On February 19, the long-awaited initial carbon capture tax credit guidance was issued by the IRS. The guidance is divided between two documents: Revenue Procedure 2020-12 and Notice 2020-12. Below is an overview and some initial observations. This is the first round of guidance as important issues remain to be addressed.
Section 45Q provides a tax credit for the capture of “qualified carbon oxide.” The tax credit is based on each metric ton of carbon oxide captured for the first 12 years of the operation of the carbon capture equipment. The dollar amount of the tax credit depends on what is done with the carbon oxide and when the carbon capture equipment is placed in service, but the amount varies from $10 to $50 per metric ton.
Tax Equity Partnership Guidance in Revenue Procedure 2020-12
The revenue procedure provides a safe harbor for partnership tax equity transactions. The safe harbor is a hybrid of principles from the wind safe harbor in Revenue Procedure 2007-65 and the historic tax credit safe harbor in Revenue Procedure 2014-12.
Revenue Procedure 2020-12 has an example of a “flip” partnership transaction that is similar to the example in Revenue Procedure 2007-65. The partnership has two partners: an investor and a developer. The investor is initially allocated 99% of the profit and loss (including tax credits) and the right to cash distributions in varying percentages; upon the investor achieving an agreed after-tax internal rate of return, the partnership “flips” with the investor being allocated 5% of the profit and loss and having a 5% cash distribution right. The developer is allocated the balance of the tax attributes and distributed the balance of the cash.
50 Percent PayGo
Revenue Procedure 2020-12 varies from Revenue Procedure 2007-65 in some critical ways. First, the investor may make up to half of its capital contributions on a “paygo” basis (i.e., based on the amount of carbon captured and, accordingly, the amount tax credits generated), while Revenue Procedure 2007-65 permits only 25% of the capital contributions to be subject to a paygo arrangement. This increased threshold provides tax equity investors with important flexibility as half of their investment can be contingent on the project’s performance.
After-Tax IRR Flip Point
Revenue Procedure 2020-12 follows the “flip” mechanics from Revenue Procedure 2007-65, rather than Revenue Procedure 2014-12: Revenue Procedure 2014-12 provides that the flip can occur on a date certain in historic tax credit transactions, while there is no comparable language in Revenue Procedure 2020-12; its example has the flip occurring upon the investor’s achievement of “an agreed after tax internal rate of return” which is the same language as Revenue Procedure 2007-65.
Put Right at Then Fair Market Value
Revenue Procedure 2020-12 provides that the investor may have the right to “put” its partnership interest at a price equal to the then fair market value of the interest to the developer. This can give the investor confidence that it can exit the transaction, although, it does not know in advance at what price. This parameter is consistent with the safe harbor for historic tax credits in Revenue Procedure 2014-12. In contrast, Revenue Procedure 2007-65 only permitted the developer to have a “call” option over the investor’s interest and at first required the call price to be then fair market value; however, after requests from wind developers, the IRS in Announcement 2009-69 softened the rule to provide that a fixed price that was a reasonable projection of fair market value was permissible.
Revenue Procedure 2020-12 contains arguably vague caveats that were first introduced in Revenue Procedure 2014-12. These include:
- “The Investor’s Partnership Interest must constitute a bona fide equity investment with a reasonably anticipated value commensurate with the Investor’s overall percentage interest in the [tax equity partnership], separate from any federal, state, and local tax deductions, allowances, credits, and other tax attributes to be allocated … to the Investor.”
- “The value of the Investor’s Partnership Interest may not be reduced through fees (including developer, management, and incentive fees), or other arrangements, that are unreasonable compared with fees or other arrangements for a carbon oxide capture [equipment] that does not qualify for the Section 45Q Credit.”
- “The Investor’s return from its investment in the [tax equity partnership] must not be limited in a manner comparable to a preferred return representing a payment for capital.”Finally, Revenue Procedure 2014-12 contained language that the historic tax credit industry requested that “Nothing … prohibits the payment of any accrued but unpaid fees, preferred returns, or tax distributions owed to the Investor.” Possibly in the interest of brevity, that clarifying language is not in Revenue Procedure 2020-12.
Notice 2020-12 provides definitions of certain key terms and guidance on beginning construction for tax credit qualification purposes.
The beginning construction guidance is important because for carbon capture projects to qualify for tax credits construction must being prior to 2024. Notice 2020-12’s start of construction guidance is generally consistent with the guidance in Notice 2018-59, which applies to the solar projects , which is generally consistent with the guidance in Notice 2013-29 and its progeny which apply to wind projects.
Like the solar and wind notices, Notice 2020-12 contains two methods to “begin construction” either (i) spend five percent of the ultimate tax basis of the project or (ii) undertake “significant physical work,” which can be done offsite or onsite, and, if necessary, by a contractor that signs a binding written contract prior to starting work.
Six Year Continuity Safe Harbor for Beginning Construction
Further, like the solar and wind notices, Notice 2020-12 requires that the project be continually advanced from the time that construction is deemed to have begun through completion of the project. Further, like the wind and solar notices, it provides a “continuity” safe harbor if the project is completed within a certain number of years, it will be deemed to have satisfied the requirement of continuous advancement. For wind and solar, that is four calendar years after construction started, so if a wind project began construction in 2016 then to meet this safe harbor it must be operational by the end of 2020. However, carbon capture was given six calendar years.
The begun construction deadline for carbon capture is not later than 2023, which means that those projects could not be operational until 2029 and meet the tax credit deadline. One can only speculate if the reason for the longer safe harbor period was a view that carbon capture projects take longer to construct than wind and solar projects. The offshore wind industry would be grateful if a similar six year period was extended to it in light of the permitting and engineering challenges it is contending with.
Notice 2020-12 contains five technical definitions: “qualified carbon oxide,” “qualified facility,” “industrial facility,” “direct air capture facility” and “carbon capture equipment.” Feedback from the industry is needed to determine if these definitions merit clarification or revision.
Tax Credit Recapture Awaits to be Addressed
There is vague statutory language providing for tax credit recapture that has been an obstacle to tax equity investments in carbon capture projects. This initial round of rules provided little comfort on this issue.
The statutory language is “Secretary shall, by regulations, provide for recapturing the benefit of any credit allowable … with respect to carbon oxide which ceases to be captured … in a manner consistent with the requirements of this section.” This language leaves the reader wondering if one molecule of carbon released one century later results in recapture of all of the tax credits claimed with respect to carbon captured by the project in question, which would admittedly seem to be an unreasonable result. We have to wait for guidance on this issue.
The only recapture comfort provided in the initial guidance is in Revenue Procedure 2020-12 which confirms that taxpayer may enter into contractual arrangements to protect itself from this risk: “This requirement does not prohibit the Investor from procuring insurance, including recapture insurance, from persons not related to the Developer, any other Investor, an Emitter, or an Offtaker.” Further, guarantees are permissible:
The following guarantees may be provided to the Investor or the [tax equity partnership]: (i) guarantees for the performance of any acts necessary to claim the Section 45Q Credit (including ensuring proper secure geological storage of the qualified carbon oxide through disposal, or use as a tertiary injectant, or utilization); and (ii) guarantees for the avoidance of any act (or omissions) that would cause the Project Company to fail to qualify for the Section 45Q Credit or that would result in a recapture of the Section 45Q Credit.
But among other issues, insurance and guarantees typically have fixed periods during which they apply, while the statutory language does not specify an outside date after which tax credit recapture cannot be triggered. The industry can only hope that the second round of guidance is published promptly and addresses tax credit recapture in a commercially pragmatic manner.