The Inflation Reduction Act of 2022 (the "IRA") now allows firms to develop and sell clean energy tax credits.
Now that Treasury and the IRS have released final regulations on the IRA's transferability provisions for sales of tax credits, we've prepared the CliffsNotes version with everything you need to know about energy tax credit sales.
Here's how it works: a developer may sell all (or a portion of) credits in the year they are created to unrelated for-profit buyers by completing a pre-filing registration online and making an irrevocable transferability election on its tax return. Sales proceeds are excluded from taxable income (or treated as tax-exempt income to partnerships and S corporations). The buyer of the credits is treated as the taxpayer and must report the credits on its tax return in the year that consideration for the credits is "paid in cash." A buyer's payments are not deductible. A buyer may not resell credits.
Additional housekeeping items include:
- Carrybacks and Carryforwards: Buyers can take advantage of the IRA's expanded 3-year carryback period and 22-year carryforward period for purchased credits.
- No Gross Income: Any spread between the amount paid for a credit and the amount of the credit is not taxed.
- Multiple Buyers: A developer may sell portions of a credit to multiple buyers (but may not sell a bonus credit separately from a base credit).
- Pre-Filing Registration: Developers must apply online for a registration number on the IRS portal that launched in December. The preamble to the final regulations instructs prospective sellers of credits to refer to the user guide (available here) for specifics on when registration numbers will be issued. According to the user guide, the IRS recommends registering early—at least 120 days before filing a return—to allow time for review, and notes that they will try to issue a registration number "even where the registration submission is made close in time before the registrant's filing deadline," although "[i]n such cases, the registrant should anticipate that the tax return on which the elective payment or transfer election is made may undergo heightened scrutiny to mitigate the risk of fraud and duplication that pre-filing registration is intended to address before a payment is issued." Many commenters have remarked that there are no more opportunities for fraud than those in traditional tax equity, which does not require registration. Further, given the hard deadline set for sales of tax credits, the preamble acknowledges the need to expedite the registration process to provide more comfort to buyers. However, the IRS declined to specify a timeframe for issuing registration numbers.
- Buyer Reporting: A selling developer and a buyer must jointly prepare a "transfer election statement" describing the proposed transfer of the credits. The final regulations confirm that a partnership agreement or a purchase and sale agreement may qualify for this purpose if it contains sufficient information to validate the existence of the credits as set forth in the regulations. A buyer must include the statement in its tax return in the year the credits are purchased.
- Excessive Credit Transfers: Buyers are also liable for any adjustments caused by excessive credit transfers, which include a 20% penalty unless the buyer can demonstrate reasonable cause.
The final regulations generally reaffirm the rules as proposed (as we discussed in our last update, available here), citing the need to prioritize administrability in the preamble. Here is everything that made the final cut:
- Recapture Tax: If a project later loses its eligibility for credits as result of, among other things, the sale of the investment credit property during the applicable recapture period, the final regulations confirm that the buyer of any credits bears the risk of any recapture tax. A developer must provide notice to a buyer of the events that would trigger recapture, which do not include a sale of partnership or S corporation interests because a buyer would not be liable for recapture tax under those circumstances. The preamble rejected the argument that the risk should more appropriately be directly borne by sellers of credits because they control whether a recapture event occurs. In any case, buyers have seemingly gotten comfortable with the risk of recapture tax, possibly due to the growing availability of tax insurance (which we discussed here).
- Passive Activity Rules: Many were hoping the final regulations would articulate circumstances in which purchased credits may be treated as arising from non‐passive activity—or remove the restrictions entirely—to broaden the potential pool of buyers of credits to include individuals. The final regulations confirm that other than the "limited circumstance" in which a buyer of credits "materially participates" in the seller's business, purchased credits will only offset passive income of buyers subject to the passive activity rules. This will make it harder for small energy projects to attract buyers, as individuals will be unlikely to purchase these credits.
- No Advance Payments: In addition, the final regulations confirm that sales of credits are required to be "paid in cash" on an annual basis, rejecting comments suggesting that "advanced commitments" include advance payments under a single transfer agreement to facilitate forward sales of production tax credits. The preamble states that there is no prohibition on loaning funds to a developer, which means that a developer can finance a project with a bank loan secured by future sales proceeds that the developer will receive from a buyer when the credits are subsequently delivered.
- No Separate Transfers of Bonus Credits: A developer may sell a "portion" of a credit, but may not sell a bonus credit separately from its base credit. Some have argued that allowing bonus credits to transfer separately would be crucial for establishing a robust market for sales of energy tax credits, particularly as Treasury works to finalize guidance on the eligibility criteria for these potentially lucrative bonus tax credits. The final regulations confirm that the bonus credit is not a separate credit that would be eligible for sale, but rather increases the amount of the credit that can be claimed or sold.
- Lessees May Not Sell Credits: If a taxpayer is only allowed to claim a credit as a result of an election (g., as a lessee of the project), it is not permitted to sell the credits. Comments from members of the carbon sequestration industry pointed out that this would effectively bar many firms that are directly engaged in carbon recapture from selling these credits because such firms can only claim the credits when project owners make specific elections. The preamble states that a credit is "determined" with respect to an eligible taxpayer where the taxpayer owns the underlying credit eligible property or, if ownership is not required, otherwise conducts the activities giving rise to the credit. The preamble confirms that "otherwise conducts activities giving rise to the credit" should be construed narrowly, such that merely operating a carbon sequestration plant would not suffice.
- Qualification as a REIT: The preamble provides more certainty to REITs, clarifying that sales of credits do not constitute dealer activity, and that eligible credits that have not yet been transferred will be disregarded for purposes of the REIT asset test.
One key item that the final regulations have left open to be addressed in future guidance is the tax treatment of transaction costs such as professional fees, success-based fees and insurance. The preamble states that the tax treatment of transaction costs is governed by general tax principles, but acknowledged the need for further guidance specific to energy tax credit sales.
Another significant update on energy tax credits is the release of the long-awaited guidance package (available here) on the technology-neutral electricity tax credits that will replace the production tax credit ("PTC") and investment tax credit ("ITC") in 2025. The proposed rules largely adhere to the current rules governing PTCs and ITCs, while also expanding the eligibility criteria to include new technologies.
As Treasury hastens to finalize IRA guidance ahead of a potential change in administration, the biggest open questions relate to the "direct payment" election that allows tax-exempt and governmental entities to receive a cash refund from the IRS. Comments to proposed rules (available here) applicable to certain jointly operated projects indicate a pressing need for workable tax structures that will permit tax-exempt entities to join with taxable investors for their capital and expertise. In addition, Treasury and the IRS have requested comments on whether tax-exempt entities may be able to receive direct payment for purchased credits. The comment period will end on December 1, 2024.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.