On January 6, 2021, the US Internal Revenue Service (the “IRS”) issued final regulations (T.D. 9944) (the “Final Regulations”) on the Section 45Q carbon capture tax credit (the “Carbon Credit”). The Final Regulations implement numerous provisions of the proposed regulations (REG-112339-19) (the “Proposed Regulations”) that were issued last year but contain certain investor-friendly changes and additions. Key changes that ought to be well received by investors include (i) reducing the recapture period for the tax credit to three years (from the Proposed Regulations’ five years), (ii) permitting aggregation for purposes of meeting minimum capture requirements (which would benefit smaller carbon capture facilities), (iii) providing clarification with respect to the definition of carbon capture equipment and (iv) detailing standards and other information regarding “secure geological storage.”
Section 45Q Overview
Section 45Q of the Internal Revenue Code of 1986, as amended (the “Code”) was enacted by Congress to incentivize the capture, sequestration and other qualifying use of carbon oxide. Section 45Q allows taxpayers a tax credit for each metric ton of qualified carbon oxide that is captured using carbon capture equipment that is placed in service at a qualified facility and either (i) disposed of in secure geological storage (and not used in certain manners), (ii) used as a tertiary injectant in an enhanced oil or natural gas recovery project and then disposed of in secure geological storage or (iii) otherwise utilized in a manner permitted by Section 45Q (including for any other purpose for which a commercial market exists, with limited exceptions).
The amount of Carbon Credit available to taxpayers depends, in part, on the date the carbon capture equipment is originally placed in service and how the carbon is disposed. For carbon capture equipment placed in service at a qualified facility on or after February 9, 2018, during the 12-year period from the date such equipment is placed in service, the credit can be as much as $50 per metric ton of qualified carbon oxide for permanent sequestration and as much as $35 per metric ton for enhanced oil recovery purposes. Taxpayers must own the carbon capture equipment and either physically or contractually ensure the capture and disposal, injection or utilization of such carbon oxide. Further, an owner of carbon capture equipment may also elect to transfer its Carbon Credit to a party with whom the owner contracts for sequestration.
The Code authorizes the IRS to recapture the benefits of the tax credit if previously captured carbon oxide ceases to be captured, disposed of or used as a tertiary injectant in the required manners.
On February 19, 2020, the IRS issued IRS Notice 2020-12 (the “Notice”) and Revenue Procedure 2020-12 (the “Revenue Procedure”) to address two key aspects of the Carbon Credit. Specifically, the Notice provides guidance with respect to the “start of construction” requirement under the Code, and the Revenue Procedure establishes a safe harbor under which partnership allocations of the Carbon Credit will be respected. The Notice and the Revenue Procedure are addressed in this prior Mayer Brown Legal Update.
On May 28, 2020, the IRS issued the Proposed Regulations to clarify the requirements for use of the Carbon Credit for carbon oxide captured using equipment originally placed in service on or after February 9, 2018. Among other things, the Proposed Regulations detailed certain standards requirements needed to be met by secure geological storage sites and third-party verification procedures, exceptions to the general credit attribution rules, procedures for a taxpayer to elect to allow third-party taxpayers to claim the credit, standards for measuring utilization of qualified carbon oxide and rules for credit recapture by the IRS. The Proposed Regulations provided important guidance to the carbon capture industry, but certain questions remained unanswered.
Key provisions of the Final Regulations are as follows:
Section 45Q requires the Carbon Credit to be recaptured when qualified carbon oxide ceases to be captured, disposed of or used as a tertiary injectant. The Proposed Regulations contained a five-year recapture period (with certain limitations). The Final Regulations shorten the recapture period from five years to three years and provide that the recapture of credit is taken into account in the year in which the leakage occurs and is reported.
The risk of qualified carbon oxide leakage leading to a recapture event is usually the greatest in the years in which the qualified carbon oxide is injected. The likelihood of leakage decreases over time as the qualified carbon oxide becomes stable. Regarding lowering the recapture period from five to three years, the preamble to the Final Regulations notes that a three-year period “sufficiently accounts for risk and reduces the compliance burden that would be imposed by a five-year recapture period.” The IRS also notes the lower compliance burdens on both taxpayers and the IRS itself in making this change.
Aggregation for Qualification
The Final Regulations allow taxpayers, in certain circumstances, to aggregate carbon capture facilities for purposes of meeting the minimum capture requirements for purposes of claiming the Carbon Credit. Taxpayers may apply the rules of Section 8.01 of Notice 2020-12 to treat multiple facilities as a single facility for purposes of determining whether a facility satisfies the requisite annual carbon oxide capture thresholds to be treated as a qualified facility.
Broadly Defined “Commercial Market”
As noted above, the Carbon Credit applies, in part, for utilization of the captured carbon in certain situations, including for “any other purpose for which a commercial market exists as determined by Treasury.” The Proposed Regulations did not define what constitutes a “commercial market.”
The Final Regulations define the term broadly as a market in which a product, process or service that utilizes carbon oxide is sold or transacted on commercial terms. The Final Regulations do not restrict the definition by limiting it to certain specific products or markets.
The amount of the Carbon Credit from sales into commercial markets wherein the captured carbon can be utilized is determined through an analysis of lifecycle greenhouse gas emissions (an “LCA”). The Final Regulations retain the concept of an LCA, including the requirement that the LCA conform with ISO 14044:2006 (with an additional reference to ISO 14040:2006). The Final Regulations clarify that LCAs must be prepared and documented in conformance with the ISO standard. The IRS rejected a number of suggestions to allow taxpayers to claim Section 45Q credits without preapproval of the LCA, or at least while the LCA is under review. The commenters had suggested that this requirement would likely result in significant approval delays, dampening commercial interest in these projects. The IRS did at least note that it would provide separate guidance on the LCA submission and review process, including regarding the length of time necessary for an LCA review.
The Final Regulations also include a requirement that the analysis demonstrate a net reduction of carbon dioxide equivalents (as compared to a comparison system). As the Code currently provides, this reduction may be achieved by capturing and permanently isolating qualified carbon oxide from the atmosphere or by displacing the qualified carbon oxide from being emitted into the atmosphere through use of certain required processes.1
Under the Final Regulations, the LCA must be approved by the IRS before the taxpayer files a claim for the Carbon Credit with respect to the utilization of the carbon dioxide.
Definition of “Carbon Capture Equipment”
The Final Regulations provide that “carbon capture equipment” generally includes all components of property that are used to capture or process carbon oxide until the carbon oxide is transported for disposal, injection or utilization. The list of qualifying carbon capture components and the excluded components is removed.
Generally, carbon capture equipment does not include components of property used for transporting qualified carbon oxide for disposal, injection or utilization. However, the Final Regulations provide that carbon capture equipment includes a system of gathering and distribution lines that collect carbon oxide captured from a qualified facility or multiple qualified facilities that constitute a single project. Overall, the revisions provide a functionality-based definition of carbon capture equipment and provide flexibility without limiting the definition of carbon equipment solely to a list of components.
Credit Only Available for Qualified Carbon Oxide
The Final Regulations reiterate that only carbon dioxide or other carbon oxide may be qualified carbon oxide that is eligible for the Carbon Credit. The Carbon Credit is not computed on all greenhouse gases and is based solely on qualified carbon oxide measured at the source of capture and utilized.
Secure Geological Storage
For captured carbon oxide used in enhanced oil recovery, such captured carbon oxide must be disposed of by the taxpayer in secure geological storage. The Final Regulations retain the Proposed Regulations’ approach by continuing to permit taxpayers to satisfy the standards for “secure geological storage” under either ISO or EPA standards to establish that qualified carbon oxides are being securely stored. The Final Regulations also contain further information on licensure, qualifications and credentials for those certifying “secure geological storage.”
The Final Regulations provide other significant changes, including:
- Permitting multiple binding written contracts.
- Requiring taxpayers who have existing contracts to conform such contracts to be eligible for the Carbon Credit.
- Confirming that a contractor for the disposal, injection or utilization of an electing taxpayer’s qualified carbon oxide may qualify as a credit claimant.
- Explaining whether a physical modification or equipment addition may be treated as newly placed in service.
- Clarifying that the failure to satisfy the reporting requirement will result in an inability to claim the credit in that taxable year.
- Harmonizing conflicting provisions regarding liquidated damages.
- Clarifying that carbon capture equipment that is originally placed in service at a qualified facility on or after February 9, 2018, may be owned by a taxpayer who does not own the industrial facility at which such carbon capture equipment is placed in service.
- Clarifying that for each single process train of carbon capture equipment, only one taxpayer will be permitted to claim the Carbon Credit, although multiple owners may form a partnership to allocate the credits among themselves pursuant to the Revenue Procedure.
- Clarifying that pipelines are generally not considered carbon capture equipment.
- Clarifying the 80/20 rule with respect to previously owned equipment and the appropriate unit of carbon capture equipment.
- Adopting a 90 percent bright line test regarding carbon dioxide production wells at natural carbon dioxide-bearing formations or at naturally occurring subsurface springs.
- Clarifying situations where reinjection of carbon oxide into a qualified enhanced oil or natural gas recovery project will trigger a recapture event.
- Disallowing taxpayers from performing remedial actions or otherwise curing a leak to avoid a credit recapture.