/>iThis past summer, the Treasury and Internal Revenue Service (IRS) published proposed Treasury Regulations (88 FR 40528 and 88 FR 40496) under two key provisions of the Inflation Reduction Act of 2022 (IRA) designed to enable taxpayers and tax-exempt entities to monetize certain energy-related federal tax credits. Section 6417 allows certain tax-exempt and governmental entities that historically could not benefit from such tax credits to receive direct payments from the government in lieu of such tax credits. Section 6418 permits taxpayers to transfer all or a portion of certain energy-related tax credits to unrelated parties for cash. By broadening the universe of organizations that are able to make use of energy-related tax credits through the direct pay provisions and creating a more direct pathway for taxpayers interested in financing energy projects to share credits through transferability, these provisions stand to significantly expand the market for investment in energy projects.
This article begins with some background regarding the Direct Pay Rules and the Transferability Rules and provides a summary of certain important aspects of its increased applicability to a wider range of taxpayers.
Background
Prior to the enactment of Sections 6417 and 6418 under the IRA, investors typically accessed renewable energy credits by investing in so-called “tax equity” partnerships (also referred to as “flip partnerships”), which owned renewable energy facilities and disproportionately allocated profits, losses, and tax credits to investors with the tax capacity to use such credits. Investors in such partnerships, however, necessarily assumed the risks inherent in an operating energy production business. As a result, such investors typically were large and sophisticated, and thus able to handle the diligence burden, legal and accounting costs, and risk involved in such partnership arrangements. Now, with the allowance of direct pay under Section 6417 (“Direct Pay Rules”) and transferability under Section 6418 (“Transferability Rules”), the monetization of renewable energy credits has been made easier and more accessible to a broader range of investors.
Direct Pay Rules
Historically, federal income tax credits associated with investments in and production of clean energy technologies have been non-refundable. As a result, tax-exempt entities that typically don’t have current tax liabilities against which the credits can be applied would not have had any use for such tax credits. The Direct Pay Rules now allow certain eligible project owners to receive cash payments from the IRS in lieu of being allocated tax credits. The proposed Treasury Regulations provide procedures for making the election under Section 6417 (the “Direct Pay Election”), a new framework for determining the amount and timing of those payments, and special rules for the types of entities that are eligible to participate in the Direct Pay Program (as discussed below).
Applicable Entities
The proposed Treasury Regulations provide that the following entities are eligible to make the Direct Pay Election: exempt organizations under Section 501(a); government bodies and political subdivisions within (including the U.S. territories, states, and the District of Columbia, Indian tribal governments, Alaska Native Corporations, and their respective political subdivisions); agencies and instrumentalities of a state, the District Columbia, and Indian tribal government, a U.S. territory, or a political subdivision within said governmental bodies; the Tennessee Valley Authority; and Rural electric cooperatives (“Applicable Entities”).
Entities that are not Applicable Entities (“Electing Taxpayers”) may also make the Direct Pay Election, provided that such Electing Taxpayers can only make a Direct Pay Election with respect to the following credits:
• Cardon oxide sequestration credit under Section 45Q;
• Clean hydrogen production credit under Section 45V; and
• Advanced manufacturing production credit under Section 45X.
It is important to note that Electing Taxpayers can only make the Direct Pay Election with respect to these three credits for a five-year election period. It should also be noted that where the credit-generating property is held through a disregarded entity, the determination of the availability to make the Direct Pay Election is determined with respect to the tax owner of the disregarded entity.
Passthrough Entities
The proposed Treasury Regulations provide additional rules with respect to passthrough entities seeking to make the Direct Pay Election. The preamble clarifies that passthrough entities can only receive direct payments in respect of credits under Sections 45Q, 45V, or 45X. This holds true even if all of a partnership’s partners are Applicable Entities that would be entitled to make the Direct Payment Election if they owned their interests in the project directly.
Moreover, only a passthrough entity – not the owners of such entity – is permitted to make the Direct Pay Election. Also, the passive activity credit rules do not limit direct payments available to a passthrough entity even if all of the passthrough entity’s owners otherwise would be subject to the passive activity credit rules in their separate capacity. Direct payments made to a passthrough entity are treated as tax-exempt income, and each passthrough entity owner’s share of the tax-exempt income is equal to its distributive share of the otherwise applicable credit for each taxable year.
While these passthrough rules will facilitate investments by individuals otherwise subject to the passive activity credit rules, the rules may well discourage investment by tax-exempt entities, which will need to be especially careful to avoid creating unintended tax partnerships with their financial counterparties. In the case of the investment tax credit under Sections 48 and 48E, the stakes will be even higher because the IRS has left in place rules that can render partnership-owned projects funded by tax-exempt partners wholly ineligible for such credits, notwithstanding that such tax-exempt partners are effectively treated as taxpayers for all other purposes relevant to such credits.
Transferability Rules
As mentioned above, developers of renewable energy projects commonly enter into complex tax equity structures with tax-equity investors (typically corporations) that have sufficient tax liability to soak up the tax credits generated by the projects. These tax-equity investors help fund the development of the underlying credit-generating projects in exchange for a return on their investment realized through disproportionate allocations of the tax credits and depreciation deductions generated from the project to the tax-equity investors. As a result of the complexity involved in such structures, only a limited pool of large and sophisticated investors had the ability to engage in such transactions. The IRA’s new Transferability Rules under Section 6418 changed all of that.
Eligible Transferees and Certain Transfer Rules
Transferability of energy tax credits is available to a broad class of taxpayers, including individuals, C corporations, trusts, and estates. Generally, eligible taxpayers who can make a transfer election (“Transfer Election”) are taxpayers other than certain tax-exempt and governmental entities eligible to make the Direct Pay Election under Section 6417. The cash amount received as consideration for the transfer is not included in the transferor’s income and is not deductible by the transferee purchasing the tax credit.
Further, the proposed Treasury Regulations confirm Section 6418 does not limit the number of transfers that can be made by an eligible tax credit transferor and the number of transferees to whom such credits can be transferred. However, the eligible transferor cannot sell more credits than are generated by the underlying “credit eligible properties” (as defined under the proposed Treasury Regulations). Further, the same tax credits cannot be transferred more than once.
It is important to note that it is possible that a taxpayer is eligible for both the Direct Pay Election and the Transfer Election; however, if the taxpayer chooses to make the Direct Pay Election pursuant to Section 6417, the same taxpayer cannot also make a Transfer Election pursuant to Section 6418.
An additional aspect of the Transferability Rules that broadens the availability of energy tax credits to a larger group of taxpayers is the opportunity for brokered transfers. As noted above, a tax credit may only be transferred once under Section 6418. The preamble to the proposed Treasury Regulation under Section 6418 notes, however, that an arrangement using a broker to match transferors and transferees should not violate this rule, assuming the arrangement at no point transfers the federal income tax ownership of a tax credit to the broker or any person other than the ultimate transferee. In addition, the proposed Treasury Regulations make clear that allocations of transferred credits by a transferee that is a partnership to its partners do not violate the no-additional-transfer rule.
Application of Passive Activity Rules
Under Section 469, a tax credit is subject to limitation if associated with a “passive activity.” Such limitation generally equals the amount by which credits from all passive activities allowable for the tax year, including various renewable energy tax credits, exceed the regular tax liability of the taxpayer for the tax year allocable to all passive activities. Any credit disallowed for a taxable year as a result of the passive activity limitation generally can be carried forward to later taxable years, subject to the same limitation.
A “passive activity” is any trade or business in which the taxpayer does not “materially participate” and rental activity beyond certain limits. Material participation is defined as when a taxpayer’s involvement in the business or trade is substantial and is also regular and continuous. Treasury Regulations provide detailed guidance as to the requirements for material participation.
The passive activity rules in Section 469 apply to individuals, trusts, and estates, but do not apply to corporations (subject to certain exceptions). For passthrough entities, the passive activity rules apply at the level of the shareholder or partner. Limitations in Section 49 and Section 50(b) (including the tax-exempt use property limitations) affect the amount of eligible credit that can be transferred. However, the passive activity rules in Section 469 do not affect the amount of eligible credit that can be transferred but do affect the amount of credit that can be utilized by the transferee. Since typical tax equity investors do not materially participate in the tax equity partnership’s underlying energy production business, the passive activity rules would apply unless the investors are corporations (subject to certain exceptions). With the application of these rules, a transferee subject to Section 469 would only be able to use purchased tax credits against tax liabilities associated with passive income generated from other sources (provided that such transferee does not materially participate in the underlying credit-generating activity).
Closing Observations
The allowance for direct pay and for transfers of renewable energy tax credits under the IRA is a major change and opens up the purchase of such credits to new categories of transferees.
However, as discussed above, only certain Applicable Entities may fully take advantage of the Direct Pay Election, and many individuals (as well as estates, trusts, personal service corporations, and closely held corporations) still may not be able to benefit from the Transferability Rules due to the passive activity limitations of Section 469. That being said, the transferability of credits could prove attractive to those individuals with passive income from other sources.
In addition, the Transferability Rules do not extend to depreciation deductions. Therefore, a developer may still want to use a traditional tax equity partnership structure over using the new Transferability Rules to transfer tax credits in order to get the value of both the credits and the depreciation deductions.
As a final note, as a result of the limitation of the passive activity rules on individuals, the Transferability Rules appeared to reflect a policy that the transferee market should not extend to individuals. However, this last week, the Treasury announced that it is considering allowing individuals to buy clean energy credits from companies. “As a policy matter, we did struggle with this a lot, but didn’t ultimately think that it was needed to meet the climate and economic goals,” Sarah Ritchey Haradon (Attorney Advisor at the Treasury) said, adding that “there was no indication that Congress intended for individuals to participate.” We will be monitoring these rules and will keep you updated on any additional guidance provided by the Treasury.
