Proposed Regulations to Demystify the Lucrative IRC Section 45X Credit

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A version of this article was published December 22, 2023, on Bloomberg Tax.

Businesses that make and sell energy components received a long-awaited rule proposal from the US Department of Treasury Department on December 14, 2023, regarding the advanced manufacturing production tax credit under Internal Revenue Code (IRC) Section 45X.

The proposed regulations provide much needed recommendations on this highly technical and lucrative credit. In addition to providing granular technical guidance on specific eligible components, companies across the energy sector—battery technology, solar, wind, and inverters—should consider the following takeaways.

Taxpayer Production Requirement

Eligible components must be produced by the taxpayer to qualify under Section 45X(a)(1). The proposal states that qualified production requires a substantial transformation of inputs into a complete and distinct eligible component, excluding companies performing final stage minor assembly from eligibility.

This effectively means that the eligible component undergoes an advanced manufacturing process, starting with the raw materials and subcomponents that results in a final ready-to-use product.

Companies and their accountants consequently must document the specific manufacturing process at a granular technical level and explain the substantial transformation. The manufacturing process is likely to be an audit focus, as it appears prone to abuse from taxpayers performing only final assembly in the United States.

Contract Manufacturing

Certain companies that used outsourced manufacturing submitted comments urging the Treasury to credit the contracted payor, not the contract manufacturer, pointing as an example to rules once applicable to the domestic production activities deduction.

The proposed rules in Section 45X reject this, stating the party that may claim the credit is the taxpayer, generally, the contract manufacturer, that performs the actual production activities that results in the eligible component.

The Treasury laid out an option allowing the credit to be assigned over to the contractee if both parties agree. This was a big win for companies that design and sell eligible components but outsource production to contract manufacturers. It will allow them to negotiate terms that enable them to benefit from the credit, whether through assignment of the credit or favorable pricing terms.

Manufacturers that thought may not qualify given their contractor status may now qualify if they can negotiate terms that enable them to benefit from the credit, whether through assignment of the credit or favorable pricing terms.

Related Person Election

The related person election outlined in Section 45X(a)(3)(B) was an area of much needed guidance, because the tax code’s function and its purpose was unclear.

One of Section 45X credit’s primary requirements is that eligible components must be sold to an unrelated party, with the related party election being a potential exception. The related person election, if made by the taxpayer, allows the sale of components to a related person to be treated as if made to an unrelated person.

The proposed rules clarify that the related person election is intended, at least in part, to address the common situation of organizations having separate manufacturing and sales entities. The proposed rules lay out the specific process for making this election. Tax professionals will need to take note, as the election must be included with a timely filed original return.

What remains unclear is whether the related party election and a taxpayer’s ability to take the Section 45X credit applies to situations where such components are sold to a related party, but that related party doesn’t ultimately sell to an unrelated party. This could, for example, include electronic vertical takeoff and landing companies that will both build and operate their aircraft.

Credit Applicability for 2023

The Inflation Reduction Act states that Section 45X credit is effective for components produced and sold after December 31, 2022. The proposed regulations state that to be eligible for the credit in 2023, production of the component must have been completed after December 31, 2022, but that production could have begun prior to January 1, 2023.

As a result, companies and their accountants will need to track when the eligible component was sold and when it first began production. This may be challenging, as inventory is commonly netted at warehouses without records showing the production date.

The potential magnitude of Section 45X credits can’t be understated, potentially amounting to tens of millions of dollars or more for some companies each year. The rules are well thought out by the Treasury and are complex, partly because the credit hinges on the taxpayer undergoing an advanced manufacturing process to produce an eligible component that has very distinct specifications.

Given the magnitude of 45X credits, taxpayers and their advisors should fully grasp these rules.

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If you have questions about tax credits related to Section 45X, please contact your Moss Adams professional.

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