Section 45Q Proposed Regulations Provide Guidance on Secure Geological Storage, Carbon Oxide Utilization, Retrofitting, and Recapture
On May 28, 2020, the IRS released proposed regulations under section 45Q (the “Proposed Regulations”) that had been widely anticipated since the expansion of the statute in 2018. The Proposed Regulations, which follow closely on the heels of IRS guidance regarding tax equity partnership flip structures and start of construction, are proposed to be effective prospectively for taxable years beginning on or after the date of finalization, but taxpayers may choose either to apply the final regulations or to rely on the Proposed Regulations for taxable years beginning on or after February 9, 2018. Below follows a summary of the highlights in this newest section 45Q guidance.
- Clarification of “contractually ensures.” The section 45Q credit is taken by the person that captures the qualified carbon oxide (in the case of a facility originally placed in service before February 9, 2018) or owns the carbon capture equipment (in the case of a facility originally placed in service on or after February 9, 2018). In both cases, such person must “physically or contractually ensure” the disposal of the carbon oxide, either through secure geological storage (“disposal”), use for tertiary injection and disposal through secure geological storage (“injection”), or utilization in a manner consistent with section 45Q(f)(5) (“utilization”). The Proposed Regulations generally impose a “binding written contract” standard for when a taxpayer is considered to “contractually ensure” the fate of the captured carbon oxide. In addition to being enforceable under state law against both the taxpayer and the party physically performing the disposal, injection or utilization, the contract cannot limit damages to a specified amount (in contrast to analogous guidance in the investment tax credit (“ITC”) and production tax credit (“PTC”) areas, there is no exception for limitations of damages to 5% or more of the contract price, but liquidated damages provisions are explicitly allowed). Multiple contracts are permitted; each contract must include commercially reasonable terms and provide for enforcement of the party’s obligation to dispose, inject or utilize the carbon oxide. The contract must obligate the injecting or utilizing party to comply with various standards and notice requirements stated elsewhere in the Proposed Regulations. Certain information about each contract must be reported annually on Form 8933 by each party to the contract.
- Guidance regarding Section 45Q(f)(3)(B) Election. Alternatively, an election may be made (the “Section 45Q(f)(3)(B) Election”), by the capturing person or carbon capture equipment owner, as the case may be, to allow the disposing, injecting, or utilizing person to claim the section 45Q credit instead. The Proposed Regulations specify that the Section 45Q(f)(3)(B) Election may be for all or part of the section 45Q credits for a taxable year, and the electing taxpayer may choose to allow one or more claimants to claim the credits (so long as the credit is prorated among multiple claimants in proportion to the amount of qualified carbon oxide disposed of, injected, or utilized by each claimant). The election, which comes with various information requirements (including, if applicable, information relating to the facility where qualified carbon oxide is disposed of or injected), must be made in accordance with Form 8933 and filed with the taxpayer’s tax return for the relevant year, with elections on amended returns allowable only in limited transition and COVID-19 related situations (and in no event for taxable years beginning after the date of the issuance of the Proposed Regulations).
- Definition of “carbon capture equipment.” Section 45Q generally requires that qualified carbon oxide be captured using “carbon capture equipment,” but does not define this term. The Proposed Regulations provide a functionality-based definition, such that carbon capture equipment generally 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. Specifically, the equipment must be used to either separate, purify, dry, and/or capture carbon oxide that would otherwise be released into the atmosphere from an industrial facility; remove carbon oxide from the atmosphere via direct air capture; or compress or otherwise increase the pressure of carbon oxide. Carbon capture equipment generally includes components of property necessary to perform a physical action to capture qualified carbon oxide. Carbon capture equipment excludes certain equipment (e.g. pipelines and transport vessels) used to transport captured qualified carbon oxide for disposal, injection or utilization, but includes certain gathering and distribution systems that transport captured carbon oxide to a pipeline used to transport carbon oxide from multiple taxpayers or projects.
- Definition of “industrial facility.” Section 45Q also requires that qualified carbon oxide be captured using carbon capture equipment at a “qualified facility,” which must be an “industrial facility” (unless it is a “direct air capture facility” described in section 45Q(e)(1)). Section 45Q does not define “industrial facility.” The Proposed Regulations, adopting the approach of Section 3.03 of Notice 2020-12, indicate that an industrial facility must produce 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.” However, facilities that produce carbon dioxide from wells at natural carbon dioxide-bearing formations or naturally occurring subsurface springs are excluded.
- Adoption of 80/20 Rule for qualified facilities. Section 45Q(a) generally provides a larger credit for qualified facilities that are originally placed in service after February 9, 2018 (the date of enactment of the Bipartisan Budget Act of 2018). The Proposed Regulations permit retrofitted qualified facility or carbon capture equipment to qualify as originally placed in service even if 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 (i.e. the cost of the new components of property plus the value of the used components of property). This so-called “80/20 Rule,” which originally appeared in wind PTC guidance during the 1990s, has been a major part of the section 45 and section 48 “repower” guidance since 2016. The Proposed Regulations explicitly allow for certain pipeline costs associated with transporting captured carbon oxide to be included in the 80/20 test.
- Guidelines for “secure geological storage.” Unless the captured carbon oxide is used in a manner described in section 45Q(f)(5) (e.g. fixed through growing of algae or bacteria, or chemically converted into a material or chemical compound that is securely stored), it must be “disposed of by the taxpayer in secure geological storage.” Section 45Q(f)(2) directs the Secretary of the Treasury, in consultation with the Administrator of the Environmental Protection Agency (“EPA”), the Secretary of Energy, and the Secretary of the Interior, to establish regulations for “determining adequate security measures for the geological storage of qualified carbon oxide . . . such that the qualified carbon oxide does not escape into the atmosphere.”
The “secure geological storage” standard of section 45Q implicates two non-tax regimes that are described in the preamble to the Proposed Regulations. First, under the EPA’s Underground Injection Control (“UIC”) program, a UIC well permit must be obtained for the correct class of well. Generally speaking, Class II wells are used to inject fluids associated with oil and natural gas production and Class VI wells are used to inject carbon dioxide into deep rock formations. Second, operators that inject carbon dioxide underground are also subject to the EPA’s Greenhouse Gas Reporting Program (“GHGRP”), pursuant to which Class VI wells are subject to 40 CFR Part 98 subpart RR (“subpart RR”) and must implement an EPA-approved site-specific Monitoring, Reporting, and Verification Plan (“MRV Plan”) in addition to basic reporting requirements on carbon dioxide received for injection, but Class II wells are subject to 40 CFR Part 98 subpart UU (“subpart UU”) and need only meet the aforementioned basic reporting requirements (although the owner or operator can opt into subpart RR). The instructions to the current version of Form 8933 state that “secure geological storage” requires EPA approval of an MRV Plan, thus implying that Class II wells must also opt into subpart RR in order for the “secure geological storage” standard of section 45Q to be met.
To allow Class II wells to meet the “secure geological storage” standard without the owner or operator opting into the MRV Plan requirements of subpart RR, the Proposed Regulations state that qualified carbon oxide, if used as a tertiary injectant in a qualified enhanced oil or natural gas recovery project, is considered to be disposed of by the taxpayer in secure geological storage if the qualified carbon oxide is stored in compliance with certain International Organization for Standardization (“ISO”) standards endorsed by the American National Standards Institute (“ANSI”) under CSA/ANSI ISO 27916:19. However, whereas a taxpayer can generally self-certify the volume of carbon oxide claimed for purposes of section 45Q if the taxpayer opts into subpart RR with respect to a Class II well, such documentation must be certified by a qualified independent engineer or geologist if the Class II well instead meets the “secure geological storage” standard under CSA/ANSI ISO 27916:19. The Proposed Regulations also explicitly confirm that the qualified carbon oxide must be injected into a well that complies with applicable UIC regulations.
- Guidelines for “utilization” of qualified carbon oxide. As an alternative to secure geological storage, section 45Q(f)(5) provides that qualified carbon oxide may also be “utilized” in certain specified ways, including fixation through photosynthesis or chemosynthesis, chemical conversion to a material or chemical compound in which the qualified carbon oxide is securely stored, or any use for a purpose “for which a commercial market exists” (other than as a tertiary injectant in a qualified enhanced oil or natural gas recovery project) as determined by the Secretary. The statute defines the amount “utilized” in this manner as the amount of qualified carbon oxide that the taxpayer demonstrates to have been either “captured and permanently isolated from,” or “displaced from being emitted into,” the atmosphere. Such demonstration must be based upon an analysis of lifecycle greenhouse gas emissions (“LCA”) and subject to requirements set by the Secretary in consultation with the Secretary of Energy and the Administrator of the EPA.
The Proposed Regulations state that the taxpayer must measure the amount of captured and “utilized” carbon oxide through direct measurement and a written LCA report consistent with ISO 14044:2006, “Environmental management — Life cycle assessment — Requirements and Guidelines,” both of which must be performed or verified by an independent and properly licensed third party. However, the Proposed Regulations reserve on providing standards for the LCA and state only that the report must be subject to a technical review by the Department of Energy (“DOE”), with final approval of the LCA determined by the IRS “in consultation with” the DOE and the EPA. The Proposed Regulations also reserve on the definition of “commercial market” for purposes of section 45Q(f)(5).
- Recapture. Section 45Q(f)(4) directs the Secretary to provide regulations for recapturing the credit if qualified carbon oxide ceases to be captured, disposed or, or used as a tertiary injectant in a manner consistent with the requirements of section 45Q. The Proposed Regulations impose recapture on a project by project basis, and only to the extent that the amount of leaked qualified carbon oxide in a taxable year exceeds the amount of qualified carbon oxide that is disposed of in secure geological storage or used as a tertiary injectant in that same taxable year (with any such reduction in recapture giving rise to a corresponding decrease in the credit for that year, provided that no such offset is permitted if there is an intentional removal of qualified carbon oxide from secure geological storage). The leaked amount must be quantified under specific standards (either subpart RR or CSA/ANSI ISO 27916:19). Echoing the section 50(b) recapture rules applicable to the ITC, the recapture period ends upon the earlier of five years after the last taxable year in which the taxpayer claimed the credit, or the date monitoring ends under subpart RR or CSA/ANSI ISO 27916:19 (as the case may be). Recapture amounts are calculated on a last-in-first-out basis, with proration across multiple units of carbon capture equipment if the leaked qualified carbon oxide was captured from multiple units of equipment that were not under common ownership, and proration across multiple taxpayers if the carbon capture equipment was transferred or if a taxpayer made an election under section 45Q(f)(3)(B) with respect to a portion of the credit. Recapture is not triggered, however, by actions unrelated to the “selection, operation, or maintenance of the storage facility, such as volcanic activity or terrorist attack.” 
Section 45Q in its current expanded form is the newest major renewable credit to enter the books, and any guidance will—for better or worse—raise comparisons to the section 45 PTC for wind projects, as well as the section 48 ITC for solar projects. The similarities between the Proposed Regulations and various aspects of the existing PTC and ITC rules are unsurprising, but a few subtle differences may raise eyebrows. Why, for example, does the definition of “binding written contract” (in the context of when secure geological storage has been “contractually ensured”) not allow for the limitation of damages to at least 5% of the total contract price, as is the case in the PTC and ITC guidance? Why did the drafters of the Proposed Regulations self-consciously borrow the five-year recapture period stated in section 50, but omit to incorporate the rule in section 50 that reduces the amount subject to recapture by 20% for each non-recapture year that passes?
Potential gaps in guidance can arise from importing PTC and ITC rules into the incipient section 45Q framework. The addition of the 80/20 Rule in determining when a project is originally placed in service is an important example. In the context of wind turbines, it is relatively clear what components are part of a “facility” for purposes of the 80/20 Rule because Revenue Ruling 94-31 explicitly states that each turbine, together with its tower and supporting pad, is a separate facility. There is no comparable guidance in the context of a carbon capture facility described in section 45Q. Another aspect of the 80/20 Rule that can create complexity is the valuation of retained components. The economics of a carbon capture facility may be significantly different from the economics of a solar or wind project, as current IRS guidance acknowledges that a taxpayer may receive no payments for its activities relating to carbon oxide sequestration.
Perhaps the most complex issue in the Proposed Regulations is the question of how certain scientific conclusions will be demonstrated and evaluated. In determining whether the “secure geological storage” standard has been met, for example, the relevant metrics are simply set out in some combination of existing EPA regulations and international standards, as the case may be. The inference is that there is no need to invoke the direct input of the DOE or the EPA, as the IRS presumably can evaluate whether these criteria have been met by reviewing an independent third-party report. In the context of a written LCA report, however, the Proposed Regulations are surprisingly vague about the nature and level of review required. Not only must the report contain documentation consistent with specified ISO standards, but it must also be subject to both a technical review by the DOE and final approval by the IRS “in consultation with” both the DOE and the EPA. Where should the scientific analysis begin, and the tax analysis end? Put another way: how deeply enmeshed should the IRS get in the question of whether a certain ISO or EPA standard has been met for tax purposes? The Preamble to the Proposed Regulations requests comments on “how to achieve consistency in boundaries and baselines so that similarly situated taxpayers will be treated consistently,” as well as comments generally on “Standards of Lifecycle Analysis,” so the extent to which Treasury and the IRS will either assert jurisdiction over scientific conclusions, or defer to other agencies, remains to be seen.
Doubtless these questions, and others, will be answered as the section 45Q framework develops. In the meantime, the Proposed Regulations present an initial picture of a complicated multi-agency regime that likely will require significant technical and tax expertise to navigate.
 § 45Q(f)(3)(A)(i), (ii).
 Prop. Reg. § 1.45Q-1(h)(2)(i), (iii).
 Prop. Reg. § 1.45Q-1(h)(2)(ii).
 Prop. Reg. § 1.45Q-1(h)(2)(iii).
 Prop. Reg. § 1.45Q-1(h)(2)(iv).
 Prop. Reg. § 1.45Q-1(h)(3).
 Prop. Reg. § 1.45Q-2(c).
 Prop. Reg. § 1.45Q-2(c)(1).
 Prop. Reg. § 1.45Q-2(c)(2).
 Prop. Reg. § 1.45Q-2(c)(3).
 Prop. Reg. § 1.45Q-2(d).
 Prop. Reg. § 1.45Q-2(g)(5).
 Rev. Rul. 94-31, 1994-1 C.B. 16.
 Notice 2016-31, 2016-23 I.R.B. 1025.
 Preamble to the Proposed Regulations at 40; see also https://www.epa.gov/uic.
 Prop. Reg. § 1.45Q-3(b)(2).
 Prop. Reg. § 1.45Q-3(d).
 Prop. Reg. § 1.45Q-3(b)(3).
 I.R.C. § 45Q(f)(5)(B).
 Prop. Reg. § 1.45Q-4(c).
 Prop. Reg. § 1.45Q-4(e).
 Prop. Reg. § 1.45Q-4(c)(3).
 Prop. Reg. § 1.45Q-4(d).
 Prop. Reg. § 1.45Q-5(a).
 Prop. Reg. §§ 1.45Q-5(b); -5(g)(6), Example 1; -5(h).
 Prop. Reg. § 1.45Q-5(c).
 Prop. Reg. § 1.45Q-5(f).
 Prop. Reg. § 1.45Q-5(g)(2).
 Prop. Reg. § 1.45Q-5(g)(3).
 Prop. Reg. § 1.45Q-5(g)(4).
 Prop. Reg. § 1.45Q-5(i).
 Notice 2013-29, § 4.03; Notice 2018-59, § 7.03.
 Preamble to the Proposed Regulations at 32.
 1994-1 C.B. 16.
 Rev. Proc. 2020-12, 2020-11 I.R.B., § 4.09.