SUMMARY
Since perhaps 1978 the Internal Revenue Code provided tax credits as a means of incentivizing the investment in (principally) solar and wind facilities. Since then, the nature of the investments that qualify for the credits have been broadened and the credit levels and approaches have increased, decreased, been phased in and phased out over time.
This article will touch upon only some of the more mainstream alternative energy investments and the associated tax credits currently in effect. Legislation is subject to change under the new administration with potential changes to the Tax Code within the first 100 days.
LEGISLATIVE BACKGROUND
The Inflation Reduction Act largely focused on incentivizing alternative energy investments, including electric vehicles as well as creating the ability to transfer (sell) many investment tax credits, creating a whole new means of shifting capital via the tax code.
Let’s look at where we are with respect to the tax credits largely enhanced by the Inflation Reduction Act.
GENERAL TRENDS
Many companies have recognized that climate change and the goal of having a zero-carbon footprint perhaps by 2030 are real considerations for doing business in the US currently. As such, many C-level executives have established mandates within the companies they run, that individual departments must consider the effect on the environment of any future investment to be made and must also consider the use of alternative energy facilities when applicable. Much has been said recently about the use of alternative energy to assist in the powering of data centers which are being driven by the growth and demands of Artificial Intelligence.
BACKGROUND OF TAX CREDITS
Congress has previously incentivized demand for alternative energy development by providing favorable tax benefits for investing in such projects. Tax benefits lower the after-tax cost of these investments usually by providing tax credits based on the investment cost or the production of the energy. These credits are largely a means of making the cost of energy generated from alternative sources to be on a par with the cost of traditional, usually carbon-based energy production sources. As such, the U.S. government has been subsidizing investments in alternative energy projects for many years. The original investment tax credit for solar and wind projects was initiated in 1978 for 10%. In 1992 the 10% credit was made permanent. Since then, the credit rates have grown, shrunk, become more complicated and been broadened somewhat by the Inflation Reduction Act. At times the credits were even available to be refunded in cash as a grant to the originator.
The credits are based on different baselines, such as the cost or fair market value of the property being constructed or acquired, the production of actual energy, the production of certain clean fuels, or the remediation of certain gaseous elements such as carbon dioxide, to name just a few. Thus, if an entity is for instance, installing a facility that will potentially create a polluting byproduct such as carbon dioxide, by installing a carbon sequestrating component to the facility to capture the carbon and sequester it in a secure geological formation, the entity may be entitled to a tax credit.
Bear in mind that tax incentives exist all throughout the Tax Code, often as a means of incentivizing a course of action that Congress feels is beneficial to either the country as a whole or to their own personal or constituent’s interests.
THE CURRENT CREDITS
Let’s briefly go over some of the tax credits available. I will not quote IRC sections per se, since the Tax Code is often written with circuitous cross references and in fact, the referenced section may change from version to version. At the end of the day, one should examine any form of investment planned and ask (i) does the investment have an alternative energy aspect, (ii) is there a specified tax credit available for making the investment and (iii) how can my entity benefit from that credit given its tax circumstances. I mention tax circumstances, because even if the entity is a tax-exempt entity such as a municipal or local government or a tax-exempt entity such as a hospital, there are often ways that a tax credit can be monetized so that the tax-exempt entity can also benefit from the availability of the tax credits.
SECTION 48 INVESTMENT TAX CREDIT
The investment tax credit is a credit applied to the tax bill based on the cost of the asset or facility acquired. The credit previously was a straight 30% credit against the cost, but with the IRA the credit has been made more complicated by Congress, as a means of incentivizing specific actions as follows:
| Base Credits | 6% |
| Prevailing Wage & Apprenticeship | 24% |
| Total Headline Credit | 30% |
| Bonus credits | |
| Domestic Content | 10% |
| Situated in Energy Community | 10% |
| Potential Bonus Credits | 20% |
| Potential total credits | 50% |
The baseline credit of 6% is available for the project cost without restrictions other than the project was a qualifying energy project and is located in the U.S.
The Prevailing Wage and Apprenticeship credit kicker is available when the project is constructed paying prevailing wages to the workers and having a qualifying apprenticeship program in place. These elements obviously become more difficult to prove and document.
The Domestic Content kicker is meant to provide a benefit for the components manufactured in the U.S. Again, this becomes more difficult to document. Bear in mind that the labor component for a facility constructed in the U.S. would likely be eligible for this kicker.
The Energy Community kicker is based on where the property is situated and is usually defined as a census tract or a brownfield site.
Typical Qualifying Facilities: Solar, Wind, Fuel cells and Standalone energy storage (such as battery storage)
SECTION 45 PRODUCTION TAX CREDIT
The production tax credit (PTC) is generated over a ten-year period from the commencement of production and is based on a rate per kilowatt hour of energy produced during the subsequent 10 years. The rate per kilowatt hour is established at the start of the construction of the project provided it meets the timeline for entering commercial operation. The PTC is associated with the actual project itself and not the owner. That is, if a PTC project is sold to another party, the PTCs continue for the remaining periods left in the 10-year period.
One elects to claim PTC instead of an ITC (when a choice or option is available) when certain factors come into play when analyzing the prospective level of credit that can be generated. The more efficient the project, the more likely PTC may be selected.
When the present value of the probable generation of the PTCs over the 10-years is expected to exceed the ITC available by a large number, an owner will prefer to obtain the credit in this manner. For instance, assume a $100 million investment generates a $30 million ITC; how much would the PTC present value have to be and how confident would the investor have to be that the energy will be produced, to convince an investor to select the PTC approach?
The PTC is based on a credit per kilowatt hour of energy produced and similarly bifurcated into different elements:
| Base credit | |
| Base line credit per kilowatt Hour | $0.0055 |
| Prevailing Wage & Apprenticeship | $0.0220 |
| Headline credit | $0.0275 |
| Bonus credits | |
| Domestic Content | $0.00275 |
| Situated in Energy Community | $0.00275 |
| Potential bonus credits | $0.0055 |
| Potential total credit | $0.0330 |
PROs and CONs of ITC vs PTC
| ITC PROs | ITC CONs |
| Fixed percentage of cost or acquisition price | Limited to the fixed percentage and cost of the project. May be limited to a fair market value appraised amount, thus cost overruns are not eligible for the credit. |
| Amount of ITC is easily determined upfront based on the construction cost | Reduces the tax depreciable base of the asset by ½ of the ITC. |
| Received fully in the first year of a project | Proportionate recapture if disposed of within the credit’s defined five-year life. |
| PTC PROs | PTC CONs |
| Substantially greater value than ITC because of greater risk; see risks under “Cons”. | Riskier compared to ITC in that the credit is based on actual energy production over 10-years, which could fall below projections |
| Credit can be greater than planned since planning is always conservative. | Recipient would need to have a steady taxable income base (10 years) to utilize the credit in each of the years of the credit. |
| Can be transferred (sold) anytime during the 10-years. | |
| No vesting/ required holding period |
TRANSFERS (SALES) OF SELECTED TAX CREDITS
We have discussed only a few of the available tax credits in the alternative energy marketplace above, and those being the more frequently encountered credits. There are basically 11 such credits available under the IRA. All but the credits generated by the Section 45W Qualified Commercial Clean Vehicles may be separately transferred (sold).
Virtually any company may be able to be generating electricity using a solar facility. Solar facilities as we know vary in size from a home-mounted solar array to a utility grade installation.
Wind energy facilities tend to be found in highly structured arrangements where a wind developer builds a large wind farm and sells the power often times to a utility over say a 20 to 25-year term. Thus, wind farms are less frequently seen as being owned by an industrial company other than perhaps very, very large industrial companies such as Amazon that have a large demand for power. A quick Google search will show that most wind farms have a “big name” energy company owning it or buying the power from it.
Energy storage facilities (batteries) may generally be attached to wind or solar generating facilities and now are eligible for tax credits.
Most of these credits may arise frequently within virtually any type of legal entity, including some variations of tax-exempt entities. Several other tax credits are more specific as to the nature of the basis for the credit. For instance, above we mentioned the credit for “carbon sequestration’. This type of credit has a somewhat narrower scope in that only companies that are generating carbon have the need to capture that carbon and sequester it underground. Compare that to the numerous entities that could utilize for instance, a solar installation, whether placed on their roof, on the ground or even on top of car ports.
The market for tax credit transfers in 2024 was estimated to be in the range of $10 billion dollars worth of credits!
SEC 45W – QUALIFIED COMMERCIAL CLEAN VEHICLES
While we are all familiar with the tax credits we can receive as an individual when acquiring a hybrid or electric vehicle, companies are recognizing that should they desire to migrate their fleets of vehicles to either hybrids or electric vehicles (EVs), they too can create qualifying tax credits. Unlike the personal credits, corporate credits are not limited by the income of the user. The credits are up to 30% for full electric vehicles, topping out at $7,500 for most EVs in a typical company’s fleet of cars. For a typical $60,000 EV, that $7,500 represents a 12.5% credit!
If the company also acquires qualifying vehicles with a GVWR of over 14,000 pounds, they can qualify for a credit of up to $40,000.
In these situations, the tax basis of the vehicle is reduced 100% by the credit and there is no recapture other than in unusual circumstances, like selling the vehicle to a tax-exempt entity.
When the fleet is acquired and managed by a vehicle fleet management company, you should analyze the economics very closely to determine if the fleet management company is passing some of the tax credit benefits through to you in the form of a lower rent. We have seen some fleet management companies that do not have the capacity to utilize the tax credits and thus may not be passing them back to the lessees. In those cases, CFOs should push to incorporate a structured approach where another third party, such as a bank lessor, can claim the credit and pass some of it to the lessee in the form of lower rents. This requires some coordination with the fleet management company which is still involved in the acquisition, maintenance and disposition of the vehicles.
ACCOUNTING FOR THE TAX CREDITS
One of the more “irritating” aspects of these investments is dealing with the tax accounting for the specific tax credits themselves and secondarily the tax accounting related to the depreciable basis reductions when they exist. The tax credits are generally presented below the net income-before-taxes line, within the tax provision line. As such the tax credits often fall outside the usual financial measurements many companies look for, in particular Return-on-Investment. Many times I have seen the struggles from companies trying to figure out how they can get the tax benefits somehow incorporated into their book reporting above-the-line so that divisional management does not have to explain to non-accountant higher-ups how the return on an investment is robust when it can’t be seen in the actual financial statements.
Below are brief explanations of the norms for accounting for these credits. Again, this is not an extensive explanation but merely an introduction for financial types to understand where the numbers reside.
PTC ACCOUNTING
The PTC accounting flows through the tax provision line as a reduction in the tax provision. Since the PTC may vary by year its effect on the tax provision likewise may vary by year and it may, depending on its materiality, also affect the effective tax rate. That is, since the PTC fluctuates annually in some cases, the effective tax rate may appear to not be steady and thus not well managed. All of this of course depends on how large the PTC is compared to the rest of the tax provision.
ITC ACCOUNTING
Generally, ITC may be accounted for on either the “flow through” method or the “deferred” method. Another new method is briefly discussed below. The flow through method acts to reduce the tax provision and tax liability in total in the year it is recognized. Thus, again the existence of the ITC may act to reduce the effective tax rate. Under the deferred method the ITC is treated as a deferred tax liability, but which is not a future deferred tax liability to be paid. Rather the deferred credit is amortized as a credit to reduce the tax provision based on either the life of the underlying asset or the vesting period for the credit.
An additional nuance of the ITC is that the credit acts to reduce the tax basis of the asset by ½ of the credit. As such the book depreciation and tax depreciation over the life of the asset do not equal. Effectively this is a permanent book-to-tax difference. Most Big 4 firms indicate that the difference is taken into the tax provision using a simultaneous equation calculation which tends to be a confusing exercise. I think a better approach may be to simply calculate and record the tax provision in components. That is, the tax effect of the book depreciation of the asset would be adjusted for the basis reduction. For example, a $1 million asset generates a $210,000 federal tax benefit using a 21% federal tax rate. If the basis of the asset was reduced to $850,000 as a result of a 30% tax credit, then the tax benefit of the tax depreciation is $178,500 ($850,000 x 21%). We could achieve the proper book provision by simply using a 17.85% rate applied to the book depreciation.
Given the transferability of the tax credits, a new approach is also being explored by the industry. The approach is like the accounting for a government grant which is addressed under IASB 20 but not under US GAAP. In certain circumstances, when a credit can be transferred (sold) and the taxpayer expects to do that, some Big 4 have argued that the credit may be used to reduce the book basis of the asset rather than flowing the credit through the tax provision line. This will bring the credit up over the tax provision line by using it to reduce the book depreciation expense line. However, some accounting firms argue that when an entity intends to use the credit, it should flow the credit through the tax provision line using either the flow through or the deferred method. Whether this decision process may be applied on an individual credit basis is yet unknown. But what we do know is that using the credit as an offset against the asset cost may solve some managerial reporting issues.
CONCLUSION – Having a daughter who is an environmental engineer, I have always been keen on alternative energy and clean vehicles. The current Tax Code is loaded with alternative energy and clean energy tax credits. While the current administration may seek to change that, we nonetheless need to understand where the credits apply and how they may affect the cost of doing business and ensure that we are utilizing the credits when available. Understanding where to start looking is one basic approach.
