On Feb. 19, 2020, the IRS issued Notice 2020-12 and Revenue Procedure 2020-12 regarding carbon capture tax credits (IRC Section 45Q). Notice 2020-12 (the begin construction notice) provides guidance to determine when construction begins on carbon capture equipment for purposes of eligibility for claiming carbon capture tax credits. Rev. Proc. 2020-12 (flip safe harbor) provides a safe harbor for allocating the carbon capture tax credits among partners in a partnership, similar to the safe harbor “flip” rules for tax equity investments in wind energy projects or for the historic rehabilitation tax credit.
Section 45Q allows a federal tax credit for carbon that is captured from “qualified facilities” and then either used in commercial product, used for enhanced oil recovery (EOR) or secured in a geological formation. The credit can reach up to $50 per metric ton for carbon sequestered into geological formations or up to $35 per metric ton for carbon used in EOR.
In the case of carbon capture equipment that is originally placed in service at a qualified facility on or after Feb. 9, 2018, the credit is available during the 12-year period beginning on the date the equipment was originally placed in service. The credit can be claimed by the person who owns the carbon capture equipment and physically or contractually ensures the capture of the carbon dioxide and its use in the EOR project or by the person that uses the carbon dioxide in the EOR project. A qualified facility means any industrial facility or direct air capture facility, the construction of which begins before Jan. 1, 2024 (or where the construction of the carbon capture equipment begins before Jan. 1, 2024, if the original design of the facility did not include such carbon capture equipment), that meets certain annual minimum thresholds for carbon capture.
The Begin Construction Notice
The long-awaited guidance follows established IRS rules for “beginning of construction” in the solar and wind industries. A taxpayer may begin construction of a carbon capture project under two alternative methods: by meeting the “Physical Work Test” or the “Five Percent Safe Harbor Test.” Each of these tests is further described below.
Physical Work Test
Under the Physical Work Test, a taxpayer satisfies the begin construction requirement when physical work of a “significant nature” begins. This test focuses on the nature of the work performed. There is no fixed minimum amount of work or monetary threshold that must be met to satisfy the Physical Work Test. Both on-site and off-site physical work may count toward beginning of construction.
On-Site Physical Work
To further assist taxpayers, the begin construction notice contains the following examples of on-site physical work:
- The excavation for and installation of foundations (for the project as well as for buildings to house equipment necessary to the project), including the setting of anchor bolts into the ground and the pouring of the concrete pads of the foundation
- 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 for disposal, utilization or use as a tertiary injectant
- The installation of components necessary for carbon capture processes, such as membranes, sorbent vessels, adsorbers, compressors, engines, motors, power generators and regenerators, reboilers, turbines, pressure vessels and other vessels, piping and pipelines, pumps, heat exchangers, solvent pumps, filters, recycling units, electrostatic filtration, water wash equipment, lube oil systems, dehydration systems, glycol contractors, specially designed flue gas ducts, conditioners, cooling towers, absorber units, and other types of gas separation, liquification or processing equipment
- The installation of equipment and other work necessary for the disposal of qualified carbon oxide in secure geological storage, as described in § 45Q(a)(1)(B) and (a)(3)(B), at the geological storage site, which may be at a different location than the qualified facility or carbon capture equipment
Off-Site Physical Work
Off-site work completed by a third party under a binding written contract with the taxpayer may also satisfy the Physical Work Test. It is important that this off-site work not be for a part or equipment that is or could be in the inventory of the third-party manufacturer. It is also important that manufacturing of the off-site components not begin before the binding written contract is entered into. To further assist taxpayers, the begin construction notice contains the following examples of off-site physical work:
- The manufacture of mounting equipment and support structures such as racks, skids and rails
- The manufacture of components necessary for carbon capture processes, such as membranes, sorbent vessels, adsorbers, compressors, engines, motors, power generators and regenerators, reboilers, turbines, pressure vessels and other vessels, piping and pipelines, pumps, heat exchangers, solvent pumps, filters, recycling units, electrostatic filtration, water wash equipment, lube oil systems, dehydration systems, glycol contractors, specially designed flue gas ducts, conditioners, cooling towers, absorber units, and other types of gas separation, liquification or processing equipment
- The manufacture of components necessary for disposal of qualified carbon oxide in secure geological storage, as described in § 45Q(a)(1)(B) and (a)(3)(B), such as valves, specialized casing or other components of a wellhead or well
- The manufacture of equipment necessary for disposal of qualified carbon oxide in secure geological storage, as described in § 45Q(a)(1)(B) and (a)(3)(B), such as wellhead equipment, booster compressors and monitoring equipment for a storage site
Five Percent Safe Harbor
Under the Five Percent Safe Harbor Test, a taxpayer satisfies the begin construction requirement when the taxpayer pays or incurs 5 percent or more of the total cost of the carbon capture equipment to be installed at the qualified facility. Total cost takes into account all costs properly included in the depreciable basis of the carbon capture project. This includes costs for front-end engineering and design or other approaches for front-end planning common to projects of a similar scope and complexity. The 5 percent expenditure does not include the cost of land or property not integral to the carbon capture equipment.
If there are cost overruns so that the total costs of the carbon capture equipment exceeds its anticipated costs so that the amount initially incurred is less than 5 percent of the total coast, then the taxpayer is not treated as satisfying the Five Percent Safe Harbor in that initial year. The taxpayer might satisfy the Five Percent Safe Harbor in a subsequent year, or may place in service a portion of the facility if it is composed of multiple units.
Continuity Requirement (Continuous Construction or Continuous Efforts)
Under the Physical Work Test and Five Percent Safe Harbor Test, a taxpayer must demonstrate continuous progress toward completion once construction has begun. Under the Physical Work Test, a taxpayer must maintain a “continuous program of construction.” Under the Five Percent Safe Harbor Test, a taxpayer must make “continuous efforts to advance toward completion.” These continuity requirements are determined by the relevant facts and circumstances. The IRS provided taxpayers with the following list of items that might show continuous efforts under the Five Percent Safe Harbor Test:
- Paying or incurring additional amounts included in the total cost of the qualified facility or carbon capture equipment
- Entering into binding written contracts for the manufacture, construction or production of components of the qualified facility or components of the carbon capture equipment or for future work to construct the qualified facility or carbon capture equipment
- Obtaining necessary permits
- Performing physical work of a significant nature (as described in Section 5.02 of this notice)
A continuous program of construction under the Physical Work Test involves continuing physical work of a significant nature, as described above under (“On-Site Physical Work” and “Off-Site Physical Work”).
Continuous construction or continuous efforts can be paused or disrupted by matters that are beyond the taxpayer’s control. The IRS provided the following list of “excusable disruptions,” which will not be considered as indicating that a taxpayer failed to continue to develop or construct a facility during the disruption period:
- Delays due to severe weather conditions
- Delays due to natural disasters
- Delays in obtaining permits or licenses from any federal, state, local or Indian tribal government
- Delays at the written request of a federal, state, local or Indian tribal government regarding matters of public safety, security or similar concerns
- Interconnection-related delays, such as those relating to the completion of construction on a new carbon dioxide pipeline or necessary upgrades to resolve capacity or congestion issues that may be associated with a project’s planned interconnection
- Delays in the manufacture of custom components
- Delays due to labor stoppages
- Delays due to the inability to obtain specialized equipment of limited availability
- Delays due to the presence of endangered species
- Financing delays
- Delays due to supply shortages
Continuity Safe Harbor
If the carbon capture equipment or the qualified facility is placed in service by the end of the calendar year that is no more than six calendar years after the calendar year in which construction of the project begins, the continuity requirements under either test will be deemed to have been met. It is worth noting the excusable disruptions described above do not extend the “continuity safe harbor,” so a project will need to be placed in service before the end of the sixth full tax year after it has begun construction if a taxpayer would prefer the continuity safe harbor over demonstrating continuous efforts or continuous construction by the relevant facts and circumstances.
Transfers of Projects
In addition to guidance on the begin construction requirement, the begin construction notice also provides guidance on transferring a carbon capture project. Specifically, it states that property originally intended for a certain site may be transferred to another site, and any work performed or amounts paid or incurred at the initial site may be taken into account in determining when the carbon capture property satisfies the begin construction tests.
Additionally, a developer may begin construction of a qualified facility and then later sell or transfer the project to another unrelated taxpayer. This transfer will allow the buyer to step into the shoes of the original developer with respect to the begin construction test, so long as the transfer consisted of more than just tangible personal property. The begin construction notice specifically prohibits a new taxpayer to step into the shoes of the original developer with respect to satisfying either the Physical Work Test or the Five Percent Expenditure Test if the transfer was only personal property (i.e., consisted only of safe harbored equipment). Transfers between related taxpayers (i.e., at least 20 percent common ownership) are not subject to this restriction.
Existing carbon capture facilities can qualify for the larger tax credit under 45Q (or take advantage of the ability to pass through the tax credits to the carbon off-taker) if the taxpayer can demonstrate the retrofit project added at least 80 percent new equipment value to the facility. This 80/20 rule has been used frequently in the wind energy industry to retrofit older wind projects and requalify them as new equipment under Section 45. A retrofitted projected is considered new property when it is composed of no more than 20 percent used property by value.
The Flip Safe Harbor
The flip safe harbor provides guidelines to taxpayers wanting to raise capital through tax equity investment. It is worth noting that the flip safe harbor closely follows Revenue Procedure 2007-65 (the flip safe harbor for wind energy projects) and Revenue Procedure 2014-12 (the flip safe harbor for historic rehabilitation tax credits). The flip safe harbor provides structure points for the development and ownership of a qualified facility in a partnership form. If properly organized and operated, a partnership described in the flip safe harbor can allocate up to 99 percent of the credit to the “investor(s).” An investor is typically not in the business of owning and operating carbon capture projects, but instead invests in the partnership primarily to benefit from the tax credits, depreciation and other cash flows. If the partnership structure satisfies certain requirements as set forth in the flip safe harbor, the IRS will treat the investor as a partner in the partnership and will treat the partnership as properly allocating the tax credits in accordance with the partnership allocation regulations under IRC 704(b). These requirements include the following:
- The developer must have a minimum 1 percent interest in each material item of partnership income, gain, loss, deduction and credit at all times.
- Each investor must have, at all times during the period it owns a partnership interest, a minimum interest in each material partnership item equal to at least 5 percent of the investor’s percentage interest in each such item for the taxable year in which the investor’s percentage share of that item is the largest (as adjusted for sales, redemptions or dilutions of its interest).
- Each investor’s interest must constitute a bona fide equity investment with a reasonably anticipated value commensurate with such investor’s overall percentage interest in the partnership, separate from any federal, state and local tax deductions, allowances, credits and other tax attributes. This reasonably anticipated value must be contingent upon the partnership’s net income, gain and loss or must not be substantially fixed in amount or substantially protected from losses from the partnership’s activities.
- The investor must make and maintain a minimum unconditional investment of at least 20 percent of its initial fixed commitment. This minimum investment for the term of its investment can be reduced by operational distributions.
- The investor cannot receive unreasonable fees or put in place non-arm’s-length transactions to reduce the value or risk of the investor’s interest in the partnership.
- Up to 49 percent of the investor’s total capital contributions can be made on a “paygo” basis (i.e., based on the amount of carbon captured) or otherwise be contingent in amount.
- Neither the developer, the investor nor any related person can have a “call” right to buy the carbon capture equipment or the investor’s partnership interests (other than a contractual right or agreement for a present sale).
- The investor may have the contractual right to “put” (or sell) its partnership interest to the developer, but only at a price equal to the then-fair market value of the investor’s interest.
- Neither the developer nor a related party may (i) guarantee or otherwise insure the investor’s ability to claim the credit, by cash payment or otherwise, in the event the IRS challenges any portion of the partnership’s transactional structure, or (ii) guarantee to the investor certain distributions from the partnership to the developer.
- The developer can provide completion guarantees; operating deficit guarantees; environmental indemnities; financial convents; guarantees regarding proper disposal, storage or utilization of the captured carbon; and guarantees for the performance of the developer’s acts or omissions to ensure qualification of the Section 45Q tax credits.
- Long-term carbon oxide supply agreements, off-take agreements and equipment leases are not considered guarantees (even if between related parties) so long as those are entered into on an arm’s-length basis. These supply and off-take agreements can be on a “supply all,” “supply-or-pay,” “take all,” “take-or-pay” or “securely-store-or-pay” basis.
- The developer or a related person may not lend any investor funds to acquire its interest in the partnership.
- In accordance with Treasury Regulations Section 1.704-1(b)(4)(iii), allocations of the credit must be in the same proportion as the partners’ respective distributive shares of income from the partnership’s activities relating to carbon oxide sequestration. If the partnership does not generate income from carbon oxide sequestration activities, then allocations of the credit must be in the same proportion as the partners’ distributive shares of the loss or deduction (or other downward capital account adjustments) associated with the cost of capture and disposal, use as a tertiary injectant or utilization of the qualified carbon oxide.
The flip safe harbor provides a clear path for developers of carbon capture facilities to secure tax equity investment through the developed “flip partnership” model frequently used in the wind industry. Both the begin construction notice and the flip safe harbor are guidance welcomed by the industry and will allow carbon capture projects to be properly structured to take advantage of the carbon capture tax credit.