Treasury Issues Final Regulations on Section 45Q Tax Credits for Carbon Capture and Sequestration

On January 6, 2021, the Internal Revenue Service (the “IRS”) and the Department of the Treasury released highly anticipated final regulations (the “Final Regulations”) on the Internal Revenue Code Section 45Q carbon capture and sequestration (“CCS”) credit in order to implement changes made to the credit by the Bipartisan Budget Act of 2018 (the “BBA”) (available here). The release of the Final Regulations follows the release of a notice of proposed rulemaking on May 28, 2020 (the “Proposed Regulations”).

The Final Regulations are in addition to two other items of guidance under Section 45Q the IRS previously released on February 19, 2020: Notice 2020-12, which addresses the beginning of construction requirement for CCS projects (the “BOC Guidance”), and Revenue Procedure 2020-12, which addresses the allocation of Section 45Q credits in partnership flip structures (the “Partnership Guidance”).

The Final Regulations follow changes made in December 2020 to Section 45Q in the Taxpayer Certainty and Disaster Relief Act of 2020. That legislation extended the time period available to become eligible to qualify for the Section 45Q credit by two years by requiring that construction of CCS facilities must begin before January 1, 2026, rather than January 1, 2024, as provided under prior law.

This update provides background on the CCS credit and a description of key aspects of the Final Regulations, the BOC Guidance and the Partnership Guidance.

Background

Congress originally enacted Section 45Q in 2008 to provide a tax credit to taxpayers that capture and sequester carbon dioxide. However, the Section 45Q credit failed to achieve widespread utilization by carbon dioxide generating industries and their financing partners due to various deficiencies in the statute. Significant amendments were made by the BBA to address many of the shortcomings of Section 45Q, including:

• increasing the credit amount;
• providing for transferability of credits;
• expanding the credit to include not only carbon dioxide, but also other carbon oxides;
• decreasing the minimum carbon capture thresholds to qualify for the credit;
• permitting the credit for a 12-year credit period;
• eliminating an industry-wide cap on the credit (previously 75 million metric tons per year); and
• allowing the credit for a broader range of sequestration methods.

As amended, Section 45Q generally provides a tax credit to taxpayers that capture qualified carbon oxide using carbon capture equipment at a qualified facility, and that (i) dispose of it in secure geological storage (“disposal”), (ii) use it as a tertiary injectant in a qualified enhanced oil or natural gas recovery project and dispose of it in secure geological storage (“injection”), or (iii) utilize it for certain other purposes as permitted by statute or regulation (“utilization”).

The amount of the Section 45Q credit depends on the year in which qualified carbon oxide is captured and sequestered, and whether such qualified carbon oxide is disposed, injected or utilized. The per metric ton amount of the credit is generally as follows:

Year	Injection and Utilization	Disposal
2017	$12.83	$22.66
2018	$15.29	$25.70
2019	$17.76	$28.75
2020	$20.22	$31.77
2021	$22.68	$34.81
2022	$25.15	$37.85
2023	$27.61	$40.89
2024	$30.07	$43.92
2025	$32.54	$46.96
2026	$35.00	$50.00

For taxable years after 2026, the 2026 amounts will be adjusted annually for inflation. The credit is available for the 12-year period beginning on the date that the carbon capture equipment is originally placed in service.

A Section 45Q Credit is only available for qualified carbon oxide captured with carbon capture equipment that is placed in service at a “qualified facility.” Under the statute, a “qualified facility” is any industrial facility or direct air capture facility, the construction of which begins before January 1, 2026, if (i) construction of carbon capture equipment begins before such date, or (ii) the original planning and design for such facility includes installation of carbon capture equipment. Additionally, the carbon capture equipment must meet certain minimum carbon oxide capture thresholds, which are dependent on the type of qualified facility and the carbon oxide emissions at such qualified facility.

To qualify for the Section 45Q Credit, an owner of carbon capture equipment can either physically sequester the relevant qualified carbon oxide itself or “contractually ensure” that the relevant qualified carbon oxide is sequestered, subject to recapture of the credits. Additionally, an owner of carbon capture equipment can elect to transfer its Section 45Q Credits to a party with whom the owner contracts for sequestration.

The Final Regulations

The Final Regulations provide clarity on several key issues for CCS developers, investors, and other stakeholders, including (i) the definitions of “qualified facility” and “carbon capture equipment”; (ii) how to “contractually ensure” sequestration, (iii) transferring Section 45Q credits, (iv) what constitutes “secure geological storage,” (v) “utilization” of carbon oxide, and (vi) recapture of Section 45Q credits.

The Final Regulations apply to taxable years beginning on or after the date they are published in the Federal Register. However, taxpayers may choose to apply the Final Regulations for taxable years beginning on or after February 9, 2018, the effective date of the BBA. Alternatively, taxpayers may rely on the Proposed Regulations for taxable years beginning on or after February 9, 2018, and before the date the Final Regulations are published, provided such taxpayers follow the Proposed Regulations in their entirety and in a consistent manner.

Qualified Facility

In General. As discussed above, a “qualified facility” is any industrial facility or direct air capture facility, the construction of which begins before January 1, 2026, and (i) the construction of carbon capture equipment begins before such date or (ii) the original planning and design for such facility includes installation of carbon capture equipment. In addition, qualified facilities must meet the following annual capture thresholds of qualified carbon oxide:

• a facility which emits not more than 500,000 metric tons of qualified carbon oxide into the atmosphere during the taxable year must capture at least 25,000 metric tons of qualified carbon oxide during the taxable year that is utilized;
• an electricity generating facility not described above must capture at least 500,000 metric tons of qualified carbon oxide during the taxable year; and
• a direct air capture facility, or any other facility not described above, must capture at least 100,000 metric tons of qualified carbon oxide during the taxable year.

The Final Regulations provide for an annualization of qualified carbon oxide emission and capture amounts in the year that carbon capture equipment is placed in service at a qualified facility. This is a welcome rule that prevents a taxpayer from having to delay placing equipment in service until the beginning of a new year solely for purposes of satisfying the minimum capture thresholds.

Applicable Facility Election. Section 45Q(f)(6)(A) provides that with respect to an “applicable facility” that captures at least 500,000 metric tons of qualified carbon oxide during a taxable year, the owner of the carbon capture equipment may elect to have such facility and any carbon capture equipment placed in service at such facility deemed as having been placed in service on February 9, 2018. Section 45Q(f) (6)(B) defines “applicable facility” as a qualified facility (i) which was placed in service before February 9, 2018, and (ii) for which no taxpayer claimed a credit under Section 45Q in regard to such facility for any taxable year ending before February 9, 2018.

As in the Proposed Regulations, the Final Regulations provide that a taxpayer may make the Section 45Q(f)(6) election by filing a statement of election with the taxpayer’s income tax return, in accordance with Form 8933, for each taxable year in which the credit arises. Taxpayers are not permitted to file amended federal income tax returns to revoke prior claims of Section 45Q credits to qualify to make the Section 45Q(f)(6) election. The Final Regulations clarify some potential ambiguity in the Proposed Regulations by specifically referring to the person that owns the carbon capture equipment and physically or contractually ensures the capture and sequestration as the person who can make the Section 45Q(f)(6) election.

For purposes of satisfying the minimum carbon capture thresholds, an applicable facility may utilize the single project rule (discussed immediately below).

Single Project Rule. For purposes of satisfying the minimum capture thresholds, the Final Regulations allow a taxpayer to apply the rules of section 8.01 of Notice 2020-12 to treat multiple facilities as a single facility. Notice 2020-12 provides a nonexclusive list of factors indicating that multiple qualified facilities or units of carbon capture equipment are operated as part of a single project, including (i) facilities or units owned by a single legal entity, (ii) facilities or units that are constructed in the same general geographic location or on adjacent or contiguous pieces of land, (iii) a single system of gathering lines or a single off-take operation is used to collect and deliver carbon oxide to a transportation pipeline, (iv) carbon oxide captured from the facilities is sequestered pursuant to a shared contract, (v) the facilities or units are described in one or more common environmental or other regulatory permits or are required to collectively report their activities, (vi) the facilities or units were constructed pursuant to a single contract providing Front-End Engineering and Design (“FEED”) or similar services covering the full scope of the single project, (vii) the facilities or units were constructed pursuant to a single master construction contract, and (viii) the construction of the facilities or units was financed pursuant to the same loan agreement.

The 80/20 Rule. The Final Regulations provide for an 80/20 rule such that a qualified facility or carbon capture equipment may qualify as originally placed in service even though it contains some used components of property, provided the fair market value of the used components of property is not more than 20% of the qualified facility or carbon capture equipment’s total value (the cost of the new components of property plus the value of the used components of property) (the “80/20 Rule”). For these purposes, the cost of a new qualified facility or carbon capture equipment includes all properly capitalized costs of the new qualified facility or carbon capture equipment. For purposes of the 80/20 Rule only, properly capitalized costs may, at the option of the taxpayer, include the cost of new equipment for a pipeline owned and used exclusively by that taxpayer to transport qualified carbon oxides captured from that taxpayer’s qualified facility that would otherwise be emitted into the atmosphere.

Industrial Facility. Section 45Q does not define industrial facility. The Final Regulations adopt the definition of industrial facility provided in section 3.03 of Notice 2020-12, such that an industrial facility is a facility that produces a qualified carbon oxide stream from a fuel combustion source or fuel cell, a manufacturing process or a fugitive qualified carbon oxide emission source that, absent capture and disposal, injection, or utilization, would otherwise be released into the atmosphere as industrial emission of greenhouse gas or lead to such release.

An industrial facility does not include a facility that produces carbon dioxide from carbon dioxide production wells at natural carbon dioxide-bearing formations or a naturally occurring subsurface spring. For purposes of determining whether a well is producing from a natural carbon dioxide-bearing formation or naturally occurring subsurface spring, the Final Regulations replace the facts and circumstances standard and 10% safe harbor provided in the Proposed Regulations and adopt a 90% test. Under this test, a carbon dioxide production well at natural carbon dioxide-bearing formations or a naturally occurring subsurface spring means a well that contains 90% or greater carbon dioxide by volume.

The Final Regulations also provide an exception for wells at natural carbon dioxide-bearing formations or naturally occurring subsurface springs that contain a product other than carbon dioxide. This exception provides that a well meeting the 90% test will not be treated as a carbon dioxide production well at a natural carbon dioxide-bearing formation or a naturally occurring subsurface spring if: (a) the gas stream contains a product, other than carbon oxide, that is commercially viable to extract and sell, without taking into account the availability of a commercial market for the carbon oxide that is extracted or any Section 45Q credit that might be available; (b) the taxpayer provides an attestation from an independent registered engineer with experience in feasibility studies for natural gas extraction that the gas stream contains a product, other than carbon oxide, that is commercially viable to extract and sell, without taking into account the availability of a commercial market for the carbon oxide that is extracted; (c) a direct air capture facility is not used to capture carbon oxide from the gas stream; and (d) any carbon oxide extracted from the deposit is used as tertiary injectant in an enhanced oil or natural gas recovery project or as feedstock of a utilization project (i.e., the cycling of the gas from the deposit to a processing facility and then back to the deposit will not be considered the capture and storage of carbon oxide for purposes of the Section 45Q credit).

Electricity Generating Facility. Section 45Q does not define electricity generating facility. Like the Proposed Regulations, the Final Regulations define an electricity generating facility as a facility that is subject to depreciation under MACRS Asset Class 49.11(Electric Utility Hydraulic Production Plant), 49.12 (Electric Utility Nuclear Production Plant), 49.13 (Electric Utility Steam Production Plant) or 49.15 (Electric Utility Combustion Turbine Production Plant).

Direct Air Capture Facility. The Final Regulations reiterate the definition of “direct air capture facility” provided in the statute of any facility which uses carbon capture equipment to capture carbon dioxide directly from the ambient air, except the term does not include any facility which captures carbon dioxide that is deliberately released from naturally occurring subsurface springs or using natural photosynthesis.

Carbon Capture Equipment

Section 45Q does not define carbon capture equipment. As in the Proposed Regulations, the Final Regulations define carbon capture equipment in terms of its functionality. However, based on comments to the Proposed Regulations that they would cause confusion in practice, the Final Regulations remove the list of qualifying carbon capture components and excluded components. The Final Regulations provide that carbon capture equipment includes all components of property that are used to capture or process qualified carbon oxide until the qualified carbon oxide is transported for disposal, injection or utilization, including equipment used for the purpose of:

• separating, purifying, drying, and/or capturing qualified carbon oxide that would otherwise be released into the atmosphere from an industrial facility;
• removing qualified carbon oxide from the atmosphere via direct air capture; or
• compressing or otherwise increasing the pressure of qualified carbon oxide.

Components of property related to the function of capturing qualified carbon oxides, such as components of property necessary to compress, treat, process, liquefy, or pump qualified carbon oxides, are included within the definition of carbon capture equipment. The Final Regulations also provide that carbon capture equipment generally does not include components of property used for transporting qualified carbon oxide for sequestration. However, the definition of carbon capture equipment does include a gathering and distribution system that collects qualified carbon oxide from one or more qualified facilities that constitute a single project to transport the qualified carbon oxide away from the qualified facility or project to a pipeline used by multiple taxpayers.

The Final Regulations clarify that all components that make up an independently functioning process train capable of capturing, processing and preparing carbon oxide for transport should be treated as one unit of carbon capture equipment. In addition, the Final Regulations clarify that carbon capture equipment that is originally placed in service at a qualified facility on or after February 9, 2019 may be owned by a taxpayer other than the taxpayer that owns the industrial facility at which the carbon capture equipment is placed.

Contractually Ensure Sequestration

In General. As discussed above, the Section 45Q credit is attributable to the person that owns the relevant carbon capture equipment and physically or “contractually ensures” the sequestration of qualified carbon oxide. Under the Final Regulations, a taxpayer contractually ensures the disposal, injection or utilization of qualified carbon oxide if the taxpayer enters into a “binding written contract” that requires the party that physically carries out the sequestration (the contractor) to do so in the manner required under Section 45Q and the Final Regulations. A “binding written contract” must be enforceable under state law against both the taxpayer and the contractor (or a predecessor or successor of either).

In addition, the Final Regulations provide that contracts ensuring the sequestration of qualified carbon oxide must include commercially reasonable terms, provide for enforcement of the contractor’s obligation to perform the sequestration of the qualified carbon oxide and obligate the contractor to comply with the relevant provisions of the Final Regulations.

The Final Regulations also provide that a taxpayer may enter into multiple contracts with multiple parties for the sequestration of qualified carbon oxide.

Liquidated Damages. The Proposed Regulations contained seemingly conflicting provisions regarding damages – one that prohibited a contract that limited damages “to a specified amount” and one that allowed liquidated damages. Consistent with Section 8.02(1) of Notice 2020-1, the Final Regulations harmonize these conflicting provisions by providing that a contract 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.

Subcontracts. Unlike the Proposed Regulations, the Final Regulations make clear that a taxpayer may enter into a binding written contract with a general contractor that hires subcontractors to physically carry out the sequestration of the qualified carbon oxide, provided that the contract binds the subcontractors to the requirements for a “binding written contract” set forth in the Final Regulations. However, as discussed below, the Section 45Q credit may not be transferred to the subcontractor.

Pre-Existing Contracts. If a taxpayer entered into a contract for the sequestration of qualified carbon oxide prior to the date the Final Regulations are published in the Federal Register that does not satisfy the requirements of the Final Regulations, the taxpayer must enter into new contracts or amend existing contracts that conform the Final Regulations within 180 days of their publication in the Federal Register.

Reporting. The existence of, and specific information regarding, each contract must be reported annually to the IRS by each party to the contract, regardless of the party claiming the credit.

Transferring Credits

Under Section 45Q, the owner of the carbon capture equipment (electing taxpayer) may elect to pass the credit to the person that disposes of, utilizes or injects the qualified carbon oxide (credit claimant). The Final Regulations provide that an electing taxpayer can allow the credit to be claimed by one or multiple allowable credit claimants, but if an electing taxpayer allows multiple credit claimants to claim Section 45Q credits, the maximum amount of credits allowable to each claimant is in proportion to the amount of qualified carbon oxide disposed of, utilized, or injected by the credit claimant.

Elections to allow the Section 45Q credit to another taxpayer must be filed annually with the electing taxpayer’s original tax return (but not an amended return). The ability to make the election on an annual basis and with respect to multiple contractors should allow potential electing taxpayers and contractors to make tax efficient elections on a year-by-year basis.

Both the electing taxpayer and credit claimant must file Form 8933 with their tax return, and the credit claimant must also attach the Form 8933 of the electing taxpayer. If the taxpayer claiming the Section 45Q credit fails to satisfy this reporting requirement, that taxpayer will not be able to claim the Section 45Q credit. However, the failure of one party (e.g., the electing taxpayer) to properly file its Form 8933 with the IRS will not impact the ability of the other party (e.g., the credit claimant) to claim the Section 45Q credit.

Secure Geological Storage

Both disposal and injection require that qualified carbon oxide be disposed of in secure geologic storage. Section 45Q(f)(2) provides that the Treasury Secretary, in consultation with the Administrator of the EPA, the Secretary of Energy and the Secretary of the Interior, shall establish regulations for determining adequate security measures for the geological storage of qualified carbon oxide under Section 45Q(a) such that the qualified carbon oxide does not escape into the atmosphere.

The Final Regulations for secure geological storage mostly follow EPA regulations and apply different rules depending on whether qualified carbon oxide is being disposed of in secure geological storage or is being used as an injectant in connection with a qualified enhanced oil or natural gas project and then disposed of by the taxpayer. Under EPA regulations, injection of qualified carbon oxide for geological sequestration beneath the lowermost formation containing an underground source of water requires a UIC Class VI permit. Operators that inject qualified carbon oxide underground are also subject to the EPA’s Greenhouse Gas Reporting Program (“GHGRP”) requirements in 40 CFR Part 98 subpart RR (“subpart RR”). Under subpart RR, operators of UIC Class VI wells are required to report basic information on carbon dioxide received for injection, and to develop and implement an EPA-approved site-specific Monitoring, Reporting, and Verification Plan (an “MRV Plan”).

Under EPA regulations, an MRV Plan is not required before injection operations begin. However, the Final Regulations make clear that the MRV Plan must be developed and implemented before Section 45Q credits may be claimed. Because an MRV Plan typically takes 12 to 18 months to develop and implement, and requires EPA approval, this requirement could significantly delay the development of CCS projects.

Under EPA regulations, injection of carbon dioxide in connection with enhanced oil recovery or natural gas recovery requires a UIC Class II permit. Operators that inject carbon dioxide for these purposes are subject to the EPA’s GHGRP requirements in 40 CFR Part 98 subpart UU (“subpart UU”). Under subpart UU, operators of UIC Class II wells are required to report basic information on carbon dioxide received for injection and are not required to develop and implement an MRV Plan.

The requirements of subpart RR, including the MRV Plan requirement, generally do not apply to the injection of qualified carbon oxide in connection with enhanced oil recovery or natural gas recovery, unless (i) the owner or operator opts into subpart RR, or (ii) the facility holds a UIC Class VI permit for the well used for enhanced oil recovery. While tax credits are available if injectors of qualified carbon oxide in connection with enhanced oil recovery or natural gas recovery report under subpart RR, the Final Regulations provide that, as an alternative to reporting under subpart RR, the operator may elect to report under a standard adopted by the International Organization of Standardization: CSA/ANSI ISO 27916:19 (Carbon Dioxide Capture, Transportation and Geological Storage - Carbon Dioxide Storage using Enhanced Oil Recovery (CO2-EOR)) (the “ISO Standard”). Reporting under the alternative ISO Standard provides relief for UIC Class II operators from the requirement to develop and implement an MRV Plan. However, if a taxpayer reports under the ISO Standard, the taxpayer must prepare and provide documentation to an independent engineer or geologist, who then must certify that the documentation is accurate and complete. The Final Regulations also provide that the certification must be accompanied by an affidavit from the engineer or geologist stating under penalties of perjury that the engineer or geologist is independent from the taxpayer, electing taxpayer, and/or credit claimants, as applicable. By contrast, self-certification is permitted for taxpayers that report in compliance with subpart RR. Unlike the alternative rule for UIC Class II operators to report under the ISO Standard, there is no such alternative rule for UIC Class VI operators to report under the ISO Standard instead of subpart RR.

Utilization

Section 45Q(f)(5) provides that “utilization of qualified carbon oxide” means (i) the fixation of such qualified carbon oxide through photosynthesis or chemosynthesis, such as through the growing of algae or bacteria; (ii) the chemical conversion of such qualified carbon oxide to a material or chemical compound in which such qualified carbon oxide is securely stored, or (iii) the use of such qualified carbon oxide for any other purpose for which a commercial market exists (with the exception of use as a tertiary injectant in a qualified enhanced oil or natural gas recovery project), as determined by the Secretary. In order for the Secretary to determine whether a commercial market exists, the Final Regulations require a taxpayer to submit a statement attached to its Form 8933 substantiating that a commercial market exists for its particular product, process or service.

Section 45Q(f)(5) further provides a methodology to determine the amount of qualified carbon oxide utilized by the taxpayer. Such amount is equal to the metric tons of qualified carbon oxide which the taxpayer demonstrates, based upon an analysis of lifecycle greenhouse gas emissions (“LCA”) and subject to such requirements as the Secretary, in consultation with the Secretary of Energy and the Administrator of the EPA, determines appropriate, were (i) captured and permanently isolated from the atmosphere, or (ii) displaced from being emitted into the atmosphere.

The Final Regulations provide that the LCA must be in writing and either performed or verified by a professionally licensed independent third party. The LCA must contain certain documents consistent with ISO 14044:2006, “Environmental Management- Life cycle assessment- Requirements and Guidelines” as well as a statement documenting the qualifications of the third-party.

The Final Regulations provide that the LCA must be submitted to the IRS and the Department of Energy (“DOE”). Based on commenters’ concerns about delays, the Final Regulations streamlined the LCA review and approval process by providing that the DOE will conduct a technical review of each LCA and the IRS will determine whether to approve the LCA. Addressing concerns that an LCA may not be approved before a taxpayer is barred from filing an amended return by the statute of limitations, the preamble states that priority in the LCA review process will be given to prior tax years. The preamble also provides that taxpayers may rely on the Final Regulations to submit an LCA, but the IRS will issue separate procedural guidance that provides additional details regarding the LCA submission and review process.

Recapture

Section 45Q(f)(4) directs the Treasury Secretary to provide regulations for recapturing the benefit of any Section 45Q credit allowable with respect to any qualified carbon oxide which ceases to be captured, disposed of or used as a tertiary injectant in a manner consistent with the requirements of Section 45Q.

Under the Proposed Regulations, the recapture period, which is the open period during which a recapture event may occur, begins on the date of the first injection of qualified carbon oxide for disposal in secure geological storage or use as a tertiary injectant and ends the earlier of 5 years after the last taxable year in which the taxpayer claimed a Section 45Q credit or the date monitoring ends under subpart RR or the alternative ISO Standard. Based on comments to the Proposed Regulations, the Final Regulations reduce the recapture period from 5 years to 3 years. In addition, the Final Regulations clarify that the recapture period ends 3 years after the last taxable year in which the taxpayer claimed a Section 45Q tax credit or was eligible to claim a credit that it elected to carry forward. Accordingly, the 3-year period begins in the year that the Section 45Q credit is generated, regardless of whether the taxpayer carries the credit forward and utilizes it in a later year.

The Final Regulations provide for a 3-year lookback period (reduced from 5 years in the Proposed Regulations) during which the IRS may recapture tax credits after a leakage event. The amount of leakage is first applied and offset against the amount of qualified carbon oxide captured and sequestered in the current year, then applied and offset against the amount of qualified carbon oxide captured in the prior five years under a last-in, first-out (“LIFO”) methodology, to the extent of such amounts. Under this approach, the amount of leaked qualified carbon oxide is recaptured at a tax credit rate for the year in which it is applied under this methodology. The amount of the recaptured tax credit must be added to the amount of tax due in the taxable year in which the recapture event occurs.

Although the IRS requested comments on how to apply the recapture provisions with respect to tax credits that are carried forward to future taxable years due to insufficient income tax liability in the current taxable year, the Final Regulations to do not address the application of the recapture provisions to credit carry forward. Rather, the preamble to the Final Regulations states that Section 45Q credit carryforwards should not be affected by any recapture of prior year credits, because the recapture is taken into account in the year in which the leakage occurs.

Where a recapture event occurs with respect to a secure geological storage location in which the stored qualified carbon oxide had been captured from more than one unit of carbon capture equipment that was not under common ownership, the recapture amount must be allocated among the taxpayers that own the multiple units of carbon capture equipment pro rata on the basis of the amount of qualified carbon oxide captured from each of the multiple units of carbon capture equipment. Similarly, a pro rata approach to the recapture of tax credits applies in the event of a recapture event where the leaked amount of qualified carbon oxide is deemed attributable to qualified carbon oxide with respect to which multiple taxpayers claimed tax credits.

A limited exception to recapture applies in the event of a leakage of qualified carbon oxide resulting from actions not related to the selection, operation or maintenance of the storage facility, such as volcanic activity or a terrorist attack. As provided in Rev. Proc. 2020-12, a taxpayer may obtain recapture insurance to protect against recapture. Such insurance may be particularly desirable for projects with tax equity investors that want to manage risks regarding investments in projects that claim Section 45Q credits.

Notice 2020-12: BOC Guidance

Although Section 45Q includes a December 31, 2025 deadline for beginning construction for entitlement to the Section 45Q credit, Congress did not define when construction would be treated as having begun, instead leaving that to the IRS to define. Notice 2020-12 provides that guidance and is largely consistent with the beginning of construction notices previously issued for other renewable energy facilities.

Notice 2020-12 provides two methods to establish that construction of a qualified facility or carbon capture equipment has begun for Section 45Q purposes – starting physical work of a significant nature (the “Physical Work Test”) or paying or incurring 5% or more of the total cost of the qualified facility or carbon capture equipment (the “5% Safe Harbor”). Construction will be deemed to begin on the first date that either method is satisfied, and both methods require continuous progress toward completion of construction (the “Continuity Requirement”).

Physical Work Test

The Notice states that construction has begun when the taxpayer begins physical work of a significant nature. The determination of whether physical work of a significant nature has begun is a facts and circumstances analysis. The Physical Work Test focuses on the nature of the work performed rather than the amount of work or the cost thereof, and the Notice confirms that there is “no fixed minimum amount of work or monetary or percentage threshold required to satisfy the Physical Work Test.”

Physical work can either be performed by the taxpayer directly or by other persons under a binding written contract, and the work may be performed on-site or off-site. 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).

Notice 2020-12 identifies two categories of activities that do not qualify as physical work of a significant nature: preliminary activities and inventory activities. The guidance provides examples of preliminary activities that would not qualify, including securing financing, exploring, researching, obtaining permits and licenses, conducting test drilling to determine soil condition (including to test the strength of a foundation), excavating to change the contour of land, clearing a site and removing existing foundations or any components that will not be used in the project. The guidance also states that physical work of a significant nature does not include work performed, either by the taxpayer or by another person under contract, to produce components of a qualified facility or carbon capture equipment that are in existing inventory or are normally held in inventory.

5% Safe Harbor

Construction of a qualified facility or carbon capture equipment will be considered to have begun if the taxpayer pays or incurs (depending on the taxpayer’s method of accounting) 5% or more of the total cost of the qualified facility or carbon capture equipment. The total cost of the qualified facility or carbon capture equipment includes all costs included in the depreciable basis of the qualified facility or carbon capture equipment. Costs associated with FEED activities or other approaches for front-end planning may be considered to determine whether the 5% Safe Harbor has been met. A taxpayer may look through to costs paid or incurred by another person with whom the taxpayer has entered into a binding, written contract with respect to the project construction.

Notice 2020-12 provides clarity on how cost overruns shall be treated for the purposes of the 5% Safe Harbor. For a single project comprised of multiple qualified facilities or units of carbon capture equipment, if the total cost exceeds the anticipated cost such that the amount a taxpayer paid or incurred is less than 5% of the actual total cost of the project when placed in service, the 5% Safe Harbor can be satisfied with respect to some, but not all, of the qualified facilities or units of carbon capture equipment comprising the 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 paid or incurred. For a single qualified facility or unit of carbon capture equipment that cannot be separated into multiple properties, however, if the amount paid or incurred in a given year ultimately is less than 5% of the total cost when the qualified facility or unit of carbon capture equipment is placed in service, the 5% Safe Harbor will not be satisfied.

Continuity Requirement

Both the Physical Work Test and the 5% Safe Harbor have a Continuity Requirement, which requires the taxpayer to 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.

Transfers

There is no statutory requirement that the taxpayer that places a qualified facility in service also be the taxpayer that begins construction on the facility. As such, a transfer of a fully- or partially-developed facility does not necessarily disqualify the facility under the Physical Work Test or the 5% Safe Harbor. However, a transfer solely consisting of tangible personal property between unrelated parties does disqualify the property such that any work performed or amounts paid or incurred by the transferor with respect to the transferred property will not be taken into account in determining whether the transferee meets the Physical Work Test or the 5% Safe Harbor.

Retrofits

Notice 2020-12 applies the 80/20 Rule described above for purposes of determining whether retrofitted qualified facilities or carbon capture equipment qualify for the Section 45Q Credit. 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.

Single Project Rule

For purposes of establishing that construction of a qualified facility or carbon capture equipment has begun, 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 facilities or units) may be treated as a single project. The factors used to determine with multiple qualified facilities or units of carbon capture equipment are operated as part of a single project are discussed above under the “Single Project Rule” heading in the discussion of the definition of a “qualified facility” in the Final Regulations. 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.

Revenue Procedure 2020-12: Partnership Guidance

The developer (or “sponsor”) of a project that generates tax credits often does not have sufficient taxable income to efficiently utilize such credits. A developer will thus frequently look for a “tax equity investor,” who can efficiently utilize such credits, to provide an equity investment in the project. The investment will be structured to allocate tax credits and certain other tax attributes generated by the project (such as depreciation) to the tax equity investor in an efficient manner.

A structure that has been widely used in other tax equity transactions is a “partnership flip,” where a developer and one or more tax equity investors form a “project company” that is treated as a partnership for tax purposes to own and operate the relevant tax credit-generating property. A tax partnership provides a developer and investors flexibility to allocate project company tax items in a manner that ensures the majority of tax credits and other relevant tax attributes are allocated to tax equity investors that can use them, while distributing cash generated by the project company in a different proportion than the tax allocations.

In a typical partnership flip transaction, a developer contributes the relevant property to the project company and one or more tax equity investors purchase interests in the project company from the developer or the project company. The majority of taxable income, losses and tax credits (and usually a smaller portion of cash distributions) are then allocated to the investors until the investors hit a target after-tax rate of return (or, in some transactions, until a specified date). Once the investors hit the target rate of return (or upon the specified date), the tax allocations “flip,” such that the majority of taxable income, losses and any remaining tax credits are allocated to the developer. A developer will often have a call option to purchase (and/or an investor will have a put option to sell to the developer) an investor’s project company interest for fair market value at some point following the flip (though as discussed below, a developer call option is not permitted for CCS partnership flips under the relevant IRS safe harbor).

Revenue Procedure 2020-12 provides a safe harbor under which an investor will be respected as a partner/owner in (rather than a lender to) a partnership that owns carbon capture equipment and thus will be entitled to an allocation of available Section 45Q tax credits.

Under Revenue Procedure 2020-12, an investor, together with the developer, will be respected as a partner of a project company partnership that owns the carbon capture equipment if all of the requirements described below are satisfied.

Project Developer’s Minimum Partnership Interest. The developer must have a minimum 1% interest in each material item of partnership income, gain, loss, deduction, and credit at all times during the existence of the partnership.

Investor’s Partnership Interest. Each investor must have an interest in each material item of partnership income, gain, loss, deduction, and credit at all times that is at least 5% of its largest interest percentage. In addition, 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. The bona fide equity investment requirement could be difficult to apply in practice and it ignores the reality that the tax benefits will comprise a significant portion of any investor’s return on its investment. It is also not consistent 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.”

Investor’s Minimum Unconditional Investment. At all times, an investor’s minimum investment must be at least 20% of the fixed capital investment plus any reasonably anticipated contingent investment required to be made by the investor. The investment amount may be reduced through cash distributions from the operation of the project. The investor must not be protected from loss of the minimum investment by the developer, other investors or certain other persons.

Contingent Consideration. More than 50% of an investor’s investment must be fixed and determinable, meaning that contingent consideration is limited to 50% of an investor’s investment. For this purpose, contributions for ongoing project expenses will not be treated as contingent payments by the investor.

Put and Call Rights. Neither project developers nor investors may have a call option to purchase the carbon capture equipment or a partnership interest at a future date. In addition, an investor may not hold a put option to require any person to purchase the partner’s partnership interest at a future date at a price that is more than its fair market value.

Guarantees and Loans. No party involved in the project company may directly or indirectly guarantee the investor’s ability to claim Section 45Q tax credits or a repayment of tax credits if challenged by the IRS, or distributions or other consideration. The developer may not lend any funds to the investor to acquire the investor’s interest in the project company or guarantee any indebtedness incurred in connection with that acquisition.

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.

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.

Allocation of the Section 45Q Credit. Allocations under the partnership agreement must satisfy requirements under section 704(b). Tax credits and any recapture must be allocated in accordance with Treas. Reg. § 1.704-1(b)(4)(ii). If the project company generates receipts from its sequestration activities, an allocation of the Section 45Q credit in the same proportion as their respective distributive share of income is treated as being made in accordance with the partner’s interest in the partnership. If the project company does not receive payments from its sequestration activities, an allocation of the Section 45Q credit in the same proportion as the partners’ loss or deduction associated with the cost of capture and disposal will be treated as in accordance with the partners’ interest in the partnership.

Example. The Revenue Procedure provides an example in which the IRS applies these requirements to a typical tax equity “flip” partnership. The following chart describes the project company’s distributions of cash and allocations of gross income/loss and Section 45Q credits during three periods:

	Developer		Investor
	Cash	Gross Income/Loss & Section 45Q Credits	Cash	Gross Income/Loss & Section 45Q Credits
Period 1	100%	1%	0%	99%
Period 2	0%	1%	100%	99%
Period 3	95%	95%	5%	5%

Period 1 runs from the date of the investor’s investment until the earlier of (i) the date the developer receives an agreed cash return, which may be an amount equal to the aggregate contributions made by the developer, or (ii) a fixed outside date. When Period 1 ends, Period 2 begins.

Period 2 will continue until the investor achieves an agreed after-tax internal rate of return (the “Flip Point”). When Period 2 ends, Period 3 begins. If the Flip Point occurs before Period 1 ends, Period 1 ends at that time, and Period 3 begins.

Period 3 will continue for the remaining life of the project.

Under the facts provided in the example, 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 credits in accordance with Section 704(b) of the Internal Revenue Code and the regulations thereunder.

If you have further questions, please contact Michael Snider, David Weil, or Peter Rose.