IRS Issues Guidance on Partnership Flips for Carbon Capture Projects
On February 19, 2020, the Internal Revenue Service (the “IRS”) issued Revenue Procedure 2020-12, which provides guidance on allocations of the carbon oxide sequestration credit under section 45Q (the “Section 45Q Credit”) of the Internal Revenue Code (the “Code”) in partnership flip transactions.
The IRS also 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 Section 45Q Credit. We have addressed Notice 2020-12 in a separate alert here.
Revenue Procedure 2020-12 follows Revenue Procedure 2007-65 (as amended by Announcement 2009-69), which provides guidance concerning allocations of PTCs under section 45 of the Code for partnership flips involving wind facilities (the “Section 45 Safe Harbor”), and Revenue Procedure 2014-12, which provides guidance concerning allocations of rehabilitation credits under section 47 of the Code (the “Section 47 Safe Harbor”). Although Revenue Procedure 2020-12 is similar in broad respects to Revenue Procedure 2007-65 and Revenue Procedure 2014-12, it is materially different from each in certain respects.
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.
Section 45Q Safe Harbor – In General
Revenue Procedure 2020-12 establishes a safe harbor (the “Section 45Q Safe Harbor”) under which the IRS will treat partnerships as properly allocating, in accordance with section 704(b) of the Code, the Section 45Q Credit.
The Section 45Q Safe Harbor applies to any partnership (a “Project Company”) that validly claims the Section 45Q Credit. Partners in a Project Company may include a project developer (a “Developer”) and one or more investors (“Investors”), each of which may be an initial partner in the Project Company or may later become an Investor by acquiring an interest in the Project Company (a “Partnership Interest”) either directly from the Project Company by contribution or from another partner by purchase. The Project Company typically owns the carbon capture equipment (the “Equipment”). In addition to the Project Company, the Developer, and the Investors, carbon oxide capture and sequestration transactions may involve lenders, one or more carbon oxide emitters (“Emitters”), one or more construction contractors, one or more qualified carbon oxide purchasers (“Offtakers”), and one or more project operators.
If a Project Company, Developer, and Investor(s) satisfy all of the requirements of the Section 45Q Safe Harbor, the IRS will treat the Investor as a partner in the Project Company and will treat the Project Company as properly allocating the Section 45Q Credit in accordance with section 704(b).
Although Revenue Procedure 2020-12 is nominally effective for transactions entered into on or after March 9, 2020, it explicitly provides that taxpayers may rely on it for transactions entered into before that date.
The Treasury Department and the IRS have requested comments on the requirements of the Section 45Q Safe Harbor.
Section 45Q Safe Harbor – Requirements
- Developer’s Minimum Partnership Interest. The Developer must have a minimum one percent Partnership Interest in each material item of partnership income, gain, loss, deduction, and credit at all times during the existence of the Project Company. This requirement is consistent with the Section 45 and Section 47 Safe Harbors.
- Investor’s Minimum Partnership Interest. Each Investor must have, at all times during the period it owns a Partnership Interest, a minimum interest in each material item of partnership income, gain, loss, deduction, and credit equal to at least five percent of the Investor’s percentage interest in each such item for the taxable year for which the Investor’s percentage share of that item is the largest (as adjusted for sales, redemptions, or dilutions of its interest). This requirement is consistent with the Section 45 and Section 47 Safe Harbors.
- Requirements Regarding the Investor’s Partnership Interest. The Investor’s Partnership Interest must constitute a bona fide equity investment with a reasonably anticipated value commensurate with the Investor’s overall percentage interest in the Project Company, separate from any federal, state, and local tax deductions, allowances, credits, and other tax attributes to be allocated by the Project Company to the Investor (the “bona fide equity investment requirement”). An Investor’s Partnership Interest is a bona fide equity investment only if that reasonably anticipated value is contingent upon the Project Company’s net income, gain, and loss, and is not substantially fixed in amount. Likewise, the Investor must not be substantially protected from losses from the Project Company’s activities. The Investor’s return from its investment in the Project Company must not be limited in a manner comparable to a preferred return representing a payment for capital. This requirement is not in the Section 45 Safe Harbor but is consistent with the Section 47 Safe Harbor. We note that the bona fide equity investment requirement could be difficult to apply in practice (and therefore undermines the notion that the 45Q Safe Harbor is a safe harbor). Furthermore, the requirement that the value be commensurate with the partnership Interest determined on a pre-tax basis arguably is at odds with the reality that the tax benefits will comprise a significant portion of any Investor’s return on its investment. It also is at odds with the example provided in Revenue Procedure 2020-12, which notes that the Investor “invests in carbon capture projects primarily to benefit from the Section 45Q Credit.”
- Arrangements to Reduce the Value of the Investor’s Partnership Interest or the Investor’s Economic Return. The value of the Investor’s Partnership Interest may not be reduced through fees (including developer, management, and incentive fees), or other arrangements, that are unreasonable compared with fees or other arrangements for a carbon oxide capture and utilization or sequestration project that does not qualify for the Section 45Q Credit, and may not be reduced by disproportionate rights to distributions or by issuances of interests in the Project Company (or rights to acquire interests in the Project Company) for less than fair market value consideration. This requirement is not in the Section 45 Safe Harbor but is consistent with the Section 47 Safe Harbor.
- Investor’s Minimum Unconditional Investment. On the date the Investor acquires a Partnership Interest, the Investor must make a minimum unconditional investment with respect to the Project Company (the “Investor Minimum Investment”). The Investor must maintain the Investor Minimum Investment throughout the duration of its ownership of its Partnership Interest, except that the Investor Minimum Investment may be reduced as a result of distributions of cash flow from the Project Company’s operation of the Equipment. Investments required to be made by the Investor in the future will not be included in the Investor Minimum Investment until the investment is actually made with respect to the partnership. The Investor Minimum Investment must be equal to at least 20 percent of the sum of the fixed capital investment plus any reasonably anticipated contingent investment required to be made by the Investor under the partnership agreement. The Investor must not be protected against loss of any portion of the Investor Minimum Investment through any arrangement, directly or indirectly, with the Developer, any other Investor, an Emitter, an Offtaker, or any person related to the Developer, other Investors, an Emitter, or an Offtaker. This requirement is consistent with the Section 45 and Section 47 Safe Harbors.
- Contingent Consideration. More than 50 percent of the sum of the fixed investment plus reasonably anticipated contingent investment to be made by an Investor with respect to a Partnership Interest must be fixed and determinable obligations that are not contingent in amount or certainty of payment. Contributions to the Project Company to pay ongoing operating expenses will not be treated as part of the Investor’s contingent investment for purposes of this requirement. This limitation is more permissive than a similar requirement in the Section 45 and Section 47 Safe Harbors, which limited contingent contributions to only 25 percent of the total expected contributions and did not exclude contributions to pay ongoing operating expenses from the calculation.
- Purchase and Sale Rights. Neither the Developer, the Investors, nor any related person may have a call option or other contractual right or agreement to purchase, at any time, the Equipment, any property included in the Equipment, or a Partnership Interest at a future date (other than a contractual right or agreement for a present sale). An Investor may not have a contractual right or other agreement to require any person involved in any part of the carbon capture transaction to purchase or liquidate the Investor’s Partnership Interest at a future date at a price that is more than its fair market value determined at the time of exercise of the contractual right to sell. This requirement is consistent with the Section 47 Safe Harbor but contrary to the Section 45 Safe Harbor, which allows a Developer call option at fair market value after the fifth anniversary of the placed-in-service date (including a call option at a fixed price that the parties reasonably believe will not be less than fair market value at the time of exercise) but prohibits an Investor put option. As a policy matter, the decision to allow a put option but prohibit a call (rather than to allow a call and prohibit a put) is difficult to square with prior IRS precedent (including the Section 45 Safe Harbor, as well as Revenue Procedures 2001-28 and 2001-29, concerning leveraged leases) and applicable caselaw (which tends to find sponsor calls less problematic than investor puts). Furthermore, the decision to have different rules applicable to the Section 45 Safe Harbor (on the one hand) and the Section 47 and Section 45Q Safe Harbors (on the other) is difficult to justify.
- Determination of Fair Market Value. Solely for the purposes of the Section 45Q Safe Harbor, any determination of the fair market value of the Equipment or a Partnership Interest may take into account contracts or other arrangements creating rights or obligations only if such contracts or other arrangements creating rights or obligations are entered into in the ordinary course of the Project Company’s business and are negotiated at arm’s length. This requirement is consistent with the Section 45 and Section 47 Safe Harbors.
- Guarantees and Loans.
- No person involved in any part of the Project Company may directly or indirectly guarantee or otherwise insure the Investor’s ability to claim the 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 Section 45Q Credit, in the event that the IRS challenges all or a portion of the transactional structure of the partnership. Further, no person involved in any part of the Project Company (or any related person) may guarantee that the Investor will receive distributions from the Project Company or consideration in exchange for its interest in the Project Company (except for a fair market value sale right). This requirement does not prohibit the Investor from procuring insurance, including recapture insurance, from persons not related to the Developer, any other Investor, an Emitter, or an Offtaker. This requirement is consistent with the Section 45 and Section 47 Safe Harbors. We note that it is helpful that Revenue Procedure 2012-12 specifically permits recapture insurance.
- The following guarantees may be provided to the Investor or the Project Company: (i) guarantees for the performance of any acts necessary to claim the Section 45Q Credit (including ensuring proper secure geological storage of the qualified carbon oxide through disposal, or use as a tertiary injectant, or utilization); and (ii) guarantees for the avoidance of any act (or omissions) that would cause the Project Company to fail to qualify for the Section 45Q Credit or that would result in a recapture of the Section 45Q Credit. Examples of guarantees permitted under this section include completion guarantees, operating deficit guarantees, environmental indemnities, and financial covenants. These examples of permitted guarantees are similar to those set forth in the Section 47 Safe Harbor. Unlike the Section 47 Safe Harbor, the Section 45Q Safe Harbor does not explicitly prohibit funded guarantees (i.e., guarantees pursuant to which money or property is set aside to fund all or any portion of the guarantee or the guarantor or any person under the control of the guarantor agrees to maintain a minimum net worth in connection with the guarantee).
- A long-term carbon oxide purchase agreement entered into on arm’s-length terms between the Project Company and an Emitter, between the Project Company and an Offtaker, or between an Emitter and an Offtaker, does not constitute a guarantee even if the Emitter or the Offtaker is related to the Project Company, and even if such contracts contain “supply all,” “supply-or-pay,” “take all,” “take-or-pay,” or “securely-store-or-pay” provisions. A long-term contract between the Project Company and the Emitter or the Offtaker pursuant to which the Project Company leases the equipment to the Emitter or the Offtaker or agrees to use the Equipment to perform services for the Emitter or the Offtaker also does not constitute a guarantee even if the Emitter or the Offtaker is related to the Project Company. This requirement is generally consistent with, but slightly more permissive than, the Section 45 Safe Harbor, which specifically precluded “take-or-pay” contracts with related parties. No similar requirement is addressed in (or relevant for) the Section 47 Safe Harbor.
- The Developer (or a person related to the Developer) may not lend any Investor the funds to acquire any part of the Investor’s interest in the Project Company or guarantee any indebtedness incurred or created in connection with the acquisition of such Investor’s interest in the Project Company. This requirement is consistent with the Section 45 and Section 47 Safe Harbors.
- Allocation of the Section 45Q Credit. Allocations under the Project Company’s partnership agreement must satisfy the requirements of section 704(b) and the regulations thereunder. The Section 45Q Credit and any recapture of the Section 45Q Credit must be allocated in accordance with Treasury Regulation § 1.704-1(b)(4)(ii). If the Project Company generates receipts from its activities relating to carbon oxide sequestration (such as payments for capturing qualified carbon oxide or for the sale of qualified carbon oxide), and those receipts give rise to valid allocations of partnership income, an allocation of the Section 45Q Credit in the same proportion as the partners’ respective distributive shares of such income will be treated as in accordance with the partners’ interests in the partnership for this purpose. If the Project Company does not receive payments for its activities relating to carbon oxide sequestration, an allocation of the Section 45Q Credit in the same proportion as the partners’ respective distributive shares of the loss or deduction (or other downward capital account adjustments) associated with the cost of the capture and disposal, use as a tertiary injectant, or utilization of the qualified carbon oxide will be treated as in accordance with the partners’ interests in the partnership for this purpose. This requirement is consistent with the Section 45 and Section 47 Safe Harbors. The rules explaining how to allocate the Section 45Q Credits (i.e., in accordance with income if the Project Company generates receipts and otherwise in accordance with loss or deduction) clarify a potential ambiguity under the Treasury Regulations and are a welcome addition.
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 Revenue Procedure 2020-12 or Notice 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 Revenue Procedure 2020-12 or Notice 2020-12.
For more information, contact any of the attorneys listed in this advisory.