Late last week, the Internal Revenue Service (“IRS”) and Department of the Treasury released the long-awaited proposed regulations (the “Proposed Regulations”) relating to investment tax credits under Section 48 of the Code (the “ITC”).  These regulations help to clarify what qualifies as energy property that is eligible for the ITC (Section 1.48-9), provide additional ITC-specific rules surrounding the increased credit amount as a result of satisfying the prevailing wage and apprenticeship requirements enacted by the Inflation Reduction Act (Section 1.48-13), and adopt various other rules relating to the ITC (Section 1.48-14).  Taxpayers may generally rely on the proposed regulations at least until final regulations are promulgated (the reliance period varies by provision, to some degree), and parties interested in commenting on the proposed regulations before final regulations are issued may submit written comments to the IRS until 60 days after the proposed regulations are formally publish in the Federal Register, which publication is expected to be on November 22, 2023.

Select specific provisions are described in more detail below.  At a high level, several takeaways of the Proposed Regulations include: confirming that owners of projects including battery energy storage systems and property eligible for the production tax credit (the “PTC”), such as solar or wind, may claim the ITC for batteries and the PTC for solar or wind (or other PTC-eligible property), indicating that the apprenticeship requirements that apply to many projects for the increased credit amount to the 30% ITC do not apply during the five-year recapture period, and clarifying ITC-eligibility for property that is jointly owned by multiple taxpayers.

Section 1.48-9 – Definition of Energy Property

Requirements for Energy Property

The Proposed Regulations generally take a technology neutral approach to identifying property that is eligible for the ITC.  These rules will be helpful in determining what property is eligible for the ITC, particularly with respect to newly eligible property such as battery energy storage systems, biogas property, electrochromic glass, and microgrid controllers.  As a general matter, the Proposed Regulations provide that ITC-eligible property includes all equipment of an otherwise-eligible project that is either functionally interdependent equipment or is an integral part of the applicable energy property.  Functionally interdependent for this purpose means that each component of property is dependent upon the placing in service of each of the other components to perform the applicable function, such as storing energy, producing electricity, producing thermal energy, producing biogas, or producing thermal energy. Integral parts of energy property must be property that is used directly in the intended function of the applicable energy property, and includes properly capitalized costs for O&M roads, certain buildings, and subsea cables and voltage transformers necessary for off-shore wind facilities to condition electricity for use on the electrical grid.  Several specific applications are described below.

• Energy storage technology – The Proposed Regulations specify that “energy storage technology” as used in Section 48 of the Code includes electrical energy storage property, thermal energy storage property, and hydrogen energy storage property, and provide additional information regarding electrical energy storage property and hydrogen energy storage property.
  
  • Electrical energy storage property – Section 48 of the Code states that electrical energy storage property includes property (other than property primarily used in the transportation of goods or individuals and not for the production of electricity) that receives, stores, and delivers energy for conversion to electricity, and has a nameplate capacity of not less than 5 kWh.  The Proposed Regulations provide specific examples of equipment that qualifies as “energy storage technology,” such as electrochemical batteries, ultracapacitors, physical storage such as pumped storage hydropower, compressed air storage, flywheels and reversible fuel cells.
  • Hydrogen energy storage property – The Proposed Regulations provide that hydrogen energy storage property includes property (other than property primarily used in the transportation of goods or individuals and not for the production of electricity) that stores hydrogen and has a nameplate capacity of not less than 5 kWh, equivalent to 0.127 kg of hydrogen or 52.7 standard cubic feet of hydrogen. Hydrogen energy storage property must store hydrogen that is solely used as energy, and not for other purposes such as for the production of end products, such as fertilizer.
• Solar energy property – The Proposed Regulations reverse the corresponding language in existing Section 1.48-9 of the Treasury Regulations (which conflicted with Section 48(a)(3)(A)(i) of the Code) by noting that equipment that uses solar energy to generate steam at high temperatures for use in industrial or commercial processes (solar process heat), and certain passive solar energy systems, qualify as solar energy property eligible for the ITC.
• Geothermal Equipment - The Proposed Regulations clarify that production, injection and monitoring wells required for production of the geothermal deposit qualify as geothermal production equipment eligible for the ITC. 
• Qualified Biogas Property – The Proposed Regulations provide that the methane content requirement found in Section 48 of the Code must be measured at the point at which gas exits the biogas production system, which may include an anerobic digester, landfill gas collection system, or thermal gasification equipment.  Under the rules described above for determining ITC-eligible equipment, ITC-eligible biogas equipment generally may include a waste feedstock collection system, a landfill gas collection system, mixing or pumping equipment, and an anaerobic digester.
• Electrochromic Glass - Under the rules described above for determining ITC-eligible equipment, ITC-eligible electrochromic glass equipment generally may include the window itself, the secondary glazing property that incorporates the electrochromic glass property (if applicable), electronic controls such as power electronics, sensors, wires, and software systems, and the balance of window and installation components including glass, flashing, framing, and sealants.

Section 1.48-13: Rules Relating to the Increased Credit Amount for Prevailing Wage and Apprenticeship Requirements

The Proposed Regulations also provide much needed clarity regarding the application of the apprenticeship requirements in the alteration or repair of projects and recapture, as well as other key points listed below.

• Apprenticeship Rules Do Not Apply During Recapture Period – Confirm that recapture may apply with respect to projects for which the prevailing wage rules are not satisfied during the five-year recapture period (assuming they applied in the first instance), but does not incorporate such rules for any such failure to satisfy the apprenticeship requirements during such period.
• Penalty Not Applied if Recaptured - Incorporate the rule under Section 1.45-7 of the proposed regulations (focusing on prevailing wage and apprenticeship rules) that the $5,000 per non-compliant laborer and mechanic penalty is not assessed if the 30% ITC is claimed but recapture occurs because the prevailing wage requirements are not satisfied during the recapture period.  
• Base ITC as Default - Further clarify that the taxpayer would be entitled to the base 6% ITC in the event of a recapture resulting from failure to comply with the prevailing wage rules during the recapture period.
• 20% Annual Step Down - Confirm the recapture amount for failing to satisfy the prevailing wage requirements during the recapture period is subject to the typical 20% annual step down.
• Reporting Requirements - Provide that taxpayers that claim the 30% ITC are required to include with tax returns filed for years including the recapture period, information with respect to the payment of prevailing wages for any alteration or repair of the project during the recapture period (assuming the prevailing wage and apprenticeship requirements applied in the construction of the applicable project).

Within this section, the Proposed Regulations also provide clarification regarding the 1 MW (AC) exception for claiming the 30% ITC.  First, the determination whether an energy project has a maximum net output of less than 1 MW is determined based on the nameplate capacity.  Second, the Proposed Regulations indicate that electrochromic glass property, fiber-optic solar energy property, and microgrid controllers are not eligible for the 1MW (AC) exception because such energy properties do not generate electricity or thermal energy. Finally, special rules are provided to assist taxpayers in determining theelectrical or thermal generating capacity of certain types of energy property, such as electrical energy storage property, hydrogen energy storage property, specified clean hydrogen production facilities, and qualified biogas property.

Section 1.48-14 – Various Rules Applicable to Energy Property

The Proposed Regulations provide additional rules regarding retrofitted energy property, incremental cost limitations, ownership of energy property and qualified interconnection costs.

• Retrofitted Energy Property – While the Proposed Regulations provide that energy property generally does not include equipment that is an addition to, or modification of, an existing energy property, the Proposed Regulations incorporate an exception for property that satisfies the well-established 80/20 rule. 
• Incremental Cost Limitations – The Proposed Regulations clarify that for assets that do not qualify as energy property standing alone but cost more because of their association with qualifying property, the excess of the total cost of such property over the amount that would have been expended absent the associated energy property is included in eligible basis for purposes of calculating the amount of ITC.  This incremental cost rule is easily illustrated in the case of reflective roofing that both provides shelter and assists with the generation of electricity.  If the cost of reflective roofing is $15,000 and non-reflective roofing would have been $10,000, then the $5,000 incremental cost is eligible for the ITC.
• Special Rules Concerning Ownership – Provide rules clarifying ITC-eligibility in situations where multiple taxpayers each own a portion of the applicable energy property, such as fractional interests in common tenancies.  The clarifications in these rules may help enable more ownership structures involving both tax-exempt and taxable entity owners.
• Qualified Interconnection Costs – Describe in more detail the requirements that need to be satisfied for interconnection costs to be eligible for the ITC for certain projects.