- The U.S. Department of the Treasury and IRS on Nov. 17, 2023, released long-awaited proposed regulations (Proposed Regulations) regarding the investment tax credit (ITC) under Section 48 of the Internal Revenue Code.
- The Proposed Regulations offer key guidance on solar, wind and other long-standing incentivized technologies, as well as for newer qualifying technologies added to Section 48, including energy storage and qualified biogas property.
- This Holland & Knight alert provides an overview of the Proposed Regulations and how they affect those seeking the ITC.
The U.S. Department of the Treasury and IRS on Nov. 17, 2023, released long-awaited proposed regulations (Proposed Regulations) regarding the investment tax credit (ITC) under Section 48 of the Internal Revenue Code. Section 48 was originally enacted in 1962, with the current regulations published in 1981 and last updated in 1987.
The Proposed Regulations provide critical guidance on long-standing technologies incentivized under Section 48, including solar, wind, biomass and geothermal, as well as newer qualifying technologies added to Section 48 by the Inflation Reduction Act of 2022 (IRA) – among them energy storage and qualified biogas property. The Proposed Regulations also provide additional clarity on the 80/20 Rule, calculating the qualified investment for purposes of Section 48 and when property is considered placed in service. Finally, the Proposed Regulations update certain portions of the prevailing wage and apprenticeship proposed regulations that were issued in August 2023. Though the Proposed Regulations were issued under Section 48 specifically, some of the concepts and rules are instructive when considering other renewable energy tax credits.
This Holland & Knight alert provides only a summary of the Proposed Regulations and is not intended as an exhaustive description of all topics covered therein.
1. Energy Property
Section 48 provides that the ITC is available for energy property. The Proposed Regulations address what is included in energy property, providing that such term generally means a "unit of energy property." A unit of energy property means all functionally interdependent components of property owned by the taxpayer that are operated together and that can operate apart from other energy properties within a larger energy project.
The applicable tests for determining when components of property are functionally interdependent are:
The Proposed Regulations further provide that all property that is an "integral part" of the energy property is considered energy property for purposes of the ITC. Property owned by a taxpayer is an integral part of an energy property owned by the same taxpayer if it is used directly in the intended function of the energy property and is essential to the completeness of the intended function.
Multiple energy properties may include shared property that may be considered an integral part of each energy property. In such instances, if owned by taxpayer at least in part, the cost basis for the shared property should be allocated to each energy property.
Helpfully, the rules also set forth properties that are considered integral parts of energy property for purposes of determining the property included in the calculation of the ITC.
As energy property includes only tangible property, Prop. Treas. Reg. § 1.48-9(d)(2) also provides that energy property does not include power purchase agreements (PPAs), goodwill, going concern value or renewable energy certificates (RECs).
Holland & Knight Insight The categorization of "integral" is consistent with guidance issued by the IRS in the Section 1603 grant context, where Congress authorized a grant in lieu of the ITC to assist taxpayers in light of the 2008 economic downturn. Further, the view in the Proposed Regulations that energy property does not include PPAs, RECs and other intangibles should not be a surprise to taxpayers, as it is consistent with the government's long-standing position in Alta Wind I Owner-Lessor C, et al. v. U.S. (Nos. 13-402, 13-917, 13-935, 13-972, 14-47, 14-93, 14-174, 14-175, 17-997) and other similar cases. Finally, taxpayers should note that to be eligible for the ITC, the basis or cost of such property must be recovered using a method of depreciation and cannot be recovered through a deduction of the cost basis (such as under Section 179).
2. Multi-Owner Energy Property
A common question addressed by the Proposed Regulations is whether different taxpayers can own different parts of the energy property. Prop. Treas. Reg. § 1.48-14(e)(2) provides that a taxpayer that owns an energy property is eligible for the ITC only to the extent of the taxpayer's eligible basis in the energy property. In the case of multiple parties that hold ownership shares in an energy property, each party is eligible for the Section 48 credit to the extent of the party's fractional ownership interest.
Further, the proposed rules also provide that if a taxpayer owns both a unit of energy property and at least a portion of the related power conditioning and transfer equipment (or other integral parts), that taxpayer would be able to calculate the ITC on the eligible basis of the energy property, including the taxpayer's basis in the integral power conditioning and transfer equipment. However, if power conditioning and transfer equipment owned by one taxpayer is an integral part of an energy property owned by an unrelated taxpayer, the taxpayer that owns the power conditioning and transfer equipment would not be eligible for the ITC, but the taxpayer that owns the energy property would be eligible for the Section 48 credit.
Holland & Knight Insight This proposed rule is unfavorable to taxpayers with jointly owned projects, such as may be common in the case of offshore wind and landfill gas to renewable natural gas (RNG) projects. Taxpayers impacted by the rule should consider submitting comments in response to the Proposed Regulations.
3. Placed in Service
Section 48 provides that the ITC is available for energy property placed in service during the taxable year. Prop. Treas. Reg. § 1.48-9(b)(5) adopts the traditional test for determining whether energy property is placed in service by providing that such property is placed in service in the earlier of 1) the taxable year in which, under the taxpayer's depreciation practice, the period for depreciation with respect to such energy property begins or 2) the taxable year in which the energy property is placed in a condition or state of readiness and availability for a specifically assigned function, whether in a trade or business or in the production of income.
The Proposed Regulations specify that energy property in a "condition or state of readiness and availability for a specifically assigned function" includes components that are acquired and set aside for use as replacements in order to avoid operational time loss – e.g., emergency spare parts and equipment that is acquired for a specifically assigned function and is operational but is undergoing testing to eliminate any defects. By contrast, components purchased for use in construction of energy property would not be considered placed in service at acquisition.
Holland & Knight Insight The test in the Proposed Regulations aligns with existing guidance under Sections 167 and 168 and Section 48 regarding when property is treated as placed in service. Taxpayers should remain aware of the five-factor test traditionally used by courts and the IRS in determining when electricity generation and transmission property has been placed in service. Such factors are 1) whether the necessary permits and licenses for operation have been obtained, 2) whether critical preoperational testing has been completed, 3) whether the taxpayer has control of the facility, 4) whether the unit has been synchronized with the transmission grid (applicable for energy generation projects) and 5) whether daily or regular operation has begun. See, e.g., Rev. Rul. 84-85.
4. 80/20 Rule
Prop. Treas. Reg. § 1.48-14(a) provides for the continued application of the 80/20 Rule to energy property under the ITC. Under the 80/20 Rule, retrofitted energy property may be considered originally placed in service even if it contains some used components in certain instances. This rule is met if the fair market value of the used components of the unit of energy property is not more than 20 percent of the total value of the unit of energy property, taking into account the cost of the new components of property plus the value of the used components of the unit of energy property. The 80/20 Rule is applied separately to each unit of energy property that is part of an energy project.
Holland & Knight Insight The Proposed Regulations adopt the long-standing 80/20 Rule present in prior IRS guidance, including Rev. Rul. 94-31 and Notice 2018-59. The Treasury Department and IRS have requested comments on whether "second life" batteries should be considered new components for purposes of the 80/20 Rule as applied to energy storage technologies.
5. Dual Use Property
Dual use property uses energy derived from both a qualifying source (i.e., an energy property under Section 48) and from a nonqualifying source. Dual use property qualifies as energy property if its use of energy from nonqualifying sources does not exceed 50 percent of its total energy input during an annual measuring period – any lower amount and the ITC is unavailable. By contrast, if the energy used from qualifying sources is between 50 percent and 100 percent, only a proportionate amount of the eligible basis of the energy property will be taken into account in computing the amount of the ITC.
Holland & Knight Insight Prior to enactment of the IRA, qualifying sources were required to be at least at the 75 percent level; the Proposed Regulations reduce that amount to 50 percent. Given that cliff effect, taxpayers must ensure that the 50 percent cliff is satisfied. Prior to the IRA, the 75 percent cliff was largely applicable to energy storage property, and great care had be given to the charge coming from the grid versus the charge coming from solar, wind or other qualifying property to ensure that excessive charging from the grid did not disqualify energy storage property from ITC eligibility. Post-IRA, energy storage property is separately incentivized, reducing or eliminating the relevance of the 50 percent cliff to energy storage. The Treasury Department and IRS have requested comments regarding the application of the dual use property rule to microgrid controllers and other energy property.
Types of Energy Property
Prop. Treas. Reg. § 1.48-9(e) modifies or adopts preexisting definitions of energy property incentivized by Section 48 before enactment of the IRA and provides much-needed clarity on the newly incentivized energy properties added to Section 48 by the IRA.
1. Solar Energy Property
The Proposed Regulations adopt the statutory definition of solar energy property and clarify that solar energy property includes solar electric generation equipment (equipment that converts sunlight into electricity through the use of devices such as solar cells or other collectors), solar process heat equipment (equipment that uses solar energy to generate steam at high temperatures for use in industrial or commercial processes section) and equipment that uses solar energy to heat or cool a structure or provide hot water for use in a structure.
2. Electrochromic Glass Property
Electrochromic glass property is defined as property that uses electricity to change its light transmittance properties (both visible and near-infrared light) in order to heat or cool a structure. The Proposed Regulations clarify that windows, including secondary windows (also referred to as secondary glazings), that incorporate electrochromic glass are treated as electrochromic glass property. Importantly, Prop. Treas. Reg. § 1.48-9(c)(ii)(B) provides performance and quality standards that are a prerequisite to electrochromic glass being considered energy property for purposes of Section 48. Specifically, windows that incorporate electrochromic glass must be rated in accordance with the National Fenestration Rating Council (NFRC), and secondary glazing systems must be rated in accordance with the Attachments Energy Rating Council (AERC) Rating and Certification Process or subsequent revisions.
3. Geothermal Property
Consistent with prior guidance, the Proposed Regulations define geothermal property as including equipment employed to produce, distribute or use energy derived from a geothermal deposit, but only in the case of electricity generated by geothermal power up to (but not including) the electrical transmission stage. Geothermal equipment also includes production equipment, equipment necessary to bring geothermal energy from the subterranean deposit to the surface, including well-head and downhole equipment (such as screening or slotting liners, tubing, downhole pumps, and associated equipment), and production, injection, and monitoring wells required for production of the geothermal deposit, and distribution equipment, equipment that transports geothermal energy from a geothermal deposit to the site of ultimate use, equipment that transports geothermal fluids between the geothermal deposit and the power plant, and components of a building's heating and/or cooling system, such as pipes and ductwork that distribute within a building the energy derived from the geothermal deposit.
4. Qualified Fuel Cell Property
The Proposed Regulations adopt the statutory definition of qualified fuel cell property, as modified by the IRA, and provide that a fuel cell power plant is an integrated system comprising a fuel cell stack assembly or linear generator assembly and associated balance of plant components that convert a fuel into electricity using electrochemical or electromechanical means.
5. Qualified Microturbine Property
The Proposed Regulations adopt the statutory definition of qualified microturbine property.
6. Combined Heat and Power (CHP) System Property
The Proposed Regulations adopt the statutory definition of CHP system property and clarify that such property does not include property used to transport the energy source to the generating facility or to distribute energy produced by the facility.
7. Qualified Small Wind Energy Property
The Proposed Regulations adopt the statutory definition of qualified small wind energy property. Prop. Treas. Reg. § 1.48-9(c)(ii)(A) provides performance and quality standards that are a prerequisite to qualified small wind property being considered energy property for purposes of Section 48. Specifically, the American Wind Energy Association Small Wind Turbine Performance and Safety Standard 9.1-2009, or subsequent revisions (AWEA); the International Electrotechnical Commission 61400-1, 61400-2, 61400-11, 61400-12, or subsequent revisions (IEC); or the ANSI/ACP 101-1-2021, Small Wind Turbine Standard or subsequent revisions (ACP).
8. Geothermal Heat Pump Equipment
The Proposed Regulations adopt the statutory definition of geothermal heat pump equipment.
Holland & Knight Insight Taxpayers should consider providing comments to the Proposed Regulations where the rules simply adopt the statutory definition of energy property without additional clarity.
9. Waste Energy Recovery Property (WERP)
The Proposed Regulations adopt the statutory definition of WERP and provide that if any WERP is part of a system that is considered CHP property, such WERP is not treated as WERP for purposes of Section 48 unless the taxpayer elects to not treat such system as a CHP property.
Holland & Knight Insight The Proposed Regulations largely adopt the statutory definitions of energy property incentivized under Section 48 before enactment of the IRA. In light of the Proposed Regulations' adoption of the functional interdependence test and integral part test, taxpayers should carefully determine the proper basis for determining the qualified investment and, thus, the amount of the ITC.
10. Offshore Wind
Section 48(a)(5) allows for taxpayers to make an election for the ITC in lieu of the Section 45 production tax credit (PTC) to apply with respect to certain energy facilities, including wind generation facilities. The Proposed Regulations clarify that, with respect to offshore wind, all components of the offshore wind facility, up to and including the transformer and switchgear housed in the onshore substation, are energy property included in the basis of the offshore wind facility for purposes of computing the Section 48 credit.
Holland & Knight Insight The clarification provided in the Proposed Regulations is welcome clarity and aligns with the view of the Joint Committee on Taxation, which noted that "[q]ualified offshore wind facilities are qualified wind facilities … and include property owned by the taxpayer necessary to condition electricity for use on the electrical grid such as subsea cables and voltage transformers."1
11. Energy Storage
The IRA added standalone energy storage technology, which includes electrical energy storage property, thermal energy storage property and hydrogen energy storage property, to the list of property eligible for the Section 48 ITC. The Proposed Regulations provide clarity regarding the various types of energy storage property:
- Electrical energy storage property includes rechargeable electrochemical batteries of all types (such as lithium ion, vanadium flow, sodium sulfur and lead-acid), ultracapacitors, physical storage (such as pumped storage hydropower, compressed air storage and flywheels) and reversible fuel cells.
- Thermal energy storage property includes thermal ice storage systems that use electricity to run a refrigeration cycle to produce ice that is later connected to the HVAC system as an exchange medium for air-conditioning the building, heat pump systems that store thermal energy in an underground tank or borehole field to be extracted for later use for heating and/or cooling, and electric furnaces that use electricity to heat bricks to high temperatures and later use this stored energy to heat a building through the HVAC system.
- Hydrogen energy storage property must have a nameplate capacity of not less than 5 kWh of hydrogen and must store hydrogen that is solely used as energy and not for other purposes, such as for the production of end products such as fertilizer. Hydrogen energy storage property includes a hydrogen compressor and associated storage tank and an underground storage facility and associated compressors.
The IRA also incentivizes electrical and hydrogen energy storage property previously placed in service if a modification is made to the storage property to increase nameplate capacity.
Holland & Knight Insight The preamble to the Proposed Regulations notes that the examples of energy storage are not exclusive, which provides flexibility for future technological advancements. With respect to hydrogen energy storage, the Treasury Department and IRS note that the type of hydrogen storage medium (for example, physical-based or material-based) is not limited to specified types. The Treasury Department and IRS have requested comments on alternative approaches to assessing limitations on the use of hydrogen energy storage property, including whether additional clarification is needed regarding the production of energy from hydrogen, and what type of documentation would be needed to demonstrate that a hydrogen energy storage property was used to store hydrogen solely used for the production of energy.
12. Qualified Biogas Property
The IRA added qualified biogas property to the list of property eligible for a Section 48 ITC. The Proposed Regulations adopt the statutory definition of qualified biogas property, which provides that such property also "includes any property that is part of such system that cleans or conditions such gas." However, the Proposed Regulations take the position that gas-upgrading equipment is not included in the definition of qualified biogas property. A waste feedstock collection system, landfill gas collection system, mixing or pumping equipment, and an anaerobic digester are examples of qualified biogas property under the proposed rules.
Holland & Knight Insight Notably, Section 48(c)(7) provides that property "which cleans or conditions" gas is includible in the definition of qualified biogas property and does not place any restrictions on the cleaning and conditioning property. The proposed position with regard to upgrading equipment is inconsistent in its position with regard to similar equipment for other ITC-eligible technologies. (For more information on the impact of the Proposed Regulations to renewable natural gas projects, see Holland & Knight's previous alert, "Section 48 Proposed Regulations Detail Treatment of Qualified Biogas Property," Nov. 20, 2023.)
13. Microgrid Controllers
The Proposed Regulations adopt the statutory definition of a microgrid controller and clarify that while a microgrid controller must operate as part of a qualified microgrid, such qualified microgrid includes an electrical system that is capable of operating in connection with the larger electrical grid, regardless of whether a connection to the larger electrical grid exists.
14. Interconnection Property
The IRA amended Section 48 to provide that amounts paid or incurred by the taxpayer for qualified interconnection property in connection with the installation of energy property that has a maximum net output of not greater than 5 megawatts (MW) (as measured in alternating current) is eligible for the ITC. The 5 MW limitation is measured at the level of the energy property and is measured by nameplate generating capacity of the unit of energy property at the time the energy property is placed in service.
Prevailing Wage and Apprenticeship Rules
The Proposed Regulations also withdraw earlier proposed regulations specific to the prevailing wage and apprenticeship (PWA) requirements and repropose such rules as they relate to Section 48. Although the reproposed regulations provide additional clarity, they are not intended to be a significant deviation. In particular, the Proposed Regulations repropose regulations to clarify the statutory exception for smaller energy projects with a maximum output of less than 1 MW (under which such projects are deemed to have met PWA requirements (One-Megawatt Exception)) and the recapture rules under Section 48(a)(10)(C) relating to the PWA requirements. Finally, the Proposed Regulations provide a definition of energy projects for purposes of application of the PWA requirements.
The Proposed Regulations make clear that during the five-year recapture period, the failure to meet prevailing wage requirements may subject taxpayers to recapture of the increased credit amount, with an annual recapture ramp-down of 20 percent of the recapture amount. Taxpayers, however, can still utilize the correction and penalty procedures to avoid recapture. For this purpose, the five years begin when the energy property is placed in service and is measured in 365-day year increments (366 days in case of leap year), regardless of when taxpayer's taxable year is measured. The Proposed Regulations state that taxpayers will be required to verify compliance annually to the IRS during the recapture period.
Holland & Knight Insight Taxpayers must ensure that project operation and maintenance (O&M) agreements provide for the necessary recordkeeping to enable taxpayers to meet the yearly verification requirements during the ITC recapture period.
2. Treatment of Energy Property as a Single Project
The Proposed Regulations establish that the definition of an energy project is for purposes of the PWA requirements. Specifically, under the Proposed Regulations, "energy project" means one or more energy properties that are operated as a single project. Multiple energy properties would be considered one energy project if at any point during construction they are owned by a single taxpayer (or related taxpayers) and two or more of seven factors announced are present, e.g., the energy properties are constructed on contiguous pieces of land.2 Taxpayers must be consistent in the treatment of multiple energy properties as a single project for purposes of the PWA requirements, the domestic content bonus credit amount and the energy communities bonus credit amount.
Holland & Knight Insight The factors provided in the proposed regulations for determining where energy properties may be considered a single energy project are those presented in prior IRS "begin construction" guidance, such as Notice 2018-59. The inclusive definition of "energy project" requires careful consideration, particularly as it impacts the One-Megawatt Exception or the date on which construction is considered as begun for all energy properties that are part of a single energy project.
3. One-Megawatt Exception
Section 48 provides an exception to the PWA requirements for projects that are under 1 MW of electricity. The Proposed Regulations note that the previous PWA requirement regulations did not address how to determine the maximum net output of a project. The Proposed Regulations state that for energy projects that generate electricity, the project's nameplate capacity can be used. However, the Proposed Regulations state that for those energy projects that do not produce electricity, the One-Megawatt Exception is unavailable, which would impact electrochromic glass property, fiber-optic solar property and microgrid controllers.
Holland & Knight Insight Though the Proposed Regulations offer much needed clarity on certain aspects of Section 48, ambiguities remain. Taxpayers are encouraged to submit comments in response to the Proposed Regulations prior to Jan. 22, 2024, for both areas in which the Treasury Department and IRS requested comments and for any other areas of interest.