Bloomberg Tax
March 21, 2023, 8:45 AM

Decoding the Tax and Climate Law’s ‘Green’ Credit Complexities

Sam Kamyans
Sam Kamyans
Allen & Overy LLP

The Inflation Reduction Act significantly expands technologies eligible for federal income tax credits and, in certain instances, enables the federal government to send cash payments directly to taxpayers. Energy transition projects often are eligible for multiple tax credits, perhaps as a function of their complexity, though the new law is coordinated to prevent perceived excess stacking of tax credits.

The law’s architecture doesn’t disable one credit to the detriment of another, but taxpayers claiming one credit may be prevented from claiming another credit in the same taxable year, while having some options for annual toggling. In certain instances, deciding which credit to claim can change each year that the project operates, up to the end of the credit cycle.

The law’s flexibility and complexity presents a series of decision trees to project sponsors and financing parties, enabling creative financing opportunities. This article illustrates a few of these dynamics from the viewpoint of sponsors and lenders.

Clean Fuel, Hydrogen, and Carbon Capture

Because a single project may qualify for multiple credits, taxpayers should model multiple scenarios to maximize their projects’ value. The fuel industry requires perhaps the most complicated modeling exercise, as fuel projects may be eligible for one or more of the 12-year Section 45Q carbon capture and sequestration credits;10-year Section 45V hydrogen credits; and temporary Section 45Z clean fuels credit, which is operational for tax years 2025 to 2027.

Each of the 45Q and 45V credits are eligible for a direct federal cash payment to any taxpayer for the first five years of the credit cycle. All of these credits can be sold on the open market using the new law’s transferability provisions.

A transportation-fuel ethanol production facility outfitted with a CCS credit element qualifies for both a 12-year 45Q credit and a 45Z clean fuels credit. Section 45Z requires the taxpayer to select either 45Q or 45Z if the clean fuel is produced at the facility undertaking the CCS activities. The statute allows a taxpayer to toggle between 45Z and 45Q on an annual basis. This option enables the taxpayer to determine whether the value of 45Z exceeds the value of 45Q in any given year.

The next decision is determining which credit the taxpayer can monetize at a higher value. This becomes an important financing consideration, because the taxpayer can receive five years of direct cash payments from the government in lieu of 45Q credits. The five-year cash guarantee provides certainty to lenders and equity investors seeking credit monetization as the primary source for a return on, and of, their capital; that certainty may outweigh an uncertain stream of cash from monetizing 45Z, even if those credits theoretically have a higher value.

Adding to the complexity, taxpayers that use the five-year cash payment option may permanently lose out on 45Z if the five-year 45Q cash payment cycle ends after 45Z’s current sunset date. But taxpayers who can amortize a loan within the five-year direct cash payment period then have a seven-year stream of 45Q credits thatthey can monetize through sales on the open market or with a tax equity investor.

If the clean fuel uses hydrogen as a feedstock (such as sustainable aviation fuel), each of the credits is available at various parts of the value chain. SAF typically is produced at a standalone facility but can use feedstock that has generated a 45Q, 45V, or 45Z credit—for instance, using dehydrated clean ethanol.

Section 45Z, as noted above, turns off each of 45Q and 45V if the SAF is produced at the same facility that can claim those credits. While the facilities are likely to be separate, if they’re different business units of the same taxpayer, the related party rules under 45Z can limit credit stacking by disabling 45Z for a clean fuel sold to a related party to produce SAF. In that instance, the related party seller of the clean fuel may claim 45Q, which has no related party limitations, and the SAF producer a higher 45Z credit.

If SAF feedstock is blue hydrogen eligible for the 45Q credit (for example, a steam methane reforming hydrogen process with CCS), then it appears that a hydrogen producer claiming 45Q in any given year, in lieu of 45V, is permanently precluded from claiming 45V, leaving only 45Q. A taxpayer claiming 45V can toggle, presumably only once, to 45Q; the SAF producer can evaluate 45Z eligibility.

If the SAF input is green hydrogen, meaning there’s no CCS element, the producer can claim only 45V, and the SAF producer can evaluate 45Z eligibility. In all iterations, claiming 45Q/V and 45Z assumes the processes aren’t undertaken in the same qualified facility within the meaning of 45Z.

This dynamic highlights the legal considerations, modeling, and financial forecasting exercise underpinning clean fuel operations. Will sponsors seek a mixture of clean fuels credits and then move to hydrogen credits? Should sponsors use five years of direct payments and monetize the rest on the back end with a tax equity investor? Similar considerations arise where a multifaceted project has components giving rise to production tax credits and investment tax credits—for example, a solar and battery combination plant.

Lenders Want Certainty

From the lender’s perspective, the sponsor monetizing a credit through tax equity (versus electing direct pay) is effectively a singular input for loan pricing. Specifically, with credit monetization, the lender will size and lend against the tax equity investor’s credit profile vis-a-vis the committed cash stream.

If the sponsor instead elects for direct payment, the lender will loan against the government’s commitment, with appropriate guardrails. But the lender may require a five-year amortization on the loan absent a forward tax equity commitment for the post-direct-pay period credits (five or seven years, respectively, for hydrogen and CCS).

The process for claiming direct pay under the new law remains unclear, and the Section 1603 cash grant from 2009 remains the most recent analogue for project finance. That’s not to say lenders will be loath to finance direct pay projects, but borrowers and lenders will have to sort through issues not implicated by traditional tax equity financing.

John Marciano, Sam Guthrie, and Mike Sykes at Allen & Overy contributed to this article.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Sam Kamyans is a partner in Allen & Overy’s projects, energy, natural resources, and infrastructure practice. He has experience in partnership tax structuring and negotiating key tax deal points in transactions focused on financing renewable energy infrastructure and carbon capture.

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