On Oct. 2, 2015, the IRS issued Notice 2015-70 requesting comments on future guidance related to the definition of qualifying energy property under Sec. 48. The notice states that Treasury and the IRS "anticipate" they will issue new regulations to define certain types of property qualifying for the investment tax credit (ITC). This item describes the evolution of the ITC, information about the timing and scope of potential future regulations, and potential issues that the IRS may attempt to address in the guidance.
Request for Comments and the Importance of Future Guidance to Energy Credits
Based on history, it would be unusual for the IRS to formally request public comments if new guidance were being considered in the form of another notice, revenue ruling, or revenue procedure, not regulations. Notice 2015-70 expressly notes the intention to update the current regulations under Sec. 48, which the IRS has not revised since 1987. The 2015-2016 Priority Guidance Plan the IRS released on July 31, 2015, included a new project listed as "Guidance on the definition of qualifying energy property under §48." The notice confirms the project will likely result in new regulations.
The IRS requested comments that address the following:
1. Whether only property that actually produces electricity may be considered energy property or whether property such as storage devices and power conditioning equipment may also be considered energy property;
2. Whether dual-use property should qualify for the credit and, if so, under what circumstances. If it should qualify, what portion of the basis of dual-use property should be taken into account in computing the energy percentage;
3. Comprehensive definitions of the property described in Section 3 of the notice;
4. Definitions of terms such as storage devices, power conditioning equipment, transfer equipment, and other property commonly used in conjunction with property described in Section 3 of the notice, as well as definitions of parts related to the functioning of these items; and
5. The need for other energy-related definitions.
The deadline for submitting comments was Feb. 16, 2016. The IRS may first issue proposed regulations, which must be drafted, reviewed, and published—a process that often takes significant time. Proposed regulations often take up to a year or even many years to issue. Although not as likely, it is also possible that the IRS will issue temporary regulations that provide immediate guidance to taxpayers prior to publishing final regulations.
After the IRS issues proposed regulations, taxpayers have another chance to formally comment prior to the publication of the final regulations. Issuing final regulations may also take a significant amount of time.
Taxpayers may find it difficult to obtain private letter rulings on these issues while the regulation process is underway. It is possible that the IRS would issue proposed regulations as early as the spring of 2017, followed by a 60-day window for comments on the proposed regulations and a public hearing held approximately three weeks after the 60-day comment window. Based on this estimate, the IRS would promulgate final regulations no earlier than the fall of 2018.
Past Regulations Relating to Sec. 48 and Energy Credits
In 1981, the IRS issued final regulations under Sec. 48 that are still in effect (Regs. Sec. 1.48-9). In 1987, the IRS revised its regulations for "dual use equipment." These regulations clarified that certain equipment that uses solar, wind, or geothermal energy is eligible for the energy ITC to the extent the equipment uses a qualified energy source, so long as the use of nonqualified energy does not exceed 25% of the total energy used by the equipment in an annual measuring period (Regs. Sec. 1.48-9).
Potential Topics to Be Addressed in Future Regulations
The issuance of new regulations may open the door to significant changes to the ITC, or at least clarifications of long-standing areas of ambiguity. Old ITC regulations and the current Sec. 48 present a number of inconsistencies, contradictions, and out-of-date examples that call into question the validity and authority of these old regulations relative to more recent statutory modifications by Congress. For example, the old Sec. 48 regulations contemplated "storage devices," but language and examples largely focus on thermal storage, which results in many open questions about their clarity and practical utility when analyzing electric/battery storage paired with energy sources such as solar and wind. Other industries have introduced new technologies into the market that are not well-defined in the regulations. For example, the regulations do not define terms such as "power conditioning equipment" and "transfer equipment," and they do not identify the components that make up combined heat and power systems, fuel cells, or microturbines.
New guidance may affect all technologies that are currently eligible to receive an ITC, including solar, wind, geothermal, biomass, waste, hydropower, combined heat and power, fuel cells, microturbines, and others.
The following are examples of issues that repeatedly emerge for taxpayers and practitioners. This is not an exhaustive list, but rather an illustration of the potentially broad scope for future regulations.
Issues Impacting Multiple Industries
Dual-use equipment and dual-function allocations: The regulations often require that all or a portion of the ITC be reduced to the extent that the qualifying energy property performs another function and/or uses a nonqualifying source of energy. For example, the regulations provide limited guidance about structural components that may support qualifying energy property while simultaneously serving another purpose (e.g., a building roof, carport, or light pole). The regulations do not provide clear methodologies for allocating basis between the qualifying activity and the nonqualifying activity.
With respect to the use of nonqualifying sources of energy, dual-use equipment rules for solar, wind, and geothermal energy create a percentage threshold for energy inputs to remain eligible. Specifically, dual-use equipment is qualifying energy property (1) only if its use of energy from sources other than the qualifying energy source does not exceed 25% of its total energy input in an annual measuring period, and (2) only to the extent of its basis of cost allocable to its use of the qualifying energy source during an annual measuring period (e.g., see Regs. Sec. 1.48-9(d)(6)). At the outset, the dual-use equipment rules and examples primarily contemplate thermal energy applications that are not easily applied to electricity.
Application of the dual-use equipment rules to energy storage has been particularly unclear over the last several years. In 2011 and 2012, the IRS issued two letter rulings permitting taxpayers to claim a full 30% ITC on the eligible basis of storage devices paired with wind farms (Letter Rulings 201142005 and 201208035). Both taxpayers contemplated using storage devices for grid services such as frequency regulation, in which a certain portion of battery inputs of electricity would be from the grid. Nonetheless, the IRS did not apply the dual-use equipment rules and require a corresponding ITC reduction. In 2012, the IRS issued a letter ruling for a combined solar photovoltaic and battery system that concluded a taxpayer must reduce the ITC claimed on a storage device in cases in which the storage device is charged with solar and nonsolar energy (e.g., grid power) (Letter Ruling 201308005). In these cases, the IRS deemed the components dual-use equipment under Regs. Sec. 1.48-9(d)(6) and determined that the equipment is solar energy property: (1) only if its use of energy from sources other than solar energy does not exceed 25% of its total energy input in an annual measuring period, and (2) only to the extent of its basis of cost allocable to its use of solar energy during an annual measuring period.
Under Regs. Sec. 1.48-9, the annual measurement is required each year during the ITC's five-year recapture period. If the annual measurement percentage attributable to the qualifying energy source in a given year drops in the subsequent year, then the taxpayer must recapture a proportionate share of the ITC. Furthermore, the taxpayer may not claim an additional credit if the annual measurement percentage increases in a subsequent year.
Treasury regulations provide for an annual measurement of energy inputs on a Btu basis, but no additional clarity is provided for electric storage and market applications where measurement of gross energy inputs is difficult or technically impossible (e.g., certain behind-the-meter configurations). The regulations do note that the IRS may accept any method that, in the IRS's opinion, accurately establishes the relative annual use by dual-use equipment of the qualifying energy source and energy derived from other sources. In crafting the dual-use equipment provisions in 1987, Treasury acknowledged other measurement methods may be acceptable, including methods that do not reflect actual, relative energy inputs.
Integral property rule: Sec. 48 as it existed immediately prior to the passage of the Omnibus Budget Reconciliation Act of 1990, P.L. 101-508 (former Sec. 48), included a provision for both a "general" investment tax credit (under Sec. 48(a)(1)) as well as a special investment tax credit for certain "energy property" listed under former Sec. 48(l). Former Sec. 48(l)(4) included "solar energy property" as eligible "energy property."
Regs. Sec. 1.48-9(b) clarifies that the "general" rules of former Sec. 48 apply to "energy property" by providing: "Energy property is treated under [former Sec.] 48(l)(1) as meeting the general requirements for [Sec.] 38 property set forth in [Sec.] 48(a)(1)" (Regs. Sec. 1.48-9(b)(1)(i)). Also: "In general, [Sec.] 48(a) otherwise applies in determining if energy property is [Sec.] 38 property" (Regs. Sec. 1.48-9(b)(2)(i)).
Although the "general" investment tax credit was removed from the statute as part of Omnibus Budget Reconciliation Act of 1990, the credit for "solar energy property" essentially remained intact but for certain minor organizational changes. Therefore, the "general" rules of former Sec. 48 continue to apply to the definition of solar energy property under Sec. 48(a)(3)(A)(i).
Under Regs. Sec. 1.48-1(d)(4), property that is not tangible personal property may qualify for the ITC if it is an "integral part" of the qualifying activity. Property is integral "if it is used directly in the activity and is essential to the completeness of the activity."
New regulations may clarify that the integral-property rule continues to apply to the current ITC rules under Sec. 48, reflecting the consistent broad application of the rule to the ITC since the rule was promulgated in 1964 (T.D. 6731; RP1 Fuel Cell, LLC, 120 Fed. Cl. 288 (2015), citing New England Elec. Sys., 28 Fed. Cl. 720 (1993)).
Structural components: Regs. Sec. 1.48-1(c) makes clear that otherwise tangible personal property merely contained in or attached to a building may still constitute tangible personal property for purposes of the ITC even when that property may be deemed a fixture under state law.
Regs. Sec. 1.48-1(e) provides the general rule that buildings and structural components do not qualify as ITC-eligible property. However, Regs. Sec. 1.48-9(b) provides that structural components of a building may qualify for the ITC. Moreover, Rev. Rul. 79-183 provided an exception to the general rule in concluding that "a structural component of a building, which is so specifically engineered that it is in essence part of the machinery or equipment with which it functions, will qualify . . . for purposes of the investment tax credit."
New regulations may clarify that tangible personal property will still be respected as such for ITC purposes even if it is contained in or attached to a building. Future regulations may also clarify that any property, such as a structural component, that is "other tangible property" that is integral to the generation of electricity should continue to be included as qualifying energy property as provided in Regs. Sec. 1.48-1(d)(1) and Rev. Rul. 79-183.
Other energy-related definitions: Sec. 45 ITC in lieu of PTC: Notice 2015-70 is silent on the extent to which ITC regulations should be applied to Sec. 45 technologies eligible for the production tax credit (PTC) for which taxpayers are permitted to claim an ITC in lieu of a PTC under Sec. 48(a)(5) (the "ITC in lieu of PTC"). Property described in Sec. 45(d) (i.e., wind, geothermal, biomass, trash, landfill gas, hydropower, etc.) was never defined on a component basis as were technologies under the Sec. 48 regulations because the PTC is based on a source of energy used by a facility to produce electricity. Assuming a qualifying energy source is used, the specific components that make up the facility are irrelevant to the actual computation of the credit. The intersection of PTC and ITC rules has created a number of uncertainties.
For example, no guidance explicitly addresses whether a taxpayer may claim an ITC in lieu of PTC on tangible personal property newly added to an existing facility for which a Section 1603 Treasury grant was previously claimed. Section 1603 grants provided by Treasury (the 1603 program) allowed a qualifying facility to claim a cash grant in lieu of the ITC and PTC (Section 1603 of the American Recovery and Reinvestment Act of 2009, P.L. 111-5).
With respect to dual-use equipment rules, qualifying open-loop biomass facilities under Sec. 45 may incorporate fossil fuel co-firing and remain eligible for the PTC, as long as co-firing is limited to the "minimum necessary" for startup and flame stabilization only (Notice 2008-60, §3.02(3)). Therefore, as long as a taxpayer limits its facility's consumption of fossil fuel to startup and flame stabilization purposes, the facility may remain a fully qualified open-loop biomass facility under Sec. 45. However, if the taxpayer elects to claim the ITC in lieu of PTC, it is unclear whether dual-use equipment rules under the ITC regulations for solar, wind, and geothermal energy property should be applied and require a reduction corresponding to the biomass property's percentage of fossil fuel consumption for startup and flame stabilization. It should be noted that Treasury concluded that a reduction was required for purposes of the 1603 grant program.
Trash Facilities
A qualifying trash facility may be eligible for an ITC in lieu of PTC if it uses municipal solid waste to produce electricity (Sec. 45(d)(7)). Municipal solid waste has the meaning given the term "solid waste" under Section 2(27) of the Solid Waste Disposal Act (SWDA, 42 U.S.C. §6903) (Sec. 45(c)(6)). Without any accompanying Treasury regulations, it appears that a taxpayer may be required to determine whether a material is "solid waste" under the SWDA, its successor statute, and other U.S. Environmental Protection Agency (EPA) guidance, including various EPA regulations (RP1 Fuel Cell, LLC, citing the Resource Conservation and Recovery Act, 42 U.S.C. §6905; EPA publication "Identification of Non-Hazardous Secondary Materials That Are Solid Waste," 76 Fed. Reg. 15456, 15514 (March 21, 2011)). As taxpayers lack guidance in the application of these provisions, many would benefit from updated guidance, such as a clarification that a trash facility's solid waste determination for tax credit purposes should be based only on a plain reading of the SWDA statute.
Conclusion
Many issues are ripe to be addressed in new guidance, and new regulations would likely significantly affect renewable and other alternative energy projects. Industries that use the Sec. 48 ITC should carefully consider issues of importance and monitor comments submitted before the end of the comment period to prepare for forthcoming proposed regulations.
EditorNotes
Alex Brosseau is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.
For additional information about these items, contact Mr. Brosseau at 202-661-4532 or abrosseau@deloitte.com.
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