On Aug. 16, 2022, President Joe Biden signed into law the Inflation Reduction Act of 2022 (IRA), which includes new and revised tax incentives for clean energy projects. This alert provides a summary of the IRA impact on solar energy tax credits, which were extended and significantly expanded. Additional alerts will provide summaries of the IRA’s impact on other clean energy technologies.
Tax Incentives for Commercial Solar Generation
Prior Law — Investment Tax Credit for Solar Energy Property
Before the enactment of the IRA, the Section 48 investment tax credit (ITC) applied to solar energy generation projects. Solar generation facilities were eligible for an ITC claim and subject to the standard phase-out of that credit (i.e., maximum credit of 26% in 2020-2022, which dropped to 22% in 2023 and then 10% in 2024 and thereafter).
Extension of ITC for Solar Energy Property
The IRA retains the Section 48 credit for solar generation projects and reestablishes an opportunity to claim a 30% tax credit. Under the revised statute, the full 30% rate is deemed a “bonus rate” that taxpayers are entitled to only if the project is under 1MW of generation output or if the new prevailing wage and apprenticeship requirements (discussed below) are met. Otherwise, a base ITC rate of 6% applies to solar generation. The Section 48 ITC applies to solar projects that begin construction before the end of 2024, after which the new Section 48E ITC applies to solar and other projects that generate carbon-free energy.
New Section 48E Applies ITC to Solar Through at Least 2033
The IRA introduces a technology-neutral tax credit for clean energy generation projects placed in service after Dec. 31, 2024. Distinct from the technology-specific tax credits under the existing ITC regime, under Section 48E, taxpayers will be able to claim a 30% bonus credit based on emission measurements, which requires zero or net-negative carbon emissions. Solar is a non-emitting source of electricity generation and will be eligible for this credit. The Section 48E ITC also includes the base rate/bonus rate structure of Section 48, making the new prevailing wage and apprenticeship requirements relevant under this credit as well.
The Section 48E ITC will be available until at least 2033. The statute has a planned phase-out that reduced the credit value over a three-year period beginning in the first calendar year after the “applicable year,” which is the latter of (i) 2032 or (ii) the calendar year in which the Secretary determines that the annual greenhouse gas emissions from electricity generation are 75% lower than 2022. Assuming 2032 is the “applicable year,” the phase-out reduces the maximum ITC value (30% bonus credit) rapidly; the full credit will last until 2033, drop to 22.5% (75% of the maximum) in 2034, and 15% (50% of the maximum) in 2035. Thereafter, this ITC is no longer available.
Prevailing Wage and Apprenticeship Requirements
As mentioned, to qualify for the 30% bonus rate under Sections 48 and 48E, a solar generation project will need to satisfy the prevailing wage and apprenticeship (PWA) requirements. The PWA requirements are designed to ensure that workers on solar generation projects are paid fair wages and that a certain percentage of the workforce consists of qualified apprentices. Taxpayers must meet the PWA requirements for all projects that begin construction on or after Jan. 29, 2023, unless they are smaller-scale projects of under 1MW of capacity.
The IRS gave taxpayers the first piece of guidance on these standards in Notice 2022-61, released in late November 2022. Under the PWA requirements, taxpayers must pay prevailing wages to all “laborers and mechanics” (distinct from managerial and administrative workers) who work on a project throughout its construction and for five years after the project is placed in service. Taxpayers have an affirmative duty to use wages established by the Department of Labor, either published wages or wages obtained through a specific determination.
The PWA requirements also require qualified apprentice employment of no fewer than the “applicable percentage,” which is generally determined by total labor hours performed. The applicable percentage is 10% for projects that begin construction in 2022, 12.5% for projects that begin construction in 2023 and 15% for projects that begin construction in 2024 or later. Taxpayers can support compliance with the PWA requirements through documenting the wage rates provided, the employees who performed construction work on the project (and whether they are qualified apprentices), the classifications of work they performed, their hours worked in each classification and the wage rates paid for the work. It is important to note that the IRS is not requiring PWA record keeping to be distinct from standard record keeping to sustain deductions.
For deeper discussion of the PWA requirements and current IRS guidance in Notice 2022-61, see McGuireWoods’ November 2022 alert “IRS Issues Prevailing Wage and Apprenticeship Guidance — Starts 60-Day Clock,” and December 2022 alert “Inflation Reduction Act Creates New Tax Credit Opportunities for Energy Storage Projects.”
10% Adder for Domestic Content
Solar generation projects placed in service after Dec. 31, 2022, that satisfy a new domestic content requirement will be entitled to a 10% additional ITC (2% for base credit). To qualify for this bonus, the taxpayer must certify that any steel and iron or any manufactured product that is a component of the facility was produced in the United States. Construction material made primarily of steel or iron must be 100% produced in the United States, but this does not apply to steel or iron used as components or subcomponents of other manufactured products. A manufactured product will be deemed to have been produced in the United States if no less than the “adjusted percentage” of the total costs of all such manufactured products is attributable to manufactured products (including components) that are mined, produced or manufactured in the United States.
The adjusted percentage is generally 40% for facilities that begin construction before 2025, 45% for facilities that begin construction in 2025, 50% for facilities that begin construction in 2026, and 55% for facilities that begin construction after 2026.
10% Adder for Energy Communities
Solar generation projects placed in service after Dec. 31, 2022, and located within an “energy community” will be entitled to a 10% additional ITC (2% for base credit). An energy community is defined to include (i) a brownfield site; (ii) a census tract or any adjoining tract in which a coal mine closed after Dec. 31, 1999, or a coal-fired electric power plant was retired after Dec. 31, 2009; and (iii) an area that has (or, at any time during the period beginning after Dec. 31, 1999, had) significant employment or local tax revenue related to the extraction, processing, transport or storage of coal, oil or natural gas.
Adders for Solar in Low-Income Communities
Certain qualified solar facilities with a maximum output of less than 5 MW may be eligible for an additional ITC. Projects that receive an allocation of a 1.8 GW environmental justice capacity limitation can receive an additional 10% credit if located in a low-income community or on Indian land, or an additional 20% credit if such project is part of a qualified low-income residential building project or qualified low-income economic benefit project. Projects must apply for the allocation under a program that has yet to be established but must be created by mid-February 2023, per statute.
New Section 45/45Y PTC for Solar
The Section 48 ITC has applied to solar generation projects for more than 15 years, but the IRA has made solar eligible for the Section 45 production tax credit (PTC) for the first time. Instead of a one-time 30% ITC given in the year a solar project is placed in service, the solar PTC can be claimed every year over a 10-year credit period at the present rate of 2.6¢/kWh generated (rates will fluctuate going forward). The qualifications for solar generation facilities are the same under either credit, as are the PWA requirements and most of the adders, but the PTC represents an opportunity to generate more value than the ITC for large-scale solar projects over time. Notably, the adders for low-income solar installations apply only to the solar ITC.
Refundable ITC for Tax-Exempt Entities
The ITC and PTC for solar are refundable credits for tax-exempt entities, state and local governments, Indian tribal governments, Alaska Native Corporations, the Tennessee Valley Authority and rural electric cooperatives. The refundability rules should be similar under either the ITC or PTC. Although final guidance may alter the rules somewhat, taxpayers should expect that projects with a 1MW or larger capacity must satisfy the domestic content requirements if they begin construction after 2023. If not, the refundable credit amount will be reduced by 10% for projects that begin construction in 2024 and by 15% for projects that begin construction in 2025. No refundable credit will be permitted for projects that begin construction in 2026 or later if they do not satisfy the domestic-content requirements. Additionally, an exception to the domestic-content requirement likely will apply if those components are not produced in the United States in sufficient available quantities, or if the inclusion of domestic content would increase the overall project costs by more than 25%.
Direct Transfer of the ITC
The IRA added a provision to permit project owners (other than tax-exempt entities) to make an election to transfer the ITC and PTC to an unrelated third party. The amount that the third party paid for the tax credit must be in cash, is not included in the gross income of the transferee and is not deductible to the transferor. An election to transfer the tax credits must be made on or before the due date for the tax return in the year the credits were determined, so credits that are carried forward cannot be transferred later. Also, once a credit is transferred, the credit cannot be further transferred by the transferee.
These direct transfer rules likely will have a significant impact on project financing, as sponsors might elect to simply monetize the tax credit rather than bringing in tax equity partners. However, the tax credit market may seek indemnities from sponsors and parent guaranties related to the tax credits’ original determination and qualification. This could have a separating effect in a tax credit market between creditworthy sponsors and the rest of the industry. Expect tax insurance to play a large role in the new tax credit transfer market.
Tax Incentives for Residential Solar Generation
Section 25D Tax Credit for Homeowner-Owned Solar Energy Property
Distinct from the solar generation ITC in Section 48, for most of the past two decades, homeowners have had a separate (and mutually exclusive) tax credit in Section 25D that applied to small-scale solar energy generation projects attached to a primary or secondary residence. Residential solar installations were eligible for a tax credit claim against the project expenditures and subject to a phase-out, with maximum credit of 26% in 2020-2022, which dropped to 22% in 2023, and then 0% in 2024 and thereafter.
The IRA substantially overhauled the solar ITC, but its amendment of Section 25D was primarily a restoration of a full credit value and extension of the credit for a 12-year period. The solar credit under Section 25D has increased to 30% (from 26%) for installations completed after Dec. 31, 2021, and the 30% credit is sustained until Dec. 31, 2032. The credit will drop to 26% in 2033, to 22% in 2034 and to 0% in 2035 and thereafter.
Distinctions From the ITC — Different Calculations and No Enhanced Requirements or Credit Adders
The Section 25D credit often gets conflated with the Section 48 solar ITC because they offer a similar 30% tax credit for an installation of solar generation. But that is essentially where the similarities end between these two credits.
One major difference is that the value of a solar ITC is determined by the fair market value of the generation asset. In contrast, a Section 25D credit is determined only by the costs of installation expenditures, i.e., the direct labor and the equipment to create a functioning solar generation system. A business taxpayer typically establishes a fair market value for ITC purposes by getting an independent appraisal, which considers multiple factors beyond labor and equipment (such as the capacity to generate income). This often results in a credit amount that is materially higher than what could be claimed under Section 25D.
Another major difference is that the ITC percentage is set by the tax year when the project begins construction, whereas the amount of a Section 25D credit is determined by the year when the installation is complete. A business taxpayer could lock in a 30% tax credit value by breaking ground on a project in 2033, even if it is not complete until 2035. A homeowner who paid for solar in December 2032 and did not have the project installed until February 2033 would be forced to take a 26% tax credit, even if the project started in a 30% credit year. Fortunately, residential-scale installations typically can be completed in a day, so in reality, this becomes an issue only for a homeowner seeking to install solar at the end of a calendar year.
In addition to these fundamental differences, the Section 25D credit also is not entitled to any of the ITC value enhancers for installation in low-income areas or in energy communities or for domestic content, discussed above. On the positive side, the prevailing wage and apprenticeship standards do not apply to the Section 25D credit; therefore, taxpayers do not have to clear that administrative hurdle to get the full 30% tax credit.