(This guest blog was authored by Orrick Herrington & Sutcliffe LLP and republished with permission. Please note this content does not necessarily represent the views or policies of ASBO International and its members, nor imply any endorsement by the association and its officer or affiliates.)
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Inflation Reduction Act Levels Renewable Energy Playing Field for Tax-Exempt Entities
August 26, 2022
By Charles C. Cardall, Scott W. Cockerham, Brandon Dias, Richard J. Moore, Wolfram Pohl, and John Stanley
Historically, only taxpaying entities could take advantage of federal tax credits for renewable energy and other qualifying projects. Tax-exempt entities, such as municipal utilities and rural electrical cooperatives, as well as cities, counties, school districts, Indian tribal governments and 501(c)(3) organizations, could not directly benefit from tax credits for such projects. Because tax credits normally are earned only by the project owner, the historical regime drove a high degree of private ownership of renewable energy projects. The Inflation Reduction Act of 2022, enacted on August 16, 2022 (the “Act”), somewhat levels the playing field by providing a direct payment in lieu of tax credits for qualifying projects owned by most tax-exempt entities. This changes the market for these types of projects, and opens up the door for projects to be owned by tax-exempt entities, financed by tax-exempt bonds and receive direct payments of tax credits.
Orrick’s initial high-level observations about this change in law, focused on renewable energy projects are:
- The two primary types of tax credits are the investment tax credit (“ITC”), which is a one-time credit based on a percentage of the qualifying costs of a project, and the production tax credit (“PTC”), which is an annual credit based on the amount of energy produced and sold by a project over a 10-year period.[1] While some renewable energy projects may qualify for both the ITC and PTC, an entity is only permitted to take one of these credits for any particular project.This will require a decision as to which credit provides better benefits.
- Projects already under construction may qualify for direct payments in lieu of tax credits if they are placed in service after 2022.This may provide an unexpected financial benefit for such projects.
- Projects qualifying for the ITC and PTC that also qualify for tax-exempt financing can be 100% financed with tax-exempt bonds, while only resulting in a 15% reduction in the amount of the tax credit.
- The direct pay tax credits under the Act are available to states and political subdivisions (which include cities, counties, school districts, and many other local governmental entities such as municipal utilities), Indian tribal governments, Alaska Native Corporations, rural electric cooperatives, the Tennessee Valley Authority, and any organization exempt from federal income tax, which includes 501(c)(3) organizations and various other tax-exempt entities.
- As amended by the Act, these tax credits generally have a “base” rate, which can be increased significantly if the project meets certain prevailing wage and apprenticeship requirements.[2] New tax credit “adders” are available to increase the amount of some credits for projects incorporating sufficient U.S. domestic content (steel, iron, or manufactured products) and for projects located in certain identified communities or locations.
- For renewable projects that begin construction in 2024 or 2025 and qualify for the ITC or PTC, the amount of the direct payment will be reduced unless certain U.S. domestic content requirements are met or an exception applies. Project that begin construction in 2026 will not qualify unless they meet the U.S. domestic content requirements or an exception applies.
- Congressional drafters took deliberate measures to attempt to protect the direct pay tax credits from sequestration.
Many, if not most, tax-exempt entities are not familiar with the details of these tax credits. The discussion below is intended to provide a broad overview of the federal tax credits for renewable energy projects and other qualifying projects that are eligible for direct payments to tax-exempt entities under the Act.[3] The law governing tax credits is complex, and whether a specific project qualifies for tax credits, and how much of the tax credits a project might qualify for, will depend on numerous factors, including project timing and cost allocations. This discussion is intended as an overview, and questions about specific projects or qualifications should involve discussions with legal counsel.
Tax-Exempt Entities and Direct Payments
The direct payment tax credits under the Act are available to states and political subdivisions (which include cities, counties, school districts, and many other local governmental entities such as municipal utilities), Indian tribal governments, Alaska Native Corporations, rural electric cooperatives, the Tennessee Valley Authority, and any organization exempt from federal income tax, which includes 501(c)(3) organizations and various other tax-exempt entities.
The direct payment applies only to tax years beginning after December 31, 2022, and requires an election to be made to receive the credit, generally on the tax return filed in the year in which the project is placed in service. For tax-exempt entities that do not file tax returns, guidance will be issued by the Treasury Department addressing the timing and process for claiming the direct pay tax credit.
Tax Credits for Renewable Projects—Production Tax Credits and Investment Tax Credits
The Internal Revenue Code of 1986 (the “Code”) generally provides for two types of tax credits for renewable projects—the PTC and the ITC—each of which has its own structure and qualifications. Certain types of projects may qualify for both credits, although an entity is only permitted to claim one type, in which case it is necessary to evaluate the likely benefits over time between the different options.
Many, but not all, of the tax-exempt entities eligible to receive direct payments also have the ability to finance their capital projects with tax-exempt debt. To the extent that a project is financed with tax-exempt debt and eligible for the PTC or ITC, the amount of the tax credit is reduced by the lesser of (i) 15% or (ii) the portion of the qualifying project that has been financed with tax-exempt debt. Because this is a “lesser of” test, this allows such projects to be financed 100% with tax-exempt debt, while only reducing the direct pay tax credit by 15%.
The Act includes provisions intended to encourage or require U.S. domestic content (steel, iron, or manufactured products) in projects qualifying for direct payment of the PTC or ITC. For projects beginning construction in 2024 or later, the amount of the direct payment is reduced or eliminated unless those projects meet certain U.S. domestic content requirements or an exception applies.[4] The applicable amount of manufactured product required ramps up from 40% to 55% for projects beginning construction between 2024 and 2027, with certain lower percentages prior to 2028 for offshore wind projects. Certain exceptions to this domestic content requirement will be provided by the Treasury Department, including where meeting the domestic content requirement would increase the project cost by more than 25%, or where domestic content is not available in sufficient quantities or of sufficient quality. In addition to that specific phase out of the direct payment option for the PTC and ITC, there is an overall phase out of these tax credits, which reduces the amount of the tax credits for projects that begin construction after the later of (i) 2032, or (ii) the year in which it is determined that the annual greenhouse gas emissions from the production of electricity in the United States is at least 25% of the emissions for 2022.
Production Tax Credits under § 45 and § 45Y. The PTC provides an ongoing tax credit for the first ten years of a project based on the amount of renewable energy produced in each year and sold to an unrelated person (subject to certain exceptions). For projects placed in service prior to 2025, the PTC under Section 45 of the Code is available for following specific types of projects, each of which have their own definitions and requirements under the Code:
- wind
- biomass (closed-loop and open-loop)
- solar
- geothermal
- municipal solid waste
- hydropower
- marine and hydrokinetic
For projects placed in service after 2025, there is a new technology-neutral tax credit under Section 45Y that is not referred to as a production tax credit, but which provides the same tax credits for energy generated from projects that emit zero greenhouse gases. For ease of reference, the discussion below refers to both the Section 45 credits and the Section 45Y credits as PTCs. (In addition, please see the discussion of the separate zero-emission nuclear power production tax credit further below).
As modified by the Act, the PTC has a base rate of 0.3 cents/kWh, and an increased rate of 1.5 cents/kWh for projects meeting prevailing wage and apprenticeship requirements. These rates are adjusted for inflation, such that the base rate for 2022 is 0.52 cents/kWh and the increased rate for 2022 is 2.6 cents/kWh. Qualifying for the increased rate requires the prevailing wage requirements (i.e., Davis-Bacon requirements) to be met during construction of the project and for any ongoing repairs or alterations of the project during the time the project is receiving the PTCs. The apprenticeship requirements require a certain amount of the labor hours to be performed by qualified apprentices under a federally registered apprenticeship program. Guidance will be published about both of these requirements by the Treasury Department, and there is a delay in the effective date of these requirements, such that projects will qualify for the increased rate regardless of these requirements if the project begins construction on or before the date that is 60 days after the Treasury Department issues guidance on these requirements.
In addition, there are bonuses available to increase the amount of the PTCs. Projects that incorporate sufficient content (steel, iron, or manufactured products) produced in the United States can qualify for a 10% increase in the amount of the PTC. As described above, meeting these domestic content requirements is also necessary to avoid the phase out of the direct payment for projects beginning in 2024 or later. Projects located in “energy communities,” which are brownfield sites, certain areas with sufficient direct employment or local tax revenues related to fossil fuels and above average unemployment, and certain areas in which a coal mine or coal-fired electric plant has closed, may qualify for an additional 10% increase in the amount of the PTC. As noted above, the total tax credits may be reduced by up to 15% to the extent of any tax-exempt financing of the project.
Investment Tax Credits under § 48 and § 48E. While the PTCs are ongoing credits based on the amount of energy produced, the ITC is a one-time tax credit based on a percentage of the qualifying costs of a project. For projects placed in service prior to 2025, the ITC under Section 48 of the Code is available for the following specific types of renewable energy projects, each of which have their own definitions and requirements under the Code:
- solar
- fiber-optic solar
- fuel cells
- geothermal
- small wind energy
- waste energy recovery
- combined heat and power
- heat pump
- energy storage (e.g., batteries)
- biogas
- microgrid controllers
In addition, the costs of interconnection property with a maximum net output not exceeding 5 MW (e.g., transmission equipment necessary to connect qualifying projects to the grid), may be included in the costs of qualifying projects.
For projects placed in service after 2025, Section 48E allows a similar new investment tax credit that is technology neutral, but which generally has a similar structure for projects that are expected to have zero greenhouse gas emissions. For ease of reference, the discussion below refers to both the Section 48 credits and the Section 48E credits as ITC.
As modified by the Act, the ITC has a base rate of 6% of the applicable costs of the qualifying project, with an increased rate of 30% for projects meeting prevailing wage and apprenticeship requirements. Those requirements are similar to the requirements described above for the PTCs, including the delayed effective date, such that projects will qualify for the increased rate regardless of these requirements if they begin construction on or before the date that is 60 days after the Treasury Department issues guidance on these requirements.
As with the PTC, there are bonuses that can increase the amount of the ITC if certain requirements are met. For projects incorporating sufficient domestic content, the amount of the ITC will be increased by 10% (and as described above, meeting these domestic content requirements is also necessary to avoid the phase out of the direct payment for projects beginning construction in 2024 or later). An additional 10% increase can apply to projects located in “energy communities,” as defined above. Specifically for wind and solar projects qualifying for the ITC, there are increases in the credits that may be received for projects located in low-income communities or on Indian land, with additional increases for certain qualifying projects located on low-income housing projects or that are part of certain low-income economic benefit projects. This additional increase for qualifying wind and solar projects will require an allocation of an annual limitation to be administered by the Treasury Department. And ,as noted above, the total tax credits may be reduced by up to 15% to the extent of any tax-exempt financing of the project.
Other Tax Credits Eligible for Direct Payment
In addition to the tax credits described above that apply to renewable energy projects, the Act allows direct payments for certain specialized tax credits, which have their own timing and qualification requirements. Some of these tax credits may be useful for many tax-exempt entities, such as the availability of direct pay tax credits for the purchase of clean commercial vehicles. Whereas others, such as the credit for manufacturing of certain renewable energy components, are less likely to relate to activities of tax-exempt entities.
Carbon Sequestration under § 45Q. This provides a tax credit per metric ton of carbon captured and either deposited in secure geologic storage, used in certain oil and gas recovery projects, or put to another use that results in the permanent disposal of the carbon. The project must generally begin construction before 2033 to qualify, and must meet certain annual capture requirements. The tax credit generally applies for the first 12 years of the project, and the tax credit rate varies depending on the method of capture and use of the captured carbon, as well as meeting the prevailing wage and apprenticeship requirements.
Zero-Emission Nuclear Power Production under § 45U. Very similar to the PTC described above, this provides a tax credit per kWh of electricity produced from qualified nuclear power facilities and sold to unrelated persons during the year, beginning with electricity sold in 2024 and ending in 2032. The amount of the tax credit is subject to reduction according to a formula based on the plant’s gross receipts. This tax credit does not require new construction of a nuclear plant, but instead applies to qualifying nuclear plants constructed before the date of enactment of the Act. The amount of the credit is also dependent upon meeting prevailing wage requirements (although not apprenticeship requirements).
Qualified Commercial Vehicles under § 45W. For most tax-exempt entities (but excluding certain farmers cooperatives), a direct pay tax credit is available for up to 30% of the cost of qualified commercial clean vehicles placed in service before 2033. There is a limit of $7,500 for vehicles with a gross weight of less than 14,000 pounds, and $40,000 for other vehicles.
Alternative Fuel Vehicle Refueling Property under § 30C. A tax credit is allowed for alternative fuel vehicle refueling property, such as electric vehicle charging stations. The credit is up to 30% of the costs of the property placed in service before 2033, with the specific percentage depending on the property financed and whether the prevailing wage and apprenticeship requirements are met. There is a $100,000 limitation on the amount of the credit for any single item of property. In addition, the property must generally be located in either a low-income census tract or a non-urban area.
Production of Clean Hydrogen under § 45V. This provides a tax credit per kilogram of qualified clean hydrogen produced from a qualifying facility over a 10 year period. The credit rate varies depending on the amount of greenhouse gas emissions resulting from the production process, as well as meeting the prevailing wage and apprenticeship requirements. There is an option to elect an ITC in lieu of a production-based credit.
Clean Fuel Production under § 45Z. For certain clean transportation fuels produced after 2024, a tax credit per gallon of fuel is allowed, with the specific amount dependent upon the fuel produced and meeting the prevailing wage and apprenticeship requirements.
Advanced Manufacturing Production under § 45X. This is a tax credit provided for manufacturing of certain components within the United States, largely those necessary for renewable energy projects, such as solar cells, wind energy components, inverters, batteries, and any critical mineral. The amount of the credit depends on the type of components being manufactured, and begins to phase out for components sold in 2030, with the tax credit ending in 2032.
Advanced Energy Projects under §48C. Advanced energy projects, as defined in Section 48C, are generally improvements to industrial or manufacturing facilities to (i) produce or recycle certain components of renewable energy projects, such as solar cells, wind energy components, fuel cells, and batteries, (ii) reduce the greenhouse gas emissions from the industrial or manufacturing facility by at least 20% through installing certain components, or (iii) process, refine or recycle critical materials. The tax credit is 30% of the qualified costs of such project, but requires an allocation of credits from the Internal Revenue Service and the Department of Energy.
Footnotes
[1] The tax credit for carbon oxide sequestration, which is mechanically similar to the PTC, has a 12-year credit period.
[2] Prior to the Act, these tax credits were in a phasedown period where the amount of the credit was generally lower than the historical “full” rate. As amended by the Act, the “base” rate for these credits represents a significant reduction from the historical “full” rate, but if the prevailing wage and apprenticeship requirements are met, a project can qualify for the historical “full” rate.
[3] This discussion is tailored to the tax credits eligible for direct payments to tax-exempt entities, and does not address issues limited to taxpaying entities, such as the limited tax credits available as direct payments to taxpayers, the transferability of tax credits by taxpayers, or projects placed in service prior to the date on which the direct payment to tax-exempt entities becomes available.
[4] This phase out does not apply to projects of less than 1MW.
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About Orrick
Orrick’s legal team draws from our experienced public finance, renewables and tax lawyers who advise clients at the intersection of tax-exempt entities and tax credits. In addition to our consistently top ranked Public Finance practice that focuses on tax-exempt financing, our Energy practice has helped clients pioneer the renewable energy market since its inception. We advise market-leading participants in every type of renewable energy project, including solar, wind, offshore wind, battery storage, biofuels and biomass, and geothermal. (Learn more here.)