The Inflation Reduction Act, signed into law on August 16, 2022, brings federal tax credit investment opportunities that don’t require tax equity structures and allow for the purchase and sale of certain federal tax credits like many states already allow.
New Opportunities for Taxpayers
There are two noteworthy provisions of the Inflation Reduction Act related to federal income tax credits:
- Direct pay provisions. Federal income tax credits related to carbon capture, clean hydrogen, and manufacturing of components for renewable generation facilities are refundable through direct payment at 100% of their value for both taxable and tax-exempt entities, while other credits for renewable generation are refundable to tax-exempt entities only.
- Tax-credit transfers. For taxable entities, these credits can be monetized through transfers to a third party at a negotiated amount.
While many direct pay credits are generally limited to tax-exempt taxpayers and to specific credit types, the transferable credits can be used by all taxpayers. Individual use may be restricted based on passive activity rules.
Federal tax law has historically prohibited the outright sale of federal income tax credits, which leads to the depreciation of the value of the credits in the hands of developers or other owners who lack the tax liability to effectively use such credits.
The law evolved to allow certain credits (and accelerated tax depreciation) to be generated in a partnership and, if certain rules are met, to be allocated to the partners with tax capacity in exchange for an upfront cash payment to the partnership (or directly to the other partner).
In these transactions, the partners with tax capacity are known as tax equity investors. The transactions themselves are called tax equity transactions or flip partnership transactions because the tax equity investor’s allocation of partnership items is reduced, or flips down, after allocation of tax credits and depreciation deductions.
Transferable credits could be a game changer for developers and owners of renewable energy and other types of clean energy projects, since they provide alternatives to often costly and complex tax equity structures.
Developers and other owners will need to analyze the benefit of transferring credits to the cost of not being able to monetize the tax depreciation associated with the project, which isn’t transferable or eligible for direct pay under the Inflation Reduction Act.
Given the complexity and larger transaction costs associated with traditional tax equity transactions, small- to medium-sized projects may consider transferring credits versus setting up a tax equity structure. Returns sought by tax equity investors versus discounts required by tax credit buyers may also factor into this decision.
With respect to credits generated over time, such as production tax credits (PTC), the ability to transfer credits in advance of or shortly after generation would be beneficial, as it could allow for more efficient bridge financing, engineering, procurement, and construction contract payoffs.
The IRS has yet to release guidance on the credit transfer process, but the timing of the transfer may impact financing costs for taxpayers generating credits.
Tax Credit Transfers
Newly added Internal Revenue Code (IRC) Section 6418 established under the Inflation Reduction Act allows eligible taxpayers to elect to transfer the following credits (in whole or in part) to an unrelated third party as defined under IRC Sections 267(b) and 707(b)(1).
Clean Vehicle Tax Credits
- IRC Section 30C alternative fuel vehicle refueling property credit
Renewable Energy Generation Tax Credits
- IRC Section 45 renewable electricity production credit
- IRC Section 48 energy investment tax credit
- IRC Section 45Y clean electricity production credit
- IRC Section 45U zero-emission nuclear power production credit
- IRC Section 48E clean electricity investment credit
Carbon Sequestration Tax Credits
- IRC Section 45Q credit for carbon oxide sequestration
Clean Fuel Tax Credits
- IRC Section 45V clean hydrogen production credit
Energy Manufacturing Tax Credits
- IRC Section 45X advanced manufacturing production credit
- IRC Section 45Z clean fuel production credit
- IRC Section 48C advanced energy project credit
IRS Request for Comments
The IRS released Notice 2022-50, requesting comments on the transferability (and direct pay) provisions of the Inflation Reduction Act by November 4, 2022. While taxpayers wait for the Secretary of Treasury and the IRS to release guidance, practitioners are left asking questions.
Federal Tax Impact of Credit Transfers
What’s known thus far is that the cash payment to the transferor isn’t taxable income, and the payment by the transferee isn’t deductible as a tax payment or other business deduction.
Buyers should expect some gain for using the credit based on the discount, because such gain isn’t specifically identified as exempt.
State Tax Impact of Credit Transfers
It remains to be seen how states will treat the proceeds from federal tax credit transfers and corresponding payments as not all states conform to the IRC. This lack of conformity could result in disparate treatment of the gain on the sale and purchase discount among the states.
Penalties apply in the case of an overstated credit and equal the amount of credit overstated plus an additional 20%, unless taxpayers can show good reason, the parameters of which aren’t yet defined. Penalties may be waived at the secretary’s discretion.
The IRS may issue additional guidance on the penalties, as Notice 2022-50 specifically requested comments on this topic and Section 6418 includes a transferee reasonable cause exception relating to penalties from excessive credit transfers.
Credit transfers related to progress expenditures aren’t allowed and would require the project to be in service for the credit transfer, though the transfer process itself is still undetermined. Purchased tax credits may only be transferred once and have a three-year carryback and 22-year carryforward.
An election to transfer a credit earned by a flow-through entity, including S corporations (S corp), is made at the entity level. The amount received is tax-exempt income for purposes of IRC Sections 705 and 1366, based on the member or shareholder’s distributive share.
The basis of the property related to the credit is subject to a 50% reduction of the amount of the credit under IRC Section 50(c). Additional guidance is needed to determine whether an S corp or partnership can purchase credits and flow them through to the owner(s).
When to Claim the Credit
The transferee must begin claiming the credit in the first tax year applicable to the transferor.
For example, if a transferee purchases an investment tax credit under IRC Section 48 during 2023, the year the project was placed into service, the transferee must first claim the tax credit in 2023.
When to Transfer
Elections to transfer these certain credits may be made as early as February 12, 2023, and no later than the extended due date of a transferor’s tax return, as applicable.
For example, should a partnership place a transferable tax credit eligible project in service on February 1, 2023, they can’t elect to transfer the credits until February 12, 2023. They would then have until the extended due date of the 2023 tax year return, or September 15, 2024, for the onetime transfer the credit.
A taxpayer or buyer purchasing those credits will use them starting with their 2023 tax year and then carry them back three years to 2020 or forward to 2045.
Elections to transfer applicable investment tax credits and production tax credits are made in the year the credits are generated. Such an election once made is irrevocable and may not be made as it relates to credits that are carried backward or forward.
When and how to make the election is still uncertain, though comments have been requested in Notice 2022-50 as it pertains to IRC Section 6418(a).
Information Reporting and Registration Processes
The IRS is expected to create information reporting and registration processes for Inflation Reduction Act transferable credits, along with means to report and track transfers by amount, type, and year.
Until this guidance exists, negotiating purchase and sale agreements may be challenging, though some buyers and sellers may enter into letters of intent pending the receipt of guidance for projects under construction. Tax credit lenders may request to see agreements in place before releasing funds to aid construction.
Buyer and Seller Considerations
Credit buyers will be considered the party liable for any recaptured credits. Because of this, buyers and sellers may consider an indemnification clause and insurance against credit risks.
Tax Credit Transfer Agreement Considerations
Tax credit buyers should consider working with their tax and legal advisors when drafting tax credit transfer agreements to determine appropriate protections and indemnification clauses. Some buyers may also ask for an independent CPA project cost audit of the tax credit basis.
Insurance Against Credit Risks
Purchasers of credits may consider purchasing insurance or require the seller to insure the credit against certain risks. Tax credit insurance has a long history, though its current use typically applies to tax equity transactions for many credit programs.
The four most common risks in tax equity transactions are:
The year of the credit could also be a risk if an IRS audit deemed that the facility wasn’t placed into service during the year the credit was transferred and applied.
Once the IRS provides guidance on the credit certification and registration process, credit buyers will need to consider the credit transfer risks and evaluate the need for tax credit insurance.
Potential Limitations for Applicable Corporations
The act imposes a new 15% corporate alternative minimum tax (CAMT) on certain applicable corporations to the extent that their tentative minimum exceeds the regular US federal income tax liability plus liability for the base erosion and anti-abuse tax (BEAT).
An applicable corporation's tentative minimum tax is a 15% minimum tax on its annual adjusted financial statement income (AFSI) to the extent it exceeds the CAMT foreign tax credit for the tax year.
To the extent a corporation is subject to the CAMT, the corporate tax may be reduced by tax credits under the Inflation Reduction Act provisions. The total credit is limited to the extent of 75% of the taxpayer's net income tax that exceeds $25,000 (with no limit against the first $25,000).
Unresolved Issues for Transferable Tax Credits
Passage of the Inflation Reduction Act still leaves much to be determined with several considerations regarding federal transferable credits, such as:
Applying Rules in a Partnership Context
It’s unclear how the rules apply in the partnership context, including whether partnerships formed solely to purchase tax credits will be respected as valid tax partnerships, and if partnerships can combine traditional tax equity arrangements (to monetize depreciation) with the sale of credits outside of the partnership.
Application Issues for Individuals
How these credits apply to individual taxpayers and whether passive activity income rules apply remains unclear. Whether transferred credits can be used to offset portfolio income such as interest, dividends, and capital gains also remains a question.
Currently, federal tax credits may only be used by individual taxpayers to offset passive activity income unless they materially participate in the trade or business giving rise to such credit.
Transferable Tax Credit Market Variables
While the market for federal transferable tax credits has yet to fully evolve, discounts could range from 6% to 15% or more depending on a variety of factors, such as:
- Size of credit
- Strength of indemnity
- Credit type and transfer process
- Quality of energy offtake agreements
- Existence of tax credit insurance
- Timing of guidance issued by the IRS
- Environmental, social, and governance preferences
- Geographic location of the project
- Taxability of gain on purchase discount
Predictions point toward accelerated adoption and use of clean energy technologies, likely due to the Inflation Reduction Act. Some are already racing to bring their projects to market, given some program caps.
Many of the largest utility scale projects, like wind and solar, will probably still use traditional tax equity, while the middle market and newest technologies may elect to transfer the tax credits under the new Inflation Reduction Act provisions.
We’re Here to Help
To discuss how the Inflation Reduction Act could affect your tax credit transfer options or other Tax Credits & Incentives, contact your Moss Adams professional.