On June 14, 2023, the U.S. Internal Revenue Service (IRS) and the Department of the Treasury (Treasury) issued proposed regulations and FAQs regarding the direct payment of tax credits under Section 6417 of the Internal Revenue Code of 1986, as amended (Code)1, and the transferability of tax credits under Section 6418 as well as temporary regulations regarding the mandatory prefiling information and registration requirements.
The proposed regulations provide helpful guidance and clarity on several issues raised by various stakeholders in their discussions and submissions to the IRS as well as issues encountered in transfer transactions and arrangements that were executed, or are being negotiated, in the market.
Each set of proposed regulations and related preamble is in excess of 100 pages. A detailed analysis of the various provisions in these regulations is forthcoming. This alert summarizes the highlights for each set of regulations.
Section 6417 — Direct-pay election
Starting in 2023 and before January 1, 2033, an applicable entity2 can make an election that would treat it as having made a tax payment equal to the value of the applicable tax credits it would otherwise be eligible to claim (direct-pay election). Such entity can claim a refund for the excess taxes it paid or is deemed to have paid. Effectively, this option makes the applicable tax credits “refundable” tax credits.
The direct-pay election can also be made by taxpayers that are not applicable entities (electing taxpayers) for a period of five years with respect to the Section 45Q carbon capture credits, Section 45V clean hydrogen credits, and Section 45X advanced manufacturing credits.
The relevant proposed regulations provide the following clarifications and guidance:
- Prefiling registration. As a condition of, and prior to, the transfer of any portion of the eligible credits, the transferor-taxpayer is required to register, provide relevant information about the taxpayer and the eligible credits, and obtain a registration number. The mandatory registration process will take place through an IRS electronic portal expected to be established prior to the end of 2023.
- Applicable entities; partnerships are not applicable entities. The direct-pay election can be made by the owner of the relevant property (or the entity that performs the required activities) only if it is an applicable entity or an electing taxpayer. In this regard, the proposed regulations provide that a partnership is not an applicable entity even if it is partially or wholly owned by tax-exempt or other applicable entities and therefore is not eligible to make a direct-pay election except in the case of facilities for which electing taxpayers can make direct-pay elections (discussed more fully below). If the relevant facility is owned through a tenancy-in-common arrangement, each tenant-in-common that is an applicable entity can make the direct-pay election with respect to its undivided interest and its share of the credit. If the project is held by a disregarded entity, for tax purposes, only its regarded owner, to the extent it is an applicable entity, can make the election.
- Partnerships as electing taxpayers. Partnerships can qualify as electing taxpayers. Accordingly, to the extent a partnership is treated as the owner of the relevant facility for U.S. federal income tax purposes, it can make the direct-pay election with respect to Section 45Q carbon capture credits, Section 45V clean hydrogen credits, and Section 45X advanced manufacturing credits as electing taxpayers. As mentioned above, such election would only be applicable for a five-year period.
- Instrumentalities are now applicable entities. The regulations clarify that the term “applicable entity” also includes any agency or instrumentality of any state, D.C., or any subdivision thereof.
- Timing of election. The direct-pay election must be filed together with the taxpayer’s original tax return. No election can be made on an amended tax return. No late-filing relief is available.
- No reduction of the tax credits due to grants or tax-exempt financing. Applicable entities (or electing taxpayers) are not required to reduce the basis of the property and the amount of the investment tax credits by any grants or tax-exempt financing used to construct or acquire the eligible property. However, the aggregate amount of the tax credits and the tax-exempt financing proceeds cannot exceed the overall cost of the eligible property.
- No direct-pay election allowed for purchased credits. No election is allowed with respect to credits previously transferred to the relevant entity (e.g., by way of Section 6418, the inverted lease pass-through election, or the 45Q carbon capture election to the sequestration party).
Section 6418 – Transfer of tax credits
Section 6418 provides that eligible taxpayers may transfer all, or a portion of, their eligible credits to a taxpayer that is not related to the transferor taxpayer (within the meaning of Section 267(b) or 707(b)(1)). Consideration for such transfer must be paid in cash, is not includible in the income of the transferor taxpayer, and is not deductible to the transferee taxpayer. Credits may not be transferred more than once.
The relevant proposed regulations add the following clarification and guidance:
- Prefiling registration. As a condition of, and prior to, the transfer of any portion of the eligible credits, the transferor-taxpayer is required to register, provide relevant information about the taxpayer and the eligible credits, and obtain a registration number. The mandatory registration process will take place through an IRS electronic portal that is expected to be established prior to the end of 2023.
- Applicable or electing taxpayers. The transfer of eligible credits and the applicable transfer election need to be made by the owner of the relevant property (or the entity that performs the required activities). In the case of a tenancy-in-common arrangement, each tenant-in-common can make the transfer election with respect to its undivided interest. In the case of a project held by a partnership, only the partnership itself (and not its partners) can elect to transfer the eligible credits. If the project is held by a disregarded entity, for tax purposes, its regarded owner needs to make the election.
- Timing of election. The transfer election needs to be filed together with the taxpayer’s original tax return. No election can be made on an amended tax return.
- Sale for cash. Consideration for the sale of the credit needs to be 100% in cash. If any other consideration is paid (e.g., other property, services), the entire transfer will be disallowed. In this regard, if the parties have other arrangements in place (e.g., service agreements), the IRS is likely to review the entire relationship between the parties to ensure that the consideration for the credit transfer consists solely of cash. The full payment for the purchase of the credits must be made no earlier than the year the credit is generated and no later than the date in the following year on which the transfer election is made (i.e., the date on which the tax return that includes the transfer election is filed). A contractual commitment to purchase tax credits that is executed in advance of the actual transfer is allowed, but payment for the credits must be made within the timeframe described in the preceding sentence. Thus, projects that generate annual credits (e.g., Section 45 production tax credits, Section 45Q carbon capture tax credits, and Section 45V clean hydrogen tax credits) require buyers to make annual payments for the purchased credits.
- Distribution of cash proceeds. Cash proceeds received by a partnership from the sale of its tax credits can be distributed to the partners in any manner agreed in the partnership agreement, without regard to the way the tax-exempt income or any remaining tax credits are allocated.
- Strict one-time transfer rule. A buyer of the tax credits cannot sell or transfer the credits. The proposed regulations take the position that even if the credits were transferred to the taxpayer using other allowed transfer mechanisms (e.g., an inverted lease pass-through election of the credits from lessor to lessee, a transfer of Section 45Q carbon capture tax credit from the owner of the carbon capture equipment to the party that is contractually obligated to perform the sequestration services), such transferee-taxpayer cannot then transfer the credits to another party. However, in a sale-leaseback transaction, the lessor, as a new owner of the property, can transfer such credits to a third party for cash pursuant to Section 6418.
- Allocation of transferred credits does not count as a transfer. The allocation of the purchased tax credits by a transferee-partnership to its partners is allowed and does not violate the one-time transfer rule.
- Broker arrangements allowed. Broker arrangements are allowed as long as the broker-entity’s role is to “match” taxpayers with transferee-entities and it does not receive or take ownership of any portion of the credit that is later transferred to the ultimate buyer.
- Bonus credits cannot be separately transferred. A project eligible for the increased credit amount due to satisfying of the “domestic content” requirement or its location in an “energy community” or “low-income community” cannot transfer such bonus credit separate from the transfer of the base credits itself. As such, an eligible taxpayer that transfers a portion of its credit amount will transfer the proportionate share of the base credits and the bonus credit.
- Flexibility in transferring and allocating partial credits by partnership. A partnership can sell a partner’s distributive share of the tax credits and allocate the remaining credits to the other partners. This special rule provides flexibility to partnerships and their partners to determine how the tax credits will be monetized and allows for a different outcome for each partner based on its own desire and tax capacity. This is achieved by first having the partnership determine each partner’s respective share of the credit, pursuant to its distributive share of the partnership’s relevant items of income or loss. Then the partnership may decide, pursuant to an agreement by the partners, which portion of each partner’s eligible credit is to be transferred and the portion of each partner’s eligible credit amount is to be retained and allocated to such partner. Each partner’s share of the tax-exempt income from the sale of its distributive share of the credits is then allocated to such partner.
- Purchased credits could reduce estimated taxes. The preamble to the proposed regulations provides that the transferee may take into account in calculating its estimated taxes the credits it purchased or intends to purchase.
- The “at risk” and “passive activity loss” rules continue to apply. The proposed regulations do not provide any relief related to these rules. As such, individuals and closely held C corporations will continue to have limited ability to invest in renewable energy projects or purchase credits.
- Recapture. The transferee-entity generally is liable for any recapture of the credits. Thus, if investment tax credit (ITC)-eligible property ceases to qualify as ITC-eligible property during the recapture period, the credits acquired by the transferee will be subject to recapture. In this regard, the proposed regulations make clear that indemnity provisions intended to contractually allocate recapture risk to the transferor are permitted and will not affect the effectiveness of the credit transfer. The proposed regulations also provide an important exception to the general rule that recapture liability is imposed on the transferee. In cases where recapture is triggered by a disposition of a partner’s interest in a transferor partnership, the consequences of such recapture will apply only to the disposing partner and not to the transferee.
1Unless otherwise specified, all references to “Section” are to the Code.
2The term “applicable entities” includes only tax-exempt organizations, a state or subdivision of a state, the Tennessee Valley Authority, Indian tribal governments, any Alaska Native corporation, or any corporation operating on a cooperative basis that is engaged in furnishing electric energy to persons in rural areas.
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