A Brief Overview of the Inflation Reduction Act’s Clean Energy Tax Credit Provisions

The Inflation Reduction Act (IRA) signed into law on August 16, 2022 has generated explosive interest in clean and renewable energy investment in the United States. The IRA reflects the U.S.’s unequivocal expression of its ambition to become “the global leader in clean energy technology, manufacturing, and innovation.” The approximately $740 billion package, with nearly $400 billion earmarked for energy and climate projects, has prompted the European Union to put forward a Green Deal Industrial Plan to enhance the competitiveness of Europe’s clean energy industry and the United Kingdom to propose a set of energy security and climate change policies.

Treasury and the IRS have published notices seeking public comments on various clean energy tax credit provisions and issued guidance on some key aspects of those provisions. The government has also ramped up coordination with other federal agencies such as the Department of Energy and the Environmental Protection Agency to implement the law. Part I of this article gives an overview of the energy tax credit provisions in the IRA. Part II discusses guidance issued to date. Part III identifies some remaining questions and challenges.

I. Overview of the IRA’s Energy Tax Credits

The investment tax credit (ITC) was first enacted in the Energy Tax Act of 1978 as a temporary ten percent tax credit for certain energy property and equipment using energy resources other than oil or natural gas. The Energy Policy Act of 1992 passed the first production tax credit (PTC), an inflation-adjusted tax credit equal to 1.5 cents per kilowatt-hour of electricity generated using wind or closed-loop biomass systems. Over the next decades, Congress revised both the PTC and ITC and introduced new energy tax credits to support U.S. commercialization of innovative renewable energy technologies in the U.S. Key concepts such as “beginning of construction” and “placed in service,” used to determine when a taxpayer can claim a tax credit and in what amount, also evolved through IRS guidance.

The IRA similarly expanded existing energy tax credits. For example, the IRA restored the section 45 PTC and the section 48 ITC to their full pre-phaseout rates and expanded the section 48 ITC to cover standalone energy storage (including battery storage as well as hydrogen storage). There are, however, several changes that distinguish the IRA from its predecessors.

First, the IRA created a new two-tier rate structure that applies to most PTCs and ITCs, consisting of a base credit amount and an additional credit amount above the base credit for projects that meet certain labor requirements, known as the prevailing wage and apprenticeship requirements. The base credit amount is one-fifth of the full rate. For example, if an ITC-eligible solar power plant with a cost basis of $1 million satisfies all relevant section 48 requirements including the labor requirements, the plant would be eligible for an ITC equal to 30 percent of its cost basis, or $0.3 million. If, however, the solar power plant fails to meet the labor requirements, the available ITC is reduced to 6 percent of its cost basis, or $60,000. Whether an energy project satisfies the labor requirements thus has a material impact on the economics of the project.

Second, under the prevailing wage requirement, all laborers and mechanics employed by a taxpayer or its contractors or subcontractors in the construction, alteration, or repair of a project must generally be paid the same local prevailing wages paid on federal construction jobs. Under the apprenticeship requirement, taxpayers must demonstrate that a certain percentage of total labor hours of the construction, alteration, or repair work (including work performed by any contractor or subcontractor) is performed by qualified apprentices and that a certain number of apprentices are employed in such work. The Department of Labor oversees setting wage and apprenticeship standards, and many interpretive issues are tied to labor provisions in the Davis-Bacon Act of 1931 and similar state prevailing wage laws.

Third, the IRA provides three types of bonus credits that further increase the available PTC and ITC: (1) the “energy communities” bonus, (2) the “low-income communities” bonus (application only to the ITC), and (3) the domestic content bonus. Depending on the location and domestic content use of the energy project, projects placed in service after 2022 may be eligible for up to 10 percentage points (in the case of ITC-eligible projects) and 10 percent (in the case of PTC-eligible projects). For example, if the solar power plant project assumed above satisfies all relevant section 48 requirements and is placed in service in an energy community and satisfies the domestic content bonus requirement, it may be eligible for a 50 percent ITC (i.e., the 30 percent full credit plus 10 percent energy community bonus plus 10 percent domestic content bonus), or $0.5 million.

Fourth, the IRA introduced two new mechanisms to monetize energy tax credits. Renewable energy developers often have not had enough tax capacity to utilize the tax credits and depreciation deductions generated by energy projects and so have traditionally monetized those tax benefits by bringing tax equity investors with sufficient tax liability into the projects through joint ventures. These “tax equity” or “flip partnership” deals are relatively complex and consequently had a limited pool of potential investors. The IRA changed this dynamic by providing two alternatives to a tax equity structure. Under the section 6417 direct pay mechanism, certain tax-exempt and governmental entities can elect to receive cash payments from the IRS in lieu of claiming tax credits. Under the section 6418 transferability mechanism, most taxpayers other than tax-exempt and governmental entities eligible for direct pay can instead sell all or a portion of their tax credits to an unrelated party in exchange for cash. The cash is neither includible in the income of the transferor nor deductible by the transferee. The transferee cannot transfer the credit further.

II. IRS Notices and Other Guidance

An important step in understanding the IRA is figuring out how to interpret each part consistent with congressional intent and sound tax administration. For example, what does it mean for an energy project or facility be in an energy community? What is an energy community? What does it mean to transfer a credit? Who should be considered a laborer or mechanic under the prevailing wage and apprenticeship requirements? These are illustrative of questions raised by various industry groups, environmental groups, and other interested parties following the IRA enactment. Treasury and the IRS have published notices requesting comments from the public on some of these questions on a wide range of tax credit provisions.

Notice 2022-61 provides initial guidance on the prevailing wage and apprenticeship requirements. The notice clarifies that projects must “begin construction” by January 28, 2023 in order to be exempted from the prevailing wage and apprenticeship requirements, as determined under the existing begin-construction principles. In addition, the notice defines several terms by reference to existing Department of Labor regulations which may require further interpretation by the Department of Labor. The Department of Labor also issued the final rule on August 8, 2023 regarding the administration and enforcement of the Davis-Bacon labor standards, which includes several provisions relevant to satisfying the prevailing wage and apprenticeship requirements. On August 30, 2023, Treasury and the IRS released proposed regulations (REG-100908-23) providing additional guidance regarding the specific requirements to comply with the prevailing wage and apprenticeship requirements.

Notice 2023-29 provides initial guidance on the energy community bonus credit. This notice clarifies qualification criteria for each of the three categories of energy communities: (1) brownfields, (2) statistical areas, and (3) coal closure tracts. The IRS subsequently published two additional notices that modify and expand on that initial guidance. Notice 2023-45 deals with the brownfield site safe harbor for certain projects and clarifies that if a construction of a project begins on or after January 1, 2023 in a location that is an energy community as of the beginning-of-construction date, then the location will continue to be considered an energy community for that project for the duration of the credit period (if the project is PTC-eligible) or on the placed-in-service date (if the project is ITC-eligible). Notice 2023-47 provides updated information on the statistical areas and coal closure tracts categories.

Similarly, Notice 2023-38 provides initial guidance on the domestic content bonus credit. As a general matter the credit requires that all iron and steel and at least 40 percent (increasing over time to 55 percent) of the cost of all manufactured products that are components of a project upon completion of construction must be produced in the United States. The domestic content notice provides rules for complying with the minimum percentage for manufactured products and establishes a safe harbor classifying certain parts of utility-scale solar projects, onshore and offshore wind projects, and battery storage projects into steel or iron or manufactured products.

June 2023 proposed regulations (REG-101607-23) on the direct pay mechanism and proposed regulations (REG-101610-23) on the transferability mechanism provide rules related to an IRS pre-filing registration process and special rules applicable to partnerships and S corporations, among other things. Importantly, the transferability proposed regulations describe rules relating to tax credit recapture, including which party bears the risk of recapture and notice requirements associated with the recapture event and recapture amount. The transferability proposed regulations also clarify when a transfer does and does not constitute a disallowed second transfer. Temporary regulations on the pre-filing requirements (TD 9975) were also issued, and a series of FAQs have been posted on the IRS website.

The government has also published guidance relating to other IRA energy tax credit provisions, including (among other things) the final regulations (TD 9979) and Revenue Procedure 2023-27 on the program to allocate environmental justice solar and wind capacity limitation; Notices 2023-18 and 2023-44 on the section 48C advanced energy project tax credit; and Notices 2023-01, 2023-09, and 2023-16 on the section 45W and section 30D tax credits for clean vehicles.

III. Remaining Issues and Conclusion

Although the government has addressed many of the issues raised by commentators, there are more questions that need to be answered. For example, the eligibility and amount of some of the energy tax credits, such as the new section 45Z clean fuel production tax credit and the new section 45V clean hydrogen production tax credit, depend on the definition of “facility.” There is no Code definition of the term, and guidance on this point is minimal. The scope of such a definition could significantly change the economic feasibility of a project.

As an illustration, consider a taxpayer that owns and operates a clean hydrogen production plant and a transportation fuel ethanol production plant. The two plants are co-located, and the taxpayer uses hydrogen produced from the hydrogen production plant as a feedstock to produce transportation fuel ethanol. Section 45V creates a new 10-year PTC for each kilogram of qualified clean hydrogen produced. Section 45Z provides a new PTC for low-carbon fuels that increases based on the magnitude of carbon saving. Section 45Z excludes from the definition of “qualified facility” a facility where a section 45V credit is allowed. If the two plants are treated as a single facility, the taxpayer must choose either section 45Z or section 45V and cannot stack the two credits. If, however, the two plants are treated as two separate facilities, the taxpayer can potentially claim both credits, in each case assuming all applicable requirements are met. The question of what a facility is existed prior to the IRA, but the application of the existing understanding or lack thereof to new tax credits and new technologies has proven challenging. Not surprisingly, various iterations of this question have appeared on comment letters.

It remains to be seen how the new energy tax credit regime established under the IRA will take shape in the coming months and years. A recent bill passed by the Republican-majority House of Representatives proposes to repeal a range of energy credits and climate programs in the IRA, adding uncertainty to the future of the IRA energy tax credit regime. Other climate stakeholders want stricter eligibility requirements. Political pressures from both left and right, as well as competitive pressures from Europe and Asia, will likely also inform the government’s interpretative decisions.