On June 14, 2023, the IRS issued proposed regulations (the “Proposed Regulations”)^[1] with respect to energy tax credits which are directly payable to State and local governmental entities as well as to 501(c)(3) organizations as a result of the enactment of the Inflation Reduction Act of 2022 (the “Act”).^[2] At the same time, the IRS published additional commentary with respect to these credits in the form of Frequently Asked Questions.^[3] This article, which follows and updates our May 8, 2023 client advisory describing the Act’s provision of such payable tax credits for clean energy investments (also referred to as “refundable investment tax credits” or “refundable ITCs”), will briefly recap the Act’s refundable ITC provisions and then highlight the Proposed Regulations that are most directly applicable to the refundable ITCs, including: (i) the clarification of who can elect to receive refundable ITCs; (ii) the procedures for making those elections; and (iii) other relevant rules.

The Act made refundable ITCs, along with other energy credits, available to State and local governments, as well as 501(c)(3) organizations, as cash payments. These tax exempt entities can claim a refundable ITC for up to 30% or more of the investment’s cost if it meets size or labor requirements. Additional bonuses are available for using domestic content and locating the investment in a low-income community. The Act, however, also applies a 15% “haircut” to the amount of the refundable ITC based on the allocation of the proceeds of tax-exempt bonds to finance all or a portion of the capital costs of a clean energy project. For more details, please see our prior client advisory on the Act’s refundable ITC provisions.

Who Can Elect to Receive Refundable ITCs

The Act allows refundable ITCs to be claimed by “applicable entities,” which includes State and local governments as well as 501(c)(3) organizations. The Proposed Regulations confirm that agencies and instrumentalities of State and local governments can also claim refundable ITCs, meaning that public school districts and hospitals owned or controlled by States or city or county governments are eligible to claim a refundable ITC subsidy.

Applicable entities usually must directly own the clean energy investment to claim a refundable ITC, but the Proposed Regulations provide an exception for an applicable entity in the situation where (i) the applicable entity wholly owns a subsidiary which is treated as an entity disregarded from its owner for federal income tax purposes (e.g., a single-member LLC) and (ii) the subsidiary owns the clean energy investment. In this case, as the subsidiary does not file its own tax returns, the applicable entity that controls the subsidiary can claim a refundable ITC with respect to the indirectly-held clean energy investment. As an example, under the Proposed Regulations, if a city creates a single-member LLC to make a clean energy investment and to own the resulting clean energy project, the city would be able to claim the refundable ITC for that investment.

Additionally, the Proposed Regulations confirm that if an applicable entity owns a clean energy investment in a tenancy-in-common arrangement, it can claim a refundable ITC with respect to its undivided ownership interest in the investment.

Unfortunately the Proposed Regulations exclude another common investment structure from the refundable ITC regime. Partnerships (as well as S corporations) are not applicable entities, and their partners (or owners) cannot claim refundable ITCs for investments owned by the partnership or S corporation. For example, if a city entered a joint venture with a private developer to upgrade energy facilities and a partnership jointly owned by the city and the developer made the investment, neither the joint venture partnership nor the city would be able to claim a refundable ITC. Worse, the same outcome would result under the Proposed Regulations even if the partnership were comprised exclusively of applicable entities such as cities or towns who could claim refundable ITCs in their own right.  The preamble to the Proposed Regulations acknowledges that prior feedback had anticipated that partnerships could claim refundable ITCs at least to the extent of partnership interests held by applicable entities, but the IRS stated in the preamble to the Proposed Regulations that it believes the partnership exclusion is the better interpretation of the statutory language and is not as difficult to administer.^[4]

Refundable ITC Election Process

Prior to claiming refundable ITCs as hereinafter described, an applicable entity will need to preregister its eligible projects and obtain a registration number for each clean energy project which will be the basis for a refundable ITC election. The IRS will create an electronic portal where taxpayers will obtain registration numbers, but the portal is not yet available. If the investment changes after a registration number is changed (e.g., transferred to a new owner in a reorganization), the applicable entity will need to update the registration or acquire a new registration number. Registration numbers will be good for one tax year, but may be renewed.

An applicable entity will claim refundable ITCs on its annual federal income tax return. Applicable entities that do not file a tax return will file a return on Form 990-T to make the election, and the Form 990-T will be due on the fifteenth day of the eleventh month after the entity’s tax year (November 15 for calendar tax years).^[5] The IRS has not yet indicated how tax return forms will change to accommodate the election, particularly for State and local governmental entities that historically have had no occasion to file a Form 990-T.

The refundable ITC election must be made on the originally filed tax return. It cannot be made for the first time on an amended return, and the Proposed Regulations specifically exclude this election from Section 9100 late-filing relief.

Other Relevant Rules

If the IRS finds during an examination that it paid too much as a refundable ITC to an applicable entity, that entity must repay the excess refund to the IRS. The applicable entity may also have to pay a penalty equal to 20% of the excess refund if it cannot show a reasonable cause for the error in claiming the excessive refundable ITC payment.

Applicable entities can only elect payment of refundable ITCs which are determined with respect to the applicable entity. They cannot elect payment of tax credits which are acquired from another party, including by purchase pursuant to Section 6418 of the Internal Revenue Code.

Finally, if an applicable entity uses so-called tax-exempt income, including income from certain grants and forgivable loans, to make a clean energy investment that qualifies for a refundable ITC, the total of (i) the amount of tax-exempt income used for the investment and (ii) the refundable ITC must not exceed the overall cost of the investment. If the total is greater than the investment’s cost, the refundable ITC will be reduced so that the total is equal to and not in excess of the investment’s cost.

The preceding is a brief overview of the Proposed Regulations with respect to refundable ITCs.  Please note that the Proposed Regulations are not yet finalized and may be substantially modified after the IRS considers public comments.^[6]  Hinckley Allen’s Tax and Public Finance Groups stand ready to assist with the development of strategies to ensure that you capture the maximum value available under federal tax law through tax-exempt bond financing and the refundable ITC program.

[1] Section 6417 Elective Payment of Applicable Credits, 88 Fed. Reg. 40528 (June 21, 2023).  The Proposed Regulations can be found at https://www.federalregister.gov/documents/2023/06/21/2023-12798/section-6417-elective-payment-of-applicable-credits.

[2] Inflation Reduction Act of 2022, H.R. 5376, 117th Cong. (2022).

[3] The FAQ can be found at https://www.irs.gov/credits-deductions/elective-pay-and-transferability-frequently-asked-questions-elective-pay.

[4] Section 6417 Elective Payment of Applicable Credits, 88 Fed. Reg. at 40534. This element of the Proposed Regulations has received some notable pushback from commentators, including the American Hospital Association, and may be reconsidered by the IRS in the course of finalizing the regulations in this area.

[5] The Form 990-T is statutorily due on the fifteenth day of the fifth month of the following year, but the Proposed Regulations provide an automatic six-month extension for this purpose.

[6] Significant comments were submitted by, among others, the National Association of Bond Lawyers and the American Hospital Association.