Money (That’s What I Want): IRA’s Direct Pay Mechanism Benefits Tax-Exempt Entities
Historically in the United States, Congress supported renewable energy development through the Internal Revenue Code by granting taxpayers income tax credits, including PTCs and ITCs, for investing in renewable energy facilities and property. However, these credits can be inefficient due to both timing considerations and constraints on the ability of certain categories of taxpayers and organizations to claim such credits.
PTCs are income tax credits based on the production of renewable energy over a period of several years. PTCs are typically available to a taxpayer only after an upfront capital investment. Renewable energy project developers seeking to claim a PTC need to fully fund the development costs of a renewable energy project and only realize the benefit of the PTCs over an extended period of time. ITCs may be claimed by a developer on an income tax return for the year in which the renewable energy property is placed in service (i.e., still after the upfront investment has been made), but with less of a timing inefficiency than PTCs since the ITC is obtained all at once rather than over a period of several years.
Either way, an income tax credit is traditionally only an offset against US federal income taxes payable by a taxpayer. Many tax-exempt organizations could not directly benefit from PTCs and ITCs under prior law because they did not have taxable income to credit against. As a result such organizations could not use the incentives to develop projects.
This mismatch in ability to produce or invest versus availability of credits in the renewable energy space is addressed, somewhat imperfectly, by a variety of tax-equity financing structures. Such structures enable investors with taxable income to buy into a project earlier, when a developer needs funds, and then receive the tax credits associated with a project after the construction and implementation of the project. These structures can be complex, and often the costs needed to set up and administer the structures can be prohibitive. Further, these structures require the developer to discount the face value of the tax credit so that the investor is compensated for the time value of money associated with the credit and the overall risk associated with the project. Consequently, certain developers — particularly developers with smaller potential projects and developers organized as tax-exempt organizations, such as churches, universities and hospitals, in addition to publicly-owned utilities and certain cooperative electric companies — did not take advantage of these structures.
The IRA introduced a new concept to address these inefficiencies faced by tax-exempt entities and other market participants. The concept, referred to in the industry as “direct pay” (or “elective pay”), opens the door to a variety of tax-exempt entities interested in developing renewable energy projects on their sites.
In a twist, certain entities – particularly tax-exempt entities, certain governments and government instrumentalities (specifically, state, local, and Tribal governments), publicly owned utilities, and rural electric cooperatives - are now permitted to make a direct pay election on a tax return. In this case, the US Internal Revenue Service (IRS) will treat such entity as if it had made an overpayment of US federal income tax in an amount equal to the tax credit derived by the entity. The IRS will then refund the “overpayment” to the entity, regardless of whether the entity would have been subject to US federal income taxation in the first place. Accordingly, if a tax-exempt entity that otherwise would not have any federal income tax liability derives a PTC or an ITC, the direct pay election would effectively cause the US government to pay for the tax credit at face value.
The introduction of direct pay makes it easier for tax-exempt entities to take advantage of renewable energy tax credits and, by extension, access more affordable, carbon-free energy. Although some inefficiencies are still present (such as the upfront development costs), the financial incentives of tax credits can be accessed without reliance on burdensome tax equity structures.
To be sure, there are still situations where tax equity structures may be preferred (for example, to match the timing of funding a project to the project’s required expenditures, and also to capture other tax benefits that are not addressed by the IRA, such as depreciation deductions related to renewable energy property). The benefits of a tax-equity structure are typically associated with larger-scale, repeatable projects developed by larger entities with the infrastructure to handle the costly administrative and compliance work required to implement and maintain such a structure. On the other hand, the direct pay election allows tax-exempt entities of any size or scale to benefit from tax credits and utilize clean energy in a way that was simply financially inaccessible in the past, greatly expanding the potential for the future development of renewable energy infrastructure.
In June 2023, the US Department of Treasury and IRS released guidance and a Frequently Asked Questions document related to direct pay. The guidance also addressed “transferability,” another new concept in the energy tax credit space, that allows taxpayers who are not eligible to make a direct pay election to transfer a tax credit to another taxpayer for cash. With respect to direct pay, the guidance clarifies requirements for entities to make the direct pay election, including that the entity or taxpayer generally must own the property from which the income tax credit is derived. The guidance also includes defined terms, procedural rules for making the election, special rules for taxpayers or entities that are partnerships or S corporations, and rules regarding mandatory pre-filing registration.
The guidance also explains that when grants or forgivable loans, which are exempt from U.S. federal income taxation, are used to construct or acquire property related to a renewable energy credit, the basis of that property and a direct pay election is not reduced (although, in that case, the tax credit derived is limited to the cost of the property less such tax-exempt financing). This will enhance opportunities to layer funding from multiple programs. However, tax credits that were transferred to the applicable entity under the transferability provisions introduced by the IRA are ineligible for the direct pay election. Lastly, the guidance states that direct payments will only be made by the US government after the tax return for the applicable year is filed by the applicable entity.
For applicable entities interested in utilizing direct pay, the guidance lists several important logistical requirements and deadlines. As stated above, applicable entities are required to pre-register if they intend to claim ITC or PTC credits and to claim credits and direct payments on a normally filed US federal income tax return or, if the entity is not ordinarily required to file a return, by filing a Form 990-T, Exempt Organization Business Income Tax Return (and proxy tax under section 6033(e)). Entities must also file completed source credit forms, a completed Form 3800, General Business Credit, and any additional information required (e.g., supporting calculations). The deadline for required US federal income tax return is the due date for such return, including extensions of time, for the taxable year for which the election is made. For most tax-exempt and government entities, including Tribal governments, this is generally four and a half months after the end of the entity’s tax year. Applicable entities are not allowed to make a direct pay election on an amended return, and no administrative relief will be granted for tax credits claimed on late-filed returns. For applicable entities without annual filing requirements, the regulations provide an automatic six-month extension, meaning that a Form 990-T would not be due until 10 and a half months after the end of the entity’s tax year. Applicable entities must also satisfy the pre-registration requirements in order to receive the direct payment of tax credits.
Efforts to take advantage of the direct pay regime are already underway in cities and municipal utilities around the country. Regardless of the growing number of projects and attention that the direct pay regime has spurred, we are still only beginning to understand its wider implications for renewable energy. Given the filing deadlines and extensions for most applicable entities, the industry has not even seen a complete tax filing season with direct pay in effect. The tax-equity market, as well as the nascent transferability market (also created by the IRA), are rapidly shifting to consider the direct pay regime. For now, it is unclear what renewable energy infrastructure financing will look like in the near future.
What is certain is that the new direct pay financing mechanism presents an unprecedented opportunity for tax-exempt organizations to expand renewable energy development, upgrade their facilities, reduce ongoing energy costs, and reduce their carbon footprints at a significantly lower cost than ever before.
ArentFox Schiff is closely monitoring developments under the IRA, including with respect to the direct pay rules. To discuss how the direct pay rules or other provisions of the IRA may affect your business or organization, please contact the tax professionals at ArentFox Schiff.