On May 28, 2020, Treasury and the IRS issued Proposed Regulations under Section 45Q of the Code, which provides for a production tax credit for persons who physically or contractually ensure the capture and disposal of qualified carbon oxide. The Proposed Regulations address the requirements for capture and disposal, the use of qualified carbon oxide as a tertiary injectant in a qualified enhanced oil or natural gas recovery project, and the utilization of qualified carbon oxide in a manner that qualifies for the credit. The IRS previously requested comments on issues arising under Section 45Q in Notice 2019-32. On March 9, 2020, the IRS published Revenue Procedure 2020-12, which provides a safe harbor for allocating Section 45Q credits in a partnership flip structure and Notice 2020-12, which provides guidance on when construction of a carbon capture facility or carbon capture equipment has begun.
With respect to carbon capture using equipment described in Sections 45Q(a)(1) and (2) (originally placed in service before the date of enactment of the Bipartisan Budget Act of 2018 (the “BBA”) on February 9, 2018), the amount of the Section 45Q credit is an inflation adjusted $20 or $10 per metric ton depending upon how the captured carbon is stored or utilized.
With respect to carbon capture equipment described in Section 45Q(a)(3) and (4) (originally placed in service on or after February 9, 2018), the Section 45Q credit is one of two “applicable dollar amounts” multiplied by the metric tons of captured qualified carbon oxide for the twelve-year period beginning on the date the carbon capture equipment is placed in service. The applicable dollar amount ranges from $22.66 to $50 for each metric ton of captured carbon for calendar years through 2026, or from $12.83 to $35 for each calendar year per metric ton captured for calendar years through 2026, depending upon how the captured carbon is sequestered. The higher dollar credits are available for captured carbon oxide that is neither utilized as a tertiary injectant in a qualified oil or natural gas recovery project nor used in manner described in Section 45Q(f)(5) (e.g., fixation through photosynthesis, chemical conversion, or other commercial use). For periods after 2026, the credit amount is an inflation adjusted $50 or $35 per metric ton of captured carbon, depending on method of sequestration.
For certain large carbon capture facilities (no less than 500,000 metric tons of carbon capture per taxable year) that have not previously claimed Section 45Q credits, the taxpayer can elect to have the facility and applicable carbon capture equipment treated as placed in service on February 9, 2018, thereby qualifying for the larger credit amounts.
For carbon capture equipment placed in service before February 9, 2018, Section 45Q credits are available until the year in which the Secretary, in consultation with the Administrator of the EPA, certifies that 75 million metric tons of qualified carbon oxide have been taken into account under Section 45Q(a) (pre-BBA) and Section 45Q(a)(1) and (2).
Contractual Assurance of Disposal, Injection, or Utilization of Qualified Carbon Oxide
Section 45Q credits for pre-BBA facilities are available to the person that captures and physically or contractually ensures the disposal of qualified carbon oxide through secure geological storage and that either (i) does not use the qualified carbon oxide for a purpose described in clause (ii) or (iii) (referred to as “disposal”), (ii) uses the qualified carbon oxide for tertiary injection and disposal through secure geological storage (referred to as “injection”), or (iii) utilizes the qualified carbon oxide in a manner described in Section 45Q(f)(5) (referred to as “utilization”). Section 45Q credits for post-BBA facilities are available to the person who owns the carbon capture equipment and physically or contractually ensures the capture and disposal, injection, or utilization of such qualified carbon oxide.
The Proposed Regulations provide a framework for the types of contracts, terms, and reporting requirements that will demonstrate the contractual assurance of the capture and disposal, injection, or utilization of qualified carbon oxide. The Proposed Regulations clarify that a taxpayer may contract with multiple parties for portions of its captured qualified carbon oxide with each using different methods of ensuring the disposal, injection, or utilization of such qualified carbon oxide. Form 8933, Carbon Capture Sequestration Credit, will be used to report the existence of each contract and the contracting parties, along with specific information regarding contracts for disposal of qualified carbon oxide or use as a tertiary injectant. The Proposed Regulations provide that in the case of contractually ensured disposal, injection, or utilization of qualified carbon oxide, the contract must be a written contract binding under state law against all parties that does not limit damages to a specified amount. The binding written contract must include reasonable terms for enforcement and may, but need not, contain other terms, such as long-term liability provisions, indemnity provisions, or penalties for breach of contract or liquidated damages. While the Proposed Regulations require the contract include mechanisms for enforcement, no specific method is required, thereby allowing contracting parties to tailor their agreements to meet their business needs. The requirement in the Proposed Regulations that in order to be considered a binding written contract the contract may not limit damages to a specific amount is at odds with the subsequent provisions of the Proposed Regulations that a binding written contract may include liquidated damages provisions. This conflict could be reconciled if the final Regulations include a provision similar to Treasury Regulation Section 1.168(k)-1(b)(4)(ii)(A), which states that a contractual provision that limits damages to an amount equal to at least five percent of the total contract price will not be treated as limiting damages to a specified amount.
Election to Transfer the Credit to Certain Other Taxpayers
As amended by the BBA, Section 45Q credits may be transferred to another person who may be in a better position to use the credit. Specifically, Section 45Q(f)(3)(B) provides that the taxpayer entitled to Section 45Q credits may elect to allow the person that disposes, injects, or utilizes the captured qualified carbon oxide to claim the credit. The Proposed Regulations provide that a transfer election must be made annually no later than the due date (including extensions) for the transferring taxpayer’s applicable tax return. Such an election may not be made on an amended return, except that an election may be made on an amended return or administrative adjustment request under Code section 6227, for any taxable year ending after February 9, 2018, but not for taxable years beginning after June 2, 2020. The election must be made on Form 8933 and filed by both the taxpayer and the transferee of the credit.
Transfer elections may be made for all or a portion of the Section 45Q credits and may be made for one or more transferees. If Section 45Q credits are transferred to more than one transferee, the Proposed Regulations provide that the maximum amount of credit allowable to each transferee is proportional to the amount of qualified carbon oxide disposed of, injected, or utilized by each transferee. The Proposed Regulations provide guidance for those taxpayers or partnerships that wish to file amended returns to take advantage of these transfer provisions, which must be filed within the applicable statute of limitations for the taxable year for which the amended return is filed. Partnerships that choose not to file an amended return as permitted under Revenue Procedure 2020-23 may nevertheless make a late election by filing an administrative adjustment request on or before October 15, 2021, but no later than the applicable period of limitations for making partnership adjustments under Section 6235. Transfer elections may not be made on any amended return for tax years beginning after June 2, 2020.
Qualified Carbon Oxide
The Proposed Regulations provide several helpful definitions of key terms that are left undefined in the statute. However, because the term “qualified carbon oxide” is adequately defined in Section 45Q, the Proposed Regulations conform to the statutory text, adding that only qualified carbon oxide captured and disposed of, injected, or utilized in the United States is taken into account.
Carbon Capture Equipment
Section 45Q does not define the term “carbon capture equipment”. The Proposed Regulations fill that gap by providing 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, and list specific items that are included and excluded from that definition.
Section 45Q defines a “qualified facility” as a facility the construction of which begins before January 1, 2024 and either the construction of the carbon capture equipment begins before such date, or the original planning and design for the facility includes the installation of carbon capture equipment. Commenters requested that proposed regulations include an 80/20 rule similar to that set forth in Rev. Rul. 94-31, which held that for Section 45 purposes a facility that includes some used property would still qualify as originally placed in service, provided the fair market value of the used property is not more than 20% of the completed facility’s total value. The Proposed Regulations include a similar 80/20 rule and provide that solely for purposes of such rule, the cost of a new qualified facility or carbon capture equipment includes all properly capitalized costs of the new qualified facility or the new carbon capture equipment. Further, for purposes of applying the 80/20 rule, capitalized costs of the qualified facility or carbon capture equipment may include a special purpose pipeline owned and used exclusively by the taxpayer to transport captured qualified carbon oxide that would otherwise be emitted into the atmosphere.
Secure Geological Storage
Section 45Q(f)(2) provides that the Secretary, in consultation with the Administrator of the EPA, the Secretary of Energy, and the Secretary of the Interior, must establish regulations for determining adequate security measures for the geological storage of qualified carbon oxide under Section 45Q such that the qualified carbon oxide does not escape into the atmosphere. This would include storage at deep saline formations, oil and gas reservoirs, and unminable coal seams under such conditions as the Secretary may determine under such regulations.
The proposed regulations provide two options for a taxpayer to establish compliance with the secure geological storage requirement of Section 45Q(f)(2): (a) compliance with the EPA’s Greenhouse Gas Reporting Program under 40 CFR part 98 subpart RR (referred to as “Subpart RR”), or (b) compliance with the International Standard Organization (ISO) standard endorsed by the American National Standards Institute (ANSI) under CSA/ANSI ISO 27916:19. A taxpayer that reports volumes to the EPA pursuant to Subpart RR may self-certify the volume of qualified carbon oxide claimed for purposes of Section 45Q. If a taxpayer determines such volumes pursuant to the ISO standard, a qualified independent engineer or geologist must certify annually that the taxpayer’s internally prepared documentation of compliance with the ISO standard is accurate and complete. Although requested by commenters, the Proposed Regulations do not include state reporting rules as a reporting alternative for purposes of disposal using geological storage.
Utilization of Qualified Carbon Oxide
For purposes of Section 45Q(f)(5)(A), the utilization of qualified carbon oxide means (i) the fixation of such qualified carbon oxide through photosynthesis or chemosynthesis, (ii) the chemical conversion of such qualified carbon oxide into a material or chemical compound in which the 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 (except for use in injection). Section 45Q(f)(5)(B) provides a methodology to determine the amount of qualified carbon oxide utilized by the taxpayer, which is equal to the metric tons of qualified carbon oxide which the taxpayer demonstrates, based on an analysis of lifecycle greenhouse gas emissions, are (i) captured and permanently isolated from the atmosphere, or (ii) displaced from being emitted into the atmosphere, through the use of the methods described in Section 45(f)(5)(A). Commenters sought guidance about the methodologies for making an acceptable life cycle analysis (LCA). The Proposed Regulations provide that the LCA must be in writing and either performed or verified by a professionally-licensed third party that uses generally accepted standard practices of quantifying the greenhouse gas emissions of a product or process by comparing that impact to a baseline. The analysis must contain documentation consistent with certain ISO life cycle assessment standards, as well a statement of the qualifications of the third party expert. The LCA report must be submitted to the IRS and the DOE, and will be subject to technical review by the DOE. The IRS, in consultation with the DOE and the EPA, will then determine whether to approve the LCA. Treasury and the IRS are seeking additional comments on how to achieve consistency in boundaries and baselines so that similarly situated taxpayers are treated consistently.
Section 45Q credits are subject to recapture with respect to any qualified carbon oxide that ceases to be captured, disposed or, or used as a tertiary injectant in a manner consistent with the requirements of the statute. The Proposed Regulations provide that the Section 45Q credit recapture period 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 five years after the last taxable year in which the taxpayer claimed a Section 45Q credit or the date monitoring ends under the EPA subpart RR requirements or the CSA/ANSI ISO 27916:19 standard.
Several commenters requested a recapture safe harbor for injection operators who are operating in compliance with established standards set by Treasury and the IRS for secure geological storage. The Proposed Regulations do not provide such a safe harbor, but do limit the recapture period similar to the recapture provisions for investment tax credits under Section 50(a)(1). Specifically, the Proposed Regulations provide that any recapture amount will be accounted for in the year it is identified and reported. If, during the recapture period, it is determined that sequestered qualified carbon oxide has leaked into the atmosphere, the taxpayer will have a recapture amount if the leaked amount of qualified carbon oxide exceeds the amount of qualified carbon oxide disposed of in secure geological storage or used as a tertiary injectant in the taxable year. The excess amount of leaked qualified carbon oxide will be recaptured at a credit rate determined on a LIFO basis assuming that the excess leaked qualified carbon oxide is deemed attributable first to the first preceding year, then to the second preceding year, and then up to a maximum of the fifth preceding year.
The taxpayer must add the amount of the recaptured Section 45Q credit to the amount of tax due in the taxable year in which the recapture event occurs. The Proposed Regulations also provide rules for the leakage of sequestered qualified carbon oxide that was captured by carbon capture equipment owned by different taxpayers or with respect to which multiple taxpayers claimed Section 45Q credits. Finally, the Proposed Regulations provide a limited exception to recapture in the event of leakage resulting from actions not related to the selection, operation, or maintenance of the storage facility, such as volcanic activity or terrorist attack. The deliberate removal of sequestered qualified carbon oxide will result in recapture in the year of removal.
Request for Additional Comments
Treasury and the IRS also request comments on how to apply the recapture provisions to Section 45Q credits that are carried forward as a result of the Section 38 credit utilization limitations in the taxable year the credits are generated.
The Proposed Regulations provide welcome guidance regarding the technical requirements for sequestration of qualified carbon oxide, the reporting requirements for calculating the capture and disposal, injection, or utilization of qualified carbon oxide, as well as the procedural requirements for Section 45Q credit transfer. The credit recapture provisions, which limit the period during which a leakage event requires recapture to five years after the last Section 45Q credit is taken, and which limit the lookback period to five years, should allow potential industry participants to analyze the impact of a recapture event in their financial models for potential qualified sequestration projects.