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.
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.
General
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]
Sales to Related Persons
Anti-Abuse Rules
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.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following:
[1] A special rule is provided with respect to solar grade polysilicon, electrode active materials, and applicable critical minerals, for which the term “produced by the taxpayer” means “processing, conversion, refinement, or purification of source materials, such as brines, ores, or waste streams, to derive a distinct eligible component.” Notably, costs related to the extraction of raw materials are not included as production costs, though the Treasury and the IRS continue to consider whether to include such costs.
[2] A contract manufacturing arrangement is defined for these purposes simply as an agreement providing for the production of an eligible component, provided that the agreement is entered into before production thereof is complete. The Proposed Regulations include a few specific exceptions to this definition intended to ensure that such components are custom made rather than supplied from inventory.
[3] For solar grade polysilicon, electrode active materials, and applicable critical minerals, the secondary “production” process includes the processing, conversion, refinement, or purification of an eligible component to derive a distinct eligible component that is solar grade polysilicon, electrode active materials, and applicable critical minerals.
[4] For purposes of Section 45X, two persons are treated as related if they would be treated as a single employer under Section 52(b) of the Code.
[5] Taxpayers may seek guidance from preexisting Treasury regulations that use the term “substantial transformation.” Most notably, the cross-border subpart F rules include “substantial transformation” as a manufacturing activity excluded from foreign base company sales income. In that context, however, guidance is also limited—the few examples in the regulations for substantial transformation consist of the conversion of wood pulp to paper, steel rods to screws and bolts, and the canning of fish.