IRA’s Advanced Manufacturing Production Credit: IRS Publishes Proposed 45X Regulations

The Internal Revenue Service’s proposed Section 45X regulations, released on December 15, provide US-based manufacturers with much-anticipated guidance for a credit that has been available since the beginning of 2023.

The Internal Revenue Service (IRS) and the US Department of the Treasury (Treasury) published proposed regulations (Proposed Regulations) on December 15, 2023, setting forth proposed rules applicable to the advanced manufacturing production credit under Section 45X of the Internal Revenue Code (Code) enacted under the Inflation Reduction Act of 2022 (IRA).

The Proposed Regulations, which are less stringent than many feared, provide helpful rules to assist US-based manufacturers of clean tech energy industry equipment and critical minerals in navigating a credit that has been available since the beginning of 2023. While the guidance is generally straightforward, a fundamental definition remains elusive.

THE SECTION 45X ADVANCED MANUFACTURING PRODUCTION CREDIT

As detailed in a prior Morgan Lewis LawFlash and as part of the congressional effort in the IRA to incentivize onshoring of the entire chain of production relating to the clean tech energy industry, Section 45X provides a production tax credit (PTC) for specified eligible components (either individually or integrated into other eligible components) produced within the United States and sold to unrelated persons (or, upon election, to related persons).

Eligible components, which must be produced and sold in a trade or business of a taxpayer, include finished equipment and component parts of both onshore and offshore wind power generation facilities, solar power generation facilities, electricity inverter equipment, energy storage equipment, and critical minerals.

Under the Code, the applicable Section 45X credit rate is based on the specific type of component produced and sold. The Section 45X PTCs remain at their maximum rate until 2030, at which time they step down by 25% per year until they expire in 2033. However, the Section 45X PTC for critical materials continues in perpetuity without reduction.

Credits claimed under Section 45X are eligible for the IRA’s new monetization methods as follows: (1) through “direct payment” under Section 6417 of the Code for those types of entities generally eligible for this method of monetization (e.g., tax-exempt and governmental entities); (2) through “direct payment” under Section 6417 of the Code for five years for those types of entities not generally eligible for such monetization approach (e.g., taxable entities); and (3) through a credit transfer under Section 6418 of the Code.

See our prior discussion of the current proposed regulations for “direct payment” and credit transfers.

PROPOSED REGULATIONS

General

• Most notably, the Proposed Regulations provide that the term “produced by the taxpayer” for purposes of Section 45X means:

  a process conducted by the taxpayer that substantially transforms constituent elements, materials, or subcomponents into a complete and distinct eligible component that is functionally different from that which would result from mere assembly or superficial modification of the elements, materials, or subcomponents. [1]

• While production activities (i.e., substantial transformation) must occur within the United States, the constituent elements, materials, and subcomponents used in the production of an eligible component need not be domestically produced.
• Generally, only the taxpayer that directly performs the production activities bringing about the substantial transformation is eligible to claim the Section 45X credit. However, parties entering a contract manufacturing arrangement for the production of custom materials or equipment (including a multilateral arrangement) may contractually agree on the party who will claim the Section 45X credit. [2] The IRS will not challenge such agreement, provided it contains certain requisite information.
• Production of eligible components must be completed, and sales of such eligible components must occur, after December 31, 2022 (though production may have begun prior to such cutoff).
• For a taxpayer to claim a Section 45X credit for an eligible component that is integrated, incorporated, or assembled into another eligible component produced and sold by such taxpayer, such initial eligible component must generally undergo a second “production” process (i.e., substantial transformation) [3] into “another complete and distinct eligible component,” or into a distinct product that is not itself an eligible component.
• For Section 45X credit amounts that are measured by “10 percent of the costs” of production of the respective eligible component (i.e., electrode active materials and critical minerals), only production costs are taken into account—not any material procurement or extraction costs. The preamble to the Proposed Regulations solicits taxpayer comments as to how extraction costs should be includible for determining the credit amount in a manner that protects against duplication of credit amounts across the production chain and builds in safeguards against the possibility for fraud.
• For most (but not all) eligible components, substantiation requirements are set forth requiring taxpayers document that such eligible components meet prescribed technical engineering or physical requirements or specifications.
• The Proposed Regulations provide more detailed descriptions and requirements with respect to eligible components than are provided in the Code. Manufacturers would be advised to review Proposed Regulations Sections 1.45X-3 and 1.45X-4 with care to ensure their products comply with the specifications set forth therein.

Sales to Related Persons

• Absent a Related Person Election, a taxpayer that produces and sells an eligible component to a related person is treated as selling such component to an unrelated person only if and when the related person sells such eligible component (or item into which the eligible component has been integrated, incorporated, or assembled) to an unrelated person.
• If a Related Person Election is made, the treatment as a sale to an unrelated person is accelerated to the time the sale is made to the related person. [4]
• The IRS may require information to be included in the Related Person Election that it deems necessary for purposes of preventing duplication, fraud, or any improper or excessive credit amount determined under Section 45X. The information to be required in such election is not provided in the Proposed Regulations, though it suggests as examples the name(s) and EINs of all related persons; a listing of the eligible components that are sold; and the intended purpose of the sale to or from the related persons.
• A Related Person Election is made yearly and applies on a trade-or-business-wide basis for sales during that year to all related persons.

Anti-Abuse Rules

• No Section 45X credit is allowed if “the primary purpose of the production and sale of an eligible component is to obtain the benefit of the Section 45X credit in a manner that is wasteful, such as discarding, disposing of, or destroying the eligible component without putting it to a productive use.” This is a facts-and-circumstances determination.
• A similar anti-abuse rule is provided for the Related Person Election, though it is supplemented by a special rule that prevents claiming of a Section 45X credit for defective components—i.e., components that do not meet the requirements of Section 45X or the regulations thereunder.

OBSERVATIONS AND TAKEAWAYS

The Proposed Regulations strike a balance between setting forth generally straightforward and taxpayer-favorable guidance while guarding against various potential abuses. One important ambiguity, however, is that the Proposed Regulations rely on the term “substantial transformation” to define production but do little to explain what such term means.

The definition of “produced by the taxpayer”—“substantially transforming” constituent elements or subcomponents into a functionally different eligible component—is a helpful starting point (particularly given that Section 45X does not provide any definition).

However, instead of providing further color on the meaning of this terminology, the Proposed Regulations focus on what is not substantial transformation, such as mere assembly, superficial modification, partial transformation, and the production of only one part of a completed eligible component. Little is set forth to help taxpayers determine exactly when activities rise beyond those insufficient processes into “substantial transformation.” [5]

Notwithstanding this absence of detail, taxpayers are still likely to be relieved that the IRS and Treasury did not choose to institute a more stringent standard akin to the requirements to qualify for the “domestic content” adder (which we discussed in a previous LawFlash).

In particular, the decision to not subject constituent elements, materials, and subcomponents to a domestic production requirement will allow manufacturers to avoid the difficult process of downstream substantiation/verification and focus solely on the location of the “substantial transformation.”

Additionally, the Proposed Regulations provide practical rules in approaching the production of eligible components both through multiparty contracts and among related parties. The flexibility accorded to contract manufacturing arrangements will allow manufacturers, contractors, and subcontractors that together produce an eligible component to effectively share the Section 45X credit among themselves (e.g., by using the agreed allocation of Section 45X credits to offset or supplement the contract price). Similarly, the IRS and Treasury do not appear to establish complicated roadblocks against claiming the Related Person Election for related-party sales/manufacturing arrangements.

At the same time, the Proposed Regulations guard against potential abuses by setting forth various rules to avoid a double-counting of benefits, including that only the taxpayer that performs the underlying “production” may claim a Section 45X credit and certain cost-based Section 45X credits do not take into account component costs.

Furthermore, broad anti-abuse rules put taxpayers on notice that wasteful production activities, including through the abuse of transactions between related parties, will not be tolerated. In doing so, the IRS and Treasury recognize that the Section 45X credit can provide incentives to produce equipment and other materials in a way that has no commercial reality and do not further the policy goals underlying the credit (contribution to the development of secure and resilient supply chains), especially when the benefit of the Section 45X credit exceeds the cost of production.

One final point of interest is that, unlike other recent guidance (both in the form of IRS notices and other proposed regulations), the Proposed Regulations do not explicitly state that taxpayers may rely on them pending forthcoming final regulations. Furthermore, it is not entirely clear from the Proposed Regulations whether, once finalized, the regulations will be retroactive back to 2023. Hopefully the IRS and Treasury will make the standard of interim reliance clear.