New investment tax credit regulations issued by the Internal Revenue Service on Friday answered a number of questions that the market has had about investment credits on renewable energy projects, but left some other questions unanswered. 

The regulations are merely proposed. The IRS will collect comments through January 22, 2024.

This is the first wholesale rewrite of the investment tax credit regulations in 42 years.

Most Notable

The IRS confirmed that production tax credits (PTCs) can be claimed on the electricity output from a wind, solar or other renewable energy project while an investment tax credit (ITC) is claimed on a co-located battery. 

This was not a surprise since Richard Neal (D-Massachusetts), the chairman of the House tax-writing committee, said on the House floor shortly before the vote on the Inflation Reduction Act that such a result was intended, but the tax equity market has been waiting for confirmation before financing projects based on split tax credits. 

The IRS confirmed that an ITC can be claimed on the export cable that moves electricity from an offshore wind project to shore and on the substation and transformer on land.  The offshore wind industry had been urging the Treasury to clarify that these assets qualify for an ITC since late 2018. 

The export cable, substation and transformer must be owned by the same taxpayer that owns the rest of the offshore wind project or by a related party. Two companies are considered related if there is more than 50% overlapping ownership.

The IRS said no ITC can be claimed on later improvements to a project, unless the improvements are so extensive as to lead effectively to construction of a new project. The IRS uses an 80/20 test to identify when improvements are extensive enough. The amount spent on improvements would have to be at least four times the value of the used parts retained from the old facility for the owner to be considered to have built a new project. 

This position is contrary to longstanding precedent. An ITC has been part of the US tax code off and on since 1962. The ITC was originally conceived as an inducement to US companies to invest in new plant and equipment. Airlines were able to claim additional ITCs on new engines added to aircraft, and a utility could claim an ITC on a new boiler added to a power plant.

The new proposed regulations say the principle that an ITC cannot be claimed on later improvements does not apply to electricity and hydrogen storage facilities originally put in service in 2023 or later.  However, any such improvement would have to increase the storage capacity by at least 5 kilowatt hours or the hydrogen equivalent.

The IRS did not explain what baseline should be used to test the capacity increase. Batteries degrade over time. However, the IRS suggested that the capacity is determined by the manufacturer, perhaps unintentionally suggesting the capacity is fixed when the battery leaves the factory. 

There is no similar provision for later improvements to thermal storage facilities.

Wage and Apprentice

The tax credits in the Inflation Reduction Act came with significant fine print. The same "prevailing wages" that are paid on federal construction jobs must be paid to mechanics and laborers who work on the project during construction and on any alterations or repairs during the next five years after the project is completed. Qualified apprentices must also be used for at least 12.5% to 15% of total labor hours, depending on when construction of the project starts for tax purposes.

 There is controversy around whether apprentices must be used for work on post-construction alterations and repairs. The IRS said yes in proposed regulations on the wage and apprentice requirements in late August. 

 As a consequence, most companies have been requiring operations and maintenance contactors not only to pay prevailing wages, but also to use qualified apprentices. Failure to do either during the first five years after a project is placed in service leads to recapture of 80% of the unvested ITC claimed on the project. The ITC vests ratably over five years. The project owner can avoid recapture by making a cure payment within 180 days after being notified by the IRS of the failure. For more detail, see "Wage and Apprentice Requirements" here.   

 The new proposed ITC regulations define "recapture event" as a failure to pay prevailing wages, but do not mention failure to use apprentices.

 Any company buying ITCs should make sure the seller reports annually to the IRS on compliance with the prevailing wage requirements during the ITC recapture period. The IRS said it expects such reports to have to be submitted with annual tax returns. The tax credit seller must notify the buyer of any recapture. The buyer must repay the US Treasury for any recaptured tax credit. The buyer is usually indemnified by the seller. 

 Any project with a maximum net output of less than 1 MWac is exempted from the wage and apprentice requirements. 

 The IRS said dynamic glass, fiber-optic solar equipment and microgrid controllers are not eligible for the 1-MW exemption because they do not produce any output.

 Batteries qualify or not based on their maximum net output. The IRS did not explain whether the outputs of a solar rooftop system and related battery are combined or counted only once, but it said a residential rooftop system on a single roof should be treated as a single "unit of energy property."

Thermal equipment, like geothermal heat pumps and solar process heating equipment, is tested based on the energy equivalent of one megawatt of electricity output. One megawatt of electricity output is 3.4 million Btus per hour. For hydrogen storage assets, 10,500 standard cubic feet of hydrogen per hour are equivalent to one megawatt. For anaerobic digesters and landfill gas collection systems that produce methane from biomass, the gas flow rate must be less than 10,500 standard cubic feet an hour, after converting the gas output into a maximum net volume flow using the appropriate high heat value conversion factors found in an EPA table.

Single Project

Anyone developing a project that has two or more phases, that is spread over adjacent properties or that has multiple facilities -- like a wind farm with multiple turbines, adjacent solar and wind projects that share the same substation, or a solar project with a co-located battery -- must determine whether the different parts are a single project. 

This can affect a number of issues, such as when construction starts, how domestic content calculations are done to determine whether the owner qualifies for a domestic content bonus credit, whether a project that straddles an eligible location qualifies for an energy community bonus credit, and how the required apprentice calculations work.

Most of the market has been consulting a set of single project factors that the IRS released in 2013 and repeated in 2018 in Notices 2013-29 and 2018-59 to determine what should be considered a single project.

The new proposed IRS regulations complicate things by adopting two more single project tests.

For purposes of the prevailing wage requirements -- but apparently not the apprentice requirements -- and for purposes of the domestic content and energy community bonus credits -- but not an LMI bonus credit for community wind and solar projects in low and moderate-income areas -- multiple facilities on which ITCs will be claimed will be treated as a single project if they have the same owner and check at least two of seven other boxes at any time during construction.  (Related companies with more than 50% overlapping ownership are treated as the same owner.)

The seven boxes are the separate facilities are constructed on contiguous pieces of land or they have a common offtake agreement, common intertie, common substation, common environmental or regulatory permits, are built under a common master construction contract or are financed under a single construction loan agreement.  A common tax equity financing is not one of the factors.    

Alternatively, if they are treated as a single project under the single project factors in Notices 2013-29 and 2018-59, they will be a single project.

However, a facility on which PTCs will be claimed will not be treated as a single project with a facility on which an ITC is claimed.  Thus, a wind or solar project on which PTCs are claimed will not be a single project with a co-located battery.

Treatment as a single project is not optional.  Either the multiple facilities are a single project or they are not. 

The domestic content calculations may work differently for a wind farm on which PTCs are claimed than one on which ITCs are claimed.  The domestic content guidance the IRS issued in May (Notice 2023-38) appears to suggest the domestic content calculations should be done "facility" by "facility," meaning by testing each turbine, pad and tower separately.  Thus, at least in a wind project on which PTCs will be claimed, some turbines may qualify for a domestic content bonus credit while others do not.  An IRS clarification would be helpful.  The ITC domestic content calculations are done for the entire project.

The new proposed ITC regulations adopt yet another single project test for purposes of a 5-MWac capacity limit on projects that are allowed to fold network upgrade payments to utilities into ITC basis.

New power projects connecting to the utility grid must reimburse the transmission utility for the cost of any improvements needed to the grid to accommodate the additional electricity.  Owners of small renewable energy projects with maximum net outputs of up to 5 MWac can add network upgrade payments to the ITC basis in the their projects as long as the amounts will not be reimbursed by the utility through transmission credits.

The new proposed ITC regulations include four examples that suggest a project owner will not have to treat small adjacent facilities as a single project for purposes of this 5-MWac limit in most cases.

In one example, a solar facility and a wind facility on contiguous pieces of land connect to the grid through the same intertie, but are owned by different taxpayers.  Each has a maximum net output of 5 MW.  They share a common interconnection agreement that allows a maximum output of 10 MWac to be sent to the grid.  The two facilities are treated as separate projects with maximum net outputs no greater than 5 MWac. 

In the next three examples, a company owns three small solar facilities in close proximity.  The maximum net output of each is only 4 MWac.  All three facilities connect to the grid through a common gen-tie line.  In one example, each facility has its own interconnection agreement allowing for a maximum output of 4 MWac.  In the next example, there is a single interconnection agreement covering all three facilities allowing up to 12 MWac of electricity to be supplied to the grid.  In the last example, there is both a single interconnection agreement and a single power purchase agreement covering all three facilities.  In all three cases, the projects are treated as three separate facilities because they are capable of producing only 4 MWac of electricity in fact.

ITC Assets

The new regulations elaborate on what parts of a project an ITC can be claimed.

It can only be claimed on the generating equipment and not transmission assets, intangibles like a power contract, interconnection agreement and renewable energy credits, land and buildings.  Not all structures are buildings.  A structure that is basically a shell over generating equipment that is expected to torn down when the equipment is removed may be considered part of the equipment.

The IRS distinguishes between parts of a project that are "functionally interdependent," meaning they must all be placed in service for the project to work, and components that are integral to the intended use, such as generating electricity.

An ITC can ordinarily be claimed on both, subject to ownership issues discussed below.    

The integral equipment does not have to be physically adjacent to the project. 

Fences are not functionally interdependent or integral.  Roads may or may not be depending on the use.  Access roads that are used primarily for access to the site, or for visitor or employee vehicles, are not integral.  Onsite roads used to move equipment needed for operations and maintenance are integral.

The new proposed regulations confirm that pumped-storage hydroelectric projects are a form of energy storage facility.  The Inflation Reduction Act authorized ITCs for electricity and hydrogen storage facilities and for thermal storage facilities that are directly connected to HVAC systems and used to heat or cool interiors of residential or commercial buildings.

An ITC can be claimed on hydrogen storage equipment, even where PTCs are claimed for producing clean hydrogen at the hydrogen plant that produces the hydrogen, but hydrogen -- rather than a hydrogen carrier like ammonia or methanol -- must be stored, and the stored hydrogen must be used to produce energy rather than an end product like fertilizer.  The IRS asked for comments on what documentation taxpayers should provide to prove the storage is for energy production.

The IRS also said an ITC may be claimed on batteries used to recharge vehicles if they are not in the vehicles.  This may provide another route to an investment tax credit on charging stations that do not qualify for tax credits under section 30C because they are in urban areas.

An ITC can be claimed on "biogas property."  The IRS said the term includes not only anaerobic digesters that convert animal manure and food waste to gas, but also landfill gas collection systems.  The gas must be at least 52% methane when it exits the anaerobic digester or landfill gas collection system.  Equipment to clean or condition the gas also qualifies, but only if the same taxpayer or two companies with more than 50% overlapping ownership own both the anaerobic digester or landfill gas collection system and the cleaning and conditioning equipment.

The IRS distinguished between cleaning and conditioning equipment and "upgrading equipment necessary to concentrate the gas into the appropriate mixture for injection into a pipeline through removal of other gases such as carbon dioxide, nitrogen, or oxygen."  It said the latter is not part of the system on which an ITC can be claimed.  The difference between two types of equipment is unclear.

Ownership Issues

The IRS said that if different taxpayers own different parts of a project that are functionally interdependent, no one can claim an ITC. 

An example is geothermal heat pumps.  A heat pump requires both underground equipment and pipes and ducts in a building above ground to heat the building during winter and withdraw heat to cool the building during summer.  The IRS said that if different taxpayers own the different parts, no one can claim an ITC, unless the two taxpayers have more than 50% overlapping ownership.

Ownership is also an issue with integral equipment.  The regulations say company A cannot claim an ITC on a component that is integral to company B's project, unless A and B have more than 50% overlapping ownership or the component can operate as a standalone energy facility in its own right.  However, the fact that A cannot claim an ITC on its integral component will not stop B from claiming an ITC on the rest of the project.

Dual-Use Equipment

Some equipment, like solar thermal equipment or pipes and ducts that are part of a geothermal heat pump system, qualify for an ITC only if the energy source is at least X% solar or geothermal.  The percentage had been 75%.  The new proposed regulations reduce it to 50%.

The ITC must be prorated to the extent the percentage is between 50% and 100%.  Thus, if it is 70% in the year the equipment is put in service, the ITC is 70% of the ITC that could otherwise be claimed.

The IRS used to require full or partial recapture of the unvested ITC if the benchmark percentage established in year 1 fell in any of the next four years.  The new proposed regulations require recapture only if the percentage falls below 50% in any of the next four years.

Dual use is not relevant to a battery or other energy storage facility.  Thus, it is irrelevant whether a battery stores electricity from the utility grid or a renewable energy source.

80/20 Test

The IRS said the 80/20 test for assessing whether a project has been so extensively rebuilt to qualify as new is applied in ITC projects to each "unit of energy property," meaning "all functionally interdependent components . . . owned by the same taxpayer [or affiliates with more than 50% overlapping ownership] that are operated together and can operate apart from other energy properties within a larger energy project."

Thus, if an ITC is claimed on a wind farm, the 80/20 test is applied to the entire wind farm rather than to each turbine, pad and tower separately.  This may drive the decision whether to claim PTCs or an ITC.  With PTCs, some repowered turbines may qualify as new while others do not.  Moreover, with PTCs, equipment that is not part of a turbine, pad and tower, like a step-up transformer, can be excluded from the test.  With an ITC, either the entire project is new due to extensive rebuilding or it is not.

The IRS said recycled components can be treated as new spending for purposes of the 80/20 calculations when weighing improvements to a battery or hydrogen storage facility.  Batteries have more complicated issues than other assets because they must be augmented over time to offset degradation of battery cells.  The IRS asked for comments on use of recycled components, including whether "second life" batteries should be considered new components for assessing the amount of new spending versus the value of used components. 

Other Issues

The IRS said no ITC can be claimed on assets whose tax basis is deducted entirely in the year the project is placed in service.  This does not apply to projects on which a depreciation bonus is claimed. 

An example is where a business buys business equipment, like batteries or electric vehicles, whose costs are deducted under section 179 of the tax code.  Section 179 allows up to $1 million a year in asset cost to be expensed, meaning deducted immediately.  The $1 million is reduced to the extent the assets cost more than $2.5 million.

Many companies ask whether tax credits can be "stacked" by claiming more than one federal tax credit on the same project. 

The IRS said another federal credit cannot be claimed on the same tax basis on which an ITC was claimed.  It also said section 45Q tax credits cannot be claimed for capturing carbon emissions using capture equipment "included in any . . . facility" on which an ITC is claimed.

The IRS said in Q&A 27 in Notice 2013-70 that where a rooftop solar system is owned by a homeowner who uses it both to generate electricity for his or her own use and also to sell excess power through net metering to the local utility, the homeowner must determine the percentage of the solar system that is put to residential use as opposed to use generating excess electricity for sale.  A residential solar credit can be claimed by the homeowner under section 25D of the tax code only to the extent of the residential use.

The proposed regulations confirm that an ITC can be claimed on the rest.  The two tax credits would not claimed on the same tax basis in such cases.  The IRS did not address the potential recapture issues in such cases if the percentage of the project considered put to business use changes before the end of the five-year ITC recapture period.

Some projects share facilities such as a common substation and transformer.  The IRS said the cost of these facilities must be "properly allocated" between the two facilities.  For example, if adjacent solar and wind projects use the same substation and each pays 50% of the construction cost, each would include the amount it pays in basis.

Developers have a choice of claiming PTCs or an ITC on most renewable energy projects.  Some types of projects, like wind farms, qualify for PTCs, but an election must be made under section 48(a)(5) of the tax code to claim an ITC on the project.   

Many people ask whether the election requires showing that the project can check all the boxes required to claim PTCs before a valid election can be made to claim an ITC instead.  For example, to claim PTCs under current law, the electricity ordinarily cannot be sold to affiliate.  The IRS said electricity sales to an affiliate are not a bar to electing an ITC on the project.