Government Issues Much-Anticipated Guidance on the Carbon Sequestration Credit

On May 28, the Treasury Department and the Internal Revenue Service (collectively, Treasury) issued proposed regulations under section 45Q, the credit for carbon oxide sequestration. The proposed regulations are comprehensive and detailed, addressing many issues on which commenters have requested clarification and explanation. However, some questions remain and will hopefully be addressed in final regulations. Key guidance in the proposed regulations, and some of these open questions, are described below. 

• Additional Pathway for Secure Geologic Storage
• Parameters Laid Out for Contractual Assurance
• Helpful Guidance Provided on "Transfer" Election
• Broad Definition of Carbon Capture Equipment May Cause Confusion
• Additional Guidance Provided on Scope of "Industrial Facility"
• Regulations Adopt 80/20 Rule
• Initial Framework for Utilization Laid Out
• Five-Year Lookback Period Introduced for Credit Recapture
• Conclusion

Additional Pathway for Secure Geologic Storage

Notice 2009-83, the key guidance under the old section 45Q credit program, was issued while the Environmental Protection Agency (EPA) was still writing the Greenhouse Gas Reporting Rules. This has created some uncertainty as to the precise requirements for adequate security measures that must be adopted to demonstrate secure geologic storage. 

In general, operators who inject carbon oxide must do so under an appropriate EPA Underground Injection Control (UIC) well permit. Class II permits generally are used for wells that inject fluids (including carbon oxides) for enhanced recovery of oil or natural gas. Class VI permits generally are used for wells which inject carbon oxides for the purpose of geologic sequestration and not for use in enhanced recovery of oil or natural gas. Class VI wells are required to comply with the more stringent rules under Subpart RR of the EPA Greenhouse Gas Reporting Rules (Subpart RR rules). Class II wells are permitted to comply with the less stringent rules under Subpart UU of the EPA Greenhouse Gas Reporting Rules (Subpart UU rules) but may opt into Subpart RR reporting. The Subpart RR rules require an EPA-approved site-specific Monitoring, Reporting, and Verification Plan (MRV Plan), but the Subpart UU rules do not require an MRV Plan.

Historically, some taxpayers have taken the position that reporting under Subpart RR is not required to claim a section 45Q credit in the context of injection of qualified carbon oxides in enhanced oil recovery at a Class II well. The IRS has taken the position that an approved MRV Plan is required in order to demonstrate secure geologic storage, but this position has only been expressed in the instructions to Form 8933, which are not binding guidance. In addition, some taxpayers have been concerned that being required to opt into Subpart RR may create a misalignment with state mineral property and natural resource conservation laws, as well as accepted industry practices and commercial arrangements. 

The proposed regulations clarify the meaning of secure geologic storage and provide an additional pathway beyond compliance with Subpart RR. Under the proposed regulations, the International Organization for Standardization (ISO) standard on sequestration endorsed by the American National Standards Institute (i.e., CSA/ANSI ISO 27916:19) (ISO standard), can be used as an alternative for UIC Class II wells. Both Subpart RR and the ISO standard require an assessment and monitoring of potential leakage pathways; quantification of inputs, losses, and storage through a mass balance approach; and documentation of steps and approaches. Under the proposed regulations, operators of UIC Class II wells that follow the ISO standard could elect to report under Subpart RR but would not be required to do so. Rather, they could continue to report to the EPA under Subpart UU. The proposed regulations do not provide for an alternative to Subpart RR reporting for UIC Class VI wells because all UIC Class VI wells are already subject to Subpart RR reporting requirements.

Taxpayers that rely on the ISO standard must satisfy additional certification requirements. A taxpayer that reports volumes of carbon oxide to the EPA pursuant to Subpart RR may self-certify the volume of carbon oxide claimed for purposes of section 45Q. In contrast, if a taxpayer determines volumes pursuant to the ISO standard, the taxpayer may prepare documentation as outlined in the ISO standard internally, but such documentation must be provided to a qualified independent engineer or geologist, who then must certify that the documentation provided, including the mass balance calculations as well as information regarding monitoring and containment assurance, is accurate and complete. 

Some of the commenters advocating for the application of the ISO standard suggested that the proposed regulations require that all relevant documentation of the amount of qualified carbon oxide stored for purposes of the section 45Q credit be retained and made available for public review, and the total quantity of qualified carbon oxide stored for long-term containment be reported annually. However, Treasury explained in the preamble to the proposed regulations that while Treasury appreciates the importance of shared and open information in this context and encourages transparency, Congressional action would be required to mandate this kind of disclosure. The preamble explains that there is no statutory requirement in section 45Q for taxpayers, federal agencies, or industry groups to publicly display this information or otherwise make it available. In addition, the Treasury itself is limited in what it can disclose because of the rules prohibiting the public disclosure of taxpayer information under section 6103. 

Parameters Laid Out for Contractual Assurance 

The proposed regulations clarify which contract provisions are necessary to contractually ensure capture and disposal in secure geologic storage (disposal), use as a tertiary injectant in enhanced oil recovery (injection), or utilization as described in section 45Q(f)(5) (utilization). This is important because a taxpayer is not required to physically carry out the disposal, injection, or utilization of qualified carbon oxide to claim the section 45Q credit if the taxpayer contractually ensures in a binding written contract that the party that physically carries out the disposal, injection, or utilization of the qualified carbon oxide does so in the manner required under section 45Q and the regulations. In particular, (in the absence of a section 45Q(f)(3)(B) election, discussed below), the person who may claim the section 45Q credit is: (i) for facilities placed in service before February 9, 2018, the person that captures and physically or contractually ensures the disposal, injection, or utilization of qualified carbon oxide; and (ii) for facilities placed in service after February 8, 2018, the person that owns the carbon capture equipment and physically or contractually ensures the capture and disposal, injection, or utilization of qualified carbon oxide. 

Under the proposed regulations, in order to contractually ensure disposal, injection, or utilization of qualified carbon oxide, a taxpayer must enter into a binding written contract. A written contract will be considered binding only if it is enforceable under state law against both the taxpayer and the party that physically carries out the disposal, injection, or utilization of the qualified carbon oxide, or a predecessor or successor of either, and does not limit damages to a specified amount. A taxpayer may enter into multiple binding written contracts with multiple parties for the disposal, injection, or utilization of qualified carbon oxide.

In addition, several contract provisions are required or permitted. Contracts ensuring the disposal, injection, or utilization of qualified carbon oxide must: 

• Include commercially reasonable terms and provide for enforcement of the party’s obligation to perform the disposal, injection, or utilization of the qualified carbon oxide;
• For qualified carbon oxide that is intended to be disposed or injected, obligate the disposing party to:
  • comply with the Subpart RR rules, or, in the case of qualified carbon dioxide injected in enhanced oil recovery, the ISO standards;
  • comply with the documentation requirements on IRS Form 8933; and
  • in the case of a recapture event, promptly inform the capturing party of all information that is pertinent to the recapture (i.e., location of leak, quantity of qualified carbon oxide leaked, dollar value of section 45Q credit attributable to leaked qualified carbon oxide) of section 45Q credits under the regulations; and
• For qualified carbon oxide that is intended to be utilized, obligate the utilizing party to comply with the regulations governing utilization. 

Contracts ensuring the disposal, injection, or utilization of qualified carbon oxide may, but are not required to include: 

• Long-term liability provisions, indemnity provisions, penalties for breach of contract, or liquidated damages provisions;
• Information including how many metric tons of qualified carbon oxide the parties agree to dispose of, inject, or utilize; and
• Minimum quantities that the parties agree to dispose of, inject, or utilize. 

These rules will help guide taxpayers in drafting contracts that will meet the contractual assurance standard. As a result, the rules will help enhance the certainty regarding which taxpayers can claim section 45Q credits. 

However, at least one key gap remains in these rules. Many commenters requested flexibility in allowing a chain of contractual assurance so that, for example, the taxpayer who owns carbon capture equipment could contract with a person who transports qualified carbon oxide who in turn could contract with a third person who physically carries out disposal, injection, or utilization. The proposed regulations do not directly address this issue. It would be helpful if final regulations clarified (with an example) that direct contractual privity between the taxpayer to which the credit is attributable and the person who physically disposes, injects, or utilizes the qualified carbon oxide is not required so long as there is a chain of contractual privity. 

Helpful Guidance Provided on "Transfer" Election 

Section 45Q(f)(3)(B) provides that the taxpayer to which the credit is attributable may elect to allow the person that disposes of the qualified carbon oxide, utilizes the qualified carbon oxide, or uses the qualified carbon oxide as a tertiary injectant to instead claim the credit (the
section 45Q(f)(3)(B) election). The proposed regulations provide guidance regarding who may make a section 45Q(f)(3)(B) election and the time and manner for making a section 45Q(f)(3)(B) election. 

The proposed regulations provide that section 45Q(f)(3)(B) elections may be made for all or a portion of the available section 45Q credit and may be made for a single or multiple credit claimants. The electing taxpayer must provide a copy of the taxpayer’s Form 8933 to each claimant, and each claimant must attach that copy to its own Form 8933. The proposed regulations also provide that section 45Q(f)(3)(B) elections must be made on an annual basis. These provisions should allow greater flexibility for taxpayers who wish to change a section 45Q(f)(3)(B) election from year to year or transfer portions of the credit to multiple parties. 

Moving forward, taxpayers will not be able to change their section 45Q(f)(3)(B) elections on amended returns. The proposed regulations provide that a section 45Q(f)(3)(B) election must be made no later than the due date (including extensions) for filing the taxpayer’s federal income tax return or Form 1065 (in the case of partnerships), and may not be made on an amended federal income tax return. An exception exists for amended returns (or administrative adjustment requests) for taxable years ending after February 9, 2018 but on or before the date of publication of the proposed regulations. 

Guidance regarding the interaction of a transfer election and the guidance on partnership allocations of section 45Q credits provided in Rev. Proc. 2020-12 would be helpful. The guidance in Rev. Proc. 2020-12, including the safe harbor provided by Section 4 of the Rev. Proc., generally appears to be premised on the ownership of the carbon capture equipment by the partnership that claims the section 45Q credit (referred to as the “Project Company” in the guidance). However, when a section 45Q(f)(3)(B) election is made, the Project Company generally will not be the owner of the carbon capture equipment. It is not clear how or whether Treasury would expect the guidance in Rev. Proc. 2020-12 to apply in such a situation. 

Broad Definition of Carbon Capture Equipment May Cause Confusion 

The proposed regulations include definitions of certain key terms that were left undefined in the statute, including “carbon capture equipment.” The proposed regulations provide that in general, carbon capture equipment includes all components of property that are used to capture or process carbon oxide until the carbon oxide is transported for disposal, injection, or utilization. Further, the proposed regulations list specific items that are included in, or excluded from the definition of carbon capture equipment. Components of property related to the function of capturing carbon oxides, such as components of property necessary to compress, treat, process, liquefy, or pump carbon oxides, are included within the definition of carbon capture equipment. Components of property related to transporting carbon oxides for disposal, injection, or utilization, such as pipelines or transport vessels, are not included in the general definition. However, a single gathering and distribution system that collects and transports carbon oxide to a pipeline is considered carbon capture equipment. 

This broad definition means that multiple distinct pieces of equipment that produce a single stream of qualified carbon oxide may all be treated as “carbon capture equipment.” For example, one piece of equipment might separate carbon oxide from other gases, while another piece of equipment might compress the separated carbon oxide, while a third piece of equipment might treat the carbon oxide. This may create confusion because a section 45Q credit generally is attributable to the owner of carbon capture equipment at a qualified facility (for equipment placed in service after February 9, 2018). The proposed regulations do not address the consequences if more than one taxpayer owns distinct pieces of equipment that all produce a single stream of qualified carbon oxide. Is a taxpayer required to own all of the carbon capture equipment that produces a single stream of qualified carbon oxide in order to claim a section 45Q credit, or is the taxpayer only required to own a portion of such equipment?  If the latter, does the credit need to be apportioned among different taxpayers that own different portions and, if so, how will the credit be apportioned? 

Additional Guidance Provided on Scope of "Industrial Facility" 

Section 45Q also does not define the term “industrial facility.” In general, in order to be a qualified facility under section 45Q, a facility must be either a direct air capture facility or an industrial facility. 

The proposed regulations generally follow prior subregulatory guidance on the meaning of “industrial facility.” Consistent with prior guidance, the proposed regulations provide that an industrial facility is a facility that produces a carbon oxide stream from a fuel combustion source or fuel cell, a manufacturing process, or a fugitive carbon oxide emission source that, absent capture and disposal, would otherwise be released into the atmosphere as industrial emission of greenhouse gas or lead to such release. Also consistent with this guidance, the proposed regulations provide that an industrial facility does not include a facility that produces carbon dioxide from carbon dioxide production wells at natural carbon dioxide-bearing formations or a naturally occurring subsurface spring. 

However, the proposed regulations expand on this prior guidance. The proposed regulations provide that a deposit of natural gas that contains less than 10% carbon dioxide by volume is not a natural carbon dioxide-bearing formation. For other deposits, whether a well is producing from a natural carbon dioxide-bearing formation is based on all the facts and circumstances. The proposed regulations also define the term “manufacturing process” as “a process involving the manufacture of products, other than carbon oxide, that are intended to be sold at a profit, or are used for a commercial purpose.” All facts and circumstances with respect to the process and products are to be taken into account. As illustrated by the proposed regulations, if a natural gas reservoir contains both carbon dioxide and methane, and the taxpayer constructs equipment to separate the two and enters a contract to sell only the carbon dioxide, the separation process is not a manufacturing process. But if the taxpayer separates and sells both gases, it would be a manufacturing process. 

Regulations Adopt 80/20 Rule 

The 80/20 rule has long been a mainstay of renewable energy projects. The 80/20 rule provides that a facility that contains some used property generally can still qualify as originally placed in service, so long as the fair market value of the used property is not more than 20% of the facility’s total value (the cost of the new property plus the fair market value of the used property). In general, the 80/20 rule permits taxpayers to qualify for a new credit period for qualified facilities when they make very substantial capital expenditures. 

The proposed regulations adopt the 80/20 rule and adapt them to the context of the section 45Q credit. The proposed regulations provide that a qualified facility or carbon capture equipment may qualify as originally placed in service even though it contains some used components of property, provided the fair market value of the used components of property is not more than 20% of the qualified facility or carbon capture equipment’s total value (the cost of the new components of property plus the value of the used components of property). For purposes of the 80/20 rule, the cost of a new qualified facility or carbon capture equipment includes all properly capitalized costs of the new qualified facility or carbon capture equipment. Solely for purposes of the 80/20 rule, properly capitalized costs of a new qualified facility or carbon capture equipment may, at the option of the taxpayer, include the cost of new equipment for a pipeline owned and used exclusively by that taxpayer to transport carbon oxides captured from that taxpayer’s qualified facility that would otherwise be emitted into the atmosphere. 

By adopting the 80/20 rule, the proposed regulations will allow existing facilities that make substantial investments in retrofitting their equipment to claim section 45Q credits under the new post-Bipartisan Budget Act provisions. This welcome addition will help incentivize taxpayers to improve carbon capture on existing facilities. 

Initial Framework for Utilization Laid Out 

The Bipartisan Budget Act added carbon oxide utilization, described in section 45Q(f)(5), as an additional avenue for claiming section 45Q credits. Section 45Q(f)(5)(A) provides that “utilization of qualified carbon oxide” means (i) the fixation of such qualified carbon oxide through photosynthesis or chemosynthesis, such as through the growing of algae or bacteria; (ii) the chemical conversion of such qualified carbon oxide to a material or chemical compound in which such qualified carbon oxide is securely stored; or (iii) the use of such qualified carbon oxide for any other purpose for which a commercial market exists (with the exception of use as a tertiary injectant in a qualified enhanced oil or natural gas recovery project), as determined by the Treasury Secretary. 

Section 45Q(f)(5)(B) provides a methodology to determine the amount of qualified carbon oxide utilized by the taxpayer. Such amount is equal to the metric tons of qualified carbon oxide which the taxpayer demonstrates, based upon an analysis of lifecycle greenhouse gas emissions and subject to such requirements as the Treasury Secretary, in consultation with the Secretary of Energy and the Administrator of the EPA, determines appropriate, were (i) captured and permanently isolated from the atmosphere, or (ii) displaced from being emitted into the atmosphere, through use of a process described in section 45Q(f)(5)(A). The term “lifecycle greenhouse gas emissions” in section 45Q is given the same meaning as the term under the Clean Air Act, as in effect on February 9, 2018, except that “product” is substituted for “fuel” each place it appears in the Clean Air Act. Under the Clean Air Act, net emissions of all greenhouse gases (and not just carbon oxides) must be taken into account with the mass values for each greenhouse gas is adjusted to account to reflect its relative global warming potential. 

Treasury, in consultation with the EPA and the Department of Energy (DOE), concluded that a lifecycle analysis (LCA) must be in writing and either performed or verified by a professionally-licensed third party that uses generally-accepted standard practices of quantifying the greenhouse gas emissions of a product or process and comparing that impact to a baseline. In particular, the analysis must contain documentation consistent with ISO standard 14044:2006 (“Environmental management — Life cycle assessment — Requirements and Guidelines”), as well as a statement documenting the qualifications of the third party. 

The proposed regulations further require a taxpayer to submit an LCA report to the IRS and the DOE. The LCA will be subject to a technical review by the DOE, and the IRS, in consultation with the DOE and the EPA, will determine whether to approve the LCA. Treasury requested comments on how to achieve consistency in boundaries and baselines so that similarly situated taxpayers will be treated consistently. The preamble also states that Treasury is willing to consider issuing guidance on particular fact patterns. 

Treasury did not comprehensively address all issues related to carbon utilization, reserving several complex issues for further regulation, including standards for an LCA and the definition of a commercial market. Importantly, the regulations include the recognition that, in an LCA, “greenhouse gas emissions” means the aggregate quantity of emissions, where the mass values for all greenhouse gases are adjusted to account for relative global warming potential. 

Five-Year Lookback Period Introduced for Credit Recapture 

Section 45Q credits have always been subject to recapture (although carbon utilization under the post-Bipartisan Budget Act is not subject to the recapture provision) for carbon oxides that cease to be captured and disposed of consistent with the requirements of section 45Q. Although Notice 2009-83 provided some guidance on the recapture provision, the absence of comprehensive guidance and the open-ended nature of recapture risk has been an impediment to the incentive provided by section 45Q credits. 

The proposed regulations address this prior uncertainty by providing comprehensive guidance and a five-year lookback period. The proposed regulations provide that any recapture amount will be accounted for in the taxable year that it is identified and reported. If, during the recapture period, a taxpayer, operator, or regulatory agency determines that qualified carbon oxide has leaked to the atmosphere, the taxpayer will have a recapture amount if the leaked amount of qualified carbon oxide exceeds the amount of qualified carbon dioxide disposed of in secure geological storage or used as a tertiary injectant in that taxable year. If the leaked amount does not exceed the amount captured, it will reduce the amount stored or injected for purposes of claiming the credit in the current year. 

The excess amount of leaked qualified carbon oxide will be recaptured at a credit rate calculated on a LIFO basis (that is, the excess leaked qualified carbon oxide will be deemed attributable initially to the first preceding year, then to second preceding year, and then up to the fifth preceding year) to simplify the calculation of the recapture amount. The taxpayer must add the amount of the recaptured section 45Q tax credit to the amount of tax due in the taxable year in which the recapture event occurs. Consistent with this five-year lookback period, the proposed regulations provide that the recapture period will end on the earlier of: (i) five years after the last taxable year in which the taxpayer claimed a section 45Q credit (the “post-credit-claiming period”); or (ii) the date monitoring ends under the Subpart RR rules or the ISO standard. Treasury requested comments on how to apply the recapture provisions to section 45Q credits that are carried forward to future tax years due to insufficient tax liability in the current tax year. 

Some taxpayers may be concerned that a five-year lookback period (and/or a five-year post-credit-claiming period) may be too long. Many commenters suggested shorter periods. For example, a submission by the Carbon Capture Coalition written and reviewed by leading experts in subsurface geologic storage of carbon dioxide explained how, taken together, physics and flow mechanics, experience with and tools for subsurface management of buoyant fluids, combined with regulatory requirements suggest that: (i) cases of loss of volumes of carbon dioxide that would approach the commercial volumes sequestered during a two-year period are highly improbable; and (ii) potential carbon dioxide losses occur principally during injection and/or early in a project, while a field is being actively monitored for injection pressures and conformance. This kind of evidence tends to support a substantially shorter lookback period and post-credit-claiming period. Treasury did, however, request comments on the length of the look-back period. 

The proposed regulations also include rules for allocating a recapture amount among taxpayers that own the multiple units of carbon capture equipment or among taxpayers that claimed section 45Q credits generated by a single unit of carbon capture equipment. The proposed regulations also provide a limited exception to recapture in the event of a leakage of qualified carbon oxide resulting from actions not related to the selection, operation, or maintenance of the storage facility, such as volcanic activity or a terrorist attack. Finally, the proposed regulations provide that if qualified carbon oxide is deliberately removed from a secure storage site, a recapture event occurs in the year in which the qualified carbon oxide is removed from its original storage. 

Conclusion 

While some questions remain, the proposed regulations are an important step forward in providing investors in carbon capture projects with the certainty that is needed for the robust development of the carbon capture industry. Importantly, the government permitted reliance on the proposed regulations. Comments on the proposed regulations must be received within 60 days of the date of publication in the Federal Register.