On May 28, 2020, the IRS proposed long-awaited regulations that address key areas of uncertainty in existing guidance for Internal Revenue Code Section 45Q (45Q) carbon capture and sequestration tax credits. Although some questions remain unanswered, the regulations are a significant step towards reducing regulatory uncertainty and fostering a functional market for 45Q credits. This article will focus on the regulations’ key takeaways for transaction structuring, while also highlighting technical clarifications of significant import for this nascent industry.


One of the most significant questions facing potential participants in the 45Q market was whether and how the IRS would address recapture, i.e., treatment of 45Q credits that are claimed with respect to sequestered carbon oxide, where that sequestered carbon oxide is subsequently released into the atmosphere. The potential for carbon oxide sequestered underground to “leak” over time makes recapture rules extremely important for the economic modeling and viability of 45Q projects. To this end, the new regulations set forth a “recapture period” during which leaks can lead to recapture, the method for applying recapture for tax purposes, and the technical monitoring regimes which may be used to quantify carbon oxide leaks. These new regulations have the potential to significantly improve transactional certainty by creating boundaries around how recapture will be treated, although certain ambiguities do remain.

  1. Recapture Period

Under the new regulations, the recapture period starts on the date of the first injection of qualified carbon oxide for disposal in secure geological storage or use as a tertiary injectant, and ends on the earlier of (1) five years after the last taxable year in which the taxpayer claimed section 45Q credits and (2) the date monitoring ends under the applicable monitoring regime. Although the recapture period itself lasts for seventeen years, the risk of recapture is mitigated by limiting the “look-back” period for recapture to the five years prior to the year in which the recapture event occurs. These mechanics are described further below.

  1. Tax Treatment of Recapture Events

During the recapture period, if more carbon oxide is sequestered at a project than leaked (and attributable to such project) in the present taxable year, no recapture event occurs. In that situation, if there is leakage, the value of any credits generated that year are offset by the amount of any carbon oxide that is leaked that year. However, if more carbon oxide is leaked (and attributable to such project) in the present taxable year, a recapture event occurs. In that event, there could be uncertainty as to how to attribute the leaked carbon oxide to the prior taxable years in which it was sequestered. Since the value of the credit changes each year, the year to which the recapture is allocated is important for calculating the amount of the recapture.

The new regulations establish a “last-in, first-out” principle for calculating the value of such recapture: any net leak of carbon oxide in the present taxable year will offset the previous taxable year’s credits at such year’s credit rate; if there is still a net leak, then the next prior year’s credits are offset at such year’s credit rate. This “lookback period” is capped at 5 years, meaning that if there are insufficient credits from the prior five years to offset the value of the leaked carbon oxide, any remaining shortfall is not recaptured. In each case, the recapture amount is reported on the tax return for the taxpayer in the taxable year in which the recapture event occurs, and taxpayers who apportion the credits among themselves bear the recapture burden proportionately.

  1. Recapture Apportionment among Third Parties

Although the proposed regulations establish that recapture is applied proportionately to unaffiliated project owners who claim credits with respect to the same carbon oxide capture facility, the regulations do not address the fact pattern where multiple unaffiliated projects sequester, or contract with separate third parties to sequester, carbon oxide in the same medium (e.g. multiple facilities pumping liquified carbon oxide to and storing it in the same retired gas well). Whether and to what extent a leak from a sequestration medium can be attributed to a particular taxpayer is an important technical and administrative question that will likely bear on this issue. We would like to see the final regulations directly address this topic as this uncertainty could restrict parties’ willingness to engage in transactions where the carbon oxide captured by one facility is sequestered along with that of other facilities.

  1. Monitoring and Reporting

A cornerstone of the relative simplicity, limited scope and predictability of the recapture rules is the ability of market participants and the IRS to ensure that the storage and utilization of carbon oxide can be ensured and monitored over time. The proposed regulations address the methodology for defining the life cycle of the sequestration medium and quantifying leakage. Previously, 45Q projects disposing of captured carbon oxide or using it as a tertiary injectant for enhanced oil recovery needed to follow the operating and reporting standards (including with respect to leakage calculations) set forth in 40 CFR Part 98 Subpart RR – Geologic Sequestration of Carbon Dioxide (“Subpart RR”). The new regulations clarify that, in the case of projects using captured carbon oxide as a tertiary injectant for enhanced oil recovery project participants may instead elect to follow the standards set forth in CSA/ANSI ISO 2916.19. However, the proposed regulations expressly do not allow the use of state-promulgated standards and they require that, if project participants elect to follow CSA/ANSI ISO 2916.19, they must also provide third party verification of leakage measurements.  They also require, in the case of captured carbon oxide that is not stored and is utilized in some manner other than as a tertiary injectant, third party verification of the lifecycle analysis of the net greenhouse gas emissions of such utilization methodology. The sufficiency of these methodologies for accurate leakage measurement (and, indeed, operation and reporting of 45Q sequestration sites) and lifecycle analysis is a technical matter that market participants should carefully consider.

  1. Recapture Bottom Line

The proposed recapture rules have the potential to be particularly beneficial to market participants because they create a relatively simple approach to apportioning recapture over the project’s life and among persons claiming credits in connection with the project, create a relatively limited recapture period and similarly limited look back period within that recapture period, and prevent the additional time and expense of amending prior years’ returns by assessing recapture liability in the year in which it occurs.

Contracts and Sharing 45Q Credits with Contract Counterparties

45Q credits may be claimed by taxpayers who physically own equipment and who physically or contractually ensure that the carbon oxide will be sequestered. The proposed regulations not only clarify the kinds of contractual arrangements that need to exist for a taxpayer to ensure that one or more counterparties will sequester the captured carbon oxide in a manner sufficient to qualify under Section 45Q, but also provide guidelines as to how the taxpayer can permit such counterparties to themselves utilize 45Q credits, rather than the taxpayer. Notably, the mere presence of one or more contracts with respect to the sequestration of captured carbon oxide is not sufficient for the taxpayer to have qualified for 45Q credits, and also does not effectuate a transfer of credits by itself. Instead of promulgating form contracts or contractual provisions, the proposed regulations include a handful of broadly-stated requirements. In short, the contracts must be binding under state law, be commercially reasonable and include enforcement mechanisms, though no particular mechanisms are required.  And, to the extent that the parties to the contract wish to permit a party other than the taxpayer to utilize some portion of the 45Q credits, the taxpayer must file appropriate elections in connection with its tax return filings. . The use of these broader standards does result in some uncertainty regarding what the IRS will or will not deem sufficient. But, the IRS’s commentary on the proposed regulations suggests that their intent is to promote contractual flexibility. We expect that the approach taken by the proposed regulations will overall be a benefit to market participants by allowing for innovation and flexibility in transaction structure and risk sharing.

Placed-in-Service Timing, Qualifying Equipment and the 80/20 Rule

Section 45Q establishes a generally more favorable credit regime for facilities placed in service on or after February 9, 2018 than those before. Before the new regulations were proposed, it was unclear to what extent new equipment installed at a facility placed in service prior to February 9, 2018 could qualify for the new regime. The proposed regulations clarify that the new equipment can qualify for the new regime to the extent that it results in an expanded capture capacity of the facility. The proposed regulations also include, for a facility that was previously placed in service but adds new capacity, a methodology for apportioning the captured carbon oxide between the two credit regimes.

In addition, the proposed regulations include application to 45Q facilities of the “80/20 Rule” familiar to wind production tax credit market participants. All credits generated by carbon capture equipment placed in service prior to February 9, 2018, but subsequently retrofitted can qualify for the new regime if, among other things, no more than 20% of the fair market value of the carbon capture equipment in the retrofitted facility is previously-used equipment.

Further, the proposed regulations include examples of what components are included in, and excluded from, the definition of carbon capture equipment. In general, the equipment includes capture-related equipment and excludes equipment for transporting captured carbon to its place of sequestration. There is an exception for dedicated pipeline built for a particular capture facility. Market participants should consider the definition from a technical perspective to assess the suitability and comprehensiveness of the list.

Other Topics

The proposed regulations address a few other topics, including a definition of “industrial facility” and the methodology to determine how much carbon oxide is “utilized” for purposes of determining certain Section 45Q credits. The regulations also establish rules addressing tax return preparation and other related matters. While these topics will also impact market participants as they plan potential transactions, they are not the focus of this article.

Final Observations

 Although the proposed regulations do directly address several key topics with respect to which potential market participants have had significant uncertainty, the nascent carbon capture and sequestration market will require continuing technical, regulatory and commercial cooperation and innovation to address remaining economic and technical challenges (we briefly discuss a few of these in an earlier blog post).  The proposed regulations are subject to a sixty day comment period beginning on the date then they are published in the Federal Register.  The IRS has expressly solicited input on a couple of topics that have and have not been addressed by the proposed regulations, but market participants may comment on any portion of the proposed regulations.