On June 14, 2023, the IRS released proposed regulations within Section 6418 Transfer of Certain Credits concerning the election under the Inflation Reduction Act of 2022 (IRA) to transfer certain energy tax credits. The industry has eagerly awaited these proposed regulations as the original statute left a number of critical unanswered questions that made the much-hyped "marketplace" for tax credits difficult to implement. Some of these questions have now been answered. Below are some of our observations as to what the future may entail if the regulations are finalized to match the proposed form.
- Tax Insurance Will Be a Staple of the Market Place
The IRA has provided a boon for the tax insurance industry as it quickly became one of the key drivers of policies. For the uninitiated, the general goal of tax insurance is to provide liquidity to a taxpayer in the event of an adverse tax result, including defense costs. In the context of the tax credits, tax insurance has already been widely adopted by the industry to cover the risk of tax credit recapture under Section 50(a) of the Code, and it is not unusual for insurance to cover the tax consequences arising from a tax equity financing a transaction from soup to nuts.
The proposed regulations made clear what many assumed would be the case – the risk of tax credit recapture is expressly borne by the purchaser of tax credits, and the parties are free to contract for the seller of tax credits to indemnify the purchaser against this risk. We expect a market will quickly coalesce to provide a synthetic indemnity for this recapture risk and pricing for tax credits will build in the cost of obtaining this buy-side tax insurance policy, which would include premiums, underwriting fees, and brokerage fees.
- Passive Activity Limitations Will Eliminate the Retail Investor from the Marketplace
Historically, there have been a number of barriers that have drastically limited taxpayers' ability to monetize energy tax credits. Due to the historical lack of transferability, tax equity financing has been the principal way of monetizing tax credits. A number of hurdles must be overcome before tax equity financing is viable for an investor, including cost barriers to create the prerequisite tax structures, the lack of a marketplace from which investment opportunities can be found, and the uncertainty of credit recapture risk. Even if those hurdles can be overcome, however, the passive activity and at-risk limitations all but eliminate the ability of most taxpayers to utilize tax credits not directly generated by them. Consequently, the marketplace was effectively limited to large financial institutions who are not limited by those rules.
The proposed regulations provide that transferred credits are subject to the passive activity limitation rules of Section 469, requiring the transferee taxpayer to treat the credits received as passive activity credits, as defined in Section 469(d)(2) to the extent the specified credit portion exceeds passive tax liability.
In short, we see some barriers to expanding the marketplace have been lifted by the transferability rules – namely eliminating the need for expensive tax equity financing (in some scenarios) and tax insurance likely filling the gap in risk – but the scope of taxpayers who may be able to actually use these credits may remain limited.
- Pass-Through Rules Provide for Syndication Opportunities
While the IRA made clear tax credits cannot be transferred twice, the proposed regulations have offered an alternative means of syndicating tax credits via the pass-through rules. Specifically, one can form a tax partnership – or S-Corporation – consisting of a number of persons seeking tax credits, who can theoretically gain economies of scale by joining a partnership designed to utilize such tax credits. The allocation of tax credits amongst partners in a partnership is not considered a second transfer of the tax credit.
- Room for Brokers: But Don't Touch!
The proposed regulations make clear that a broker may help facilitate a tax credit transaction, but the proposed regulations make explicit that a broker cannot at any point become the owner – for tax purposes – of the credits.
- There Will Be No Marketplace for Stand-Alone "Bonus Credits"
There had been some chatter about the possibility of simply selling the bonus portion of one's tax credit – the domestic content or energy community adders that provide for an additional 10% tax credit rate provided certain prevailing wage and apprenticeship standards are met. As these bonus rates come with a higher degree of risk than the base credit, this could have created a marketplace where the base credit sells at a lower discount to the Dollar than the bonus credit. The proposed regulations close the door on that opportunity, as tax credits must be divided pro-rata across the tax credit – applying the maximum rate.
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