The Inflation Reduction Act, which provides financing, initiatives, and offers option for transferable energy tax credit and incentives hasten the shift to a clean energy economy, is the most significant piece of climate legislation in American history.
Enacted into law on Aug. 16, 2022, introduces federal tax credit investment opportunities that don’t require tax equity structures and allow for the purchase and selling of certain federal tax credits like several states now allow.
Days before Congress’s 2022 August Recess, the U.S. Senate surprised many by announcing a significant legislative proposal to meet today’s climate and energy security challenges. The Inflation Reduction Act of 2022, a budget reconciliation package that won’t gain the same bipartisan support as more recent legislation, represents the compromise needed to activate opportunities that reclaim the promise of a better tomorrow. (Photo by https://sustainablepittsburgh.org/)
There are two important elements of the Inflation Reduction Act pertaining to federal income tax benefits.
Provisions for direct pay. While some federal income tax credits for renewable generation are only refundable to tax-exempt entities, others, such as those for carbon capture, clean hydrogen, and the production of components for renewable generation facilities, are refundable to both taxable and tax-exempt entities at 100% of their value through direct payment.
Tax-credit transfers. For taxable entities, these credits can be marketed by transfers to a third party at a stipulated sum.
The transferable credits can be used by all taxpayers, unlike many direct pay credits that are typically only available to tax-exempt taxpayers and certain credit categories. Depending on the guidelines for passive activities, individual use may be limited.
The direct sale of federal income tax credits has long been forbidden by federal tax law, which causes the value of the credits to depreciate in the hands of developers or other owners who lack the tax responsibility to utilize such credits.
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The law evolved to allow certain credits, and accelerated tax depreciation, to be created in a partnership and, if certain requirements are followed, to be awarded to the partners having tax capacity in exchange for an advance financial payment to the partnership or directly to the other partner.
In these deals, the partners with tax capacity are known as tax equity investors. The transactions themselves are called tax equity transactions or flip partnership transactions because the tax equity investor’s allocation of partnership items is lowered, or flips down, after allocation of tax credits and depreciation deductions.
Since they offer substitutes for frequently expensive and complicated tax equity arrangements, transferable credits could be a game changer for those who construct and own renewable energy and other sorts of clean energy projects.
An Overview of Clean Energy Tax Legislation in the Inflation Reduction Act. The Inflation Reduction Act of 2022 is the largest ever commitment made by the United States to fight climate change, in the form of almost $400 billion in tax incentives aimed at reducing carbon emissions and accelerating the country’s energy transition away from fossil fuels. (Photo via https://www.mossadams.com/)
Developers and other owners will need to weigh the value of transferring credits against the expense of not being able to monetize the tax depreciation connected with the project, which isn’t transferable or eligible for direct pay under the Inflation Reduction Act.
Given the complexity and increased transaction costs associated with traditional tax equity transactions, small and medium-sized projects might profit from transferring credits versus setting up a tax equity structure. This choice may also be influenced by the returns that tax equity investors seek against the discounts that tax credit buyers demand.
The capacity to transfer credits before or soon after generation would be advantageous with regard to credits created over time, such as production tax credits (PTC), as it could enable more effective bridging financing and engineering, procurement, and construction contract payoffs.
On August 16, 2022, President Biden signed the Inflation Reduction Act (IRA) into law. The IRA includes a myriad of tax credits, grants and loan programs aimed at accelerating the transition to clean energy. Among the many clean energy provisions contained in the IRA, the IRA extends certain tax credits, expands the eligibility for certain tax credits, creates new tax credits, and provides a mechanism for tax exempt entities, like municipally-owned utilities and electric cooperatives, to monetize the benefit of tax credits. Below is a general summary of the tax credits of the IRA available for utility-scale solar and energy storage projects. (Photo via https://www.dykema.com/)
The time of the transfer may affect the financing costs for taxpayers who are producing credits, but the IRS has not yet released guidance on the credit transfer procedure.
Credit transferability (new Sec. 6418): The Inflation Reduction Act has provisions that permit the transfer of some credits. An eligible taxpayer may decide to transfer all (or any portion stated in the election) of an eligible credit to an unaffiliated transferee taxpayer in accordance with the new Section 6418. However, the transfer must be made in cash, cannot be deducted by the paying taxpayer, and is not allowed to be counted as income for the recipient taxpayer. Moreover, the transfer must only occur once (i.e., the transferee cannot make a subsequent election to further transfer any portion of the transferred credit).
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The taxpayer must opt to transfer the credits no later than the due date (including extensions) for the tax return for the tax year for which the credit is determined, and such choice, once made, is irrevocable. For the following tax credits, the transfer election under new Sec. 6418 is an option:
Tax credits for clean vehicles
- IRC Section 30C alternative fuel vehicle refueling property credit.
Tax credits for generating renewable energy
- IRC Section 45 renewable electricity production credit.
- Energy investment tax credit under IRC Section 48.
- Credit for clean electricity production under IRC Section 45Y.
- Nuclear power production credit under IRC Section 45U.
- Investment credit under IRC Section 48E for clean electricity.
Tax incentives for carbon sequestration
- IRS Section 45Q credit for sequestering carbon dioxide.
Tax incentives for Clean fuel
- IRC Section 45V clean hydrogen production credit.
Tax credits for manufacturing energy
- Credit for advanced manufacturing production under IRC Section 45X.
- IRC Section 45Z clean fuel production credit.
- Advanced energy project credit under IRC Section 48C.
Many of the largest utility scale projects, such as wind and solar, will probably still use traditional tax equity, while the middle market and newest technologies may elect to transfer the tax credits under the new Inflation Reduction Act provisions. (Photo via https://www.bizjournals.com/)
By means of Notice 2022-50, the IRS has invited feedback on the Inflation Reduction Act’s transferability and direct pay requirements by November 4, 2022. Practitioners are left with questions as people wait for direction from the IRS and the Secretary of the Treasury.
So far, it has been established that neither the cash payment made by the transferee nor the cash payment made by the transferor is deductible as a tax payment or other business expense.
Because such gain isn’t clearly mentioned as being exempt, buyers can anticipate some gain when using the credit based on the discount.
Given that not all states adhere to the IRC, it is unclear how states will handle the proceeds from federal tax credit transfers and matching payments. This lack of consistency could result in unequal treatment of the gain on the sale and purchase discount throughout the states.
Penalties occur in the case of an inflated credit and equal the amount of credit overstated plus an additional 20%, unless taxpayers can establish good reason, the boundaries of which aren’t yet defined. The secretary may choose to waive penalties.
The IRS may provide further explanation on the penalties because Section 6418 contains a transferee fair cause exception with respect to penalties from excessive credit transfers and Notice 2022-50 explicitly asked views on this subject.
Progress expenditure credit transfers are not permitted and would require that the project be operational for the credit transfer, though the specifics of the transfer procedure are still being worked out. Bought tax credits have a three-year carryback period and a 22-year carryforward period, and they can only be transferred once.
A flow-through entity, including S corporations (S Corp), may choose to transmit a credit earned by the entity. This choice is made at the entity level. Based on the member’s or shareholder’s distributive share, the amount received qualifies as tax-exempt income under IRC Sections 705 and 1366.
According to IRC Section 50, the basis of the associated property is subject to a 50% reduction of the credit amount (c). If a S corporation or partnership can buy credits and pass them on to the owner, more clarification is required.
On August 16, 2022, President Biden signed into law the most significant piece of legislation for the renewable energy and storage space in almost 20 years. The Inflation Reduction Act (IRA) is a slimmer version of the Build Back Better bill that West Virginia Senator Joe Manchin opposed in its original form. The federal government will provide tax incentives up to $369 billion for new solar, wind, thermal, and energy storage devices over the next decade. The IRA was signed into law just as some renewable energy provisions were about to lapse. The former laws also did not provide any federal tax incentives for the standalone energy storage or clean hydrogen industries. (Photo via https://www.marcumllp.com/)
The transferee must start utilizing the credit in the transferor’s first applicable tax year.
For instance, if a transferee acquires a tax credit for investments under IRC Section 48 in 2023, the year the project was put into operation, the transferee must first file a tax credit claim in 2023.
A transferor may elect to transfer these specific credits as early as February 12, 2023, and no later than the extended due date of their tax return, as appropriate.
For instance, if a partnership starts a project that qualifies for a transferable tax credit on February 1, 2023, they won’t be able to choose to transfer the credits until February 12, 2023. They would then have until the 2023 tax year’s extended due date, which is September 15, 2024, to transfer the credit just once.
The credits may be used beginning with the 2023 tax year and then carried back three years to the 2020 tax year or ahead to the 2045 tax year by a taxpayer or buyer who purchases them.
The credits may be used beginning with the 2023 tax year and then carried back three years to the 2020 tax year or ahead to the 2045 tax year by a taxpayer or buyer who purchases them.
Elections to transfer relevant investment tax credits and production tax credits are made in the year the credits are generated. Such election, once made, cannot be changed with respect to credits that are carried either backwards or forwards.
Although comments regarding Notice 2022-50 with regard to IRC Section 6418(a) have been requested, the exact date and method of making the election are still unknown.
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Transferable credits under the Inflation Reduction Act are planned to have information reporting and registration procedures established by the IRS, as well as ways to track and report transfers by type, amount, and year.
Negotiating purchase and sale agreements may be difficult until this information is available, although some buyers and sellers may enter into letters of intent while waiting for this guidance for projects that are still being built. Before providing funds to support development, tax credit lenders may ask to see signed contracts.
Credit buyers will be held responsible for any credits that are reclaimed. Due to this, buyers and sellers may think about including an indemnification clause and purchasing credit risk insurance.
Tax credit buyers should consider engaging with their tax and legal advisers when establishing tax credit transfer agreements to determine suitable safeguards and indemnification clauses. An independent CPA project cost audit of the tax credit basis may also be requested by some buyers.
Credit buyers may decide to purchase insurance or demand that the seller insure the credit against specific risks. Although tax credit insurance has a lengthy history, the majority of the time it is used nowadays for tax equity transactions for credit programs.
In tax equity transactions, the four most typical risks are:
Structure.
Qualification.
Valuation.
Recapture.
The year of the credit may potentially be a danger if an IRS audit deemed that the facility wasn’t taken into operation during the year the credit was transferred and applied.
Credit buyers will need to think about the credit transfer risks and assess the requirement for tax credit insurance once the IRS issues guidelines on the credit certification and registration procedure.
In the event that some applicable firms’ tentative minimum exceeds their ordinary U.S. federal income tax due plus their base erosion and anti-abuse tax liability, the act levies a new 15% corporate alternative minimum tax (CAMT) on them (BEAT).
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The estimated minimum tax for an applicable corporation is 15% of its annual adjusted financial statement income (AFSI), up to the amount that it exceeds the CAMT foreign tax credit for the tax year.
If a corporation is subject to the CAMT, tax credits under the terms of the Inflation Reduction Act may be used to offset the corporate tax. The overall credit is capped at 75% of the taxpayer’s excess net income tax beyond $25,000 (the first $25,000 is unrestricted).
Several questions remain unanswered regarding federal transferrable credits after the Inflation Reduction Act’s passage, including:
The rules’ applicability in the context of partnerships is unclear. For example, it is unknown whether partnerships formed solely to buy tax credits will be recognized as legitimate tax partnerships or whether partnerships can combine conventional tax equity arrangements to monetize depreciation with the sale of credits outside of the partnership.
It is still unclear how these credits affect particular taxpayers and whether laws governing passive activity income apply. Whether transferable credits can be used to offset portfolio income such as interest, dividends and capital gains also remains a concern.
Unless they materially participate in the trade or business giving birth to the credit, individual taxpayers are currently the only ones who can use federal tax credits to offset passive activity income.
Although the market for federal transferable tax credits has not yet developed to its full potential, discounts might be anywhere from 6% and 15% or more depending on a number of variables, including:
- Credit amount.
- Strength of indemnity.
- Kind of credit and transfer procedure.
- Quality of energy offtake agreements.
- Tax credit insurance is present.
- Timing of IRS guidance releases.
- Preferences in governance, society, and the environment.
- Geographic location of the project.
- Taxability of gain on purchase discount.
Beginning in 2025, taxpayers with zero emissions facilities would have the option to choose between a new technology neutral PTC or ITC. (Photo via https://www.velaw.com/)
According to predictions, the Inflation Reduction Act will likely hasten the adoption and use of sustainable energy technologies. With some program restrictions, some people are already rushing to get their projects to market.
While the middle market and newest technologies may choose to transfer the tax credits under the new Inflation Reduction Act provisions, many of the larger utility size projects, including wind and solar, are likely to continue using traditional tax equity.
