On February 19, 2020, the IRS published two guidance documents (links here and here) of significant legal and commercial importance to the nascent market for carbon capture and sequestration production tax credits set forth in Section 45Q of the Internal Revenue Code. Although there are certain differences, the guidance bears striking similarity to existing guidance relied upon by participants in the existing wind production tax credit (Wind PTC) tax equity market. Because of the highly developed state of the Wind PTC market, the similarities make it likely that existing Wind PTC deal structures could be adapted for the 45Q tax credits, thereby improving market adoption and transactional efficiencies. On the other hand, technical and economic differences exist between wind generation and carbon sequestration that need to be overcome in order for a robust 45Q tax credit market to develop. While we are continuing to review and consider this new guidance, we have some preliminary observations as to its practical implications on potential 45Q tax credit transactions.
Similarities between 45Q Credits and Wind PTCs
There are significant similarities between the 45Q and Wind PTC regimes. Both provide for tax credits measured by production (in the case of Wind) or capture (in the case of carbon oxide). The new guidance fleshes out the 45Q regime in a manner very similar to the existing Wind PTC regime. It contemplates an investor-developer partnership-flip model common in Wind PTC markets, with (a) cash sharing that can change over time and (b) tax items being allocated separately from cash distributions until an internal rate of return is reached, after which the tax equity investor retains a minimum of five percent of tax items and cash. The guidance may also permit sale-leaseback and inverted lease structures. Because these structures have been extensively negotiated and documented in the Wind PTC market, they could be adapted to use in 45Q tax credit transactions.
The guidance also clarifies 45Q's requirement that qualifying projects begin construction prior to 2024, establishing safe harbor rules analogous to those in the Wind PTC markets: a physical work test and five percent safe harbor test. Tax equity investors' familiarity with these concepts, together with diligence norms surrounding their documentation in the Wind PTC market, also pose a likely opportunity for increased transactional efficiencies in the 45Q space.
Also of note is the guidance's clarification that 45Q project companies do not need to own carbon disposal sites, avoiding a potential source of liability that could dampen tax equity investors' interest in investing. This is analogous to project companies that own wind generation facilities, whose assets only need to extend to the point of interconnection.
Other Opportunities, Challenges and Uncertainties
Perhaps the biggest structural difference between Wind PTC guidance and the new 45Q guidance concerns pay-as-you-go (PAYGO) contributions. Up to fifty percent of 45Q contributions may be contingent and deferred, compared to only twenty five percent in Wind PTC transactions. This higher limit offers investors greater flexibility compared to Wind PTC markets, and could create a long-term income stream that could be used to support debt financing or the cost of operating and maintaining the project.
Significant challenges remain in the development of 45Q markets. Carbon capture facilities are very expensive to construct and operate, and the market for carbon oxide is at a fledgling stage. It remains to be seen whether the 45Q regime will spur sufficient investment to result in technological improvements of comparable magnitude to those in the wind generation industry. In addition, although captured carbon oxide does have some proven uses for enhanced oil recovery, building materials and fuel production, at present those uses would provide a limited stream of operating income. (A carbon tax, if implemented, would be expected to increase demand for carbon capture and sequestration, thereby increasing 45Q projects' income.) Accordingly, at present, carbon capture facilities are significantly more dependent upon tax credits' ability to offset capital costs.
A related issue for potential 45Q tax equity investors is that such a relatively small income stream, combined with large up front capital costs, is likely to result in a large negative capital account and deficit restoration obligation and a very long period to reverse that negative capital account. The potential for large deficit restoration obligations is a limiting factor even in the Wind PTC market despite its higher potential for generating income from operations.
A final point of uncertainty is that the guidance has not clarified how to measure 45Q recapture, and what the consequences of various levels of, or time frames for, recapture might be. We are hopeful, but not certain, that the IRS will provide further guidance with respect to this topic.
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