IRS Issues Beginning of Construction Guidance for Carbon Capture Projects
On February 19, 2020, the Internal Revenue Service (the “IRS”) issued Notice 2020-12, which provides guidance on when construction of a qualified facility that includes carbon capture equipment will have begun for purposes of the carbon oxide sequestration credit under section 45Q (the “Section 45Q Credit”) of the Internal Revenue Code (the “Code”).
The IRS also issued Revenue Procedure 2020-12, which provides guidance on allocations of Section 45Q Credits in partnership flip transactions. We have addressed Revenue Procedure 2020-12 in a separate alert here.
Notice 2020-12 is similar in many respects to the beginning of construction guidance issued for wind facilities and other facilities that are eligible for the PTC under section 45 of the Code or the ITC in lieu of the PTC under section 48 of the Code, and to guidance issued for solar facilities and other facilities that are eligible for the ITC under section 48 of the Code (the “Prior Guidance”). Although the rules in Notice 2020-12 should be familiar to those who have worked with the Prior Guidance, this client alert covers the applicable rules in detail.
Background
The Section 45Q Credit is the sum of the following four amounts.
For carbon capture equipment originally placed in service at a qualified facility before February 9, 2018:
1. $20 per metric ton (adjusted for inflation) of qualified carbon oxide captured by the taxpayer using such equipment, disposed of by the taxpayer in secure geological storage, and not used by the taxpayer as described in Section 2, below; and
2. $10 per metric ton (adjusted for inflation) of qualified carbon oxide captured by a taxpayer using such equipment, and either used by the taxpayer as a tertiary injectant in a qualified enhanced oil or natural gas recovery project and disposed of by the taxpayer in secure geological storage, or utilized by the taxpayer in any of certain specified uses enumerated in section 45Q(f)(5) of the Code.
For carbon capture equipment originally placed in service at a qualified facility on or after February 8, 2018:
3. The applicable dollar amount (as determined under section 45Q(b)(1) of the Code) per metric ton of qualified carbon oxide that is (A) captured by the taxpayer using such equipment during the 12-year period beginning on the date such equipment is placed in service and (B) disposed of by the taxpayer in secure geological storage and not used by the taxpayer as described in Section 4, below; and
4. The applicable dollar amount (as determined under section 45Q(b)(1) of the Code) per metric ton of qualified carbon oxide that is (A) captured by the taxpayer using such equipment during the 12-year period beginning on the date placed in service and (B) either used by the taxpayer as a tertiary injectant in a qualified enhanced oil or natural gas recovery project and disposed of by the taxpayer in secure geological storage or utilized by the taxpayer in any of certain specified uses enumerated in section 45Q(f)(5) of the Code.
Construction of a qualified facility must begin before January 1, 2024, and either construction of carbon capture equipment must begin before such date, or the original planning and design for the qualified facility must include installation of carbon capture equipment.
Two Methods for Beginning Construction
Notice 2020-12 provides two methods by which a taxpayer can satisfy the beginning of construction requirement: (i) starting physical work of a significant nature (the “Physical Work Test”) or (ii) paying or incurring 5% or more of the costs of the qualified facility or carbon capture equipment (the “5% Safe Harbor”). Both methods require that a taxpayer make continuous progress toward completion once construction has begun (the “Continuity Requirement”).
Although a taxpayer may satisfy both methods of establishing the beginning of construction, construction will be deemed to have begun on the date the taxpayer first satisfies one of the two methods. However, a taxpayer that fails to satisfy the 5% Safe Harbor in one year because of cost overruns may use the Physical Work Test in a later year to establish the beginning of construction as long as that occurs before 2024.
Physical Work Test
The Physical Work Test requires that a taxpayer begin physical work of a significant nature. Whether and when physical work of a significant nature has begun will depend on the relevant facts and circumstances.
- No Fixed Minimum. Note that the test requires that the taxpayer “begin” (as opposed to complete or make substantial progress toward the completion of) physical work of a significant nature. As Notice 2020-12 states, the Physical Work Test “focuses on the nature of the work performed, not the amount or the cost. Assuming that physical work performed is of a significant nature, there is no fixed minimum amount of work or monetary or percentage threshold required to satisfy the Physical Work Test.” This is consistent with the Prior Guidance and with public statements from IRS and Treasury officials with respect to the Prior Guidance.
- Work Under Binding Written Contract. Work performed by the taxpayer and work performed for the taxpayer by other persons under a binding written contract that is entered into before the manufacture, construction, or production of the qualified facility or carbon capture equipment is taken into account to determine whether construction has begun.
- On-Site and Off-Site Work. Both off-site and on-site work may be taken into account. Generally, off-site physical work of a significant nature may include the manufacture of mounting equipment, support structures such as racks, skids, and rails, components necessary for carbon capture processes, and components or equipment necessary for disposal of qualified carbon oxide in secure geological storage. If a manufacturer produces components of property for multiple qualified facilities or units of carbon capture equipment, a reasonable method must be used to associate individual components of property with a particular purchaser. On-site physical work of a significant nature for qualified facilities or carbon capture equipment may include the excavation for and installation of foundations for the project or for buildings to house equipment necessary to the project, the installation of gathering lines necessary to connect the industrial facility to the carbon capture or other necessary equipment before transportation away from the facility, the installation of components necessary for carbon capture processes, and the installation of equipment and other work necessary for the disposal of qualified carbon oxide in secure geological storage (which may be at a location different from the location of the qualified facility or carbon capture equipment).
- Preliminary Activities. Physical work of a significant nature does not include certain preliminary activities, even if the cost of the activities is included in the depreciable basis of the qualified facility or carbon capture equipment. Preliminary activities include, among other things, securing financing, exploring, researching, obtaining permits and licenses, conducting test drilling to determine soil condition, clearing a site, excavating to change the contour of the land (as distinguished from excavation for a foundation), and removal of existing foundations or any components that are not part of the qualified facility or carbon capture equipment.
- Inventory. Physical work of a significant nature does not include work (whether performed by the taxpayer or another person) to produce components of a qualified facility or carbon capture equipment that are either in existing inventory or are normally held in inventory by a vendor.
5% Safe Harbor
The 5% Safe Harbor requires that a taxpayer pay (if using the cash method) or incur (if using the accrual method) 5% or more of the total cost of the qualified facility or carbon capture equipment. Costs associated with Front-End Engineering and Design (FEED) activities or other approaches to front-end planning common to similar projects may also be considered.
- The Numerator of the 5% Safe Harbor. The applicable requirements for “paying or incurring” a cost are highly technical and filled with traps for the unwary. It is very important to have tax counsel review supply agreements and other contracts the costs of which are intended to satisfy the 5% Safe Harbor.
- The Denominator of the 5% Safe Harbor. All costs properly included in the depreciable basis of the qualified facility or carbon capture equipment are taken into account to determine whether the 5% Safe Harbor has been met.
- Cost Overruns – Single Project with Multiple Qualified Facilities or Units of Carbon Capture Equipment. If the total cost of a single project comprised of multiple qualified facilities or multiple units of carbon capture equipment exceeds its anticipated total cost, so that the amount a taxpayer actually paid or incurred with respect to the single project turns out to be less than 5% of the total cost of the single project when it is placed in service, the 5% Safe Harbor is not fully satisfied. However, the 5% Safe Harbor will be satisfied with respect to some, but not all, of the qualified facilities or units of carbon capture equipment comprising the single project, as long as the total aggregate cost of those qualified facilities or units of carbon capture equipment is not more than 20 times greater than the amount the taxpayer paid or incurred. Notice 2020-12 does not address how to determine whether there is more than one “qualified facility” or “unit of carbon capture equipment”. To mitigate the risk of cost overruns, taxpayers may wish to incur significantly more than 5% of the project costs.
- Cost Overruns – Single Qualified Facility or Unit of Carbon Capture Equipment. If the total cost of a single qualified facility or unit of carbon capture equipment that is not part of a single project comprised of multiple qualified facilities or multiple units of carbon capture equipment exceeds its anticipated total cost, so that the amount a taxpayer actually paid or incurred with respect to the single facility or unit as of an earlier year is less than 5% of the total cost of the single facility or unit at the time it is placed in service, then the taxpayer will not satisfy the 5% Safe Harbor with respect to any portion of the single qualified facility or unit or carbon capture equipment in such earlier year.
- Look-Through Rule. Under the so-called “Look-Through Rule,” a taxpayer may take into account amounts paid or incurred by a contractor. For a qualified facility or carbon capture equipment, or components thereof, that are manufactured, constructed, or produced for the taxpayer by another person under a binding written contract with the taxpayer, amounts paid or incurred with respect to the qualified facility or carbon capture equipment by the other person before the qualified facility or carbon capture equipment is provided to the taxpayer are deemed paid or incurred by the taxpayer when the amounts are paid or incurred by the other person for federal income tax purposes.
Continuity Requirement
Where a taxpayer has satisfied the Physical Work Test, the Continuity Requirement requires that the taxpayer maintain a continuous program of construction, which involves continuing physical work of a significant nature. Where a taxpayer has satisfied the 5% Safe Harbor, the Continuity Requirement requires that the taxpayer make continuous efforts to advance toward completion of the qualified facility or carbon capture equipment. In each case, whether the Continuity Requirement is satisfied depends on the relevant facts and circumstances.
Certain disruptions in a taxpayer’s continuous construction or continuous efforts to advance toward completion of a qualified facility or carbon capture equipment that are beyond the taxpayer’s control will not be considered as indicating that a taxpayer has failed to satisfy the Continuity Requirement. Notice 2020-12 provides a non-exclusive list of these “excusable disruptions.” For a single project comprised of multiple qualified facilities or multiple units of carbon capture equipment, whether an excusable disruption has occurred must be determined in the calendar year in which the last of multiple qualified facilities or units of carbon capture equipment is placed in service.
Notice 2020-12 provides a safe harbor (the “Continuity Safe Harbor”) pursuant to which the Continuity Requirement is deemed to be satisfied if a taxpayer places a qualified facility or carbon capture equipment in service by the end of a calendar year that is no more than six calendar years after the calendar year during which construction of the qualified facility or carbon capture equipment began (the “Continuity Safe Harbor Deadline”). For example, if construction begins on a qualified facility or carbon capture equipment on January 15, 2021, and the qualified facility or carbon capture equipment is placed in service by December 31, 2027, the qualified facility or carbon capture equipment will satisfy the Continuity Safe Harbor. The excusable disruption rules do not apply for purposes of applying the Continuity Safe Harbor. The six-year Continuity Safe Harbor period is a welcome extension of the four-year period that applies to ITC and PTC projects and appears to be appropriate given the longer development and construction periods for carbon sequestration projects.
Taxpayers that began construction on a qualified facility or carbon capture equipment by satisfying either the Physical Work Test or the 5% Safe Harbor, or both, before the effective date of Notice 2020-12 (March 9, 2020), may use the effective date as the date that construction began. A taxpayer that began construction before March 9, 2020 under both the Physical Work Test and the 5% Safe Harbor may choose either method (but not both) for purposes of applying the rules of Notice 2020-12.
Furthermore, as noted above, a taxpayer that fails to satisfy the 5% Safe Harbor in one year because of cost overruns may use the Physical Work Test in a later year to establish the beginning of construction as long as that occurs before 2024.
Under the so-called “disaggregation rule”, multiple qualified facilities or units of carbon capture equipment that are treated as a single project may be disaggregated and treated as multiple separate qualified facilities or units of carbon capture equipment for purposes of the Continuity Safe Harbor. The disaggregated separate qualified facilities or units of carbon capture equipment that are placed in service before the Continuity Safe Harbor Deadline will be eligible for the Continuity Safe Harbor. The remaining disaggregated separate qualified facilities or units of carbon capture equipment may satisfy the Continuity Requirement under the facts and circumstances determination.
Because the facts and circumstances tests for the Continuity Requirement are difficult to apply in practice, we expect that most taxpayers will ensure that they satisfy the Continuity Safe Harbor.
Transfers
A taxpayer that places a qualified facility into service may elect to claim the Section 45Q Credit even if the taxpayer did not own the qualified facility when construction began. Accordingly, the general rule is that a fully or partially developed facility may be transferred without losing its qualification under the Physical Work Test or the 5% Safe Harbor. However, an exception provides that if a transferor transfers solely tangible personal property (or contractual rights to such property under a binding written contract) to an unrelated transferee, the transferee cannot take into account work performed or amounts paid or incurred by the transferor for purposes of the Physical Work Test or the 5% Safe Harbor. For this purpose, whether a transferor and transferee are related is determined under section 197(f)(9)(C) of the Code, which at a high level requires 20% overlapping ownership. Accordingly, for a transferee to take into account the physical work performed by or the costs incurred by a transferor, either the transferee and transferor must be related or the transferred property must include project assets other than tangible personal property or the rights to acquire tangible personal property.
A special rule provides that if a taxpayer begins construction of a qualified facility or carbon capture equipment with the intent to develop the qualified facility or carbon capture equipment at a certain site, and thereafter transfers components of the qualified facility or carbon capture equipment to a different site, the taxpayer may take into account the work performed or the amounts paid or incurred before the site transfer for purposes of the Physical Work Test or the 5% Safe Harbor.
Retrofits
Notice 2020-12 applies the so-called “80/20 Rule” for purposes of determining whether retrofitted qualified facilities or carbon capture equipment qualify for the Section 45Q Credit. Under the 80/20 Rule, a qualified facility or carbon capture equipment may qualify as originally placed in service even though it contains some used components if the fair market value of the used components of property is not more than 20 percent of the qualified facility or carbon capture equipment’s total value. For this purpose, the total value is the cost of the new components of property plus the value of the used components of property, and the cost of new property includes all properly capitalized costs. In the case of a single project comprised of multiple qualified facilities or units of carbon capture equipment, the 80/20 Rule is applied to each qualified facility or unit of carbon capture equipment comprising the single project.
For purposes of the beginning of construction requirement, the Physical Work Test and the 5% Safe Harbor are applied only with respect to the work performed on, and amounts paid or incurred for, new components of property used to retrofit used components of property or an existing qualified facility or carbon capture equipment. For the 5% Safe Harbor, all costs properly capitalized in the basis of the qualified facility or carbon capture equipment are taken into account.
Other Rules
- Single Project. For purposes of the begin construction test, multiple qualified facilities or units of carbon capture equipment that are operated as part of a single project (along with any components of property that serve some or all such qualified facilities or units of carbon capture equipment) may be treated as a single project. Whether multiple qualified facilities or units of carbon capture equipment are operated as part of a single project depends on the relevant facts and circumstances applicable to the qualified facilities or carbon capture equipment, including whether they (i) are owned by a single entity; (ii) are constructed in the same general geographic location or on adjacent or contiguous pieces of land; (iii) share a single system of gathering lines or a single off-take operation used to collect and deliver carbon oxide to a transportation pipeline; (iv) share a contract for the disposal, utilization, or use of the qualified facilities’ captured carbon oxide as a tertiary injectant; (v) are described in the same environmental or other regulatory permits or are required to collectively report their activities; (vi) are constructed pursuant to a single contract providing FEED or similar services covering the full scope of the project; (vii) are constructed pursuant to a single master construction contract; and (viii) are financed pursuant to the same loan agreement. Whether multiple qualified facilities or units of carbon capture equipment are operated as part of a single project is determined in the calendar year during which the last of the multiple qualified facilities or units of carbon capture equipment is placed in service.
- Binding Written Contracts. Notice 2020-12 follows the definition of “binding written contract” from the Prior Guidance. For this purpose, a written contract is binding only if it is enforceable under local law against the taxpayer or a predecessor and does not limit damages to a specified amount (for example, by use of a liquidated damages provision). A contractual provision that limits damages to an amount equal to at least 5% of the total contract price will not be treated as limiting damages to a specified amount. It is important to keep in mind that subsequent changes to a contract, including with respect to design specifications, may raise questions as to whether the contract was a “binding written contract” in the first place.
- Master Contracts. Notice 2020-12 follows the master contract rule from the Prior Guidance. Under that rule, if a taxpayer enters into a binding written contract for a specific number of components of property to be manufactured, constructed, or produced for the taxpayer by another person under a binding written contract (the master contract), and then through a new binding written contract (the project contract) assigns its rights to certain components of property to an affiliated special purpose vehicle that will own the qualified facility or carbon capture equipment for which such components of property are to be used, work performed or amounts paid or incurred with respect to the master contract may be taken into account in determining when construction begins with respect to the qualified facility or carbon capture equipment.
Issues Not Addressed
The IRS previously requested comments on issues arising under section 45Q of the Code, including several specific issues enumerated in Notice 2019-32. Issues raised in Notice 2019-32 but not addressed in Notice 2020-12 or Revenue Procedure 2020-12 include:
- Criteria used to demonstrate secure geological storage;
- Standards for triggering and measuring recapture of the Section 45Q Credit with respect to any qualified carbon oxide that ceases to be captured, disposed of, or used as a tertiary injectant in a manner consistent with the requirements of section 45Q of the Code;
- Issues relating to the election under section 45Q(f)(3)(B) of the Code to transfer the Section 45Q Credit to a person that disposes of, utilizes, or uses the qualified carbon oxide;
- Issues relating to the determination of the amount of metric tons of qualified carbon oxide utilized by the taxpayer, captured and permanently isolated from the atmosphere, or displaced from being emitted into the atmosphere; and
- Clarification of various statutory terms and phrases used in section 45Q of the Code.
The IRS anticipates issuing further guidance in the near future on issues not addressed in Notice 2020-12 or Revenue Procedure 2020-12.
For more information, contact any of the attorneys listed in this advisory.