Internal Revenue Service Provides Additional Clarification on Section 45X Credit Rules

The Internal Revenue Service (IRS) recently issued proposed regulations under Internal Revenue Code (IRC) Section 45X Advanced Manufacturing Production Credit, expanding definitions and providing additional safeguards against fraud. The notice of proposed rulemaking includes four regulations detailed below. Section 45X was newly added to the Code August 16, 2022, by the Inflation Reduction Act (IRA) of 2022; therefore, manufacturers have been waiting for more than a year to get clarity. “We are not surprised that this guidance took over a year, given that the IRA effected so many code sections,” states Ian Boccaccio, Principal and Practice Leader for Income Tax at Ryan.

Background

The IRA created a collection of related tax credits and incentives promoting domestic clean and renewable energy production. The Advanced Manufacturing Production Credit under Section 45X supports the domestic production of equipment and components (solar, wind, batteries, and inverters) and critical minerals. The purpose of this credit is to incentivize the manufacturing of equipment required by those seeking to take advantage of many other credits included in the IRA. Consequently, the Section 45X credit is the cornerstone for the achievement of numerous goals of that legislation.

Section 45X(a) provides that, for purposes of the general business credit under IRC Section 38, the Advanced Manufacturing Production Credit for any taxable year is an amount equal to the sum of the credit amounts determined under Section 45X(b), with respect to each eligible component. Any eligible component produced and sold by the taxpayer is considered only if the production and sale occur in a trade or business of the taxpayer to an unrelated person. However, a taxpayer can make an election to treat a sale of components by the taxpayer to a related person as if it were made to an unrelated party.

Section 45X(b) details the credit amounts for each type of eligible component, whereas Section 45X(c) defines the term “eligible component” to mean any solar energy component, any wind energy component, any inverter as defined, any qualifying battery component, and any applicable critical mineral.

Section 45X(d) provides, in part, that sales of eligible components are considered under Section 45X only for eligible components that are produced within the United States or a U.S. territory. The section also provides that for purposes of the Section 45X credit, a person is treated as having sold an eligible component to an unrelated person if such component is integrated, incorporated, or assembled into another eligible component that is sold to an unrelated person.

Initial Industry Feedback

Scott Stogsdill, Director of Energy Incentives at Ryan, notes that “feedback thus far from industry experts has been mixed. One positive aspect is that these regulations are helpful in clarifying for custom components whether the buyer or manufacturer seller would receive the tax incentive.” The regulations lay out that the contract for purchase must be in advance of the actual manufacture and that it must be a material change to the design as compared to previously created parts by the manufacturer for the buyer to take the tax incentive. More importantly, the special rule for “contract manufacturing agreements” is extremely helpful in this context. The two parties can negotiate who gets the tax incentive, and the IRS will not challenge it. This is a move in the right direction that will make IRS examination easier. Compare this to current litigation in other tax incentives, such as Section 41 Research Credit or Section 179D Commercial Energy Deduction, where the intent of the taxpayer parties is clear, but the IRS ignores it. “This is a big win that needs to be adopted for other tax incentives,” says Mr. Stogsdill.

Mr. Boccaccio observes that “the biggest negative was regarding the definition of ‘eligible component’ because the proposed regulations lack examples of what qualifies instead of just examples of what would not qualify—common industry feedback on guidance such as this.” A specific example can be found in 1.45X-1(f)(1) related to the definition of “integrated, incorporated, or assembled.” The definition is that the final product be “substantially transformed into a complete and distinct eligible component functionally different from that which would result from mere assembly or superficial modification of the eligible components…” Examples A, C, D, E, and F are all in the negative (examples of minor assembly or superficial modification), without a clear example of what would qualify. (This is a common blind spot in IRS guidance.) The one positive example (Example B) contemplated 100% production of all three subcomponents in-house by a single manufacturer. There is a total lack of a positive example, which would qualify, where one or more subcomponents are sourced from another company. “Therefore, a better example section would be helpful to distinguish the exclusion of ‘mere assembly or superficial modification’ versus what the author intended.”

The intent was to bolster U.S. manufacturing in the renewables marketplace. While Regulation 1.45X-1(d)(1) states that the tax credit is only valid for eligible components produced within the United States, the regulations lack any domestic production rule for the subcomponents itself. Therefore, related to the conversation on mixed-sourced subcomponents, many industry leaders feel that overseas competitors (like the Chinese) can take advantage of the tax credit by selling subcomponents to U.S. manufacturers. Mr. Stogsdill believes that “adoption of the ‘Domestic Content’ rules similar to IRS Notice 2023-38 issued earlier this year for Sections 45, 45Y, 48, and 48E should have been stronger in regards in legislative intent.” From a public policy perspective, a Domestic Content rule would open the way for small U.S.-based manufacturers to fulfill the subcomponent supply chain. “Overall, 45X in combination with Sections 45 and 48 should be a huge boost to the manufacturing market and the U.S. economy by lowering the cost of purchasing the equipment by the ultimate consumer—a good step in the right direction, but it could do more.”

Overview of Proposed Regulations

Proposed regulation Section 1.45X-1 provides an overview of the general rules regarding the advanced manufacturing production credit and explains how to calculate the amount of the credit provided under Section 45X for any taxable year. The proposed regulation defines the term “produced by the taxpayer” for both primary and secondary production. It states that neither minor assembly of constituent inputs nor superficial modification of a final eligible component is included in the definition of “produced by the taxpayer,” with examples provided. 

Proposed regulation Section 1.45X-1 also defines the term “contract manufacturing arrangement” to mean any agreement providing for the production of an eligible component if the agreement is entered into before the production of the eligible component. Proposed regulation Section 1.45X-1 also explains the special rule allowing parties to a contract manufacturing arrangement to agree on which party will claim the Section 45X credit.

This proposed rule would further define the term “integrated, incorporated, or assembled” to mean the production activities by which eligible components are substantially transformed into another complete and distinct eligible components.

Proposed regulation Section 1.45X-1 provides a general anti-abuse rule that would make the Section 45X credit unavailable in extraordinary circumstances in which, the primary purpose of the production and sale of an eligible component is to obtain the benefit of the Section 45X credit in a manner that is wasteful, such as discarding, disposing of, or destroying the eligible component without putting it to a productive use. An example illustrating this anti-abuse rule will be provided.

Proposed regulation Section 1.45X-2 states the general rule that the amount of the Section 45X credit for any taxable year is equal to the sum of the credit amounts determined under Section 45X(b) with respect to each eligible component that is produced by the taxpayer and sold to an unrelated person. Section 45X(d)(1) provides that persons are treated as related to each other if they would be treated as a single employer under the regulations prescribed under IRC Section 52(b). The proposed regulation would provide an example to illustrate the treatment of sales of multiple integrated eligible components to related and unrelated persons with a Related Person Election.

Proposed regulation Section 1.45X-3 provides definitions for determining the credit amount and documentation requirements for solar energy components, wind energy components, inverters, and qualifying battery components as well as rules for applying the phase out of the Section 45X credit. The term “eligible component” is defined as any solar energy component, any wind energy component, any inverter, any qualifying battery component, and any applicable critical mineral. This proposed regulation would clarify the definition of each type of solar energy component and define the term “solar energy component.”

Proposed regulation section 1.45X-3 defines “battery-grade materials” to mean the processed materials found in a final battery cell or an analogous unit or the direct battery-grade precursors to those processed materials. It also states that a taxpayer may claim only one Section 45X credit, with respect to a material that qualifies as both an electrode active material and an applicable critical mineral. This proposed regulation explains that the costs incurred for purposes of determining the credit amount include costs, as defined in regulation Section 1.263A-1(e), that are paid or incurred within the meaning of IRC Section 461.

Proposed regulation Section 1.45X-3 would provide the rules for the phase-out of the Section 45X credit. The proposed regulation provides the phase-out percentages. The phase-out percentage would be equal to 75% for eligible components sold during calendar year 2030; 50% for eligible components sold during calendar year 2031; 25% for eligible components sold during calendar year 2032, and 0% for eligible components sold after calendar year 2032. The phase-out percentages would be applied based on the year the eligible component is sold rather than the year in which the eligible component is produced by the taxpayer. These phase-out rules described do not apply to applicable critical minerals as defined below.

Proposed regulation Section 1.45X-4 provides definitions of applicable critical minerals contained in Section 45X(c)(6), in particular, that the term “graphite” means graphite (both natural and synthetic) that is purified to a minimum purity of 99.9% graphitic carbon by mass. Consistent with the general intent of IRS Section 45X, the proposed regulation would clarify that the term “99.9 percent graphitic carbon by mass” means graphite that is 99.9% carbon by mass. This interpretation reflects that various forms of matter are 99.9% carbon, such as carbon black, so the word “graphitic” is providing additional clarification regarding the application of the carbon. This interpretation provides an incentive for the domestic production of the type of graphite that is used in the renewable energy and energy storage industry, including both synthetic and natural graphite for use in electric vehicle batteries.

Proposed regulation Section 1.45X-4 also defines “commodity-grade aluminum” as aluminum that has been produced directly from aluminum that is sold on international commodity exchanges, such as commercial grade aluminum that is 99.7% aluminum by mass. The proposed regulation provides that for an applicable critical mineral, the credit amount is equal to 10% of the costs incurred by the taxpayer, with respect to production of such materials. It would also require the taxpayer to document that their product meets the criteria for an applicable critical mineral with a certificate of analysis provided by the taxpayer to the person to which the taxpayer sold the applicable critical mineral.

Effective Date

Each of the proposed regulation sections 1.45X-1 through 1.45X-4 is to apply to eligible components for which production is completed and sales occur after December 31, 2022, and during taxable years ending on or after the date of publication of the final regulations in the Federal Register. The phase-out of the tax incentive begins in 2030 (at 75%), 2031 (at 50%), 2032 (at 25%), and a full sunset of this provision for products sold in 2033.

Next Steps

A public hearing, with respect to this notice of proposed rulemaking, has been scheduled for February 22, 2024, at which time public comments on the proposals will be addressed.

Please contact our Ryan tax professionals for information on how these changes impact your business.

TECHNICAL INFORMATION CONTACTS:

Ian Boccaccio
Principal
Ryan
469.399.4545
ian.boccaccio@ryan.com

Scott Stogsdill
Director
Ryan
469.399.4496
scott.stogsdill@ryan.com

RYAN AUTHORS:

Mark L. Nachbar
Principal
Ryan
630.515.0477
mark.nachbar@ryan.com

Mary Bernard
Director
Ryan
401.272.3363
mary.bernard@ryan.com

The material presented in this communication is intended to provide general information only and should solely be seen as broad guidance and not directed to the particular facts or circumstances of any individual who may read this publication. No liability is accepted for acts or omissions taken in reliance upon the content of this piece. Before taking (or not taking) any action, readers should seek professional advice specific to their situation from Ryan, LLC or other tax professionals. For additional information about this topic, please contact us at info@ryan.com.