Direct Payment of Credits
Topic 1: Mechanics of Direct Pay for Tax-Exempt Entities
Q1: Who is eligible for direct pay? What is an "applicable entity"?
Applicable entities are eligible for direct payment of tax credits. "Applicable entities" include tax-exempt organizations, states, political subdivisions such as local governments, Indian tribal governments, Alaska Native Corporations (ANCs), the Tennessee Valley Authority (TVA), rural electric cooperatives and U.S. territories. Agencies and instrumentalities of state, local, tribal and U.S. territorial governments also are applicable entities.
Q2: How does an applicable entity obtain direct payment of credits?
In order to obtain a credit, the proposed regulations require applicable entities to file a tax return. For tax-exempt entities, there has been some uncertainty surrounding what tax return to file, particularly for entities (such as state, local and tribal governments) that do not normally file tax returns.
In the proposed regulations, the Treasury Department and IRS clarify that tax-exempt entities must claim credits by filing Form 990-T (Exempt Organization Business Income Tax Return). This form is familiar to charities and other organizations exempt from tax under Section 501(a) that have unrelated business income. However, other tax-exempt entities such as state, local and tribal governments typically would not file Form 990-T. Nevertheless, such entities must file a 990-T in order to obtain direct payment of credits.
Applicable entities must also file any form required to claim the relevant tax credit (source credit forms), a completed Form 3800 (General Business Credit) and any additional information required in the instructions to the forms.
Q3: When is the tax return filed? Is there a deadline to claim direct payment of tax credits?
An elective payment election must be made on an original, timely filed return (including extensions). This means the deadline is the due date (including extensions of time) for the tax return for the taxable year for which the election is made. For most tax-exempt and government entities, including Indian tribal governments, this is generally 4.5 months (for example, May 15 for a calendar year taxpayer) (or up to 10.5 months with extensions) after the end of the entity's tax year. No election is permitted to be made on an amended return, and no administrative relief will be granted for credits claimed on late-filed returns.
For applicable entities without an annual filing requirement (including state, local and tribal governments), the proposed regulations provide for an automatic six-month extension. This means that the 990-T for these entities would not be due until 10.5 months after the end of the entity's tax year.
Q4: How is an applicable entity's tax year determined?
For tax-exempt entities filing Form 990-T, the return must be filed using the organization's established accounting period. If the organization does not have an established accounting period, the return should be filed on a calendar-year basis.
Q5: Is there a registration requirement for a taxpayer to receive direct payment of credits?
Yes. An applicable entity or electing taxpayer (defined below) must satisfy the pre-filing registration requirements in order to receive the direct payment of tax credits. The pre-filing must be completed online through an IRS electronic portal that is under development.
The applicable entity or electing taxpayer must list all applicable credits it intends to claim and each applicable credit property that contributed to the determination of such credits as part of the pre-filing submission (or amended submission).
Q6: When is a new registration required?
Each applicable credit property must have its own registration number. A registration number is only valid with respect to the applicable entity or electing taxpayer that obtained the registration number, and such number is only valid for the taxable year in which it was obtained. If an elective payment election will be made with respect to an applicable credit property for a taxable year after a registration number has been obtained, the applicable entity or electing taxpayer must renew the registration for the subsequent year.
An applicable entity or electing taxpayer must amend a previously submitted registration information if a change occurs before the registration number is used, even if such number has already been obtained.
Q7: Does the receipt of the registration number mean the IRS has deemed the taxpayer eligible for the credit?
No. An applicable entity or electing taxpayer must include the registration number of the applicable credit property on their annual tax return for the taxable year. The preamble to the proposed regulations cautions that the completion of the pre-filing registration requirements and receipt of a registration number does not, by itself, mean the applicable entity or electing taxpayer is eligible to receive a payment with respect to the applicable credits determined with respect to the applicable credit property. The review process to be employed by the IRS prior to issuing a registration number is unclear.
Topic 2: Direct Payment of Section 45V, Section 45Q and Section 45X Credits
Q1: Can taxpayers other than an applicable entity elect to receive direct payment?
Yes, any non-applicable entity (e.g., a taxable entity, including a corporation) can elect direct payment of the credits under Section 45V (clean hydrogen), 45Q (carbon capture sequestration) or 45X (advanced manufacturing). Such a taxpayer is referred to as an "electing taxpayer."
Q2: How can an electing taxpayer receive direct payment of a credit under Sections 45V (clean hydrogen), 45Q (carbon capture sequestration) or 45X (advanced manufacturing)?
An electing taxpayer must complete the pre-filing registration process discussed above. If an electing taxpayer makes a direct payment election, the electing taxpayer is treated as an "applicable entity" for purposes of making a direct payment election but only with respect to the applicable credit property that is the subject of the election.
Q3: Can an electing taxpayer elect to take a Section 48 investment tax credit (ITC) in lieu of the Section 45V clean hydrogen production tax credit (PTC) elect direct payment?
No. An electing taxpayer who elects to treat qualified property that is part of a specified clean hydrogen production facility as energy property for purposes of the Section 48 ITC cannot make a direct payment election with respect to such facility.
Q4: How is the election for direct payment made?
An election must be made separately for each applicable credit property. For Section 45V, the applicable credit property is a qualified clean hydrogen production facility. For Section 45Q, the applicable credit property is a single-process train placed in service at a qualified facility. For Section 45X, the applicable credit property is a facility in which eligible components are produced. Only one election may be made with respect to any specific applicable credit property.
Q5: For how long is the election effective?
The direct payment election applies for the taxable year in which the election is made and each of the four subsequent taxable years that end before Jan. 1, 2033.
However, an electing taxpayer may revoke the elective payment election with respect to an applicable credit property. The revocation applies to the taxable year in which the revocation is made and each subsequent taxable year. Once revoked, an election cannot be reinstated.
Q6: Can an electing taxpayer also transfer the credit under Section 6418?
No. An electing taxpayer cannot make a transfer election under Section 6418 with respect to any applicable credit for which a direct payment election was made.
However, if the election for direct payment is revoked, any credit determined with respect to applicable credit property can be transferred pursuant to a transfer election under Section 6418, as long as the taxpayer meets the requirements of Section 6418 and the regulations thereunder.
Q7: Can partnerships and S corporations elect direct payment of credits under Section 6417?
Yes. However, partnerships and S corps can only elect direct payment with respect to Sections 45V, 45Q and 45X.
Because the election for direct payment is made at the entity level, a partnership with partners who themselves are applicable entities (e.g., a tax-exempt entity partner) is not considered an applicable entity and is unable to elect direct payment. Therefore, partnerships and S corporations are only permitted to make an election like any other "non-applicable entity" (i.e., only for Sections 45V, 45Q and 45X).
Q8: How are direct payments made to partnerships and S corporations allocated to partners and shareholders?
The IRS will make a payment to a partnership or S corporation equal to the amount of such credit. As with any refund request, the IRS may undertake an audit before making a direct payment.
Before determining any partner's distributive share (or shareholder's pro rata share) of a credit, the credit is reduced to zero. The amount of direct payment is treated as tax-exempt income for purposes of Sections 705 and 1366. A partner's distributive share of the tax-exempt income is equal to such partner's distributive share of the otherwise applicable credit for each taxable year as determined under Treas. Reg. §1.704-1(b)(4)(ii).
Further, the proposed regulations clarify that a partnership cannot make a partial 6417 election (for tax-exempt partners) and a 6418 election (for its taxable partners).
Transferability of Credits
Topic 1: Mechanics of Credit Transferability
Q1: Are "direct pay" and "credit transferability" the same?
No. Direct pay and credit transferability are mutually exclusive. For most of the credits, direct pay is available only to "applicable entities" or electing taxpayers, as discussed above. Other taxpayers can utilize the transferability provisions to monetize certain tax credits that are identified below.
Q2: What credits are eligible for transferability?
Eligible credits include: Section 45 (PTC), Section 48 (ITC), Section 45Q (carbon oxide sequestration), Section 30C (alternative fuel vehicle refueling), Section 45U (zero-emission nuclear), Section 45V (clean hydrogen), Section 45X (advanced manufacturing), Section 45Z (clean fuels), Section 48C (qualifying advanced energy project), Section 45Y (technology neutral PTC) and Section 48E (technology neutral ITC).
Q3: Can "bonus credits" for satisfying domestic content, energy community or low-income community rules be transferred?
Yes, but only if transferred with the underlying credit to which the bonus credits attach.
Q4: Can a credit be transferred more than once?
No. A credit can only be transferred one time. The use of a broker to facilitate a credit transfer would not be considered a transfer itself. However, a dealer who purchases the credit to sell to a subsequent seller would be subject to the "no additional transfer" rule.
Q5: Can credits be transferred for consideration other than cash?
No. Only cash and cash equivalents such as cashier's check, money order, wire transfer, ACH transfers or other bank transfers of immediately available funds are eligible for consideration.
Q6: What is the earliest and latest time that consideration for a credit can be paid?
Cash consideration must be paid no earlier than the first day of the transferor's taxable year in which the credit is generated and no later than the due date for the tax return (including extensions) that includes the transfer statement election. Project developers that need funding in advance of such time period may be able to obtain a loan from a transferee, but should give careful consideration of how best to effect that loan so that the loan is not deemed consideration for the tax credit outside of the time period provided in the proposed regulations.
Q7: What is a transfer statement?
A transfer statement generally includes the following: name, address and taxpayer identification number for both the transferor and transferee, a description of the type and amount of the eligible tax credit transferred, the timing and amount of cash paid for the eligible tax credit transferred, and the registration number of the project. The statement must be signed under penalties of perjury by both the transferor and transferee.
A separate transfer statement must be completed for each year in the case of multiyear transfers. A transfer statement must accompany the claim for credit.
Q8: For federal income tax purposes, is the payment includible in income by the payee or deductible by the payer?
No. The difference between the amount paid by a transferee for credits and the amount of taxes reduced by use of such transferred credits is not includible in income. The IRS has warned that it will consider whether taxpayers are treating amounts as paid for tax credits when they are in substance paid for other goods or services.
Q9: How do I register my project for transfers?
As with direct pay, credit transfers must be registered with the IRS. The IRS will establish a portal on which taxpayers will be able to electronically pre-file for registration of projects eligible for credit transferability. Although the details of the process will not be available until later this year, the required information will include details about the taxpayer (including name, address, EIN and type of entity), information to be specified by the portal instructions to enable verification that the entity is a taxpayer eligible to transfer credits, the taxpayer's taxable year, the type of tax returns normally filed, the intended eligible credits, the eligible credit project, its physical location (address and longitude and latitude coordinates), beginning of construction and placed-in-service dates, and a contact person.
Upon completing this process, the IRS will provide a registration number for each eligible credit property. It will be important to complete this pre-filing process in sufficient time to have a valid registration number to include upon the filing of the tax return claiming the credit or, if earlier, upon completion of the transfer statement.
It is currently unclear how long the registration process will take, the extent to which there may be a back-and-forth with the IRS if it desires more information, in what circumstances the IRS will decline to provide a registration number and what would be the appeal process for any such denial. Projects that are not preregistered are ineligible for credit transfers, so the timing of such process is critical.
Q10: Can registrations of credits be renewed or amended?
Registrations must be renewed each year that the credits are transferred. For example, to transfer the Section 45 PTC, the transferor must register the credit generated in each year that the transferor wishes to transfer the credit.
If facts regarding a certain registration change, the taxpayer must update the registration. The registration is made under penalties of perjury.
Q11: Are partial transfers of credits permissible?
Yes. Eligible taxpayers may transfer all or a portion of an eligible credit generated from a single eligible credit property. Transferors may also sell an eligible credit generated from a single eligible credit property to multiple unrelated parties in the same tax year. The same registration number can be used for all transferees of an eligible tax credit generated by the same eligible credit property, but separate registration numbers must be obtained for separate facilities.
Q12: Is the transferee entitled to depreciation on the property to which it has purchased credits?
Only the tax owner of the property is entitled to claim depreciation. Taxpayers seeking to monetize depreciation may consider traditional tax equity structures such as the partnership flip or sale-leaseback. The tax owner must reduce tax basis by 50 percent of the claimed credit amount with respect to any investment tax credit.
Topic 2: Risk-Bearing of Transferred Credits
Q1: Who bears the risk of excessive credit transfers or recapture?
In situations in which there has been a transfer of tax credits greater than what was available for transfer (defined as an "excessive credit transfer") or when there is recapture of the tax credit in a year after the transfer and use of the credit by the transferee, the risk of loss is on the party benefiting from the use of the tax credit, which is the transferee. The transferee may (and likely will) have a contractual indemnification from the transferee that will need to be carefully negotiated and may include tax credit insurance.
Q2: What happens if a transferred tax credit is later disallowed or recaptured?
The transferee of the tax credit is the party that must repay the amount of the disallowed tax credit as tax to the government for which payment is owed. In situations in which the transferor retains a portion of the credit for its own use – if there is a later year adjustment in the allowable credits – the adjustment is first applied to the transferor. Only after the adjustment is applied to the transferor is an excess treated as an excessive credit transfer with respect to the transferee.
The same applies in a recapture situation. If a tax credit is later found to be wholly or partially subject to recapture, the transferee is the party that must repay the amount of the recaptured credit to the government. The transferor is required to notify the transferee if a recapture event occurs.
Q3: What if a credit is transferred to multiple transferees and credit disallowance or recapture occurs?
If it is later determined that some or all of the credits transferred are excessive credit transfers, the regulations provide that the amount of the excessive credit transfer is prorated among the various transferees. Each transferee is liable to the government in an amount equal to the total excessive credit transferred multiplied by the transferee taxpayer's portion of the total specified credit portions transferred to all transferees.
Q4: Are transferees subject to penalties for excessive credit transfers?
There is a 20 percent penalty for transferees for excessive credit transfers, subject to an exception for reasonable cause, thus necessitating requisite due diligence prior to agreeing to a purchase. Since recapture is a condition subsequent, not an excessive credit at inception, it is not subject to the penalty.
The regulations provide reasonable cause relief provisions for the excessive credit transfer liability of a transferee in which all relevant facts and circumstances will be evaluated in determining reasonable cause. The most important factor is the extent of the transferee taxpayer's efforts to determine that the amount of specified credit portion transferred by the eligible taxpayer to the transferee taxpayer is not more than the amount of the eligible credit determined with respect to the eligible credit property for the taxable year in which the eligible credit was determined and has not been transferred to any other taxpayer. Extensive due diligence by the transferee – along with reliance on credible third-party advisors and experts – are cited as facts and circumstance justifying a reasonable cause finding.
Q5: Are transferors liable for excessive credit transfers?
The transferor of an excessive credit transfer is not subject to liability to the government. Because the transferee is the party liable, it is expected that the transferee will seek contractual protection from the transferor, which results in the transferor being indirectly liable.
This risk shifting likely will make the negotiation and documentation of tax credit transfers more involved than if the transferor remained liable to the government. Further, as part of that risk shifting, there will likely be certain due diligence protocols adopted by prospective transferees of tax credits in the hope of demonstrating reasonable cause relief if an excessive credit transfer is determined to apply later.
Topic 3: Special Rules for Pass-Through Entities
Q1: Do the "at risk" rules apply for purposes of credit transfers?
Section 49 provides certain "at risk" rules that reduce the amount of transferable ITC credits by the nonqualified nonrecourse financing with respect to the credit base (i.e., the tax basis for which the ITC would otherwise be available). Under the proposed regulations, where a partnership or S corporation that elects to transfer an eligible credit (a "transferor partnership" or "transferor S corporation"), the Section 49 at-risk rules are taken into account at the partner or shareholder level as of the close of the taxable year in which the investment credit property is placed in service. Thus, if the credit base of the investment credit property is limited to a partner or shareholder by Section 49, then the amount of the eligible credit determined by the transferor partnership or transferor S corporation is also limited.
A transferor partnership or transferor S corporation that transfers any portion of an ITC with respect to an investment credit property must request from each of its partners or shareholders, respectively, that is subject to Section 49, the amount of such partner's or shareholder's nonqualified nonrecourse financing with respect to the investment credit property as of the close of the taxable year in which the property is placed in service.
Q2: How does a change in nonqualified nonrecourse financing affect transferor partnerships and S corporations?
For purposes of the recapture rules, any net increase in the amount of nonqualified nonrecourse financing during the recapture period for a partner or shareholder in a transferor partnership or transferor S corporation would not result in recapture to a transferee taxpayer. The recapture rules for increases in nonqualified nonrecourse financing amount for partners or shareholders in a transferor partnership or transferor S corporation apply to at the partner or shareholder level.
Net decreases in the amount of nonqualified nonrecourse financing during the recapture period do not result, however, in additional eligible credits that can be transferred by the applicable partner, but can result in additional ITC that can be used by the applicable partner or shareholder.
Q3: Can a partnership that owns a disregarded entity transfer credits belonging to such entity?
Eligible credit property can be owned by an entity disregarded as separate from the transferor partnership or transferor S corporation for federal income tax purposes and transferred under the mechanics of Section 6418.
Q4: How is consideration from credit transfer treated with respect to partners and shareholders?
Any tax-exempt income resulting from the transfer of a specified credit by a transferor partnership or transferor S corporation is treated as investment income and not passive "trade or business" income for purposes of the passive loss limitation rules under Section 469. As a result, such tax-exempt income is not treated as passive income to any partners or shareholders who do not "materially participate" in the partnership's trade or business.
Q5: Are the recapture rules for transferors different for partnerships and S corporations?
Existing regulations provide that if a partner's interest in the general profits of a partnership is reduced as a result of certain events during the recapture period by a certain percentage of the partner's interest in general profits for the taxable year of the partnership in which the investment credit property is placed in service, recapture can occur to such partner. A similar provision applies to S corporation shareholders.
While the proposed regulations provide that a transferee taxpayer bears the recapture tax associated with any transferred eligible investment tax credits, the recapture events resulting from "indirect" partner dispositions do not result in recapture tax liability to a transferee taxpayer but instead result in recapture tax liability to the disposing partner. Any recapture to a disposing partner is calculated based on the partner's share of the basis of the property to which the eligible credits were determined.
Q6: How is consideration from the transfer of credits allocated among partners in a transferor partnership?
Amounts received as consideration for a transfer of eligible credits by a transferor partnership are treated as tax-exempt income for purposes of Section 705. Each partner's distributive share of tax-exempt income is based on the partner's distributive share of the otherwise eligible credit for each taxable year. The proposed regulations confirm that the tax-exempt income resulting from the transfer of credits should be allocated to the same partners and in the same proportionate amount, as the specified credit would have been allocated if not transferred.
The regulations provide partnerships with the flexibility to enable each partner to determine whether to sell any of the credits otherwise allocable to the partner, and if so, how much. If less than all eligible credit(s) with respect to an eligible credit property held by a transferor partnership are transferred, the proposed regulations permit the tax-exempt income to be allocated to those partners that desired to transfer their distributive share of the underlying credits. To take advantage of this provision, the transferor partnership first determines each partner's "eligible credit amount," which is its distributive share of the otherwise eligible credits determined with respect to the eligible credit property. The transferor partnership may then determine the portion of each partner's eligible credit amount to be transferred and the portion of each partner's eligible credit amount to be retained and allocated to such partner.
Q7: How is consideration from the transfer of credits allocated where a partner in a transferor partnership is itself a partnership?
The proposed regulations clarify that upper-tier partnerships (i.e., partnerships that are direct or indirect partners of transferor partnerships) are not eligible taxpayers with respect to credits allocated by an underlying transferor partnership. Any tax-exempt income allocated to an upper-tier partnership as a result of the transfer of a credit by a transferor partnership is to be allocated among its partners as of the same time – and in the same proportionate amount – as the eligible credit would have been allocated if not transferred by the transferor partnership.
Q8: How are payments made for the transfer of credits allocated among partners in a transferee partnership?
Corresponding to the provisions for transferor partnerships, cash payments by transferee partnerships for credits are treated as Section 705(a)(2)(B) expenditures. Each partner's distributive share of any acquired credits is based on such partner's distributive share of the Section 705(a)(2)(B) expenditures used to fund the purchase of such acquired credits. Any allocations of credits by transferee partnerships do not violate the "no-additional-transfer rules" under Section 6418.
Upper-tier partnerships that are direct or indirect partners in transferee partnerships would determine each partner's distributive share of the transferred credit in accordance with the same rules the transferee partnership determines its partners' distributive shares of the transferred credit.
Looking Ahead
Q1: What can I do if I have comments or questions regarding these proposed and temporary regulations?
Many taxpayers may have comments or questions about particular aspects of this guidance. Taxpayers can submit written comments to the Treasury Department and IRS until Aug. 14, 2023, and may testify at a hearing on this guidance that is scheduled for Aug. 21, 2023. Such comments and testimony may impact what is included in final regulations, in the registration portal or in other guidance.
Q2: Given that these are proposed and temporary regulations, are taxpayers engaging in direct pay and transferability?
Yes. Although the guidance does not answer all of the questions that taxpayers need to have answered and some uncertainties remain, the guidance does address a large number of important questions. The transferability market is now very active, and companies eligible for direct pay and transferability are actively working to determine their preferred monetization mechanisms.