On Feb. 19, 2020, the Internal Revenue Service released partial guidance on the implementation of section 45Q tax credits related to the capture and sequestration of carbon dioxide. The section 45Q tax credit was updated on Feb. 9, 2018, as part of the Bipartisan Budget Act (Pub. L. 115-123) to increase the amount of the tax credit per ton and to broaden the applicability to include “qualified carbon oxide.” The new IRS guidance is designed to assist in implementing the modified law.
The 2018 law removed the volume cap applicable to the tax credit, expanded the definition to include not just carbon dioxide but other carbon oxides such as methane, and raised the amount of the tax credit per ton. Carbon oxides captured and used for enhanced oil recovery can now receive a tax credit of up to $35 per ton, while carbon oxides deposited in secure geological storage can receive a tax credit of up to $50 per ton.
In May 2019, the IRS requested public comments on several different aspects of implementing the tax credit, and suggested that those comments would be used to formulate “regulations and other guidance.” The guidance documents released on Feb. 19, 2020, are the first products of this long-awaited implementation process.
The IRS guidance addresses (1) the “beginning of construction” and “continuous construction” requirements for qualifying projects and (2) a “safe harbor” for the allocation rules affecting investors in business partnerships claiming the tax credit. The IRS suggested that additional guidance will be issued “in the near future” relating to (3) what qualifies as secure geological storage and (4) the recapture of the tax credit for carbon oxide that is no longer captured.
- Construction Definitions.
In order to qualify for the credit, construction must begin on a qualified facility before Jan. 1, 2024. The beginning of construction requirement may be satisfied by meeting one of two tests: (1) the Physical Work Test or (2) the Five Percent Safe Harbor Test. Demonstrating continuity of construction is also required. This continuity requirement may be met by satisfying the six-year continuity safe harbor.
- Physical Work Test. Construction will have “begun” when “work of a significant nature” occurs and a “continuous program of construction” is maintained. There is no fixed minimum amount of work required in dollar or percentage terms. Off-site manufacturing of components can qualify. However, preliminary activities like obtaining financing, securing permits, or conducting research do not qualify.
- Five Percent Safe Harbor. If five percent or more of the total cost of the qualified facility or carbon capture equipment is paid or incurred, then construction will be considered to have begun. Continuous efforts to advance towards completion must be demonstrated. Cost overruns are counted for purposes of calculating the five percent threshold.
- Six-Year Continuity Safe Harbor. If a qualified facility or carbon capture equipment is placed in service by the end of a calendar year that is no more than six years after the year in which construction began, then the continuity of construction requirement will be deemed to be satisfied.
- Safe Harbor for Business Partnerships.
In general, a partner’s share of the section 45Q tax credit is determined by the partnership agreement or, if the agreement does not provide an allocation, a partner’s share is determined in accordance with a partner’s interest in the partnership. Partners may include a project developer and one or more investors. Section 45Q and the new guidance require that individuals or entities claiming the tax credit must have a financial stake in the project partnership.
A partnership will be treated as properly allocating the section 45Q tax credit if a number of conditions are met, including (but not limited to):
- The developer must have a minimum one percent interest in each material item of income, gain, loss, deduction, and credit;
- Each investor must have a minimum interest in each material item of partnership income, gain, loss, deduction, and credit equal to at least five percent of the investor’s interest for the taxable year in which such interest is the largest;
- An investor’s partnership interest must be a “bona fide equity investment”;
- An investor’s investment in the project must equal “at least 20 percent of the sum of the fixed capital investment plus any reasonably anticipated contingent investment required to be made by the investor under the partnership agreement.”
The most important guidance from the IRS is yet to come. Many believe the guidance on permanent storage will have the most impact on industry investments. Some are also urging Congress to enact a multi-year extension of the tax credit due to the two-year delay in the release of guidance documents, which has impacted investment decisions. Stakeholders are also advocating for an extension of the construction start deadline, which lasts only through 2023 under current law.
We expect that Congress will continue to press the IRS to expedite this process so that incentives intended to accelerate the development of carbon capture technologies can become a reality.