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Largely Taxpayer-Friendly Final Regulations Released Under Section 45Q Carbon Capture Credit

January 12, 2021

The US Department of Treasury and the Internal Revenue Service released anticipated final regulations pertaining to the federal income tax credit for carbon capture projects under Section 45Q of the Internal Revenue Code on January 6, 2021. The final regulations in certain significant respects respond favorably to taxpayer comments to the proposed regulations released on May 28, 2020.

Section 45Q of the Internal Revenue Code of 1986, as amended, 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. Congress originally enacted the Section 45Q credit in 2008, but more recently extended and expanded the credit under the Bipartisan Budget Act of 2018, PL 115-123.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, eligibility for and the amount of the Section 45Q credit depend 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 in a manner described in Section 45Q(f)(5) (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 begins before January 1, 2026, and related carbon capture equipment that has either similarly begun construction before January 1, 2026, or the original planning and design for the applicable qualified facility includes installation of the carbon capture equipment, are eligible for the credit (with such eligibility dates recently extended from January 1, 2024, pursuant to the Consolidated Appropriations Act, 2021, described in our prior LawFlash).

For additional background and context on recent Section 45Q guidance, please also see our prior LawFlashes on the release of the proposed regulations, as well as the Internal Revenue Service’s (IRS’s) release of Notice 2020-12 (which provided guidance on satisfying the Start Construction Rule to qualify for the Section 45Q tax credit) and Revenue Procedure 2020-12 (which provided a safe harbor for tax equity investments using a “flip” partnership structure).

Some of the final regulations’ more significant refinements to or departures from the prior proposed regulations include the following:

  • A significant and much requested departure from the position taken in the proposed regulations is that the final regulations reduce the proposed regulations’ five-year post–Section 45Q credit recapture period applying to Disposal and Injection facilities to a three-year period. Specifically, the Section 45Q recapture period begins on the date the subject carbon capture activities begin and ends on the earlier of three years (rather than 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 final regulations provide additional clarity regarding how the Section 45Q credit applies for Utilization. For Utilization, the Section 45Q credit applies with respect to captured qualified carbon oxide that is 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 as determined by the US secretary of the Treasury. The proposed regulations did not elaborate on the “other purpose for which a commercial market exists” standard, and understandably many taxpayer comments requested guidance on this issue. The final regulations respond by providing a very broad definition for “commercial market” (“a market in which a product, process, or service that utilizes carbon oxide is sold or transacted on commercial terms”), but require the claiming taxpayer to submit a statement attached to its election tax form (Form 8933) substantiating that a commercial market exists for its particular product, process, or service so that the government can determine if the activity is eligible. The preamble to the final regulations also indicates the government will provide additional details on this standard or the information to be provided in forthcoming instructions to the Form 8933 or other additional guidance.
  • The final regulations set forth revised requirements for conducting, substantiating, and reporting the lifecycle analysis necessary to claim the Section 45Q credit for Utilization. The final regulations retain the proposed regulations’ requirement that the taxpayer obtain approval of its lifecycle analysis performed or verified by an independent and qualified third party before claiming the Section 45Q credit for a taxable year. The final regulations require that the taxpayer submit its lifecycle analysis report to the US Department of Energy for its technical review, and that the IRS will determine whether to approve such report. The preamble to the final regulations indicates that the IRS will issue separate procedural guidance that provides additional details regarding the lifecycle analysis submission and review process, including the length of time necessary for a lifecycle analysis review.
  • The final regulations remove the examples of types of property constituting or not constituting qualifying carbon capture equipment in favor of a single, generally applicable standard.
  • The final regulations reiterate that “qualified carbon oxide” eligible for the Section 45Q credit only includes carbon dioxide or other carbon oxide. It does not include other greenhouse gases (such as methane), notwithstanding that these additional gases are included in a lifecycle analysis necessary to substantiate Utilization.
  • The final regulations clarify that carbon capture equipment that is originally placed in service at a qualified facility on or after February 9, 2018, may be owned by a taxpayer other than the taxpayer that owns the industrial facility at which the carbon capture equipment is placed in service.
  • The final regulations permit the aggregation of multiple facilities into a single facility under the Notice 2020-12 standards for purposes of satisfying the requisite annual carbon oxide capture thresholds to be eligible for the Section 45Q credit.
  • The final regulations clarify that for a carbon capture equipment owner ensuring Disposal, Injection, or Utilization by contracting with another party to provide these services under a qualifying binding written contract, those services may be provided by the service provider itself (the general contractor) and/or by other service providers (the subcontractors) entering into separate qualifying binding written contracts with the general contractor. However, the final regulations permit the carbon capture equipment owner to elect to pass through the Section 45Q credit to only the service providers directly contracting with the owner to conduct the carbon capture activities (general contractors), rather than a person contracting with such service providers (subcontractors).
  • Consistent with the proposed regulations, the final regulations do not require additional public disclosure of carbon capture and sequestration activities or submission materials to claim the Section 45Q credit.

CONCLUSION

The final regulations under Section 45Q should be relatively welcome to the carbon capture and storage industry in providing additional clarity to the standards, and relief from some of the more restrictive provisions, of the proposed regulations.

Principally, the final regulations reduce the five-year post-credit recapture period of the proposed regulations to three years. The prior five-year recapture period had been viewed by the industry as a significant impediment to attracting investment in projects generating Section 45Q credits (e.g., by “tax equity investors”), as many potential investors resisted accepting risk on this extended recapture period at the cost of capital being considered to make these investments economically viable. Hopefully, the reduction in investor risk associated with this shorter recapture period (perhaps also reflected in the reduced cost of tax insurance policies to cover this risk) will help spur investment in carbon capture facilities.

The final regulations do not, however, provide certainty for claiming the Section 45Q credit in all circumstances. Significantly, the final regulations do not provide eligibility guidance that taxpayers can prospectively rely on to support satisfying the “other purpose for which a commercial market exists” standard for Utilization. The final regulations require that the method used by the taxpayer be submitted with the tax return claiming the credit, and the preamble explicitly declined to address whether particular factual situations would be eligible. As a result, taxpayers seeking to qualify for this type of Utilization have no assurance that their constructed carbon capture facilities will qualify for the credit. Hopefully forthcoming guidance will provide specific examples of activities or factual situations that will satisfy this test. Similarly, the final regulations retain the proposed regulations’ requirement that a taxpayer’s lifecycle analysis to claim the Section 45Q credit for Utilization be approved before claiming the credit.

Finally, the continued vitality of the final regulations is not entirely free from doubt as of the date of this publication. The final regulations provide for an expedited effective date as of their filing in the Federal Register. And, President-elect Joseph Biden has indicated that released administrative regulations not yet published in the Federal Register or effective by January 20, 2021, may be subject to a delayed effectiveness or withdrawal pending further review. We do note, however, that President-elect Biden has in the past expressed support for the carbon capture and storage industry and the Section 45Q credit, such that withdrawal or delay of the final regulations if not published in the Federal Register or otherwise effective by January 20, 2021, is not certain.

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CONTACTS

Morgan Lewis has 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:

Philadelphia
Casey S. August
Paul A. Gordon

Washington, DC
J. Daniel Skees
Scott D. Clausen