The IRS has released guidance on complying with the carbon capture credit under IRC Section 45Q as amended by the Bipartisan Budget Act of 2018 (BBA). In Notice 2020-12, released on February 19, 2020, the IRS addresses how to determine when construction has begun on a qualified facility or on carbon capture equipment that may be eligible for the IRC Section 45Q credit. In Revenue Procedure 2020-12, released the same day, the IRS establishes a safe harbor under which the IRS will treat partnerships as properly allocating the IRC Section 45Q credit.

The IRS said it will not issue private letter rulings or determination letters on the issues in the guidance.

Background

IRC Section 45Q allows credits for qualified carbon oxide captured by taxpayers using carbon capture equipment at a qualified facility. A "qualified facility" is defined in IRC Section 45Q(d) as any industrial or direct air capture facility for which construction begins before January 1, 2024, and that captures certain amounts of qualified carbon oxide, depending on its size.

Notice 2020-12: Determining when construction of a qualified facility has begun

Effective for tax years beginning after December 31, 2017, construction of a qualified facility that includes carbon capture equipment must begin before January 1, 2024, to qualify for the IRC Section 45Q credit.

Similar to prior Notices related to wind and solar, Notice 2020-12 establishes two methods under which taxpayers can establish when construction began; the physical work test and the 5% safe harbor. In addition, Notice 2020-12 explains the continuity requirement, under which a taxpayer must make continuous progress towards completion once construction has begun in order to qualify for the IRC Section 45Q credit. Notice 2020-12 provides a six-year safe harbor to satisfy the continuity requirement. Eligibility for the IRC Section 45Q credit for projects that take longer will be determined based on the relevant facts and circumstances. A taxpayer may satisfy one or both methods of establishing the beginning date of construction, but construction will be deemed to have begun, for purposes of the continuity requirement, on the date the taxpayer first satisfies one of the two methods.

A qualified facility may be transferred without losing its qualification under the physical work test or the 5% safe harbor. There is an exception, however, for any work performed or amount paid for a transfer consisting solely of tangible personal property to an unrelated party.

Methods for establishing beginning of construction

Under the physical work test, construction of a qualified facility or carbon capture equipment begins at the start of physical work "of a significant nature," if the taxpayer maintains a continuous program of construction. Under Notice 2020-12, whether work is of a significant nature "focuses on the nature of the work performed, not the amount or the cost." Offsite work of a significant nature includes manufacturing components, such as those necessary for disposal of qualified carbon oxide in a secure geological storage. Onsite work that qualifies includes the installation of foundations, gathering lines and other equipment necessary for carbon capture processes. Preliminary work, however, such as securing financing, research, clearing a site, and preparing the site for building, is not considered physical work of a significant nature.

Under the 5% safe harbor test, construction of a qualified facility or carbon capture equipment begins when a taxpayer (1) pays or incurs 5% or more of the total cost of the qualified facility or carbon capture equipment, and (2) makes continuous efforts to advance towards completion of the qualified facility or carbon capture equipment. The costs properly included in the depreciable basis of the qualified facility or carbon capture equipment are considered in making the calculation.

Revenue Procedure 2020-12: Safe harbor for partnerships allocating carbon capture credits

Revenue Procedure 2020-12 establishes a safe harbor under which partnerships will be treated as properly allocating, under IRC Section 704(b), the IRC Section 45Q credits. The IRS noted that compliance with the safe harbor does not necessarily mean that the partnership is otherwise entitled to validly claim the IRC Section 45Q credit. Under Revenue Procedure 2020-12, partnerships can include partners that are project developers and investors.

To qualify for the safe harbor:

• The developers and investors must have certain minimum interests
• The investor must make a certain minimum unconditional investment in the partnership
• More than 50% of the fixed investment plus reasonably anticipated contingent investment must be fixed and determinable obligations that are not contingent upon the amount or certainty of payment
• Neither the developer nor the investor may have purchase rights for the equipment for a future date
• An investor may not have a contractual right to require any person involved in the transaction to purchase or liquidate the investor's partnership interest at a future date for above fair market value
• The partnership may not guarantee or otherwise insure the investor's ability to claim the IRC Section 45Q credit, the cash equivalent of the credits or the repayment of any portion of the investor's contribution due to inability to claim the IRC Section 45Q credit
• The IRC Section 45Q credit and any recapture of the credit must be allocated in accordance with Treas. Reg. Section 1.704-1(b)(4)(ii)

Implications

The overall guidance on complying with the carbon capture credit under IRC Section 45Q takes an approach that will look familiar to taxpayers in the wind and solar industries. The guidance establishes the same fundamental rules for determining when a facility has begun construction, leveraging the requirement of physical work of a significant nature and providing for a 5% safe harbor.

Notice 2020-12 also includes a continuity requirement (as in prior guidance) requiring taxpayers to maintain continuous construction (effort) to advance towards completion of the qualified facility or carbon capture equipment. The new six-year safe harbor for this continuity standard will significantly reduce the burden of demonstrating that there was continuity over the entire period from start of construction to project completion, reducing the risk that an otherwise qualified project will not qualify for the IRC Section 45Q credit.

Additionally, the guidance provides more leniency in two particular areas compared to its renewable energy counterparts:

• While a partnership cannot guarantee the IRC Section 45Q credit to an investor, long-term carbon purchase agreements that provide for guaranteed payments are permissible, even between related parties.
• A 50% PAYGO structure (all capital contributions are made over the project's life instead of up front) is permitted, compared to 25% for the wind production tax credit.

Overall, the guidance is a good start to support deployment of carbon capture technology because it presents viable paths for developing and financing carbon capture and storage projects. We are closely monitoring future guidance, particularly related to the following topics:

• Recapture rules, and in particular, how recapture would work in the event of facility leakage, which could be a potential risk after the IRC Section 45Q credits are claimed
• Further clarification on "utilization" of the captured carbon, which could allow more market participants, other than those from the oil and gas industry, to access the IRC Section 45Q credits

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