Recently issued Internal Revenue Service Notice 2020-12 and Revenue Procedure 2020-12 (together, the “new guidance”) provide long-anticipated, albeit incomplete, guidance regarding the tax credit for carbon oxide sequestration (the “carbon capture credit”) under tax code Section 45Q. The new guidance generally tracks similar guidance previously issued by the IRS for wind and solar projects, with a few key differences, which are discussed below.
Under current law, the availability of the carbon capture credit is contingent, among other requirements, on the taxpayer “beginning construction” on a qualified carbon capture facility prior to Jan. 1, 2024. While the new guidance is useful in making the determination when such “beginning of construction” requirement is met, as well as, how to structure investments in such projects and allocate the carbon capture credits among the partners, it does not shed sufficient light on how to determine whether the underlying project qualifies for the carbon capture credit as an initial matter, or under what circumstances such credits might be recaptured, under the ominously vague “recapture” provisions in Section 45Q(f)(4).
Accordingly, the consensus in the industry appears to be that the new guidance, although a welcome development and generally taxpayer-friendly, is lacking and as such will likely fail to significantly jumpstart the initiation of carbon capture projects, the commercial viability of which would otherwise depend on the receipt of the carbon capture credits.
Nonetheless, the IRS has indicated that additional guidance, in the form of proposed regulations, is forthcoming and has solicited comments regarding the relevant aspects of such regulations. We remain hopeful that these regulations will be issued in the near future, providing the industry with much needed clarity on these lingering threshold questions. Only then would developers obtain the certainty needed in order to complete the development of such projects, and investors be able to reach their final investment decisions.
The current Covid-19 pandemic and its economic implications add yet another layer of uncertainty to this industry and, as will be discussed below, additional legislative changes may be needed in order to allow for appropriate investments in this space.
Section 45Q, as amended by the Bipartisan Budget Act of 2018, provides a tax credit to taxpayers who use carbon capture equipment to capture and sequester qualified carbon oxide at a “qualified facility.” To qualify, after capturing the carbon oxide, the taxpayer must either:
- Dispose of the carbon oxide in secure geological storage; or
- Use the carbon oxide (i) as a tertiary injectant in a qualified enhanced oil or natural gas recovery project and then dispose of it in secure geological storage; or (ii) in certain fixation projects using photosynthesis or chemosynthesis, in certain projects involving chemical conversion and subsequent storage, or for certain other purposes for which a commercial market exists, as will be determined by the Treasury Department.
The statute defines a “qualified facility” as an industrial facility or a direct air capture facility that meets certain minimum qualified carbon oxide capture requirements and, as described further below, on which construction began before Jan. 1, 2024.
Carbon capture credits are generated with respect to carbon capture equipment during the 12-year period following such equipment’s “placed in service” date.
The value of the carbon capture credit ranges from $10 to $50 per metric ton, depending on the usage of the captured carbon oxide and the applicable year. Projects that utilize the captured carbon for permitted commercial use, such as enhanced oil recovery, could be eligible for a carbon capture credit of up to $35 per ton. Enhanced oil recovery involves injecting carbon dioxide into existing oil reservoirs in order to push oil to the surface using the created pressure. Projects that capture carbon and securely store it in a “secure geological storage” could be eligible for a greater amount of credit—up to $50 per ton.
Section 45Q further provides that the Treasury Department will promulgate regulations explaining what constitutes “secure geological storage.” The regulations would be issued in consultation with the Environmental Protection Agency and would be designed to ensure that qualified carbon oxide would not subsequently “leak” into the atmosphere after having been captured. No such regulations have been promulgated to date, and neither Notice 2020-12 nor Rev. Proc. 2020-12 provides any insight on this subject.
Moreover, while the party eligible to claim the carbon capture credit would presumptively be the owner of the equipment effecting the capture, the statute provides that such owner may elect to transfer the credit to another party that either stores the carbon oxide or puts it towards a permitted use, pursuant to procedures to be outlined in regulations. Similarly to the above, no such regulations yet exist providing additional insight as to transfers of the carbon capture credit, and neither Notice 2020-12 nor Rev. Proc. 2020-12 addresses the subject.
To finance their carbon capture equipment and qualified facilities (“carbon capture project”), developers are looking into the use of tax-equity structures. These structures are regularly used in wind and solar projects, with the most common structure being the “flip partnership.”
In general, a wind flip partnership is a partnership, for tax purposes, between a developer and one or more tax equity investors (a “project company”). Until the time the tax equity investors achieve an agreed after-tax internal rate of return (flip rate), 99% of all partnership taxable items, including tax credits and losses, are generally allocated to them, with a different (albeit lower) percentage of cash distributions. Once the flip rate is reached, the allocations “flip,” and going forward, the developer generally is allocated 95% of the partnership taxable items and cash, while the remaining 5% is allocated to the investors.
As discussed below, Rev. Proc. 2020-12 adopts and blesses the use of such flip partnerships for Section 45Q projects and for allocating the carbon capture credits among the partners.
Beginning of Construction Requirement
A carbon capture credit is available with respect to a qualified facility only if the construction of such facility began before Jan. 1, 2024, with either (i) the construction of carbon capture equipment used at the facility also beginning before such date, or (ii) the original planning and design for the facility having included the installation of carbon capture equipment.
Generally, consistent with Notice 2013-29 (applicable to wind projects (and together with the additional IRS Notices published afterwards to clarify and enhance such initial guidance, “wind guidance”)) and Notice 2018-59 (applicable to solar projects (and together with the wind guidance, “wind and solar guidance”)), taxpayers may satisfy the beginning of construction requirement by meeting either a “physical work” test or the 5% safe harbor, as provided in Notice 2020-12 (“5% safe harbor”).
Physical Work Test
Under the physical work test, a carbon capture project is treated as beginning construction once a taxpayer has begun work of a significant nature on the project. Whether physical work of a significant nature has occurred is a facts and circumstances inquiry, turning on the nature of the work performed rather than the amount or cost of the work. Physical work may be performed by the taxpayer or by a third party under a binding written contract, and may be performed on-site or off-site.
Notice 2020-12 provides several non-exclusive examples of on-site physical work of a significant nature, including:
- the excavation for and installation of foundations,
- the installation of a system of gathering lines necessary to connect the industrial facility to the carbon capture equipment or other equipment necessary to the qualified facility before transportation away from the qualified facility,
- the installation of components necessary for carbon capture processes, and
- the installation of equipment and other work necessary for the disposal of qualified carbon oxide.
Notice 2020-12 also provides several non-exclusive examples of off-site physical work of a significant nature, including:
- the manufacture of mounting equipment and support structures,
- the manufacture of components necessary for carbon capture processes, and
- the manufacture of components and equipment necessary for disposal of qualified carbon oxide in secure geological storage.
Unlike the wind and solar guidance, Notice 2020-12 does not expressly require that physical work be with respect to property used as an integral part of the carbon capture project. The above examples, however, are largely consistent with such a requirement.
In addition, Notice 2020-12 provides that physical work of a significant nature does not include preliminary activities, such as securing financing, clearing a carbon capture project site, or obtaining permits and licenses. Also excluded is work to produce components of a project that either are in existing inventory or are normally held in inventory by a vendor.
5% Safe Harbor
Under the 5% safe harbor, construction begins once a taxpayer pays or incurs at least 5% of the total cost of the carbon capture project. Relevant costs include all costs included in the depreciable basis of the project as well as certain front-end planning, design, and engineering costs.
Notice 2020-12 provides relief for cost overruns similar to analogous provisions of the wind and solar guidance. If a carbon capture project is a “single project” comprised of multiple qualified facilities or units of carbon capture equipment, and the 5% safe harbor is not met with respect to the project, the taxpayer is nevertheless permitted to treat the 5% safe harbor as satisfied with respect to a proportionate share of the facilities or units. For example, if a taxpayer incurs $250,000 of costs in 2023 to construct a single project comprised of five qualified facilities and, when placed in service in 2026, the total cost of the project is $6 million, the taxpayer may treat the 5% safe harbor as being satisfied in 2023 with respect to four of the five facilities. Notice 2020-12 provides detailed guidance on what constitutes a single project.
It is worth noting that, in contrast to the wind guidance, which allows for the taxpayer to rely on the partial 5% safe harbor as long as it pays or incurs at least 3% of the total cost of the carbon capture project, no such minimum threshold amount was included in Notice 2020-12.
In addition, a taxpayer who fails to satisfy the 5% safe harbor may test the carbon capture project under the physical work test. Accordingly, in the example above, the taxpayer may seek to establish the beginning of construction of the fifth facility under the physical work test.
Once construction has begun, taxpayers must further satisfy an additional “continuity” requirement by making continuous efforts to complete the carbon capture project (in the case of the 5% safe harbor) or by maintaining a continuous program of construction until the completion of the project (in the case of the physical work test).
Notice 2020-12 deems this continuity requirement to be satisfied if the project is placed in service by the end of a calendar year that is no more than six calendar years after the calendar year during which construction began (the “continuity safe harbor”). This six-year safe harbor period is more favorable than the four-year period contained in the wind and solar guidance, and likely reflects the longer time horizon for carbon capture projects as compared to wind and solar projects.
Projects that fail to meet the continuity safe harbor will be tested under a facts and circumstances analysis. As with wind and solar projects, we expect that most taxpayers contemplating tax equity structures in the carbon capture context will also seek to rely on the continuity safe harbor.
Transfers and other Requirements
Notice 2020-12 generally tracks the transfer rules in the wind and solar guidance. Accordingly, Notice 2020-12 provides that a fully or partially-completed facility may be transferred (to a related or unrelated party) without losing its qualification under the physical work test or 5% safe harbor. A transfer consisting solely of tangible personal property, however, generally will cause such property to lose its qualification, unless the transferee and transferor are related. For this purpose, a partner is treated as being related to a partnership if such partner holds a greater than 20% interest in either the capital or the profits of such partnership.
In such cases with respect to carbon capture projects, it is likely that tax equity investors would require the transferor of equipment to remain a partner and a related party to the transferee-entity for a certain period following such transfer. In similar cases involving wind and solar projects, tax equity investors generally require the person transferring only qualified equipment to remain a related party for a period of at least two years following such transfers, to mitigate any concern of the potential applicability of the “disguised sale” rules in Section 707(a)(2)(B). Certain structuring and advance planning could potentially allow for a shorter holding period.
Notice 2020-12 includes further guidance on additional matters and issues, such as binding contracts, master contracts, and look-through rules, which generally tracks similar guidance provided in the wind and solar guidance.
Structure and Safe Harbor for Allocating Carbon Capture Credits
As a general rule, under U.S. tax law, a person is eligible to receive allocations of credits, and other tax items, from a partnership only if such person is treated as a partner in such partnership for U.S. federal income tax purposes.
Rev. Proc. 2020-12 provides a safe harbor (the “carbon capture safe harbor”), pursuant to which the IRS will treat an investor in a project company that is structured as a flip partnership as a partner for all tax purposes. Where such carbon capture safe harbor is met, allocations of partnership items to such investor, including allocations of the carbon capture credits, will be respected for U.S. federal income tax purposes.
For the carbon capture safe harbor to apply, taxpayers must satisfy all applicable requirements set forth in Rev. Proc. 2020-12, which conceptually tracks the structure and requirements provided in Rev. Proc. 2007-65, which sets out the analogous “allocation safe harbor” in the wind project context.
Similar to Rev. Proc. 2007-65, the carbon capture safe harbor explicitly blesses the partnership flip structure. As further explained below, there are, however, several differences between Rev. Proc. 2020-12 and the safe harbor requirements set forth in Rev. Proc. 2007-65.
Bona Fide Equity Interest
Rev. Proc. 2020-12 makes clear that an investment in the project company must constitute a “bona fide equity investment” with a reasonably anticipated value commensurate with the investor’s overall percentage interest in the project company. This generally requires that the value of the interest be subject to both upside and downside risk and not resemble a preferred return representing a payment for capital. The value of the investor’s interest may not be reduced through fees it receives, if the amount of such fees is unreasonable compared with fees or other arrangements in similar projects that do not qualify for carbon capture credits.
While this requirement was not explicitly present in Rev. Proc. 2007-65, many practitioners already consider the issue when structuring flip partnerships for wind and solar projects, based on guidance issued by the IRS for historic rehabilitation tax credits under Rev. Proc. 2014-12. We expect that practitioners will also look to such guidance when applying the carbon capture safe harbor.
Unconditional Investment and Increased PAYGO
When the investor acquires its interest in the project company, it must make an unconditional investment, equal to at least 20% of the total capital investments plus reasonably anticipated contingent investments. The investor must maintain this investment for as long as it maintains its interest in the project company, with the exception that such investment amount may be reduced by distributions out of the project company’s operations. In addition, the investor may not be protected against loss of such investment through arrangements with parties associated with the project.
To address certain concerns investors might have about the uncertainty of the amount of available carbon oxide and its capture and usage processes, Rev. Proc. 2020-12 allows for an increased amount of an investor’s contingent payments, as compared to wind projects. Per the carbon capture safe harbor, up to 49.99% of the aggregate investment of the tax equity investor could be contingent and paid on a “pay as you go” (PAYGO) basis. For this purpose, amounts contributed to pay ongoing operating expenses are not treated as PAYGO.
Put Option Allowed; No Call Option
Unlike for wind projects, the carbon capture safe harbor permits the tax equity investor to have a put option to sell its partnership interest in the project company to the developer, or to any other person involved in the project, as long as the exercise price does not exceed its fair market value as determined at the time the option is exercised.
Unlike wind projects, however, the carbon capture safe harbor does not allow the developer, the investors or any related person to have a call option to purchase the equipment, the project, or the partnership interest of another party.
It is unclear why the IRS deviated on this issue from the guidance it provided for wind projects. Call options, especially those with a fixed exercise price, are a key component of the structure and economics of the parties in wind projects, allowing both developers and tax equity investors some flexibility in managing their exit strategies. It is unfortunate that such a key feature was not included in Rev. Proc. 2020-12. Tax equity investors, however, will likely appreciate the added certainty that put options provide with respect to their own exit strategy, despite their inability to set a fixed exercise price at the outset of their investment.
Guarantees and Carbon Purchase Agreement
In general, an investor may not receive guarantees from parties associated with the carbon capture project with respect to its ability to claim the carbon capture credits or the cash equivalent thereof, receive distributions from the project company, or obtain a particular price for the sale of its interest in the project company. The carbon capture safe harbor does not, however, prohibit investors from obtaining similar guarantees or insurance from third parties, including recapture insurance.
Further, the carbon capture safe harbor specifically permits the investor and the project company to obtain guarantees concerning the performance of acts necessary to obtain the carbon capture credits and the non-performance of acts that would cause the project company to fail to qualify for, or lose via recapture, such carbon capture credits. Permitted guarantees include guarantees relating to proper storage of qualified carbon oxide, as well as completion guarantees, operating deficit guarantees, environmental guarantees, and financial covenants.
Likewise, the carbon capture safe harbor permits agreements entered into on arm’s-length terms between the project company and an emitter or offtaker, concerning the long-term purchase of carbon oxide, leases of carbon capture equipment by the project company, and certain services to be provided by the project company. Unlike power purchase agreements (PPAs) in wind projects, such carbon purchase agreements could be entered into with the offtaker or the emmiter (or between offtakers and emitters), even if they are related to the project company and even if such agreements are “take-or-pay” agreements.
These differences in the permitted guarantees and allowed purchase contracts will provide increased flexibility to carbon capture projects and structures and will allow investors to have greater certainty in their expected economics, which should enhance the level of interest and, ultimately, investment in, such projects.
The Covid-19 Effect
The current Covid-19 crisis and its ongoing economic effects are expected to directly impact the growth of the carbon sequestration industry, in general, and the amount and timing of investments in and financing of projects, in particular. First, expected delays in the supply and delivery of equipment, as well as general delays in the timeframe for construction, may impact the ability of some projects to meet the “beginning of construction” deadline and of other projects to meet the continuity safe harbor.
Second, the expected decrease in the economic performance of many companies, and the resulting reduction in their 2020 taxable income, are likely to affect the general level of market appetite for additional investments in tax credit deals. As such, there is a risk of a significant decrease in investments in and financing of existing and new projects. Tax equity investors may decide to sit on the sidelines until both the market and their own financial situation become clearer.
Similar issues are currently affecting the wind and solar industry. On March 19, 2020, the American Wind Energy Association (AWEA), together with the Solar Energy Industries Association (SEIA), sent a letter to Congress describing the expected impact of the Covid-19 crisis on these industries and calling for urgent legislative changes to address such concerns.
The carbon sequestration industry will require similar actions and policy changes. Most important is the need to address the expected shortage in financing for projects and the monetization of the relevant carbon capture credits. This could be achieved by setting rules similar to those that were issued following the 2008 financial crisis, including alternatives like the former Section 1603 cash grant program, or by providing developers or investors with the ability to receive direct payments for, or refunds in respect of, carbon capture credits, in the event the relevant parties do not have sufficient taxable income to utilize such carbon capture credits.
The industry has been attentively watching the regulatory developments with respect to carbon capture credits since the Bipartisan Budget Act of 2018 turned a tax benefit, the means of qualification for which was not commercially viable, into a promising new incentive that could be available through already-familiar tax equity structures.
No doubt, the new guidance has answered most of the key questions that Section 45Q raised with respect to the qualification and structuring aspects of related projects, and has adopted provisions broadly similar to (and in many cases more taxpayer-friendly than) guidance already familiar to the renewables industry. Nevertheless, the utility of the new guidance is ultimately premised on taxpayers having already successfully concluded that their carbon capture projects and activities will qualify for carbon capture credits—a task that remains unfeasible at the level of certainty most tax equity investors are accustomed to in the current market.
In the absence of guidance geared at fleshing out the crucial threshold determination of credit qualification, taxpayers eager to deploy capital into carbon sequestration projects are therefore likely to remain on the sidelines. Adding to this lack of impetus is the specter of uncertainty surrounding the events and circumstances that will trigger a recapture of such carbon capture credits, further jeopardizing the economic viability of such projects.
As mentioned above, the IRS indicated that additional guidance, in the form of proposed regulations, is forthcoming. What should such additional guidance look like?
More clarity is needed on what qualifies as a “secured geological storage” and what events would trigger a recapture of carbon capture credits.
Some pundits have called for safe harbors providing that as long as certain objectively measureable steps have been taken, e.g., qualification for and maintenance of EPA permits premised on meeting certain federal storage standards and subject to minimum permissible post-capture atmospheric leakage, carbon capture credits will be treated as both (i) having been sufficiently qualified for, and (ii) not subject to subsequent recapture.
In addition, thought should be given to exclusions from recapture for events that are out of the parties’ control, such as leakage due to earthquakes or other natural events or disasters. Further, a fixed recapture period should be set, similar to the five-year recapture period for the investment tax credits under Section 48, to allow for some level of certainty and finality for the tax equity investors’ risk of recapture.
Finally, due to the lost years to develop this industry since 2018, mainly due to the lack of sufficient guidance on critical issues until recently, and the current ongoing Covid-19 crisis, the industry would benefit from an extension of the final deadline of the “beginning of construction” requirement beyond 2023 and from certain legislative changes to mitigate the expected shortage in financing alternatives.
Such additional guidance and legislative changes in this area may represent the tipping point for tax equity investors, who have been largely sitting on the bench and anxiously awaiting the right moment to take to the field.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Hagai Zaifman is a partner at White & Case LLP in New York, Michael Rodgers is an associate in Houston, and Brandon Dubov is an associate in New York.