On August 16, 2022, President Biden signed the Inflation Reduction Act (IRA) into law, marking the most significant action Congress has taken on clean energy and climate change in U.S. history. 

A key component of the IRA is a little-known provision known as tax credit transferability. Why does that matter? Consider a recent deal at Bank of America. The deal utilized the tax-credit transferability to help fund a $1.5 billion wind energy transaction. Specifically, the bank purchased $580 million in wind energy tax credits from renewable-power developer Invenergy. The funds helped Invenergy purchase a portfolio of renewable-energy projects from utility American Electric Power. And the funding eventually allowed the buyers to raise more debt and close the $1.5 billion deal.

But what are tax credits?

Tax credits reduce a company’s overall tax liability, which is the amount of money owed in taxes to the government. While tax credits are not new, the IRA expanded two types of tax credits targeting clean energy development: the clean electricity production tax credit (PTC) and the clean electricity investment tax credit (ITC). 

PTC subsidizes the production of clean electricity by awarding credits to clean energy sources on a per-kilowatt-hour basis. The more clean energy produced, the larger the tax break, making it a compelling incentive for investment in renewable energy.

ITC, on the other hand, supports new investment in clean electricity installations by giving qualified companies tax breaks based on the project’s total cost. The base credit is 30% of the project’s cost, making the new energy generation all the more appealing to project developers — especially since it is paid upfront, not based on a project’s performance. 

What is the problem with the old tax credits?

Despite their benefits, a big problem was that many companies couldn’t fully utilize their tax credits. The old tax credit system was only useful for taxpayers with large enough tax liability.

Who got left behind by tax credits?

Energy startups, for instance, had to navigate complex financing arrangements with tax-heavy banks since they don’t generate large enough profits to claim the tax benefits. This often ended up benefiting banks more than the projects themselves as banks charged fees to organize those complex arrangements. 

Additionally, the old tax credit system failed to incentivize entities that don’t pay income taxes at all, such as non-profits and universities. This limited their desire to transition towards cleaner energy, making the effect of the tax-credit system minimal. 

How was Bank of America able to purchase tax credits from another entity?

Bank of America took advantage of the IRA’s new tax credit transferability. Thanks to the IRA, taxpayers can transfer, or sell, all or a portion of their tax credits to other taxpayers. Since many green projects/companies do not generate profits yet, they have low tax liability and thus unused tax credits.

The IRA allowed green companies to sell their unused tax credits to entities with higher tax liability, infusing cash into those companies. 

What is the process for tax-credit transfer?

Tax credits from the ITC and PTC are expected to sell at a discount, much like how some off-season clothes sell below their original price. Purchasers, therefore, buy the tax credits at a reduced cost, even though the IRS credits them for their full value. This yields a net benefit. Prices for tax credits are expected to exceed 90 cents on the dollar so a large company might only pay $90 million for $100 million of tax credits. This is low enough that buyers make a meaningful profit, and it provides much-needed capital to cash-strapped start-ups.  

In addition to transferability, what else is modified from the old tax credit system? 

Although the Bank of America deal did not make use of this, another option known as “direct pay” was introduced along with transferability. The direct pay option allows untaxed private and public entities to receive a direct payment equivalent to 12 applicable tax credits, including renewable electricity production credit, clean hydrogen production credit, energy credit, and clean electricity investment credit, among others. A school district could get a direct payment for installing solar panels across campuses, for example. 

This new access to tax credits will be especially important for public utilities, which generate 15% of all power in the U.S. and serve one in seven Americans. Given the large proportion of power public utilities produce, the decision they make between traditional or renewable energy is impactful to the environment. With the direct pay option available, there should be greater incentives for them to choose the cleaner option. 

But now one might question, if tax credits can be converted directly into cash, why do we still need the transferability option? This is because only tax-exempt organizations, such as non-profits or tribal organizations, are applicable entities. The green start-ups that are expected to generate profit in the long term, for example, are not eligible for direct pay. 

What are the remaining uncertainties?

There are still uncertainties around how the Internal Revenue Service (IRS) determines whether certain projects are eligible for tax credits. While the system enables tax credits to be transferred, there might be limitations on the extent to which companies can use these transferred credits to reduce their tax liabilities. After all, it would be unrealistic if one could just take advantage of the transferability forever. 

Furthermore, the long-term impact of the green tax credit system on the clean energy sector and the overall transition to sustainable practices is uncertain. It remains to be seen whether the system will attract more investment and accelerate green initiatives, especially since there is no rigid requirement, other than large tax liability, on the buyer of transfer tax credits. It can become controversial if the companies taking advantage of the transferability are fossil fuel companies. 

In summary, what are the incentives behind the new guidance? 

Policymakers hope the new system will expand access to tax incentives that encourage investment in clean energy technologies. And since purchasers of tax credits can be any company with large enough tax liability, not just the large banks, renewable projects can bring money from different sources. 

By transferring tax credits directly to banks and other taxpayers, clean-energy businesses can now raise money more easily. The businesses buying the tax credits can use them to lower their tax bills, while sellers can make progress on their clean-energy developments. Nonprofits and public entities, under direct pay, also have stronger incentives to purchase green facilities and to participate in the green transition.