IRA Guidance Watch: Domestic Content Guidance Issued in Notice 2023-38

On May 12, 2023, the IRS issued Notice 2023-38 (the “Notice”), which provides eagerly awaited guidance on the enhancement to the production tax credit (“PTC”), clean energy production tax credit (“CEPTC”), investment tax credit (“ITC”), and clean energy investment tax credit (“CEITC”) for projects meeting certain U.S.-manufactured content requirements, in Sections 45(b)(9), 45Y(g)(11), 48(a)(12), and 48E(a)(3)(B) of the Code, respectively (commonly known as the “Domestic Content Adder”). 

While forthcoming proposed regulations (“Proposed Regulations”) will apply to taxable years ending after May 12, 2023, taxpayers may rely on the Notice retroactively for any qualified facility, energy project, or energy storage technology that is potentially eligible for the Domestic Content Adder.  

Background

The Domestic Content Adder increases the PTC and CEPTC by 10% of the otherwise available credit (without taking into account the energy community enhancement in Section 45(b)(11)) and increases the ITC and CEITC by 10 percentage points (assuming that certain prevailing wage and apprenticeship requirements are met). 

To qualify for the Domestic Content Adder for purposes of the PTC and CEPTC, a qualified facility must meet two statutory requirements. First, any steel or iron that is a component of the completed facility must be produced in the United States (the “Steel or Iron Requirement”). Second, any manufactured product which is a component of the completed facility must be produced in the United States (the “Manufactured Products Requirement”), a requirement that is deemed met if 40% (20% in the case of offshore wind) of the total costs of all such manufactured products of such facility are “attributable to manufactured products (including components) which are mined, produced, or manufactured in the United States” (the “Adjusted Percentage Rule”). Such rules incorporate by reference 49 CFR § 661 and, in the case of steel and iron, 49 CFR § 661.5, which comprise part of the “Buy America” regulations setting forth U.S.-manufactured content requirements for federal government contracts (collectively, the “Buy America Rules”). Similar rules apply at the “energy project” level for purposes of qualifying for the Domestic Content Adder under the ITC and CEITC. (We note that in the case of the CEPTC, the 40% (20% for offshore wind) threshold will gradually phase up for projects that begin construction in 2025 onwards and will eventually reach 55% for projects beginning construction in 2027 onwards (2028 for offshore wind).)

Prior to the issuance of the Notice, considerable uncertainty surrounded the application of the Domestic Content Adder, in part because the Buy America Rules generally focus on public transportation projects and not power projects. The meaning of terms such as “manufactured product” and “component,” in the context of a renewable energy project, was unclear. In addition, while the Buy America Rules require that all construction materials made primarily of steel or iron (e.g., structural steel or iron) be U.S.-manufactured, the distinction between steel or iron used in construction materials and steel or iron used as components or subcomponents of manufactured products was not always immediately apparent. A particularly vexing question was whether relatively inconsequential items such as nuts and bolts, the provenance of which may be difficult to track, might constitute steel or iron used in construction materials and thus be subject to the Steel or Iron Requirement.

Manufactured Products, Components, and Subcomponents

As a threshold matter, the Notice elucidates the statutory language by providing a clear hierarchy of object classes. At the top is the “Applicable Project” (i.e., the qualified facility or energy project, as applicable), which is composed of “Applicable Project Components”— articles, materials, or supplies, whether manufactured or unmanufactured, that are directly incorporated into the Applicable Project. Some (not all) Applicable Project Components may be steel, iron, or “Manufactured Products.” Each Manufactured Product is composed of Manufactured Product Components—articles, materials, or supplies, whether manufactured or unmanufactured, that are directly incorporated into the Manufactured Product. 

Perhaps most importantly, in “Table 2 — Categorization of Applicable Project Components,” the Notice allows taxpayers to rely on the IRS’ categorization of certain items in solar, onshore wind, offshore wind, and battery storage projects as either (i) steel or iron or (ii) Manufactured Products. Under this safe harbor, steel or iron rebar in foundations, solar module racking, wind turbine towers, pile or ground screws (solar) and jacket foundations (offshore wind) constitute steel or iron items subject to the Steel and Iron Requirement. Conversely, each solar module, solar tracker, wind turbine, set of wind tower flanges, inverter, battery pack, and battery container/housing is a Manufactured Product. Additional Manufactured Products are listed in the case of offshore wind projects, including each transition piece, monopile, export cable, inter-array cable, and offshore substation. 

For a few Manufactured Products, the Notice also lists constituent Manufactured Product Components. Components of a wind turbine include the nacelle, blades, rotor hub, and power converter; components of a solar module include the photovoltaic cells, mounting frame or backrail, glass, encapsulant, backsheet, junction box (including pigtails and connectors), edge seals, pottants, adhesives, bus ribbons, and bypass diodes; and components of a battery pack include the cells, packaging, thermal management system, and battery management system. 

Observations

• By the Notice’s own admission, Table 2 — while extremely helpful in some respects — is not necessarily exhaustive. It does not identify components within inverters, substations, or trackers, for example, nor does it identify any Manufactured Products or components thereof for less commonplace renewables projects, such as biomass, geothermal, biogas, or fuel cell projects. Additional identifications of Manufactured Products and components thereof in the Proposed Regulations could prove very useful.

Steel or Iron Requirement

The Notice confirms, consistent with the Buy America Rules, that the Steel or Iron Requirement applies to Applicable Project Components that are construction materials made primarily of steel or iron and are structural in function and does not apply to steel or iron used in Manufactured Product Components or subcomponents of Manufactured Product Components. Crucially, the Notice confirms that certain items, “such as nuts, bolts, screws, washers, cabinets, covers, shelves, clamps, fittings, sleeves, adapters, tie wire, spacers, door hinges, and similar items,” may be made primarily of steel or iron but are not structural in function, and thus are not subject to the Steel or Iron Requirement.

Consistent with the Buy America Rules, the Notice confirms that the Steel or Iron Requirement is met if all manufacturing processes with respect to any steel or iron items that are Applicable Project Components (except metallurgical processes involving refinement of steel additives) take place in the United States.

Observations

• While most practitioners believed, even prior to the issuance of the Notice, that items such as nuts and bolts were unlikely to prevent taxpayers from claiming the Domestic Content Adder, it was frequently anticipated that such items would be carved out from the Steel or Iron Requirement through a de minimis rule. Interestingly, the IRS chose not to implement a de minimis rule, but rather to interpret broadly the category of items that are non-structural in function. Such an approach may support treating other types of equipment, such as torque tubes, as non-structural items made primarily of steel or iron.
• The Notice does not provide specific guidance on what “manufacturing processes” relate to steel or iron for purposes of the Steel or Iron Requirement. The Notice does not explicitly confirm that manufacturing processes for steel and iron begin with the smelting process and do not include processing relating to the iron ore and/or scrap feedstock. The Notice also does not explicitly confirm whether “manufacturing” includes any processes after steel or iron is cast into sheets, rolls, or other forms. It is hoped that the Proposed Regulations will provide examples of processes considered to be associated with the manufacturing of steel and iron for purposes of the Steel or Iron Requirement.

Manufactured Products Requirement and Adjusted Percentage Rule

The Manufactured Products Requirement is met if all Applicable Project Components that are Manufactured Products are produced in the United States or are deemed to be produced in the United States. Consistent with the Buy America Rules, the Notice confirms that a Manufactured Product is produced in the United States (a “U.S. Manufactured Product”) only if (1) all of its manufacturing processes take place in the United States and (2) each Manufactured Product Component is of U.S. origin, i.e., “manufactured in the United States, regardless of the origin of its subcomponents.” All Applicable Project Components that are Manufactured Products are nonetheless deemed to be produced in the United States if the Adjusted Percentage Rule is satisfied. For purposes of the Domestic Content Requirement, “manufacturing” requires “the application of processes to alter the form or function of materials or of elements of a product in a manner adding value and transforming those materials or elements so that they represent a new item functionally different from that which would result from mere assembly of the elements or materials.”

In applying the Adjusted Percentage Rule, the numerator is equal to (i) the cost of all U.S. Manufactured Products that are Applicable Project Components and (ii) the cost of all Manufactured Product Components of non-U.S. Manufactured Products that are Applicable Project Components, to the extent mined, produced, or manufactured in the United States. The denominator is equal to the sum of the costs of each Applicable Project Component that is a Manufactured Product. If the resulting fraction is equal to 40% (20% in the case of an offshore wind project) or greater, the Adjusted Percentage Rule is satisfied. 

To define “cost” for purposes of the Adjusted Percentage Rule, the Notice refers to Treas. Reg. § 1.263A-1(e)(2)(i), which includes only direct material costs, i.e. costs of those materials that either become an integral part of specific property produced or are consumed in the ordinary course of production, and direct labor costs, i.e. all elements of compensation (other than employee benefit costs) for full-time and part-time employees, contract employees, and independent contractors, in each case, that are paid by the manufacturer to (1) produce the Manufactured Product (in the case of a U.S. Manufactured Product or a Manufactured Product) or (2) produce or acquire the Manufactured Product Component that is mined, produced, or manufactured in the United States (in the case of a non-U.S. Manufactured Product). Both direct labor costs and direct material costs must be identified or associated with particular units or groups of units of the property produced. It is inferred that costs such as those related to purchasing activities, handling, storage, cost recovery (e.g. depreciation), taxes (including those based on sales, property, or income), repairs, maintenance, engineering, design, and interest on debt incurred during the construction period, which are described as “indirect” costs in Treas. Reg. § 1.263A-1(e)(3)(ii)-(iii), are not included in the Adjusted Percentage Rule. Moreover, direct costs of incorporating the Applicable Project Components into the Applicable Project are not counted in the numerator (or, presumably, the denominator) of the Adjusted Percentage Rule.

Observations

• The inclusion in the numerator of the Adjusted Percentage Rule of U.S.-manufactured/mined components of non-U.S. Manufactured Products incentivizes non-U.S. suppliers to include U.S.-manufactured/mined components, even if the final manufacturing process is not located in the United States. Developers who anticipate using non-U.S. manufactured equipment may wish to consider whether their suppliers can partially alter their supply chains to meet the Adjusted Percentage Rule.
• The Notice’s approach to “cost” is notably different from both the application of the “5% safe harbor” test in the beginning of construction analysis set forth in Notice 2013-29 and its progeny, as well as the 80/20 Rule for repowerings set forth in Revenue Ruling 94-31 (defined below), both of which include indirect costs.
• Despite the urging of various commentators, the Notice does not contain any safe harbors that would permit a taxpayer to reasonably rely on the representations of its equipment suppliers with respect to the Domestic Content Adder analysis. As a practical matter, taxpayers will generally be responsible for diligencing any factual and legal representations given by equipment suppliers in this regard.

Repowering and the Domestic Content Adder

Under the repowering guidance in Revenue Ruling 94-31, a facility or energy project that contains some used property may be deemed “originally placed in service” if the fair market value of the used property is 20% or less of the facility or project’s total value (i.e., sum of the fair market value of the used property plus the cost of the new property) (the “80/20 Rule”). The Notice states that an Applicable Project that is placed in service after December 31, 2022 and meets the 80/20 Rule is eligible for the Domestic Content Adder if the new property in the Applicable Project meets the requirements for the Domestic Content Adder and the taxpayer otherwise complies with the requirements in the Notice. In other words, for a repowered project to benefit from the Domestic Content Adder, only the new property — not the used property — need meet the Steel or Iron Requirement and the Manufactured Products Requirement. 

Observations

• In some cases, e.g., wind projects where repowering typically involves retaining the steel or iron components (tower and foundations), it may be significantly easier to meet the Domestic Content Adder requirements in a repowered project than in a greenfield project. The Notice thus arguably provides additional incentive for taxpayers to repower projects.
• As noted above, the definition of “cost” for purposes of the Domestic Content Adder is significantly narrower than the definition of “cost” for purposes of the 80/20 Rule. Taxpayers should be aware that separate cost calculations are required for each analysis and ensure that equipment suppliers clearly distinguish between direct and indirect costs of labor and materials in providing documentation to support each calculation.

Certification

The taxpayer must provide certain legal and factual certifications to support the Domestic Content Adder for each project for which such enhancement is claimed. The certification generally must be attached to the Form 8835, Renewable Electricity Product Credit or Form 3468, Investment Credit filed with the taxpayer’s annual return submitted to the IRS for the first taxable year in which the taxpayer reports a Domestic Content Adder for such Applicable Project, and (in the case of the PTC and CEPTC) must be reattached to later tax returns during the PTC/CEPTC period. The certification is made as of the placed in service date for the facility or project.

Observations

• The requirement to certify the Domestic Content Adder as of placed in service (as opposed to mechanical, substantial, or final completion) is a gloss on the statutory language, which merely states that the Domestic Content Adder is determined at the time of “completion of construction.” For some projects, a material amount of construction costs may be incurred subsequent to placed in service. Taxpayers should ensure that the omission of such costs from the Adjusted Percentage Rule does not adversely impact the Domestic Content Adder calculations and may consider adjusting synchronization and commissioning schedules accordingly.

Direct Pay Phasedown

Unless a project or facility qualifies for the Domestic Content Adder, direct pay under Section 6417 generally phases down for projects that begin construction in 2024 with maximum net output of over 1 MW and is completely eliminated for projects that begin construction after 2025. However, even projects that do not qualify for the Domestic Content Adder can avoid the direct pay phasedown if the Secretary of the Treasury provides an exception for situations where (1) the inclusion of steel, iron, or manufactured products which are produced in the United States increases the overall costs of construction of qualified facilities by more than 25%, or (2) relevant steel, iron, or manufactured products are not produced in the United States in sufficient and reasonably available quantities or of a satisfactory quality. No such exceptions have been provided in the Notice. 

The Notice provides much-needed clarity with respect to the mechanics of the Domestic Content Adder and will permit many development-stage projects to proceed with greater certainty about the availability of the enhancement. Nonetheless, particularly for less popular technologies not directly addressed in Table 2, such as biomass and geothermal, the process of applying the Steel or Iron Requirement and the Adjusted Percentage Rule to specific items of equipment will continue to require a reasoned interpretation of the principles of the Notice and the Buy America Rules.