Coalition Drafts Model Guidance on Carbon Sequestration Credit

November 21, 2018

Honorable David Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Ave., N.W.
Washington, DC 20220

William M. Paul
Acting Chief Counsel
Internal Revenue Service
1111 Constitution Ave., NW
Washington, DC 20024

Re: Section 45Q Carbon Sequestration Credit

Dear Messrs. Kautter and Paul:

Section 41119 of the Bipartisan Budget Act of 2018, P.L. 115-123 (the “Act”), provided for enhancement of the carbon sequestration credit under section 45Q of the Internal Revenue Code of 1986, as amended (the “Code”).¹ This letter considers the changes to section 45Q under the Act and makes suggestions for the Department of Treasury (“Treasury”) and the Internal Revenue Service (the “IRS”) to consider in issuing guidance. An example of interim guidance is enclosed as Appendix A.

We submit this letter on behalf of participants in the Carbon Capture Coalition, which brings together over 50 energy, industrial and technology companies, labor unions and environmental, clean energy and agricultural organizations.² The Coalition submits this model guidance to represent the views of its diverse stakeholders regarding the effective implementation of the enhanced section 45Q credits.

I. Background

Section 45Q was originally enacted by section 115 of the Energy Improvement and Extension Act of 2008, Pub. L. No. 110-343, 122 Stat. 3829 (October 3, 2008), and amended by section 1131 of the American Recovery and Reinvestment Tax Act of 2009, Division B of Pub. L. 111-5, 123 Stat. 115 (Feb. 17, 2009) (“prior section 45Q”). Prior section 45Q(a) provided a credit for carbon dioxide (“CO₂”) sequestration that was generally available to a taxpayer that captured qualified CO₂ at a qualified facility and disposed of the CO₂ in secure geological storage within the United States. Notice 2009-83, 2009-44 I.R.B. 588, modified by Notice 2011-25, 2011-14 I.R.B. 604, provided guidance to taxpayers on the application of prior section 45Q. Prior section 45Q(e) provided that, at such time as the IRS certified, in consultation with the EPA, that 75,000,000 metric tons of qualified CO₂ had been taken into account for purposes of section 45Q credit, the IRS would publicly announce that the section 45Q credit would cease to be available for the calendar year following such announcement (the “credit termination provision”).

Congress expanded and extended the section 45Q credit in section 41119(a) of the Bipartisan Budget Act of 2018, P.L. 115-123 (Feb. 9, 2018) (“new section 45Q”).³ The 2018 amendments apply to taxable years beginning after December 31, 2017. See P.L. 115-123 section 41119(b). New section 45Q generally provides for a tax credit in an amount equal to a dollar value per metric ton of qualified carbon oxide captured by the taxpayer and disposed of in secure geological storage, used as a tertiary injectant in a qualified enhanced oil or natural gas recovery (EOR) project and disposed of in secure geological storage, or utilized in certain ways described in section 45Q(f)(5). In general, the credit termination provision no longer applies to carbon capture equipment placed in service on or after February 9, 2018. Instead, section 45Q credits are allowed during the 12-year period beginning on the date such carbon capture equipment was originally placed in service.

Section 45Q(f)(3) provides that, except as provided in regulations prescribed by the Secretary, the section 45Q credit is generally attributable as follows: (i) in the case of carbon capture equipment originally placed in service before February 9, 2018, to the person that captures and physically or contractually ensures the disposal, utilization, or use as a tertiary injectant of the qualified carbon oxide, and (ii) in the case of carbon capture equipment originally placed in service on or after February 9, 2018, to the person that owns the carbon capture equipment and physically or contractually ensures the capture and disposal, utilization, or use as a tertiary injectant of the qualified carbon oxide. In addition, new section 45Q added section 45Q(f)(3)(B), which provides that the taxpayer to whom the credit is attributable (as described in section 45Q(f)(3)(A)) may elect, in the time and manner as the Secretary may prescribe by regulations, to have the person that disposes of the qualified carbon oxide, utilizes the carbon oxide, or uses the carbon oxide as a tertiary injectant, claim the credit in lieu of having the owner of the carbon capture equipment claim the credit.

Section 45Q(h) provides that the Secretary of the Treasury (the “Secretary”) may prescribe regulations and other guidance as may be necessary or appropriate to carry out section 45Q, including regulations or other guidance — (i) to ensure proper allocation under section 45Q(a) for qualified carbon oxide captured by a taxpayer during the taxable year ending after enactment (i.e., February 9, 2018), and (ii) to determine whether a facility is a qualified facility during such year. Section 45Q(f)(2) provides that the Secretary, in consultation with the Administrator of the Environmental Protection Agency (“EPA”), the Secretary of the Department of Energy (“DOE”), and the Secretary of the Department of Interior (“DOI”), shall establish regulations for determining adequate security measures for the geological storage of qualified carbon oxide such that the carbon oxide does not escape into the atmosphere. Section 45Q(f)(4) provides that the Secretary shall, by regulations, provide for recapturing the benefit of any credit allowable under section 45Q(a) with respect to any qualified carbon oxide that ceases to be captured, disposed of, or used as a tertiary injectant in a manner consistent with the requirements of section 45Q.

II. Issues for Which Immediate Guidance is Needed

This part describes certain issues with respect to which immediate guidance is needed by taxpayers so that they may properly structure the carbon sequestration activities intended to be encouraged by the section 45Q credits and obtain financing for such activities. These issues are incorporated into the model guidance included in Appendix A. The Coalition has provided this model guidance in a form intended to facilitate the prompt issuance of interim guidance. The model guidance also includes a number of other housekeeping matters of importance to the Coalition that are not highlighted in this letter.

A. Persons Who Contractually Ensure Disposal, Use, or Utilization of Qualified Carbon Oxide

Paragraphs (1) through (4) of section 45Q(a), as amended by the Act, require that qualified carbon oxide be “disposed of by the taxpayer,” “used by the taxpayer,” or “utilized by the taxpayer” in order for a section 45Q credit to be claimed. This language, viewed in isolation, could be read as requiring that the taxpayer physically dispose of, use, or utilize carbon oxide. However, both prior section 45Q and the amendments made to new section 45Q clearly and expressly contemplate that a taxpayer claiming a section 45Q credit need not physically dispose of, use, or utilize qualified carbon oxide if the taxpayer “contractually ensures” that the qualified carbon oxide is disposed of, used, or utilized.

Under prior section 45Q(a), the amount of the section 45Q credit was equal to the sum of:

Nevertheless, prior section 45Q(d)(5) provided that any section 45Q credit “shall be attributable to the person that captures and physically or contractually ensures the disposal of or the use as a tertiary injectant of the qualified carbon dioxide, except to the extent provided in regulations prescribed by the Secretary.” (emphasis added). Prior section 45Q(d)(5) clearly contemplated that a taxpayer who claimed section 45Q credits might not physically dispose of or use qualified CO₂, but instead might contractually ensure that another person physically disposed of or used the qualified CO₂. As a result, the phrases “disposed of by the taxpayer” and “used by the taxpayer” in prior section 45Q(a) must mean “physically or contractually disposed of by the taxpayer” and “physically or contractually used by the taxpayer,” respectively (instead of “physically disposed of by the taxpayer” and “physically used by the taxpayer,” respectively).

New section 45Q(f)(3)(A), as amended by the Act, similarly provides that a section 45Q credit is (in the absence of an election under section 45Q(f)(3)(B), discussed below) attributable to:

In implementing the changes to section 45Q under the Act, Treasury and the IRS should clarify that a person need not physically carry out the specified activities (disposal, use, or utilization) in order to claim the credit, as long as such person contractually ensures that the specified activity is carried out.

Treasury and the IRS also could provide guidance regarding the meaning of the term “contractually ensure.” For example, the guidance could provide a person is treated as contractually ensuring that a specified activity is carried out if: (i) such person enters into a contract with another person that requires either (A) such other person to carry out such activity, or (B) such other person to require a third person to carry out such activity; and (ii) such contract includes commercially reasonable terms to permit enforcement of such other party's obligation to carry out such activity. We recommend the use of “commercially reasonable terms” for enforcement, rather than a specified enforcement mechanism (e.g., specific enforcement or liquidated damages), because the enforcement provisions that are reasonable may vary from contract to contract.

B. Election under Section 45Q(f)(3)(B)

New section 45Q(f)(3)(B), as enacted by the Act, provides:

If the person described in [section 45Q(f)(3)(A)] makes an election under this subparagraph in such time and manner as the Secretary may prescribe by regulations, the credit under this section —

This election represents a key new feature of the enhanced section 45Q credit. The election is critical in ensuring that taxpayers will have sufficient flexibility in structuring carbon capture and sequestration projects so that the tax credits will have the intended effect of providing an incentive for additional carbon sequestration. To this end, the election should be implemented in a manner that facilitates this enhanced flexibility for taxpayers.

Treasury and the IRS should provide guidance regarding the method by which a taxpayer may make this election. In particular, we recommend that the taxpayer may make this election with respect to a taxable year by attaching a statement to a timely filed (including extensions) income tax return for such taxable year.

In addition, guidance should clarify that the standards for a person who “contractually ensures” disposal, utilization, or use of qualified carbon oxide, described above, also apply to a person described in section 45Q(f)(3)(B)(i). As described above with section 45Q(a), when read in isolation, the phrase “the person that disposes of the qualified carbon oxide, utilizes the qualified carbon oxide, or uses the qualified carbon oxide as a tertiary injectant” could be read as requiring the person claiming the credit to physically dispose of, utilize, or use the qualified carbon oxide. However, the words “dispose of,” “use,” and “utilize” should be read consistently wherever they appear throughout section 45Q. Just as qualified carbon oxide should be treated as “disposed of by the taxpayer,” “used by the taxpayer,” or “utilized by the taxpayer” when the taxpayer physically or contractually disposes of, uses, or utilizes the qualified carbon oxide, so too should a person be treated as someone who “disposes of the qualified carbon oxide, utilizes the qualified carbon oxide, or uses the qualified carbon oxide as a tertiary injectant” when they physically or contractually perform the specified activities.

It is unclear whether the owner of carbon capture equipment described in section 45Q(f)(3)(A) is permitted to transfer only a portion of any section 45Q credit while retaining the remainder. Section 45Q does not explicitly contemplate this possibility, unlike section 45J (also amended by the Bipartisan Budget Act), which expressly permits a taxpayer to make a transfer election “with respect to all (or any portion specified in such election) of [the section 45J] credit.” Nevertheless, section 45Q does not explicitly prohibit a partial transfer and Treasury should have the authority to permit a partial transfer as “necessary or appropriate” guidance under section 45Q(h); under section 45Q(f)(3)(B), the election is to be made “in such time and manner as the Secretary may prescribe” (emphasis added). Finally, a partial transfer is consistent with the increased flexibility of the section 45Q credit provided for by section 45Q(f)(3)(B). For this reason, we believe that Treasury and the IRS have the authority to provide for a partial transfer. We recommend that a taxpayer described in section 45Q(f)(3)(A) be permitted to elect to transfer a portion of the section 45Q credit to a person described section 45Q(f)(3)(B). The portion would be specified in the taxpayer's annual election, made on the tax return for the taxable year of the credit, as a percentage of the total credit claimed.

To illustrate these features, the guidance also could include the following example:

Corporation A owns carbon capture equipment which is originally placed in service at a qualified facility on or after the date of the enactment of the Bipartisan Budget Act of 2018. Corporation A enters into an enforceable contract with Corporation B under which Corporation B will purchase qualified carbon oxide from Corporation A. The contract between Corporation A and Corporation B requires Corporation B to ensure that qualified carbon oxide purchased under the contract will be used as a tertiary injectant for enhanced oil or natural gas recovery. Corporation B, in turn, enters into an enforceable contract with Corporation C under which Corporation B sells qualified carbon oxide to Corporation C and requires Corporation C to use such qualified carbon oxide as a tertiary injectant for enhanced oil or natural gas recovery at a well owned by Corporation C.

In accordance with the terms of the contracts, Corporation C uses qualified carbon oxide as a tertiary injectant for enhanced oil or natural gas recovery and disposes of such qualified carbon oxide in secure geological storage in each of Years 1, 2, and 3.

In Year 1, Corporation A does not make any election under section 45Q(f)(3)(B). Because Corporation A contractually ensures that the qualified carbon oxide is used as a tertiary injectant, Corporation A is treated as using such qualified carbon oxide as a tertiary injectant for purposes of section 45Q. As a result, Corporation A may claim section 45Q credits in Year 1.

In Year 2, Corporation A makes an election under section 45Q(f)(3)(B) to allow Corporation B to claim section 45Q credits. Because Corporation B contractually ensures that the qualified carbon oxide is used as a tertiary injectant, Corporation B is treated as using such qualified carbon oxide as a tertiary injectant for purposes of section 45Q. As a result, Corporation A's election under section 45Q(f)(3)(B) is valid, and Corporation B may claim section 45Q credits in Year 2.

In Year 3, Corporation A makes an election under section 45Q(f)(3)(B) to allow Corporation C to claim section 45Q credits. Because Corporation C uses the qualified carbon oxide as a tertiary injectant, Corporation A's election under section 45Q(f)(3)(B) is valid, and Corporation C may claim section 45Q credits in Year 3.

C. Recapture

Section 45Q(f)(4) provides that the Secretary shall, by regulations, provide for recapturing the benefit of any credit allowable under section 45Q(a) with respect to any qualified carbon oxide that ceases to be captured, disposed of, or used as a tertiary injectant in a manner consistent with the requirements of section 45Q. Treasury and the IRS have not yet issued detailed guidance describing the circumstances under which a section 45Q credit may be recaptured.

The section 45Q recapture provision can raise a number of complex issues which may require consultation with the EPA. Nevertheless, the potential uncertainty created by the provision can be a significant barrier to obtaining financing for carbon capture and sequestration projects. Because of the anticipated increase in demand for the credit following the amendments made by the Bipartisan Budget Act, prompt guidance is needed.

To reduce the scope of uncertainty, while still allowing guidance to be provided in a timely fashion, we recommend that Treasury and the IRS adopt a safe harbor for credit claimants that physically or contractually ensure disposal of qualified carbon oxide through projects that comply with Subpart RR of Greenhouse Gas Reporting Program or an “Equivalent Program.”

In order to satisfy the proposed safe harbor: (i) a credit claimant must either itself comply with Subpart RR or an Equivalent Program (a “Reporting Claimant”) or, alternatively, contractually ensure that an owner or operator of a well or group of wells that injects CO₂ (a “Reporting Counterparty”) complies with subpart RR or an Equivalent Program; (ii) the section 45Q credits claimed must be computed based on the total annual CO₂ mass sequestered in subsurface geologic formations, calculated in accordance with the procedure specified in Equation RR-11 or Equation RR-12 of 40 CFR 98.443, as applicable (or the corresponding provisions of an Equivalent Program), i.e., on a mass balance basis; and (iii) if a Reporting Counterparty receives carbon dioxide from multiple sources, including a credit claimant, then the credit claimant must contractually ensure that the Reporting Counterparty will meet certain allocation and reporting requirements. In general, the safe harbor would apply regardless of whether a Reporting Claimant or Reporting Counterparty injects carbon dioxide as a tertiary injectant for EOR at a Class II well that has opted into Subpart RR or injects carbon dioxide into a Class VI well that is required to comply with Subpart RR.

If a credit claimant satisfies the safe harbor, then recapture would be limited to certain circumstances. If the net amount of sequestered carbon dioxide calculated for a taxable year is negative, such amount would be subject to recapture, but only from the immediately prior taxable year of the credit claimant. Amounts subject to the safe harbor from years before the immediately prior taxable year would not be subject to recapture. Such period takes into account the general security of carbon sequestered through EOR over the past several decades and the process required by the EPA to approve a monitoring, reporting and verification (MRV) plan under Subpart RR. In addition, in the event that the EPA (or the administrator of an Equivalent Program) approves the cessation of MRV at the relevant facility, section 45Q credits subject to the safe harbor that were previously claimed with respect to such facility would no longer be subject to recapture (the lookback to the immediate prior taxable year would no longer apply). Finally, qualified carbon oxide that is reported by a Reporting Claimant as sequestered in subsurface geologic formations in accordance with Subpart RR (or an Equivalent Program) or allocated to the credit claimant by a Reporting Counterparty in accordance with the rules described above will be treated as disposed of in secure geological storage.

The proposed guidance allows a claimant to satisfy the safe harbor provision through compliance with Subpart RR of EPA's greenhouse gas reporting rule or an Equivalent Program that demonstrates secure geologic storage and quantifies the amount of carbon oxide sequestered. The Coalition did not reach consensus on standards to define an Equivalent Program. All Coalition members agree that the goal of any minimum criteria should be to maintain the integrity of the purpose of the section 45Q credit: ensuring that the claimant of the credit is, in fact, storing carbon oxide and assessing losses. Some Coalition members maintain that an Equivalent Program that demonstrates secure geologic storage and verifies credit integrity must be done through a mass-balance approach that includes sufficient site characterization and monitoring, reporting and verification methods, such as in Subpart RR of EPA's Greenhouse Gas Monitoring Rule. Though specific criteria for an Equivalent Program are not defined in the model guidance, this broad-based bipartisan coalition is working toward a set of recommendations that ensure environmental safeguards, preserve taxpayer integrity, and encourage commercial development of carbon capture technologies.

Appendix B provides additional information supporting our conclusion that this recapture period should be sufficient to fulfill the purposes of the recapture provision.⁴ The appendix explains how, taken together, physics and flow mechanics, experience with and tools for subsurface management of buoyant fluids, combined with regulatory requirements suggest that: (i) cases of loss of volumes of CO₂ that would approach the commercial volumes sequestered during a two-year period are highly improbable; and (ii) potential CO₂ losses occur principally during injection and/or early in a project, while a field is being actively monitored for injection pressures and conformance. The appendix also includes a detailed bibliography with citations to relevant technical literature.

Sincerely,

Brad Crabtree
Co-Director
Carbon Capture Coalition
(701) 647-2041 | bcrabtree@gpisd.net

Jeff Bobeck
Co-Director
Carbon Capture Coalition
(703) 516-0625 | bobeckj@c2es.org

cc:
Krishna Vallabhaneni, Acting Tax Legislative Counsel, Department of Treasury
Holly Porter, Associate Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service
Hannah Hawkins, Attorney Advisor, Office of Tax Policy (Legislative Counsel), Department of Treasury
Peter C. Friedman, Senior Technician Reviewer, Branch 6, Office of Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service
David Selig, Senior Counsel, Branch 6, Office of Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service