Leveraging Renewable Energy Credits to Reduce Effective Tax Rate and Increase ESG Ratings

The IRS recently issued proposed regulations dealing with the transfer of renewable energy tax credits between the developer of the credit and a qualified purchaser. Section 6418 of the Internal Revenue Code (“IRC”), which was enacted under the Inflation Reduction Act of 2022, permits transfers of the renewable energy tax credits for transactions that occur on or after January 1, 2023. 

Prior to the law change, developers had to seek tax equity funding in order to monetize energy credits, which involves complex tax equity and leasing structures that tend to be dominated by several large banks. This law change creates a major opportunity for various profitable enterprises to participate in renewable energy.

The eleven renewable energy tax credits that are eligible to be transferred are:

I.    Alternative fuel vehicle refueling property credit [IRC Sec. 30C]
II.    Renewable electricity production credit [IRC Sec. 45(a)]
III.    Carbon oxide sequestration credit [IRC Sec. 45Q(a)]
IV.    Zero-emission nuclear power production credit [IRC Sec. 45U(a)]
V.    Clean hydrogen production credit [IRC Sec. 45V(a)]
VI.    Advanced manufacturing production credit [IRC Sec.45X(a)]
VII.    Clean electricity production credit [IRC Sec. 45Y(a)]
VIII.    Clean fuel production credit [IRC Sec. 45Z(a)]
IX.    The energy credit [IRC Sec. 48]
X.    Qualified advanced energy project credit [IRC Sec. 48C]
XI.    Clean electricity investment credit [IRC Sec. 48E]

Benefits of Purchasing Renewable Energy Tax Credits

An entity that is able to utilize these credits is allowed to simply purchase them by paying cash. Thus, the party that wants the credits does not have to become an equity investor or to otherwise be bound to the project entity for a long period of time, as it was under prior rules.

To illustrate, suppose profitable corporation X purchases $10 million of credits for a purchase price of 90 cents on the dollar ($9 million total) on September 14 of 2023. Corporation X then reduces its Q3 U.S. federal estimated tax payment by the $10 million credit it purchased, effectively generating a cash savings of $1 million. Some of this $1 million in savings will be offset by transaction costs because there will still be due diligence, agreements, and possibly insurance costs. However, these costs are likely to be much lower than the costs the developer and investor would have incurred in connection with a tax equity structure. 

The advantages and benefits of the credit include:

1.  A permanent reduction to the corporation’s effective tax rate (”ETR”) and overall income tax expense (since it is directly tied to the existence of current tax liability),
2. The credit benefit is not taxable income to the corporation (the $1 million savings in the example above),
3.  Taxpayers have until the filing of the tax return (October 15, 2024, if calendar year) to enter into an agreement purchasing these credits, which allows time to determine the amount of credits to purchase in order to offset tax liabilities, and
4. Taxpayers can receive a very positive ESG rating since this can be viewed as an investment in clean renewable energy

Pitfalls and Issues

• Passive Activity Credit Rules Will Limit Who Can Participate

The proposed regulations limit the usefulness of the credit for purchasers who are subject to the IRC Sec. 469 passive activity loss rules. IRC Sec. 469 limits the use of passive losses and credits by certain taxpayers including individuals and closely held C corporations. Generally, the credit would be limited to the tax incurred from the income generated by other passive activities. Essentially, this limits the investment to entities that are not subject to the passive activity loss rules -- i.e., C corporations and individuals with enough passive activity income to utilize the credit. The passive activity loss rules for closely held C corporations are not severe as they are for individuals, and most would be able to benefit from the credit.

• Purchase Must Be Made in Cash

The regulations make it very clear that the IRS is interpreting the requirement that credits be purchased in cash very rigidly – the purchase must be made using immediately available funds, and be made in the form of cash, check, or ACH, which may limit the ability of smaller investors to purchase credits.

• Shifting Responsibilities

Under the regulations, the purchaser will effectively step into the shoes of the seller, which means the purchaser becomes responsible for any excessive credit transfers and any associated penalties. These issues can be mitigated by having a tax professional perform due diligence on the transaction.

• Beware of Prevailing Wage and Apprenticeship Requirements

Projects that begin construction after January 29, 2023, must meet prevailing wage and apprenticeship requirements to receive the full amount of the credit. These standards require renewable energy projects to pay laborers and mechanics a prevailing wage and to employ an adequate number of apprentices from registered apprenticeship programs. Projects that do not meet these standards will only be entitled to claim 20% of the full potential credit amount. The IRS provided guidance on these requirements in Notice 2022-61, which also details relief provisions for good faith exceptions and stiff penalties for intentional disregard of the rules. The IRS recently released proposed regulations regarding these requirements stating that penalties can be waived if the company cures the failure either within 30 days of discovery or before they have claimed they credit.

These rules also apply to the maintenance of the project in the future and presents a significant risk to the purchaser of the credit. Part of the transaction’s due diligence will require an examination of the compliance to these rules.

 Who Can Benefit

CFOs of profitable C corporations should look at the opportunity to purchase renewable energy tax credits very seriously. The benefits available to corporations that are able to take advantage of the credits go beyond tax savings and should not be overlooked.

It’s important to remember that these are proposed regulations, and subject to change. Taxpayers should engage a trusted tax advisor to help them navigate this fresh landscape to ensure their transactions result in the intended benefits.