In our previous LawFlash, we summarized the key provisions of the proposed regulations pertaining to the technical mechanical and associated measurement, reporting, and certification requirements for the Section 45Q credit. This LawFlash expands by discussing additional tax-related eligibility and administrative compliance requirements set forth in the proposed regulations.
The US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released much-anticipated proposed regulations on May 28 pertaining to the federal income tax credit for carbon capture projects under Section 45Q of the Internal Revenue Code of 1986, as amended (Code). The proposed regulations elaborate on the text of the Code by focusing on definitional, technical, and administrative requirements for qualifying for the Section 45Q credit. Helpfully, taxpayers may rely on these new proposed regulations pending their finalization.
The proposed regulations build on other recent guidance on Section 45Q credit eligibility and associated “tax equity” financing “flip” partnership structures provided by Notice 2020-12 and Revenue Procedure 2020-12. (Read our prior LawFlash for more on this topic.) Although questions remain regarding certain credit eligibility and tax equity “flip” partnership investment structures and features, the currently available guidance will hopefully provide sufficient legal certainty for developers, service providers, and investors to enter into and spur expansion of the carbon capture market.
This LawFlash discusses some of the more significant provisions of the proposed regulations, and expands upon a prior LawFlash, which focuses on some of the more technical mechanical and associated measurement, reporting, and certification requirements for the Section 45Q credit set forth in the proposed regulations.
Section 45Q provides a performance-based tax credit with respect to the disposal or utilization of qualified carbon oxide using carbon capture equipment at a qualified facility. The Section 45Q credit is flexible in that it is not limited to a particular industry; it generally may apply to industries involving the production of large quantities of carbon dioxide or monoxide. Accordingly, the Section 45Q credit is relevant not only to the electric power generation industry (for example, coal, oil and gas fired power plants), but also to various heavy production industries (for example, ethanol and fertilizer production, natural gas processing, refining, chemicals production, and the manufacture of steel and cement). The amount of the tax credit involved can be quite significant. For example, a power plant that emits and captures 5 million tons of carbon dioxide a year could generate $250 million worth of tax credits.
Congress originally enacted the Section 45Q credit in 2008, but more recently extended and expanded the credit under the Bipartisan Budget Act of 2018, PL 115-123. Section 45Q currently provides a tax credit in a specified dollar amount per metric ton of carbon oxide stored, depending on the applicable project type. Specifically, the amount of the Section 45Q credit depends on whether the captured qualified carbon oxide is disposed solely through secure geological storage (Disposal), used for tertiary injection and disposal through secure geological storage (Injection), or utilized by fixing it through photosynthesis or chemosynthesis, converting it to a material or chemical compound in which it is securely stored, or using it for any other purpose for which a commercial market exists (Utilization).
For currently in-development and future carbon capture equipment projects, the Section 45Q tax credit applies for the 12-year period following the project’s placed in service date. The tax credit dollar amount during this period escalates on a yearly basis until 2026 when it reaches either $35 or $50 per metric ton of carbon oxide stored (depending on the type of project), and for subsequent years may increase based on an adjustment for inflation. Only eligible qualified facilities the construction of which beings before January 1, 2024, and related carbon capture equipment that has either similarly begun construction before January 1, 2024, or the original planning and design for the applicable qualified facility includes installation of the carbon capture equipment, are eligible for the credit.
For currently in-development and future projects, the Section 45Q credit may be claimed by the person that owns the carbon capture equipment and physically or contractually ensures the Disposal, Injection or Utilization of the qualified carbon oxide. This person, though, may elect (in the manner prescribed under regulations) to have the Section 45Q credit claimed by another person conducting the Disposal, Injection or Utilization under contract.
Certain different rules and credit amounts apply to carbon capture equipment originally placed in service at a qualified facility before the enactment date of the Bipartisan Budget Act of 2018 (February 9, 2018).
Section 45Q includes a litany of technical terms and standards and broad authority delegated to Treasury to promulgate regulations impacting eligibility for, and possible recapture of, the Section 45Q credit for which additional guidance has been sought by practitioner and industry groups and signaled by the government (including through a formal comment request process). The proposed regulations largely address ambiguities not considered by prior guidance by providing proposed rules on credit eligibility, recapture, reporting and certification requirements on which taxpayers may currently rely pending finalization of the regulations. The following briefly discusses some of the more significant provisions of the proposed regulations.
Section 45Q allows the credit with respect to carbon capture equipment for which, in the case of Disposal or Utilization, the qualified carbon oxide is disposed through secure geological storage. The proposed regulations provide or elaborate on the technical standards for some of these terms set forth in Section 45Q.
Under the proposed regulations, carbon capture equipment consists of all components of property that are used to capture or process carbon oxide until it is transported for Disposal, Injection, or Utilization, such as components of property necessary to compress, treat, process, liquefy, or pump carbon oxides. The proposed regulations provide a list of specific components that qualify as carbon capture equipment, but also includes a list of property not constituting carbon capture equipment (principally, components of property relating to transportation of carbon oxide).
A qualified facility for which carbon capture equipment is employed includes certain direct air capture facilities capturing carbon dioxide directly from the ambient air and industrial facilities. The proposed regulations broadly define industrial facility consistent with Notice 2020-12 to include a facility that produces a carbon oxide stream from a fuel combustion source, a manufacturing process, or a fugitive carbon oxide-emission source that, absent capture and Disposal, Injection, or Utilization, would otherwise be released into the atmosphere, but excluding a facility that produces carbon dioxide through carbon dioxide production wells from natural carbon dioxide-bearing formations.
For purposes of determining when carbon capture equipment or a qualified facility that includes used property (retrofitted property) is originally placed in service, including as relating to whether the subject property was originally placed in service prior to the enactment date of the Bipartisan Budget Act of 2018, the proposed regulations adopt the so-called “80/20 Rule” initially established for purposes of the Section 45 production tax credit. This rule treats the subject carbon capture equipment or qualified facility as newly placed in service if the value of the used property does not exceed 20% of the value of the carbon capture equipment or qualified facility (based on fair market value of used property plus cost of new property).
As further described in our prior LawFlash, the proposed regulations also establish technical storage requirements and associated reporting and captured carbon volume storage certification requirements that employ existing standards of other regulatory agencies (EPA) or accepted standards adopted by the nongovernmental organization, International Organization for Standardization (ISO). The proposed regulations do not, however, require public disclosure of storage information beyond that already required by other regulatory agencies. The preamble to the proposed regulations explain that the government declined to require public disclosure particularly given that there is no statutory requirement in Section 45Q for taxpayers, federal agencies, or industry groups to publicly display this information or otherwise make it available. Separately, the proposed regulations provide rules for quantifying, certifying, and reporting captured qualified carbon oxide subject to Utilization, which report is subject to the approval of the IRS in consultation with the Department of Energy and the EPA.
Disposal, Injection, or Utilization by Contract – Contract Requirements and Election to Pass Through Section 45Q Credit
A carbon capture equipment owner may either individually carry out the Disposal, Injection, or Utilization or contract with another person or multiple other persons to carry out these activities. The proposed regulations provide a framework for the form of and certain requirements for these contracts, as well as associated annual reporting requirements. Each contract must be a binding written contract (meaning that it is enforceable under state law and does not limit damages to a specified amount), include “commercially reasonable terms and provide for enforcement of the party’s obligation to perform the [Disposal, Injection or Utilization],” and require the parties to comply with applicable eligibility, documentation, reporting and certification requirements under the proposed regulations, including with respect to a recapture event. Beyond these certain requirements, the proposed regulations are intended to provide parties broad flexibility in their agreements. Accordingly, the proposed regulations include a list of commercial provisions that may but are not required to be included in a contract, such as information regarding quantifying the amount of carbon oxide to be captured and contract enforcement and indemnity (including liquidated damages) provisions.
In addition, the proposed regulations provide substantive rules and reporting requirements for the carbon capture equipment owner to elect on a yearly basis to have one or more persons conducting the Disposal, Injection, or Utilization under contract to claim all or a portion of the Section 45Q credit. If the owner elects to allow multiple other persons to claim all or a portion of the Section 45Q credits for the year, the maximum amount of Section 45Q credits allowable to each such person is proportional to the amount of qualified carbon oxide for which the person conducts the Disposal, Injection, or Utilization. A non-owner carbon capture service provider may receive allowances of Section 45Q credits from multiple electing taxpayers in the same year.
Recapture of Section 45Q Credits
As further described in our prior LawFlash, the proposed regulations provide that a recapture of a Section 45Q credit occurs when subject qualified carbon oxide ceases to be captured, disposed of, or used as a tertiary injectant during the recapture period. The recapture period begins on the date the subject carbon capture activities begin and ends on the earlier of five years after the last taxable year in which the taxpayer claimed a Section 45Q credit or the date required secure geological storage monitoring ends under the applicable regulatory or other permitted standard. The proposed regulations provide a limited exception for recapture events resulting from actions not related to the selection, operation, or maintenance of the storage facility, such as volcanic activity or terrorist attack.
The measured and reported released carbon oxide amount for the year first effectively offsets against the amount of any eligible qualified carbon oxide otherwise subject to Disposal or Injection for the year. Any excess released carbon oxide amount is subject to recapture as additional taxes due for the year, calculated at the applicable statutory rate. The applicable rate is determined on a last-in-first-out basis (LIFO), with the excess leaked qualified carbon oxide deemed attributable first to the prior taxable year, then to the second preceding year, and then up to the fifth preceding year.
Helpfully, the preamble to the proposed regulations reaffirms the permissive provisions in Revenue Procedure 2020-12 allowing third-party-provided Section 45Q credit recapture insurance to not constitute an impermissible guarantee of a Section 45Q credit for purposes of a tax equity investment “flip” partnership structure. The preamble also solicits additional comments on how the recapture provisions should apply to Section 45Q credit carryforwards.
Morgan Lewis has longstanding experience representing clients in industries touching the Section 45Q tax credit, as well as representing sponsors, tax equity investors, and lenders in project financings subject to rules analogous to Section 45Q and associated government guidance, such as renewable energy project financings. If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers: