IRA Guidance Watch: IRS Issues Proposed Regulations on Direct Pay, Transferability

On June 14, the IRS issued proposed regulations (the “Proposed Regulations”) on Sections 6417 and 6418, which permit, respectively, certain tax-exempt taxpayers to obtain cash from the federal government in lieu of renewables tax credits (“direct pay”) and non-exempt taxpayers to transfer renewables tax credits to unrelated parties for cash (“transferability”).

The renewables tax credits covered by the direct pay and transferability regimes include not only the production tax credit (“PTC”) and clean energy production tax credit (“CEPTC”) under Sections 45 and 45Y and the investment tax credit (“ITC”) and clean energy investment tax credit under Sections 48 and 48E, but also the carbon capture credit (Section 45Q), advanced manufacturing production credit (Section 45X), hydrogen production credit (Section 45V), advanced energy production credit (Section 48C), and various credits for alternative fuels and commercial electric vehicles (collectively, the “applicable credits”). As such, direct pay and transferability are important new provisions with a significant potential impact on the financing of renewables projects. 

The Proposed Regulations would apply to taxable years ending on or after the date the final regulations are published in the Federal Register. However, entities may rely on the Proposed Regulations relating to direct pay for elective payments of applicable credit amounts after December 31, 2022, in taxable years ending before the final regulations are published in the Federal Register, provided the entities follow such proposed regulations in their entirety and in a consistent manner with respect to all elections made under Section 6417. An analogous rule applies with respect to taxpayers relying on the Proposed Regulations relating to transferability. Certain conforming changes to the partnership audit regime are proposed to apply to taxable years ending on or after the date of publication of such proposed regulations in the Federal Register.

Background

Under Section 6417, where an “applicable entity”—i.e., a tax-exempt organization, state or political subdivision thereof, Indian tribal government, Alaska Native Corporation, or corporation operating on a cooperative basis which is engaged in furnishing electric energy to persons in rural areas, or the Tennessee Valley Authority—makes a direct pay election with respect to any applicable credit “determined with respect to” such entity, such entity shall be treated as having made a payment of tax liability equal to the amount of such credit, and can thus receive a corresponding tax refund. In addition, even non-applicable entities can elect to claim direct pay for three applicable credits—those under Sections 45Q, 45V, and 45X—for five years (“Five-Year Elections”).

Except in the case of governments and political subdivisions, the direct pay election generally must be made by the due date (including extensions of time) for the return of tax for the relevant taxable year (i.e., the year in which the facility or property is placed in service). A direct pay election is generally irrevocable, except in the case of Five-Year Elections, which can be revoked once. Where a partnership holds a facility or property directly, the partnership (not the partner) makes the direct pay election and receives a direct payment from the Treasury in the amount of the credit, which is treated as tax-exempt income allocated between the partners based on their distributive shares of the applicable credit. Similar rules apply with respect to S corporations. A 20% penalty for excessive direct payment applies. 

Under Section 6418, if a taxpayer that is not an applicable entity (an “eligible taxpayer”) elects to transfer all or part of an eligible credit—i.e., an applicable credit, but without the Section 6417 placed in service requirements for Sections 45, 45Q, and 45V and excluding the credit for commercial electric vehicles—"determined with respect to” such taxpayer for any taxable year to an unrelated taxpayer (the “transferee taxpayer”), the transferee taxpayer (and not the transferor taxpayer) shall be treated as the taxpayer with respect to such credit or portion thereof. Each payment in consideration of an eligible credit shall be required to be paid in cash, shall not be includible in gross income of the transferor taxpayer, and shall not be deductible to the transferee taxpayer. An eligible credit may only be transferred once. Similar rules to Section 6417 apply with respect to penalties for excessive transfer, irrevocability and timing of election. Where a partnership holds a facility or property directly, similar to Section 6417, the partnership (not the partner) makes the transferability election and receives cash consideration for the credit, which is treated as tax-exempt income allocated between the partners based on their distributive shares of the otherwise available credit (with similar rules for S corporations). In the event of ITC recapture, the eligible taxpayer and the transferee taxpayer shall provide notice to each other of the recapture event and recapture amount, respectively.

Proposed Regulations on Direct Pay (Prop. Reg. §§ 1.6417-1 through 1.6417-6) 

Identifying Applicable Entities

The Proposed Regulations provide detailed guidance on what entities constitute applicable entities and conclude that agencies and instrumentalities of state, U.S. territory and Indian tribal governments constitute applicable entities, as do all tax-exempt organizations under Section 501(a) and members of U.S. consolidated groups (except for certain circumstances involving Alaskan Native Corporations). 

However, the Proposed Regulations state that partnerships and S corporations are not eligible to make direct pay elections (unless they make Five-Year Elections with respect to the three eligible credits, in which case the IRS will provide a payment to the partnership in the amount of the applicable credit). In lieu of partnership structures, the Preamble explains, an applicable entity can engage with other entities, including with for-profit partners, by co-owning projects through a tenancy-in-common arrangement or pursuant to a joint operating arrangement that has elected out of subchapter K treatment under Section 761.

Observations:

• The broad prohibition on direct pay for partnership structures comes as a surprise to many IRA watchers who expected the IRS to apply an aggregate approach to the direct pay election in order to facilitate the participation of tax-exempt and governmental entities in traditional flip partnership structures. Tenancy-in-common and non-partnership joint operating arrangements are relatively uncommon as strategies to monetize renewables tax credits on a large scale, and their effectiveness as substitutes for the dominant partnership structure remains to be seen (particularly in light of the lack of limited liability under a joint ownership structure). The statutory language arguably contemplates that partnerships generally can make direct pay elections. The Treasury and the IRS have requested comments on whether applicable entities can, in at least some instances, be partnerships.
• The statutory language arguably left open a possible reading that the Five-Year Election could be made more than once. The language of the Proposed Regulations and the Preamble appears to be inconsistent with such an interpretation.

Applying Section 469 to Applicable Entities

Section 6417 is applied by “turning off” or deeming satisfied certain rules that would otherwise make it difficult or impossible for tax-exempt and governmental entities to claim certain credits—for example, the restrictions on tax-exempt and governmental use of energy property in Section 50(b), and the requirement in Sections 45V and 45X that items be produced in the ordinary course of trade or business. The Proposed Regulations provide a corollary to this principle by subjecting the applicable entity to general credit limitations for persons engaged in the conduct of a trade or business, including the passive loss rules of Section 469. The Proposed Regulations also take a similar approach with respect to Section 49 (excluding certain nonrecourse financing from ITC eligible basis). Section 469, however, does not apply to a partnership making the Five-Year Election; tax-exempt income arising from such election is treated as arising from an investment activity and not from the conduct of a trade or business for purposes of Section 469, and thus is not treated as passive income to any partners who do not “materially participate” in the trade or business. 

Observation: 

• In the event that an applicable entity is an estate, trust, closely held C corporation, or personal service corporation, the limitations of Section 469 would make it difficult for the entity to adopt a traditional tax equity investor position. Interestingly, the Proposed Regulations do not explicitly state whether Section 469 applies to non-applicable entities making the Five-Year Election that are not partnerships or S corporations (which are not subject to Section 469). The Treasury and the IRS have requested comments on the application of Sections 49 and 469 to entities making direct pay elections or Five-Year Elections. 

Haircut of Applicable Credit for Restricted Tax Exempt Amounts

If an applicable entity receives a grant, forgivable loan, or other tax-exempt income for the specific purposes of construction or acquiring an investment-related credit property (“Restricted Tax Exempt Amount”), and the Restricted Tax Exempt Amount plus the otherwise available applicable credit exceeds the cost of the investment-related credit property, the applicable credit will be reduced until the sum of the applicable credit and the Restricted Tax Exempt Amount equals the cost of the investment-related credit property. The Preamble explains this rule as intended to prevent an “excessive benefit.”

Observation: 

• The new rule for Restricted Tax Exempt Amounts subjects to scrutiny any grants or tax-exempt income (e.g., donations) that may be earmarked for the construction or acquisition of renewables projects. Taxpayers may decide to examine the documentation associated with such tax-exempt income in order to prevent unintended haircuts of applicable credits.

No Direct Pay for Credits Passed Through to Lessee, Transferred Under Section 45Q(f)(3), or Acquired Under Section 6418

Under former Section 48(d), Section 50(d)(5) and Treas. Reg. § 1.48-4(a), a lessor of a project can elect effectively to “pass through” the ITC to the lessee. Similarly, under Section 45Q(f)(3), the owner of the carbon capture facility can elect effectively to pass through the carbon capture credit to the person that disposes of, uses as a tertiary injectant, or otherwise utilizes the captured carbon oxide. Emphasizing that an elective payment election must have been “determined with respect to” the applicable entity (or taxpayer making the Five-Year Election), the Proposed Regulations disallow direct pay elections from being made by the taxpayers claiming such credits, as well as by taxpayers who acquire eligible credits under Section 6418. In addition, applicable credits eligible for the Five-Year Election (i.e., Sections 45Q, 45V, and 45X) are ineligible for transfer under Section 6418 when the Five-Year Election is in effect. 

Observations: 

• The IRS’ long-rumored position on ITCs passed through by lessors to lessees is significant, not least because it removes the ability of tax-exempt and governmental entities to take advantage of direct pay through inverted leases. With partnership structures also off the table, the avenues for applicable entities to develop and invest in renewables projects alongside non-applicable entities are shrinking.
• The prohibition on so-called “chaining” of credits applies not just to the three specified instances (former Section 48(d), Section 45Q(f)(3), and Section 6418), but also to any applicable credit “otherwise not determined with respect to the applicable entity or electing taxpayer.” This broad language raises the specter of additional, unmentioned instances of perceived chaining being disallowed as well. The Treasury and the IRS have requested further comment on chaining.

Mechanics of Electing Direct Pay 

In order to claim the direct pay election on its tax return, the applicable entity must provide certain information about the project pursuant to an electronic pre-filing registration process and thereby obtain a registration number for the applicable credit property, which must be stated on the Form 3800 filed with its tax return. The direct pay election can only be made on an original tax return, including any revisions on a superseding return, and cannot be made or revised on an amended return or by filing an administrative adjustment request under Section 6227. Section 9100 relief is also unavailable for the election. The Proposed Regulations provide specific filing guidance for taxpayers who normally are not required to file federal income tax returns, such as governmental entities. 

The Proposed Regulations clarify that for the PTC and CEPTC, as well as other production-based credits for hydrogen, carbon capture and advanced manufacturing, the direct pay election, once made in the year of placed in service, applies for all subsequent years during the credit period. In addition, the direct pay election applies to the entire amount of applicable credit(s) determined with respect to each applicable credit property that is properly registered for the taxable year. 

The Proposed Regulations also provide guidance outlining when the excessive payment penalty does not apply due to reasonable cause. The Preamble states that excessive payments may arise in a “variety of situations, such as an improperly claimed bonus credit amount, an error in calculating a credit, inflated basis, failure to apply the section 38(d) ordering rules, or a misapplication of the credit utilization rules, among other things” and confirms that a recapture event is not an excessive payment.

The Proposed Regulations provide that a direct pay election by a partnership subject to the centralized partnership audit regime of the Bipartisan Budget Act of 2015 (“BBA”) can be adjusted outside of the BBA audit rules. In addition, any federal income tax liability of such partnership is an item with respect to the partnership and a partnership-related item. 

Proposed Regulations on Transferability (Prop. Reg. §§ 1.6418-1 through 1.6418-5) 

Payment in Cash

While the Proposed Regulations affirm the statutory requirement that payment for eligible credits must be made in cash, they concede that (1) the payment can be made at any time in the period between the determination of the transferred credit and the due date for completing a transfer election statement (i.e., the later of the filing of the transferor’s return for the relevant year and the filing of the transferee’s return for the relevant year), and (2) a contractual commitment to purchase credits with U.S. dollars in advance of the credit transfer, within such time period, constitutes a cash payment.

Multiple Transfers of Eligible Credit

The Proposed Regulations confirm that a transferor may make multiple elections to transfer a credit to multiple transferees. However, only a proportionate share (up to 100%) of an eligible credit, including any bonus amounts or enhancements, can be transferred. Accordingly, it is not possible to transfer a credit separate from enhancements for domestic content, energy communities and low-income communities or vice versa. In contrast to the rules for direct pay, a partnership or S corporation (not a partner/member or an upper-tier partnership) makes the transfer election with respect to eligible credit property held directly by such partnership or S corporation.

Observation: 

• In certain tax equity financings, particularly where the availability of the ITC/PTC enhancement is uncertain, the parties may wish to allocate the portion of the credit associated with the enhancement to the sponsor and permit the sponsor to transfer such credit portion for cash. While it is possible to approximate the effect of a transfer of the ITC/PTC enhancement through careful drafting of cash distribution and indemnity provisions, in some situations (e.g., involving sponsor bankruptcy scenarios) the economic result may not be entirely the same. 

No Direct Pay for Credits Passed Through to Lessee or Transferred Under Section 45Q(f)(3)

Consistent with the rules for direct pay, transfer elections are not permitted for ITCs passed through by lessor to lessee under former Section 48(d) and Section 50(d)(5) or Section 45Q credits passed through under Section 45Q(f)(3) by the carbon capture facility owner to the person that disposes of, uses as a tertiary injectant, or otherwise utilizes the captured carbon oxide, as described above.   

Applying Section 469 to Credit Transfers

The Proposed Regulations state that while restrictions on the determination of the eligible credit, such as Sections 49 and 50(b) in the case of the ITC, may limit the amount of eligible credit that can be transferred, rules limiting the amount of an eligible credit that is allowed to be claimed by the transferor, such as those under Sections 38(c) (relating to the general business credit limitation) and 469, do not limit the eligible credit, but rather apply to the transferee. In applying Section 469 to the transferee, (1) the transferred credit is treated as determined in connection with the conduct of a trade or business, and (2) the transferee is not considered to own an interest in the transferor’s trade or business at the time the work was done (as required for material participation under the passive loss rules) and cannot change the characterization of the transferee’s participation (or lack thereof) in the transferor’s trade or business by grouping multiple activities under Treas. Reg. § 1.469-4(c). 

Observations:

• In the past, the passive loss rules in Section 469 typically prevented all but the wealthiest individuals from investing in tax equity vehicles. The IRS’ eagerly-awaited position that Section 469 does not prevent transferors from transferring credits effectively opens up the tax equity market to many investors—most notably, ordinary individuals with W-2 income—who were previously hampered by their lack of passive income arising from the conduct of a trade or business. Many commercial questions surround such a sudden change in the investor landscape, including how individual investors of relatively modest means might provide adequate credit support for their credit transfers.
• Transferees, however, fare worse under the Proposed Regulations: the application of Section 469 to transferees means that an individual, estate, trust, closely held C corporation, or personal service corporation in many common fact patterns would have difficulty utilizing eligible credits as such investors typically find themselves with passive activity loss carryovers rather than excess passive activity income.

Income Recognition and Expense Deduction from Credit Transfers

Under an anti-abuse rule in the Proposed Regulations, an eligible credit transfer can be disallowed or recharacterized if the parties engage in the transaction with the principal purpose of avoiding federal tax liability “beyond the intent of Section 6418.” This rule appears to be targeted mainly towards taxpayers underpaying or overpaying for credits with a view to either maximizing tax-exempt income for the transferor, or minimizing nondeductible expense for the transferee. The Proposed Regulations confirm that even where a transferee receives a credit in excess of the amount paid for the credit, the transferee does not have to recognize the excess as gross income. However, the converse situation is still being examined by the Treasury and the IRS, which request comment on whether a transferee taxpayer can deduct a loss where the payment for the credit exceeds the amount of the eligible credit that the transferee can ultimately claim.

Where a transferor partnership receives tax-exempt income in consideration for an eligible credit transfer, such income is generally allocated consistently with each partner’s distributive share of the eligible credit that would otherwise have been allocated to the partners. However, where the transferor partnership transfers only part of the eligible credit for eligible credit property held directly by the partnership, the partnership is also allowed to allocate to each partner its contractually agreed-upon share of non-transferred eligible credits and tax-exempt income resulting from the credit transfer, subject to rules preventing double-counting of attributes.

Conversely, where a transferee partnership pays consideration for the eligible credit, the payment constitutes a nondeductible expenditure under Section 705(a)(2)(B) and the eligible credit is allocated based on each partner’s distributive share of the nondeductible expenses for the taxable year used to fund the purchase of the credit (either as specified by contract or, in the absence of such specific provision, pursuant to the partnership’s general allocation of nondeductible expenses). 

The Proposed Regulations also contain guidance regarding the interaction of the transferability regime with the REIT rules. 

Observation: 

• In a credit market that is not fully developed or highly liquid, it may often be difficult to assess whether a transferee is overpaying or underpaying for a credit. It is hoped that efficient methods to assess the approximate fair value of a credit will arise soon. In the meantime, taxpayers should proceed with caution where the transferee and transferor are parties to a separate transaction that can potentially be recharacterized as being part of the credit transfer. 

Treatment of Recapture Events

The Proposed Regulations confirm that if an ITC recapture event occurs, the transferee generally is responsible for the resulting tax increase and the transferor increases its basis in the investment tax credit property. Similar rules also apply with respect to Section 45Q recapture events. However, where the transferor is a partnership and the disposition of a partner’s interest in the transferor partnership results in a recapture event, the partner (not the transferee) is responsible for the corresponding tax increase, and the recapture event does not trigger a notice requirement by the transferor to the transferee. A similar rule applies with respect to S corporations.

Observations:

• As a practical matter, imposing recapture liability on the transferee, instead of the transferor, generally means that the transferee will simply seek to be indemnified by the transferor for any recapture liability. Such a situation would appear to favor a transferor with a strong balance sheet and/or parent guarantee—leading to uncertainty about how large-scale credit transfers can be performed by sponsors without either, such as certain sponsors owned by funds. Further, a sponsor’s reputation and credentials will play more of a factor in the market value of the credits.
• While incorporating Section 45Q into the recapture notice provisions of Section 6418 seems logical, it bears noting that the statutory language does not explicitly contemplate Section 45Q recapture events.

Mechanics of Electing Credit Transfer

In order to make a valid transfer election, each of the transferor and the transferee must include specified forms on its tax return, as well as a transfer election statement, signed by both transferor and transferee, containing specified statements and representations about the credit transfer, including confirmation from the transferor that the transferor has provided certain minimum documentation to the transferee regarding the existence of the eligible credit property, documentation of qualification for any ITC or PTC bonus amounts or enhancements, and evidence of qualifying costs or production activities. Similar to the direct pay rules, the transferor also must provide certain information about the project pursuant to an electronic pre-filing registration process and thereby obtain a registration number for the applicable credit property, which must be included on the tax returns of both the transferor and the transferee. Such registration number must be renewed for each taxable year in which an eligible credit is transferred.  

Consistent with the direct pay rules, the transfer election can only be made on an original tax return and cannot be made or revised on an amended return or by filing an administrative adjustment request under Section 6227. Section 9100 relief is also unavailable for the election. In contrast to the direct pay rules, a transfer election with respect to an eligible credit property must be made for each taxable year in which a production-related credit arises.

Similar to Section 6417, the Proposed Regulations provide guidance for when the excessive payment penalty does not apply due to reasonable cause and confirm that a recapture event is not an excessive credit transfer. All transferee taxpayers are considered as one transferee for purposes of determining the amount of an excessive credit transfer. 

The Proposed Regulations also confirm that a transferee taxpayer can apply the rules in Section 39(a)(4) (regarding a three-year carryback period for business credits) to an eligible credit, but only to the extent the eligible credit is also an applicable credit under Section 6417, taking into account the placed in service requirements for Sections 45, 45Q and 45V. 

Looking to the Future

While the Proposed Regulations provide clarity in many crucial areas, they are only the first step toward providing fulsome guidance on direct pay and transferability. Several key areas—including the controversial prohibition on partnerships making direct pay elections, the ability of transferees to claim losses with respect to purchased credits, and the application of Section 469 under both the direct pay and transferability regimes—are still open for comment. Nor do the Proposed Regulations directly address whether a transfer of a contractual right to acquire an eligible credit—or a partnership interest in a partnership that owns credits—constitutes a forbidden “second sale” of an eligible credit. Moreover, the application of Section 469 to transferees (but not transferors) of eligible credits will continue to raise novel commercial and technical questions, including those inevitably arising from large numbers of individuals entering the tax equity market. These open issues will have a material impact on the effectiveness of the direct pay and transferability regimes.