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Treasury’s Proposed Regulations on Energy Property and the Energy Investment Tax Credit

The U.S. Treasury Department (“Treasury”) and the Internal Revenue Service (the “IRS”) issued proposed regulations on November 17, 2023, updating the definition of “energy property” and making several mechanical changes to the rules for the energy credit (i.e., the investment tax credit, or the “ITC") that could have significant implications for transaction structuring. 

Among other things, the proposed regulations would:

  • Confirm that ITCs and production tax credits under section 45 of the Code (“PTCs”) can be separately claimed for co-located ITC and PTC projects without jeopardizing the qualification for either credit;
  • Define “energy project” and establish mandatory aggregation rules for multiple energy properties—mandatory grouping would apply for purposes of determining prevailing wage and apprenticeship compliance (and the exceptions to such requirements) as well as bonus credit amounts for domestic content and energy communities;
  • Provide specific definitions for the various types of assets eligible for ITCs;
  • Permit co-located energy properties (ITC with ITC or ITC with PTC) to pro-rate costs for shared power conditioning equipment (e.g., the ITC basis can include a portion of the cost for a transformer that jointly serves a PTC project);
  • Clarify the operation of the sub 1 MWac exception from prevailing wage and apprenticeship;
  • Incorporate the IRS’s long-standing “80/20 Rule” for used property and retrofitted projects; and
  • Provide rules for determining qualified interconnection costs in accordance with new section 48(a)(8) of the Code.

Below is a more detailed summary of the key provisions in the proposed regulations as well as our initial observations. The IRS will collect comments until January 22, 2024, and will hold a public hearing on February 20, 2024. 

The proposed regulations are binding on the IRS until they are either amended or superseded by published final regulations. Although the proposed regulations do not have the force of law unless and until they are adopted as final, taxpayers may rely on certain portions of them now if applied in their entirety and in a consistent manner.

Background on the Energy Credit

  • Section 48 of the Internal Revenue Code (the “Code”) provides for an ITC calculated as a percentage of the basis of each “energy property” placed in service by a taxpayer in a taxable year. The Inflation Reduction Act of 2022 (the “IRA”) significantly modified the ITC, including by expanding the types of assets that qualify, providing for bonus tax credits for assets meeting certain criteria related to domestic content, energy communities, and low-income communities, and imposing prevailing wage and apprenticeship requirements to qualify for a full 30% tax credit rate (and the full 10 percentage points for any bonus credits), subject to exceptions for projects under 1 MWac or that began construction before January 29, 2023.
  • Regulations under section 48 have not been updated since 1987. The proposed regulations both address new concepts from the IRA and formally adopt other concepts – such as the 80/20 Rule described below – that originated from other forms of tax guidance issued over the years.

The Proposed Regulations

Definition of Energy Property

  • Scope: Clarifies that an energy property includes each “unit of energy property,” which means all functionally interdependent components of property owned by a taxpayer that are operated together and that can operate apart from other energy properties within a larger energy project.
    • “Functionally interdependent” means that the placing in service of each component is dependent upon the placing in service of each of the other components.
    • In the context of electric generation property or energy storage property, components are functionally interdependent if the placing in service of each component is dependent upon the placing in service of each of the other components in order to generate or store electricity, thermal energy or hydrogen.
    • For rooftop solar, all components of property that are installed on a single rooftop are automatically considered a single unit of energy property.
  • Integral Property: Property that is used directly in the intended function of the energy property and is essential to the completeness of the intended function is also treated as energy property.
    • This includes power conditioning equipment such as transformers, inverters and converters, as well as parts related to the functioning or protection of power conditioning equipment.
    • Roads and structures can be treated as integral under certain circumstances. Fencing is not.

Observation: Confirmation that certain structures would be treated as ITC-eligible integral property is an important point for standalone storage projects in particular, which often require special structures that are a significant cost item.

  • Property that is Not Energy Property:
    • Property for which a taxpayer claims PTCs.
    • Transmission equipment such as transmission lines and towers.
    • Power purchase agreements, goodwill, going concern value, or renewable energy certificates.

Observation: Clarification that energy property does not include property for which PTCs are allowed confirms that a project owner can claim PTCs for a solar project and ITCs for a co-located battery project, alleviating a significant area of post-IRA market uncertainty. The exclusion for intangibles such as power purchase agreements and goodwill effectively codifies market practice that had developed in the wake of Alta Wind I Owner-Lessor C, et al. v. U.S., 166 Fed. Cl. 386 (Fed. Cl. June 20, 2023).

  • Technology-specific Definitions: The regulations include specific definitions for each type of energy property that qualifies for the ITC.

Observation: Notably, the regulations clarify that “qualified biogas property” does not include upgrading equipment necessary to concentrate the gas into the appropriate mixture for injection into a pipeline through removal of other gases such as carbon dioxide, nitrogen, or oxygen. The general market assumption had been that such property would be treated as “cleaning and conditioning property” eligible for the credit. It is unclear why Treasury would make this distinction given that one of the requirements of the ITC is that the gas is captured for sale or productive use, and the gas needs to be conditioned in order to be injected into a pipeline.

  • Shared Facilities: The regulations clarify that power conditioning equipment may be shared between PTC and ITC projects owned by the same or different taxpayers, and the basis for the equipment (e.g., transformers) would be allocated between the projects/taxpayers such that the portion attributable to the ITC project would also be ITC-eligible.

Aggregation Rules for Multiple Energy Properties

  • Mandatory Aggregation: Multiple energy properties are treated as a single “energy project” under rules described below.
  • Significance: The rules for determining the ITC rate (including the increased credit amount for prevailing wage and apprenticeship (and its exceptions), energy community and domestic content qualification) are tested at the “energy project” rather than “energy property” level. Accordingly, this is a critical definition for determining the ITC rate and amount.
  • Energy Project Defined:
    • Generally, an energy project includes multiple energy properties that are operated as part of a single project.
    • However, multiple energy properties are treated as a single energy project if at any point during construction they are owned by a single taxpayer (or a related taxpayer) and any two or more of the factors below are present. The energy properties:
      • are constructed on contiguous pieces of land,
      • are described in common off-take agreements,
      • have a common intertie,
      • share a common substation or thermal energy off-take point,
      • are described in one or more common environmental or other regulatory permits,
      • are constructed pursuant to a single master construction contract, or
      • are financed pursuant to the same loan agreement.

Observation: The technical rules are similar to “single project” grouping rules from IRS Notices 2013-29 and 2018-59 that are used to determine when a project begins construction; however, the ownership test and “two or more” threshold is much more aggressive than the “facts and circumstances” application from the notices, and could potentially result in properties being grouped together even in situations where they are not technically operated as a single project or even located in the same state.

  • PTC Property Excluded: “Qualified facilities” receiving PTCs that are co-located with “energy property” receiving ITCs will not be considered part of an energy project.
  • One Megawatt Exception: The exception from prevailing wage and apprenticeship for projects with net output of less than 1 MWac is also tested at the “energy project” level. However, in cases of grouped projects, the regulations do not say how the rule should be applied (e.g., whether the output of all of the grouped properties should added together and treated as one “energy project” for the purposes of meeting the 1 MWac exception).

Observation: Given the revised standards for aggregating multiple energy properties into a single energy project, the proposed regulations appear to make it harder for a taxpayer to own multiple energy projects or energy properties with each being exempt from the prevailing wage and apprenticeship requirements under the 1 MWac exception.

  • Special Effective Date: This section of the regulations is proposed to apply to energy projects that begin construction after November 22, 2023.

Observation: The regulations are silent on how to treat energy properties that should be grouped according to the rules but include properties that begin construction both before and after the effective date. Hopefully this is a point that will be clarified if the aggregation rules are included in the final regulations.

Other Rules Relating to the Increased Credit Amount

  • Clarifications Related to Prevailing Wage and Apprenticeship:
    • Taxpayers must pay prevailing wages for alteration or repair of the project during the five-year period beginning after the date the project is placed in service.

Observation: The regulations do not mention post-placement in service apprenticeship requirements, which is consistent with a plain reading of sections 45 and 48. Nevertheless there has been lingering uncertainty in the market about whether post-placement in service apprenticeship requirements could apply.

  • The IRS will prescribe a form for annual information reporting on prevailing wages during the 5-year ITC recapture period to be filed with a taxpayer’s income tax return following each such year.
  • Measuring the 1 MWac Exception:
    • The exception for electric generating projects is determined by nameplate capacity of the maximum electrical generating output in MWs of electrical (as measured in alternating current) or thermal energy that the unit is capable of producing on a steady state basis and during continuous operation under standard conditions.
    • Nameplate capacity would also be used for energy storage technologies.
    • For hydrogen energy storage property, one megawatt of electricity output is equal to 10,500 standard cubic feet of hydrogen per hour.
    • Electrochromic glass property, fiber-optic solar, and microgrid controllers are not eligible for the 1 MWac exception.

Other Rules Applicable to Energy Property

  • The 80/20 Rule: The regulations incorporate a longstanding ITC rule that treats projects with used property as new if the fair market value of the used components is not more than 20% of the total value of the unit, taking into account the cost of the new components plus the value of the used components (the “80/20 Rule”). For energy properties that are part of an energy project, the 80/20 Rule applies on a property-by-property basis.
  • Dual use property: Property that uses energy from a qualifying source (i.e., from energy property qualifying for the ITC) and from a non-qualifying source (i.e., energy property not qualifying for the ITC) can qualify for a proportional ITC as long as its use of energy from a non-qualifying source does not exceed 50% of its total energy input during an annual measuring period beginning on the date it is placed in service. The ITC is subject to recapture in subsequent years if the ITC-qualifying input falls below 50%.

Observation: The rule for dual use property is largely adopted from prior regulations. Significantly, the prior regulations required that energy from non-qualifying sources not exceed more than 25% of the property’s total energy input for such property to qualify for the ITC.

  • Qualified Interconnection Property: The IRA allows a taxpayer to claim the ITC with respect to amounts paid or incurred for certain interconnection costs for projects with a maximum net output of 5 MWac (“Qualified Interconnection Property”). The regulations clarify that while ITC-eligible, the costs themselves are not treated as part of an energy property and are not counted for the purpose of determining bonuses to the ITC (i.e., the domestic content and the energy community bonus).

Observation: The preamble clarifies that Qualified Interconnection Property is most similar in function to transmission and distribution property, neither of which is a functionally interdependent component of an energy property, nor integral to energy property. Thus, the proposed regulations conclude that Qualified Interconnection Property itself is not energy property notwithstanding that the ITC may be claimed with respect to it. This characterization appears to foreclose an argument that work on or costs incurred for Qualified Interconnection Property would cause a project to begin construction within the meaning of IRS Notices 2018-59 for and 2022-61.

  • Other Rules: The proposed regulations also include rules (i) coordinating the ITC with other federal income tax credits, (ii) providing that only the incremental costs of energy property qualify for the ITC, and (iii) describing the ITC allocation where an energy project has multiple owners (e.g., through a tenancy in common arrangement).

Observation: These rules are largely based on prior regulatory and other guidance.