On May 28, 2020, the IRS issued proposed regulations regarding carbon capture tax credits under Section 45Q of the Internal Revenue Code. The proposed regulations provide rules on secure geological storage, credit recapture, and transfer of the credit, among other items. This proposal constitutes the third set of guidance issued by the IRS with respect to the carbon capture credit. For an overview of Notice 2020-12 (the begin construction notice) and Revenue Procedure 2020-12 (flip safe harbor), see McGuireWoods’ February 2020 alert “IRS Provides Carbon Capture Tax Guidance and Safe Harbor.”
The Section 45Q credit is available for each metric ton of qualified carbon oxide that is captured using carbon capture equipment at a qualified facility and then used in commercial product (utilization), used as a tertiary injection in a qualified enhanced oil or natural gas recovery project (injection), or disposed of through secure geological formation (disposal). The amount of the tax credit increased in 2018 for projects placed in service on or after Feb. 9, 2018. The newly increased credit will reach $35 per metric ton when the captured carbon is injected or utilized and will reach $50 per metric ton when the captured carbon is disposed of in a secure geological formation. Those maximum credit amounts will apply to credits generated in tax years after 2026.
In the case of carbon capture equipment originally placed in service at a qualified facility on or after Feb. 9, 2018, the credit is available during the 12-year period beginning on the date the equipment is originally placed in service and such credit is generally available to the person who owns the carbon capture equipment and physically or contractually ensures the capture and disposal, injection or utilization of such carbon oxide. The taxpayer need not own the facility that emits the carbon oxide that is captured by the carbon capture equipment.
The proposed regulations address, among other matters, the major topics described below.
Carbon Capture Equipment
Section 45Q currently does not define carbon capture equipment. The proposed regulations define carbon capture equipment generally in terms of its functionality and includes all components of property used to capture or process carbon oxide until the carbon oxide is transported for disposal, injection or utilization. In addition, the proposed regulations list various items that are included in, or excluded from, the definition of carbon capture equipment. Specifically, components of property related to the function of capturing carbon oxides — such as property necessary to compress, treat, process, liquefy or pump carbon oxides — are included within the definition of carbon capture equipment, whereas components of property related to transporting carbon oxides for disposal, injection or utilization are not included in the general definition.
The scope of equipment included within the definition of carbon capture equipment is relevant because the Section 45Q credit is attributable 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.
Additional Carbon Capture Equipment; 80/20 Rule
The proposed regulations recognize that existing carbon capture equipment may be expanded or refurbished in a manner that qualifies for the higher credit amount under Section 45Q.
In the case of carbon capture equipment originally placed in service before Feb. 9, 2018, a physical modification or addition of equipment that results in an increase in the carbon oxide capture capacity of the original equipment will qualify for the higher Section 45Q credit if such new equipment is placed into service before the end of 2023. The higher Section 45Q credit will apply only to the amount of incremental additional carbon capture capacity due to the additional carbon capture equipment placed in service on or after Feb. 9, 2018. For instance, if the new carbon capture equipment allows for a 10 percent increase in carbon capture capacity, then the higher Section 45Q credit will apply to 10 percent of the carbon captured from the facility. Merely increasing the amount of carbon dioxide captured by existing carbon capture equipment, even if it operated above the carbon dioxide capture capacity, does not constitute the installation of additional carbon capture equipment.
If the modifications or additions to the existing carbon capture equipment are so significant that the fair market value of the equipment previously placed in service is not more than 20 percent of the total value of the carbon capture equipment (i.e., the cost of the new equipment plus the fair market value of the old equipment), then all the carbon capture equipment will be treated as new and originally placed in service on or after Feb. 9, 2018. Thus, when at least 80 percent of the total value of the carbon capture equipment is from new equipment, all of the carbon oxide captured from the carbon capture equipment will qualify for the higher Section 45Q credit.
Contractually Ensuring Disposal, Injection or Utilization of Carbon Oxide
A taxpayer is not required to physically carry out the disposal, injection or utilization of carbon oxide to claim the carbon capture credit if the taxpayer ensures in a binding written contract that the party that physically carries out the disposal, injection or utilization of the carbon oxide does so in the manner required under Section 45Q and the proposed regulations.
Such binding written contract must be enforceable against both parties under applicable state or local law and cannot limit damages of the taxpayer to less than 5 percent of the contract price. A taxpayer can enter into multiple contracts with multiple parties for the disposal, injection or utilization of carbon oxide. For example, a taxpayer that captures carbon oxide may contract with one party to dispose of a portion of its captured carbon oxide in a deep saline formation, with another party to use another portion of its captured carbon oxide as a tertiary injectant in multiple enhanced oil recovery (EOR) sites, and with several parties to utilize the remaining portion of its captured carbon oxide.
To constitute a binding written contract for these purposes, the contract must:
- include commercially reasonable terms and provide for enforcement of the party’s obligation to perform the disposal, injection or utilization of the carbon oxide;
- require the contracting party to perform any disposal, injection or utilization of the carbon oxide in accordance with the requirements applicable to each under the proposed regulations; and
- require the contracting party to promptly inform the capturing party of all information that is pertinent to any recapture event (e.g., location of leak, quantity of carbon oxide leaked, dollar value of Section 45Q credit attributable to leaked carbon oxide, etc.).
In addition, a contract may, but is not required to, include (1) long-term liability provisions, indemnity provisions, penalties for breach of contract or liquidated damages provisions; (2) information such as how many metric tons of carbon oxide the parties agree to dispose of, inject or utilize; and (3) minimum quantities the parties agree to dispose of, inject or utilize.
The existence of each contract and the parties involved must be reported to the IRS annually on a Form 8933 by each party to the contract, regardless of the party claiming the credit.
Secure Geological Storage
One of the major regulatory issues unresolved by the implementing legislation and prior IRS guidance was the issue of reporting requirements under the EPA’s Greenhouse Gas Reporting Program (GHGRP).
Section 45Q(f)(2) requires the secretary of the Department of the Treasury — in consultation with the administrator of the EPA, the secretary of the Department of Energy and the secretary of the Department of the Interior — to establish regulations that ensure carbon oxide sequestered under Section 45Q(a) does not escape into the atmosphere.
Injection of carbon oxide requires the operator to comply with Underground Injection Control (UIC) program regulations and to obtain the appropriate UIC well permits, which wells generally fall into two categories — Class II and Class VI wells. Under 40 CFR §146.5, Class II wells are used to inject fluids, including carbon dioxide, associated with oil and natural gas production. Class VI wells are used to inject carbon dioxide into deep rock formations.
Operators that inject carbon dioxide underground are also subject to the EPA’s GHGRP requirements set forth at 40 CFR Part 98. Under 40 CFR Part 98 subpart RR, Class VI wells are required to report basic information on carbon dioxide received for injection; develop and implement an EPA-approved site-specific monitoring, reporting and verification plan (MRV plan); and report the amount of carbon dioxide geologically sequestered using a mass balance approach and annual monitoring activities.
Under 40 CFR Part 98 subpart UU, facilities that inject carbon dioxide underground for EOR are required to report basic information on carbon dioxide received for injection. Currently, facilities that conduct EOR are not required by 40 CFR Part 98 to report under subpart RR unless (1) the owner or operator chooses to opt into subpart RR, or (2) the facility holds a UIC Class VI permit for the well or group of wells used for EOR. Annual reports submitted under 40 CFR Part 98 to the EPA’s GHGRP undergo verification by the EPA. and non-confidential data from these reports are published on the EPA’s website.
To address the concern of reduced reporting under subpart UU and to clarify which subpart an applicant must comply with for EOR, the IRS adopted the standard set by the International Organization for Standardization (ISO) and endorsed by the American National Standards Institute (ANSI), CSA/ANSI ISO 27916:19, “Carbon Dioxide Capture, Transportation and Geological Storage – Carbon Dioxide Storage Using Enhanced Oil Recovery (CO2-EOR).” According to the IRS, this standard is sufficient for Class II wells because the CSA/ANSI ISO 27916:19 “uses mass balance accounting, has established reporting and documentation requirements, and includes requirements for documenting a monitoring program and a containment assurance plan.” Therefore, operators “of UIC Class II wells that follow the CSA/ANSI ISO 27916:19 standard could elect to report to the EPA’s GHGRP under subpart RR but would not be required to do so” and could continue to report to the EPA under subpart UU.
The IRS further clarified what is required to certify the volumes injected under each well classification. A taxpayer reporting under subpart RR may self-certify the volume of carbon oxide claimed. A taxpayer reporting under CSA/ANSI ISO 27916:19 may prepare documentation as outlined in the CSA/ANSI internally. However, in response to concerns about internal documentation, the IRS added a requirement that a qualified independent engineer or geologist must certify that the documentation is accurate and complete.
A certification must be attached to a Form 8933 (or successor forms) and filed not later than the last date prescribed by law (including extensions) for filing the operator’s or designated owner’s federal income tax return for the first taxable year in which carbon oxide is injected into the reservoir. The operator’s continued certification is required for each subsequent taxable year until all injection activities cease and all injection wells are plugged and abandoned.
Pass-Through Election
The taxpayer that owns the carbon capture equipment can elect to pass through the Section 45Q credit to the person (credit claimant) who disposes of the carbon oxide, utilizes the carbon oxide or uses the carbon oxide as a tertiary injectant. This annual election must be made on Form 8933, which the taxpayer must file with its timely filed tax return for the applicable year (including extensions). The electing taxpayer can pass through all or part of the Section 45Q credits for that tax year to one or more credit claimants, so long as the amount passed through to each credit claimant does not exceed their proportionate amount of carbon oxide disposed of, utilized or used as a tertiary injectant by such credit claimant. The credit claimant must also file Form 8933 with its timely filed tax return for the applicable year (including extensions) that the tax credits are being passed through.
Annualization of First-Year Emissions and Capture
The proposed regulations clarify that in the first year in which carbon capture equipment is placed in service at a qualified facility, the amount of carbon oxide emitted and captured, and the annual amount of the facility’s emissions, are annualized and prorated over the partial year, based on the date the carbon capture equipment is placed in service, for purposes of satisfying the minimum thresholds for carbon oxide captured each year from a qualified facility.
Credit Recapture
Section 45Q credits claimed by a taxpayer are subject to recapture if the carbon oxide for which a credit has been claimed ceases to be captured, disposed of or used as a tertiary injectant during the recapture period. For these purposes, carbon oxide ceases to be captured, disposed of or used as a tertiary injectant if the leaked amount of carbon oxide in the taxable year exceeds the amount of carbon oxide disposed of in secure geological storage or used as a tertiary injectant in that same taxable year. The excess of the leaked amount over the stored amount is subject to recapture based on the tax credits claimed over the past five tax years, but it could be a shorter look-back period if the secure storage monitoring period has ended.
Recapture of credits is based on a last-in, first-out methodology. This means recapture applies to the most recent tax years first. If any leakage applies to a site where multiple taxpayers claimed credits over the previous five tax years, then the leakage will be applied to each taxpayer proportionately based on the amount of carbon oxide each taxpayer delivered to the site each tax year.
Recapture is not triggered in the event of a loss of containment of 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.
Recapture and leaked amounts will be reported on Form 8933.
Proposed Regulations — Comment Period and Reliance
The proposed regulations are subject to a comment period and a potential hearing before they will be issued in final form. Taxpayers may submit comments on the proposed regulations until Aug. 3, 2020. Taxpayers may rely on and choose to apply the proposed regulations for taxable years beginning on or after Feb. 9, 2018, provided the taxpayer applies the rules in their entirety and in a consistent manner.
Please do not hesitate to contact us if you would like to participate in the public comment process or have any questions about these proposed regulations or other issues relating to the Section 45Q credit.
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