The Inflation Reduction Act of 2022 (the "IRA") has enacted two significant new ways to monetize, i.e., to turn into cash, federal tax credits generated from clean energy projects such as wind, solar, hydrogen, carbon capture or renewable natural gas projects, among others.
New Internal Revenue Code section 6417 allows certain parties to elect to be treated as having made a payment of tax equal to the amount of their eligible clean energy tax credits. Thus, if the claimant does not have a tax liability against which to use the credits, the effect of the election will be to cause the government to pay a tax refund for the deemed payment of tax. For parties that do not have a tax liability, such as tax-exempt organizations and certain companies with net operating losses, the election will therefore monetize the credit and the claimant is not forced to carry forward such credits to a future year when a tax liability may arise. The election is referred to as a "direct pay" election.
The direct pay election is generally available only to tax-exempt organizations, state and local governments and municipalities, Indian tribes, rural electric cooperatives, the Tennessee Valley Authority and Alaska Native Corporations. There is an exception, however, that allows the direct pay election to be made by any taxpayer (not just tax-exempt organizations) in the case of credits under sections 45Q (carbon capture), 45V (hydrogen) and 45X (the advanced manufacturing production credit), but only with respect to the first five years of the relevant credit period.
The direct pay election evidences a Congressional intent that parties that do not have a federal tax obligation should not be prevented from enjoying the incentives offered for their clean energy investments. Extending direct pay to all taxpayers in the case of hydrogen, carbon capture and advanced manufacturing credits is expected to give a boost to those types of projects.
Credit Transfers (Sales of Credits)
A second very significant new method of monetizing tax credits is offered by the IRA in the form of Code section 6418, which provides that, starting in 2023, taxpayers may effectively sell clean energy tax credits. The transfer must be to an unrelated party and must be for "cash."
The statute provides that the cash consideration is not taxable to the transferor and is not deductible by the transferee. Only current year credits may be transferred; the transferee is to take the tax credit into account in its first taxable year ending with, or after, the transferor's taxable year for which the credit is determined. Credits may only be transferred once. The determination of whether the buyer is unrelated to the seller is to be made under sections 267(b) and 707(b)(1), which generally apply a 50% or less ownership test. The tax-exempt taxpayers eligible for the direct pay election are not eligible sellers of tax credits.
Section 6418(g)(2) provides that if any portion of the credit transferred is determined by the IRS to constitute an "excessive credit transfer," the transferee's tax liability is increased by the amount of such excessive credit transfer plus a penalty equal to 20% of such excessive credit transfer. An "excessive credit transfer" is defined as the excess of the amount of credit claimed by the transferee over the amount of such credit that is allowable. For example, if a credit claimed were disallowed on audit, there could be considered to have been an excessive credit transfer to the extent of that disallowance, in which case the transferee's tax liability would be increased plus the 20% penalty could be applied.
Certain clean energy credits are at risk of recapture, such as the section 48 investment tax credit for energy property and the section 45Q credit for carbon capture and sequestration. Subsequent events, such as a transfer of the section 48 property or, under section 45Q, a leak of the stored carbon, can cause the credit to be clawed back and the taxpayer to become liable for tax to the extent of the previously claimed credit. The parties to a credit sale will need to address which party bears the risk of recapture and provide for appropriate indemnities.
Market for Credit Sales
It is expected that markets, including online services, will develop to match buyers and sellers of credits, along with brokers offering to put buyers together with sellers in exchange for a fee. At this point, these markets are very immature but, with time, we can expect that they will become more organized and "market prices" or a standard discount for credits may develop. Because credits cannot be transferred more than once, however, an open exchange market on which credits could be re-traded is unlikely.
Under pre-IRA law, tax credits generally could not be sold or transferred. Allowing transferability of these clean energy tax credits is expected to expand the universe of potential investors and provide an alternative or supplement to tax equity financing.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.