On Aug. 16, 2022, President Joe Biden signed into law the Inflation Reduction Act of 2022 (IRA), which includes new and revised tax incentives for clean energy projects. This alert provides a summary of the IRA’s impact on tax credits for energy storage technologies, which were extended and significantly expanded. Additional alerts will provide summaries of the IRA focused on credits for other clean energy technologies.
Prior Law — Investment Tax Credit for Energy Storage
Before the enactment of the IRA, the Section 48 investment tax credit (ITC) did not apply to standalone energy storage projects. Energy storage projects could claim the ITC only when installed in connection with a new solar generation facility, and then only to the extent the energy storage project was charged at least 80% by the solar facility. The project could not claim an ITC to the extent that it was charged by the grid. These operation restrictions for energy storage projects claiming the ITC severely limited how the batteries could be used and implemented to their fullest capabilities.
Addition of ITC for Standalone Energy Storage Technology
The IRA adds Section 48(a)(3)(A)(ix) to create an ITC for standalone energy storage technology with a minimum capacity of 5 kWh. Energy storage technology includes batteries, but it also applies more broadly to any energy storage technology that receives, stores and delivers energy for conversion to electricity, or to most technology that thermally stores energy (excluding swimming pools, combined heat and power systems, and building structural components). Energy storage installations that are placed in service after Dec. 31, 2022, and begin construction prior to Jan. 1, 2025, are entitled to the existing ITC under Section 48(a). Energy storage installations that begin construction after Dec. 31, 2024, will be entitled to credits under the technology-neutral ITC under new Section 48E (discussed below).
The base ITC rate for energy storage projects is 6% and the bonus rate is 30%. The bonus rate is available if the project is under 1MW of energy storage capacity or if it meets the new prevailing wage and apprenticeship requirements (discussed below).
New Section 48E Applies ITC to Energy Storage Technology Through at Least 2033
The IRA introduces a new Section 48E ITC that provides a technology-neutral tax credit for clean energy generation and for energy storage projects placed in service after Dec. 31, 2024. Any energy storage technology that qualifies under Section 48 also will qualify under Section 48E; this is a different standard than emission-based measurement for generation, which requires zero or net-negative carbon emissions. The Section 48E ITC also includes the base rate/bonus rate structure of Section 48, making the new prevailing wage and apprenticeship requirements relevant under this credit as well.
The Section 48E ITC will begin to phase out for projects beginning construction in the first calendar year after the “applicable year,” which is the later of (i) 2032 or (ii) the calendar year in which the Secretary determines that the annual greenhouse gas emissions from electricity generation are 75% lower than in 2022. The maximum ITC value (30% bonus credit) will last until 2033, then drop to 75% of the maximum in 2034 (22.5% bonus credit), and to 50% of the maximum in 2035 (15% bonus credit). Thereafter, the ITC no longer will be available.
Prevailing Wage and Apprenticeship Requirements
To qualify for the bonus rate (30%) under Sections 48 and 48E, an energy storage project will need to satisfy the prevailing wage and apprenticeship requirements. If these requirements are not met, the project will be eligible only for the base rate (6%).
Specifically, a taxpayer will need to (i) pay “laborers and mechanics” (distinct from managerial and administrative workers) a prevailing wage, and (ii) ensure the employment of an adequate number of apprentices from registered apprenticeship programs. In Notice 2022-61, the IRS provided the first guidance on how taxpayers may demonstrate they have achieved these objectives.
Prevailing wages must match the pay rates published by the Department of Labor (DOL) for geographic areas and for types of jobs or labor classifications. If relevant wage rates have not been published, the taxpayer must affirmatively contact the DOL for a wage determination, providing the type of facility being constructed, location, proposed labor classifications, proposed prevailing wage rates, job descriptions and duties, and any rationale for the proposed classifications.
Apprentice employment generally requires that no fewer than the “applicable percentage” of total labor hours are performed by qualified apprentices. The applicable percentage is (i) 10% for projects that begin construction in 2022, (ii) 12.5% for projects that begin construction in 2023, and (iii) 15% for projects that begin construction in 2024 or later. Apprentice labor hours are the dominant factor in establishing apprentice employment but, depending on the project or contractor characteristics, the adequacy of apprentice employment also can include specific headcount requirements.
Compliance with prevailing wage and apprenticeship standards is demonstrated through recordkeeping. Notice 2022-61 included examples of the types of records a taxpayer must keep, including the wage rates provided by the DOL, the laborers and mechanics who performed construction work on the project (and whether they are qualified apprentices), the classifications of work they performed, their hours worked in each classification, and the wage rates paid for the work. The apprenticeship labor requirements have a good-faith exemption that applies if the taxpayer requests qualified apprentices from a registered apprenticeship program and the request is denied or goes without response for more than five business days — effectively keeping taxpayers from being penalized if there are insufficient apprentices to hire. Additionally, taxpayers are generally permitted to cure noncompliance with additional payments to the worker, plus interest, and/or penalty payments to the IRS.
Two exemptions from the prevailing wage and apprenticeship requirements exist:
- Smaller-scale energy storage projects (under 1MW of storage capacity) qualify for the 30% bonus rate regardless of compliance with the prevailing wage and apprenticeship requirements.
- Energy storage projects (i) not in service prior to Jan. 1, 2022, and (ii) on which construction begins prior to Jan. 29, 2023 (60 days after the IRS issued Notice 2022-61), qualify for the bonus rate regardless of compliance with the prevailing wage and apprenticeship requirements.
The clarification of recordkeeping requirements and taxpayer’s affirmative duties to get wage determinations are important developments to arise from Notice 2022-61, but the most significant aspect of the notice is the start of the 60-day clock on the second exemption. The IRS has promised additional guidance and regulations on these requirements and exemptions, which may change the recordkeeping and exemption landscape in 2023.
Refundable ITC for Tax-Exempt Entities
The ITC for standalone energy storage is a refundable credit for tax-exempt entities, state and local governments, Indian tribal governments, Alaska Native Corporations, the Tennessee Valley Authority, and rural electric cooperatives. The ITC statutes indicate that rules similar to those under the production tax credit will apply to refundability. Although final guidance may alter these rules somewhat, taxpayers should expect that projects with a 1MW or larger capacity must satisfy the domestic content requirements if they begin construction after 2023. If not, the refundable credit amount will be reduced by 10% for projects that begin construction in 2024 and by 15% for projects that begin construction in 2025. No refundable credit will be permitted for projects that begin construction in 2026 or later if they do not satisfy the domestic-content requirements. Additionally, an exception to the domestic-content requirement likely will apply if those components are not produced in the United States in sufficient available quantities, or if the inclusion of domestic content would increase the overall project costs by more than 25%.
Energy storage projects owned by taxable entities are not eligible for a refundable ITC, but instead can take advantage of the new transferability rules.
Direct Transfer of the ITC
The IRA added a provision to permit project owners (other than tax-exempt entities) to make an election to transfer the ITC to an unrelated third party. The amount that the third party paid for the tax credit must be in cash, is not included in the gross income of the transferee and is not deductible to the transferor. An election to transfer the tax credits must be made on or before the due date for the tax return in the year the credits were determined, so credits that are carried forward cannot be transferred later. Also, once a credit is transferred, the credit cannot be further transferred by the transferee.
These direct transfer rules likely will have a significant impact on project financing, as sponsors might elect to simply monetize the ITC rather than bringing in tax equity partners. However, the tax credit market may seek indemnities from sponsors and parent guaranties related to the tax credits’ original determination and qualification. This could have a separating effect in a tax credit market between creditworthy sponsors and the rest of the industry. Expect tax insurance to play a large role in the new tax credit transfer market.
Notable Determinations for Energy Storage Property
Project owners claiming the ITC when contracting with a tax-exempt offtaker must understand whether the contract with the offtaker will be considered a lease or a service contract by the IRS under Section 7701(e). This determination can shift a taxpayer’s depreciation to straight line, require fair market value purchase options, and even cause an outright denial of the taxpayer’s ability to claim the ITC. The IRA removes doubt for energy storage property, as defined in Section 48(a)(6), by explicitly stating that a service contract for operation of an energy storage facility will be respected and not recharacterized as a lease so long as four safe-harbor criteria are followed: The tax-exempt offtaker cannot have a right to operate the facility, cannot have a purchase option other than for fair market value and cannot benefit from operational cost savings, and the tax-exempt entity must have meaningful rights in the case of the project’s nonperformance under the offtake contract. Being able to rely on the service contract safe harbor under Section 7701(e) avoids uncertainty about claiming the ITC for contracts to provide storage services to tax-exempt and governmental entities.
Additionally, the IRA provides energy storage property an election out of the Section 50(d)(2) “public utility property” normalization method of accounting limitation for facilities with a capacity in excess of 500 kWhs. The normalization method creates a drag on tax credit value as compared to nonregulated taxpayers because of how public utilities are required to structure their rates. This new section should help encourage deployment of larger energy storage projects by regulated utilities as part of their infrastructure spending.
10% Adder for Domestic Content
Energy storage projects placed in service after Dec. 31, 2022, that satisfy a new domestic content requirement will be entitled to a 10% additional ITC (2% for base credit). Eligibility for the domestic content bonus credit is based on whether any steel, iron or manufactured product that is a component of the facility was produced in the United States. For this purpose, a manufactured product will be deemed to have been produced in the United States if not less than the “adjusted percentage” of the total costs of all such manufactured products is attributable to manufactured products (including components) that are mined, produced or manufactured in the United States.
The adjusted percentage is generally (i) 40% for facilities that begin construction before 2025, (ii) 45% for facilities that begin construction in 2025, (iii) 50% for facilities that begin construction in 2026, and (iv) 55% for facilities that begin construction after 2026.
10% Adder for Energy Communities
Energy storage projects placed in service after Dec. 31, 2022, and located within an “energy community” will be entitled to a 10% additional ITC (2% for base credit). An energy community is defined to include (i) a brownfield site; (ii) a census tract or any adjoining tract in which a coal mine closed after Dec. 31, 1999, or a coal-fired electric power plant was retired after Dec. 31, 2009; and (iii) an area that has (or, at any time during the period beginning after Dec. 31, 1999, had) significant employment or local tax revenue related to the extraction, processing, transport or storage of coal, oil or natural gas.
Adders for Solar- or Wind-Attached Energy Storage in Low-Income Communities
Certain qualified solar and wind facilities with a maximum output of less than 5 MW may be eligible for an additional ITC. The project must receive an allocation of environmental justice solar and wind capacity limitation, but once it does, the project can receive an additional 10% credit if located in a low-income community or on Indian land, or an additional 20% credit if such project is part of a qualified low-income residential building project or qualified low-income economic benefit project. Standalone energy storage is not eligible for this credit, but energy storage installed in connection with wind and solar projects may be eligible.
Energy Storage Credits for Homeowners
In addition to all the changes for the ITC, the IRA also revised the Section 25D credit homeowners use for residential energy storage projects, such as batteries. Like the ITC, home energy storage property previously was entitled to a credit only if it was attached to home solar generation property. Unlike the ITC, the IRS had issued rulings permitting the Section 25D credit to be claimed on energy storage retrofits to already-placed-in-service home solar. This maximum Section 25D credit was capped at 26% for 2020-2022 installations, which would drop to 22% in 2023 and become unavailable in 2024 and thereafter.
Under the IRA, beginning Jan. 1, 2023, homeowners can claim a 30% credit under Section 25D(a)(6) for standalone energy storage of 3 kWh or greater, regardless of whether it was installed concurrently with a solar generation. This credit is based on the qualified expenditures for the energy storage property, which the IRS previously characterized as the costs of the equipment and the labor to install it in a residential dwelling. The 30% Section 25D credit lasts until Dec. 31, 2032, and then drops to 26% in 2033, and 22% in 2034. The credit is unavailable in 2035 and thereafter.
McGuireWoods lawyers are experienced in energy, project finance and tax equity structures. Do not hesitate to reach out if you would like to discuss any of the above information.