The Inflation Reduction Act of 2022, P.L. 117-169, signed into law on Aug. 16, 2022, is considered the largest investment in clean energy in history, providing an estimated $663 billion of new energy-related tax credits over a 10-year period. This investment greatly expands the federal income tax credits available to incentivize clean-energy production.
The act also provides new opportunities to monetize many of the energy tax credits through direct payment and transfer elections. The following 11 tax credits are eligible to be transferred:
Monetization of investment tax credits
In some instances, a taxpayer generating an energy tax credit may not be able to fully utilize the credit. Historically, a taxpayer benefited from a credit only if it otherwise was paying tax that exceeded the credit amount. To monetize tax credits prior to the Inflation Reduction Act, the tax law allowed taxpayers to create complicated partnership structures (known as tax equity or “flip” partnerships) wherein tax credits generated by the partnership could be shared with investors. For example, a tax equity structure allowed the project owner to monetize investment tax credits (ITCs) by allocating them to the tax equity partner in exchange for cash contributed by that partner. This approach reduced the tax equity partner’s tax liability and, in turn, enabled the project owner to finance the project.
The Inflation Reduction Act now provides for the monetization of tax credits through new “transferability” provisions (Sec. 6418). The transferability mechanism under the act provides an election for eligible project owners (i.e., seller or transferor) to transfer all or a portion of eligible credits to unrelated non–tax-exempt taxpayers (Sec. 6418). Consideration paid for the transfer of such a credit is required to be paid in cash and is not includible in the transferor’s taxable income or deductible to the transferee (Sec. 6418(b)). Upon making the transfer election, both the eligible transferor and transferee taxpayer are required to attach a transfer election statement to their respective returns, and the eligible taxpayer must satisfy the prefiling registration requirements (Regs. Secs. 1.6418-2(b)(5) and 1.6418-4). Further, if the clean-energy project is owned by a partnership, including a flip partnership, any election to transfer credits must be made at the partnership level (Sec. 6418(c)(2)), and any amount received as consideration will be treated as tax-exempt income. The partner’s distributive share of such tax-exempt income is based on the partner’s distributive share of the otherwise eligible credit (Sec. 6418(c) (1)). The amount of the credit available for transfer is reduced to the extent the at-risk rules apply to the credit base, and the partnership must request from the partners their share of nonqualified nonrecourse financing.
The Inflation Reduction Act’s tax credits generally are expected to be sold at a discount under the transferability provision. The transfer is expected to provide cash flow to the transferor, while the discount is expected to reflect the substantiation and recapture risks inherent in sustaining the tax credit that are undertaken by the transferee.
Relationship between the monetization of investment credits and recapture rules
Taxpayers that claim ITCs may be required to recapture a portion of the credit if the ITC-eligible property is disposed of or otherwise ceases to be investment tax property during a five-year recapture period (Sec. 50(a) (1)(A)). That period starts when the property is placed in service. The recapture rules apply to the taxpayer claiming the ITC as a reduction in tax liability. If a recapture event is triggered in the first year after the property is placed in service, 100% of the credit is recaptured, while for recapture events triggered in subsequent years, the recapture percentage decreases by 20% each year until it reaches zero after the fifth year (Sec. 50(a)(1)(B)).
Absent Treasury regulations under Sec. 50, the IRS generally looks to Sec. 47 regulations to interpret the Sec. 50 recapture rules. Notably, there are important exceptions to the recapture of ITCs that exclude certain transfers of ITC property from “disposal” or “cessation.” For instance, an exception exists for sale-leaseback transactions, specifically, for ITC property that is disposed of and then leased back to the vendor in the same transaction (Sec. 50(a)(2)(C) and Regs. Sec. 1.47-3(g)). In such cases, the terms “disposition” and “cessation” do not apply and will not require credit recapture. Another notable exception provides that recapture is not required if there is a “mere change in the form of conducting a trade or business,” meaning that the ITC property is retained in the trade or business and the taxpayer retains a substantial interest in the trade or business (Regs. Sec. 1.47-3(f)).
When the project owner is a partnership, a partner may be subject to recapture if the partner’s interest in the general profits of the partnership is reduced as a result of certain events during the recapture period (Regs. Sec. 1.47-6). Thus, if the partners restructure their interest through a sale of their interest or a reorganization of the partnership, the partners could be subject to recapture on the reduction in their interest (Regs. Sec. 1.47-6(a)(2)). However, Regs. Sec. 1.47-6(a)(2) provides a de minimis rule that allows a partner to dispose of up to 33⅓% of their proportionate interest in the general profits of a partnership before credit recapture is required. Any recapture is calculated based on the partner’s share of the basis (or cost) of the property to which the specified credit portion was determined (Regs. Secs. 1.6418-3(a)(6) (i)(B) and 1.46-3(f)).
These same recapture rules apply to Inflation Reduction Act credits transferred in a Sec. 6418 election. The transferee of the ITC may be subject to recapture under Sec. 50 if the ITC property is disposed of or otherwise ceases to be investment tax property before the close of the five-year recapture period (Sec. 6418(g)(3)(A)). This recapture is subject to additional requirements under which the eligible taxpayer must provide notice of the occurrence of recapture to the transferee taxpayer. The notice must include all information necessary for the transferee taxpayer to compute the recapture amount, and, in turn, the transferee taxpayer must notify the eligible taxpayer of the recapture amount (Regs. Sec. 1.6418-5(d)(2)).
Additionally, the transferee taxpayer will be responsible for any amount of tax increase under Sec. 50(a), and the eligible taxpayer will be responsible for increasing the basis of the investment credit property (immediately before the recapture event) (Regs. Secs. 1.6418-5(d) (3)(i) and (ii)). However, the preamble to the final regulations under Sec. 6418 (T.D. 9993) provides that to the extent the eligible taxpayer retains any credits, recapture risk will be allocated to the eligible taxpayer for any retained credits before causing a recapture event to the transferee taxpayer. Similarly, if it is determined that there is an excessive credit transfer (i.e., a transfer of tax credits that exceeds the amount of credits that otherwise would have been allowed to the transferor) the transferee taxpayer will be responsible for the related tax liabilities (Sec. 6418(g)(2)). The preamble also articulates that the definition of an “excessive credit transfer” effectively includes an “ordering rule” by which any excessive credit transfer first reduces the tax credit retained by the eligible taxpayer before applying to the transferee taxpayer.
For example, if the amount of the credit is improperly determined by the transferor due to errors in construction beginning dates (implicating the need to meet prevailing wage standards) or placed-in-service dates (implicating the tax year in which the credit may be claimed or transferred); errors in prevailing wage and apprenticeship or domestic content calculations (thus reducing the credit amounts by the inflator and bonus credits); or improper methods to calculate cost basis, the transferee could be liable for additional tax. Note that the transferee does not recapture the credit if a partner in a transferor partnership sells or disposes of its interest in the partnership because the partner (not the transferor partnership) is subject to the recapture in that instance (as discussed above). Further, to mitigate instances of duplicate recapture of the same ITC amount, the preamble to the final regulations under Sec. 6418 clarifies that, to the extent a partner/shareholder in a transferor partnership/S corporation causes a recapture event, such amount reduces the remaining amount of ITC subject to recapture for a recapture event caused directly by the transferor partnership or the transferee S corporation.
Buy-side due diligence is crucial
Transferability provides a new way for taxpayers to monetize many of the Inflation Reduction Act tax credits alongside tax equity structures. However, taxpayers must consider additional requirements under transferability and the potential consequences of credit monetization, including recapture events and the various recapture exceptions. Because the transferee takes on the risk of recaptured or improperly calculated credits, it is imperative for buyers to perform buy-side due diligence as well as be entitled to indemnifications from sellers in credit transfer transactions.
Editor Notes
Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City.
For additional information about these items, contact Turgeon at christine.turgeon@pwc.com.
Contributors are members of or associated with PricewaterhouseCoopers LLP.