The U.S. Internal Revenue Service (IRS) and the U.S. Treasury Department (“Treasury”) have issued final regulations (T.D. 9944) (the “Final Regulations”) providing additional guidance on several aspects of the income tax credit for the capture of qualified carbon oxide (CO) under section 45Q of the Internal Revenue Code of 1986, as amended (the “Code”).[1] By largely adopting the proposed regulations released on May 28, 2020 (REG -112339-19) (the “Proposed Regulations”), with certain helpful modifications, the Final Regulations aim to alleviate some of the uncertainty previously faced by developers and should attract more widespread attention and investor participation.
The Final Regulations apply to taxable years beginning on or after January 13, 2021, although taxpayers may choose to apply the Final Regulations to taxable years beginning on or after January 1, 2018, provided the Final Regulations are applied in their entirety and in a consistent manner.
General Structure of Section 45Q
Originally enacted in 2008 and most recently amended on December 27, 2020, section 45Q provides an income tax credit for the capture of qualified CO and its disposal in permanent geological storage (“disposal”), use as a tertiary injectant to stimulate oil and gas production from marginal wells in a process commonly referred to as enhanced oil recovery or “EOR” (“injection”) or other utilization in a manner that qualifies under section 45Q(f)(5), discussed below (“utilization”).
The credit under section 45Q generally takes one of four basic forms, depending upon when carbon capture equipment (CCE) was originally placed in service and whether the captured CO was disposed of in secure geological storage, injected in an EOR project or utilized:
1. A credit of $20/metric ton of qualified CO captured using CCE originally placed in service at a qualified facility before February 9, 2018 and disposed of in secure geological storage.
2. A credit of $10/metric ton of qualified CO captured using CCE originally placed in service at a qualified facility before February 9, 2018 and either (A) used in an EOR process before being disposed of in secure geologic storage or (B) utilized in a commercial manner that qualifies for the credit.
3. A credit of $50/metric ton for qualified CO captured using CCE originally placed in service at a qualified facility on or after February 9, 2018 and disposed of.
4. A credit of $35/metric ton for qualified CO captured using CCE originally placed in service at a qualified facility on or after February 9, 2018 and either injected in an EOR process or utilized.
Expiration of the Credit: Credits under (1) and (2), above, expire when Treasury, in consultation with the Environmental Protection Agency, certifies that 75 million metric tons of qualified CO have been recaptured via the utilization of section 45Q. Credits under (3) and (4), however, may be claimed during the 12-year period beginning on the date the CCE was originally placed in service, regardless of the aggregate amount of CO captured and disposed of, injected or utilized.
Eligibility: Credits under (1) and (2), above, are made available only to the taxpayer that captures and physically or contractually ensures the disposal, injection or utilization of the captured CO. Credits under (3) and (4), above, are made available to the taxpayer that owns the CCE (whether or not the taxpayer also owns the industrial facility at which the CCE is placed in service) and physically or contractually ensures the capture and disposal, injection or utilization of the captured CO. Importantly, for credits claimed with respect to CCE placed in service on or after February 8, 2018, the taxpayer must own the CCE, but may contractually ensure both the capture and disposal, injection or utilization of the captured CO.
Beginning of construction: To qualify for the credit under section 45Q, construction of the qualified facility must begin before January 1, 2026, which requires either (i) construction of CCE to have begun before such date or (ii) the original planning and design for such facility to have included installation of CCE.
Guidance Under the Final Regulations
The Final Regulations provide additional guidance in a number of areas, including:
5. Eligibility: Where multiple taxpayers own different components within a carbon capture system or an undivided interest in the same carbon capture equipment, only one taxpayer (i.e., the taxpayer who either physically or contractually ensures the capture and disposal, injection or utilization of qualified CO) may claim the credit for each single process train of carbon capture equipment.
6. Transfers of the Credit: The taxpayer eligible to claim the credit may elect to transfer the credit to another person who contractually agrees to dispose of, inject or utilize the CO; however, further transfer of the credit to a subcontractor is not permissible.
7. Carbon Capture Equipment
The definition of “carbon capture equipment” (CCE) was broadened to include all components of property that are used to capture or process CO until the CO is transported for disposal, injection or utilization.
Modifications to CCE Capacity: Additional guidance was provided for the computation of the amount of qualified CO captured at a qualified facility that was placed in service before February 9, 2018 and for which additional CCE is placed in service on or after February 9, 2018, where the “80/20 Rule” is not satisfied.
“80/20 Rule”: Further clarification was provided around the computation of the “80/20 Rule.”
Section 45Q(f)(6) Election: Multiple facilities may be treated as a single facility for purposes of the section 45Q(f)(6) election to treat carbon capture equipment placed in service prior to February 9, 2018, instead as having been placed in service on February 9, 2018.
8. Carbon Dioxide Concentration Limitations: The definition of “industrial facility” was expanded to include any facility producing carbon dioxide from production wells at concentration levels not exceeding 90 percent carbon dioxide by volume, or which produces carbon dioxide at higher concentration levels in connection with extracting a commercially viable product other than CO.
9. Recapture: The recapture lookback period was reduced from five years to three years, and other technical aspects of recapture were clarified, including the application to terminated partnerships and recycled CO.
10. Contractually Ensuring Capture and Disposal, Injection or Utilization: The requirements of a contract to ensure the capture and disposal of, injection or utilization of the captured CO were further clarified.
11. Utilization: The term “commercial market” for purposes of the “utilization” requirement was broadly defined, and certain reporting requirements were clarified.
The following discussion provides additional information with respect to each of the above areas.
Eligibility
Where multiple taxpayers own different components within a carbon capture system or an undivided interest in the same CCE, only one taxpayer (i.e., the taxpayer who either physically or contractually ensures the capture and disposal, injection or utilization of qualified CO) may claim the credit for each single process train of carbon capture equipment, although multiple owners of carbon capture equipment may form a partnership to allocate the section 45Q credits among themselves pursuant to Revenue Procedure 2020-12.
Transfers of the Credit
A taxpayer that is otherwise eligible to claim a section 45Q credit (the “electing taxpayer”) may elect to transfer the credit (or portion thereof) to the person that enters into a contract with the electing taxpayer to (i) dispose of the qualified CO, (ii) use the qualified CO in an EOR process or (iii) utilize the qualified CO (the “credit claimant”). However, the electing taxpayer may not elect to transfer any portion of a section 45Q credit to a contractor or subcontractor that physically captures CO on behalf of the taxpayer. Moreover, a credit claimant to which the credit has been transferred may not further transfer the section 45Q credit to a subcontractor that performs the disposal, utilization or injection for the credit claimant. The election to transfer all or the portion of a section 45Q credit is made on an annual basis.
Carbon Capture Equipment
Definition: The Final Regulations adopt a functionality-based definition of CCE that generally includes all components of property that are used to capture or process CO until it is transported for disposal, injection or utilization, as well as “a system of gathering and distribution lines that collect [CO] captured from a qualified facility or multiple qualified facilities that constitute a single project (as described in Section 8.01 of Notice 2020-12, 2020-11 I.R.B. 495 …) for the purpose of transporting that [CO] away from the qualified facility or single project to a pipeline used to transport [CO] to or from one or more taxpayers and projects.” Consistent with this functionality-based approach, the Final Regulations removed the Proposed Regulations’ list of excluded components and clarified that “[a]ll components that make up an independently functioning process train capable of capturing, processing, and preparing [CO] for transport will be treated as a single unit of [CCE].”
Modification of CCE: Where CCE originally placed in service prior to February 9, 2018 (the “original CCE”) is modified by placing additional equipment in service on or after such date (the “additional CCE”), the Final Regulations provide that the amount of CO that is treated as captured using the original CCE is the lesser of (i) the total amount of qualified CO captured at such facility for the taxable year or (ii) the total amount of the CO capture capacity of the original CCE in service at such facility on February 8, 2018 (and eligible for the credit under (1) or (2), above), with any qualified CO capture at such facility in excess of such capacity treated as captured using the additional CCE (and eligible for the credit under (3) or (4), above, unlimited by the 75 million metric ton restriction). The Final Regulations clarify that the term “carbon dioxide capture capacity” means capture design capacity. In addition, the Final Regulations provide that “[a] physical modification or equipment addition that results in an increase in the carbon dioxide capture capacity of existing [CCE] constitutes the installation of additional [CCE]. Increasing the amount of carbon dioxide captured without physically modifying existing [CCE] or adding new equipment, for example, by merely operating the existing [CCE] above the carbon dioxide capture capacity, does not constitute the installation of additional [CCE].” Finally, the Final Regulations confirm that the installation of additional CCE that satisfies the “80/20 Rule” (discussed below) constitutes the installation of new CCE rather than the modification of original CCE, with the effect that the original CCE is itself treated as placed in service on or after February 9, 2018.
“80/20 Rule”: The Final Regulations adopt the “80/20 Rule” introduced in the Proposed Regulations, which provides that a retrofitted qualified facility or CCE may qualify as originally placed in service on or after February 9, 2018, even if it contains some used components of property that were previously placed into service, provided the fair market value of the used components is not more than 20 percent of the CCE’s total value. The Final Regulations provide that the relevant unit of retrofitted CCE for purposes of the “80/20 Rule” is an independently functioning process train. For purposes of the “80/20 Rule,” the Final Regulations adopt the principle set forth in the Proposed Regulations that the cost of new CCE includes all properly capitalized costs thereof and “may, at the option of the taxpayer, include the cost of new equipment for a pipeline (the cost of equipment for a new pipeline, not equipment used to repair an existing pipeline) owned and used exclusively by that taxpayer to transport CO captured by that taxpayer’s qualified facility or CCE that would otherwise be emitted into the atmosphere.” The Final Regulations further clarified that the numerator of the “80/20 Rule” is for “new equipment, which does not include previously used equipment that is purchased by a taxpayer for use in a project.” This position on previously used equipment is consistent with that taken by the IRS and Treasury with respect to the production tax credit.
Section 45Q(f)(6) Election: Where CCE is placed in service by a taxpayer at a qualified facility prior to February 9, 2018, but no taxpayer claims any section 45Q credits for any taxable year ending before such date, the taxpayer may make an election under section 45Q(f)(6) on an annual basis to treat the facility, and any CCE placed in service at such facility, as having been placed in service instead on February 9, 2018, provided that the facility captures not less than 500,000 metric tons of CO for the year for which the section 45Q(f)(6) election is made. The Final Regulations describe the manner for making the section 45Q(f)(6) election. Importantly, the Final Regulations generally permit multiple facilities to be aggregated and treated as a single facility for purposes of determining whether the requisite annual CO capture thresholds—including the 500,000 metric ton threshold for the section 45Q(f)(6) election—are satisfied, in accordance with the aggregation rules of Section 8.01 of Notice 2020-12.
Carbon Dioxide Concentration Limitations
10 Percent Safe Harbor: To qualify for the credit under section 45Q, CO must be captured at a qualified facility, which includes any “industrial facility” that meets certain requirements. For this purpose, the Proposed Regulations excluded from the term “industrial facility” any facility that produces carbon dioxide from carbon dioxide production wells at natural carbon dioxide-bearing formations or naturally occurring subsurface springs (“CO2 Wells”). Under the Proposed Regulations, whether a well constituted a CO2 Well was based on all the facts and circumstances, but the Proposed Regulations provided a 10 percent safe harbor under which a deposit of natural gas that contains less than 10 percent carbon dioxide by volume was not considered a natural carbon dioxide-bearing formation.
Greater-Than-90 Percent Test: Commenters sought clarification on how the 10 percent safe harbor would be applied, with some commentators proposing a higher threshold or bright line rule. In response, the Final Regulations replace the facts and circumstances standard and the 10 percent safe harbor with a new test pursuant to which a CO2 Well means a well that contains 90 percent or greater carbon dioxide by volume (the “Greater-Than-90 Percent Test”). Any such production well meeting the Greater-Than-90 Percent Test will not qualify as an “industrial facility” unless such well contains a product other than CO that is commercially viable to extract and sell without taking into account the availability of a commercial market for the extracted CO or any section 45Q credit.
Recapture Requirements
Three-year Lookback Period: The Proposed Regulations contemplated a five-year lookback period for recapturing the benefit of any section 45Q credit attributable to leakage from secure geological storage. The Final Regulations reduce the lookback period to three years but generally apply the same “last-in-first-out” recapture framework. In other words, if a leak is discovered, the recapture amount will be accounted for in the taxable year in which the leakage is identified and reported. If the leaked amount does not exceed the CO captured and stored in such year, there is no recapture amount and no further adjustments to prior taxable years will be required. If the leaked amount exceeds the CO captured and stored in the taxable year in which the leakage is reported, then the excess must be recaptured by multiplying the metric tons of excess CO by the appropriate statutory credit rate on a last-in-first-out basis, such that section 45Q credits claimed in prior years are recaptured in reverse order up to a maximum of the third preceding year. Recapture adjustments attributable to the three-year lookback period are added to the amount of tax due in the taxable year in which the recapture event occurs.
Scope of Recapture: The Preamble to the Final Regulations confirms that a recapture event occurs when qualified CO for which a section 45Q credit has been claimed ceases to be (i) disposed of in secure geological storage or (ii) injected as a tertiary injectant during the recapture period. Recapture does not apply when qualified CO is utilized, likely because the LCA (discussed below) should already account for the net CO captured through the lifecycle of the applicable product or service.
Terminated Partnerships: The Final Regulations clarify that, if a partnership is the relevant taxpayer that claimed section 45Q credits and terminates under Code section 708(b)(1) prior to a recapture event, the partners of that terminated partnership at the time the section 45Q credit was claimed will be the taxpayers allocated the recapture amount.
Recycled CO: Recapture may also result in connection with the deliberate removal from storage of qualified CO that was previously disposed of or injected. However, if such CO is recaptured, recycled and reinjected as part of the EOR project, that qualified CO will be considered recycled CO, and, if reinjected into the same qualified EOR project it was originally injected into, it will not be considered deliberately removed from a secure geological storage site for purposes of the recapture provisions.
Contractually Ensuring Capture and Disposal, Injection or Utilization of CO
Contractual Requirements: The Final Regulations reiterate that a taxpayer is not required to physically carry out the capture (in the case of CCE placed in service on or after February 9, 2018) or the disposal, injection or utilization (in all cases) of CO if the taxpayer contractually ensures in a binding written contract that the party that physically carries out the capture, disposal, injection or utilization (as applicable) of the CO does so in a manner required under section 45Q and the Final Regulations. A taxpayer may enter into one or more such contracts with multiple parties (which may be related parties), as well as a binding written contract with a general contractor that hires subcontractors to physically carry out the capture, disposal, injection or utilization of the qualified CO.
For this purpose, a written contract is binding only if it is enforceable under applicable state law against both the taxpayer and the other party (or any predecessor or successor thereof) and does not limit damages to a specified amount. However, the Final Regulations provide an exception for contractual provisions that limit damages to an amount equal to at least five percent of the total contract price, which will not run afoul of the damage limitation rule.
The other requirements of contracts ensuring the disposal, injection or utilization of CO set forth in the Proposed Regulations are adopted by the Final Regulations. To the extent a taxpayer’s contracts do not satisfy any of these requirements, a taxpayer has 180 days from the publication of the Final Regulations to amend such contracts.
Reporting: The Final Regulations require that the existence of each contract and the parties involved be reported to the IRS annually on a Form 8933, Carbon Oxide Sequestration Credit (or applicable successor form), by each party to the contract, regardless of the party claiming the credit. Furthermore, the Final Regulations require the party that contracts with the taxpayer claiming the credit to provide that taxpayer with a copy of the counterparty’s signed Form 8933, which form must be attached and filed by the taxpayer in order to claim the credit with respect to any qualified CO that is disposed of, injected or utilized in that taxable year pursuant to that particular contract. The Final Regulations, however, clarify that the counterparty’s failure to file its own Form 8933 will not adversely affect the taxpayer’s eligibility for the credit as long as the taxpayer obtains and files a copy of the signed Form 8933 from such counterparty.
Utilization
The Final Regulations define “utilization” of qualified CO as one of three uses: (i) fixation through photosynthesis or chemosynthesis, (ii) chemical conversion to a material or chemical compound in which such CO is securely stored or (iii) use of such qualified CO “for any other purpose for which a commercial market exists” (with the exception of use in EOR). The Final Regulations provide additional guidance on the third prong of the “utilization” definition by defining “commercial market” and clarifying the determination of the amount of CO utilized.
The Final Regulations define “commercial market” as “a market in which a product, process, or service that utilizes [CO] is sold or transacted on commercial terms.” Taxpayers are required to submit a statement attached to Form 8933 substantiating that such a commercial market exists for the particular product, process or service, in claiming credits for “utilization.”
The amount of qualified CO “utilized” by the taxpayer is equal to the metric tons of qualified CO that the taxpayer demonstrates, based on a lifecycle greenhouse gas emissions analysis (LCA), were (i) captured and permanently isolated from the atmosphere or (ii) displaced from being emitted into the atmosphere, in each case, through use of one of the above processes—not to exceed the amount of CO measured at the source of capture.
Lifecycle greenhouse gas emissions (expressed in carbon dioxide equivalent (“CO2-e”)) are “the aggregate quantity of greenhouse gas emissions (including direct emissions and significant indirect emissions such as significant emissions from land use changes) related to the full product lifecycle, including all stages of product and feedstock production and distribution, from feedstock generation or extraction through the distribution and delivery and use of the finished product to the ultimate consumer, where the mass values for all greenhouse gases are adjusted to account for their relative global warming potential according to Table A-1 of 40 CFR Part 98 subpart A.” In short, LCAs are used to verify the amount of CO “utilized” for purposes of the section 45Q credit. LCAs are required to conform with certain ISO standards and either be performed or verified by an independent third party. Importantly, LCAs submitted to the IRS will be subject to technical review by the Department of Energy, and approval must be received prior to claiming section 45Q credits.
