In proposed regulations (REG-112339-19), the IRS explains two new carbon capture credits enacted in 2018 under IRC Section 45Q for qualified carbon oxide captured by taxpayers using carbon capture equipment at a qualified facility.

The proposed regulations address, among other things, (1) secure geological storage, (2) contracting with third parties for the disposal, injection, or utilization of qualified carbon oxides and allowing third parties to claim the IRC Section 45Q credits, (3) the definition of the recapture period for carbon oxides that are not properly captured, and (4) clarification on "utilization" of captured carbon.

The proposed regulations would apply to tax years beginning on or after the date the final regulations are published in the Federal Register. Taxpayers may choose to apply the final regulations for tax years beginning on or after February 9, 2018 (when IRC Section 45Q was amended by the Bipartisan Budget Agreement (BBA)). In addition, taxpayers may apply the proposed regulations for tax years beginning on or after February 9, 2018, and before the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register, provided the taxpayers follow the proposed regulations consistently and in their entirety.

Background

IRC Section 45Q credits can be claimed for 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.

The BBA created two new credits for carbon oxide captured using equipment originally placed in service on or after February 9, 2018, allowing up to:

• $50 per metric ton of qualified carbon oxide for permanent sequestration
• $35 for enhanced oil recovery purposes or utilization

In February, the IRS released Notice 2020-12, addressing 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 established a safe harbor under which the IRS will treat partnerships as properly allocating the IRC Section 45Q credit (see Tax Alert 2020-0432).

The IRS has released the proposed regulations to "provide a framework for the types of contracts, terms, and reporting requirements that will demonstrate the contractual assurance of the capture and disposal, injection, or utilization of qualified carbon oxide."

The proposed regulations would apply to persons that qualify for the credit by physically or contractually capturing and disposing of qualified carbon oxide, using qualified carbon oxide as a tertiary injectant in a qualified enhanced oil or natural gas recovery project, or utilizing qualified carbon oxide.

Contracts for disposal, injection or utilization of carbon oxide

The proposed regulations would allow taxpayers to enter into multiple contracts with multiple parties for the disposal, injection or utilization of qualified carbon oxide — the contracts can be with different parties for different methods. The contracts must be written and binding and include commercially reasonable terms of enforcement. The contracts must be reported to the IRS annually on Form 8933, Carbon Oxide Sequestration Credit.

Election of credits

Eligible parties may designate someone to elect to the claim the credits, as well as the time and manner of those elections. The elections must be made annually on a federal income tax return, not an amended return (except from February 9, 2018 through the date of publication of the proposed rules). Both parties to the election must file Form 8933, Carbon Oxide Sequestration Credit.

The elections may be made for all or a portion of the available IRC Section 45Q credit and may be made for a single or multiple credit claimants, with the maximum amount of credits allowable to each credit claimant proportional to the amount of qualified carbon oxide disposed of, utilized, or used as a tertiary injectant by the credit claimant.

Secure geological storage

The proposed regulations would set the standard for demonstrating secure geological storage required to qualify for the credits. IRC Section 45Q(f)(2) requires using EPA standards to establish regulations for determining adequate security measures for the geological storage of qualified carbon oxide so it does not escape into the atmosphere.

Operators that inject carbon dioxide underground as part of the enhanced oil recovery process would also be subject to the EPA requirements. The proposed regulations would allow the standard adopted by the International Organization for Standardization (ISO) and endorsed by the American National Standards Institute (ANSI) (CSA/ANSI ISO 27916:19) as an alternative to the EPA standard for enhanced oil recovery. The proposed regulations would not, however, allow standards set by the states because those rules may have different reporting requirements and different governing bodies to which carbon dioxide injection projects must report. "Adopting such rules would not promote uniformity and would increase the administrative burden on the IRS significantly," the IRS said.

Utilization of carbon oxide

The proposed regulations would require taxpayers utilizing the carbon oxides for qualified uses to submit a written lifecycle analysis (LCA) consistent with ISO 14044:2006 (Environmental management — Life cycle assessment — Requirements and Guidelines). The LCA must be either performed or verified by a professionally licensed third party. The IRS, in consultation with the DOE and EPA, will review and approve the LCA. The regulations do not provide specific standards for the LCA but require the use of generally accepted standard practices of quantifying greenhouse gas emissions.

Definition of recapture period

The IRS may "recapture" the IRC Section 45Q credit allowed for qualified carbon oxide that ceases to be properly captured, disposed of, or used as a tertiary injectant.

The proposed regulations clarified timing of the recapture period, stating that it would:

• Begin on the date of the first injection of qualified carbon oxide for disposal in secure geological storage or use as a tertiary injectant
• End the earlier of (1) five years after the last tax year in which the taxpayer claimed an IRC Section 45Q credit, or (2) the date monitoring ends under the applicable standard

The proposed regulations do not provide a recapture safe harbor, which some commenters had requested for injection operators that were operating in compliance with standards set by the Treasury Department and the IRS for secure geological storage.

Any recapture amount will be accounted for in the tax year that it is identified and reported.

If qualified carbon oxide has leaked into the atmosphere, the proposed regulations specify that the recapture amount is the leaked amount of qualified carbon oxide that exceeds the amount of qualified carbon dioxide disposed in secure geological storage or used as a tertiary injectant in that tax year. That excess amount will be recaptured at a credit rate calculated on a last-in first-out (LIFO) basis (the excess leaked qualified carbon oxide will be deemed attributable first to the first preceding year, then to second preceding year, and then up to the fifth preceding year). The taxpayer must then add the amount of the recaptured IRC Section 45Q tax credit to the amount of tax due in the tax year in which the recapture event occurs.

According to the proposed regulations, recapture amounts and credits would be allocated pro rata when multiple parties own the carbon recapture equipment or claim the credits. If multiple parties own the carbon capture equipment in one location, the recapture amount would be allocated among the taxpayers that own the equipment pro rata, based on the amount of qualified carbon oxide captured from each owner's equipment. Similarly, if the leaked amount of qualified carbon oxide were deemed attributable to qualified carbon oxide for which multiple taxpayers claimed IRC Section 45Q credits, the recapture amount would be allocated on a pro-rata basis among those taxpayers.

In addition, a recapture event occurs in the year in which qualified carbon oxide is removed from its original storage if it is deliberately removed from that site.

The proposed regulations would allow an exception for leakage from actions unrelated to the selection, operation, or maintenance of the storage facility, such as volcanic activity or a terrorist attack.

Implications

The proposed regulations address several critical outstanding items for the IRC Section 45Q credits that had impeded investment in these projects until now. They clarify the standards for geological storage, election of the credits, applicable recapture rules, and standards for measuring the qualified carbon oxide amounts for lifecycle analysis.

In particular, the rules for electing to transfer the credit to a third party, along with the guidance on the recapture, could help attract investors that can efficiently utilize the credits.

The guidance still does not answer some questions, such as the effects on the tax credit if the IRS rejects a taxpayer's LCA for a utilization project.

The Treasury Department and IRS are seeking public comments on several issues including:

• How to achieve consistency in boundaries and baselines so that similarly situated taxpayers will be treated consistently
• Defining commercial markets and standards for lifecycle analysis
• How to apply the recapture provisions to credits that are carried forward to future tax years due to insufficient income tax liability in the current year

Taxpayers can submit comments on the proposed regulations during the 60-day period following the publication of the proposed regulations in the Federal Register.

These regulations, along with previously issued guidance, present a viable path for taxpayers to move forward with carbon capture and sequestration or utilization projects, either as a developer or as a financier.

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