The Inflation Reduction Act’s energy- and climate-related tax provisions

Editor: Susan Minasian Grais, CPA, J.D., LL.M.

The Inflation Reduction Act of 2022, P.L. 117-169, represents a monumental and unprecedented investment in the adoption and expansion of renewable and alternative energy sources. The legislation provides $369 billion to (1) incentivize and accelerate the buildout of renewable energy; (2) advance the adoption of electric vehicle technologies; and (3) improve the energy efficiency of buildings and communities.

Before discussing these changes and their implications for taxpayers in more detail, a high-level summary may be helpful.

Broad overview

With respect to energy transition and renewable energy, the Inflation Reduction Act:

• Includes a two-tiered credit structure for many of the applicable tax credits, under which there is a base amount, which can be increased to a bonus amount, so long as requirements to pay prevailing wage rates and employ qualified apprentices for a certain percentage of the work are met (or an exception applies);
• Includes, for tax credits related to certain technologies, an additional credit amount based on meeting domestic content requirements;
• Includes a direct-pay provision under a new Sec. 6417 (effectively treating tax credits generated by a renewable energy project as equivalent to taxes paid on a filed return), but it applies only in certain circumstances;
• Includes a new transferability provision under a new Sec. 6418, which permits, in certain circumstances, the one-time sale or transfer of certain tax credits (including those under Secs. 30C, 45, 45Q, 45U, 45V, 48, and several others) in exchange for cash;
• Extends the carryback period for certain tax credits to three years;
• Extends and modifies the Sec. 45 production tax credit (PTC) for projects beginning construction before 2025, including a new PTC for solar property and the extension of the geothermal-related PTC;
• Extends and modifies the Sec. 48 investment tax credit (ITC) for projects beginning construction before 2025, including expanding the definition of ITC-eligible property to include energy storage, qualified biogas property, and microgrid controllers, and adds new rules for certain solar and wind facilities placed in service in connection with low-income communities;
• Provides for new technology-neutral, clean-energy-related PTCs and ITCs beginning in 2025;
• Extends and modifies Sec. 45Q carbon capture, use, and sequestration. Related tax credits (including higher credit amounts, a later beginning-of-construction deadline of before Jan. 1, 2033, and lower annual capture requirements);
• Adds a specific clean hydrogen PTC (new Sec. 45V);
• Includes a zero-emission nuclear power production credit (new Sec. 45U);
• Makes changes for biodiesel, renewable diesel, and alternative fuel credits under Sec. 6426 and related provisions; and
• Includes provisions related to electric vehicles and other energy-efficient technologies and clean fuels.

Overall, many of the Inflation Reduction Act’s provisions, at least with respect to energy transition and renewable energy investments, ought to spur development and investment. However, the new energy and climate rules can be complex, and it is important for taxpayers to understand the rules and how they apply to their particular projects.

The discussion below examines many of the energy and climate aspects of the legislation in greater detail.

Two-tiered credit structure

To begin with, the Inflation Reduction Act contains a two-tiered credit amount structure for many applicable tax credits. Specifically, many of the credits have a lower base credit amount that can be increased up to five times if the taxpayer can satisfy applicable prevailing wage or apprenticeship requirements.

In general, under the prevailing wage requirements, the Inflation Reduction Act requires all laborers, mechanics, and workers to be paid the prevailing wage rates that would be earned by similarly employed workers in the relevant area during project construction (and, during the credit term, for repairs and alterations). Separately and subject to certain exceptions, to meet the apprenticeship requirements, qualified apprentices have to perform an applicable percentage of total labor hours for project construction. Further, the Inflation Reduction Act establishes certain options to cure the failure to meet either the prevailing wage or apprenticeship requirements.

Implications: Taxpayers are agdeemedh to have met the prevailing wage and apprenticeship requirements until 60 days after Treasury provides the required guidance. Although it is difficult to anticipate how long it will take to develop these rules, taxpayers should begin to evaluate their ability to satisfy these critical prevailing wage and apprenticeship provisions now.

Direct pay and transferability

The new energy- and climate-related provisions allow a direct-pay election in some circumstances and enable certain credits to be transferred.

Direct pay (new Sec. 6417): Under new Sec. 6417, an “applicable entity” (see below) can make a direct-pay election (effectively treating tax credits generated by a renewable energy project as equivalent to taxes paid on a filed return), but only for certain tax credits, including:

• Certain portions of the Sec. 30C alternative fuel vehicle refueling property credit;
• The Sec. 45 PTC for facilities placed in service after Dec. 31, 2022;
• The Sec. 45Q credit (for capture equipment originally placed in service after Dec. 31, 2022);
• The new Sec. 45U zero-emission nuclear power production credit;
• The new Sec. 45V hydrogen PTC (for facilities placed in service after Dec. 31, 2012);
• The Sec. 45W credit for commercial vehicles (for tax-exempt entities);
• The new Sec. 45X advanced manufacturing credit;
• The technology-neutral PTC (new Sec. 45Y) and ITC (new Sec. 48E);
• The new Sec. 45Z clean fuel production credit;
• The Sec. 48C qualifying advanced energy credit; and
• The Sec. 48 ITC.

As noted above, the direct-pay option can be used only by “applicable entities,” which generally only include tax-exempt entities, state or local governments, the Tennessee Valley Authority, Indian tribal governments, or an Alaska Native corporation. However, certain important exceptions to the “applicable entity” limitation exist, so any eligible taxpayer can elect direct pay for:

• The first five years of the new Sec. 45V credit for the production of clean hydrogen;
• The first five years of the Sec. 45Q credit (starting with any tax year after Dec. 31, 2022, in which the taxpayer has placed in service carbon capture equipment at a qualified facility); and
• A five-year period of the new Sec. 45X advanced manufacturing credit.

For the Sec. 45Q credit, the directpay election applies separately with respect to carbon capture equipment originally placed in service by the applicable entity during a tax year. Additionally, any non–tax-exempt and nongovernmental taxpayers that elect direct pay related to the new Sec. 45V clean hydrogen credit can revoke their election (the revocation lasts for the balance of the five-year period).

From a procedural perspective, a direct-pay election generally (1) applies separately to each applicable facility; (2) must be made in the first year the facility (or applicable equipment) is placed in service; and (3) applies for the full applicable credit term period, subject to the time-limited direct-pay options for certain taxpayers described above. Certain credits tie the ability to elect direct pay to the satisfaction of the domestic content requirements. Additionally, partnerships or S corporations that directly hold a facility or property eligible for the credit must make the direct-pay election, and the partnership or S corporation receives the direct payment (as opposed to the partners or owners). Finally, an additional 20% penalty can apply to taxpayers receiving “excessive payments.”

Importantly, beginning in fiscal year 2023 and each fiscal year thereafter, the portion of any direct payment made to a taxpayer under a Sec. 6417 election (or any amount treated as a payment made by the taxpayer under Sec. 6417(a)) will increase by 6.0445% (in order to make the taxpayer whole in the event of a potential sequestration).

Transferability of credits (new Sec. 6418): The Inflation Reduction Act contains provisions that allow certain credits to be transferred. Under new Sec. 6418, an eligible taxpayer can elect to transfer all (or any portion specified in the election) of an eligible credit to an unrelated transferee taxpayer. The transfer, however, must be paid in cash, not be included in the income of the recipient taxpayer, and not be deductible by the paying taxpayer. Further, the transfer must be a one-time transfer (i.e., the transferee cannot make a subsequent election to further transfer any portion of the transferred credit).

The taxpayer must elect to transfer the credits no later than the due date (including extensions) for the tax return for the tax year for which the credit is determined, and any election, once made, is irrevocable. The transfer election under new Sec. 6418 is available for the following tax credits:

• The Sec. 30C alternative fuel vehicle refueling property credit;
• The Sec. 45 PTC;
• The Sec. 45Q carbon capture, use, and sequestration credit;
• The new Sec. 45U zero-emission nuclear power production credit;
• The new Sec. 45V clean hydrogen production credit;
• The new Sec. 45X advanced manufacturing production credit;
• The technology-neutral PTC (new Sec. 45Y) and ITC (new Sec. 48E);
• The new Sec. 45Z clean fuel production credit;
• The Sec. 48C qualifying advanced energy project credit; and
• The Sec. 48 ITC.

Transfer elections related to the Sec. 45 PTC or the credits under Sec. 45Q, 45V, or 45Y must be made separately for each applicable facility and for each tax year during the 10-year period beginning on the date the facility was placed in service (or, for Sec. 45Q carbon capture, use, and sequestration purposes, for each year during the 12-year period beginning on the date the carbon capture equipment was originally placed in service at such facility).

The Inflation Reduction Act does not allow applicable entities, as defined for direct-pay purposes, to elect to transfer credits. As noted above, applicable entities are defined for direct-pay purposes as tax-exempt entities, state or local governments, the Tennessee Valley Authority, Indian tribal governments, or Alaska Native corporations. An additional 20% penalty can apply to “excessive credit transfers.” For eligible credits resulting from property held by a partnership or S corporation, any election to transfer a credit must be made at the partnership or S corporation level.

Implications: The new Sec. 6418 introduces more options for project developers and sponsors to monetize tax attributes, thus giving them alternatives to tax equity financing. It is too early to tell whether the direct transfer of tax credits (which will not monetize depreciation or provide an opportunity to “mark up” ITC assets) is more attractive than tax equity. This will depend largely on the ultimate pricing of the direct transfer tax credits and the development of an efficient project-level debt market that could offset the failure to monetize depreciation or benefit from a markup inherent in tax equity structures.

Modified credit carryback

The Inflation Reduction Act provides for a three-year carryback period (instead of a one-year period) for certain credits, including:

• The Sec. 30C credit for alternative fuel vehicle refueling property;
• The Sec. 45 PTC;
• Sec. 45Q;
• The Sec. 48 energy credit;
• The zero-emission nuclear power production credit under new Sec. 45U;
• The credit for production of clean hydrogen under new Sec. 45V;
• The technology-neutral PTC and ITC (new Secs. 45Y and 48E, respectively);
• The qualifying advanced energy project credit under Sec. 48C;
• The clean fuel production credit under new Sec. 45Z;
• The credit for advanced manufacturing production under new Sec. 45X; and
• The Sec. 45W credit for qualified commercial vehicles (in certain situations).

Energy production and generation

The Inflation Reduction Act made significant changes to the Sec. 45 PTC and the Sec. 48 ITC.

Sec. 45 PTC: Under prior law, the PTC was largely unavailable for projects that began construction after Dec. 31, 2021. The Inflation Reduction Act extends the PTC-related beginning-of-construction deadline to projects that begin construction before Jan. 1, 2025. Importantly, the Inflation Reduction Act reinstates the PTC for solar projects (that begin construction before Jan. 1, 2025), and the beginning-of-construction deadline for geothermal projects is further extended. The Inflation Reduction Act also eliminates the credit rate reduction for qualified hydroelectric production and marine and hydrokinetic renewable energy property.

The PTC is now subject to the two-tiered credit structure, with a base credit amount and a bonus credit amount.

The Inflation Reduction Act also includes a domestic content bonus for the PTC. This allows taxpayers to increase their Sec. 45 PTC by 10%, so long as the applicable requirements are met related to the percentage of the total cost of components that are mined, produced, or manufactured in the United States, or in relation to the location of qualified facilities in applicable “energy communities” (which generally include certain brownfield sites; certain areas that historically had significant employment related to the extraction, processing, transport, or storage of coal, oil, or natural gas; or a Census tract where certain coal mines or coal-fired power plants used to operate). The Inflation Reduction Act also includes certain phaseout provisions for the domestic content rules, as well as other ancillary provisions.

Finally, the Inflation Reduction Act requires a limited reduction of the Sec. 45 PTC where tax-exempt bonds are used to provide the financing for the qualified facility.

The Sec. 45 PTC amendments apply to facilities that are placed in service after Dec. 31, 2021, with the exception of the following provisions, which apply to facilities placed in service after Dec. 31, 2022: (1) taxexempt bond financed facilities; (2) domestic content; (3) certain phaseout provisions; (4) energy communities; and (5) hydropower.

Implications: The modifications to the Sec. 45 PTC — specifically, the inclusion of certain technologies, extension through 2024, and switchover to the technology-neutral credit regime — ought to be positively received. Providing certainty and the ability to forecast investment decisions and related returns is critical in capital-intensive industries.

Sec. 48 ITC: Under prior law, the ITC began phasing out for certain projects beginning construction after Dec. 31, 2019. The Inflation Reduction Act extends the ITC for most projects that begin construction before Jan. 1, 2025 (except for geothermal property, which is extended to before Jan. 1, 2035, although such credit is subject to a phaseout schedule). For projects that began construction after Dec. 31, 2019, and that were placed in service prior to Jan. 1, 2022, the ITC credit amount is 26%. For projects placed in service after Dec. 21, 2021, the limited ITC amount/ phaseout generally does not apply.

Similar to the Sec. 45 PTC and other credits, the Sec. 48 ITC is subject to the two-tiered investment structure (with the top, bonus rate being achieved if the prevailing wage and apprenticeship requirements are met, with similar exceptions to those of the Sec. 45 PTC).

The Inflation Reduction Act expands the Sec. 48 ITC to include three new technologies — standalone energy storage, qualified biogas property, and microgrid controllers — if construction begins by Dec. 31, 2024.

A potentially unpopular change from prior legislative proposals is the absence of the 30% ITC for transmission, with the Inflation Reduction Act providing that a Sec. 48 ITC only applies to qualified interconnection property used in installing energy property with a maximum net output of no greater than 5 megawatts.

In general, many of the amendments to the Sec. 48 ITC are effective for facilities placed in service after Dec. 31, 2021. For the Sec. 48 ITC related to stand-alone energy storage, qualified biogas property, microgrid controllers, or certain other technologies, however, the Sec. 48 ITC is effective for property placed in service after Dec. 31, 2022.

Implications: The inclusion of certain technologies under the Sec. 48 ITC, its extension through 2024, and the switchover to the technology-neutral credit regime should be positively received. For example, the inclusion of stand-alone storage and qualified biogas is a helpful development, and renewable natural gas investments should benefit, as renewable natural gas often consists of 96% to 98% methane. Providing certainty and the ability to forecast investment decisions and related returns is critical in capital-intensive industries.

Sec. 45Q carbon oxide sequestration credits

Under prior law, eligible carbon oxide sequestration credit projects were required to begin construction before Jan. 1, 2026. The Inflation Reduction Act extends that beginning-of-construction deadline to Jan. 1, 2033, and decreases the annual capture requirements.

The Sec. 45Q carbon oxide sequestration tax credit, which was increased by the Inflation Reduction Act, is subject to the two-tiered credit regime, with a lower base rate and a higher bonus rate if the prevailing wage and apprenticeship requirements are met (similar to those described above).

The Inflation Reduction Act allows certain taxpayers to elect to have the 12-year credit term begin on the first day of the first tax year in which a Sec. 45Q tax credit is claimed if certain specific conditions are met. This applies to carbon capture equipment originally placed in service at a qualified facility on or after the date the Bipartisan Budget Act of 2018 was enacted if (1) no taxpayer has claimed a credit under Sec. 45Q for the equipment for any prior year; (2) the facility where the equipment is placed in service is located in an area affected by a federally declared disaster after the capture equipment was originally placed in service; and (3) the disaster resulted in the facility or equipment ceasing to operate after it was originally placed in service.

Like the Sec. 45 PTC and the Sec. 48 ITC, the revised Sec. 45Q has similar rules on reducing the credit when tax-exempt bonds are used in financing the facility. The amendments generally apply (with certain exceptions) to facilities or equipment placed in service after Dec. 31, 2022.

Implications: The increased credit amount, the lowering of the annual capture amounts, the extension of the beginning-of-construction deadline, and the potential for some direct pay or transferability should be well received in the carbon capture, use, and sequestration marketplace, as many projects are depending on an increased credit to become economically viable.

Some final thoughts

Now that the Inflation Reduction Act has been enacted, the focus will turn to understanding the details of implementing regulations and guidance as taxpayers evaluate the legislation’s impact. Taxpayers should carefully analyze what the act’s changes mean from a capital allocation and deployment perspective, as well as how some of the changes could impact current, pending, or potential transactions and investments. Thoughtful and detailed analysis, including quantitative analysis, will be essential to properly analyze the act’s potential impacts in this area.

Editor Notes

Susan Minasian Grais, CPA, J.D., LL.M., is a managing director at Ernst & Young LLP in Washington, D.C. Contributors are members of or associated with Ernst & Young LLP. For additional information about these items, contact Ms. Grais at 202-327-8788 or susan.grais@ey.com.