Final U.S. Regulations Issued on the Sale of Energy Tax Credits

On April 25, 2024, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued final regulations (Final Regulations)¹ on the transferability of certain energy tax credits, pursuant to Section 6418 of the Internal Revenue Code of 1986, as amended (Code),² which was enacted as part of the Inflation Reduction Act of 2022 (IRA). The Final Regulations are available here.

Background

As discussed in this Sidley Update, the IRA significantly changed the renewable energy tax credit regime. One of the main changes was providing alternative ways to monetize renewable tax credits by allowing certain entities to either (i) receive a cash payment from the government in lieu of tax credits by utilizing a “direct-pay” election, pursuant to Section 6417, or (ii) sell tax credits to third parties, pursuant to Section 6418.

Section 6418 provides that eligible taxpayers may transfer all, or a portion of, eligible tax credits to a buyer not related to the transferor-taxpayer (within the meaning of Section 267(b) or 707(b)(1)). Consideration for such transfers 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 following are the “eligible tax credits” that could be transferred:

• Alternative fuel vehicle refueling property tax credits under Section 30C
• Production tax credits under Section 45 (PTC)
• Carbon capture and sequestration credits under Section 45Q (45Q Credits)
• Zero-emissions nuclear power production credits under Section 45U
• Clean hydrogen production credits under Section 45V (45V Credits)
• Advanced manufacturing production credits under Section 45X
• Clean electricity production credits under Section 45Y
• Clean fuel production credits under Section 45Z
• Investment tax credits under Section 48 (ITC)
• Qualifying advanced energy project credits under Section 48C
• Clean energy investment credits under Section 48E

The Proposed Regulations

On June 14, 2023, the IRS and Treasury issued proposed regulations and FAQs regarding the direct payment of tax credits, under Section 6417, and the transferability of tax credits, under Section 6418, as well as temporary regulations regarding the mandatory prefiling information and registration requirements. Highlights of these proposed and temporary regulations are summarized in this Sidley Update.

Following a review and comment period, during which the IRS and Treasury received about 80 comment letters from various market participants, with numerous comments and suggestions for changes to the proposed regulations, the IRS and Treasury issued the Final Regulations.

The Final Regulations

The Final Regulations largely adopted the proposed regulations, with no significant changes. The following are a few noteworthy items addressed in the preamble or included in the Final Regulations as changes to the proposed regulations.

No expansion of the “pool” of buyers to include individuals and closely held corporations. Many commenters requested to exempt buyers of tax credits from the “passive activity loss” rules. In rejecting this request, the IRS and Treasury provided that Congress considered the application of the rules governing the determination and the utilization of tax credits, and in cases in which Congress desired to alter the application of certain rules, it provided as such. No such change was made with respect to the “passive activity loss” rules.

Accordingly, individuals, trusts, and closely held corporations remain subject to these rules, which generally limit their ability to participate in the transfer and tax equity markets.

Clarification for partnership with tax-exempt partners. The Final Regulations clarified that partnerships qualify as “eligible taxpayers” and as such can elect to transfer their eligible tax credits even if they are wholly or partially owned by tax-exempt entities (or other “applicable entities” under Section 6417). However, if such a partnership is eligible for the ITC (including ITCs potentially eligible for transfer, pursuant to Section 6418), the amount of the ITC may be subject to the limitations and reduction, pursuant to Sections 50(b)(3) and 50(b)(4) as applicable, on account of the tax-exempt partners.

No separate sale of “bonus” credit amounts; only “vertical transfers” are allowed. The Final Regulations adopt the “one credit” concept from the proposed regulations, pursuant to which eligible taxpayers cannot sever the “bonus” credit amount from the base credit and therefore cannot separately transfer the “bonus” credit itself (if, for example, the project is located in an “energy community” or meets the “domestic content” requirement and therefore is eligible for an additional 10% credit). Rather, the transferor-taxpayer is only allowed to transfer either the entire eligible credit amount or a portion of the eligible credit amount, which would include a proportionate share of each component of such credit amount, including any “bonus” credit taken into account (Vertical Transfer). The IRS concluded that because a “bonus” credit is only an increase to the base credit amount, it is not by itself considered as a credit that could be transferred.

Due to the requirement for a Vertical Transfer, both sellers and buyers should always consider the eligibility of the relevant project for both the base amount of the credit and the “bonus” amount, even if otherwise they were expecting to sell or purchase only credits in amount equal to the “bonus” portion.

Cash consideration cannot be paid in advance. The proposed regulations provided that full payment for the purchase of the tax credits must be made no earlier than the year the credit is generated and no later than the due date for filing the transfer election (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 as long as actual payments for purchasing the credits are made within the above timeframe.

Numerous commenters requested that the final regulations allow buyers to also pay in advance for the purchase of tax credits generated in future years (e.g., for PTCs, 45Q Credits, or 45V Credits), similar to the manner in which tax equity investors often fund their investment in advance, based on agreed assumptions and modeling. The Final Regulations rejected these comments and adopted the same “paid in cash” definition and timeline included in the proposed regulations, as described above, with no changes.

One-time transfer limitation and no secondary market. The Final Regulations reiterate the one-time transfer rule and confirm that no liquid trading market is allowed. The preamble to the Final Regulations specifically provides that brokers or intermediaries that act to satisfy the requirement for making a transfer election (including receiving a transfer election statement themselves) may be treated as transferees, which will prevent a second transfer to the ultimate buyer. If a broker or an intermediary provides liquidity and makes payments to the seller of the credits, such payments will be taxable to the sellers, as they will not be received from the transferee taxpayer.

Transfer election can be revised on an amended return. The transfer election must be made on the original filed tax return (including any extensions of time), and no election can be made on an amended return. However, the Final Regulations provide that an eligible taxpayer may make or revise the transfer election on a superseding return, and may correct on its amended return, a numerical error in a transfer election properly made on its original tax return.

We note that correcting a numerical error on an amended tax return requires that there was a substantive item to correct, and it does not include “correcting” a blank item or an item in an initial return or transfer election that is described as being “available upon request.”

Partners’ distributive share of the tax credits can be revised up until the tax return due date. A partner’s distributive share of the tax-exempt income resulting from the sale of tax credits by the partnership is based on that partner’s proportionate distributive share of the applicable eligible credit.

Section 761(c) provides that a partnership agreement includes any modifications of the agreement made on or before the due date (not including extensions) of the partnership tax return for the applicable taxable year. The preamble confirms that a partnership agreement may be revised, including to change the portion of each partner’s share of the eligible credits to be transferred and retained and its share of the resulting tax-exempt income, up until the due date of the partnership’s annual tax return.

Reducing estimated tax payments prior to completing the tax credit purchase. The preamble to the proposed regulations explained that a transferee taxpayer could take into account in calculating its estimated tax payments tax credits that it has purchased or intends to purchase. Addressing certain comments regarding the “intends to purchase” phrase, the preamble clarifies that this phrase refers to a situation in which the taxpayer plans to complete a transaction that would qualify the taxpayer as a transferee-taxpayer but the tax credits were not yet transferred. The IRS and Treasury clarified that even if all the requirements for a tax credit transfer under the Final Regulations have not yet been satisfied, a transferee taxpayer could incorporate the eligible credit in its estimated tax calculations. However, the transferee remains liable for any additions to tax to the extent it has an underpayment of estimated tax (e.g., the tax credit purchase transaction fails to close at a later time).

Impact on REITs. The Final Regulations clarify several issues applicable to real estate investment trusts (REITs) and reiterate certain aspects that were addressed in the proposed regulations, with the intention of facilitating REITs’ participation in the tax credit transfer market.

Recognizing that REITs may continuously earn and sell eligible credits and, therefore, need certainty with respect to their REIT qualification, the Final Regulations provide that eligible credits that have not yet been transferred pursuant to Section 6418 are disregarded for purposes of the REIT’s asset test. In addition, cash received by an eligible REIT as consideration for the transfer of tax credits is not included in its gross income. Because the transaction does not result in any net income, the transfer of tax credits by a REIT does not pose a prohibited transaction tax issue and is also not treated as a sale of property and thus does not count as one of the “seven sales” safe harbor for REITs.

Conclusion

In 2023, the first year in which the tax credits transfer rules were applicable, the market quickly ramped up, and it is estimated that tax credit deals worth approximately $7 billion to $9 billion were executed. The market continued to show significant activity and strength in the first quarter of 2024. The certainty provided by the Final Regulations is expected to increase stability and predictability in the tax credit transfer market and is likely to promote additional growth and increase the number of participants, whether as sellers or buyers, as more companies are entering the market every day.

¹ Treasury Regulation Sections 1.6418-1 through 1.6418-5.
² Unless otherwise specified, all references to “Section” are to the Code.