Turning Tax Credits into Cash: IRS and Treasury Release Proposed Direct Pay and Transferability Regulations

On June 14, 2023, the IRS and Treasury Department released proposed regulations regarding the monetization of certain clean energy tax credits, as well as temporary regulations regarding mandatory information and registration requirements for taxpayers planning to transfer or elect direct pay for their tax credits. These proposed regulations are a step in the direction of providing much needed clarification regarding the scope and eligibility requirements for direct pay and transferability, including special rules applicable to passthrough entities and the repayment of excessive payments. We expect taxpayers will find some good, and some bad, in the proposed rules.

Background

One of the landmark changes enacted by the Inflation Reduction Act of 2022 (IRA) was the creation of two new mechanisms for monetizing tax credits – direct pay and transferability.[1] Direct pay is primarily intended to benefit tax-exempt and governmental entities, and transferability is for everyone else.

Under the direct pay rules, certain “applicable entities” may elect to treat the amount of any eligible credit as a payment of tax and receive a cash refund to the extent the amount of the credit exceeds their federal income tax liability. Applicable entities are generally defined to include tax-exempt and governmental organizations. Such entities may make a direct pay election with respect to the major investment and production tax credits, as well as credits for electric vehicles and charging stations.[2] In addition, all other taxpayers may elect to be treated as an applicable entity and make a direct pay election, but solely with respect to the Section 45Q credit for carbon capture and sequestration, the Section 45V credit for production of clean hydrogen, and the Section 45X credit for advanced manufacturing.

Under the transferability rules, “eligible taxpayers” may elect to transfer all or a portion of the major investment and production tax credits to an unrelated party in exchange for cash.[3] Eligible taxpayers are generally defined as any taxpayer, including, under a special set of rules, partnerships and S corporations (rather than their owners), other than an applicable entity. The unrelated transferee may then claim the transferred credits on their tax returns. The cash consideration for the transfer of the credits is not included in the eligible taxpayer’s gross income and is not deductible by the transferee.

The Proposed Regulations

In order to implement the direct pay and transferability rules established by the IRA, significant guidance from the IRS and Treasury is required. The proposed direct pay and transferability regulations that have been released are the first bite at the administrative guidance apple, and while comprehensive, will likely garner significant comments from the public regarding problems, potential changes, and areas needing further clarification. The proposed rules are extensive and technical, and their implications will take some time to sort out. This alert does not provide a complete description or summary of the regulations, but instead summarizes certain of our initial impressions.  

The proposed direct pay regulations clarify which entities are eligible to make the direct pay election, lay out the process and timeline for making a direct pay election and receiving a refund, provide special rules applicable to partnerships and S corporations, and provide rules regarding repayment of excessive payments. Items of note include:

• The definition of applicable entity is expanded to include not only tax-exempt organizations and governmental entities, but also any agency or instrumentality of any governmental entity. Prior to this guidance, some universities, hospitals, and school districts were uncertain if they qualified.
• Partnerships and S corporations are not applicable entities and cannot make a direct pay election, regardless of whether their owners are applicable entities. Prior to this guidance, it was unclear whether an applicable entity that owned eligible energy property through a partnership would be able to make a direct pay election with respect to their share of the eligible credit property.
• Applicable entities may partner with other entities (including for-profit partners) and still be eligible to make a direct pay election if they own eligible credit property through an unincorporated joint venture (that has properly elected out of Subchapter K) or through a tenancy in common (TIC). The proposed regulations clarify that in this situation, each owner is considered to own an undivided interest in or share of the underlying property and any applicable credits are determined separately with respect to each owner. The explanation of the provisions noted that “this type of arrangement provides some flexibility for tax-exempt and government entities to participate in [direct pay] with other entities.” However, in our experience, this “flexibility” may prove challenging to take advantage of given the typical challenges surrounding TIC arrangements and the uncertainty associated with their income tax treatment.
• An applicable entity cannot acquire credits from another party and then make a direct pay election with respect to the acquired credits. In order to make a direct pay election, the applicable entity must own the underlying tax credit property or otherwise conduct the activities giving rise to the credit.
• In determining whether there has been an excessive payment (subject to a 20% penalty tax), the IRS will take into account the credit utilization rules, including the at-risk rules and passive activity limitations. An excessive payment may arise where there is an improperly claimed bonus credit amount, an error in calculating a credit, inflated basis, or a misapplication of the credit utilization rules. An applicable entity may avoid the 20% penalty tax by demonstrating reasonable cause, as determined under existing standards.
• With respect to basis reduction and recapture, rules similar to Section 50 apply for purposes of the direct pay election. The recapture rules are separate from the excessive payment rules, and do not result in an excessive payment. Note that these rules only apply to the investment tax credit.
• The direct pay election must be made on a taxpayer’s original tax return for the taxable year for which the tax credit is determined, filed no later than its due date (taking into account any extensions). There would be no administrative relief for a direct pay election that was not timely filed.

The proposed transferability regulations bear a number of similarities to the proposed direct pay regulations, and address which credits are eligible to be transferred, specify the process and timing for making a transfer election, clarify the treatment of payments made in connection with a transfer and the transferee’s treatment of the acquired credit, and provide special rules applicable to partnerships and S corporations and regarding the consequences of an excessive transfer or recapture event. Items of note include:

• The definition of eligible taxpayer is broad and includes any person subject to tax in the United States, including taxpayers that have employment or excise tax obligations, even if they do not have federal income tax obligations. However, tax-exempt and governmental entities are not eligible taxpayers and cannot elect to transfer tax credits.
• An eligible taxpayer is required to register and make a transfer election separately for each credit-generating property it owns. For example, an election to transfer production tax credits is made with respect to each facility, whereas an election to transfer investment tax credits is made for each energy property.
• In order to transfer a tax credit, the eligible taxpayer must own the underlying eligible credit property or otherwise conduct the activities giving rise to the credit. The IRS indicated that a purchaser/lessor in a sale-leaseback transaction would be treated as owning the underlying property and would be able to elect to transfer any credits generated by it. By contrast, if an election is made under Treasury Regulations Section 1.48-4 to pass through investment tax credits to a lessee of a property, the lessee is not eligible to transfer the credits.
• A tax credit can only be transferred once. This means that tax credits cannot be sold through a dealer (where the credit transfers to the dealer before being transferred to the transferee) but can be sold through a broker who matches eligible taxpayers with transferees.
• The proposed regulations establish an anti-abuse rule that disallows the transfer of a credit where the parties have engaged in the transaction or a series of transactions with the principal purpose of avoiding tax liability beyond the intent of the transferability rules. The IRS notes that this could include transactions that are intended to decrease the eligible taxpayer’s gross income or increase a transferee taxpayer’s deductions, such as could be the case if an eligible taxpayer over- or under-charged for services to a customer who is also purchasing credits from them.
• Transferees generally bear any recapture risk and liability for excessive transfers of credits. However, there is no restriction on eligible taxpayers agreeing to indemnify transferees for any liabilities as a result of recapture of excessive transfer. Where there are multiple transferees, any recapture risk or liability for excessive transfers is borne proportionately by each of the transferees. 
• In the case of an excessive transfer, a transferee may avoid the 20% penalty tax by demonstrating reasonable cause. Under the proposed regulations, determination of reasonable cause includes an evaluation of the transferee’s efforts to determine that the amount of eligible credit transferred is not more than the credit determined with respect to the property and was not transferred to any other taxpayer. The proposed regulations include a list of factors in determining reasonable cause, including review of the eligible taxpayer’s records.    
• If a transferee acquires tax credits from an eligible taxpayer that is a partnership or S corporation, any recapture event that occurs at the eligible partnership’s or S corporation’s partner or shareholder level (such as an indirect disposition or increase in the amount of nonqualified nonrecourse financing) will not result in recapture of the tax credit acquired by the transferee.
• In the case of a partnership or S corporation, only the partnership or S corporation may elect to transfer tax credits. Thus, for example, if a partnership or S corporation forgoes the election and passes through the tax credits to its owners, its owners cannot then elect to transfer the credits.
• The transfer election must be made with the eligible taxpayer’s original tax return for the taxable year for which the tax credit is determined, filed no later than its due date (taking into account any extensions). The eligible taxpayer is required to include a transfer election statement with the tax return and represent that it has provided the transferee with the required minimum documentation regarding the validity of the transferred credits. There is no administrative relief for a transfer election that is not timely filed.

In addition to the proposed regulations described above, the IRS also issued temporary regulations describing the pre-filing registration process that taxpayers must comply with in order to make a valid direct pay or transfer election. In general, taxpayers that intend to make a direct pay or transfer election must register with the IRS through its electronic portal and provide the IRS with certain information regarding their identity, and the applicable credits and credit property. The IRS notes that more information about the pre-filing registration process will be available by late 2023.

The proposed regulations are a step in the right direction for a tax credit regime with significant promise for clean energy investments. That said, although transferring credits may appear, on its face, simpler than traditional tax equity financing, we expect meaningful diligence and risk allocation issues to be present in tax credit sales, particularly given the risks that to the buyers of these credits, as evidenced above. Tax insurance, among other things, may eventually play a role here.

Special Considerations for REITs

While the proposed regulations do not contain specific rules for REITs, in the preamble to the proposed regulations the IRS addressed a number of comments from stakeholders regarding the treatment of tax credits for purposes of the REIT asset, income, and prohibited transaction rules. The IRS confirmed that income from the transfer of a tax credit by a REIT would not be treated as generating prohibited transaction income (because it is excluded from gross income) and that the receipt of or right to receive a tax credit does not result in income to the REIT. Interestingly, the IRS sidestepped questions from stakeholders regarding whether credits that have not yet been transferred are treated as a real estate asset, cash, or cash items (and thus will not create any REIT asset test issues). Instead of addressing the character of the tax credits, the IRS instead simply noted that the “paid in cash” and “timing of sale requirements” for transferring tax credits should assist REITs in managing any issues that arise as a result of having tax credits on their balance sheets that have not yet been transferred. Similarly, in response to questions from stakeholders regarding the treatment of the sale of energy by a REIT for purposes of the prohibited transaction rules, the IRS pointed to the preamble to TD 9784 (clarifying the definition of real property for purposes of the REIT rules), which notes that until additional guidance is published by the IRS and Treasury, the IRS will not treat income from the sale of electricity as a prohibited transaction so long as the electricity is generated by distinct energy-producing assets (e.g., a solar array) that serve an inherently permanent structure (e.g., a building), and the REIT does not sell more electricity to a utility company than it purchases from that utility company with respect to that inherently permanent structure. All other sales of electricity would have to be analyzed under general tax principles and on a facts and circumstances basis to determine whether the sales are subject to the prohibited transaction rules.

[1] Pursuant to Sections 6417 and 6418 of the Internal Revenue Code, respectively.

[2] A direct pay election may be made with respect to the following clean energy credits: the investment tax credit (Section 48), the production tax credit (Section 45), the carbon oxide sequestration credit (Section 45Q), the technology neutral investment tax credit (Section 48E), the production tax credit (Section 45Y), the alternative fuel vehicle refueling property credit (Section 30C), the zero-emission nuclear power production credit (Section 45U), the clean hydrogen production credit (Section 45V), the advanced manufacturing production credit (Section 45X), the clean fuel production credit (Section 45Z), the qualifying advanced energy projects credit (Section 48C), and the qualified commercial vehicle credit (Section 45W).  

[3] An election may be made to transfer any of the credits subject to the direct pay election, other than the qualified commercial vehicle credit (Section 45W), which is not eligible to be transferred.