry. The Notice provides examples of activities that would constitute off-site or on-site physical work of a significant nature. Under the Five-Percent Safe Harbor, a taxpayer can satisfy the requirement if the taxpayer has paid or incurred five percent or more of the total cost of the facility before the deadline for beginning project construction. The total cost of the facility generally includes all costs paid or incurred by the taxpayer properly included in the depreciable basis of the project and may include front-end engineering and design costs. The Notice also provides helpful guidance for applying these tests when the work is being performed for the taxpayer by a third party under a binding written contract, when the final costs exceed prior estimates, and when multiple properties compose a single project that, in each case, generally incorporates standards applied in prior guidance regarding construction projects in other contexts.
Once the beginning of construction standard is met under either the Physical Work Test or the Five-Percent Safe Harbor, the taxpayer must maintain a continuous program of construction (the “Continuity Requirement”). In other words, it is not sufficient to satisfy one of those two tests but then to stop work (except as a result of certain excusable disruptions). For the Physical Work Test, a continuous program involves continuing physical work of a significant nature, which will again be a facts and circumstances inquiry. For the Five-Percent Safe Harbor, the taxpayer must also demonstrate continuous efforts to advance towards completion, including the payment of additional amounts included in the costs of the facility, entering into binding written contracts for additional property or work, obtaining necessary permits and performing physical work of a significant nature.
Fortunately, the guidance also contains a familiar safe harbor pursuant to which a taxpayer may satisfy the Continuity Requirement (the “Continuity Safe Harbor”). Under this safe harbor, a taxpayer is deemed to satisfy the Continuity Requirement if it places the facility into service before the end of the calendar year that is six calendar years after the calendar year during which construction began. For example, if construction began in mid-2020, the Continuity Safe Harbor is satisfied if the property is placed in service by December 31, 2026. This six-year safe harbor, as compared to the four-year safe harbor granted to renewable projects, is a welcome break given the lengthy timeline for construction of these facilities.
Guidance on Partnership Allocation Issues: Rev. Proc. 2020-12
Tax equity financing for carbon capture projects is expected to occur through the use of partnerships that will earn the credit and then allocate it among the partners, including the partners that are tax equity investors. In similar partnerships used in other tax equity financing arrangements (frequently referred to as “flip” partnerships due to the changing percentage interests of the partners in the tax attributes of the partnership), questions have arisen regarding whether the investors will be respected as true partners. In response, the IRS has previously provided a set of safe harbor rules under which the IRS will respect the investor partners in wind projects and the allocation of the tax credits among the partners. The IRS has now provided a similar set of rules for section 45Q tax credit partnerships by releasing Rev. Proc. 2020-12. In general, the rules validate the use of flip partnerships for allocating section 45Q credits among partners. In order for a taxpayer to rely on the safe harbor for allocation of the credit among partners in a partnership, the parties’ agreement must have the following provisions and not contain certain specified prohibited provisions, as described below.
Partner’s Interest Requirements. The Rev. Proc. provides that the developer of the carbon capture facility must have a minimum one percent partnership interest in each material item of partnership income, gain, loss, deduction or credit at all times and the investor must have a minimum interest in those items equal to five percent of the investor’s maximum percentage interest in each such item. The investor is also required to make an upfront minimum unconditional investment equal to at least 20 percent of the investor’s total fixed capital investment and more than 50 percent of that amount must be a fixed and determinable obligation that is not contingent in amount or certainty of payment. The Rev. Proc. also provides that the investor’s return from its investment in the company must not be limited in a manner comparable to a preferred return representing a payment for capital.
Purchase and Sale Rights. If the investor or developer partner has a built-in right to buy or sell either the carbon capture equipment or the interest in the partnership, then such partner could be considered to lack meaningful entrepreneurial risk with respect to the investment. Accordingly, the safe harbor offered by the Rev. Proc. prohibits the developer, other investors or related persons from having call options or other contractual rights to purchase the carbon capture equipment or a partnership interest at a future date or rights allowing an investor to sell to persons involved in the transaction or liquidate its interest at a price greater than fair market value at the time of sale.
Guarantees. Similarly, no party involved in the transaction may directly or indirectly guarantee the credits or their cash equivalent to the investor. A closely-watched issue in this regard was whether securing feedstock that produces the carbon or securing obligations to purchase the captured carbon (for example, in EOR) would be allowed. The desire on the part of the IRS to observe that the partners have entrepreneurial risk has led the IRS to require in other contexts that the partners must bear the risk that, for example, the wind does not blow (although certain weather derivative contracts are allowed).
Fortunately, the IRS has recognized that restricting such means of providing security to investors in a carbon capture partnership would essentially kill such partnerships because, in order to invest in a carbon capture deal, the investor needs to know that the capture activity will be possible and that the offtake or sequestration has been secured by contract as well. Therefore, the Rev. Proc. provides that the following guarantees are permissible: (i) guarantees for the performance of any acts necessary to claim the Section 45Q credit (including ensuring proper secure geological storage of the qualified carbon oxide through disposal, or use as a tertiary injectant, or utilization); and (ii) guarantees for the avoidance of any act (or omissions) that would cause failure to qualify for, or recapture of, the credit, including completion guarantees, operating deficit guarantees, environmental indemnities, and financial covenants. A long-term carbon oxide purchase agreement does not constitute a guarantee even if such contract is with parties related to the partnership and contains “supply all,” “supply-or-pay,” “take all,” “take-or-pay,” or “securely store-or-pay” provisions.
Allocation of 45Q Credits. As among the partners, section 45Q tax credits earned by the partnership must be allocated in accordance with the provisions of Treas. Reg. section 1.704-1(b)(4)(ii), which provides that tax credits “must be allocated in accordance with the partners’ interest in the partnership” and that certain credits that arise from an expense or investment will be considered to be so allocated if the credits are allocated in accordance with the partners’ shares of partnership loss or deduction. Rev. Proc. 2020-12 clarifies how to apply the regulatory rule when allocating the section 45Q credit since the credit is not expressly based on a partnership expense or on a revenue item but on the number of tons of carbon oxide captured. Accordingly, Rev. Proc. 2020-12 provides that, if the project company generates receipts from its activities (such as payments for selling the carbon oxide for EOR), an allocation of the credit in the same ratio as the partners’ shares of such income will be treated as in accordance with the partners’ interests in the partnership for this purpose. Conversely, if the company does not receive payments for its activities, an allocation of the credit in the same ratio as the partners’ respective shares of the loss or deduction associated with the cost of the capture and disposal, use as a tertiary injectant, or utilization of the qualified carbon oxide will be treated as in accordance with the partners’ interests in the partnership.
Additional Guidance, Please
Treasury has signaled that it will release additional guidance in the near future. Some of the important issues with respect to which guidance is lacking include:
The meaning of “secure geological storage.” The single biggest problem for taxpayers looking to access the credit has been determining the level of compliance that the IRS will require with EPA regulations regarding underground injection. Section 45Q(a) requires that the captured carbon be placed in “secure geological storage” even if it is used in EOR. Without guidance on this point, taxpayers cannot be sure they are in compliance and entitled to the credit.
Lifecycle Emissions. Section 45Q(f)(5)(B)(i) provides that the amount of carbon utilized (as opposed to injected for permanent geologic storage) is equal to the amount which the taxpayer demonstrates, based upon an analysis of lifecycle greenhouse gas emissions, are permanently isolated from the atmosphere. There are many open questions with respect to how the lifecycle analysis should be performed.
Transferring the Credit. A very unique feature of the section 45Q credit is the inclusion of a mechanism to permit transfer of the credit from the party that owns the carbon capture equipment to the taxpayer that sequesters or uses the captured carbon oxide. There have been many questions relating to the process for doing so, including whether a taxpayer could transfer part of its available credit amount and retain the remainder.
Credit Recapture. The tax credit can be lost or recaptured, i.e., reversed, thereby triggering tax liability (and, potentially, any guaranty the developer has given the investor of no recapture) if the carbon oxide with respect to which the credit was claimed subsequently escapes back into the atmosphere or ceases to be used in a manner consistent with the statutory requirements. Specifics are needed regarding the method for determining whether a release back into the atmosphere has occurred and how many years later a release could trigger recapture of a previously claimed credit.
Although this week’s guidance has been well-received and is certainly helpful, we look forward to receipt of additional guidance soon.
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