On July 27, 2022, Senators Manchin and Schumer released the text of the proposed Inflation Reduction Act of 2022 (IRA),1 which would extend and expand the tax credits associated with clean energy. In a change from prior proposals, the IRA would narrow the previously proposed direct pay regime2 that would allow an election of a cash payment from the IRS in lieu of tax credits. As narrowed, the direct pay rules would apply only to (i) tax-exempt and governmental entities or (ii) taxpayers generally that are claiming credits for hydrogen production, carbon capture or advanced manufacturing production.
However, the IRA proposes a "transferability regime"3 that would allow project owners to monetize the credits by transferring them to other taxpayers - selling tax credits for cash. A follow-up to Direct pay ain't all it's cracked up to be, this article explains the mechanism of transferability and what the new proposed regime means for renewable energy developers.
What is transferability regime?
Transferability regime is a legislative proposal whereby taxpayers can sell all or part of their tax credits to an unrelated party. The sale must be for cash, and there is a 20 percent penalty if the claimed credit exceeds what the project was entitled to. The proceeds would be exempt from income but not deductible to the buyer. However, once a credit is transferred, the transferee cannot transfer it further. Also, credits which have been carried back or carried forward may not be transferred. The IRA would expand the carry back period for tax credit from one year to three years and the carry forward period from 20 years to 22 years.
In contrast to direct pay, transferability would be a market based system whereby project owners would have to incentivize tax credit buyers to purchase their tax credits by offering the credits for less than 100 cents on the dollar. Most project owners will be ineligible for the direct pay regime, which would have yielded them 100 cents on the dollar for their tax credits.
Also, "applicable entities" as defined for direct pay purposes (i.e., a tax exempt entity, a State or local government, the Tennessee Valley Authority, an Indian Tribal Government, or any Alaska Native Corporation) may not transfer credits; Senators Manchin and Schumer, apparently, did not want these entities to tangle with tax credit buyers. The transferability rules do not relax the passive activity loss rules that apply to individuals, so the buyers of tax credits will continue to, generally, be banks, insurance companies and publicly traded corporations.
If a project is owned by a partnership, the partnership would be the entity to make the transferability election and sell the tax credits.4 It appears that if a partnership has an "applicable entity" (e.g., a tax exempt entity) and a regular taxpayer, that the partnership may not qualify for either transferability5 or direct pay.6
The mechanics of transferability regime
Unlike the direct pay proposal in Build Back Better Act, neither the IRA's transferability nor direct pay rules impose requirements on projects that do not apply energy tax credits generally. Specifically, whether using transferability, direct pay or using tax credits in the usual manner, sixty days after rules are published by the IRS, projects over one megawatt must pay wages comparable to what union workers are paid and apprentices must be hired (or show that there is not an apprenticeship program in the area).
Also, whether tax credits are transferred or not, there are three tax credit bonuses available: a ten percent bonus for the production tax credit (i.e., an additional $2.60 per mWh for the wind production tax credit) and a ten percentage points bonus for the investment tax credit (e.g., 40% rather than 30%) for each of (i) meeting the domestic content requirement, (ii) locating the project in an energy community (generally communities with job losses due to the closure of coal mines or coal-fired projects or building on a brownfield site) or (iii) for projects less than five megawatts (a/c) locating in low income communities.
An assignment agreement of a transfer
When parties decide to transfer a credit, they will need to enter into an assignment agreement. Even though, it sounds simpler than a partnership agreement or a lease, the agreement will still need to contain certain complex provisions. For instance, a buyer will likely want to include conditions precedent that will need to be satisfied before the buyer contribute to ensure that the project qualifies for tax credits. These conditions precedent will likely include a tax opinion, to give the buyer comfort the project in fact qualifies for the tax credits it is purported to, and for investment tax credit projects a cost segregation report and an appraisal to confirm the amount of the investment tax credit.
Further, the buyer will likely include an indemnity provision. The IRS can still challenge the amount of the tax credit claimed by the buyer. Such challenge is less likely with production tax credits, but history shows that taxpayers and the government can disagree about the amount of basis eligible for an investment tax credit. Therefore, the buyer will want some kind of protection in the form of an indemnity. The project owner and the buyer of the credit would need to negotiate (1) what payment assurance supports the indemnity; (2) how long the indemnity last will last; (3) in case of an IRS audit (i) what rights will the seller would have to refute assertions by the IRS that the tax credit was overstated (ii) what the seller's obligation is to provide information and assistance; and (4) the seller's responsibility for the buyer's legal and accounting fees to contest any IRS audit. Indemnity payments would be taxable income to the tax credit buyer, so the tax credit buyer would likely require that assignment agreement that indemnity payments be grossed-up for the income tax imposed thereon.
It is unclear in the proposed transferability rules as to what happens if an owner of an investment tax credit project decides to transfer the project (or more than a one-third interest therein) in the first five years of its operations or to remove it from service: would the project owner or the tax credit buyer suffer the recapture? This needs to be clarified in legislative history or guidance published by the IRS. If the buyer of the investment tax credit could suffer recapture due to a transfer by the owner of the project or the project being removed from service, the buyer will want the assignment agreement to restrict the owner's ability to transfer during the five year recapture period and have the owner commit to operate the project in accordance with prudent industry practice.
The indemnity issue will also likely make sponsors with strong balance sheets more attractive than thinly capitalized sponsors. Therefore, there will likely continue a "Tale of Two Cities" with well-capitalized sponsors able to sell their credits on the most favorable terms while new market entrants receiving a relatively cold reception from buyers who will be concerned about their ability to satisfy an indemnity.
What about accelerated depreciation?
Taxpayers may assume that if a refund is available for renewable energy tax credits that a refund would also be available for accelerated depreciation. The proposed transferability rules, however, do not monetize accelerated depreciation. Even though the accelerated depreciation is a less valuable tax attribute than tax credits, it still something sponsors will want to capture value for. If a sponsor is going into a deal to monetize the depreciation in transaction with a tax equity investor, then why not also include the tax credits.
Investment tax credit and transferability
It will be difficult to qualify for an investment tax credit for more than cost (e.g., $80) without third party investor forming a partnership to sell the project for fair market value (e.g., $100). Pursuant to the Treasury Regulation Section 1.1502-3(a)(2), a sale between members of a consolidated group does not result in a step-up for investment tax credit purposes. Forming a partnership between affiliates to avoid the regulation would require negotiating the partnership anti-abuse rule.7
Production tax credits and transferability
Production tax credits are generated over a ten year period. Revenue Procedure 2007-65 requires a tax equity investor to make a 20% minimum investment at the outset and a total of 75% (i.e., another 55%) to be fixed and determinable (i.e., not contingent based on performance of the project). In practice, this means that 75% is usually funded upfront in tax equity partnership deals. In contrast, tax credit buyers are likely to want pay for tax credits year-by-year.
For sponsors to receive the cash upfront to cover construction and other costs for production tax credits, they are either going to need to motivate the buyers to pay in advance but at a discount or to "factor" the future payments from the buyer with a lender. Then there will be a question of what happens if the project under produces, so there are fewer tax credits available for the buyer. Such a scenario would likely be addressed by sizing the payment for future tax credits or the factoring thereof at the "P99" production forecast. However, that requires an independent engineer's report to provide a forecast, and for the tax credit buyer or factoring financier to be comfortable with that forecast. Further, there is a 98 percent probability that the project will produce in excess of that forecast, so if the tax credit buyer pays in advance for credits from future years the project owner would likely ask the buyer to make an additional payment for additional production. Alternatively, it appears the project owner could sell such additional credits to a different taxpayer. Such complexity diminishes the appeal of transferability versus tax equity structures.
Reduced tax benefit for transferability
The proposed transferability rules provide that the buyer does not qualify for a tax deduction for its payment for the tax credits. Currently, tax equity investors are entitled to a 50% tax deduction for the value of the investment tax credit allocated to them;8 there is no basis adjustment for production tax credits, so effectively all of a tax equity investor's contribution for production tax credits is tax deductible. Therefore, a tax equity investor is entitled for tax deductions for each dollar of tax equity contribution that a buyer of tax credits would not be entitled to. Therefore, everything else being equal, a corporate taxpayer would receive more benefit from a $1 investment in a tax equity deal than from purchasing $1 of tax credits. The proposed transferability provide that the payment received by the seller is not subject to tax.
The 50 percent basis reduction for the investment tax credit would be applied to the project owner. This is necessary because the tax credit buyer has no basis in the project.9
The newly proposed transferability regime could be a game changer for the tax equity market. It can expand the base of potential investors and simplify structures of projects. However, the regime will not apply to depreciation and will not entitle the buyer of the tax credit to any tax deductions, which means that legacy tax equity financing structures will continue to be relevant. Further, transferability has its own complexity that the market will need to adapt to.
 IRA is a budget reconciliation bill authorizing $369 billion in spending on energy and climate change, $300 billion in deficit reduction, 3 years of Affordable Care Act subsidies, prescription drug reform, and tax reform.
 Direct pay was a legislative proposal whereby tax credits for newly constructed wind, solar and other renewable energy projects as wells as carbon capture tax credits would be treated as a payment of tax. If the taxpayer, taking into account the deemed tax payment for the credits, had "overpaid" its taxes it could elect a cash refund from the IRS.
 See Inflation Reduction Act of 2022, H.R. 5376, 117th Cong. Transferability regime would be provided for in new Internal Revenue Code section 6418, the text of which starts on page 514 of the PDF version.
 Proposed Internal Revenue Code section 6417(c)(1)(A). The direct pay proposal does not address a tax-exempt entity as a member of a partnership.
 Treas. Reg. § 1.701-2 - Anti-abuse rule. The anti-abuse regulations permit the IRS to recharacterize a transaction that involves the use of a partnership, if a principal purpose of the arrangement is to reduce substantially the present value of the partners' "aggregate federal tax liability" in a manner inconsistent with subchapter K. Essentially the rule prevents a taxpayer using a partnership to obtain a tax benefit that is not available without a partnership subject to effectively business purpose exceptions.