Treasury Releases First Proposed Regulations on Advanced Manufacturing Credit
On Thursday, December 14, the United States Department of the Treasury and the Internal Revenue Service released proposed regulations relating to the advanced manufacturing production tax credit under Section 45X of the Internal Revenue Code1 (the “Section 45X credit”). This guidance (the “Proposed Regulations”) is the first of its kind interpreting the Section 45X credit, and provides much-anticipated assistance to taxpayers in the form of the following:
- General rules applicable to the Section 45X credit, including a definition of the term “produced by the taxpayer.”
- Rules relating to the determination of production costs for certain components and providing additional color on the interaction of the Section 45X credit with the credit provided for under section 48C of the Code (i.e., the advanced energy project credit).
- Rules allowing for identification of the proper credit claimant in the case of contract manufacturing.
- Rules governing sales to unrelated persons through a person related to the taxpayer, including rules governing the election to treat sales of eligible components to related persons as if made to unrelated persons under Section 45X(a)(3)(B) of the Code (a “Related Person Election”).
- Definitions for certain eligible components, including solar energy components, wind energy components, inverters, and qualifying battery components, and phase-out rules.
- Definitions for applicable critical minerals that are eligible components.
A public hearing regarding the Proposed Regulations has been scheduled for February 24, 2024, at 10:00 AM Eastern Standard Time. Comments on the Proposed Regulations to be discussed at the hearing are due by February 13, 2024.
Background
The Section 45X credit was recently added to the Code by way of the Inflation Reduction Act (the “IRA”) and has served as an exciting new incentive that, in contrast to traditional pre-IRA renewable energy tax incentives for project developers, benefits manufacturers of components of renewable energy projects, as well as producers of certain critical minerals, provided such manufacture and production is sourced to the United States.2 Specifically, the Section 45X credit incentivizes the production and sale of certain eligible components including solar and wind energy components, inverters, qualifying battery components and certain “applicable critical minerals.” Impactfully, the Section 45X credit is also one of only three incentives for which “direct pay” is generally available for all taxpayers.3
A taxpayer hoping to claim the Section 45X credit must establish that it has (i) produced an eligible component or critical mineral in the United States, and (ii) during the applicable taxable year, sold such component or mineral to a person unrelated to the taxpayer.4
Person who can claim the Section 45X credit – “Produced by the taxpayer”
The Proposed Regulations clarify that “produced by a taxpayer” for these purposes means a process conducted by the taxpayer that substantially transforms constituent elements, materials, or subcomponents into a complete and distinct eligible component that is functionally different from that which would result from mere assembly or superficial modification of the elements, materials, or subcomponents.5 Moreover, partial transformation will not be sufficient for these purposes.6 Special rules apply in the case of solar grade polysilicon, electrode active materials, and applicable critical minerals, in which case production must entail processing, conversion, refinement, or purification of source materials, such as brines, ores, or waste streams in order to derive a distinct eligible component.7
The Proposed Regulations also provide special rules specifying which taxpayer may claim the Section 45X credit in the context of contractual arrangements.8 Where the contract for the production of an eligible component is entered into before the production of the component is completed, the default rules provide that the party that engages in the production activity is the party entitled to the credit, however the parties may agree to an alternative allocation of the Section 45X credit, provided the requirements of Section 45X of the Code are otherwise met.9 In such cases, the IRS will not challenge such agreements as long as the relevant parties execute valid, signed certification statements demonstrating mutual agreement as to the decision.10
Observation
The standard proffered by the Proposed Regulations, whereby taxpayers may contractually designate the party that may claim the Section 45X credit, provides much-desired flexibility and certainty to an area very much in need of the same. This development is particularly welcome given how common contractual arrangements are in the industry in connection with the production of eligible components. Notably, however, taxpayers must ensure that notwithstanding this flexibility, the other requirements of the statute remain fulfilled with respect to the arrangement – including, specifically, that there is an actual sale to a third party. For these purposes, tax designations apply – in other words, sales to entities that are regarded for legal purposes but disregarded for purposes of federal income tax, will not be respected as true sales and could present a trap for the unwary.
Sale to Unrelated Party
Like other production tax credits, the Section 45X credit requires not only that a taxpayer engage in “qualified production” of applicable components or minerals, but also sell such components or minerals to a party unrelated to the taxpayer.11 As a result, the Section 45X credit generally cannot be claimed until the year of such sale.12
Consistent with the related party standard under the general production tax credit under Section 45 of the Code, the Proposed Regulations adopt the related party standard of Section 52(b) of the Code.13 The Proposed Regulations also provide that when a taxpayer produces and sells an eligible component to a related person that integrates, incorporates, or assembles the eligible component into another eligible component, the taxpayer generally may claim the Section 45X credit at the time a related person’s sale to the unrelated person occurs.14
The Proposed Regulations also provide additional color on the Related Person Election mentioned above. Under this election, a taxpayer may treat the sale of an eligible component to a related person as if made to an unrelated person in order to satisfy the requirements of Section 45X(a)(1)(B) of the Code. The Related Person Election can be useful in order to, for example, accelerate when a taxpayer may claim a Section 45X credit, as they do not need to wait until subsequent sales by the related purchaser to a third party.15
Observation
In addition to the benefit of potentially taking the Section 45X credit in an earlier year, making a Related Person Election could help taxpayers alleviate some of the internal compliance and contractual burdens of having to track subsequent sales, which would otherwise be necessary in order to confirm the year the credit could be claimed.
Quantifying Applicable Costs
In the case of the majority of eligible components (e.g., solar energy components, wind energy components, inverters, and qualified battery components), the Section 45X credit is determined by multiplying the amount of the eligible component produced by a set dollar amount (for example, in the context of an onshore wind project, each nacelle produced for a wind turbine is assigned a value of 5 cents multiplied by the total rated capacity of the completed turbine).16 However, in contrast to the above, in the case of electrode active materials and critical minerals, the Section 45X credit is instead calculated as 10% of the costs incurred to produce the eligible component or mineral.17 In the context of the above, the Proposed Regulations provide guidance regarding how to determine such costs.
In order to determine includible production costs for these purposes, the Proposed Regulations reference Section 263A and the unified capitalization rules.18 As the preamble to the Proposed Regulations notes, only the costs associated with production activities that add value to the eligible component, and which are conducted by the taxpayer producing the component, are considered qualified production costs and are counted for purposes of the applicable 10% amount. Importantly, the preamble also notes that for both electrode active materials and critical minerals, direct materials costs, indirect materials costs, and costs related to the extraction or acquisition of raw materials are excluded from production costs.
Anti-Abuse
The Proposed Regulations also introduce certain anti-abuse rules, targeting situations in which the amount of the applicable Section 45X credit for a particular component or mineral exceeds the cost of producing such component or mineral.19 As the preamble to the Proposed Regulations notes, in such situations, the concern is that taxpayers would be economically incentivized to engage in wasteful “excess” production of unnecessary or extraneous components solely for the purpose of claiming the Section 45X credit, rather than for a legitimate business purpose.
Under these anti-abuse provisions, the Section 45X credit may be disallowed to the extent a taxpayer’s primary purpose in producing an eligible component is determined to have been wasteful, such as discarding, disposing of, or destroying the eligible component without putting it to a productive use.20 This determination is to be based on the facts and circumstances.21
Observation
In cases where the Section 45X credit is disallowed, taxpayers should be wary that excessive direct payment and excessive credit transfer penalties may unexpectedly apply.
Other highlights from the Proposed Regulations include:
- While the Proposed Regulations reiterate the statutory rule that the basis of property taken into account for purposes of a Section 48C credit may not also be taken into account for purposes of the Section 45X credit, in cases where a taxpayer owns independently functioning production units at a single manufacturing site, it should be possible for one independent unit to claim the Section 48C credit and the other to claim the Section 45X credit.22
- Production of eligible components may have begun before the effective date of the Section 45X credit, as long as they are completed and sold after December 31, 2022.23
- The Proposed Regulations introduce a new certificate of analysis (COA) requirement to document critical minerals.24
1 Hereinafter, references to the “Code” will refer to the “Internal Revenue Code.”
2 IRC § 45X.
3 IRC § 6417(d)(1)(D).
4 IRC § 45X(a).
5 Prop. Reg. § 1.45X–1(c)(1)(ii).
6 Prop. Reg. § 1.45X–1(c)(1)(i).
7 Prop. Reg. § 1.45X–1(c)(2).
8 Prop. Reg. § 1.45X–1(c)(3)(ii).
9 Prop. Reg. § 1.45X–1(c)(3)(ii)(A) & (iii).
10 Prop. Reg. § 1.45X–1(c)(3)(iii).
11 IRC § 45X(a).
12 IRC § 45X(a)(1)(B).
13 Prop. Reg. § 1.45X–2(b)(2).
14 Prop. Reg. § 1.45X–2(e)(3)(i).
15 Prop. Reg. § 1.45X–2(d)(2).
16 IRC § 45X(b)(2)(A)(ii).
17 IRC § 45X(b)(1)(J),(M).
18 Prop. Reg. § 1.45X–4(c)(3).
19 Prop. Reg. § 1.45X–1(i).
20 Prop. Reg. § 1.45X–1(i)(1).
21 Id.
22 Prop. Reg. § 1.45X–1(g)(4).
23 Prop. Reg. § 1.45X–1(c)(4).
24 Prop. Reg. § 1.45X–4(c)(4).
