Treasury Guidance on Direct Pay

On June 14, 2022, the Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) issued (i) proposed regulations regarding the direct payment in lieu of claiming specified tax credits under Section 6417 (the “Direct Pay Proposed Regulations”) of the Internal Revenue Code of 1986 (the “Code”),¹ and (ii) proposed regulations regarding the direct payment of tax credits under Section 48D (the “AMIC Direct Pay Proposed Regulations”). Treasury and IRS issued temporary regulations regarding the applicable pre-filing registration requirements for elective payments and credit transfer elections (the “Temporary Regulations”). The IRS also posted Frequently Asked Questions (FAQs) regarding the direct payment of tax credits.

Direct Pay Proposed Regulations

The Inflation Reduction Act of 2022 added Section 6417 to the Code, which allows tax-exempt organizations and entities to elect to treat certain clean energy tax credits as direct payments against tax (the “Direct Pay Election”). Organizations and entities eligible for the Direct Pay Election include organizations exempt from federal income tax (such as Section 501(c) organizations), US states and political subdivisions, the Tennessee Valley Authority, Alaska Native Corporations and Indian tribal governments (“Applicable Entities”). The Direct Pay Election is available for production tax credits determined under Section 45, investment tax credits determined under Section 48 as well as several other energy credits (“Applicable Credits”). The Direct Pay Election is also available with respect to taxable entities with respect to three tax credits: (1) the credit for the production of clean hydrogen under Section 45V (“Section 45V Credits”); (2) the credit for carbon oxide sequestration under Section 45Q (“Section 45Q Credits”); and (3) the advanced manufacturing production credit under Section 45X (“Section 45X Credits”). Taxable entities eligible to make an election for those tax credits are referred to as “electing taxpayers” in the Direct Pay Proposed Regulations. 

The Direct Pay Proposed Regulations provide significant clarity regarding the scope of entities eligible to be treated as an Applicable Entity and credit amounts eligible to be treated as an Applicable Credit, as well as issues relating to electing taxpayers and the procedures and limitations applicable to the three tax credits eligible for elective payment for electing taxpayers, and the technical mechanics and timing requirements for making the Direct Pay Election. The proposed regulations also clarify that the Direct Pay Election is not available to Applicable Entities that acquire Applicable Credits pursuant to a “transfer” under new Section 6418. Selected guidance provided in the Direct Pay Proposed Regulations is described below:

Applicable Credits – With respect to Applicable Entities, the entire amount of an Applicable Credit, including any eligible bonus credit amounts (such as the “Energy Community,” “Low Income Community,” and “Domestic Content” bonus credit amounts), is eligible for the Direct Pay Election. The Direct Pay Proposed Regulations do not appear to permit the taxpayer to split an Applicable Credit with respect to an “applicable credit property” (i.e., taxpayers may not make a Direct Pay Election with respect to a portion of the Applicable Credit and transfer the remaining portion with respect to an applicable credit property).

Electing taxpayers (described below) would be eligible for the Direct Pay Election with respect to the entire amount of the Section 45V Credits, Section 45Q Credits and 45X Credits (see below). Stakeholders had requested guidance regarding the use of the direct payment against their quarterly estimated tax payments. The preamble to the Direct Pay Proposed Regulations explains that the regulations do not address this issue “because taxpayers can determine, based on their projected tax liability, the correct amount of estimated tax to pay in order to avoid a section 6654 or section 6655 estimated tax penalty at the end of the year.”    

Notably, Applicable Credits purchased pursuant to a “transfer” under Section 6418, as well as credits acquired by a lessee from a lessor through an election to pass the credits through to the lessee pursuant to former Section 48(d), will not be eligible for the Direct Pay Election. In the preamble to the Direct Pay Proposed Regulations, Treasury and the IRS declined to adopt the comments offered by certain stakeholders that would have permitted transferees to “chain” a Direct Pay Election with respect to purchased credits.

Applicable Entities – The Direct Pay Proposed Regulations answered many outstanding questions from stakeholders regarding parties qualifying as Applicable Entities and generally confirm a broad group of tax-exempt organizations and governmental entities qualifying as Applicable Entities. All organizations exempt from tax pursuant to Section 501(a), including tax-exempt entities organized in US territories and the District of Columbia, are Applicable Entities and are eligible to make the Direct Pay Election. In addition, the governments of US territories and the District of Columbia are eligible to make the election. Further, any agency, instrumentality or political subdivision (such as a city, county, water district, school district, economic development agency, public university or public hospital) of a US state or territory or the District of Columbia is eligible to make the election. Stakeholders had requested that the guidance recognize that those secondary-level entities, which state and local governments often act through with respect to investments such as the relevant projects covered by the Applicable Credits, qualify as Applicable Entities. However, entities treated as exempt under US state law but not treated as exempt under US federal law will not be eligible. An Applicable Entity that owns credit-generating property through a disregarded entity is eligible to make the election. 

Notably, the Direct Pay Proposed Regulations stipulate that partnerships² are not Applicable Entities for purposes of the Direct Pay Election. However, a partnership that is an electing taxpayer (see below) may make a Direct Pay Election with respect to the Section 45Q Credits, the Section 45V Credits and the Section 45X Credits. In the event that a partnership makes a Direct Pay Election for such credits, any deemed payment pursuant to the election is treated as tax-exempt income for purposes of Section 705 and each partner’s distributive share of the tax-exempt income is allocated pursuant to the rules of Section 704(b) that pertain to allocations of tax credits.

Related to this confirmation, Treasury and IRS declined to adopt the guidance requested from stakeholders that would permit Applicable Entities to enter into a partnership with taxable parties and for those Applicable Entities to then make a Direct Pay Election. Treasury and IRS explained that they do not view this arrangement to be permitted under the statute. However, the Direct Pay Proposed Regulations permit that Applicable Entities may join together with taxable entities, in an ownership arrangement (such as a tenancy-in-common or pursuant to a joint operating agreement) that has elected out of the partnership rules of subchapter K and make a Direct Pay Election with respect to such Applicable Entity’s share of Applicable Credits. Treasury and IRS explained that this rule may provide some flexibility for joint arrangements with tax-exempts.

Electing Taxpayers. Although Section 6417 provides significant detail with respect to electing taxpayers and the three credits for which they may make a Direct Pay Election, the Direct Pay Proposed Regulations clarify a number of key issues raised by stakeholders. The Direct Pay Election is available for only one five-year period. Electing taxpayers may not make a second Direct Pay Election for an additional five-year period—even if, for example, the relevant tax credit period extends beyond that initial five-year period.

However, the Direct Pay Proposed Regulations make a significant clarification with respect to the Section 45X credits. The Direct Pay Election is generally made with respect to each “applicable credit property”—both with respect to Applicable Entities and electing taxpayers—in accordance with the underlying requirements of the Applicable Credit. In the case of Section 45X Credits, stakeholders requested clarification whether the Direct Pay Election—for electing taxpayers—applied on a facility-by-facility (versus a taxpayer) basis similar to other Applicable Credits. The Direct Pay Proposed Regulations confirm that the applicable credit property for Section 45X purposes is determined on a facility-by-facility basis whether the facility existed on or before, or after, December 31, 2022. Thus, existing manufacturing facilities that produce eligible components (as defined under Section 45X) and new manufacturing facilities would be eligible for a separate five-year direct payment period. The Direct Pay Proposed Regulations define the applicable credit property for Section 45X purposes as “a facility that produces eligible components, as described in guidance under sections 48C and 45X.” Recently released guidance under Section 48C (see IRS Notice 2023-44) defines a Section 45X facility to include separate manufacturing production lines.

The Direct Pay Proposed Regulations define the applicable credit property for Section 45V purposes as “a qualified clean hydrogen production facility described in section 45V(c)(3).” It is expected that forthcoming guidance under Section 45V will further define the “qualified clean hydrogen production facility.” Note that if an electing taxpayer elects to treat qualified property that is part of a specified clean hydrogen production facility as energy property under Section 48(a)(15), the electing taxpayer would not be able to make a Direct Pay Election with respect to such facility.

The Direct Pay Proposed Regulations define the applicable credit property for Section 45Q purposes as “a single process train described in [Treas. Reg.] §1.45Q-2(c)(3).” Treas. Reg. §1.45Q-2(c)(3) defines a “single process train” as “[a]ll components that make up an independently functioning process train capable of capturing, processing and preparing carbon oxide for transport will be treated as a single unit of carbon capture equipment.” Thus, the Direct Pay Election would apply separately to each independently functioning process train for Section 45Q purposes.

Making the Direct Pay Election – The Direct Pay Election is made on an Applicable Entity’s annual tax return, which must include a completed Form 3800 General Business Credit, as well as any other form required to claim the Applicable Credit. Elections must be made on the initial return filed for the applicable year and must be filed by the applicable due date (including extensions) for such return (or, in the case of an organization that is not required to file an annual return, the date that such organization would otherwise be required to file a return under Section 6033(a), which is generally four and a half months after the end of the applicable tax year). Elections made solely through an amended tax return will not be accepted. 

Once a Direct Pay Election has been made by an Applicable Entity, it is irrevocable and applies with respect to any Applicable Credit for the taxable year in which the election was made. For production tax credits determined under Section 45(a), the election applies to the 10-year period beginning on the date the credit-generating facility was initially placed in service. The deemed payment of tax that occurs as a result of a Direct Pay Election is treated as occurring on the date the election is made.

Registration – Taxpayers are required to register before filing the tax return on which the Direct Pay Election is made and provide certain information related to each property with respect to which the Applicable Credit will be determined. After the pre-filing registration is complete, the taxpayer will receive a unique registration number for each property. The registration number is valid only for the taxable year for which it is obtained and must be renewed for subsequent years. In addition, if the facts regarding the property change, the registration must be amended. The registration process and the Temporary Regulations are further described in an additional client alert that can be found here.

One key area that remains unclear under the proposed and temporary regulations is the scope of the IRS pre-filing review process for the Direct Pay Election and the IRS’s audit procedures following the filing of the relevant tax returns and forms. The regulations indicate that registration is required before the filing of the taxpayer’s original tax return on which the Direct Pay Election would apply but the timing of the registration and the IRS’s discretion in providing a registration number is not clear. For example, if the Applicable Entity or electing taxpayer fails to provide sufficient information with the pre-filing registration, it is not clear what procedures the IRS will follow in requesting additional information. It is also noteworthy that the preamble to the Direct Pay Proposed Regulations indicate that Treasury and IRS intend to treat the Direct Pay Election as a “special enforcement matter” under Section 6241(11), thereby bypassing the centralized partnership audit regime set forth in the Bipartisan Budget Act of 2015 (“BBA”) and not applying the BBA rules to adjustments with respect to partnership-related items that affect the amount or existence of a payment to a BBA partnership, or credit or refund to the BBA partnership under Section 6417.      

Excessive Payments – The Direct Pay Proposed Regulations define an excessive payment as an amount equal to the excess of the amount treated as a payment or made as a payment pursuant to a Direct Pay Election over the amount of the Applicable Credit that would otherwise be allowable under the Code. Excessive payments are subject to a 20% penalty. However, the 20% penalty does not apply if the Applicable Entity demonstrates to the IRS’s satisfaction that it resulted from reasonable cause. The preamble to the Direct Pay Proposed Regulations states that “existing standards of reasonable cause will inform the determination by the IRS of whether reasonable cause has been demonstrated for this purpose”—see, e.g., Section 6664 and the underlying regulations. The tax for excessive payments applies in the year the determination of the excessive payment is made even if the determination year is a later year than the year in which the credit was claimed. Thus, if the Direct Pay Election is made for an Applicable Credit for the 2023 tax year but the IRS makes its determination in 2025, the excessive payment tax increase and penalty would be imposed for the 2025 tax year.

The preamble to the Direct Pay Proposed Regulations explains that excessive payments “may arise in a variety of situations, such as an improperly claimed bonus credit amount, an error in calculating a credit, inflated basis, failure to apply the Section 38(b) ordering rules, or a misapplication of the credit utilization rules, among other things.”

Additional Rules – Tax-exempt funds (such as proceeds from certain grants or forgivable loans) used to purchase or construct credit-generating property are includible in the basis of such property for purposes of determining the Applicable Credit amount for the Direct Pay Election. However, such amount will be reduced to the extent that the tax-exempt funds and the credit amount exceed the actual cost of the credit-generating property.

The Direct Pay Proposed Regulations provide rules similar to the rules of Section 50 with respect to the recapture of direct payments as a result of credit recapture events and clarify that a credit recapture event will not result in an excessive payment (i.e., will not trigger a penalty under those rules). Reporting of recapture of an Applicable Credit is to be made on an Applicable Entity’s or electing taxpayer’s annual tax return, including Form 4255, Recapture of Investment Credit, in the manner specified by Treasury and the IRS in future guidance.

A Direct Pay Election is available only for tax years beginning after December 31, 2022. The election is only available after the Applicable Credit has been earned and is eligible to be claimed on an annual return (generally, Applicable Credits are earned in the tax year in which the credit-generating property is placed in service in the case of an investment tax credit or when sale of an eligible item occurs in the case of production tax credits).

Effective Date – Taxpayers may rely on the Direct Pay Proposed Regulations for taxable years beginning after December 31, 2022, until the date the final regulations are published in the Federal Register, provided the taxpayers follow the Direct Pay Proposed Regulations in their entirety and in a consistent manner.

The direct pay guidance was issued in the form of a notice of proposed rulemaking by Treasury and IRS with accompanying proposed regulations—bypassing the normal process involving the IRS’s issuance of “sub-regulatory” guidance in the form of an IRS Notice. This form of guidance invokes formal regulatory procedures, including the submission of written public comments, which are due by August 14, 2023 and a public hearing, which is scheduled for August 21, 2023.

AMIC Direct Pay Proposed Regulations

The Creating Helpful Incentives to Produce Semiconductors (CHIPS) Act of 2022 added Section 48D to the Code, which entitles taxpayers to claim an advanced manufacturing investment credit (“AMIC”) on property that is used as part of an advanced manufacturing facility (defined as a facility with the primary purpose of manufacturing semiconductors or semiconductor manufacturing equipment), provided that such property is placed in service after December 31, 2022. The amount of the AMIC equals 25% of the basis of such property. Section 48D(d) allows taxpayers to elect to treat the AMIC as a direct payment against tax (the “AMIC Direct Pay Election”). 

On March 23, 2023, Treasury and the IRS published proposed regulations under Section 48D (the “Prior AMIC Proposed Regulations”). The Prior AMIC Proposed Regulations clarified certain key terms under Section 48D (including “eligible taxpayer,” “qualified property,” “advanced manufacturing facility,” and “semiconductor”), and addressed AMIC eligibility requirements, certain pre-filing registration requirements and the AMIC Direct Pay Election.

The AMIC Direct Pay Proposed Regulations provide additional clarity regarding rules for making an AMIC Direct Pay Election, the calculation of a “double benefit,” certain rules with respect to partnerships, pre-registration rules and certain basis reduction rules. Selected guidance provided in the AMIC Direct Pay Proposed Regulations is described below:

Rules for Making the AMIC Direct Pay Election – The AMIC Direct Pay Proposed Regulations clarify that the AMIC Direct Pay Election must be made on the initial annual tax return filed for the tax year in which the AMIC is determined and must be filed by the applicable due date (including extensions) for such return. Elections made solely through an amended tax return will not be accepted. The annual return must include a completed Form 3800 General Business Credit, as well as any required completed source credit forms and any additional information or supporting calculations required in the instructions to such forms. Taxpayers making an AMIC Direct Pay Election must also include a statement attesting, under penalty of perjury, that they are not a foreign entity of concern, that they have not engaged in an “applicable transaction” (as defined in recapture rules under Section 50(a)(3)) with respect to the credit-generating property during the year in which the credit-generating property was placed in service and that they will not claim a double benefit under Section 48D(d)(3) with respect to the AMIC.

Denial of Double Benefit – The AMIC Direct Pay Proposed Regulations provide additional clarity regarding the methodology for determining the amount of the AMIC that is treated as a “double benefit” under Section 48D(d)(3). Pursuant to such methodology, the AMIC Direct Pay Election reduces the actual AMIC amount to zero for purposes of calculating an electing taxpayer’s annual tax liability. However, such amount is deemed to have been allowed for all other purposes under the Code (including the basis reduction and recapture rules under Section 50 and the underpayment of estimated taxes rules of Sections 6654 and 6655).

Partnership Rules – In the case of an AMIC determined with respect to property held directly by a partnership, the AMIC Direct Pay Election may be made by the partnership, and Treasury will make a payment directly to the partnership equal to the AMIC amount. Pursuant to Section 48D(d)(2)(A), such payment is treated as tax-exempt income for purposes of Section 705 and each partner’s distributive share of the tax-exempt income is allocated pursuant to the rules of Section 704(b) that pertain to allocations of tax credit. The AMIC Direct Pay Proposed Regulations treat the tax-exempt income as arising from an investment activity rather than arising from the conduct of a trade or business for purposes of the passive activity loss rules of Section 469. Accordingly, the tax-exempt income will be treated as passive income for any partners who do not materially participate in such investment activity. 

In addition, the AMIC Direct Pay Proposed Regulations stipulate that the Section 49 at-risk rules apply at the partner level for purposes of the AMIC Direct Pay Election. Accordingly, the amount of the AMIC determined by a partnership making an AMIC Direct Pay Election is limited to the extent such credit base is limited by Section 49 with respect to a partner. A partnership that makes an AMIC Direct Pay Election must request from each of its partners that are subject to the Section 49 at-risk rules, the amount of such partner’s nonqualified nonrecourse financing for credit-generating property as of the close of the tax year in which the credit-generating property was placed in service.

Registration – Taxpayers are required to register before filing the tax return on which the AMIC Direct Pay Election is made and provide certain information related to each qualifying investment in an advanced manufacturing facility with respect to which the AMIC will be determined. After the pre-filing registration is complete, the taxpayer will receive a unique registration number for each qualified investment. The registration number is valid only for the taxable year for which it is obtained and must be renewed for subsequent years. In addition, if the facts regarding the qualifying investment change the registration must be amended. The registration process and the Temporary Regulations is further described in an additional client alert that can be found here: [insert link to Section 6418 Client Alert].

Basis Reduction – The AMIC Direct Pay Proposed Regulations provide that the adjusted basis of credit-generating property must be reduced by the amount of the AMIC for which a taxpayer has made an AMIC Direct Pay Election. Basis reduction would also apply for partnerships making an election.

Effective Date – Taxpayers may rely on the AMIC Direct Pay Proposed Regulations for taxable years beginning after December 31, 2022, until the date the final regulations are published in the Federal Register, provided the taxpayers follow the AMIC Direct Pay Proposed Regulations in their entirety and in a consistent manner.

The AMIC direct pay guidance was issued in the form of a notice of proposed rulemaking by Treasury and IRS with accompanying proposed regulations—bypassing the normal process involving the IRS’s issuance of “sub-regulatory” guidance in the form of an IRS Notice. This form of guidance invokes formal regulatory procedures, including the submission of written public comments, which are due by August 14, 2023 and a public hearing, which is scheduled for August 24, 2023.

¹ Unless otherwise stated, Section references in this Client Alert are to the Code.

² The Direct Pay Proposed Regulations also provide rules regarding S corporations. Those rules are not described in this alert.