The Department of the Treasury and the IRS on December 14 issued proposed regulations to implement the advanced manufacturing production credit introduced by the Inflation Reduction Act under Internal Revenue Code Section 45X.
Section 45 X provides eligible taxpayers a tax credit for the US production of eligible components related to clean energy technologies.
The IRS on October 24, 2022, had requested comments on issues arising under Section 45X, and received over 300 public comment submissions.
The proposed regulations aim to provide clarity for eligible taxpayers seeking to claim the credit. Several key issues raised by industry and stakeholders that were addressed by the proposed regulations are discussed below.
Production activity
One of the key requirements of the Section 45X credit is that the taxpayer must produce the eligible component. However, Section 45X does not provide a description of the level of activity necessary for a component to be considered “produced by the taxpayer.” The proposed regulations provide greater clarity on the required activity for a taxpayer to meet the production requirement.
According to the proposed regulations, the term “produced by the taxpayer” generally refers to a process conducted by the taxpayer that substantially transforms constituent elements, materials, or subcomponents into a complete and distinct eligible component. This transformation must result in a functional difference, going beyond mere assembly or superficial modification.
Partial transformation that does not lead to substantial transformation of the constituent elements, materials, or subcomponents into a complete and distinct eligible component is not included in the definition of “produced by the taxpayer.” To illustrate this concept, the proposed regulations provide an example whereby a taxpayer is ineligible for the Section 45X credit because it produces only a portion of an eligible component, but not the entire eligible component.
Additionally, minor assembly of constituent elements, materials, or subcomponents, or superficial modification of the final eligible component, does not qualify as "produced by the taxpayer" unless the taxpayer also engages in the process resulting in substantial transformation. The proposed regulations provide several examples to illustrate cases whereby a taxpayer engaged in mere assembly or superficial modification is ineligible for the Section 45X credit.
The proposed regulations do provide a special rule for solar grade polysilicon, electrode active materials, and applicable critical minerals, as “produced by the taxpayer” in these cases means processing, conversion, refinement, or purification of source materials, such as brines, ores, or waste streams, to derive a distinct eligible component.
Contract manufacturers
Taxpayers often utilize contract manufacturers to produce various components used in their trade or business, but before the proposed rules were issued, it was unclear which party may claim the Section 45X credit in scenarios involving eligible components. Stakeholders wondered if the IRS would adopt an approach similar to that used for other tax credits and deductions that follows the rights and risks associated with the arrangement.
The proposed rules provide that in contract manufacturing arrangements of eligible components, the parties may determine by agreement who may claim the Section 45X credit. The IRS will not challenge such agreements provided all parties execute valid certification statements. Taxpayers should be careful, however, in scenarios where a contract manufacturer produces an eligible component for the taxpayer’s use. Because there is no sale of the eligible component (i.e., the contract manufacturer produces an eligible component for the taxpayer’s use), no Section 45X credit may be generated in those scenarios.
Unrelated person sales requirement
The Section 45X credit is generally generated at the point of sale of the eligible component to an unrelated person. The proposed regulations adopt the definition of the term “related person” used in Section 52(b). Note, however, that the unrelated person rule may be satisfied by a sale to a related person who subsequently sells the eligible component to an unrelated person. In such cases, the Section 45X credit may be claimed at the point of sale to the unrelated person.
This paradigm is also applicable when a taxpayer produces and sells an eligible component to a related person who integrates, incorporates, or assembles the eligible component into another eligible component. In such cases, the taxpayer may claim the Section 45X credit when the related person’s sale to the unrelated person occurs. To alleviate the administrative burden of tracking when the subsequent sales occur, taxpayers may use the Related Person Election as outlined in Section 45X and clarified in the proposed rules.
With a Related Person Election, a taxpayer may treat the sale of an eligible component to a related person as if made to an unrelated person. The election applies to all sales of eligible components by the taxpayer to the related person during the taxable year with respect to that trade or business. The Related Person Election can also accelerate when a taxpayer may claim a Section 45X credit, as they do not need to wait until subsequent sales by other persons.
Anti-abuse concerns
Recognizing the value of the Section 45X credit and potential for abuse, Treasury and the IRS provide robust anti-abuse provisions in the proposed rules. In some cases where the cost of producing certain eligible components is less than the amount of Section 45X credit available to produce those eligible components, the Treasury and the IRS expressed concerns over incentivizing taxpayers to produce eligible components solely for the purpose of claiming the Section 45X credit rather than for productive use.
If the facts and circumstances lead the government to believe that a taxpayer’s primary purpose in producing an eligible component is wasteful, the Section 45X credit may be disallowed. In that case, excessive payment and excessive credit transfer penalties may also apply. Specifically, the Treasury and IRS present an example whereby a taxpayer may be motivated to produce and sell eligible components to both related and unrelated parties in order to claim the Section 45X credit, understanding that neither party plans to resell or use the eligible components, utilizing accommodation fees to facilitate the transactions.
The Related Person Election is not available to taxpayers that utilize the election to sell components to related parties that plan to put the components to improper use or if the components were inherently defective, because they cannot be used for their intended purpose as an eligible component.
The government is similarly concerned about scenarios where the Section 45X credit exceeds the cost of production, which could incentivize behavior that goes against the intent of Section 45X. To address this concern, the Treasury and the IRS added an anti-abuse provision to the proposed regulations that would recognize that the Related Person Election may remove an important safeguard and that selling to an unrelated party would mitigate the risks in those scenarios.
Costs incurred by the taxpayer
The Section 45X credit is generally calculated by multiplying the volume or amount of eligible components by a predetermined credit amount. For electrode active materials and critical minerals, however, the Section 45X credit is instead calculated as 10% of the costs incurred to produce the eligible component. Note that in some cases, such as with lithium carbonate, a material may be both an electrode active material and a critical mineral, and the taxpayer may elect to claim the Section 45X credit for either category, but not both.
Section 45X does not specify what is included in the costs incurred by the taxpayer for purposes of calculating the Section 45X credit. The proposed regulations, unsurprisingly, follow the Section 263A rules to determine includable production costs. However, for both electrode active materials and critical minerals, direct materials costs, indirect materials costs, and costs related to the extraction or acquisition of raw materials are excluded from production costs.
Treasury and the IRS provide an explanation for these exclusions, stating that their intention is to appropriately credit value-added activities involved in the production of electrode active materials and critical minerals. While purchasing raw materials may enable a taxpayer to produce the eligible component, it is not considered an activity that adds value on its own. Therefore, only the costs associated with production activities that add value to the eligible component, conducted by the taxpayer producing the component, are considered for the 10% cost incurred amount for the Section 45X credit.
Treasury and the IRS also express concerns in the proposed regulations about potentially duplicating costs for multiple credits in cases where an electrode active material or critical mineral is later incorporated into another electrode active material or critical mineral. They invite comments on whether costs for extraction and other similar value-added activities in raw material production should be included, provided that these costs can be effectively administered by the IRS while addressing the government's concerns about cost duplication.
Other highlights from the proposed regulations include:
- The sale requirement may be met with an end product that is not itself an eligible component (such as an electric vehicle), as long as an eligible component is sold as part of that end product.
- Production of eligible components may have begun before the effective date of the Section 45X credit, as long as they are completed and sold after December 31, 2022.
- The proposed rules distinguish between 48C and 45X facilities for operations that may seek to claim both credits.
- The regulations provide definitional clarity on eligible components and critical minerals.
- A certificate of analysis (COA) requirement is introduced to document critical minerals.
Next steps
Before the proposed regulations are adopted as final regulations, the IRS and Treasury will consider any comments regarding the notice of proposed rulemaking that are submitted to the IRS by February 13, 2024. A public hearing has been scheduled for February 22, 2024.
Written by Jesse Tsai, Gabe Rubio and Courtney Sandifer. Copyright © 2023 BDO USA, P.C. All rights reserved. www.bdo.com
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