The Inflation Reduction Act of 2022 (the “IRA”) now allows firms to develop and sell clean energy tax credits.  In our last update, available here, we discussed the latest developments on the “direct pay” rules, the clean hydrogen credit and the new guidance on the energy community bonus tax credit.

Ranking Member of the House Ways and Means Committee Richard Neal recently touted the IRA’s importance for bolstering domestic manufacturing and the market for electric vehicles, concluding that the IRA has caused “unprecedented strides in tackling climate change while growing the clean energy economy.” 

Still, given the novelty, it may take time for the market for tax credits to fully develop.

As noted in a recent update, available here, tax insurance may help move things along by providing comfort to prospective buyers of credits.

Here are some of the risks that tax insurance might mitigate:

• Credit Amount: Buyers of credits face the possibility that credit amounts will be reduced during an audit, thereby increasing buyer’s tax liability.  The investment tax credit is determined based on the value of the underlying project, making high-value projects susceptible to IRS scrutiny.  The IRS may challenge certain assumptions made by appraisers and require more support for value conclusions.  It may become standard practice to obtain tax insurance policies to protect against losses caused by these audit adjustments.
• Recapture Tax: If a project later loses its eligibility for credits as a result of, among other things, the sale (including the foreclosure) of the investment credit property during the applicable recapture period, then the buyer of any credits bears the risk of any recapture tax.  Insurance may cover recapture tax caused by events that are outside of the developer’s control, such as natural disasters that take projects out of service.  Similarly, a lender that provided initial financing may not agree to a forbearance, and a foreclosure that takes place within the recapture period would result in recapture tax to a buyer.  Conversely, insurance may not protect a buyer from recapture events that are within the seller’s control.  In such cases, the seller may agree to indemnify the buyer.  However, buyers would be wise to seek insurance policies with specific single-event triggers for additional protection against financially strained developers.    
• Tax Structure: Another inherent risk is that the IRS may not recognize the intended tax structure of the project.  With the introduction of the transferability provisions of the IRA, developers may now utilize “hybrid” structures that allow them to sell the project to a partnership for a stepped-up basis (as was the benefit of traditional tax equity structures) and then sell the credits to an unrelated buyer.  Despite hybrid structures gaining popularity, law firms may be hesitant to provide unqualified tax opinions given the novelty of the market.  Insurance could potentially fill this gap.
• Bonus Credits: The domestic content and energy community bonus credits each provide the opportunity to increase the amount of the investment tax credit by 10%.  However, it is still unclear who qualifies for bonus credits.  Moreover, the determination involves analyzing highly sensitive data about suppliers’ production costs—information that developers and their suppliers are hesitant to disclose to competitors.  Hiring professionals to preserve confidentiality adds another cost that may deter developers from pursuing bonus credits.  Insurance may be available to provide comfort in light of the emerging market for the new bonus credits.

As the tax insurance market moves towards standardization, it will eventually become more accessible to smaller developers, who may be able to obtain a single blanket policy that covers a portfolio of projects in order to reduce underwriting and due diligence costs.  We expect tax insurance to play a crucial role in supporting the market for energy tax credits.