Clean Energy Tax Credit Transferability Rules Finalized

On April 25, 2024, the Treasury Department and the IRS released final regulations (the “Final Regulations”) under Section 6418, which was created by the Inflation Reduction Act of 2022 and generally permits sales of certain federal income tax credits. Specifically, Section 6418 provides for an election to transfer certain clean energy tax credits between unrelated taxpayers, simplifying monetization of such tax credits. This new transferability mechanism has brought a host of new corporate taxpayers into the market as tax credit purchasers and is expected to continue to provide increased flexibility in financing clean energy.

The Final Regulations replace the proposed regulations published in June 2023. After a period of receiving and considering stakeholder comments on the proposed regulations, the IRS largely adopted the proposed regulations with some modifications. These Final Regulations generally provide rules for the election to transfer tax credits, including rules applicable to both buyers and sellers of credits (“Transferees” and “Transferors,” respectively).

Key Points:

• Derivative instruments or other arrangements that do not result in the filing of a transfer election statement are not “transfers.”
• The “ordering rule,” which puts the seller of tax credits in a first-loss position to the extent of any unsold tax credits from a given project, only applies to disallowance and not to recapture.
• Tax credit sales continue to require sales of a proportionate share (“vertical slice”) of each sold tax credit, and bonus/adder credits (“horizontal slices”) cannot be sold separately.
• Application of passive activity rules at the transferee level is generally maintained, with acknowledgment that a transferee may be an active participant in the credit-generating activity.
• Cash payments for tax credits expected to be generated in future years are still not allowed to be treated as tax-exempt income and must instead be structured as loans.
• The rules regarding amended tax returns and “superseding tax returns” have been updated, generally allowing taxpayers to correct only clerical errors.

The Final Regulations also provide additional guidance regarding excessive credit transfers, recapture events and other clarifying rules applicable to transferability. This alert highlights key changes and clarifications set forth in the Final Regulations. The Final Regulations are generally effective on July 1, 2024.

A “redline” comparison of the Final Regulations against the proposed regulations can be found here.

Derivatives

Treasury received several comments that indicated a perceived ambiguity as to the extent of the prohibition against multiple transfers of the same tax credit.  Treasury clarified that a transfer only takes place once all of the requirements set forth in Treas. Reg. 1.6418-2(b) are met, which such requirements include filing the transfer election statement alongside an annual tax return.  Thus, various forms of derivatives (such as an option agreement that requires the party to sell or purchase a tax credit at a pre-agreed price) should not constitute transfers upon their creation.  However, the other side of the coin is that payments made pursuant to those arrangements that are not cash consideration from the ultimate buyer to seller of the tax credit may not be excluded from taxable income of the seller.  E.g., a “premium” paid by a potential purchaser for a call option on a tax credit may not be treated as part of the consideration paid for that tax credit.

Excessive Credit Transfers, Recapture and the “ordering rule”

For purposes of understanding the key point of these changes, it is important to keep in mind that there are generally two means by which a tax credit can be reduced or lost.  The first is “disallowance,” which is when the IRS determines on audit that the tax credit was claimed in an amount greater than allowed.  The second means is “recapture,” which is when a tax credit was valid initially but something happens later to cause that tax credit to be lost or “recaptured.”  In other words, tax credits can only be “recaptured” if they validly existed in the first place, where as “disallowance” means the tax credit was not valid to begin with.

Code Section 6418(g)(2) provides that if an amount of tax credit claimed by a Transferee is greater than the amount of tax credit otherwise allowable to the Transferor, an Excessive Credit Transfer, the excess amount is imposed as a tax and subject to a 20% penalty. The Final Regulations confirm that any disallowed tax credit in an excessive credit transfer first reduces the tax credit retained by the Transferor before reducing the tax credit to any Transferee. Under the excessive credit transfer rules, Transferor will be subject to a tax credit reduction up to the amount of the tax credit it has retained before Transferee’s tax credit is reduced. For example, assume a Transferor claims a 30% ITC for a $100 project, retains $10 of the ITC and sells the remaining $20. The IRS later revalues the project at $80, reducing the ITC from $30 to $24. Under the final regulations, the Transferor’s $10 credit is reduced to $4, but there is no excessive credit transfer because the credit claimed by the Transferee is less than the amount that would otherwise be allowable to the Transferor, even after the revaluation. If there are multiple transferees, their respective tax credit is reduced on a pro rata basis.  Treasury calls this the “ordering rule” and argues that the statutory definition of excessive credit transfers “effectively includes an ordering rule so that any disallowed eligible credit first reduces the eligible credit retained by an eligible taxpayer before applying to any transferee taxpayer.”

However, Treasury goes on to state that the “ordering rule” does not apply to recapture. The Final Regulations clarify that if the Transferor retains any amount of the tax credit after the transfer, the Transferor is responsible for the pro rata portion of the recapture liability equal to the portion of the tax credit it retained. The Transferee is then liable for the portion of the recapture liability equal to the percentage of the tax credit transferred. The Final Regulations also clarify that in cases of a Transferor partnership with a partner that causes a recapture event for which it is liable, such credit recapture amount borne by the partner reduces the remaining recapture amount liability for which a Transferee may be liable in the future.

Normally, all of the cash consideration paid from a transferee to a transferor in a tax credit transfer is exempt from tax.  However, the income received by a Transferor that directly relates to an excessive credit transfer is not exempt from taxation as the Final Regulations in Treas. Reg. §1.6418-5(a) provide that a proportionate amount of the cash consideration paid to the Transferor is no longer excluded from income. More specifically, the amount of a Transferee’s payment that directly relates to the excessive credit transfer equals: (i) the total consideration paid in cash by the Transferee for the specified credit portion multiplied by (ii) the ratio of (A) the amount of the excessive credit transferred to the Transferee to (B) the amount of the transferred specified credit portion claimed by the Transferee.

Anti-Abuse Rule

A transfer may be disallowed, or the federal income tax consequences of any transaction effecting a transfer may be recharacterized, if the parties have engaged in the transaction or series of transactions to effect the transfer with a principal purpose of avoiding any Federal tax liability beyond the intent of Section 6418, such as avoiding gross income. The anti-abuse rule is intended to recharacterize transfers if the price paid is not economically supportable and is unreasonable based on the facts and circumstances of the transaction. The facts and circumstances would dictate whether the Transferor and Transferee were engaging in an abusive transaction. Under the proposed regulations, a transfer could be recharacterized or disallowed if the principal purpose was tax avoidance beyond the intent of Section 6418. Under the final regulations, a transfer may be recharacterized or disallowed if tax avoidance is one of the principal purposes (as opposed to the principal purpose).

Additionally, the Final Regulations revise language and examples concerning the proposed regulations’ use of “the average transfer price” objective standard for determining abusive transactions, instead implementing a more subjective “arm’s length price” standard. The IRS acknowledged that average price data may not be currently available, may take more time to develop and will most likely be dependent on the facts and circumstances of the transaction.

Corrections on Amended Returns

The Final Regulations clarify that a transfer election cannot be made for the first time on an amended return, withdrawn on an amended return or made or withdrawn by filing an administrative adjustment request (AAR). However, a transfer election filed by a Transferor may be made or revised on a superseding return. Additionally, the final regulations modify the proposed regulations by providing that a numerical error with respect to a properly claimed transfer election may be corrected on an amended return or by filing an AAR. Note that a properly claimed transfer election that may be corrected does not include blank items or items described as “available upon request.”

If a Transferor’s correction results in an increase in the amount of the tax credit reported, the increased amount must be reflected on the credit source forms with the Transferor’s amended return or AAR. The increased tax credit cannot be reflected by either Transferor or Transferee on the transfer election statement. Decreased tax credit amounts must be reflected on the credit source forms with Transferor’s amended return or AAR and the transfer election statement reducing the amount of the tax credit reported. As discussed above, the amount of the decrease first reduces the amount of the tax credit that is retained and not transferred by Transferor. Any remaining portion of the decrease then reduces the amount of tax credit reported by the Transferee. If the tax credit was transferred to more than one transferee taxpayer, the reduction to each transferee taxpayer’s tax credit is on a pro rata basis.

One of the examples in the Final Regulations suggests that in the case of a decrease, the transferee taxpayers should file an amended return reducing the amount of transferred credit claimed to avoid a determination of excessive credit transfer.  It is not clear whether this is meant to signal that reasonable cause relief will not be available in this circumstance absent such filing of an amended return.

REITS and Trusts

The Final Regulations also provide guidance designed to facilitate REIT and Trust Grantor participation in tax credit transfers. The Final Regulations clarify that tax credits that have not yet been transferred are disregarded for purposes of the REIT asset test and that cash received is not included in a REIT Transferor’s gross income so the transfer does not pose a REIT prohibited transaction tax issue. Additionally, the Final Regulations provide that the transfer is not a sale of property for purposes of the REIT prohibited transactions rules and, thus, does not count as one of the seven sales described in those provisions. Finally, a grantor of a trust as described in Section 671 may make a transfer election with respect to eligible credit property held directly by the portion of the trust that Grantor is treated as owning under Section 671.

Passive Loss Limitations

The proposed regulations provided that Section 469 passive-activity rules apply at the transferee level so that essentially any purchased tax credits will be treated automatically as passive tax credits that can only offset passive income. The Final Regulations confirmed that there is no carveout for Section 469 passive loss limitations in Section 6418 transfers. So if an individual Transferee taxpayer does not materially participate in the activity that generates a tax credit, a transferred tax credit will be treated to the Transferee as arising in connection with a passive activity. However, the Final Regulations specify that in the limited circumstance of a Transferee who materially participates in a tax credit generating activity within the meaning of section 469(h) in which Transferee owns an interest at the time the work is done, Transferee should be permitted to purchase tax credits generated from the activity (assuming taxpayers are unrelated) and treat those purchased tax credits as not arising in connection with a passive activity.

Other Topics

There were a variety of other topics and issues that the Final Regulations clarified and confirmed related to more technical issues and administrative procedures. For Section 45Q carbon capture credits, the Final Regulations clarify that ownership of a single component is required and not ownership of the entire process train.  For Transferee partnerships in tiered structures, an upper-tier partnership’s distributive share of a transferred specified credit portion is treated as an extraordinary item to the upper-tier partnership that must be allocated among the partners of an upper-tier partnership as of the time the transfer, regardless of whether the Transferee partnership and the upper-tier partnership have different taxable years under section 706(b). The Final Regulations also provide a helpful rule for 52–53-week taxpayers in that such taxable years for Section 6418 purposes are deemed to end on last day of the calendar month closest to the end of such taxpayer’s tax year.  Final regulations also revised proposed §1.6418-5(g) (redesignated as §1.6418-5(h)) so that the language now refers to both the carryback and carryforward period when describing application of the rules in Section 39.