Final refundable energy credit rules add flexibility

March 08, 2024https://www.grantthornton.com/insights/alerts/tax/2024/flash/final-refundable-energy-credit-rules-add-flexibility

The Inflation Reduction Act (IRA) created a new monetization regime under Section 6417 that allows tax-exempt entities to elect to claim 12 of the IRA’s energy credits as refundable payments. Three of the credits are also effectively refundable for all taxpayers for up to a five-year period.

The final regulations add significant flexibility to the proposed rules, including:

• Expanding the types of tax-exempt entities and electric cooperatives that can elect a refundable payment
• Simplifying the ordering rules for applying the credit to offset liability before it is refundable
• Providing procedural relief for entities not otherwise required to file tax returns
• Offering a simplified mechanism in separately proposed regulations (REG-101552-24) to allow taxpayers to elect out of partnership treatment for joint projects

The IRS held firm on several issues that received significant commentary. Tax-exempt entities will not be able to purchase credits and then elect direct payments under the final regulations, although IRS asked for additional comments on the issue (Notice 2024-27). The IRS also declined to provide relief from a requirement under Section 50(b)(1) that can restrict the availability of investment tax credits in U.S. territories. Section 50(b)(1) generally bars a credit for property “that is used predominantly outside the United States” unless specific requirements are met.

The final regulations are generally effective for tax years ending after the regulations are published in the Federal Register, but taxpayers may rely on them for earlier periods, provided they rely on them in their entirety and in a consistent manner. The IRS has not yet finalized the rules for credit transfers (see our prior alert).

Grant Thornton Insight

The IRA’s refundable payment mechanism offers powerful new opportunities for tax-exempt entities, particularly those with ambitious ESG goals or existing energy projects. Businesses pursuing credits for hydrogen production under Section 45V, carbon sequestration under 45Q, or advanced manufacturing under Section 45X can also benefit. The final rules offer helpful certainty, but the administrative burden can be substantial. Taxpayers must register before making the election, which the IRS recommends doing 120 days before filing. Taxpayers planning to elect a refundable credit on a 2023 return should assess the rules carefully and consider registering immediately.

Eligibility

The IRA provides that specific types of taxpayers can elect to receive any of the following credits as refundable payments against tax:

• Section 45 production tax credit (and the Section 45Y credit that will replace it 2025)
• Section 48 investment tax credit (and the Section 48E credit that will replace it 2025)
• Section 45U nuclear power credit
• Section 48C advanced energy property credit
• Section 45Q carbon oxide sequestration
• Section 45V hydrogen production credit
• Section 45X advanced manufacturing credit
• Section 30C alternative fuel refueling property credit
• Section 45Z clean fuel production credit that will take effect in 2025
• Section 45W credit for clean commercial vehicles

The entities eligible to make the election include:

• Any organization exempt from tax imposed by subtitle A
• Any state or political subdivision
• The Tennessee Valley Authority
• An Indian tribal government
• Any Alaska Native Corporation (ANC)
• A rural electric cooperative

The Section 45W credit has separate rules and is refundable only to tax-exempt entities as described in Section 168(h)(2)(A)(i), (ii), or (iv).

The proposed regulations generally defined the eligible categories generously, and the final rules expand them in several areas. Organizations exempt from tax will include all entities exempt from tax by Section 501(a), including any organization described in sections 501 through 530. The IRS clarified that this also includes homeowners’ associations exempt from tax under Section 501(a) by reason of subchapter F of chapter 1.

State and governments and subdivisions will include the District of Columbia and territories, plus any government agencies or instrumentalities. Indian tribal governments will also include any subdivisions, agencies and instrumentalities. The inclusion of “agencies” and “instrumentalities” is critical because these words were omitted from the statute. Many government entities such as public universities that did not separately obtain Section 501(c)(3) status were concerned they would not fit under the definition of a “subdivision.” The IRS declined to provide additional guidance on determining whether an entity qualified as an agency, instrumentality, or a political subdivision, saying it was outside the scope of the regulations.

Grant Thornton Insight

The preamble to the proposed regulations gave many examples of agencies and instrumentalities that would qualify, including public universities, school districts, public utility districts and special purpose entities like joint-action agencies, economic development corporations and joint powers authorities. But taxpayers asked the IRS for additional guidance on many other types of entities in the final regulations. The IRS said taxpayers should instead rely on existing law for these determinations, pointing to the six-factor test for determining an agency or instrumentality under Rev. Rul. 57-128 and the definition of a political subdivision in Rev. Rul. 78-276.

The definition of an ANC does not include related Alaska Native Settlement Trusts, but does incorporate consolidated groups in which the ANC is the common parent. The final regulations also clarify that rural electric cooperative include both tax-exempt cooperatives and taxable cooperatives under Section 1381(a)(2)(C).

Elections under Sections 45V, 45Q, and 45X

Any type of taxpayer can generally elect to treat the credits under Sections 45V, 45Q, and 45X as refundable payments against tax for a five-year period. The election for Section 45V and 45Q must be made for the first five years after it is placed in service. The election for 45X is available over any consecutive five-year period while the credit is in place. For years in which a refundable payment election is not in effect, taxpayers can elect to transfer their credits.

Grant Thornton Insight

Taxpayers claiming a credit under Section 45X can consider the timing of the election strategically. There are costs associated with credit transfers that can reduce the return on the credits, so transfers may be less costly in early years when production (and the corresponding credits) are lower. This would allow taxpayers to preserve the election for years with larger credits. This type of planning is not available for Section 45V and 45Q elections, which must be made effective for the year a project is placed in service, even if it’s near year-end and the credit will be insubstantial. Taxpayers can consider planning for a favorable placed in service date if refundability is critical to the value of the credits.

Making the election

The election is made on annual tax return, such as a Form 1120, Form 1120-S, Form 1065, of Form 990-T. If a taxpayer is not required to file an annual return, it must file the election on the Form 990-T (or if it is not required to file because it is in a territory, the form it would be required to file if it was located in a state). Taxpayers must register before filing, as discussed later in this article.

The election can only be made on a timely filed original return (including extension), although the final regulations provide that a numerical error can be corrected on an amended return or administrative adjustment request. The preamble also seems to acknowledge that the election could be made on a superseding return as long as the superseding return is filed by the due date of the return (including extension). Taxpayers that fail to timely file for an automatic six-month can request relief under Section 9100.

If a taxpayer is not otherwise required to file a return, then the return with the election is required by the 15^th day of the fifth month after the tax year, although the regulations provide an automatic paperless six-month extension for these entities. The final regulations provide significant flexibility for non-filing entities to select a favorable tax year for these purposes. These taxpayers may choose to file a Form 990-T based on either the calendar year or their fiscal year.

Grant Thornton Insight

The flexibility for non-filing entities to choose either a calendar or fiscal year offers relief from an issue arising out the effective dates of the credit provisions. The new IRA credits are generally available for property placed in service in 2023 or later, but the refundable payment election is only available for tax years beginning after Dec. 31, 2022. It is not uncommon for tax-exempt entities to use a fiscal tax year, and these entities are barred from making an election for a refundable credit for years beginning 2022 even if the project was placed in service in calendar 2023. Because the election is only available in the year placed in service, these tax-exempt entities are likely to generate credits that can never be used. Non-filing entities without a pre-existing tax year can use the calendar year even if they use a fiscal year for financial accounting purposes as long as they maintain adequate records to reconcile the differences between their regular books of account and their chosen tax year. Entities that already have a tax year will not have the same opportunity, as there are many restrictions for changing a tax year under Section 442.

The election is made separately for each applicable credit property, and each election must include the entire amount of credit related to that property. The guidance provides rules for determining the applicable property. In addition, for the production credits, the election generally applies to subsequent years related to that property.

The final regulations maintain a proposed rule preventing taxpayers from electing direct payment for a credit that was transferred to them under the credit transfer provisions in Section 6418. The IRS said it received many comments arguing for this kind of “credit chaining,” but it determined that Sections 6417 and 6418 are better read as two separate mutually exclusive regimes.

Grant Thornton Insight

The IRS originally asked for comments on whether exceptions to the ban on credit chaining should be made for any circumstances, such as when a transferee is involved in the project. In the preamble to the final regulations, it said it would face substantial challenges in distinguishing and administrating such exceptions but said it could still consider them in the future and requested additional comments in Notice 2024-27.

Partnerships and S corporations

For projects owned by an S corporation or a partnership, the election can only be made at the entity level. No partners or shareholders can make their own election after the credit flows out to them. Because neither a partnership or S corporation can be an applicable tax-exempt entity, the election for these entities is only available for the five-year direct pay option for the credits under Sections 45V, 45Q, and 45X.

Any refundable payment is treated as tax-exempt income for a partnership or S corporation under Sections 705 and 1366. The final regulations generally require the tax-exempt income to be allocated to partners in the same proportion as the underlying credit would have been allocated. The income is not treated as passive for purposes of Section 469. There are no restrictions in the statute or regulations for how an S corporation or partnership can use the cash proceeds or refundable credit.

Despite significant commentary, the IRS declined to allow partnerships with tax-exempts as partners to make full or partial elections to receive credit payments based on the amount of credit that would be allocated to the tax-exempts. If a tax-exempt’s project is in a partnership, it cannot elect direct pay itself as a partner and the partnership cannot elect direct pay (except for the three specified credits).

The IRS did, however, offer separate proposed regulations that will potentially make it easier for tax-exempts to enter into joint ownership arrangements by avoiding treatment as a partnership. The proposed regulations, which can be relied upon now, would provide exceptions to rules under Section 761 that restrict when unincorporated organizations can elect to be excluded from the application of Subchapter K. The exceptions would only be available for energy projects meeting specific criteria.

Income tax considerations

The final regulations clarify the effect of any grants and forgivable loans on the basis for claiming credits. The IRS did not provide any rules for taxable entities, but in the preamble to the proposed regulations, it acknowledged that grants and forgivable loans were generally taxable under Section 61 and “thus generally do not result in a reduction of basis.” The issue is more complicated for tax-exempts because grants and forgivable loans are generally exempt from tax and tax-exempt amounts used in the purchase, construction or acquisition of property can require a reduction in basis.

The final regulations provide that tax-exempt entities that use any tax-exempt amounts used to purchase, construct, reconstruct, erect, or otherwise acquire an applicable credit property described in Sections 30C, 45W, 48, 48C, or 48E can generally include these amounts in the basis for calculating the credit. An excess benefit rule caps the basis at the cost of the property plus any tax-exempt amounts.

The final regulations also adjust the application of the credits on the return and the amount considered a refundable payment. In general, taxpayers will first use the credit as a general business credit under Section 38 to offset any tax liability up to the Section 38 limitation, but only after applying all other allowable general business credits. The remaining amount of credit will be treated as a refundable payment against tax, resulting in a refund due to the taxpayer.

Registration and reporting

Taxpayers electing to claim a direct refundable payment must register before making the election. The registration will take place electronically through an IRS portal. The registration is required but does not necessarily mean the taxpayer is eligible to receive a payment. The claim can still be examined.

Taxpayers must obtain a registration number for each separate credit property and the registration number must be included on the return when the direct payment or transfer election is made. In general, a new registration number is required each year with regard to a property, but the IRS plans to offer procedures to renew them.

Registration cannot be completed earlier than the beginning of the tax year in which the credits will apply. Registration must be completed prior to filing the return making the refundability election and the IRS recommends claimants attempt to register at least 120 days before the organization plans to file its taxes.

Grant Thornton Insight

Taxpayers are not required to register 120 days before filing the return but should consider registering as soon as possible to speed up refunds and avoid processing issues. Taxpayers cannot make a refundable payment election without a registration number and it is unclear how quickly the IRS will be able to process registrations.

Taxpayers will need to go through several steps in order to register, including having the individual performing the registration process set up an ID.me account to verify identification. The preamble to the final regulations states that the final regulations do not restrict a taxpayer from authorizing a representative such as a tax professional from applying for a registration number, but information on the portal does not make it completely clear who is eligible for authorization. The process requires an attestation that the person is a corporate officer, partner, guardian, executor, receiver, administrator, trustee, or individual other than the taxpayer with legal authority to execute the authorization on behalf of the taxpayer.

Taxpayers will need to provide significant information through the registration portal, including:

• Name, taxpayer identification number (TIN), entity type, tax year, and type of return
• Information about subsidiaries included in a consolidated group of corporations
• Type of credit and type of property
• Physical location of property
• Bank account information
• Date construction began and was completed
• Any joint ownership
• Source of funds

In many cases, the IRS also wants documentation supporting the registration, such as permits, certifications, or evidence of ownership. These requirements will vary depending on the type of credit and are detailed in an IRS publication.

Next steps

The enhanced energy credits and refundable payment election alter the economics of energy projects significantly for tax-exempts. Any organization with meaningful ESG goals should re-evaluate the credit opportunities. Businesses pursuing activities under Section 45V, 45Q, or 45X should also understand the potential application of the rules and monetization options. Any taxpayer with a credit project recently competed, underway or in the planning stages should be assessing the rules carefully and potentially acting quickly to address burdensome administrative requirements. Taxpayers should also expect IRS scrutiny. The last time the IRS offered grants in lieu of energy credits (the section 1603 program), it became a major focus for compliance efforts. The IRA provided a special IRS funding allocation that is helping drive enforcement.

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