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Unpacking the Section 45X Final Regulations and Lessons Learned from 2024 Transactions

Content by Dave Bartoletti & Justin Cook
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November 5, 2024

On October 28, 2024, the IRS published Final Regulations under Section 45X of the Internal Revenue Code of 1986 covering the “advanced manufacturing production credit” (the “45X Credit”).  The 45X Credit was established by the Inflation Reduction Act of 2022 (“IRA”) to create incentives to manufacture renewable energy equipment and components within the United States.  The Final Regulations adopt the Proposed Regulations published on December 15, 2023, with limited modifications. Provided the Final Regulations are applied consistently in their entirety, the Final Regulations may be applied by taxpayers with respect to eligible components and applicable critical materials for which production is completed and sales occur after December 31, 2022 and during taxable years ending on or after October 28, 2024.

Now that the Final Regulations are in place, we believe it is an appropriate time to revisit the various requirements for obtaining the 45X Credit and take note of both regulatory developments and issues we have encountered with taxpayers seeking to claim, sell, or purchase 45X Credits.  

Dissecting the Section 45X Advanced Manufacturing Production Tax Credit

As the name suggests, the 45X Credit is a form of production tax credit, meaning the tax credit is earned based on the volume of production. Unlike most other production tax credits in the Code, the 45X Credit is earned based on manufacturing output of certain renewable energy components.  It is also one of the few credits under the IRA that may be sold to a tax credit purchaser or claimed directly by the taxpayer under elective pay.   

The 45X Credit criteria can be summarized at its very highest level as follows: the “taxpayer” claiming the 45X Credit must “produce” in the “United States” an “eligible component” for “sale” as part of its “trade or business” to an “unrelated person.” Each of these quoted components are discussed below:

the Taxpayer…

Generally speaking, the person that directly performs the production activities that bring about a substantial transformation resulting in the eligible component and sells such eligible component to an unrelated person is the “taxpayer” who may claim the 45X Credit. The regulations provide leeway for situations where production of an eligible component is performed in whole or in part under a “contract manufacturing arrangement” (i.e., an agreement entered into before the production of the eligible component to be delivered that does not constitute a “routine purchase order for off-the-shelf property”). When a contract manufacturing arrangement exists, the parties to such agreement may determine by agreement the party who shall claim the 45X Credit. The Final Regulations include four examples demonstrating contract manufacturing arrangements.

Neither the Code nor Regulations provide further guidance as to what constitutes a “taxpayer” for the 45X Credit. It would appear that generally applicable terms in the Code, such as the Section 7701(a)(14) definition of a “taxpayer,” would apply. This may be of critical import in a situation where the claimant taxpayer is not a U.S. person and/or operates from a U.S. possession that is outside of the jurisdiction of the U.S. federal income tax, but may pay other U.S. federal taxes (including, but not limited to, federal employment taxes) such that the claimant qualifies as a taxpayer for purposes of the 45X Credit.

We would be remiss without noting that depending on the eligible component (e.g., battery components), simply identifying the taxpayer may not be the end of the analysis. For economic reasons, it may be critical that the unrelated purchaser (discussed below) or its end users remain eligible for other clean energy tax credits, such as the Section 30D clean vehicle tax credit. In such a case, the unrelated purchaser may need to inquire into whether the taxpayer is not a “foreign entity of concern,” for which there is an entirely different set of fulsome Final Regulations for the taxpayer to consider that are outside of the scope of this discussion.   

must Produce …

One of the more uncertain components of satisfying the 45X Credits criteria can be evidencing “production.” Taxpayers and advisors must engage in the task of parsing the component creation process in detail in an effort to delineate what constitutes a “substantial transformation of constituent elements, materials and subcomponents into a complete and distinct eligible component,” in contrast to “partial transformation” and “minor assembly or superficial modifications.”  The Final Regulations add some flexibility to the benefit of taxpayers when compared to the Proposed Regulations, where the term “mere assembly” was used as an antonym to “substantial transformation.” The Treasury Department and the IRS acknowledged that certain eligible components, such as solar modules and battery modules using battery cells, are produced primarily by assembling other components and the intention was not to exclude these processes. Further, certain eligible components are by their nature not manufactured (such as the production of applicable critical materials), and in that case the term “substantial transformation” requires that the constituent elements be “processed, converted, refined, or purified to derive a distinct eligible component.”

The Final Regulations also explicitly permit the production of an eligible component using recycled materials (referred to as “secondary production”). This is a welcome addition to those participating in secondary production as the Proposed Regulations’ failure to explicitly address this matter created uncertainty that hindered the ability of affected taxpayers to achieve full value for 45X Credits in the transferability market.

in the United States …

Production must occur in the United States or a possession thereof (within the meaning of Section 638(2)). The Final Regulations confirm that the domestic production requirement does not apply to constituent elements, materials, and subcomponents used in the production of eligible components.  Instead, the domestic production requirement under Section 45X applies only with respect to the eligible components.  While taxpayers will undoubtedly welcome this interpretation, it places pressure on the taxpayers and advisors to delineate between an eligible component and its subparts not only for purposes of determining what constitutes “production,” but also what constitutes “domestic” production.  This will require an analysis that is, at least in part, similar to the domestic content analysis required under Sections 45(b)(9) and 48(a)(12) where taxpayers must distinguish between manufactured products, manufactured product components, and subcomponents.

an Eligible Component  

The term “eligible component” refers to the manufacturing of specific clean energy components listed in Section 45X, such as solar energy components, wind components and certain battery components (including mining of critical minerals), among other listed items. The Final Regulations go into significant detail into each listed component.  While the Final Regulations largely adopt positions set forth in the Proposed Regulations, there are several important modifications.  For example, the Final Regulations add a requirement (which was neither expressly stated in the statute or Proposed Regulations) that “polymeric backsheets” only qualify as eligible components if at least partially composed of a polymer.  While the nuances of the rules as applied to each eligible component go beyond the scope of this article, we do note this highly facts-and-circumstances exercise is a critical component to qualification.

for sale as part of such Taxpayer’s trade or business 

Calculation of the 45X Credit is determined based on eligible components produced by the taxpayer and, during the taxable year, sold by the taxpayer in the ordinary course of its trade or business. 

Applicable Federal income tax principles apply to determine whether a transaction is in substance a sale (or the provision of a service or some other disposition). A sale is considered to be in a taxpayer’s trade or business by reference to the rules of Section 162 defining a “trade or business.” 

to an Unrelated Person

Section 45X(d)(1) provides that persons are treated as related to each other if such persons would be treated as a single employer under the regulations prescribed under Section 52(b). The Final Regulations reference Section 7701(a)(1) for the definition of “person,” Section 52(b) for determining who is a “related person,” and “unrelated person” by inverse to the definition of a “related person.”

Section 45X(a)(3)(A) provides a special rule for purposes of the 45X Credit that a taxpayer is treated as selling components to an unrelated person if such component is sold to such unrelated person by a person related to the taxpayer. This exception appears to be a recognition of the fact that a Company may have horizontally integrated parts of its supply chain such that the related party sale is not abusive but rather an ordinary part of the production process no different than the related party purchasing the eligible component from a third party.  In enacting Section 45X, Congress appears to have recognized this provision may be abused and for that reason, Section 45X(a)(3)(B) requires the taxpayer to affirmatively elect via its tax returns to make this related party sale and claim the 45X Credits and submit with such tax return such information or registration as the Secretary deems necessary for purposes of preventing duplication, fraud, or any improper or excessive amount determined under Section 45X(a)(1). The Final Regulations focus on this element of the test, providing specific rules for application to consolidated groups, application to partnerships, and other anti-abuse rules that discourage activities determined to be abusive such as a related party’s improper use of eligible components purchased or the sale of defective components to a related party. The Regulations also provide rules and examples to permit 45X Credits in the case of certain sales of eligible components to a related person who then integrated such components or assembles them into another complete and distinct eligible component that is subsequently sold to an unrelated person (e.g., X creates and sells photovoltaic wafers to related party Y, who incorporates the wafers into photovoltaic cells which are sold to unrelated party Z. In this case, X may claim a 45X Credit in the year Y sold the eligible component to Z).

Determining the Credit Amount & Substantiating the Credits

The method of calculation of the credit amount varies depending on the eligible component. Metrics include capacity, weight, and cost. The regulations provide rules for capacity and weight tied to the specific type of eligible component. With respect to credits determined based on production costs (i.e., electrode active materials and applicable critical materials), the Final Regulations provide both additional detail and clarifications. For example, the Final Regulations expanded the scope of production costs by permitting taxpayers to include (1) extraction costs related to the extraction of such materials or minerals in the United States in the calculation of production costs if paid or incurred by the taxpayer, and (2) direct and indirect materials costs if such costs do not relate to the purchase of such materials or minerals that are, at the time of purchase, an eligible component. In a clarification that limits the scope of costs, the Final Regulations confirm that a taxpayer may not double-count the same production costs incurred for production of more than one eligible component.

The Final Regulations provide for substantiation requirements that vary depending on the type of eligible component produced and for certain situations where additional information is needed, such as in the case of a contract manufacturing arrangement. Generally speaking, the substantiation comes in the form of a certification issued by either the taxpayer, applicable suppliers, or in some cases an accredited third-party body, coupled with an obligation to maintain in its books and records data considered relevant to qualification for the 45X Credit based on the eligible component.  While there are some commonalities in these requirements (i.e., maintaining records of production volume), the specifics with respect to substantiation and obligations to maintain books and records varies greatly depending on the eligible component being produced.  For example, eligible components where qualification is based on capacity must maintain evidence of capacity, whereas eligible components that rely on costs to quantify the credit must maintain lists of direct and indirect material costs.

We view the credit calculation methodologies and substantiation requirements as reasonable, despite the level of detail and technical nature of the information required, in light of the nature of the 45X Credits. However, as it is a production tax credit, 45X Credits require actual production before eligibility may be confirmed and the amount may be calculated.  Accordingly, we have seen some clients struggle with the added time and expense burden incurred in assuring themselves, investors, lenders, and tax credit purchasers that the 45X Credits will be valid and properly substantiated.  While this makes financing a new manufacturing facility more complicated than compared to an investment tax credit, we have seen 45X Credits accepted as collateral to secure construction debt.  Further, given the nature and complexity of the credit, we also see this as an opportunity for tax credit purchasers to obtain highly discounted production tax credits in exchange for advancing payments based on reasonable projections.

Credit Phase-Out.

Beginning with eligible components sold after December 31, 2029, the amount of the 45X Credit determined with respect to such eligible component is equal to the product of the amount determined under Sections  1.45X-3(b) through (e) of the Final Regulations with respect to such eligible component, multiplied by a phase-out percentage. The phase-out percentage is equal to 75% for eligible components sold during calendar year 2030; 50% for eligible components sold during calendar year 2031; 25% percent for eligible components sold during calendar year 2032, and 0% for eligible components sold after calendar year 2032. The phase-out rules apply to all eligible components except applicable critical minerals.

At this time, the phase-out hasn’t been of material concern to our clients who are working through the construction process; however, it won’t be long until the phase-outs start materially affecting project financial models and consequently impact project economics.