Understanding Direct Pay and Transferability for Tax Credits in the Inflation Reduction Act

President Joe Biden’s landmark climate legislation, the Inflation Reduction Act, makes historic investments in moving the nation toward a clean energy economy. Biden’s climate plan expanded clean energy tax credits to incentivize renewable energy deployment that will also support new, high-quality jobs;¹ strengthen domestic supply chains and manufacturing capabilities; and invest in low-income and energy communities. Importantly, to make these clean energy tax credits more accessible, the Inflation Reduction Act created new opportunities for tax credit monetization. These monetization options will have a profound impact on clean energy finance by expanding the ease, accessibility, and availability of capital.² The Inflation Reduction Act introduced two major monetization methods for commercial and utility-scale energy projects:

1. Transferability: This process allows for-profit project owners to monetize certain tax credits by transferring them to other taxpayers. Essentially, this enables renewable project owners and developers to sell tax credits for cash and simplifies financing for clean energy projects.³
2. Direct pay: This process allows entities exempt from income tax—such as nonprofits, state/local/Tribal governments, publicly owned utilities, and rural electric cooperatives—to claim the equivalent amount of tax credit in the form of a direct payment from the IRS.⁴ This enables tax-exempt entities to take advantage of clean energy tax credits for the first time.

Clean electricity tax credits were originally intended to go directly to the developer of the energy project; the solar, wind, or other developer would claim the tax credit as a subsidy to their project costs. However, private clean energy developers often do not have the income tax liability—the amount owed in income taxes to the federal government—to benefit from the tax credits and subsidize the cost of managing the energy project. Simply put, smaller developers typically don’t owe enough in federal income taxes for the tax credit to be beneficial.

Developers also often cannot benefit from depreciation. Clean energy developers can take a depreciation deduction, which is a tax benefit that aims to reflect the fact that their assets lose value over time. The deduction lowers the developer’s income that is subject to tax. However, if a developer does not have sufficient income, deductions provide less or no benefit.

Clean energy developers that are unable to benefit from tax credits and depreciation have traditionally formed partnerships with tax equity investors, which are most commonly banks such as JPMorgan or Bank of America, to monetize, or access, the value of the tax credits and depreciation. This is one type of tax equity financing.

Tax equity financing describes transactions in which the developer allocates the tax credits to another party in exchange for an equity investment. For example, the developer assigns the rights to claim the tax credit to an investor. In exchange for the tax credit, the investor makes an equity investment—meaning that they provide upfront cash to the developer to help finance the project, receiving in return an ownership stake in the project and the future use of the tax credits.

What are the complications of a traditional tax equity financing structure?

• It’s complicated and costly to maneuver these tax partnerships, which slows down the rate of renewable uptake. Establishing these partnerships and complying with tax law requires significant legal, accounting, and consulting services. The costs of these services are often up to 15 percent of the value of the original tax credit.⁵ These complications and fees pose significant barriers to building clean energy projects for both smaller developers and investors, who may not want to face the steep learning curve of tax equity financing.
• Developers do not own the assets outright at the start. The investor owns some share of the assets and can influence certain major decisions. Developers often have to buy out the investor later, which introduces additional difficulty and expense.
• It’s not conducive to financing small, individual projects. Because of the complexity of these transactions and the investors’ tax appetite—the amount of taxable income that an investor wants to offset—investors typically seek large utility-scale projects. Developers of smaller projects often have to wait until they accumulate a critical mass of solar projects that will be attractive for investment before they can access tax equity financing and benefit from tax credits. Due to high fixed costs of tax equity transactions, many small projects either require high returns to the investor, can be very costly, or are unable to access tax equity at all.
• Investor demand for tax equity is uncertain and sensitive to market volatility. Typically, investors do not fully commit to a project until they are confident they will have sufficient tax capacity to claim the credits. These things can obviously change over the course of a year, particularly when there is an economic downturn: 46 percent of investors reported a “decrease or significant decrease” in the availability of tax equity in 2020.⁶

The Inflation Reduction Act creates a new opportunity to monetize credits via transferability, which allows commercial, for-profit companies—for example, a private solar or wind developer—to sell their tax credits for cash. The cash from the transfer is not included in the seller’s taxable income, and it is not deductible from the buyer’s taxable income, either.

According to the U.S. Department of Energy Solar Energy Technologies Office:

Transfer of credit: Eligible taxpayers who are not eligible for direct payment, may sell all, or a portion, of the tax credits for a given year to an unrelated eligible taxpayer. Payments for the credit must be made in cash and are not considered gross income, for federal purposes (i.e. no federal taxes are owed on receiving the payment and no deduction is available to the tax credit buyer for making the payment). A penalty of 20% may apply where excess credits are claimed.⁷

What does transferability mean for the renewable energy landscape?

Tax credit transferability is a significant development that will likely shake up the market and accelerate renewable construction and deployment. Developers will be able to sell their tax credits outright in exchange for cash. They no longer have to enter complicated legal partnerships with investors and assign over the rights to claim a tax credit in order to finance their projects. This change has many potential benefits:

• Eliminates the additional, necessary expenses of forming the tax partnership: These may include fees from legal, accounting, and consulting services.
• Opens the option for direct ownership: Developers can now own their projects fully for the life of the project and don’t have to 1) split ownership with investors or 2) undergo further complicated processes to buy them out and regain their shares later.
• Broadens the pool of potential investors: Because the transactions will be simpler, the supply of investors interested in financing renewable projects is expected to dramatically increase—particularly the many investors of different sizes who previously would not want to face the learning curve of tax equity financing. Now, they can be brought into the market.
• Increases competition: A larger pool of investors will likely increase the demand and competition for the tax credits, allowing developers to retain more of the value of the credits they generate. In traditional equity financing, a hypothetical developer could sell $1 of a tax credit and receive $0.85 back in cash. With increased competition, developers can raise more cash per dollar of tax credit.
• Broadens the pool of projects: Transferability may increase access to financing for smaller projects, which have historically been unattractive to large investors who were often unwilling to undertake the arduous work of forming a tax partnership for a small amount of tax credit. Further, smaller developers may not have previously had the relationships or resources to form these partnerships in the first place.

In short, the simplicity of monetizing tax credits through transferability may make renewable energy projects easier and more attractive for investors to help finance.

Compared with private developers who were able to form partnerships to claim tax credits in exchange for cash investments, entities such as nonprofit and governmental organizations that are exempt from income tax were largely ineligible to receive clean energy credits since they have no tax liability.⁸ This has significant implications for publicly owned utilities and electric cooperatives, which are energy providers that function as nonprofits.

Publicly owned utilities and electric cooperatives serve roughly 28 percent of customers in the United States;⁹ however, they face a significant financial disadvantage compared with private, investor-owned utilities that can capture the tax credit benefits directly or via tax equity financing partnerships. Prior to the passage of the Inflation Reduction Act and direct pay provisions, public power utilities and electric co-ops had to form long-term, power purchase agreements (PPAs) for clean electricity with private entities that could claim the credits. PPAs are contracts that allow nonprofit and public entities to enter into a formal agreement/contract with private companies that could claim the tax credits. The project would be owned by the third party, and not the nonprofits themselves. These third-party ownership programs are complex and require additional expenditures and capacity to leverage. Further, only a margin of the financial benefits is passed through to the nonprofit, lessening the incentive.

The Inflation Reduction Act removed the eligibility restrictions on governmental and tax-exempt entities for clean energy credits by introducing direct pay, which allows these entities to directly benefit from the tax credits.¹⁰ Essentially, the IRS will treat these tax credits as an overpayment of taxes, and it will refund the overpayment to the entity regardless of whether the entity is subject to tax.

According to the U.S. Department of Energy Solar Energy Technologies Office:

Direct pay option: Tax-exempt organizations (i.e. non-profits), states, municipalities, the Tennessee Valley Authority, Indian Tribal governments, any Alaskan Native Corporation, and any rural electric cooperative can receive a refund from the IRS for tax credits on projects placed in service after 2022.¹¹

Direct pay finally allows governmental and tax-exempt entities to leverage the climate, health, and economic benefits associated with renewable energy deployment.¹² Local governments, public utilities, rural electric cooperatives, and other nonprofit institutions such as hospitals and universities can now take direct advantage of clean electricity tax credits.¹³

The U.S. Department of the Treasury and IRS are expected to release guidance on direct pay and transferability shortly. Here are a few important issues that the Treasury and IRS must discuss and provide clarity on in their upcoming guidance:

• It’s unclear whether territory governments are eligible for direct pay. The statute does not explicitly extend direct pay to Puerto Rico and other U.S. territories. However, it provides sufficient flexibility for the Treasury to provide clear eligibility guidance for territories to fully benefit from the Inflation Reduction Act. The Treasury must issue guidance specifying that territories such as Puerto Rico, its subdivisions, and Puerto Rican nonprofit entities, fall within the definition of an “organization exempt from [federal income] tax.”¹⁴
• More clarity is needed around domestic content requirements reducing or eliminating the direct pay credit amount. If the project does not meet domestic content requirements, an otherwise eligible project will only receive 90 percent of the direct payment if construction begins in 2024, 85 percent of the direct payment if construction begins in 2025, and no direct payment at all if construction begins in 2026 or later. The statute directs the secretary of the treasury to provide exceptions to this rule if the domestic content requirements increase the costs of construction by more than 25 percent or if the required materials are not produced in the United States in sufficient quantity or quality. The Treasury must provide outreach and technical assistance to entities electing direct pay, including to ensure they are aware of and understand how to comply with domestic content requirements.
• Transferability shifts audit risks in ways that are complicated for both taxpayers and the IRS. If the developer sells an invalid tax credit to a buyer, the buyer of the transferred credit is the one who ultimately bears the consequence and has to pay it back. The Treasury could consider ways to shift the audit risk back to the credit seller since the seller is the stakeholder responsible for complying with the law.
• Depreciation tax benefits are not transferable. Since transferability does not extend to depreciation deductions, a developer may still want to use a traditional tax equity financing structure over using transferable tax credits to get the value of both the credits and the depreciation deductions.
• There is a potentially long lag time between when tax-exempt entities make clean energy capital investments and when they receive the direct pay credit. A tax-exempt entity could have built and placed a clean energy project into service in January 2023 and might not receive the associated credit until May 2024 because of the lag time between electing the credit and when IRS provides the tax refund. Because of this, entities that cannot afford to make capital investments for a project more than one year before receiving the credit may need to seek bridge financing.

The inclusion of new direct pay and transferability mechanisms in the Inflation Reduction Act widely expands the reach of clean energy tax credits to allow eligibility for smaller businesses, nonprofits, local governments, rural electric cooperatives, and many other entities that have typically been at a disadvantage or excluded from receiving financial incentives for making investments in the clean energy economy. The Treasury and IRS must work to get this right to increase the accessibility of clean energy capital and fully realize the potential of these transformative provisions.

The author would like to thank Jarvis Holliday, Shanée Simhoni, and the NYU Tax Law Center’s Climate Tax Project team for their contributions.