The Inflation Reduction Act’s investments are bearing fruit by creating good-paying jobs, strengthening our energy security, tackling climate change, and improving services the IRS provides to taxpayers.

The IRA development in terms of tax credits, included:

  1. Extension of the production tax credit (PTC) and the investment tax credit (ITC) for electricity generated from wind, solar and certain other renewable resources.
  2. Expansion of the resources eligible for the PTC and ITC, including by allowing the ITC for energy storage technologies such as batteries.
  3. Extension and expansion of the tax credits for carbon capture, utilization and sequestration.
  4. Introduction of new technology-neutral PTCs and ITCs for electricity generated with zero emissions to replace the current parameters of the PTC and ITC when they expire.
  5. Adding new tax credits to produce hydrogen and certain energy equipment manufacturing, and
  6. Adding new tax credits for electricity generation at qualifying nuclear facilities that were in operation prior to the enactment of the IRA.

In addition to the goal of decarbonization, the IRA aims to achieve other policy goals by changing the structure of the PTC and ITC to allow the full credit amount only if certain prevailing wage and apprenticeship (PWA) requirements are met and by adding bonus credits for projects located in energy communities, located in certain low-income communities or constructed with a certain amount of domestic content. The IRA also introduced the opportunity to transfer certain federal income tax credits to third parties (referred to herein as transferability), which creates a new avenue to monetize those tax credits as an alternative (or enhancement) to traditional tax equity structures.

The risks associated with tax credit transactions can be described through the following table:

Element Of Risk Risk Description
Project risk If projects take longer to be placed in service due to issues such as labor shortage or supply chain delays, projects could either not be built or be delayed – pudhin credit generation into future tax years.
Recapture If a project is taken out of service in the 5-year recapture period (destroyed and not rebuilt), the credit can be “Recaptured” by the government, stepping down 20% per year. Treasury guidance limited a previous, more expansive recapture policy, which had also applied to partnership interests being sold.
Eligible basis + disallowance If credits are improperly field or if the value of the investment tax credit is found to be overstated in the case of an audit, a portion of credits may be clawed back with associated penalties.
Seller Creditworthiness Need to make sure that any indemnification provided by credit sellers has a sufficient backing

Tax credit compliance is fraught with risk and complex to manage. Tax credit investors and transfer buyers, including those utilizing the new T-Flip structures and corporate buyers leveraging tax transfer marketplaces, are all subject to IRA audit risk and the associated tax credit losses and/or expensive non-compliance penalties.

Who holds the risk?

In terms of risk management, tax credit transactions tend to focus on protecting the investor from recapture audit risk, but compliance risks affect the entire clean energy project value chain.

Risks across the value chain:

  • Insurers - Tax credit insurers ultimately hold claim risk, but do not have oversight over EPCs, sub-contractors, or supplier compliance.
  • Investors - Investors do not have insight into whether their investments are compliant with IRA requirements.
  • Developers - Project developers need to protect investors but don’t have a way of understanding or reporting whether engineering, procurement, and contractors (EPCs), sub-contractors, or suppliers are compliant.
  • EPC - EPCs can’t guarantee prevailing wage and apprenticeship (PWA) compliance for projects.
  • Sub – Contractors - Sub-contractors do not have the capabilities to comply with PWA requirements- they rely on contractors for this.
  • Suppliers - Suppliers are hesitant to share the confidential cost data required for IRA domestic content compliance.

Risk Mitigation

What can developers do to mitigate risks? They can provide sponsor indemnifications, require EPC contracts to guarantee PWA compliance, hire an accounting firm to do an AUP (Agreed Upon Procedures) review, and even offer to pay for insurance, but none of these methods fully protect investors. In other words, even with all these efforts, a tax credit buyer could still fail an IRS recapture audit, which would trigger a cascading set of insurance claims and lawsuits through the entire project value chain.

Risk assessment.

Pre-IRA, traditional energy project risk mitigation typically began with a series of questions about a developer’s track record and the project technology size and scope. The questions then focused on an EPC’s history, supplier bankability, and supplier technology risk.

IRA tax credits have created a new, additional layer of risk. Tax credits can be worth 30%, 40%, or even 50% of the value of a project, but need to be protected from IRS recapture audit risk with meticulous proof of compliance throughout a project’s lifecycle.

These are the four key factors to describe the risk from the tax credit investor/transfer buyer:

  1. Unchartered territory: In a typical investment risk assessment, investors have resources like credit rating agencies, historical track records, and market expertise to evaluate internal and external risks. Since guidance on IRA tax credit’ compliance is new and still evolving, investors don’t have the same level of expertise or policies in place to mitigate these new risks.
  2. The role of insurance: Because tax equity investors and corporate tax credit transfer buyers assume responsibility post transaction for IRA compliance, it’s common to assume they can use tax credit insurance to cover the risks of IRS audit failure and the resulting loss of tax credits plus any penalties.

However, the market capacity of tax credit insurance is limited, tax credit insurance can be expensive, and insurance companies still expect stakeholders to have some sort of active compliance management in place to reduce risk. In short, insurance companies are not the first line of defense in IRS recapture audit failure.

  1. The limitations of accounting practices: Traditional accounting firms typically have limited risk management capabilities for IRA compliance. Because formal audits are prohibitively expensive, they offer AUP reviews, spot checks, and monthly reviews. Still, since they don’t work directly with project EPCs or subcontractors, they can’t sign off on actual compliance for the project PWA requirements.
  2. Post-build compliance- Federal PWA requirements extend beyond initial construction phase compliance. Any alterations or repairs throughout the audit recapture period need to meet PWA compliance. Without adequate PWA programs and systems in place to manage operations and maintenance (O&M) contractors, asset management teams can jeopardize tax credits for the entire project.