Following up on two pieces of guidance the IRS issued earlier this year, the IRS issued proposed regulations for the section 45Q Carbon Sequestration Credit on May 28, 2020. The proposed regulations are proposed to apply to taxable years beginning on or after the date the proposed regulations are published as final regulations, however taxpayer may choose to apply the proposed regulations to taxable years beginning on or after Feb. 9, 2018, and before the regulations are finalized. Interested taxpayers have until Aug. 3, 2020 to provide comments regarding these proposed regulations.
A credit is available under section 45Q of the Internal Revenue Code for carbon oxide capture and disposal, use or utilization activities that occur in the United States or a possession of the United States based on the price per metric ton that a taxpayer captures, disposes or utilizes. The credit is claimed on Form 8933, Carbon Oxide Sequestration Credit.
There are effectively four different ways to obtain the credit. Two ways are for equipment that was placed in service prior to the changes to section 45Q under the Bipartisan Budget Act of 2018 (BBA), and the other two ways are for carbon capture equipment that was placed in service on or after the enactment of the BBA. The BBA was enacted on Feb. 9, 2018. Additionally, the other differentiation between types of credits available is whether the captured carbon is used as a tertiary injectant or utilized in other manners described in section 45Q. The price per metric ton of carbon oxide used as a tertiary injectant is less than if the carbon oxide is disposed in secure geologic storage or utilized in another manner. Similarly the price per metric ton for equipment place in service after enactment of the BBA is greater than equipment place in service prior to the enactment of the BBA. The proposed regulations clarify several key provisions of the statutory language.
Secure geological storage
Foremost among the questions surrounding the credit is what does the term ’secure geological storage’ mean? The IRS issued interim guidance that described certain requirements for what constituted secure geologic storage by citing Intergovernmental Panel on Climate Change and the Underground Injection Control program of the Safe Drinking Water Act rules. The regulations do not appear to address what specific geologic features are required for storage to be considered secured geological storage, but do state it includes but is not limited to deep saline formations, oil and gas reservoirs and unminable coal seams.
The regulations did address certain requirements for the secure storage. The IRS adopted the requirements of regulations issued by the EPA, 40 CFR Part 98 subpart RR, for monitoring greenhouse gases and the geological sequestration of carbon dioxide. Those regulations require a site to develop and implement an EPA-approved site-specific Monitoring Reporting and Verification plan. Additionally, the proposed regulations provide that, when the carbon oxide is used as a tertiary injectant, the carbon oxide must be stored in compliance with either the EPA regulations or standards endorsed by the International Standards Institute under CSA/ANSI ISO 27916:19, Carbon dioxide capture, transportation and geological storage – Carbon dioxide using enhanced oil recovery.
Any taxpayer claiming the credit must file all documentation required by Form 8933. A taxpayer claiming the credit for qualified enhanced oil or natural gas recovery projects may self-certify the volume of carbon oxide claimed if the taxpayer reported the volumes of carbon oxide pursuant to EPA regulations. If a taxpayer determines the volumes of carbon oxide pursuant to CSA/ANSI guidance, the taxpayer must provide documentation pursuant to that guidance to a qualified independent engineer or geologist, who must then certify that the documentation showing the volume is accurate and the sequestration protocols are accurate and complete. The carbon sequestration credit is not allowed for any year for which the taxpayer fails to submit complete documentation or certification.
Election to allow the credit to another taxpayer
Section 45Q permits a taxpayer to whom the credit is attributable to make an election to allow the person who disposes of, utilizes, or uses the carbon oxide as a tertiary injectant to claim the credit. The regulations provide that the taxpayer may make an annual election no later than the due date (with extensions) of the taxpayer’s return. While the election cannot generally be made on an amended return, it is permitted on an amended return for tax years ending after Feb. 9, 2018, but not for taxable years beginning after June 2, 2020.
Pursuant to the regulations, a taxpayer may elect to allow the other person to claim all or a portion of the credit. Additionally, a taxpayer may elect to allow one or multiple other claimants to claim the carbon sequestration credit. A valid election must be made on the appropriate form, currently Form 8933, and the taxpayer making the election must provide its Form 8933 to each claimant. The election must include the taxpayer’s name, address, taxpayer identification number, location of each qualified facility, the name of the claimant, the portion of the credit attributable to the claimant and corresponding metric tons of qualified carbon oxide. The claimant must provide similar information with its timely filed tax return claiming the credit.
Definition of carbon capture equipment
The regulations provide a relatively straight-forward definition of what equipment is considered carbon capture equipment for purposes of the credit. The definition includes all components of property that are used to capture or process carbon oxide until the carbon oxide is transported for disposal. The regulations mention absorbers, compressors, conditioners, cooling towers, dehydration equipment, filters, fixtures, heat exchangers, machinery, materials, membranes, meters, monitoring equipment, motors, mounting equipment, pipes, power generators and regenerators, pressure vessels, processing equipment, pumps, scrubbers, separation vessels, solvent pumps, support structures, tracking equipment, treating equipment, turbines, among other pieces of carbon oxide related equipment. The regulations exclude components like pipelines and land or marine vessel used to transport the captured qualified carbon oxide.
The regulations adopt a helpful 80/20 rule for determining the placed in service date of a facility or carbon capture equipment that has been replaced or retrofitted. Under the rule, a qualified facility with carbon capture equipment that existed prior to Feb. 9, 2018, for example, could be treated as being placed in service at a later date by installing new carbon capture equipment in a scenario where the taxpayer places 80% of the total value of the facility’s equipment in service.
Utilization of the carbon oxide
The regulations provided some clarity for demonstrating how a taxpayer must measure carbon oxide that it utilizes. A taxpayer claiming the credit must develop a greenhouse gas life cycle assessment (LCA). The LCA must contain documentation consistent with ISO 14044:2006 to calculate how much of the carbon oxide is utilized and permanently isolated from the atmosphere.
The regulations define utilization of qualified carbon oxide to include (1) the fixation of qualified carbon oxide through photosynthesis or chemosynthesis (such as through growing algae or bacteria), (2) chemical conversion of qualified carbon oxide to a material or chemical compound in which the carbon oxide is securely stored or (3) the use of qualified carbon oxide for any other purpose for which a commercial market exists except for use as a tertiary injectant in a qualified enhanced oil or natural gas recovery project). Unfortunately, the regulations did not provide any further clarification of what the IRS considers permissible utilization in a commercial market, but reserved a paragraph in the regulations for later use.
Contractually ensuring disposal, injection or utilization of qualified carbon oxide
The regulations provide clearer guidance as what an agreement must look like between the taxpayer and a third-party to dispose, inject or utilize the qualified carbon oxide. The agreement must be binding under state law, and the agreement cannon limit damages to a specified amount.
A taxpayer can enter into a binding contract with multiple parties to ensure disposal, injection or utilization of the carbon oxide. Those contracts must contain commercially reasonable terms for enforcement of a party’s obligation to perform under the contract. If the contract is to for the disposal of qualified carbon oxide in secure geological storage or as a tertiary injectant, the contract must obligate the disposing party to follow the requirements of the proposed regulations. The contract must also obligate the disposing party to promptly inform the capturing taxpayer if there was a recapture event and all of the reportable information required by these regulations.
The regulations appear to encourage, but not require certain contractual provisions. Those provisions include the quantity of qualified carbon oxide that the parties intend to dispose pursuant to the contractual agreement, long-term liability provisions, indemnity provisions, penalties for breach of contract or liquidated damages provisions.
The regulations also create reporting requirements where there is a contract for the disposal, injection or utilization of qualified carbon oxide. The information is reported on Form 8933, and includes general information such as the name of the party with whom the taxpayer contracted with, the quantity of qualified carbon oxide disposed of, injected or utilized, and if applicable, where the carbon was stored underground.
Recapture of the credit
The regulations also provided some guidance on the recapture of the credit when certain events trigger the recapture. A recapture event occurs when qualified carbon oxide for which a credit is claimed ceases to be captured, disposed of, or used as a tertiary injectant during a period of time beginning with the first injection of qualified carbon oxide and ends five years after the last tax year in which the taxpayer claimed the credit. Further, the leaked amount of qualified carbon oxide must exceed the amount of qualified carbon oxide disposed of in secure geological storage or used as a tertiary injectant in the year that the recapture event occurs.
When a recapture event occurs during the recapture period, any taxpayer that claimed a section 45Q credit for that project must report the recaptured amount, which is product of the quantity of released carbon oxide and the statutory credit rate, the quantity of leaked qualified carbon oxide, the credit rate and a statement describing events surrounding the leaked qualified carbon oxide. The released carbon is determined using the LIFO method. The released qualified carbon oxide is accounted for in the year that the taxpayer discovered the recapture event.
Section 45Q and these regulations are highly complex. Before attempting to claim the carbon sequestration credit, we highly recommend consulting with a tax professional that has the necessary subject matter expertise in this complex area.