The U.S. Internal Revenue Service issued partial guidance Feb. 19 on how a law the U.S. Congress passed in 2018 will affect companies' eligibility to claim federal tax credits for projects involving carbon capture, utilization and sequestration, or CCUS, a technology that supporters say will be key to addressing climate change.

While the IRS provided information that companies may need for the current tax year, the agency punted until a later time two outstanding questions that experts tracking the issue said must be answered for the financial backers and would-be developers of such projects to comfortably move forward with those investments.

In February 2018, President Donald Trump signed a budget bill into law that included an extension to the Section 45Q tax credit for carbon capture systems. The bill set a deadline of Jan. 1, 2024, for projects to begin construction in order to qualify for the credit, seven years beyond the previous cutoff. The legislation also increased the value of the credits that certain types of carbon capture projects can claim.

But companies pursuing CCUS development have been waiting for implementation guidance from the IRS, including how the agency determines when construction has started on a qualified facility or equipment.

Guidance

In its Feb. 19 notice, the IRS gave two methods for establishing when construction begins: a physical work test and a 5% safe harbor. Construction will be deemed to have begun on the date that the taxpayer satisfies one of the two methods.

Under the physical work test, construction of a qualified facility or carbon capture equipment will be considered started when "physical work of a significant nature" begins, as long as the taxpayer "maintains a continuous program of construction," the guidance said. This test focuses on the nature of the work performed rather than the amount or the cost, with both off-site and on-site work taken into account.

Significant off-site physical work could include manufacturing components including support structures, membranes and sorbent vessels used for carbon capture processes, and components needed for disposing of qualified carbon oxide in secure geological storage. On-site physical work of significant nature includes excavating for and installing foundations, installing gathering lines to connect the power plant or other carbon-emitting industrial facilities to the carbon capture equipment, and installing carbon capture and disposal components.

The guidance excluded preliminary activities — such as securing financing, test drilling and permitting — from the list of potential physical work of a significant nature.

Turning to the IRS' other offered method, the 5% safe harbor test would consider construction to have started if a taxpayer incurs 5% or more of the total cost of a qualified CCUS facility or carbon capture equipment and makes "continuous efforts to advance towards completion" of that project. The IRS will consider all costs "properly included in the depreciable basis" of carbon capture facilities or equipment when determining whether the 5% threshold has been met.

But the safe harbor will not be satisfied if actual expenses exceed anticipated total costs to the point that the 5% threshold is not met by the Jan. 1, 2024, deadline.

The notice also included a "continuity safe harbor" that gives taxpayers six years to place a project into service after construction begins. In addition, the IRS offered guidance on transferring ownership of qualified facilities or carbon capture equipment. Noting that no statutory mandate exists that requires the entity building a carbon capture project to be the same one that places the facility in service, the IRS said a fully or partially developed facility may be transferred to another party without failing either the physical work test or the 5% safe harbor.

Law and government relations firm Bracewell LLP said the guidance on the start of construction for CCUS projects mirrors tax credit requirements for wind and solar power projects, although wind and solar facilities have a shorter, four-year window to complete construction.

Also on Feb. 19, the IRS created a revenue procedure regarding the structural parameters for financing CCUS projects. The procedure included a safe harbor for the allocation rules for carbon capture partnerships that is similar to the safe harbors that exist for the federal wind energy production tax credit.

More guidance coming

The IRS said it anticipates "issuing further guidance in the near future" on related issues, including secure geological storage, utilization and recapture of carbon credits.

While carbon capture proponents generally applauded the agency's Feb. 19 guidance, they lamented the amount of time the IRS took to issue it and called for the agency to act quickly to finalize the other outstanding questions.

"This work took far too long and has delayed hundreds of millions, if not billions of dollars in investments in the development and deployment of carbon capture, use and geologic storage projects that Congress sought to incentivize through its bipartisan reform of 45Q," the Carbon Capture Coalition said in a Feb. 19 statement.

The group urged the IRS to "expedite the completion of the rule as quickly as possible to avoid further days in project development."

Barbara De Marigny, an energy tax expert and partner at law firm Baker Botts LLP, suggested in an interview that the two pieces of guidance the IRS issued were not the fundamental questions developers and financers need the agency to address

"It's kind of like they're telling us how to ice the cake before they bake the cake," De Marigny said. "They're giving us all these details on partnership allocations of the tax credit and the definition of the beginning of construction ... but the really big issues that still need to get resolved are out there, and that's what we've really got to have guidance or proposed regulations on to get people to feel comfortable that they can get the credit."

In particular, the IRS has yet to define whether the tax credits apply to projects that use the carbon for enhanced oil recovery in addition to those that store the carbon in underground caverns indefinitely. In 2013 advice to IRS field attorneys, the IRS concluded that a company's use of carbon extraction at its industrial facility for enhanced oil recovery projects did not qualify as disposal in secure geological storage, De Marigny explained. But the IRS has not addressed that question since, leaving developers and financers questioning whether their projects could benefit from the tax incentive.

Another outstanding question is how the IRS is going to define the ability to claw back the tax credits if some of those stored carbon dioxide emissions somehow escape back into the atmosphere, according to De Marigny. The risk that the IRS could take back the tax credits 20 years after the project is in place if, for example, some of those emissions leak could deter financial investors from backing projects, De Marigny suggested.

De Marigny added that the likely cause of the delay for the IRS is that the remaining questions are much more environmental, scientific and technological in nature than the IRS is used to dealing with.