On Friday, November 17, 2023, the Treasury issued Proposed Regulations in connection with energy property. With some exceptions, these rules are intended to apply to property that is placed into service after December 31, 2022. There are a number of items presented but below we discuss a few highlights in particular 1) the requirement for energy property that contains previously-used components to pass the 80/20 test to claim additional ITCs 2) surprising clarifications around what constitutes “qualified biogas property” for purposes of Code section 48(c)(7), 3) clarity around what constitutes credit-eligible offshore wind property, and 4) the assertion that energy properties and a co-located qualified facility can generate both ITCs and PTCs (e.g. a wind farm co-located with battery storage). A public hearing on the proposed regulations is scheduled to be held on February 20, 2024.

Unit of energy property, energy projects, functional interdependence and tech neutrality

Fundamental to understanding the proposed regulations is the definition of energy property. Energy property is that property which might generate ITCs when placed into service. The proposed regulations provide that a unit of energy property is a collection of functionally-interdependent components that operate together and collectively can operate apart from other units of energy property. Other components that are not energy property can be deemed to be energy property if those components are required for the intended function of the energy property to which they are attached. As an example, a string of solar panels, racking, and an inverter might be a unit of energy property. Power conditioning and transfer equipment that services that string can be deemed to be energy property by being an integral part of the operation of the string. On their own, components of power conditioning and transfer equipment are not energy property. However, when paired with units of energy property, power conditioning and transfer equipment are considered energy property by virtue of their being an integral part of the function of the unit(s) of energy property. In this way, step up transformers, subsea cables, and other items identified in the proposed regulations become energy property when deployed for a certain use and within a certain ownership context. An energy project is a collection of energy properties.

Functional interdependence in the context of energy property was most recently seen in IRS Notice 2018-59, which relies upon the definition set forth in Rev. Rul. 94-31 which provides that a qualified facility is a collection of components that can be operated and metered together and can begin producing electricity separately from other components of property within a larger energy project (e.g., a single wind turbine and its associated pad and pole). The concept of functional interdependence is expanded throughout the proposed regulations in the context of particular technologies. However, generally, a collection of components is considered to be functionally interdependent provided that the “placing in service of each component is dependent upon the placing in service of each of the other components” in order to perform the energy property’s intended function. The intended function for a particular technology can be gleaned from the proposed regulations within 1.48-9(e). Drawing a perimeter of what constitutes a unit of energy property for a particular technology is crucial to applying the rules around retrofits (i.e. 80/20 analyses, discussed below), domestic content, energy communities and prevailing wage and apprenticeship requirements, and may materially impact the quantum of credit ultimately received by a taxpayer. As an example, two adjacent installations could be one property or two energy properties depending on the facts which could impact the eligibility for certain adders (e.g. domestic content) if you meet the requirements for one of the projects but not the other.

The proposed regulations suggest that the impetus for the functional interdependence test in the determination of an energy property is a step toward a technology neutral definition of energy property. That is, instead of providing a list of eligible components, a functional interdependence test contemplates the likelihood that as various technologies evolve, necessary functions might be performed by different types of components. The subjectivity involved in this type of analysis could make it more difficult for developers and investors to have confidence that they are taking strong tax positions with regard to energy property. However, taking a long view, it may benefit the industry now to begin to develop the engineering rigor to think in functional definitions in anticipation of the tech neutral ITC regime portended by Code section 48E. In general, the Treasury does seem to be signaling a gradual preference for a functional definition of property not just in the context of energy property but also in the final regulations for carbon capture and sequestration technology (TD 9944 (irs.gov)) which adopted a functional definition instead of providing an explicit list of components that constitute a carbon capture process train.

The 80/20 rule for ITC property

The 80/20 rule generally provides that an asset may be considered newly placed in service even though it contains some used property. This premise has been used in the context of qualifying wind facilities in Rev. Rul. 94-31 and IRS Notice 2013-29 (in connection with the rules around “start of construction”). Likewise, IRS Notice 2018-59 applied similar logic for the designation of an energy property as new. The new guidance provides a more robust definition of “energy property” that is instrumental in the application of the 80/20 rule for energy properties.

Proposed regulation 1.48-14 provides examples of retrofitted energy property and provides examples of when retrofitted property might generally qualify for additional ITCs. Notably, the examples provide that capital improvements to a unit of solar energy property do not generate additional ITC unless the existing, used components constitute less than 20% of the overall value of the energy property.

Improvements to energy storage technology, however, do not require fulfillment of the 80/20 test. Instead, new ITCs may be eligible for retrofitted energy storage technology by demonstrating that the improvements meet certain nameplate capacity uplift thresholds.

Qualified biogas

The introduction of the new credit for qualified biogas in the IRA has provoked increased interest in the asset class. However, the statutory language in Code section 48(c)(7) left many developers and investors unclear on exactly which components would be considered necessary to perform the intended function of a qualified biogas property. The proposed regulations express a preference for a functional definition but also provide examples of functionally-interdependent qualified biogas components including “waste feedstock collection system, a landfill gas collection system, mixing or pumping equipment and an anaerobic digester”. Notably, the preamble to the proposed regulations makes it clear that equipment used for concentrating biogas for injection into a pipeline is not part of a qualified biogas property. This proposed treatment is surprising given that biogas upgrading equipment is analogous to power conditioning equipment in the electricity generation context (which, as discussed above, is deemed to be energy property in many circumstances by serving a function integral to the operation of a unit of energy property). This particular aspect of the proposed regulations will likely spur significant commentary.

Further, as many qualified biogas facilities are retrofits of existing facilities, the imposition of the 80/20 test on energy property will force developers and investors to incorporate additional layers into their credit analyses – such taxpayers will want to understand to what extent qualified biogas spending might be considered capital improvements to existing equipment versus eligible improvements that could generate investment tax credits (if a given project reaches the threshold amount of capitalized expenditures under the 80/20 rule).

Also relevant to many qualified biogas installations is the assertion in proposed regulations 1.48-9(f)(3)(v) that buildings are generally not energy property. In order for a building to be considered energy property it is typically necessary to demonstrate that the building is in fact essentially an item or machinery or equipment. The feasibility of even converting such a structure into a usable building should be used in making a judgment as to whether such a structure can be considered energy property.

Offshore wind

For years, offshore wind projects lacked guidance specific to the asset class and were forced to rely on guidance that was designed for onshore wind projects, solar energy projects and other technologies. As developers and investors gradually discovered, offshore wind projects consisted of components and features that were in many cases not definitively addressed by the available guidance. One frequently discussed area of doubt was around the treatment of subsea export cables. In February 2022, the JCT said “qualified offshore wind facilities . . . include property owned by the taxpayer necessary to condition the electricity for use on the electrical grid such as subsea cables and voltage transformers”. This is consistent with Example 3 of section 1.48-9(f)(5) of the proposed regulations which provides an example wherein an offshore wind project’s energy property includes equipment “up to and including the transformer and switchgear housed in the onshore substation”. This clarity should remove doubt on at least this aspect of building out offshore wind properties in the waters off the United States.

Co-located energy property and qualified facilities

The proposed regulations provide that “power conditioning and transfer equipment that is shared by a qualified facility . . . and an energy property may be treated as an integral part of the section 48 energy property. Such shared property is not considered part of the qualified facility and, therefore, the sharing of such property will not impact the ability of the taxpayer to claim the section 48 credit for the energy property or the section 45 credit for the qualified facility”. An example in proposed regulation 1.48-9(f) demonstrates the application of this concept. Ever since the resurrection of the solar PTC with the IRA, stakeholders have had uncertainty around this topic. While certain sources were suggestive of legislative intent such as CREC-2022-08-12.pdf (congress.gov) (page 106), the language in the proposed regulations should allow developers and investors to move forward with increased confidence.

Qualified facilities that elect to be energy property

Production tax credit facilities (i.e. qualified facilities) described under Code section 45(d)(1) – (4), (6), (7), (9), and (11) can make an election under Code section 48(a)(5) to be treated as energy property and therefore claim a section 48 investment tax credit. Notably, the proposed regulations 1.48-14(f)(1) would provide that a qualified facility making such an election need not fulfill all of the requirements for qualifying into section 45 (e.g. third-party electricity sales). This distinction should allow those technologies in 45(d)(1) – (4), (6), (7), (9), and (11) that were otherwise limited to being in front of the meter to be installed behind the meter.

The single project test and energy property ownership by multiple taxpayers

The start of construction guidance provided in IRS Notice 2018-59 lists factors to consider when a collection of energy properties will be considered a single project for start of construction purposes. The proposed regulations provide that a superset of those factors should be used in determining whether a collection of energy properties is a single project. This determination as a single project is relevant for the consideration of domestic content and energy community adders, as well as prevailing wage requirements. Co-located energy properties (i.e. ITC projects) and qualified facilities (i.e. PTC projects) will not be considered single projects unless the qualified facilities elect to be energy properties under Code section 48(a)(5).

The proposed regulations provide clarity on scenarios where ownership of energy property is split between multiple taxpayers. The definition of energy property drives the various outcomes. As discussed above, components like power conditioning and transfer equipment are only energy property by virtue of being an integral part of the function of energy property (i.e., deemed energy property). Deemed energy property only generates credits for a taxpayer if the taxpayer also owns the functionally-interdependent components that constitute the balance of the energy property. Put another way, if a taxpayer owns a collection of solar equipment capable of generating electricity, that taxpayer (provided all the rules are otherwise fulfilled) is in a position to claim a solar investment tax credit. Further, if that taxpayer owns the associated power conditioning and transfer equipment that can likely be considered part of the energy property (deemed energy property) and therefore generate investment tax credits. However, if a taxpayer owns only the power conditioning and transfer equipment and none of the other functionally-interdependent solar equipment, that taxpayer is not in a position to be able to claim a solar investment tax credit.

Qualified interconnection property

The proposed regulations provide additional clarity on the various facts and circumstances that might allow for interconnection property serving energy projects with a nameplate below 5 MW to be ITC-eligible. Notably, qualified interconnection property per proposed regulation 1.48-14(g)(2) is not energy property and it is not integral to the function of energy property. Therefore, its presence or absence does not inform determinations that are concerned with the energy property designation (such as the domestic content adder). Much like the analysis around domestic content and prevailing wages, the designation of an installation as a single project or multiple projects for this particular purpose will affect whether the nameplate is below this required threshold.

The proposed regulations also recognize and discuss the complexity surrounding the treatment of qualified interconnection property – particularly the likelihood that project developers might receive payment or services in connection with the interconnection property expenditures. Ultimately, the Treasury and IRS request comment on the practical issues attendant to project developers with projects below a 5 MW nameplate attempting to claim ITCs on qualified interconnection property.

Changes to dual use property considerations

The dual use rule as described in TR 1.48-9 has been used historically to classify, for investment tax credit purposes, property that had a function that was not solely in connection with energy properties such as solar energy installations. Perhaps the most frequent consideration of dual use property in recent years concerned the classification of battery energy storage systems as solar energy property. With the passage of the IRA, many batteries qualify as credit-eligible on their own, without the need for a designation as solar energy property, but the question of dual use is still relevant across other asset classes. TR 1.48-9 provides that in order for an item of dual use property to be considered energy property, a property must derive at least 75% of its energy from qualifying sources. If a piece of property derived energy below this threshold it would no longer be considered energy property. The proposed regulations would reduce the required threshold from 75% to 50%. However, in any case, the assertion that a piece of dual use property is energy property must be supported by detailed energy records across each annual measuring period in the ITC recapture window. The proposed regulations provide additional guidance on how to approach data collection during the annual measuring period.

Energy efficient buildings – passive solar, geothermal and electrochromic glass

TR 1.48-9(d)(2) has provided that passive solar is not solar energy property. The proposed regulations seek to undo this limitation as no such limitation is implied in the Code. Further, the definition of what is included as geothermal property has been expanded to not just include pipes and ductwork (existing TR 1.48-9(c)(10)(iii)) but also the components of a building’s heating and cooling system. This, along with the additional definitions and requirements around electrochromic glass might be helpful in certain green building loadouts to better pencil out.

Prevailing wage and apprenticeship

The proposed regulations contain some clarifications regarding the fulfillment of prevailing wage and apprenticeship requirements, particularly: 1) describing recapture triggers and processes 2) filing requirements 3) identifying which technologies can be eligible for the 1 MW exception and 4) discussions around how a single project determination dovetails with prevailing wage requirements. The proposed regulations are in addition to the more fulsome PW&A proposed regulations provided here: Federal Register: Increased Credit or Deduction Amounts for Satisfying Certain Prevailing Wage and Registered Apprenticeship Requirements. PW&A requirements are an area of active development and discussion. For example on Tuesday November 21, 2023 an IRS hearing on the topic prompted multiple viewpoints from various stakeholders: IRS Urged to Change Prevailing Wage Requirements for Tax Credits (bloomberglaw.com)

For more information or for any other questions regarding this and other renewables and energy transition tax questions, please contact Dorian Hunt.