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Carbon Capture Tax Credit: IRS Issues Much-Anticipated Final Section 45Q Regulations

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On January 6, 2020, the Department of the Treasury and the IRS released final regulations under Internal Revenue Code section 45Q. Section 45Q offers a federal income tax credit for carbon capture and sequestration to incentivize investment in projects that will reduce emission of greenhouse gases, including through use of captured carbon oxide in enhanced oil recovery (“EOR”).

Legislation in 2018 significantly enhanced the credit but delegated development of certain key rules to the Treasury. Proposed regulations were issued on May 28, 2020, followed by a public comment period and hearing. For our analysis of the proposed regulations click here.

The final regulations have revised and provided clarification in the following areas, among others:

  • Secure geological storage of captured carbon oxide - confirmation that taxpayers may choose to comply with either EPA or ISO standards

  • Definition of “commercial markets” for utilization of captured carbon oxide - broad definition with taxpayer substantiation

  • Measurement of utilization of captured carbon oxide - lifecycle analysis conforming to ISO standards required

  • Procedures for transferring the credit to third-party taxpayers – transfer to subcontractors prohibited

  • Recapture of credit upon leakage – recapture period now limited to three years.

  • Definition of “carbon capture equipment” - a list of specific items of equipment has been deleted with the new definition dependent upon the functional use of the equipment

  • Definition of “qualified facility” – aggregation of multiple facilities to meet minimum required capture levels

The final regulations contain certain changes that respond to public commentary on the proposed regulations. The many public comment letters filed with respect to the proposed regulations can be accessed using Baker Botts' Finding Tool for 45Q Comment Letters here.

With the release of these final regulations, it is anticipated that investors and developers of carbon capture, storage and utilization (“CCUS”) projects will have enough certainty regarding credit availability to move forward with CCUS projects that have been tabled pending final guidance.

 

Section 45Q Tax Credit Overview

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, whether man-made or pulled directly from the ambient air) that is captured and sequestered by injecting the captured carbon oxide for secure permanent storage in underground geological formations, injecting the captured carbon for use in EOR or utilizing it for any purpose for which a commercial market exists. Captured carbon oxide that would otherwise have been emitted as a by-product of an industrial production process, such as LNG, ethanol or fertilizer production, is also eligible for the credit.

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 in EOR or utilized for a purpose for which there is a commercial market. 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. The credit amounts can be as much as $50 per ton captured and permanently sequestered and $35 per ton captured and used in EOR or other qualifying utilization.

 

The Meaning of “Secure Geological Storage”

The majority of captured carbon oxide 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 producers who will use it for that purpose. 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.”

Prior IRS guidance (Notice 2009-83 and Form 8933) required that “secure geological storage” meant compliance with the EPA’s greenhouse gas reporting rules, including monitoring and verification requirements, that apply to Class VI wells used for permanent carbon sequestration (“subpart RR”). This was problematic for taxpayers engaged in EOR because it did not reference the other EPA well class, Class II, that has long been used for oilfield operations including EOR, which are governed by subpart UU of EPA's greenhouse gas reporting rules.

The proposed regulations resolved this problem by offering an additional standard: taxpayers that comply with EPA subpart RR rules may self-certify the volume of captured carbon oxide but taxpayers may also use a standard provided by the International Standards Organization, ISO 27916, as long as the documentation is accompanied by certification from a qualified independent engineer or geologist that the documentation, including the mass balance calculations and information regarding monitoring and containment assurance, is accurate and complete.

The final regulations have retained this resolution by continuing to allow taxpayers to satisfy “secure geological storage” under either EPA or ISO standards and have provided additional detail regarding the certification process and credentialing of the those certifying. The certification must contain an affidavit from the certifying engineer or geologist stating that he or she is independent from the taxpayer.

 

Utilization of Carbon Oxide – Commercial Markets

In addition to sequestration of carbon oxide through burying or use in EOR, section 45Q 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.”

The proposed regulations did not address what commercial markets Treasury determined exist for carbon oxide and requested public comment on the topic. Many very specific descriptions of commercial markets for captured carbon oxide were provided in public comment letters. The IRS has, however, helpfully chosen to define commercial markets very broadly as any “market in which a product, process, or service that utilizes carbon oxide is sold or transacted on commercial terms.” Rather than calling for IRS sanctioning of markets as “commercial,” the regulations state that a taxpayer must submit a statement attached to its claim for the credit substantiating that a commercial market exists.

 

Lifecycle Analysis (“LCA”) of Utilization

Although commercial markets in which the captured carbon can be utilized are broadly defined, the amount of the credit from sales into those markets is determined by performing an analysis of the amount of the captured carbon so utilized through an analysis of lifecycle greenhouse gas emissions (an “LCA”). In general, an LCA systematically evaluates the environmental impact of a product, activity or process over its entire lifecycle.

Both the proposed and final 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 final regulations now include a requirement that the “LCA must demonstrate that the proposed process results in a net reduction of carbon dioxide equivalents when compared to a comparison system.”

The LCA must be performed by or verified by an independent third party and must contain documentation consistent with ISO 14044 regarding LCAs. The proposed regulations previously said that the IRS that would determine whether to approve the LCA “in consultation with the DOE and the EPA.” The final regulations now provide that the LCA will be subject to a technical review by the DOE but the IRS will determine whether to approve the LCA.

The final regulations contain additional detail regarding the DOE templates to be used for LCAs and retain the requirement that the LCA must be approved by the IRS before the taxpayer files a claim for the credit on the basis of utilization of the carbon oxide. The IRS has indicated it will issue separate procedural guidance regarding the submission and review process, including the length of time necessary for review.

 

Transferring the Credit

Under section 45Q(f)(3), the taxpayer otherwise eligible for the credit may make an election to cause the credit to be transferred to the person that sequesters or utilizes the captured carbon. The proposed regulations made clear that the taxpayer may transfer part or all of 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 specific instructions as to the information that should be provided by both the electing and the recipient taxpayers.

The final regulations have clarified that the credit may not be transferred to a party that performs the carbon oxide capture on behalf of the taxpayer or to a subcontractor of the party contracted to perform the sequestration or utilization.

 

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. Section 45Q does not, however, contain specific instructions 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 final regulations, like the proposed regulations, 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. 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.

The final regulations have reduced the recapture period from five years to three years. The proposed regulations would have limited the recapture period 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. Under the final regulations, 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 three 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 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 three preceding years), among multiple units (allocate pro rata) and among multiple taxpayers (allocate pro rata).

 

Additional Provisions

The final regulations contain many additional provisions, including:

  • For purposes of determining whether a facility satisfies the requisite annual carbon oxide capture thresholds, taxpayers may aggregate and treat multiple facilities as a single facility in certain circumstances.

  • The election under section 45Q(f)(6) to allow pre-2018 carbon capture facilities to receive the credit at post-2018 amounts, which is available to facilities that capture over 500,000 metric tons of carbon oxide, may be satisfied by treating multiple facilities as a single facility in certain circumstances. The regulations also clarify that such election is not a one-time election but must be made each year when applicable.

  • Under section 45Q, the taxpayer that owns the carbon capture equipment is not required to physically carry out the capture, disposal, injection or utilization of the carbon oxide if the taxpayer contractually ensures in a binding written contract that such activity will be carried out in the manner required under the regulations and containing the provisions required by the regulations. With respect to this rule the final regulations provide:

    • The owner of the carbon capture equipment may enter into a contract with a general contractor that hires subcontractors to carry out the capture, disposal, injection or utilization as long as the contract binds the subcontractors the same regulatory requirements.

    • A contract will be considered a binding contract even if it limits damages as long as the limitation equals five percent or more of the total contract price.

    • Taxpayers with pre-existing contracts that do not have such required provisions will have 180 days from the date of filing of the regulations in the Federal Register to revise their contracts to contain the required provisions.

Baker Botts’ multidisciplinary teams are at the forefront of CCUS developments and activities. We assist clients with CCUS-related projects and transactions around the world, and have been involved in the development of the regulatory framework for CCUS at the federal and state level in the United States. For more information about this practice, visit the CCUS Practice Group page at bakerbotts.com

 

 

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