These proposed regulations are the final missing piece of section 45Q guidance. While they do not adopt some of the more taxpayer-friendly proposals (e.g., a safe harbor against credit recapture for compliant injection operations and the use of standards set by states regarding secure geological storage), they do provide a reasonably balanced approach that accommodates the need for certainty potential investors in this space have been looking for. Accordingly, we expect to see an uptick in the financing and construction of the large-scale carbon capture projects that section 45Q is intended to encourage. As proposed regulations, these rules are subject to further notice and comment and may be revised before being issued in final form. However, the proposed regulations provide that taxpayers may rely on them in their current form for tax years beginning on or after February 9, 2018 provided the rules are applied consistently and in their entirety.

Background

Section 45Q of the Internal Revenue Code provides a tax credit for “qualified carbon oxide” captured using new equipment and disposed of in secure geological storage (including use as an injectant in enhanced oil or gas recovery). While a version of this credit has existed since 2008, Congress expanded the credit in 2018 to make it more attractive to investors, but uncertainty as to its implementation has significantly limited investments in these projects. In February, the IRS released a notice and revenue procedure clarifying the “beginning of construction” requirement for the 45Q credit and providing a safe harbor for tax equity partnership structures used to allocate the credit between investors and developers. However, as we pointed out in a Tax Update at the time, key investor concerns remained, including the circumstances under which taxpayers have to recapture previously claimed credits if the CO escapes and the requirements for secure geological storage. The new proposed regulations are a follow-up to the February guidance and tackle both of these issues, among others.

Recapture of Previously Claimed Credits

The proposed regulations provide guidance on the extent 45Q credits are subject to recapture in the event sequestered CO escapes back into the atmosphere. Recognizing investors will want certainty and limits on recapture exposure, the proposed regulations limit the recapture period to 5 years preceding the date a leak is discovered (the lookback period). Recapture of previously claimed credits takes a “last in, first out” approach. In other words, once a leak has been identified and quantified, the amount of leaked CO first reduces the 45Q credit in the year the leak was discovered (note that credit reductions in the year a leak is discovered are not technically “recaptured” because those credits were never actually received). If the total leaked CO exceeds the CO that would have been claimed in the discovery year, previously claimed credits are recaptured beginning with the year prior to discovery and going back a total of 5 years, applying the statutory rate for the tax credit applicable to each carryback year. To illustrate, if a taxpayer claimed credits for 100,000 tons of captured CO each year from 2021 to 2026 and a leak of 250,000 tons is discovered in 2026, first the 2026 credit for 100,000 tons is eliminated (because the leaked CO exceeds the otherwise claimed CO for 2026). Next, the remaining 150,000 tons of escaped CO offsets the 100,000 tons claimed in 2025. The remaining 50,000 tons of escaped CO offsets half the CO claimed in 2024. The amount of the recaptured credit — in this example, all the credit claimed in 2025 and half the credit claimed in 2024 — is treated as an increase in tax liability for 2026. As a result, taxpayers are not required to file amended tax returns in the event that previously claimed credits are subject to recapture. The recaptured credits do not appear to be subject to interest. In addition to the 5-year lookback period for recapture, the proposed regulations provide another potential limit on the amount of credits subject to recapture: the recapture period ends on the earlier of (i) 5 years after the end of the last taxable period for which credits were claimed, or (ii) the date monitoring is no longer required under 40 CFR Part 98 subpart RR (subpart RR) or CSA/ANSI ISO 27916:19 (the ANSI ISO standards) (note these standards are required to be used to quantify the amount of any leak). Accordingly, once the taxpayer is no longer claiming credits, the recapture exposure can be further limited if a monitoring period of less than 5 years is provided under subpart RR or the ANSI ISO standards. Reiterating the IRS’s February guidance, the preamble to the proposed regulations specifically provides that taxpayers may obtain third-party recapture insurance to protect against the recapture of tax credits.

Contractually Ensuring Storage or Injection

Section 45Q provides that the tax credit is attributable to the person who captures and physically or contractually ensures the disposal of CO or its use as a tertiary injectant. Under the proposed regulations, contractual assurance requires a binding written contract between the taxpayer and the party physically disposing of the CO. The contract must contain commercially reasonable terms, obligate the disposing party to comply with the requirements for secure storage and reporting of recapture events, and include a mechanism for enforcement of the injection or disposal obligation. However, the proposed regulations do not specify any particular provision that must be included, leaving it up to the parties to tailor agreements to their circumstances. The proposed regulations identify other terms that parties may include in the disposal contract, including the specification of minimum quantities of CO to be injected or disposed of, and indemnity, penalty, long-term liability, and liquidated damages provisions. Information about all storage contracts, including the parties involved and identifying information regarding the facility where disposal or injection takes place, must be reported to the IRS annually.

Secure Geological Storage

To claim the 45Q credit, captured CO must be disposed of in secure geological storage. This includes storage in deep saline formations, oil and gas reservoirs, and unminable coal seams. Consistent with 2009 guidance, the proposed regulations require that all owners/operators of secure geological storage facilities comply with applicable Underground Injection Control (UIC) regulations for Class VI or Class II wells. (Class VI wells are used to inject CO into deep rock formations, and Class II wells are associated with enhanced oil and natural gas recovery.) Owners/operators of Class II wells are generally required to comply with Class VI requirements and seek Class VI permitting only if there is an increased risk of endangerment posed to an underground source of drinking water. The proposed regulations modify the reporting requirements for Class II wells from those set forth in the 2009 guidance, which imposed a tax requirement for Class II wells to comply with the EPA’s subpart RR reporting requirements. (Class VI wells are otherwise required to comply with those requirements independent of any tax regulations.) This tax requirement for Class II wells would have created an obligation for them to submit a monitoring, reporting, and verification (MRV) plan to the EPA. In issuing the proposed regulations, the IRS acknowledged that the prior rule requiring all owners/operators of Class II wells to comply with subpart RR was overly burdensome, and this requirement was removed in the proposed regulations. The IRS identified the ANSI ISO standards as a viable alternative quantification methodology appropriate for purposes of implementing section 45Q. As a result, the proposed regulations allow owners/operators of Class II wells to comply with either subpart RR or the ANSI ISO standards. The IRS refused to allow the reporting rules promulgated by states as an alternative to subpart RR or the ANSI ISO standards because state rules are not uniform. A taxpayer that reports volumes of captured CO to the EPA pursuant to subpart RR may self-certify the volume of CO claimed for purposes of section 45Q. Alternatively, a taxpayer that determines volumes pursuant to the ANSI ISO standards may internally prepare documentation as outlined in the ANSI ISO standards, but a qualified independent engineer or geologist must certify that the documentation provided is accurate and complete. Such documentation and certification must be submitted to the IRS annually.