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Carbon Capture Tax Credit: IRS Issues Long-Awaited Proposed Rules

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Section 45Q offers a federal income tax credit for carbon capture, utilization and sequestration (“CCUS”) to incentivize investment in projects that will reduce emission of greenhouse gases, including through use of captured carbon oxide in enhanced oil recovery. Legislation in 2018 significantly enhanced the credit but delegated development of certain key rules to the Treasury.  On May 28, 2020, the IRS issued long-awaited proposed regulations (REG-112339-19) covering the critical topics of the meaning of  “secure geological storage,” the lifecycle analysis required for utilized carbon, the ability to transfer the credit between taxpayers and the circumstances that may give rise to recapture of the credit.


These issues are the more crucial and technically difficult issues which the IRS did not address in its previous guidance released in February covering the “beginning of construction” test for CCS projects as well as permissible partnership allocations of the tax credit, which we discussed in a prior alert. With the release of these proposed regulations, on which taxpayers are entitled to rely pending their finalization, it is hoped that investors and developers will have enough certainty regarding credit availability to move forward with CCS projects that have been tabled pending guidance.


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 or the production of hydrogen from methane, is also eligible for the credit.


The credit was significantly enhanced by amendments made by the Bipartisan Budget Act of 2018 (the “BBA”) on February 9, 2018, which, among other changes, increased the amount of the credit, eliminated an overall cap on the credit and expanded the group of persons who could be eligible for the credit and, therefore, expanded the potential for use of tax equity structures.  The amount of the credit depends on the date the carbon capture equipment is placed in service and whether the qualified carbon oxide is disposed of in secure storage, used as a tertiary injectant in EOR or otherwise utilized in a manner qualifying for the credit.  In the case of carbon oxide captured using equipment placed in service on or after February 9, 2018, the credit is available during the 12-year period beginning on the placed-in-service date.


Last summer, in IRS Notice 2019-32, the IRS indicated that it was in the process of developing regulations under section 45Q and it requested taxpayer comments on a long list of issues arising under the statute. In response, comments were submitted by 116 organizations and taxpayers.    In its Notice of Proposed Rulemaking, Reg 112339-19 (the “NPRM”), the Treasury Department and the IRS have now proposed regulations on a number of these issues.  


The Meaning of “Secure Geological Storage” 


The single biggest problem for taxpayers looking to access the credit for EOR projects has been determining what would constitute “secure geological storage” of carbon oxide used in EOR.  The majority of captured carbon currently is used for EOR and it is expected that most companies that install carbon capture facilities in the near term will do so with the intention of selling the captured carbon to producers who will use it for that purpose. The tertiary injection of carbon oxide 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.


When carbon oxide is injected for EOR, the majority of the carbon oxide remains trapped below ground in the geologic formation where the oil was located and thus it has been removed from the atmosphere. A portion of the injected carbon oxide will return to the surface with the produced oil, however.  This returned carbon oxide is usually re-injected into the well to produce more oil, again with a portion of the injected carbon oxide returning to the surface.  The end result of this cyclical, iterative process is that the majority of the carbon oxide originally injected ends up trapped in the underground formations.  Nevertheless, the nature and extent of carbon oxide storage that occurs through EOR is necessarily different from that which occurs when carbon oxide is injected into an underground formation for the sole purpose of permanent storage.  That difference has led to confusion and controversy regarding the appropriate standard to be applied to each type of injection and sequestration/storage activity.


Section 45Q(a) requires that, in order to be eligible for the credit, the captured carbon oxide, including that used in EOR, “must be disposed of by the taxpayer in secure geological storage.”    Section 45Q(f)(2) provides:  


The Secretary, in consultation with the Administrator of the EPA, the Secretary of Energy, and the Secretary of the Interior, shall establish regulations for determining adequate security measures for the geological storage of qualified carbon oxide under subsection [45Q(a)] such that the qualified carbon oxide does not escape into the atmosphere. Such term shall include storage at deep saline formations, oil and gas reservoirs, and unminable coal seams under such conditions as the Secretary may determine under such regulations.


In 2009, the IRS issued a Notice (2009-83) and included a requirement on the form used to claim the credit (Form 8933), that, in order to constitute “secure geological storage,” a taxpayer must comply with the EPA’s greenhouse gas reporting rules (“subpart RR” of 40 CFR pt. 98) that apply to facilities that inject carbon for geologic sequestration and are permitted as Class VI underground injection control (“UIC”) wells under the Safe Drinking Water Act,  including requirements that the taxpayer must:

  • Conduct a site characterization of the proposed sequestration site;

  • Conduct an assessment of the risks of carbon dioxide leakage or escape into the atmosphere at the site; and

  • Monitor potential leakage pathways at the site.

  • Obtain approval from the EPA of a Monitoring, Reporting and Verification plan (an “MRV” plan).


This guidance was problematic for those taxpayers engaged in EOR with captured carbon because it did not reference the other Safe Drinking Water Act UIC well class that has long been used for oilfield operations, including EOR, which is Class II wells.  Greenhouse gas reporting for Class II well activities are governed by subpart UU of the EPA’s greenhouse gas reporting regulations set forth in 40 CFR pt. 98.  In contrast, Class VI wells involve projects the primary purpose of which is permanent storage, i.e., trapping the carbon oxide in underground formations, and is a relatively new class of wells established in 2010.  To date, less than a handful of Class VI wells have received EPA permits.  Because the subpart RR requirements applicable to Class VI wells are much more burdensome than the subpart UU requirements applicable to Class II wells and are not designed to be applicable to EOR, reference to those requirements in the prior guidance created confusion and hesitancy on the part of taxpayers to pursue the CCS credit.


In response to Notice 2019-32, many commenters made suggestions for resolution of this problem.  One of the most common suggestions was that the standard for secure geological storage not be limited to a facility’s adherence to the EPA’s subpart RR or subpart UU rules and, instead, that taxpayers be allowed to elect to comply under a standard provided by the International Organization for Standardization referred to as ISO 27916.


The newly proposed regulations resolve this problem by incorporating both standards:  taxpayers with EOR projects that comply with EPA subpart RR rules may self-certify the volume of captured carbon oxide to demonstrate secure geological storage but such taxpayers may alternatively use the ISO 27916 standard to make such demonstration as long as the documentation is accompanied by certification from a qualified independent engineer or geologist who certifies that the documentation, including the mass balance calculations and information regarding monitoring and containment assurance, is accurate and complete.  These certifications must be made annually.


Both the ISO standard and the subpart RR requirements involve assessment and monitoring of potential leakage pathways; the use of a mass balance approach for quantification; and documentation of the steps and approaches used. However, using the ISO standard, even with the required third-party certification, may be preferable as it allows a taxpayer engaged in EOR to avoid the delays and uncertainties inherent in the subpart RR requirement for an EPA-approved MRV plan and comply with established greenhouse gas reporting regulations for EOR activities under subpart UU.


The section 45Q carbon capture tax credit is to be claimed on Form 8933 filed with the taxpayer’s federal tax return.  The documentation and certification is generally required to be submitted by the due date of the return on which the credit is claimed.  If the credit has previously been claimed without submission of the required certifications for a year ending after February 9, 2018 but before the NPRM date, they may be submitted on an amended return.  Taxpayers are entitled to apply and rely on the proposed rules for years beginning after February 9, 2018, as long as the taxpayer applies all of the proposed section 45Q regulations “in their entirety and in a consistent manner.”   


Utilization of Carbon Oxide and Lifecycle Emissions


In addition to sequestration of carbon oxide through underground storage or use in EOR, section 45 also offers the credit for utilization of the captured carbon through photosynthesis, conversion to a material or chemical compound or use for any other purpose for which a commercial market exists as determined by Treasury.  Section 45Q(f)(5)(B)(i) provides that, for purposes of determining the amount of carbon oxide so utilized, the taxpayer must demonstrate, based upon an analysis of lifecycle greenhouse gas emissions, the amount of captured carbon so utilized.


The proposed regulations do not address what commercial markets Treasury has determined exist for carbon oxide. Instead, the section of the proposed regulations that would speak to this topic is “Reserved,” as are the regulations on the topics of submission of the lifecycle analysis (the “LCA”) and standards for an adequate lifecycle analysis.  The Treasury Department and the IRS specifically ask for additional public comment on these points.


Assuming that a particular utilization qualifies, the question of measurement is to be answered through an analysis of lifecycle greenhouse gas emissions.  In general, an LCA systematically evaluates the environmental impact of a product, activity or process over its entire lifecycle.  The amount of carbon oxide that is “utilized” pursuant to the analysis would therefore vary depending upon the geographical and chronological limits for the analysis. For example, the captured amount might be decreased if emissions that occur during subsequent pipeline transport of the captured carbon are also counted.   Therefore, there has been keen interest in the parameters that the IRS would propose for the necessary LCA.


The proposed regulations provide that the term “lifecycle greenhouse gas emissions” means the direct and significant indirect emissions related to the full product lifecycle, including all stages of product and feedstock productions and distribution, from feedstock generation or extraction through the distribution and delivery and use of the finished product to the ultimate consumer, adjusting the mass values for all greenhouse gases to account for their global warming potential.


The proposed regulations would require that the measurement and LCA must be performed by or verified by an independent third party and must contain documentation consistent with ISO 14044 regarding LCAs. The LCA is to be submitted to the IRS and the Department of Energy (DOE) but it is the IRS that will determine whether to approve the LCA, although it is to do so “in consultation with the DOE and the EPA.”  There is no provision for the timing of such approval and whether it must be received prior to filing a return that claims the credit.


Who Claims the Credit?


Changes to the statute made by the BBA in 2018 mean that a taxpayer claiming the credit need not be the same party that is carrying out the capturing, sequestering or utilization activity, as long as the claiming taxpayer owns the capture equipment and it contractually obligates another party to perform such activity.  This change provided flexibility that was welcomed by the tax equity investment community but raised questions about the extent of the necessary contractual relationship.  The proposed regulations clarify that such activity must occur pursuant to a binding written contract that does not limit damages to a specified amount and that contains commercially reasonable terms for the enforcement of the parties’ obligations.  In the case of carbon oxide to be used in EOR, the disposing party must be contractually obligated to comply with the reporting and documentation provisions of the regulations, including reporting of recapture events.


Transferring the Credit 


An attractive feature of the section 45Q credit that was included in the changes made by the BBA in 2018 is that there is a mechanism to permit transfer of the credit from the party that owns the carbon capture equipment to the taxpayer that sequesters, disposes of or uses the captured CO2.  Under section 45Q(f)(3), the taxpayer otherwise eligible for the credit may make an election to cause the credit to be allowable to the person that sequesters or uses the captured carbon.  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 whether it could transfer the credit to multiple parties.


The proposed regulations also provide that the taxpayer otherwise eligible for the credit may transfer part or all the credit and may divide the credit among multiple parties when multiple parties are performing the sequestration or disposition activity, although the division must be pro rata according to the amount of carbon oxide disposed of by each party.  The election is to be made annually and the regulations contain specifics as to the information that should be provided by both the electing and the recipient taxpayers.   


Credit Recapture 

The tax credit can be lost or recaptured, thereby triggering tax liability, if the carbon 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. The statute does not contain specifics regarding the method for determining that a release back into the atmosphere has occurred, nor does it provide an outside date after which leakage would not result in credit loss.


The proposed regulations now provide that a recapture event occurs when the carbon oxide for which a credit has been claimed ceases to be captured, disposed of, or used as a tertiary injectant during the recapture period and that recapture events are determined separately for each project.  The proposed regulations define the amount of leaked carbon oxide as the amount the taxpayer quantifies as having leaked pursuant to the standard that the taxpayer has adopted, either subpart RR or ISO 27916.  If the latter, the leaked amount must be certified by a qualified independent engineer or geologist.


Recapture occurs when the leaked amount of carbon oxide in a taxable year exceeds the amount of carbon oxide disposed of or used as a tertiary injectant in that same taxable year and the recaptured tonnage is the excess of the leaked amount over the disposed of or used amount.  Accordingly, the recapture amount is equal to the product of the recaptured tonnage and the applicable statutory credit rate.


Importantly, the recapture period has been limited to the earlier of five years after the last taxable year in which the taxpayer claimed a credit or the date monitoring of leakage ends under the requirements of either subpart RR or ISO27916.  Thus, even if compliance with environmental regulations calls for monitoring for leakage for many years after the credit is claimed, the taxpayer would not be exposed to recapture beyond five years from the last year of the credit.


Recapture is taken into account in the taxable year in which it is identified and reported, not by adjusting the year in which the credit was claimed, so a taxpayer would add the recapture amount to their tax due in the year in which the recapture event occurs.  The proposed regulations also contain rules for assigning the recapture amount to credits claimed in prior years (a last-in, first-out basis up to a maximum of five preceding years), among multiple units (allocate pro rata) and among multiple taxpayers (allocate pro rata).     


Comment Process


Release of the proposed regulations started a comment period which will last until 60 days after the NPRM is published in the Federal Register.  The Treasury Department and the IRS specifically call for comments on the definition of commercial markets and standards for LCAs, among other topics.  


Baker Botts is working with clients to develop a comprehensive set of comments and recommendations to submit to the IRS as part of the notice and comment process.  If you have questions or comments that you would like advanced as part of this submission, please contact us. 

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