On June 14, 2023, the IRS released proposed regulations on the provisions created under the Inflation Reduction Act of 2022 (the “IRA”) that will allow developers to sell energy tax credits.

Transferability is expected to supplement (and in some cases may replace) the existing method of monetizing tax credits through tax equity partnership structures, and will undoubtedly expand the market for investment in energy tax credits by allowing purchasers of these credits to offset predictable taxable income.

Under new Code Section 6418, a developer may sell all (or a portion of) credits in the year they are created to unrelated for-profit buyers by completing a pre-filing registration online and making an irrevocable transferability election on its tax return. Sales proceeds are excluded from taxable income (or treated as tax-exempt income to partnerships and S corporations). A buyer of the credits is treated as the taxpayer and must report the purchase of credits on its tax return in the year that consideration for the credits is “paid in cash.” A buyer’s payments are not deductible. A buyer may not resell credits.

The proposed regulations provide some guidance on transferability. Here is the good news:

• Carrybacks and Carryforwards: Buyers can take advantage of the IRA’s expanded 3-year carryback period and 22-year carryforward period for purchased credits. Although a buyer must report its purchase of credits in the year they are purchased, the rules provide flexibility to choose when to apply the credits.
• No Gross Income: Any spread between the amount paid for a credit and the amount of the credit is not taxed.
• Multiple Buyers: A developer may sell portions of a credit to multiple buyers (but may not sell a bonus credit separately from a base credit).

The proposed regulations allocate more responsibility to buyers of credits than what was otherwise anticipated and clarify how other rules regarding credit limitations should apply:

• Buyer Reporting: A buyer and seller must jointly prepare a “transfer election statement” describing the proposed transfer of the credits. A purchase and sale agreement may qualify for this purpose if it contains sufficient information to validate the existence of the credits as set forth in the regulations. A buyer must include the statement with its tax return in the year the credits are purchased.
• Recapture Tax: If a project later loses its eligibility for credits as result of, among other things, the sale of the investment credit property during the applicable recapture period, then the buyer of any credits (who may not oversee the project) bears the risk of any recapture tax; a seller must provide notice to a buyer of a recapture event so that the buyer can calculate the recapture amount. A sale of partnership or S corporation interests would not trigger recapture because a buyer would not be liable for recapture tax under those circumstances.
• Excessive Credit Transfers: Buyers are also liable for any adjustments caused by excessive credit transfers, which include a 20% penalty unless the buyer can demonstrate reasonable cause.
• Pre-Filing Registration: The regulations provide specific guidance on the timing and manner of making the transferability election as well as the pre-filing registration process. A seller must apply for a registration number for every credit (or portion thereof) it expects to sell online through a new IRS electronic portal. It is unclear when this electronic portal will be ready.
• Lessees May Not Sell Credits: If a taxpayer is only allowed to claim a credit as a result of an election (e.g., as a lessee of the project), it is not permitted to sell the credits. The preamble states that a credit is ”determined” with respect to an eligible taxpayer where the taxpayer owns the underlying credit eligible property or, if ownership is not required, otherwise conducts the activities giving rise to the credit. Curiously, the regulations provide an example of a lessee who conducts carbon sequestration activities to conclude that such lessee would not be permitted to sell any credits because it could only claim the credits as a result of an election made by the project owner.
• Passive Activity Rules: The regulations confirm that a transferred credit is treated as earned in connection with the conduct of a trade or business for purposes of the passive activity rules, which means that unless the buyer materially participates in the seller’s business, purchased credits may only ever be applied to offset passive income for buyers subject to the passive activity rules. The regulations also confirm that the tax-exempt sales proceeds to a selling partnership or S corporation are treated as arising from an investment activity for purposes of the passive activity rules.

 Future IRS guidance is expected to address these open questions:

• Transaction Costs: The tax treatment of transaction costs for a buyer and seller is expected to be addressed in future IRS guidance.
• Treatment of Losses: Although a buyer’s payments for the credits is not deductible, the question remains as to whether a buyer is permitted to deduct a loss if the amount paid for the credit exceeds the amount of eligible credit that can be claimed. Further, it is unclear whether the buyer’s inability to deduct payments for the credits has any implications on whether such costs can be capitalized.
• Qualification as a REIT: The IRS may issue future guidance to clarify potential REIT asset test issues and whether sales of certain credits would constitute dealer activity. REITs should find some comfort in the preamble language that says there should be no prohibited transaction risk arising from a sale of credits because the sale does not result in any taxable income to the seller on which any penalty would be assessed.