On June 14, 2023, the Department of the Treasury (“Treasury”) and the Internal Revenue Service (IRS) released highly anticipated guidance relating to new Internal Revenue Code (“Code”) Section 6418, which was added as part of the Inflation Reduction Act (IRA) to provide taxpayers an alternative to monetize certain tax credits. The release included proposed regulations relating to the transferability of tax credits under Section 6418 (Transferability Guidance), temporary regulations regarding information and registration requirements (Pre-Filing Registration Guidance), and a series of frequently asked questions (FAQs).
Section 6418 has received significant interest from developers and investors because it represents a clear break from past tax policy. For the first time, pursuant to Section 6418, taxpayers are allowed to transfer all (or any portion) of an eligible credit to an unrelated taxpayer for cash consideration.
Generally, the follow tax credits may be eligible for transfer:
This client publication provides our initial impressions and key takeaways from the voluminous release. Despite some uncertainty, there is enough guidance for taxpayers to consider entering into transfer agreements, but buyers should also consider contractual tools such as indemnification clauses, tax insurance and specific documentation to support the purchase.
Taxpayers making a transfer election will be required to complete a prefiling registration through an online portal and receive a registration number for each eligible property. The registration process will require the taxpayer to provide certain information about the electing taxpayer, the eligible project, and the tax credits being transferred. Without a prefiling registration number, any attempt to transfer an eligible credit will be denied.
The pre-filing registration procedures are intended to permit the IRS to prevent duplication, fraud, improper payments or excessive payments. Most of the registration requirements are prescriptive but there is room for the IRS to ask for additional information. It remains to be seen how detailed the pre-filing review will be in practice.
The proposed regulation includes definitions and special rules applicable to partnerships and S corporations and guidance on excessive credit transfer and recapture events. Below are key issues that are addressed in the guidance.
Section 6418 contains broad language that indicates that when tax credits are transferred, the transferee is “treated as the taxpayer for purposes of this title with respect to such credit.” There have been questions about the intended scope of that language, since it may significantly impact the underlying qualification requirements.
The Transferability Guidance provides clarity by focusing on the language in the statute that provides that the tax credits are determined based on attributes of the transferor. The guidance provides that the inclusion of the word “determined” is instructive. The proposed regulations draw a distinction “between rules that impact the amount of credit determined or the credit base (and thus, the amount of eligible credit that can be transferred) versus rules that impact a taxpayer’s ability to claim a particular eligible credit against its tax liability.”
The Transferability Guidance clarifies that the eligibility of the credit is based on the eligibility of the transferor, while the ability to use that tax credit against taxable income is based on the attributes for the transferee. This general principal impacts various issues discussed below. For example, whether the taxpayer is “at-risk” pursuant to Code Section 49 goes to initial eligibility to claim a tax credit, so it is based on the transferor’s tax attributes, while issues related to the ability to use the credit against tax, such as passive loss limitations, are based on the transferee’s tax attributes.
Investment tax credits, such as those available through Section 48, or Section 48E, are generally based on the taxpayer’s cost basis in the asset. In most tax equity transactions, the tax credit eligible assets are sold to a joint venture between the developer and the tax equity investor at fair market value in a manner that allows that joint venture to claim the credit based on fair market value of the assets, as opposed to the cost to build the project. This obviously puts transferability without a similar third-party sale/step-up at a comparative disadvantage. Some taxpayers had hoped Treasury and the IRS might provide guidance to help alleviate that discrepancy. Unfortunately, as expected, the IRS confirmed that the transferred benefit is limited to the transferor’s cost basis. Even if Treasury had wanted to provide some leeway on this issue, it was always a longshot considering the statutory constraints in the underlying tax credit provisions.
Another key issue where taxpayers have been looking for is clarity around tax credit recapture. Investment tax credits can be subject to recapture if the underlying asset is disposed of, or is permanently taken out of service, during the five-year recapture period. Production tax credits for capturing CO2 emissions can be recaptured if the captured CO2 that has been sequestered leaks from underground storage within three years. Section 6418 provides that the transferor must give notice of a recapture event to the transferee, and the transferee must take that recapture into account and repay the IRS, but the statutory language did not provide any details as to how that is intended to work in practice. The Transferability Guidance helps clarify key aspects of how recapture would apply and provides relief for some types of recapture events in the partnership context that would have otherwise been expected to cause a partial recapture to the transferee.
In particular, the Transferability Guidance provides important relief to transferees from allocation shifts, upstream partnership interest transfers, or change of control events that cause recapture as to an individual partner’s portion of the tax credit. The Guidance applies an entity-based approach to applicable partnerships for purposes of tax credit transfer recapture, so only transfers/dispositions at the partnership level would cause a loss of the tax credit to the transferee. Since many assets are held directly or indirectly through partnership structures this provides some important relief.
The Transferability Guidance also expressly permits the transferor to indemnify the transferee for any recapture.
If a project is owned by a partnership, the tax credits must be sold by the partnership, not the individual partners. Under the statute, the amount of cash consideration received by the transferor partnership as consideration for the transfer is treated as tax exempt income, and a partner’s distributive share of such tax-exempt income is based on its proportionate share of the otherwise eligible credit.
A partnership that purchases tax credits must report the cash purchase as a nondeductible expense, which the Transferability Guidance provides may be allocated among the partners as determined under the partnership agreement, or in accordance with the general allocation of losses if no special allocation is provided. The Transferability Guidance also requires that transferee partnerships allocate the credit among its partners as of the time the transfer is treated as occurring. Accordingly, a partnership might be used to syndicate purchased tax credits among multiple purchasers, but any new partners would only be able to share in tax credits that arise on or after the date that they entered the partnership.
In certain limited situations, the Code allows specific tax credits to be passed through to non-owners by special election. For example, a Section 45Q credit may be transferred to a carbon off-taker pursuant to an election made under Section 45Q(f)(3)(B). Additionally, a Section 48 credit investment tax credit may be passed through to an eligible lessee pursuant to an election made under Section 50(d)(5) and Treasury Regulation §1.48-4, which allows the lessee to claim the investment tax credit based on the fair market value of the asset.
Many taxpayers have been asking whether a party that is eligible for a tax credit based on a pass-through election is eligible to transfer the credit. The Transferability Guidance is clear, that when a tax credit is passed through, it is not an eligible credit that can be transferred by the transferee taxpayer because such credit is not determined with respect to the eligible taxpayer.
Particularly as to the investment tax credit, which is based on the owner’s cost basis, some taxpayers were hoping to be able use the pass-through election to allow the investment tax credit to be transferred at fair market value without a third-party sale. The Transferability Guidance clearly forecloses that option.
Eligible taxpayers may transfer all or a portion of an eligible credit generated from a single eligible credit property. They may also sell an eligible credit generated from a single eligible credit property to multiple unrelated parties in the same tax year. A seller is able to provide the same registration number to all transferees of an eligible tax credit generated by the same eligible credit property. Any recapture or adjustment would occur on a pro rata basis.
While a taxpayer can transfer a portion of an eligible credit, a taxpayer cannot separately transfer a portion of an eligible credit related solely to a bonus credit amount. For example, the portion of an eligible tax credit related to the Domestic Context Bonus cannot be transferred separately. Thus, because an eligible credit includes the general credit as well any bonus credit amount, any partial transfer of an eligible credit would contain a pro rata portion of the general credit and each applicable bonus credit.
As discussed above, the Transferability Guidance clarifies that issues related to the ability to use the credit against tax, such as passive loss limitations, are based on the transferee’s tax attributes. Accordingly, the passive activity credit rules under Section 469 of the Code would apply to tax credit purchasers in determining whether they are eligible to claim transferred tax credits. The application of passive activity rules, combined with the activity grouping limitations included in the Transferability Guidance, will make it exceedingly difficult for any individual to claim a transferred tax credit.
The U.S. federal income tax system is pay-as-you-go, meaning that taxpayers must pay estimated taxes throughout the year, typically by making quarterly installment payments, to avoid underpayment penalties. Under the Transferability Guidance, a transferee taxpayer may take into account any specified credit portion that it has purchased, or intends to purchase, when calculating its projected tax liability and obligation to make estimated tax payments. For this purpose, a transferee should consider any limitations on the use of such specified credit portion, such as the limitation on general business credits under section 38(c), that may impact whether additional estimated taxes are due.
A transferee taxpayer remains liable for any additions to tax in accordance with sections 6654 and 6655 to the extent the transferee has an underpayment of estimated tax. So, if a taxpayer reduces its estimated tax payments based on tax credits that it intends to purchase, but the transfer transaction is not completed, there will be an additional tax cost to the taxpayer.
The IRA contains a penalty of 20% of any excessive tax credit claimed where all or a portion of the tax credit is later disallowed. The disallowance is charged first against any tax credit the seller retained but if a portion of the transferee’s tax credit is disallowed, the transferee is responsible for any penalty assessed. The transferee can avoid the penalty (but not the obligation to repay the disallowed amount), by proving it had reasonable cause to claim the report tax credit amount based the facts and circumstances, which may include records provided by the transferor, and the scope and breath of records it possesses. The seller must report any amount it was paid for disallowed tax credits as taxable income.
The Transferability Guidance clarifies that no elections will be allowed when there are noncash considerations. Cash payments should be made within the period beginning on the first day of the seller’s taxable year when the credit is determined and ending on the due date for the transfer election statement. Contractual commitments to purchase credits will not violate the paid-in-cash requirement if all cash payments are made during the required time period.
The Treasury and the IRS appear to be particularly concerned about disguised non-cash consideration, such as a discount on services provided to a customer who is also acquiring tax credits. The proposed regulations contain anti-abuse rules, applicable to multipurpose transactions to address concerns that a transferor may attempt to use a tax credit transfer transaction to avoid recognizing income from another aspect of a transaction. The IRS has the right to disallow or recharacterize a transaction that attempts to bundle tax credit transfers directly or indirectly with non-cash consideration.
The Guidance expressly permits arrangements using brokers to match eligible transferor taxpayers with purchasers, so long as ownership of those tax credits does not pass to the broker or other party prior to being sold to the transferee.
The Transferability Guidance did not contain any major surprises, and generally provides clear rules for tax credit transfers. While a few areas may still need some clean-up or additional details, the overall guidance package should provide enough clarity for the market to begin transacting.
While the rules themselves are clear, and buyers and sellers are eager to contract, it is currently unknown when the electronic portal for pre-registration will be available. The preamble to the Transferability Guidance states that Treasury and the IRS believe that it is necessary to establish a mandatory registration process that is in place before the end of the 2023 calendar year. The FAQs indicate that more information about the pre-filing registration process will be available by late 2023. While purchase transactions will be negotiated in the interim, the tax credits cannot change hands until the registration process is up and running.
Once the process is up and running, it is unknown how long the IRS will take to process applications, or whether the process will be more administrative in nature or contain a more fulsome IRS review of submitted materials. It seems likely that there will be some initial delays as the IRS irons out its review process and works through the initial wave of applications from taxpayers waiting for the registration process to open.
While things certainly would have been easier if the recapture risk stayed with the transferor, the statute is clear that the liability remains with the transferee. Some had hoped that Treasury would find a way to further streamline how recapture risk is allocated, but Treasury was boxed in by the statutory language. The work done by Treasury and the IRS to simplify recapture in the partnership context is certainly helpful.
Ultimately, transferees will need to look to an indemnity from the transferor and/or tax insurance to address recapture concerns and other qualification risks. Accordingly, the existence and quality of the available credit support backstopping the transferor’s representations will likely impact pricing on transferred credits.
Considering the apparent focus on non-cash consideration and the scope of the anti-abuse rules, parties should take particular care in structuring any tax credit sales between a buyer and seller that have other business relationships to ensure that no non-cash consideration can be inferred, particularly in the case of any other arrangements being negotiated contemporaneously with the tax credit transfer transaction.