U.S. Treasury Issues Proposed Section 45Q Regulations on Carbon Sequestration Credits

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, (ii) used as a tertiary injectant in an enhanced oil or natural gas recovery project and then disposed of in secure geological storage or (iii) otherwise utilized in another manner permitted by Section 45Q (e.g., fixation through photosynthesis or chemosynthesis). 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.  

To qualify for the 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 construction of such facility begins before January 1, 2024 and certain other requirements are met. On March 9, 2020, the IRS and Treasury issued Notice 2020-12, which provides guidance on determining when construction has begun for purposes of the beginning of construction requirement. That same day, the IRS and Treasury issued Revenue Procedure 2020-12, providing a safe harbor for partnership allocations of the Section 45Q Credit.¹  

The statute directs the IRS and Treasury to promulgate regulations with regard to certain matters relating to Section 45Q. These matters include defining secure geological storage, recapture of credits previously taken, elections allowing carbon capturers to transfer the credit to offtakers of carbon oxides and the standards for determining permissible utilization of carbon oxides (other than as a tertiary injectant).

Secure Geological Storage

The statute does not define “secure geological storage,” although it does note that such term includes storage at deep saline formations, oil and gas reservoirs and unminable coal seams under such conditions as the IRS and Treasury may determine. In determining what constitutes secure geological storage, the statute requires the IRS and Treasury to consult with EPA and other federal agencies. The Proposed Regulations appear to evidence such consultation, as the standards for secure geological storage generally rely on the relevant EPA regulatory framework applicable to carbon sequestration facilities.

Background and Applicable EPA Regulations. In general, facilities that dispose of carbon oxides underground in the United States must comply with Underground Injection Control (UIC) regulations promulgated by the EPA. Facilities that inject fluids (which may include carbon dioxide) associated with oil and gas production may be treated as Class II facilities under the UIC regulations. Other facilities engaged in “geologic sequestration” of carbon oxides under sources of drinking water may be treated as Class VI facilities. While both Class II and Class VI facilities are subject to reporting and monitoring requirements under the UIC regulations, Class VI facilities (but not Class II facilities) must comply with subpart RR of such regulations. Subpart RR involves, among other things, the development and implementation of an EPA-approved, site-specific Monitoring, Reporting and Verification Plan (MRV Plan).  

Current Form 8933 and Commenters’ Concerns With Subpart RR. Form 8933 (Carbon Oxide Sequestration Credit), which is used to claim the Section 45Q Credit and which was last updated in 2019, states that secure geological storage requires an EPA-approved MRV Plan. Commenters have noted that requiring Class II facilities to, in effect, voluntarily comply with subpart RR would impose an additional regulatory burden on such facilities. Some commenters proposed, as an alternative for such facilities, compliance with the standard adopted by the ISO, referred to as CSA/ANSI ISO 27916:19, “Carbon Dioxide Capture, Transportation and Geological Storage — Carbon Dioxide Storage Using Enhanced Oil Recovery (CO2-EOR).”  

Adoption of Alternative ISO Standard. The Proposed Regulations adopt the proposal described above and provide that the requirements for secure geological storage will be met if a facility complies with either subpart RR or the ISO standard. Some commenters also suggested that in states with regulatory “primacy” over the EPA on UIC matters, compliance with the state’s regulatory framework should suffice. The Proposed Regulations do not adopt this proposal, stressing a need for uniformity.

Recapture of Section 45Q Credits

Section 45Q states that the IRS and Treasury shall promulgate regulations providing for the recapture of Section 45Q Credits in the event that qualified carbon oxides cease to be captured, disposed of or used as a tertiary injectant. Thus, the statute envisions a system under which taxpayers will be subject to recapture of Section 45Q Credits if, in later years, the qualified carbon oxides on which such Section 45Q Credits were claimed leak back into the atmosphere. The Proposed Regulations implement this system.

Recapture Period. The Proposed Regulations provide that the “recapture period” begins on the date of the first injection of qualified carbon oxides for disposal or use as a tertiary injectant. The recapture period ends upon the earlier of (i) five years after the last year in which the taxpayer claimed Section 45Q Credits and (ii) the date on which monitoring ends under the applicable UIC or ISO standard for secure geological storage. Accordingly, a taxpayer may be subject to recapture of Section 45Q Credits throughout the entire period of time during which the taxpayer is claiming such Section 45Q Credits plus an additional five years (or shorter time required by the EPA or the ISO standard).  

Recapture Event. A “recapture event” occurs when qualified carbon oxides for which a Section 45Q Credit has been claimed cease to be captured, disposed of or used as a tertiary injectant during the recapture period but only to the extent such leakage exceeds the amount of qualified carbon oxides disposed of in secure geological storage or used as a tertiary injectant in that taxable year (such excess, the “recaptured qualified carbon oxide”). For example, if a taxpayer captures and securely disposes of 100,000 metric tons of qualified carbon oxides in year one and 200,000 metric tons in year two but determines that during year two there were 100,000 metric tons of qualified carbon oxide leakage, there would be no recapture event in year two. The taxpayer’s Section 45Q Credit in year two would be based on the net amount of qualified carbon oxides captured and disposed of in that year (i.e., 100,000 metric tons). If, however, the year two leakage were 250,000 metric tons, there would be a recapture event with respect to 50,000 metric tons of recaptured qualified carbon oxide (i.e., the excess of 250,000 metric tons of leakage in year two over the 200,000 metric tons captured in year two). The amount of leaked qualified carbon oxides is generally determined pursuant to the requirements of subpart RR or the ISO standard.

Application of Recapture; Five-Year Look-Back Period. In the taxable year of a recapture event, the taxpayer must add the “recapture amount” to its tax liability in that year. The recapture amount is equal to the product of the recaptured qualified carbon oxide and the appropriate statutory credit rate for the year in which the Section 45Q Credit being recaptured was claimed. Importantly, the calculation of the recapture amount is subject to a “look-back” period of five years. This means that if a recapture event occurs in the ninth year of a facility’s operation, only Section 45Q Credits claimed in years four through eight will be subject to recapture and reflected in the recapture amount. Within such five-year look-back period, the Proposed Regulations apply a last-in-first-out assumption—i.e., Section 45Q Credits claimed in year eight are recaptured first, year seven second, and so on. Where a recapture event relates to multiple, separate units of carbon capture equipment, or where multiple taxpayers claimed portions of the recaptured Section 45Q Credits, the recapture amount is generally determined on a pro rata basis with respect to each unit of carbon capture equipment or each taxpayer.

Limited Force Majeure Exception. The Proposed Regulations also provide a vague, limited exception to the rule of recapture, stating that a recapture event is not triggered by leakage resulting from “actions not related to the selection, operation, or maintenance of the storage facility, such as volcanic activity or a terrorist attack.” The preamble does not give any further insight on the breadth of this exception.

Election to Transfer Section 45Q Credits to Another Taxpayer

In general, Section 45Q Credits may be claimed by the person who owns the carbon capture equipment and physically or contractually ensures the capture and disposal, injection or utilization of qualified carbon oxides. However, the statute contemplates an election to allow the person who disposes of the qualified carbon oxides, utilizes the qualified carbon oxides or uses the qualified carbon oxides as a tertiary injectant to claim the Section 45Q Credits. The Proposed Regulations provide for the manner and effects of making such election.² 

Multiple Full or Partial Elections Allowed on Annual Basis. Under the Proposed Regulations, the election is made (or not made) on an annual basis with respect to the Section 45Q Credits arising during that year. Notably, the owner of carbon capture equipment may make an election with respect to the full or partial amount of such Section 45Q Credits. Further, the owner can elect to allow multiple credit claimants to claim portions of such Section 45Q Credits. Thus, to the extent there are multiple offtakers responsible for the disposal or utilization of the qualified carbon oxides giving rise to the Section 45Q Credits, such credits may be allotted to each of those offtakers.³ The electing taxpayer may not claim any of the Section 45Q Credits for which an election is made.

Election Mechanics. The election is made by filing a statement of election, in accordance with Form 8933 or successor forms, with the electing taxpayer’s federal income tax return or Form 1065 for the taxable year in which the credit arises. The election generally will not be effective if filed after the due date (including extensions) for such tax return or Form 1065. Thus, taxpayers generally may not make an election on an amended tax return or by way of administrative adjustment request. However, for taxable years ending after February 9, 2018, and beginning before the issue date of the Proposed Regulations—during which time there were no rules as to how to make the election—taxpayers may make the election on amended tax returns or by way of administrative adjustment request.

Contractually Ensuring Capture and Disposal, Injection or Utilization

As noted, Section 45Q Credits may be claimed (or transferred, pursuant to the election described above) by the owner of carbon capture equipment if such owner either physically or contractually ensures the disposal, injection or utilization of qualified carbon oxides. Accordingly, if the owner of the carbon capture equipment does not physically dispose of, inject or utilize the captured carbon oxides, it must “contractually ensure” such disposal, injection or utilization. The statute does not define what is required to “contractual ensure” appropriate disposal, injection or utilization, and commenters suggested that the IRS and Treasury should provide guidance on this matter. The Proposed Regulations respond to this suggestion and provide a general framework for determining whether disposal, injection or utilization is contractually ensured.

Binding Written Contract With Reasonable Enforcement Terms. The Proposed Regulations require a binding written contract (generally, a contract that is enforceable under state law and does not limit damages to a specified amount) that includes commercially reasonable terms for enforcement. The Proposed Regulations do not explicitly define commercially reasonable terms but rather provide that a contract may include provisions such as long-term liability, indemnities, penalties for breach of contract or liquidated damages. No specific enforcement provisions are mandated. In addition, a contract may or may not include precise or minimum quantities of carbon oxides to be disposed of, injected or utilized.  

Required Terms. For contracts requiring disposal in secure geological storage or use as a tertiary injectant, the contract must obligate the disposing or injecting party to (i) comply with the requirements discussed with respect to secure geological storage—that is, subpart RR or the ISO standard—and (ii) promptly inform the capturing party of all information relevant to any recapture event. Similarly, for contracts for utilization other than as a tertiary injectant, the contract must obligate the utilizing party to comply with the rules applicable to such utilization (a brief discussion of these rules, and the need for additional guidance, is below).

Multiple Contracts Allowed; Reporting of Contracts Required. An owner of carbon capture equipment may enter into multiple contracts with multiple parties for the disposal, injection or utilization. For example, the owner may contract with one party for the disposal of a portion of captured carbon oxides, another party for the injection of other captured carbon oxides and a third party for the utilization of the remainder. The existence of each contract must be reported annually to the IRS on Form 8933 or a successor form, along with the parties to each contract and certain other information.

Utilization (Other Than as a Tertiary Injectant) Not Addressed by the Proposed Regulations

For qualified carbon oxides that are not disposed of in secure geological storage, Section 45Q Credits will be available only if the qualified carbon oxides are utilized in certain specified manners (other than as a tertiary injectant). Under the statute, these include (i) fixation through photosynthesis or chemosynthesis, (ii) chemical conversion to a material in which qualified carbon oxides are securely stored and (iii) use for any other purpose for which a “commercial market” exists. The measurement of qualified carbon oxides so utilized is verified in part through an analysis of lifecycle greenhouse gas emissions (LCA). On this issue, the Proposed Regulations largely repeat the statutory provisions and do not provide much guidance. In particular, the Proposed Regulations reserve on providing standards for adequate LCA and on the definition of “commercial market.” The IRS and Treasury continue to request comment on these issues.

¹ See here for more information on Notice 2020-12 and Revenue Procedure 2020-12. 
² Some commenters suggested that the IRS and Treasury should provide for a broader range of potential credit claimants than that suggested by the statute—operators, service companies, tax equity providers, etc. The Proposed Regulations do not adopt this suggestion.
³ The Proposed Regulations make clear that simply entering into a contract with another person for the disposal or utilization of qualified carbon oxides does not constitute an election with respect to such person.