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Making Oil & Gas Great Again – Carbon Capture Tax Credit Regulations

There are few limits to human ingenuity.  We are witnessing this inventiveness as multiple vaccines roll out across the globe to tackle the Covid-19 pandemic.  Similar worldwide efforts may someday result in technologies to address climate change, and in particular the presence of atmospheric carbon gases which are widely-regarded as the cause. 

For now, it remains unknown what types of technologies will ultimately supply the cure.  Possibilities range from alternative energies that do not release carbon gases (the trick is finding such an energy that is reliable, abundant and affordable), to technologies that prevent carbon emitted from existing energy sources from reaching the atmosphere (carbon capture technologies, the subject of this blog post), to technologies that remove carbon from the atmosphere (maybe the only option if previous predictive modeling was correct that the atmosphere’s carbon-saturation is past the point of no return).  The solution could also lie in any combination of immediately available proven technologies and longer-term solutions that may be more tantalizing but further away from becoming realities.  At this stage, all options should be on the table. 

Given that oil and natural gas continue to play an important part in the planet’s energy mix, particularly in third world countries for the foreseeable future, policy-makers have not entirely abandoned efforts to align the usage of oil and natural gas with efforts to reduce carbon emissions.  Oil (and to a much lesser extent natural gas) are carbon emitting, both during their production and in their consumption.  But what if we could catch the carbon emitted from oil and natural gas before it ever enters the atmosphere?  Sounds like a great idea, right?  Well, it turns out others have already thought of it.  There are various carbon capture and storage technologies (otherwise known as carbon sequestration) in wide usage today, and many others in development.  Carbon oxides (including carbon dioxide) from power-plant combustion and other industrial sources may be captured, compressed and injected into underground geologic formations for permanent storage.  Carbon streams that escape from oil and gas wells during the extraction process may similarly be captured and stored in underground saline and salt formations indefinitely.

Over a decade ago, Congress added Section 45Q to the Internal Revenue Code as part of the Energy Improvement and Extension Act of 2008 to encourage the development and usage of certain carbon capture technologies.  The section was amended multiple times during the Obama and Trump administrations, most recently (and most significantly) in the Bipartisan Budget Act of 2018 (BBA), to further incentivize the construction of carbon sequestration projects.  The BBA enhanced the flexibility of Section 45Q’s framework to permit taxpayers other than the industrial facility owner to obtain the tax credit by investing in carbon capture equipment or through elections to transfer the credit.  This makes the carbon capture industry more accessible and economically attractive to investors, including participants in tax equity partnerships where the partnership-project company owns the carbon capture equipment.  However, the text of Section 45Q leaves many questions, and directs Treasury and the IRS to issue regulations to round out the edges.  Although this directive exists in the original Section 45Q enacted in 2008, no final regulations had been issued until last week when the Trump Administration “pre-released” a package of final Treasury regulations for Section 45Q. 

Section 45Q in its current 2018-version generally allows for a credit of an amount per metric ton of qualified carbon oxide (including carbon dioxide) captured by the taxpayer using carbon capture equipment.  This qualified carbon oxide must be captured according to the statute using one of three general methods.  First, the qualified carbon oxide may be disposed of in secure geological storage.  This would occur if it were injected into a geologic formation, such as a deep saline formation, an oil and gas reservoir, or an unminable coal seam.  Second, the qualified carbon oxide may be used as a tertiary injectant in a qualified enhanced oil or natural gas recovery project and disposed of in secure geological storage.  A “tertiary injectant” is qualified carbon oxide that is injected into and stored in a qualified enhanced oil or natural gas recovery project and contributes to the extraction of crude oil or natural gas.  Third, the qualified carbon oxide may be “utilized” by fixing it through photosynthesis or chemosynthesis, converting it to a material or chemical compound in which it is securely stored, or using it for any other purpose for which a commercial market exists.  The amount of the credit depends on the date the carbon capture equipment is placed in service and whether the qualified carbon oxide is disposed of in secure storage, injected, or utilized.  (For example, the credit is $20 per metric ton of carbon sequestered when using carbon capture equipment originally placed in service at a qualified facility before February 9, 2018, and disposed of by the taxpayer in secure geological storage.)

As with any complex regulatory scheme – and make no mistake about it, this one is complex – there a many areas of uncertainty.  One is what happens in the event sequestered carbon gases leak from the project’s containment system.  There are rigorous regulatory requirements for sequestration facilities, so this should be uncommon, but things happen.  Section 45Q(f)(4) requires Treasury and the IRS to promulgate regulations to provide for the recapture of section 45Q credits in the event of leakage.  In this context, “recapture” refers to the repayment of the tax credits claimed, and not to the recapturing of carbon gases that may have leaked from the project after being injected.  Questions include: (i) when the tax would be due in relation to the year of a recapture event; (ii) how long the IRS can “look back” to recapture credits in the event of leakage (lookback period); and (iii) the length of time after ceasing to claim credits during which a leakage event would lead to recapture of credits.

Under the January 6, 2021 pre-released Treasury regulations, any recapture amount will be accounted for in the taxable year that it is identified and reported, and subject to a maximum 3-year look back period.  The proposed regulations had stated a 5-year look-back period, however Treasury received data during the notice and comment period that it takes less than three years for carbon dioxide injected into an underground reservoir to become stable, and a 3-year look-back synchronizes with the statute of limitations on assessments.  It also received commentary that it would improve tax and financial statement certainty to truncate the look-back period.  In consultation with the EPA, the DOE, and the Interior Department, and considering their views on the likelihood of leakage in the years following injection into the formation designed to contain the carbon gases, Treasury adopted the 3-year look-back. 

Further, the regulations view carbon gas as fungible.  Recapture is computed by allocating the leaked carbon gas to previously claimed credits on a last-in, first-out basis (LIFO), going back the maximum of 3-years.  If there are multiple credit claimants, the recapture is allocated among the owners of the equipment or prior claimants of credits on a pro rata basis.  The aggregate amount of credits that are recaptured are a function of the number of back years, and the quantity of leakage certified by a qualified independent engineer or geologist. 

Special issues may arise in the case of partnerships.  Multiple owners of carbon capture equipment may form a partnership to allocate section 45Q credits among themselves pursuant to Revenue Procedure 2020-12.  A partnership may also be one of the multiple taxpayers that claimed section 45Q credit amounts, which case the partnership and not its partners will be the taxpayer to which the pro rata recapture amount must be allocated.  The partnership then allocates its pro rata recapture amount among its partners under Treas. Reg. § 1.704-1(b)(4)(ii).  If such a partnership terminates under Section 708(b)(1) prior to a recapture event, the partners of that terminated partnership at the time the section 45Q credits were claimed will be the taxpayers to which the pro rata recapture amount is allocated.  Importantly, practitioners should coordinate this rule with the BBA’s new partnership audit procedural regime, which may complicate how new entrants to a partnership may protect themselves from bearing the economic burden of the recapture. 

Importantly, the final regulations provide an illustrative list of exceptions to the recapture rule for certain events beyond the taxpayer’s control, such as terrorist attacks. 

For investors and their tax advisors that have been waiting for Treasury to provide greater certainty on the application of Section 45Q, these pre-released regulations may provide the clarity needed to make informed investment decisions.  It may also offer solace to those that believe incentivizing and subsidizing carbon capture is a worthwhile component of the climate change solution.  No doubt that carbon sequestering projects on an industrial scale require large upfront capital investments, and greater clarify and flexibility on the application of these rules should help encourage investments in these projects.

Notably, the Trump Administration indicated the regulations would be published in the Federal Register at a later date.  President-elect Biden's campaign indicated that the incoming Biden Administration may halt any regulations that haven't taken effect by January 20.  Hitting the pause button for the new administration to review Eleventh Hour regulatory actions by an outgoing administration is not in and of itself unusual.  Both the Trump and Obama administrations froze tax regulations until their respective administrations reviewed them.  But little about the current transition between administrations has been business as usual, so it remains to be seen how the Biden Administration will approach last-minute executive actions, including the regulations under Section 45Q.    

  • Peter A. Lowy

    Peter A. Lowy, a shareholder in Chamberlain Hrdlicka’s Houston office, is best known for his tax controversy work and deep experience in the energy sector. He also advises corporations and other taxpayers in a broad spectrum of ...