On Dec. 22, the Internal Revenue Service published long-awaited proposed regulations for hydrogen tax credits under Internal Revenue Code Sections 45V and 48. The proposed regulations address many gating questions, including providing rules for determining lifecycle greenhouse gas emissions rates resulting from hydrogen production processes and the introduction of qualified “energy attribute certificates” to ensure feedstock electricity source eligibility. Of note, the proposed regulations adopt a stringent approach to feedstock electricity source eligibility, raising important considerations for hydrogen producers, developers and investors.
The proposed regulations also provide guidance on the verification of the production and sale or use of clean hydrogen, modifying or retrofitting existing hydrogen production facilities, electing the Section 48 investment tax credit in lieu of the Section 45V production tax credit, and the interaction between Section 45Q and Section 45V tax credits.
Here, we share key takeaways from the proposed regulations as well as a high-level summary of the proposed regulations’ substantive content.
KEY TAKEAWAYS
The proposed regulations provide a step forward in structuring eligible feedstock source criteria for the hydrogen production process. Yet the regulations also display incompleteness, as evidenced by the IRS’s requests for comments across several material areas, providing time for taxpayers to interpret the rules and respond accordingly.
These current rules will impact the hydrogen and energy markets, which may require significant rethinking of the existing development and infrastructure of hydrogen energy production projects. As such, we outline some key considerations for hydrogen producers, developers and investors:
- The IRS has interpreted the statutory emissions requirements very conservatively. Many industry players were hoping for more flexibility regarding temporal matching and additionality. Notwithstanding, a deeper read of the remaining unanswered questions suggests that the final regulations may be more favorable in some of the details.
- The proposed regulations do not provide any meaningful guidance on the emissions rate determination from hydrogen production pathways that may use renewable natural gas or other fugitive sources of methane (such as from a coal mine). However, the proposed regulations’ preamble states that the IRS anticipates that biogas or biogas-based RNG must originate from the first productive use of the relevant methane for purposes of Section 45V tax credit eligibility. Affected taxpayers, especially those who contemplate or utilize derivative uses of RNG, should carefully review their current positions and provide relevant comments to the IRS.
- The IRS is soliciting comments on the mechanisms used to verify emissions related to hydrogen production, specifically for fossil fuel-powered electricity generation with carbon capture and sequestration and biomass-powered electricity generation. The IRS has delineated these types of electricity generating units as having highly variable or uncertain greenhouse gas emissions. Affected taxpayers should fully consider the requested comments and provide feedback as necessary.
- The three-pronged “pillars” test (discussed below) is incomplete. Some notable considerations on which affected taxpayers should carefully consider and provide comments include:
- The IRS seeks comments on how existing higher-emitting electricity generating facilities (pertinently, an existing fossil fuel electricity generating facility after the addition of carbon capture and sequestration) that make upgrades to subsequently deliver minimal-emitting electricity can qualify under the incrementality prong and the modification requirement as a new clean power source.
- The incrementality prong would effectively ignore feedstock generation from existing clean power sources. The IRS seeks comments via three potential pathways in which to properly consider such existing clean power sources for satisfaction of the incrementality prong. All three pathways concern avoiding the retirement or curtailment of existing clean power sources, with pertinent regards to nuclear generating facilities given the identified risk of nuclear fleet retirement.
- The proposed definition of “facility” and guidance on the interaction between Section 45Q and Section 45V provide welcomed clarity. Taxpayers should review their positions with respect to potential claims of both the Section 45Q and Section 45V tax credits, especially as it pertains to co-located equipment.
The proposed regulations would impose significant recordkeeping requirements, including verification and attestation mandates that would involve tracking raw emissions data in accordance with either the Greenhouse Gases, Regulated Emissions, and Energy Use in Transportation (GREET) model or the provisional emissions rate (PER) petition, tracing placed-in-service dates, substantiating the hourly matching method and documenting past credits claimed pursuant to Section 45Q, among other things.
PROPOSED REGULATIONS
Defining “Facility”
The proposed regulations define “facility” to mean a single production line that is used to produce qualified clean hydrogen, including all components of property that function interdependently to produce qualified clean hydrogen. “Facility” would not include equipment that is used to condition or transport hydrogen beyond the point of production or electricity production equipment used to power the hydrogen production process.
“Facility” would also not include any carbon capture equipment associated with the electricity production process. Therefore, carbon capture equipment used in the hydrogen production process that is not associated with the electricity production process could be within the meaning of “facility” if such equipment was functionally interdependent with the hydrogen production equipment and results in net emissions from the “facility” within the permitted range.
Determination of Emissions Rates: The GREET Model
The proposed regulations would require the determination of gas emissions rates, specifically lifecycle greenhouse gases, in the hydrogen production process to be calculated in accordance with the most recent 45VH2- GREET model from the U.S. Department of Energy’s Argonne National Laboratory. The GREET model only includes emissions associated with feedstock growth, gathering, extraction, processing and delivery to a hydrogen production facility. The model would also include any other emissions associated with the hydrogen production process, including electricity and any capture and sequestration of carbon dioxide used or generated by the hydrogen production facility (but not the capture and sequestration of carbon dioxide emissions from the electricity production process).
The current GREET model would initially incorporate eight hydrogen production pathways.
For hydrogen production technology or feedstock not accounted for in the GREET model (such as biomass feedstock or geologic hydrogen production), an alternative avenue is provided to allow the taxpayer to petition for a PER determination. The PER process is only available when the production technology or feedstock is not covered by the most recent GREET model and is not available solely where the taxpayer disagrees with the underlying assumptions (i.e., background data) or calculation approach used in the GREET model.
Importantly, taxpayers would need to continually ensure that the most recent GREET model is used. If a version of the GREET model becomes publicly available after the first day of the taxable year of production (but still within such taxable year), the proposed regulations grant discretion to the taxpayer to select either version as the “most recent” model.
Eligible Feedstock Electricity Sources: The Three-Pronged “Pillars” Test
The proposed regulations would significantly limit the feedstock electricity source in the hydrogen production process to be from new renewable or low-emissions sources. This would be enforced through EACs, which essentially are tradeable instruments that certify that the associated unit of energy production meets the feedstock requirements of Section 45V.
An EAC would be defined to mean a tradeable contractual instrument that is issued through a qualified EAC registry and represents the energy attributes of a specific unit of energy produced. Pertinently, the proposed regulations provide that renewable energy certificates are forms of EACs.
EACs must be “qualifying” to properly substantiate the feedstock electricity input in the hydrogen production process from renewable or other zero-emissions sources. A qualifying EAC must be verifiable by an unrelated “qualified verifier.” The requirement would apply regardless of whether the electricity generating facility is grid connected, directly connected or co-located.
A qualifying EAC must meet the three-pronged “pillars” test of incrementality, temporal matching and deliverability. The IRS noted that these requirements are important guardrails to ensure that the hydrogen production energy usage reasonably reflects the related emissions. The IRS further noted that without these requirements, there is significant risk that hydrogen production would significantly increase induced grid emissions beyond the allowable levels required to qualify for the tax credits.
Incrementality
In a broad sense, incrementality for the purposes of the proposed regulations means that the feedstock source must be “new clean power.”
Under this meaning, the incrementality prong would provide that the electricity generating facility supplying electricity feedstock must be “new” or “uprated” with a commercial operations date no earlier than (and within) 36 months of the hydrogen production facility’s placed-in-service date.
Notably, the incrementality prong would preclude powering hydrogen production from most existing electricity generating facilities, regardless of whether such facilities currently exist as renewable or “zero-emissions” sources. However, the IRS noted that it is requesting comments on whether electricity generated by existing facilities dedicated to hydrogen production may be treated as satisfying the incrementality requirement.
Temporal Matching
The temporal matching prong would require that the electricity input consumption be strictly matched to the hydrogen production output on an hourly basis (the hourly matching method). The proposed regulations would provide a transitional phase-in approach to allow taxpayers to use annual matching for electricity generated before Jan. 1, 2028. The purpose of the transition rule is to give the EAC market time to develop hourly tracking capability. For electricity generated after Dec. 31, 2027, the taxpayer must use the hourly matching method.
Deliverability
The deliverability prong would provide that the electricity generated by the electricity generating facility must be sourced in the same “region” as the hydrogen production facility.
Related to the three pillar requirements, the IRS is seeking comments related to minimal-emitting electricity generation that is used for hydrogen production, as well as input on highly variable emissions technology (fossil fuel-powered electricity generation with carbon capture equipment and biomass power electricity generation).
The IRS is also seeking comments on how to treat upgraded energy generation equipment and on the addition of carbon capture equipment to existing facilities as it relates to the incrementality requirement.
Finally, the IRS is requesting comments on circumstances where the diversion of existing clean emissions generating facilities to hydrogen production is unlikely to result in increased emissions. In short, the EAC requirement and the related three pillars are likely to be included in the final regulations but seem ripe for further clarification in future guidance.
“Sale” or “Use” of Hydrogen in the Ordinary Course of Trade or Business
The proposed regulations would provide that qualifying hydrogen must be produced in the ordinary course of trade or business of the taxpayer for the purposes of production and sale or use verifiable by an unrelated “qualified verifier.” Sale or use would mean for the primary purpose of making ready and available for sale or use. Storage of hydrogen following production is expressly included in this meaning. The sale or use of the hydrogen can occur outside the U.S.
The Section 45V credit arises in the year of hydrogen production notwithstanding that the sale or use, or verification of the sale or use, may occur in a later tax year. However, the credit may only be claimed on a tax return upon satisfaction of all verification requirements for the hydrogen production and subsequent sale or use, among other requirements.
Placed-in-Service Date for Existing Facilities That Are “Modified” or “Retrofitted”
The proposed regulations would provide possibilities to “adjust” the placed-in-service date for certain existing facilities. An existing facility originally placed in service before Jan. 1, 2023, but modified to enable the production of qualified clean hydrogen (among other stipulated requirements), will be deemed to have a placed-in-service date on the date the property required to complete the modification is placed in service.
Explicitly excluded from the meaning of facility modification, however, is the mere changing of fuel inputs to the hydrogen production process, such as switching from conventional natural gas to RNG.
Similarly, retrofits to existing property may also establish an adjusted placed-in-service date as of the date on which the new property added to the facility is placed in service, provided that the fair market value of the used property is not more than 20 percent of the retrofitted facility’s total value (i.e., the established 80/20 test).
Section 48 Investment Tax Credit Election
The proposed regulations provide guidance on the election to take the Section 48 investment tax credit for hydrogen in lieu of the Section 45V production tax credit. For taxpayers that are partnerships, the proposed regulations require that the election be made at the partnership level. The Section 48 credit is subject to potential recapture for a five-year period. The recapture provisions are set forth in Prop. Treas. Reg. Section 1.48-15(f)(2), 88 Fed. Reg. 89245.
Stacking Section 45Q and Section 45V Tax Credits
The proposed regulations follow the statutory prohibition on the stacking of Section 45Q and Section 45V credits. This means for any Section 45Q credit taken by the taxpayer, no Section 45V credit is allowed regarding claims on the same facility, and vice versa.
With respect to carbon capture equipment that may be located on the hydrogen production facility, the proposed regulations would provide that a taxpayer could perceivably claim a Section 45V credit on such equipment so long as the equipment is (1) a retrofitted carbon capture equipment deemed to be an “independently functioning process train” satisfying the 80/20 rule under Treasury Regulation Section 1.45Q-2(g)(5), and (2) no new Section 45Q credit has been allowed or claimed for such carbon capture equipment.
Anti-Abuse Provision
The proposed regulations embody a view that the purpose of Section 45V is to provide taxpayers an incentive to produce qualified clean hydrogen for a productive use. The proposed regulations would prohibit the Section 45V credit if it is determined that the primary purpose of the production, sale or use of qualified clean hydrogen is to obtain the benefit of the credit in a manner that is “wasteful” or generally inconsistent with the purpose of Section 45V. The determination of whether a taxpayer is engaged in a wasteful manner of hydrogen production will depend on the particular facts and circumstances.
Effective Date and Commentary Period
The regulations are proposed to apply to taxable years beginning after Dec. 26, 2023. However, taxpayers may rely on these proposed rules in taxable years beginning after Dec. 31, 2022, so long as they consistently follow the proposed regulations in their entirety and in a consistent manner for all taxable years through the applicability date of the final regulations.
Comments must be received by Feb. 24. A public hearing is scheduled for March 25. We hope that the comment period will spur the IRS to provide additional clarity on the outstanding questions that remain.
Carl Fleming and John Zhang also contributed to this article.