What to Know about the New Rules on Energy Credit Transfers
November 29, 2023
The Inflation Reduction Act not only created several tax credits to incentivize clean energy development, but it also added a new provision to the tax code that allows eligible taxpayers (“Sellers”) to sell unused portions of these tax credits to third parties, often at a discount from the full dollar amount of the credit. Thus, a sale of one or more eligible credits for cash to a buyer-taxpayer (“Buyer”) that can better use the credit is particularly valuable to energy start-up sellers and other energy companies that may have no ability to fully utilize these credits generated by eligible projects.
Under Internal Revenue Code (“IRC”) 6418, eligible taxpayers may sell in exchange for cash all or a portion of an eligible credit that it can’t use to a third party that may be in a better position to use that credit. Although the new tax law took effect January 1, 2023, taxpayers eagerly awaited additional information on implementing the provisions. The Internal Revenue Service recently provided this much-anticipated guidance in its proposed rules on transferring renewable energy credits.
What criteria must be met under IRC 6418?
Section 6418 allows certain taxpayers to transfer all or part of an “eligible credit” to an unrelated Buyer taxpayer. The Seller does not have to be a corporation; S corps and partnership are also eligible if they meet the criteria.
For the transfer of an eligible credit to be permissible under IRC 6418, the following criteria must be met:
- The transfer must be purchased with cash.
- The transfer will not be included in the Seller’s income and is not deductible by the Buyer.
- The Seller must own the eligible property, and another taxpayer cannot claim the tax credit from an election.
What credits are eligible for transfer under IRC 6418?
Pursuant to IRS’s proposed regulations, the following credit transfers are eligible for the 2023 tax year:
- IRC Section 30C alternative fuel vehicle refueling property credit
- IRC Section 45 production tax credit (PTC)
- IRC Section 45Q carbon capture use and sequestration (CCUS) credit
- New IRC Section 45U zero-emission nuclear power production credit
- New IRC Section 45V clean hydrogen production credit
- New IRC Section 45X advanced manufacturing production credit
- New IRC Section 48E investment tax credit (ITC)
- New IRC Section 45Y technology-neutral PTC
- New IRC Section 45Z clean fuel production credit
- IRC Section 48C qualifying advanced energy project credit
- IRC Section 48 ITC
How does Buyer risk impact pricing of the credits?
The price of credits will certainly be affected by Buyer’s risk. Although the IRS is creating a registration process (more on that below), this registration does not certify that the credit is valid. Unlike many credit transfer programs for states and territories, the IRS is not creating any pre-review or certification process that will protect Buyers from future liability if the credits turn out to be invalid. Buyers will be liable if the Seller later disposes of the property or if the total sold credit amount was overstated and should consider measures to protect themselves (also more on that below).
What are the IRS pre-registration and filing requirements?
The pre-filing registration requirements under the guidance are more substantive than anticipated by practitioners. Namely, supporting documentation must be sent to both the IRS and the Buyer. It is currently unknown when the electronic portal for the IRS mandatory pre-registration process will be available. The IRS believes that the portal should be available before the end of 2023. To take advantage of 2023 credit transfers, the Seller needs to register before filing its federal income tax return for 2023. The IRS pre-registration and filing process consists of the following steps:
- Pre-registering the underlying eligible credit property before filing the return reflecting a transfer. Any credit transfer that was not pre-registered or does not reference the registration number on the applicable tax return is essentially invalid. As part of this process, the Seller must also provide the IRS with the supporting documentation relating to the construction or acquisition of the eligible credit property (e.g., permits and leases) and provide documentation to validate the existence of the eligible credit property, any bonus credits, and the evidence of credit qualification.
- Obtaining from the Seller the registration number of the eligible credit property generating the eligible credit and all other information necessary to claim the eligible credit transferred. Taxpayers who want to transfer credits must obtain a registration number for each eligible facility or project, then give the registration number to the Buyer, who must use it to complete a transfer election statement.
- Completing a transfer election statement with the Seller. The transfer election statement, which is described in the proposed rules, must be attached to the tax returns of both parties. There is a laundry list of items that may be required to be included in a tax return in connection with a transfer election, including a “transfer election statement” that must be signed under penalty of perjury by the Seller and Buyer taxpayers. For transfers of credits that span multiple years, the election must be made for each year of the transfer. To make an election to transfer credits, the Seller must also file Form 8835, “Transfer of Clean Energy Credits.” The form must be filed by the due date of the Seller’s federal income tax return for the tax year in which the credits were earned.
- Filing a tax return. Both parties will file a tax return for the taxable year in which the eligible credit is considered under the rules of IRC Section 6418 and include the transfer election statement and other information as required by guidance. The tax return must include the registration number for the relevant eligible credit property.
What are the applicable credit “recapture” rules?
If an eligible project later becomes ineligible for the credit after the credits are transferred, the proposed rules confirm that the Buyer is liable for any recaptured tax credits. Note only certain credits are eligible for recapture. The Seller must tell the Buyer in a “timely” manner if the project is no longer eligible.
While many taxpayers had hoped that recapture would be the Seller’s responsibility, the guidance offers some leniency for partnerships and S corporations but largely leaves Buyers with a risk beyond their control. The proposed rules do, however, clarify that IRC Section 6418 does not prohibit an eligible Seller and Buyer from contracting between themselves to indemnify the Buyer against a recapture event.
The explicit allowance for guarantees is helpful, and all tax credit transfers should be expected to have a guarantee covering any losses due to recapture. It is likely that non-creditworthy counterparties will need insurance to transact competitively.
Are there excessive transfer rules?
The amount of the estimated credit to be transferred should be reasonable and based on reasonable expectations and estimates. Under the proposed rules, there is a 20% penalty for an excessive transfer credit, but that can be avoided if the Buyer can show that the transfer resulted from reasonable cause, which would be based on the relevant facts and circumstances of the transaction.
The IRS has provided a list of factors that could demonstrate reasonable cause.
Do partnerships and S corporations qualify?
The proposed rules clarify that a partnership or S corporation may qualify as an eligible Buyer or Seller of the credits and property can be owned by a disregarded entity. Importantly, income from the transfer would be treated as arising from an investment activity, not from the conduct of a trade or business.
The regulations make it clear that the IRC Section 49 at-risk regime applies to these transferable credits. Thus, if a project that could have generated $100 of credits is limited by IRC Section 49 to only $70 credits, the most the S corporation or partnership can transfer to another party is only $70.
Individuals or closely held entities buying the credit will be subject to the passive activity rules. The credit will be considered a passive activity credit, and the taxpayer will not be able to change the characterization. The credits will also be subject to the general business credit limitations. As a result, a taxpayer subject to passive loss rules would only be able to utilize purchased tax credits against tax liabilities associated with passive income generated from other sources.
Are syndicators and brokers allowed?
Syndicators or brokers for credit transfers are permitted, but because a credit may only be transferred once, they must not act as an intermediary Buyer of the credits.
What is the Bottom Line?
The rules around tax credit transfers are necessarily complex. Potential tax credit Buyers should carefully assess the potential risks and consider strategies to address them, including pursuing contractual indemnities and guarantees from the Seller, as well as performing robust diligence. Taxpayers involved in any aspect of the programs should expect IRS scrutiny. The last time the IRS offered grants in lieu of energy credits (IRC Sec. 1603 program), it became a major focus for compliance efforts. The IRS currently has a special $60 billion funding allocation to help drive additional enforcement.
If you have any questions about the energy credit transfer rules, attorneys in LP’s Tax Planning Group are here to help.