A Closer Look At Forthcoming Tax Guidance On Electric Vehicle Credits

Instead of meeting the statutory deadline for proposed rules on the critical mineral and battery component requirements of section 30D, Treasury and the IRS released a white paper previewing their plans for the proposed guidance and indicating that they plan to issue that guidance by March.

Although the white paper is only an outline of the possible rules, it does provide some clarity as to the likely direction of the proposed guidance. It also gives industry participants an early opportunity to figure out what they’ll need to know about their supply chains to comply with the coming rules.

In general, the white paper provides helpful definitions and flexibility, said Daniel T. Kiely of Mayer Brown LLP. It sets forth new processes for determining the percentage of the value of the critical minerals in a battery that is needed to meet the critical mineral requirement and the same for the battery component requirement.

Ian Elder of Jobs to Move America said it is good to see that Treasury and the IRS are taking the sourcing requirement seriously. His organization would also like to see the proposed rules include disclosures about the types of jobs that companies are adding, the amount of wages paid, and whether employees are covered by collective bargaining agreements.

Miranda Nelson, also of Jobs to Move America, said that the indication in the white paper that Treasury and the IRS would detail how to track critical minerals and how the batteries are made is promising. She noted that the Buy America certification process at the Transportation Department similarly attempts to evaluate the value of each component in the supply chain and identify the location where it was manufactured.

Nelson said that the accountability and transparency requirements regarding jobs in the American Jobs Plan could also be applied in the section 30D context for companies whose vehicles are eligible for the credit.

Definitions

The geographical requirements all look quite different from what started out in the Build Back Better Act as made-in-America requirements. Those morphed into requirements for materials to be made in North America and extracted or processed by free trade agreement partners. They now appear to be headed in the direction of “friend-shoring,” a new term coined by Treasury Secretary Janet Yellen.

The friends here are mostly European countries, who were recently calling the United States protectionist over the Inflation Reduction Act (IRA, P.L. 117-169). European car companies began last year to more aggressively expand their electric vehicle businesses in the United States, having previously focused on EU markets, according to The Wall Street Journal.

Tesla is still the worldwide leader in sales of all-EVs, with Volkswagen’s group in third place. If the overall economy continues to weaken, the EV market is expected to soften along with it, which might explain the interest from the EU in getting the United States to loosen the requirements in section 30D.

In good news for French President Emmanuel Macron and other European Union leaders, the suggested definition of free trade agreement in the white paper indicates that the proposed rules will take an expansive view of the term.

The paper notes that the term is not defined in the IRA or any other statute. The Office of the U.S. Trade Representative has a list of what it considers to be the United States’ free trade agreements, all of which are included on the white paper’s list. None of the agreements are with countries in Europe.

The key question for EV makers is what other countries, if any, will be included in the proposed and final guidance. The white paper says that the guidance will include an option for the Treasury secretary to identify additional free trade agreements after the rules are finalized. While automakers might welcome that provision, it could also result in more countries lobbying Treasury than the IRA writers intended.

Determining Value

The white paper previews other definitions that Treasury and the IRS expect to include in the proposed guidance. For example, it signals that “value,” for purposes of calculating critical mineral and battery component requirements, will mean “arm’s-length value” regardless of how closely the parties to a transaction are related.

As the EV industry matures, the trend is toward vertical integration of everything past the materials stage, and related parties are likely to be involved in the production of critical minerals and the manufacture and assembly of batteries.

For example, a battery assembly company may expand into making modules and cells; some mining companies and mineral processors are already related. To address this, the white paper suggests that the proposed guidance will adopt a definition of value that incorporates the arm’s-length price.

That price will be determined either by the actual price that was paid in an arm’s-length transaction or a price that “would be paid for the property by an unrelated purchaser determined in accordance with the principles of section 482 of the Internal Revenue Code and regulations thereunder.”

The proposed rules may elaborate on how companies are expected to evaluate related-party transactions, but in other situations when Treasury and the IRS import section 482 principles into other rules, they don’t typically explain how to apply those principles or identify whether a taxpayer should focus on certain parts of the regulations under section 482.

The proposed guidance might need to explain what a company should do if the application of its selected pricing method does not produce a single result that is the most reliable measure of an arm’s-length result.

Regulations under section 482 also cover situations in which the application of a method results in a range of reliable results and allow taxpayers to avoid adjustment if their results fall within that range. When transposed into the section 30D(e) context, Treasury and the IRS might need to explain what to do when application of the method produces a range of reliable results rather than a single result.

For example, as SAFE and the Electrification Coalition pointed out in their comment letter on Notice 2022-46, 2022-43 IRB 306, “Companies may be able to determine the value of critical minerals in advance if they are the subject of long-term supply contracts that contain specific pricing terms.”

SAFE also asked Treasury and the IRS to require that the value determination for related-party transactions be based on a transfer price calculated consistent with the guidelines in section 45X(a)(3), “or otherwise consistent with IRS practice regarding the calculation of transfer prices.”

There aren’t yet any guidelines under section 45X(a)(3), which provides that the Treasury secretary may require information or registration as she “deems necessary for purposes of preventing duplication, fraud, or any improper or excessive amount,” from taxpayers who wish to elect that a sale of components to a related party be deemed to have been made to an unrelated person.

Congress didn’t expressly invoke the principles of section 482 in section 45X, so it remains to be seen how the proposed guidance will address this situation.

The Three-Step Transition Rule for Minerals

The white paper proposed a three-step transition rule for determining compliance with the critical mineral requirements for the rest of 2023 and 2024. The first step requires a manufacturer to determine the procurement chain or chains for each critical mineral. Those chains get evaluated separately in the subsequent steps.

The second step looks at where each critical mineral procured from the chain was extracted, processed, or recycled. The anticipated rules add flexibility in this step.

The white paper proposes that if 50% or more of the value added of either the extraction steps or the processing steps occurred in the United States or a free trade agreement partner, the critical mineral will be treated as qualifying. Recycling, a small but growing piece of the supply chain, also gets the value added approach.

A critical mineral from a supply chain involving recycling will be treated as qualifying if 50% or more of the value added to the mineral by recycling is derived from recycling that occurred in North America.

In the third step, manufacturers calculate the percentage of the value of qualifying critical minerals in the battery by adding the values of all qualifying critical minerals and dividing by the sum of the values of all critical minerals in the battery.

The percentage calculation may be averaged over a period of time, which the white paper explains could be a year, quarter, or month, for vehicles from the same model line, plant, class, or a combination of those, where final assembly occurs in North America. The date of the value of the critical minerals can be any date after the final processing or recycling step, but it must be the same for all critical minerals in the battery.

“The framework of identifying your chain and identifying what has been extracted, processed, or recycled in an eligible area and how that compares to the overall value makes sense,” Kiely said.

Including the 50% value added analysis and the averaging methods shows that Treasury and the IRS want to help taxpayers comply and document their compliance, he said. Kiely added that it will be interesting to see the approach in the rules that apply after 2024 and whether the 50% value added analysis or averaging approach changes.

The Four-Step Process for Batteries

Section 30D(e)(2) requires that the percentage of the value of the components contained in the battery powering the vehicle that were manufactured or assembled in North America be equal to or greater than the applicable percentage, which starts at 50% in 2024 and increases by 10% each year until reaching 100% in 2029.

The white paper says there will likely be a four-step process to determine the percentage of the value of battery components that goes toward meeting the battery component requirement.

Step 1 is to determine whether each battery component was manufactured or assembled in North America. For section 30D purposes, “manufacturing” will mean the industrial and chemical steps taken to produce a battery component.

“Assembly” will mean the process of combining battery components into cells and modules. The proposed rules on these definitions will likely add more detail, possibly through examples, about the specific steps and processes.

The white paper says the test for determining whether the manufacturing or assembly occurs in North America will be if “substantially all of the manufacturing or assembly activities for that battery component occur in North America.”

The manufacturing or assembly location of that battery component’s constituent components won’t affect the outcome of this test for the battery component as a whole.

What does “substantially all” mean here? The proposed rules will surely explain, but recall that Treasury and the IRS have wrestled with that term before, and the answer tends to fall somewhere in the vicinity of 80%.

In the Opportunity Zone rules of section 1400Z-2, the government offered a 90% definition of substantially all for the holding period of property and a 70% definition for the use of property in the zone. Section 41(d)(1)(C) says that activities are qualified research if substantially all of them constitute elements of a process of experimentation, and reg. section 1.41-4(a)(6) sets the minimum amount at 80%.

Many of the previous times that Treasury and the IRS had to figure out the meaning of “substantially all” were involuntary. Congress wrote the phrase into the qualified small business stock rules in section 1202, the section 41 research credit, and the Opportunity Zone rules.

Here, Treasury and the IRS are including it in the regulations when it’s not in the statute. There is at least one other situation in which the regulations include “substantially all” when the statute does not: Reg. section 1.367(a)-8(b)(1)(xii) explains that the determination of whether substantially all the assets of a transferred corporation have been disposed of is based on all the facts and circumstances.

The prior instance of substantially all in the section 41 research credit rules is a potential analogue to the rule suggested in the white paper. The former rule is designed to evaluate activities to determine how many are qualified research, whereas the proposed section 30D guidance will have to be designed to evaluate battery components to determine how many are qualified.

If Treasury and the IRS decide to model the new rule on the research credit rules, it’s possible that taxpayers will evaluate whether 80% or more of the manufacturing or assembly activities for the battery component occur in North America. Reg. section 1.41-4(a)(6) measures the 80% threshold on a cost “or other consistently applied reasonable basis.” That might be a model for the battery component rules.

Steps 2 and 3 require determining the incremental value for each battery component and then determining the total value of the battery components by adding the incremental values of each component from step 2.

In the fourth step, manufacturers calculate the percentage of the value of the components manufactured or assembled in North America by dividing the total incremental value, determined in step 2, of all components that were manufactured or assembled in North America by the total value of the components determined in step 3.

The battery components calculation, like the critical minerals approach, would permit a manufacturer to select any date that is on or after the final manufacturing or assembly step for the components, as long as it is uniformly applied to all the components.

That would likewise allow manufacturers to average the percentage calculations over a year, quarter, or month for vehicles from the same model line, plant, class, or a combination of those characteristics, if the final assembly was in North America.

Timing of Guidance

The white paper promised that the proposed guidance would explain the extent to which taxpayers can rely on it until final rules are issued. The length of time that Treasury and the IRS anticipate needing between the proposed and final regulations may dictate that determination.

Considering the heavy roster of clean-energy guidance projects underway and the possibly large number of comment letters on the proposed guidance, the release of final rules could take longer than ideal.

If the proposed guidance is released in late March with a 60-day comment period, it will be nearly June before the IRS and Treasury even have all the comments to work with in preparing the final rules. Even with all possible speed, final regulations are still a fairly long way off.