IRS Releases Highly Anticipated Guidance on Domestic Content IRA Tax Credit ‘Adder’

The Internal Revenue Service and US Department of the Treasury released Notice 2023-38 on May 12, which establishes rules for testing an applicable “green” energy facility’s eligibility for a bonus federal income tax credit amount (or “adder”) attributable to the steel, iron, or manufactured product that is a component of such facility being produced in the United States as enacted under the Inflation Reduction Act of 2022.

Notice 2023-38 (Notice) provides relatively stringent rules for determining whether any steel, iron, or manufactured product incorporated into a green energy facility was produced in the United States, potentially making it challenging even for facility owners procuring equipment from US vendors to qualify or substantiate qualification for the adder. The Notice includes recordkeeping and certification requirements as well as a safe harbor list for categorizing certain common components and equipment included in utility-scale solar facilities, wind (including offshore wind) facilities, and battery energy storage technologies for purposes of a domestic content adder analysis.

The Notice clarifies that its rules serve the basis for forthcoming proposed regulations that will apply to taxable years ending after May 12, 2023, but taxpayers may rely on the rules set forth in the Notice for facilities that “begin construction” before 90 days after the publication of these proposed regulations.

Long-standing “begin construction” standards are expected to apply for purposes of such reliance.

DOMESTIC CONTENT ‘ADDER’

The Inflation Reduction Act of 2022 (IRA) made a host of changes to the Internal Revenue Code of 1986, as amended (Code), that significantly extended and expanded federal income tax credit benefits for “green” energy production, storage, and other technologies. Among these changes, the IRA enacted new bonus credit incentives (adders) that can significantly impact the amount of the applicable tax credit.

We addressed published guidance under the “energy community” adder in a prior Morgan Lewis LawFlash.

A separate “domestic content” adder applies with respect to the Code Section 48 investment tax credit (ITC) or Code Section 45 production tax credit (PTC) for eligible facilities placed in service after December 31, 2022, or the Code Section 48E ITC or Code Section 45Y PTC for eligible facilities placed in service after December 31, 2024, in each case, that contain US-produced steel, iron, or other manufactured products that are components of such facilities. Qualification for this “domestic content” adder increases a facility’s otherwise applicable PTC credit by 10% (not 10 percentage points) or its ITC rate by 10 percentage points (or 2 percentage points if the facility is subject to and does not satisfy a separate prevailing wage and apprenticeship standard, detailed in a different Morgan Lewis LawFlash).

In general, the Code requires an eligible taxpayer claiming the domestic content adder to certify to the Treasury secretary that “any steel, iron, or manufactured product which is component of [the applicable facility] (upon completion of construction) was produced in the United States” (the Domestic Content Requirement). The Code provides that the Domestic Content Requirement for steel or iron applies in a manner consistent with the Federal Transit Administration’s (FTA’s) Buy America Requirements (specified in section 661.5 of title 49, Code of Federal Regulations). With respect to manufactured products, the Code provides that such products that are components of a qualified facility are considered produced in the United States if the total cost of all such manufactured products (including components) that are mined, produced, or manufactured in the United States are at least equal to a specified “adjusted percentage” (the Adjusted Percentage Rule).

The adjusted percentage increases over time depending on the calendar year a qualified facility begins construction. For qualified facilities that begin construction before 2025, the adjusted percentage is 40%, or 20% in the case of a qualified facility that is an offshore wind facility. For non-offshore-wind qualified facilities that begin construction in 2025, 2026, or 2027 (and later), the adjusted percentage is 45%, 50%, and 55%, respectively. Similarly, for qualified offshore wind facilities that begin construction in 2025, 2026, 2027, or 2028 (and later), the adjusted percentage is 27.5%, 35%, 45%, and 55%, respectively.

The domestic content adder standard has independent significance for the refundable credit (so-called “direct pay” option) generally available to tax-exempt organizations and certain other entities after enactment of the IRA. The Code phases down and eliminates eligibility for the direct pay option with respect to the PTCs and ITCs provided under Sections 45, 45Y, 48, and 48E if the Domestic Content Requirement is not met. A complete phase out occurs on a relatively accelerated timeline such that projects beginning construction after 2025 are no longer eligible for the direct payment monetization option for these credits unless the Domestic Content Requirement is met.

However, the Code provides a limited exception from this direct pay domestic content phase out if the Treasury secretary determines that the inclusion of steel, iron, or manufactured products produced in the United States increases the overall costs of construction of qualified facilities by more than 25%, or that the relevant steel, iron, or manufactured products are not produced in the United States in sufficient and reasonably available quantities or of a satisfactory quality (the Direct Pay Domestic Content Waiver).

We discussed the direct pay provisions of the IRA in a recent LawFlash.

THE NOTICE

The Notice provides critical guidance on satisfying the Domestic Content Requirement and claiming the domestic content adder.

The Notice provides that the domestic content adder is available if an Applicable Project (generally a qualified facility, energy project, or qualified investment under Code Sections 45, 45Y, 48, or 48E) satisfies the Domestic Content Requirement and the taxpayer timely submits the required certification to the Internal Revenue Service (IRS). The Domestic Content Requirement is met only if both the Steel or Iron Requirement and the Manufactured Products Requirement are satisfied.

The Notice generally builds on definitional and categorization approaches employed by the FTA’s Buy America Requirements to identify project components and categorize such components between iron or steel equipment and manufactured product equipment for purposes of satisfying the Domestic Content Requirement. The Notice then provides rules on determining compliance with the Adjusted Percentage Rule. The steps for conducting this analysis are summarized below.

Step 1: Identify ‘Applicable Project Components’

The first step in a Domestic Content Requirement analysis requires identifying all “Applicable Project Components.” The Notice defines this critical unit of equipment for purposes of the Domestic Content Requirement in a manner identical to under the Buy America Requirements as “any article, material, or supply, whether manufactured or unmanufactured, that is directly incorporated into an Applicable Project” (emphasis added).

Some market participants had hoped that an “Applicable Project Component” subject to the Adjusted Percentage Rule would be the entire Applicable Project, potentially easing the ability to satisfy the rule. While this was not the path chosen, the Notice does potentially provide some benefit, discussed below, for components of manufactured products produced in the United States, even where the manufactured product is itself deemed not to have been produced in the United States.

Although the Notice does not elaborate on the general scope of Applicable Project Components beyond its general definition, the Notice provides a helpful “safe harbor” list (the Safe Harbor List) of common utility-scale solar and on-shore and off-shore wind power facility and battery storage facility equipment that constitute Applicable Project Components (as well as some of the applicable constituent Manufactured Product Components thereof, as described below).

This Safe Harbor List also provides the steel/iron or manufactured product categorization for each of these Applicable Project Components. Consistent with the “safe harbor” nomenclature, it is not clear whether these categorizations are (or effectively are) mandatory for applicable facilities. The Notice mentions that Safe Harbor List categorizations are “based on the FTA’s analysis and will be accepted by the IRS for those Applicable Project Components and Manufactured Product Components.”

The Safe Harbor List is included below.

Step 2: Categorize Applicable Project Components as Manufactured Products or Steel or Iron

Once each Applicable Project Component has been identified, the next key step is to determine whether the component is steel or iron subject to the Steel or Iron Requirement (generally requiring all steel or iron manufacturing processes to take place in the United States), or a Manufactured Product Component subject to the Manufactured Products Requirement (which provides a less stringent different standard based on the Applicable Percentage Rule). These requirements are described in further detail in Step 3.

A taxpayer must first determine whether the Applicable Project Component constitutes steel or iron. Consistent with the Buy America Requirements, the Notice provides that an Applicable Project Component is treated as steel or iron if it is construction material made primarily of steel or iron and is structural in function. Unfortunately, the Notice does not explain what “primarily of steel or iron” means or provide a defining percentage (e.g., 51%), but the clarification that the requirement only applies to structural steel and iron provides a helpful starting point.

The Notice also provides that the Steel or Iron Requirement does not apply to any steel or iron used in Manufactured Product Components or subcomponents of Manufactured Product Components. So, for example, items such as nuts, bolts, screws, washers, cabinets, covers, shelves, clamps, fittings, sleeves, adapters, tie wire, spacers, door hinges, and similar items that are made primarily of steel or iron are not subject to the Steel or Iron Requirement.

If an item is not “primarily of steel or iron,” then next it should be evaluated whether it is a “Manufactured Product.” Consistent with the FTA’s Buy America Requirements, the Notice defines a Manufactured Product as an item produced as a result of a “Manufacturing Process,” meaning an “application of processes to alter the form or function of materials or of elements of a product in a manner adding value and transforming those materials or elements so that they represent a new item functionally different from that which would result from mere assembly of the elements or materials.”

The identification and categorization of Applicable Project Components is not necessarily a straightforward analysis. The Buy America Requirements on which these determinations were designed to address public transportation projects and would not normally be used to analyze energy technologies.

Recognizing this challenge, the IRS and Treasury provided the Safe Harbor List. As described above, however, it is not clear whether the categorizations included on the list are elective or mandatory. For example, it may be difficult for a taxpayer to support a position that an Applicable Project Component categorized as steel or iron on the Safe Harbor List is instead subject to the separate Manufactured Product Requirement.

Step 3: Conduct Domestic-Content-Based Analysis Across Categorized Applicable Project Components

After the Applicable Project Components have been identified and categorized, they must then be tested under the Steel or Iron Requirement or Manufactured Products Requirement, as applicable. Both of these requirements must be satisfied in order for the Domestic Content Requirement to be met.

Steel or Iron Requirement

The Steel or Iron Requirement is applied in a manner consistent with the FTA’s Buy America Requirements. Unlike the Manufactured Products Requirement, the Steel or Iron Requirement must be satisfied for all steel or iron Applicable Project Components. Under this standard, all manufacturing processes with respect to any steel or iron items that are Applicable Project Components must take place in the United States, except metallurgical processes involving refinement of steel additives.

Manufactured Products Requirement

The Manufactured Products Requirement is met only if all Applicable Project Components constituting Manufactured Products are produced in the United States or are deemed to be produced in the United States under the Adjusted Percentage Rule described above.

The Notice tests each Manufactured Product and its constituent “Manufactured Product Components” (generally, any article, material or supply that is directly incorporated into a Manufactured Product) for a requisite level of US domestic content. Specifically, the Notice categorizes a Manufactured Product as a “US Manufactured Product” only if (1) all of the Manufacturing Processes for the Manufactured Product take place in the United States; and (2) all of the Manufactured Product Components of the Manufactured Product are of US origin.

A Manufactured Product Component is of US origin if it is manufactured in the United States, regardless of the origin of its subcomponents. “Subcomponent” is not defined in the guidance but under the FTA Buy America Requirements is understood to be any article, material, or supply that is one step removed from a component in the manufacturing process and that is incorporated directly into a component.

Accordingly, the Notice, like the Buy America Requirements, requires a determination of a finished product’s constituent equipment that constitutes components, as compared to subcomponents. Any components must then be tested for US manufacturing. By way of example as applied with respect to the Notice’s safe harbor categorization of an onshore wind power facility, each of the following Manufactured Product Components would be tested for US manufacturing: nacelle, blades, rotor hub and power converter.

If all Manufactured Products of an Applicable Project are US Manufactured Products, then the Manufactured Product Requirement is satisfied.

However, if any Manufactured Product of an Applicable Project is not a US Manufactured Product (e.g., any Manufactured Product Component is not of US origin), then the Applicable Project must satisfy the Adjusted Percentage Rule with respect to all of its Manufactured Products to be eligible for the domestic content adder. The Notice sets forth the following calculation convention (the Domestic Cost Percentage) for purposes of applying the Adjusted Percentage Rule.

“Domestic Cost Percentage” = “Domestic Manufactured Products and Components Cost” ÷ “Total Manufactured Products Cost”

“Domestic Manufactured Products and Components Cost” (the numerator of this equation) equals the sum of the costs of a project’s (1) US Manufactured Products and (2) Manufactured Product Components of Non-US Manufactured Products if the Manufactured Product Components are mined (derived from the extraction of ores or minerals from the ground or from the waste or residue of prior mining), produced (same meaning as manufactured), or manufactured in the United States.

Consequently, the person whose costs must be tested is the person performing the Manufacturing Process that produced the US Manufactured Product or the Non-US Manufactured Product, which may not be the project owner’s or EPC contractor’s direct vendor counterparty.

The “cost” taken into account consists of only “direct costs” (direct materials and direct labor costs), as set forth in the so-called “UNICAP” inventory tax capitalization rules, which are accrued for tax purposes by the US Manufactured Product’s manufacturer to produce the US Manufactured Product or by the Non-US Manufactured Product’s manufacturer to produce or acquire the US Manufactured Product Component.

Costs not taken into account include materials or direct labor costs of the Non-US Manufactured Product’s manufacturer to produce the Non-US Manufactured Product and costs of incorporating the Applicable Project Components into the project.

“Total Manufactured Product Costs” (the denominator of this equation) means the sum of the costs of all Manufactured Products. Similar cost counting conventions apply for purposes of calculating Total Manufactured Product Costs as those mentioned above for calculating Domestic Manufactured Products and Components Costs (though note that direct costs for Non-U.S. Manufactured Products are taken into account).

If the resulting Domestic Cost Percentage equals or exceeds the adjusted percentage that applies to the Applicable Project, the Adjusted Percentage Rule, and therefore the Manufactured Products Requirement, is satisfied.

The Notice includes a generic example illustrating how to conduct an Adjusted Percentage Rule analysis.

REPOWERED PROJECTS

The Notice clarifies that repowered facilities placed in service after December 31, 2022 that meet the so-called 80/20 rule requirement to be considered a new facility for tax purposes (i.e., the fair market value of the used property is not more than 20% of the facility’s total value calculated by adding the cost of the new property to the value of the used property) are eligible for the domestic content adder if the new property satisfies the Domestic Content Requirement.

CERTIFICATION

In addition to satisfying the Domestic Content Requirement, a taxpayer must certify for each qualified facility for which it is claiming a domestic content adder that any steel or iron items subject to the Steel or Iron Requirement or Manufactured Product that is a component of the facility upon completion of construction was produced in the United States (Domestic Content Certification Statement). The certification must occur as of the date the qualified facility is placed in service for tax purposes.

The Notice specifies that the Domestic Content Certification Statement must, among other things, include the type of green energy facility (e.g., utility-scale solar, wind, or battery energy storage technology), the location of the facility, the placed-in-service date, and the credit amount. The statement must be signed under penalties of perjury by a person with legal authority to bind the taxpayer.

A taxpayer files the Domestic Content Certification Statement on its annual tax return for the first taxable year in which such taxpayer reports a domestic content adder for a qualified facility and must attach the statement on subsequent tax returns with respect to a claim of PTCs for a qualified facility.

TAKEAWAYS

The Notice, while leaving significant ambiguities as to how the domestic content adder applies to different types of technologies, reinforces that there will be a relatively high bar for satisfying the requirement for green technology industry facilities. Critically, the Notice largely employs the FTA’s stringent Buy America Requirements at a manufactured equipment component level (rather than at the finished equipment level) and without any deviation from the absolute US manufacturing requirements for steel or iron.

For example, the Notice does not apply any permissive standard akin to the Direct Pay Domestic Content Waiver for domestic content adder qualification. The Notice does, however, recognize the challenge of applying the Buy America Requirements to new facilities and technologies not within the originally contemplated scope of these rules and provides some certainty to applicable wind, solar and battery energy storage project developers and market participants in the form of the Safe Harbor List.

Similar additional lists are likely to be released by the government in future guidance, including to provide certainty across additional technology and facility types.

In order to claim the domestic content adder, the Notice also effectively requires project owners to certify the location of manufacturing activity, as well as the associated cost, of manufactured equipment vendors and possibly their subcontractors to substantiate satisfaction of the Manufactured Products Requirement.

Accordingly, project owners (or EPC contractors on behalf of project owners) are expected in turn to seek to obtain a host of certifications from manufactured equipment vendors, including as to (1) the person conducting manufacturing activities (other than mere assembly) with respect to Manufactured Products and their Manufactured Product Components, (2) the location of such activities, and (3) the manufacturer’s applicable “direct” cost (and tax accrual) of US Manufactured Products and Non-US Manufactured Products (and cost of any associated Manufactured Product Components of Non-US Manufactured Products that are mined or manufactured in the United States).

It may be challenging for developers and EPC contractors to require vendors with respect to new procurement to provide or certify this information, especially with regards to the applicable, eligible cost amount and tax accrual. Additionally, it will likely be even more challenging to have vendors certify this information for equipment that has already been acquired. Similar certifications and concerns will also apply with respect to substantiating US manufacture of steel or iron Applicable Project Components.

Such certifications may nevertheless become palatable for US-based manufacturers seeking to market their equipment as US Manufactured Products or separately qualify for the new advanced manufacturing production credit under Code Section 45X.

The Code Section 45X credit is a manufacturer production-based tax credit attributable to the sale of certain eligible green tech industry equipment and other items produced in the United States. No guidance has to date been provided regarding the requirements for an applicable item to be “produced” in the United States for this purpose. However, to the extent such guidance requires a breakdown of the cost and manufacturing location of product components, manufacturers may be motivated to conduct open and detailed recordkeeping for this information that also supports domestic content adder substantiation for customers.