First, as described more fully below, in order to qualify for credits under Section 45Q, construction of a carbon capture facility (and in some cases, construction of the carbon capture equipment) must begin before January 1, 2024 (Beginning of Construction Requirement). Notice 2020-12 (BOC Guidance) provides guidance regarding the Beginning of Construction Requirement and, as was expected, takes an approach similar to the approach taken in analogous guidance applicable to renewable energy projects intended to qualify for investment tax credits (under Section 48 of the Code) and production tax credits (under Section 45 of the Code).
Second, because developers of carbon sequestration projects will, in many cases, be unable to utilize the Section 45Q credits generated by their projects, efficient use of those credits is likely to require the use of “tax equity” financing structures similar to those utilized in other credit-driven industries. In Revenue Procedure 2020-12 (Partnership Guidance), the IRS has established a safe harbor for carbon sequestration partnerships that satisfy certain requirements; if those requirements are satisfied, the IRS will treat the tax equity investor as a partner in the carbon sequestration partnership and will respect the allocations of credits made to the tax equity investor by that partnership. The Partnership Guidance is similar to analogous safe harbor guidance provided for partnerships generating certain other credits.
A brief summary of Section 45Q is included below, followed by a more detailed summary of each piece of guidance issued last week.
Background on Section 45Q
Section 45Q generally allows a tax credit (Section 45Q Credit) equal to a specified dollar amount per metric ton of qualified carbon oxide captured using carbon capture equipment during the year and either (i) disposed of in “secure geological storage” without being utilized for any other purpose (e.g., as a tertiary injectant in an enhanced oil or natural gas recovery project) or (ii) otherwise utilized in a manner permitted by Section 45Q (including as a tertiary injectant). The specified dollar amount used in determining the amount of the Section 45Q Credit is materially higher if the captured carbon oxide is disposed of in “secure geological storage” without being utilized for any other purpose.
The Bipartisan Budget Act of 2018 (BBA) made significant changes to Section 45Q that made carbon sequestration equipment a much more attractive investment opportunity. These changes included (i) increases in the credit values, (ii) an expansion of the list of permitted uses for captured carbon oxide, (iii) a reduction of the carbon capture thresholds required to be satisfied in order to claim the Section 45Q Credit and (iv) the removal of the volume cap on the amount of captured carbon oxide eligible for the Section 45Q Credit.
In order to qualify for the revamped Section 45Q Credit, carbon oxide must be captured at a qualified facility, which is defined to include any industrial facility or direct air capture facility capturing a specified amount of carbon oxide per year (which amount varies by type of facility), but only to the extent that the Beginning of Construction Requirement is satisfied.1 The person that owns the carbon capture equipment is generally entitled to the Section 45Q Credit, although the statute permits the IRS to adopt regulations allowing the owner of the carbon capture equipment to transfer the credit to the offtaker of the captured carbon oxide.
The BOC Guidance Regarding the Beginning of Construction Requirement
The BOC Guidance takes an approach similar to analogous guidance applicable to renewable energy projects intended to qualify for investment tax credits (under Section 48 of the Code) and production tax credits (under Section 45 of the Code). Similar to that guidance, the BOC Guidance provides two methods by which taxpayers can satisfy the Beginning of Construction Requirement. First, the taxpayer can establish that it began physical work of a significant nature prior to the deadline (Physical Work Test). Second, pursuant to a safe harbor, the taxpayer can be treated as beginning construction before the deadline by paying or incurring 5% or more of the total cost of the qualified facility or carbon capture equipment (Five Percent Safe Harbor). Construction will be deemed to have begun on the date the taxpayer first satisfies one of these two tests. In either case, in order to satisfy the Beginning of Construction Requirement, the taxpayer must also establish that it made continuous progress toward completion once construction was determined to begin under the relevant method (Continuity Requirement).
The Physical Work Test. This subjective test focuses on the nature of the work performed, not the amount or the cost. Off-site work (e.g., the manufacture of equipment and other components) and on-site work (e.g., excavation and installation of foundations and components) generally can be taken into account.
The Five Percent Safe Harbor. Construction begins under the Five Percent Safe Harbor when a taxpayer pays or incurs five percent or more of the total cost to complete. All costs properly included in the depreciable basis of a qualified facility or carbon capture equipment are taken into account in determining whether the Five Percent Safe Harbor has been satisfied.
The Continuity Requirement. In order to satisfy the Continuity Requirement, a taxpayer relying on the Physical Work Test generally must establish, based on the relevant facts and circumstances, that it maintained a continuous program of construction involving physical work of a significant nature. Similarly, a taxpayer relying on the Five Percent Safe Harbor generally must establish, based on the relevant facts and circumstances, that it made continuous efforts towards completion of the qualified facility or carbon capture equipment. In applying the relevant facts and circumstances, the BOC Guidance provides that certain disruptions in a taxpayer’s efforts to complete a qualified facility or carbon capture equipment that are beyond the taxpayer’s control generally will not cause a taxpayer to fail to satisfy the Continuity Requirement.
In light of the uncertainty that arises from the use of a facts and circumstances-based standard, the BOC Guidance helpfully includes a safe harbor providing that, so long as a qualified facility or carbon capture equipment is placed in service by the end of the sixth calendar year following the year in which construction begins under the relevant test, the Continuity Requirement will be deemed satisfied without regard to the relevant facts and circumstances. In this regard, the BOC Guidance deviates from a similar safe harbor included in the analogous investment tax credit/production tax credit guidance, where the safe harbor period ends four years following the year in which construction begins.
Other Guidance. The BOC Guidance provides that, in determining whether the Physical Work Test or the Five Percent Safe Harbor has been satisfied, physical work performed, or costs paid or incurred, by persons other than the taxpayer generally can be taken into account by the taxpayer so long as the work is performed, or costs are paid or incurred, pursuant to a “binding written contract” (generally, a contract enforceable under local law that does not limit damages to a specified amount). It also provides helpful guidance regarding the extent to which (i) multiple qualified facilities or multiple units of carbon capture equipment can be aggregated or disaggregated for purposes of applying the Physical Work Test, the Five Percent Safe Harbor and the Continuity Requirement and (ii) a qualified facility or carbon capture equipment on which construction has begun under the Physical Work Test or Five Percent Safe Harbor may be transferred without losing its qualification under those tests. On these points, the BOC Guidance is identical in all material respects to the analogous provisions in the production tax credit/investment tax credit guidance.
Given the similarities between the BOC Guidance and the analogous production tax credit/investment tax credit guidance, strategies developed to satisfy the beginning of construction requirement with respect to those credits should be replicable in the context of carbon sequestration projects, and the additional buffer provided by the extension of the Continuity Requirement safe harbor from four to six years represents a welcome and important deviation from that guidance.
The Partnership Guidance
Because developers of carbon sequestration projects will, in many cases, be unable to utilize the Section 45Q credits generated by their projects, efficient use of those credits is likely to require the use of “tax equity” financing structures similar to those utilized in other credit-driven industries.
One such structure, referred to as a “partnership flip” structure, involves the formation of a partnership between the developer and one or more tax equity investors, which partnership will own the credit-generating property. Each of the developer and the tax equity investor makes agreed-upon contributions to the partnership. The partnership’s allocation provisions typically provide that, prior to a date specified in the partnership agreement (which may be a fixed date or a date on which the tax equity investor achieves a specified rate of return), as much as 99% of the partnership’s profits or losses (and tax credits) will be allocated to the tax equity investor, with the remainder allocated to the developer. Following the flip date, the allocation percentages flip, so that the developer receives an allocation of the vast majority (as high as 95%) of the partnership’s post-flip date profits and losses. The percentage of available cash distributed to the developer and the tax equity investor will often change as certain milestones occur and may or may not align with the manner in which profits and losses are allocated.
Treasury has previously issued guidance establishing safe harbors for partnership flip structures involving production tax credit-eligible wind facilities (Wind Safe Harbor) and buildings eligible for the rehabilitation tax credit the (Rehabilitation Safe Harbor). The Partnership Guidance establishes a similar safe harbor for carbon sequestration partnerships generating Section 45Q Credits. In doing so, the Partnership Guidance borrows heavily from the safe harbor guidance issued in those other contexts.
The Safe Harbor. If a partnership satisfies all of the requirements described below, the IRS will treat (i) the tax equity investor as a partner in the partnership and (ii) the partnership as properly allocating the Section 45Q Credit in accordance with the relevant provisions of the Code.
- Developer’s Minimum Partnership Interest. The developer at all times must have at least a 1% interest in each material item of income, gain, loss, deduction and credit of the partnership.
- Tax Equity Investor’s Minimum Partnership Interest. The tax equity investor’s interest in each material partnership item at all times must be at least 5% of the tax equity investor’s highest percentage interest in each such item during any taxable year. Thus, if the tax equity investor is allocated 99% of all material items in period one, it must be allocated at least 4.95% of such items in all other periods.
- Tax Equity Investor’s Initial Minimum Unconditional Investment. The tax equity investor must make (and maintain) an unconditional initial investment equal to at least 20% of its reasonably anticipated investment. Thus, to the extent that a “pay-go” structure is utilized, in addition to the limits on contingent investment noted immediately below, care must be taken to ensure that the up-front investment is at least 20% of the reasonably anticipated investment. In addition, the tax equity investor must not be protected against loss of any portion of this minimum investment through any arrangement with the developer, another tax equity investor or any emitter or offtaker of the carbon oxide captured by the partnership.
- Limitation on Contingent Investment. This requirement limits the extent to which “pay-go” structures can be used by requiring the amount of the tax equity investor’s contingent capital contributions, as a percentage of its total investment, to be less than 50%.2
- Allocations of the Section 45Q Credits. The Partnership Guidance requires the Section 45Q credits to be allocated in one of two ways depending on the extent to which the company generates revenue from its sequestration activities. If the partnership has receipts relating to its carbon oxide sequestration activities, allocations of the Section 45Q Credits must be allocated in a manner consistent with the allocation of those receipts. If there are no such receipts, allocations of the Section 45Q Credits will be respected if they follow allocations of loss or deduction associated with the costs of such carbon oxide sequestration activities.
- Limits on Guarantees and Loans. No person involved in any part of the partnership may directly or indirectly guarantee (i) the amount of, or the ability to claim, the tax equity investor’s share of the Section 45Q Credits if the IRS challenges the transactional structure of the partnership or (ii) that the tax equity investor will receive distributions from the partnership other than in connection with certain sales of the tax equity investor’s partnership interest. Additionally, neither the developer nor any person related to the developer may lend a tax equity investor the funds (or guarantee debt of the tax equity investor) used to acquire the tax equity investor’s interest in the partnership or guarantee any debt.
The Partnership Guidance does provide certain limited exceptions to the “no guarantee” requirement that address practical difficulties that would otherwise arise. More specifically, the Partnership Guidance permits (i) guarantees for the performance of any acts necessary to claim the Section 45Q Credits (i.e., ensuring proper disposal or utilization of the captured carbon oxide) and (ii) guarantees for the avoidance of certain acts that would cause the partnership to fail to qualify for the Section 45Q Credit or result in recapture of the Section 45Q Credit. Similarly, long-term carbon oxide purchase agreements entered into on an arm’s length basis will not be treated as impermissible guarantees even if the counterparty is related to the partnership or the contract contains a “supply all,” “supply-or-pay,” “take all,” “take-or pay” or similar provision.
- Purchase and Sale Rights. Neither the developer nor the tax equity investor may have a call option or other contractual right or agreement to purchase the carbon capture equipment or a partnership interest at a future date (other than a contractual right or agreement for a present sale). Similarly, a tax equity investor may not have a put right or other similar agreement with any person involved with the carbon capture transaction to sell or liquidate the tax equity investor’s interest in the partnership at a price that is more than its fair market value determined at the time the right is exercised.
- Bona Fide Equity Investment; Limitation on Arrangements to Reduce the Value of the Investor’s Interest or Economic Return. The Partnership Guidance includes two requirements that were included in the Rehabilitation Safe Harbor but not the Wind Safe Harbor. First, a tax equity investor must make a “bona fide equity investment” commensurate with its percentage interest and based on the reasonably anticipated value of its interest (apart from tax benefits). An investment will be considered a bona fide equity investment only if the value of the investment is contingent upon the partnership’s net income, gain and loss; the investor must not be substantially protected from losses arising from the partnership’s activities and the investor’s return cannot be substantially fixed in amount or limited in a manner comparable to a preferred return. Second, the value of the tax equity investor’s interest may not be reduced through fees or other arrangements that are unreasonable, compared with the fees and arrangements for similar carbon oxide sequestration projects not qualifying for the Section 45Q Credit.
The Partnership Guidance is helpful in a number of respects. First, it implicitly accepts the utilization of “partnership flip” structures in the context of partnerships engaged in sequestration activities, even where the partnership may generate little if any cash flow from its operations. Second, even where a partnership structure is unable to satisfy all of the safe harbor requirements, it provides helpful guidance on certain aspects of tax equity structures (e.g., what the IRS views as permissible and impermissible guarantees). Third, in light of its similarity to the Wind Safe Harbor and Rehabilitation Safe Harbor, traditional tax equity investors are likely to have some prior experience with these requirements, allowing them to rely on that experience to inform their approach to negotiating and structuring investments in partnerships that are intended to generate Section 45Q Credits.
That said, the Partnership Guidance’s requirements that the tax equity investor’s investment represent a bona fide equity investment and that the value of the tax equity investor’s interest in the partnership not be reduced through unreasonable fees or other arrangements are unhelpful insofar as they introduce a level of subjectivity that is inconsistent with the purpose typically served by a safe harbor. While each of those requirements is included in the Rehabilitation Safe Harbor, there are issues that arise in applying those requirements in the context of a partnership engaged in sequestration activities that typically do not arise in the rehabilitation credit context.
First, with respect to the bona fide equity investment requirement, in light of the fact that the Section 45Q Credit may be taken with respect to carbon oxide that is captured and placed into secure geological storage, it is conceivable that little if any revenue will be generated by credit-eligible equipment, leaving the tax credits as the only material benefit generated by the partnership’s operations. Similarly, once the credit period has expired, the value of the equipment is likely to be significantly diminished. Thus, in some cases, it may be difficult to establish that a tax equity investor’s interest has any meaningful value apart from the tax benefits associated therewith. The Partnership Guidance nevertheless confirms that taxpayers may use a partnership to allocate Section 45Q Credits to tax equity investors even in a situation where the partnership will not receive payments for its activities relating to carbon oxide sequestration. The Partnership Guidance therefore implies that such arrangements should not be challenged as lacking economic substance despite the absence of a pre-tax profit motive.
Second, in determining whether a fee or other arrangement is unreasonable, the Partnership Guidance requires a comparison to fees and arrangements for similar carbon oxide sequestration projects not qualifying for the Section 45Q Credit. Given the relative infancy of the carbon sequestration technology and the likelihood that projects will only be undertaken because of the availability of the tax credit, it will be much more difficult to establish what constitutes a “reasonable” fee in the manner required by the guidance than it is in the context of the Rehabilitation Safe Harbor.
Issues Not Addressed by the Guidance
The guidance issued last week does not include guidance on matters that Treasury was directed by statute to address with regulations. In particular, Section 45Q requires Treasury to promulgate regulations providing for the recapture of credits previously taken in the event previously captured qualified carbon oxide ceases to be captured, disposed of, or used in manner consistent with Section 45Q’s requirements. It also requires Treasury, in consultation with the EPA, the Department of the Interior and the Department of Energy, to establish regulations to be used in determining what constitutes “secure geological storage” for purposes of Section 45Q. The guidance also does not include the guidance permitted, but not required, by the statute that would allow the owner of carbon capture equipment to transfer the Section 45Q credit to the offtaker who disposes of or utilizes the captured carbon oxide in a permitted manner.
1 Note that the Beginning of Construction Requirement requires not only that construction of the facility begins before January 1, 2024, but also that either (i) construction of the carbon capture equipment begins before that date or (ii) the original planning and design for the facility included installation of carbon capture equipment. Thus, beginning construction before January 1, 2024 with respect to a facility that was not originally intended to serve as a carbon capture facility will not satisfy the Beginning of Construction Requirement unless construction of carbon capture equipment for such facility also begins before that date. Stated differently, taxpayers cannot rely solely on work done on components of a facility other than the carbon capture equipment to satisfy the Beginning of Construction Requirement unless the carbon capture equipment is part of the original design.
2 In this regard, the Partnership Guidance provides more flexibility than the Wind Safe Harbor or the Rehabilitation Safe Harbor in two respects. First, the minimum fixed investment percentage under the Partnership Guidance is reduced from 75% to 50%. Second, contributions required to pay ongoing operating expenses are not treated as part of the tax equity investor’s contingent investment.
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