SERVICE ISSUES FINAL REGULATIONS ON BUSINESS ENERGY INVESTMENT CREDIT FOR SOLAR, WIND, AND GEOTHERMAL PROPERTY.

The proposed regulations, as effective prior to the final regulations, required that for equipment to qualify as solar, wind, or geothermal property, it must use only qualified energy. If property used both qualified and nonqualified energy (dual use property), it was not considered solar, wind, or geothermal property. Upon reconsideration of the underlying intent of the statute, regulation section 1.48-9 was amended to allow dual use property to qualify to the extent of its basis or cost allocable to its use of qualified energy. The allocation may be made by comparing, on a BTU basis, energy input to dual use property from qualified sources with energy input from other sources. In addition, the Commissioner may accept any other method that, in his opinion, accurately establishes the relative annual use of energy from qualified sources and energy from other sources.

The final regulations differ from those in the notice of proposed rulemaking in that the restriction on input to dual use property from nonqualified sources may not exceed 25 percent of its total energy input in an annual measuring period. The proposed regulations required that input from nonqualified sources not exceed 25 percent in any calendar year. An annual measuring period is defined as the 365-day period beginning with the day property is placed in service or a 365- day period beginning after the last day of the immediately preceding annual measuring period. The final regulations do not reflect amendments made by the Crude Oil Windfall Profit Tax Act of 1980 or subsequent legislation.

For further information, contact Keith E. Stanley, Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Ave., N.W., Washington, D.C. 20224, (ATTN: CC:LR:T), or telephone (202) 566-3458. (Full text in this issue.)

ACTION: Final regulations.

SUMMARY: This document contains final regulations under the Internal Revenue Code relating to the business energy investment credit ("business energy credit") for solar, wind, and geothermal energy property. These amendments will allow certain equipment that uses solar, wind, or geothermal energy ("qualified energy") to be eligible for the business energy credit to the extent of its basis or cost allocable to its annual use of qualified energy so long as the use of non-qualified energy does not exceed 25 percent of the total energy input of the equipment in an annual measuring period. The regulations provide the public with needed guidance.

DATES: These amendments are effective as of October 1, 1978.

FOR FURTHER INFORMATION CONTACT: Keith E. Stanley of the Legislation and Regulations Division, Office of the Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224, Attention: CC:LR:T (202-566-3458, not a toll-free number).

SUPPLEMENTARY INFORMATION:

BACKGROUND

This document contains final amendments to the Income Tax Regulations (26 CFR Part 1) under section 48 of the Internal Revenue Code of 1954. These amendments were published in proposed form in the Federal Register on December 9, 1986 (51 FR 44315). There was no public hearing. After consideration of comments regarding the proposed amendments, those amendments are adopted, as revised by this Treasury Decision.

Section 48(l) and section 1.48-9 define energy property (which is eligible for the business energy credit) as including solar, wind, and geothermal energy property. The regulations, as in effect before amendment by this document, required that for equipment to qualify as solar, wind, or geothermal property, it must use only qualified energy. If property used both qualified and non-qualified energy ("dual use property"), it was not considered solar, wind, or geothermal property.

Upon reconsideration of the legislative history, it has been determined that, while Congress did not intend that property that does not use qualified energy be eligible for the business energy credit as solar, wind, or geothermal property, Congress also did not intend to adopt an all or nothing rule for dual use solar, wind, or geothermal energy property.

Therefore, the regulations under section 1.48-9 relating to solar, wind, and geothermal property are amended to allow dual use property to qualify to the extent of its basis or cost allocable to its use of qualified energy during an annual measuring period so long as its use of non-qualified energy does not exceed 25 percent of its total energy input in an annual measuring period. This allocation may be made by comparing, on a Btu basis, energy input to dual use property from qualified sources with energy input from other sources. However, the Commissioner may accept any other method that, in his opinion, accurately establishes the relative annual use of energy from qualified sources and energy from other sources. If, for a taxable year subsequent to the taxable year that dual use property was placed in service, the basis or cost allocable to its use of qualified energy is reduced, recapture may be required in whole or in part under section 47 and section 1.47-1(h).

The amendments adopted by these final regulations differ from those in the notice of proposed rulemaking in minor respects. The final regulations modify the notice's proposed requirement that input to dual use property from non-qualified sources not exceed 25 percent of its total energy input IN ANY CALENDAR YEAR by providing that such input not exceed 25 percent of total input IN AN ANNUAL MEASURING PERIOD. Under the final regulations, an annual measuring period is also the period during which the portion of dual use equipment's basis or cost allocable to use of energy from a qualified source is measured. An "annual measuring period" for an item of dual use property is defined as the 365 day period beginning with the day it is placed in service or a 365 day period beginning the day after the last day of the immediately preceding annual measuring period. Dual use property placed in service toward the end of a calendar year that would not have qualified for the business energy credit under the notice because of a greater than 25 percent input from non-qualified sources during the relatively short period between the date placed in service and the end of that calendar year will, nonetheless, qualify under the final regulation's amendment, provided that there is no more than 25 percent non-qualified input during the 365 day period beginning with the date the property is placed in service.

Examples concerning geothermal and solar energy property were modified and expanded to illustrate (A) the determination of the portion of the basis or cost of dual use property that is attributable to energy input from a qualified source and (B) the allowance or recapture of credit for dual use property based on that determination.

A commentator suggested the adoption of a "safe-harbor" test for meeting the notice's threshold requirement that, in any calendar year, no more than 25 percent of dual use property's energy input be from non-qualified sources. Basically, it was suggested that dual use property be considered to meet that threshold requirement as long as it is part of a facility certified by the Federal Energy Regulatory Commission (FERC) as a "qualifying small power production facility" under FERC regulations (18 CFR Part 292). One of the criteria for a qualifying small power production facility, as set forth at 18 CFR section 292.204(b), is that 75 percent or more of its total energy input be from biomass, waste, renewable resources, geothermal resources, or any combination thereof and that the facility's use of oil, natural gas, and coal not exceed, in the aggregate, 25 percent of its total energy input during any calendar year period. Even if the notice's calendar year threshold requirement had been adopted, the FERC criterion would not have been narrow enough to justify adopting the suggested "safe harbor," primarily because a facility can be certified under these requirements even though its energy input is predominately from a source other than solar, wind, or geothermal, such as a biomass or waste source. Thus, there would have been no assurance, based on such certification alone, that at least 75 percent of the energy input of dual use property during a calendar year was from a geothermal, a solar, or a wind source. Although it would have been possible to provide a series of narrowly drawn safe harbors based on FERC certification, such safe harbors would probably have been of little benefit to either the Service or to taxpayers because it would still have been necessary to establish the relative energy input to dual use property from qualified and non-qualified sources if more than 75 percent of the basis or cost of that property were to qualify as energy property.

The commentator also suggested that, if the threshold requirement is met, then, for purposes of determining the portion of that property's basis or cost that qualifies for the energy credit, that property's basis or cost should be multiplied by the ratio of the cost of the qualified source property to the cost of all property providing energy input to that dual use property. The final regulations, however, generally adopt the approach taken in the notice of proposed rulemaking. Under this approach, the portion of the basis or cost of dual use property that is allocable, for a particular year, to its use of energy from a qualified source generally is the basis or cost multiplied by the ratio of the energy input from the qualified source for that year to the total amount of energy input for that year. Because, however, the final regulations provide that the Commissioner may accept any allocation method that, in his opinion, accurately reflects the relative annual amount of input to dual use equipment from its various sources, it is possible that the method suggested by the commentator would be accepted in appropriate circumstances, even though that method does not reflect actual, relative energy inputs.

The final regulations do not reflect amendments made by the Crude Oil Windfall Profit Tax Act of 1980 or subsequent legislation.

SPECIAL ANALYSES

The Commissioner of Internal Revenue has determined that this final rule is not a major rule as defined in Executive Order 12291 and that a Regulatory Impact Analysis is therefore not required. Although a notice of proposed rulemaking that solicited public comment was issued, the Internal Revenue Service concluded when the notice was issued that the regulations are interpretative and that the notice and public procedure requirements of 5 U.S.C. 553 did not apply. Accordingly, the final regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. chapter 6).

DRAFTING INFORMATION

The principal author of these final regulations is Keith E. Stanley of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations, both on matters of substance and style.

LIST OF SUBJECTS IN 26 CFR 1.01 through 1.58-8

Income taxes, Tax liability, Tax rates, Credits

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR Part 1 is amended as follows:

Paragraph 1. The authority for Part 1 continues to read in part:

Authority: 26 U.S.C. 7805. * * * Section 1.48-9 is also issued under 26 U.S.C. 38 (b) (as in effect before the amendments made by Subtitle F of the Tax Reform Act of 1984). * * *

Par. 2. Paragraphs (c)(10), (d), and (e) of section 1.48-9 are revised to read as set forth below.

Section 1.48-9 Definition of energy property.

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(c) Alternative energy property

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(10) GEOTHERMAL EQUIPMENT -- (i) Alternative energy property includes equipment (geothermal equipment) that produces, distributes, or uses energy derived from a geothermal deposit (as defined in section 1.44C-2(h)).

(ii) In general, production equipment includes equipment necessary to bring geothermal energy from the subterranean deposit to the surface, including well-head and downhole equipment (such as screening or slotting liners, tubing, downhole pumps, and associated equipment). Reinjection wells required for production also may qualify. Production does not include exploration and development.

(iii) Distribution equipment includes equipment that transports geothermal steam or hot water from a geothermal deposit to the site of ultimate use. If geothermal energy is used to generate electricity, distribution equipment includes equipment that transports hot water from the geothermal deposit to a power plant. Distribution equipment also includes components of a heating system, such as pipes and ductwork that distribute within a building the energy derived from the geothermal deposit.

(iv) Geothermal equipment includes equipment that uses energy derived both from a geothermal deposit and from sources other than a geothermal deposit (dual use equipment). Such equipment, however, is geothermal equipment (A) only if its use of energy from sources other than a geothermal deposit does not exceed 25 percent of its total energy input in an annual measuring period and (B) only to the extent of its basis or cost allocable to its use of energy from a geothermal deposit during an annual measuring period. An "annual measuring period" for an item of dual use equipment is the 365 day period beginning with the day it is placed in service or a 365 day period beginning the day after the last day of the immediately preceding annual measuring period. The allocation of energy use required for purposes of paragraph (c)(10)(iv)(A) and (B) of this section may be made by comparing, on a Btu basis, energy input to dual use equipment from the geothermal deposit with energy input from other sources. However, the Commissioner may accept any other method that, in his opinion, accurately establishes the relative annual use by dual use equipment of energy derived from a geothermal deposit and energy derived from other sources.

(v) The existence of a backup system designed for use only in the event of a failure in the system providing energy derived from a geothermal deposit will not disqualify any other equipment. If geothermal energy is used to generate electricity, equipment using geothermal energy includes the electrical generating equipment, such as turbines and generators. However, geothermal equipment does not include any electrical transmission equipment, such as transmission lines and towers, or any equipment beyond the electrical transmission stage, such as transformers and distribution lines.

(vi) EXAMPLES. The following examples illustrate this subparagraph (10):

EXAMPLE (1). On October 1, 1979, corporation X, a calendar year taxpayer, places in service a system which heats its office building by circulating hot water heated by energy derived from a geothermal deposit through the building. Geothermal equipment includes the circulation system, including the pumps and pipes which circulate the hot water through the building.

EXAMPLE (2). The facts are the same as in Example (1), except that corporation X also places in service a boiler to produce hot water for heating the building exclusively in the event of a failure of the geothermal equipment. Such a boiler is not geothermal equipment, but the existence of such a backup system does not serve to disqualify property eligible in Example (1).

EXAMPLE (3). The facts are the same as in Example (1), except that the water heated by energy derived from a geothermal deposit is not hot enough to provide sufficient heat for the building. Therefore, the system includes an electric boiler in which the water is heated before being circulated in the heating system. Assume that, on a Btu basis, eighty percent of the total energy input to the circulating system during the 365 day period beginning on October 1, 1979, is energy derived from a geothermal deposit. The boiler is not geothermal equipment. For the 1979 taxable year, eighty percent of the circulating system is geothermal equipment because eighty percent of its basis or cost is allocable to use of energy from a geothermal deposit. If, in a subsequent taxable year, the basis or cost allocable to use of energy from a geothermal deposit falls below eighty percent, recapture may be required under section 47 and section 1.47-1(h). Thus, if, on a Btu basis, only 70 percent of the total energy input to the circulating system for the 365 day period beginning October 1, 1980, is energy derived from a geothermal deposit, then there will be complete recapture of the credit during the 1980 taxable year. If, however, for that 365 day period, the portion of the total energy input that is derived from a geothermal deposit is less than 80 percent but greater than or equal to 75 percent, then only a proportional amount of credit will be recaptured during the 1980 taxable year. No additional credit is allowable in a subsequent taxable year, however, if the portion of the basis or cost allocable to use of energy from a geothermal deposit increases above what it was for a previous taxable year (see section 1.46-3(d)(4)(i)).

EXAMPLE (4). Corporation Y acquires a commercial vegetable dehydration system in 1981. The system operates by placing fresh vegetables on a conveyor belt and moving them through a dryer. The conveyor belt is powered by electricity. The dryer uses solely energy derived from a geothermal deposit. The dryer is geothermal equipment while the equipment powered by electricity does not qualify.

(d) SOLAR ENERGY PROPERTY -- (1) IN GENERAL. Energy property includes solar energy property. The term "solar energy property" includes equipment and materials (and parts related to the functioning of such equipment) that use solar energy directly to (i) generate electricity, (ii) heat or cool a building or structure, or (iii) provide hot water for use within a building or structure. Generally, those functions are accomplished through the use of equipment such as collectors (to absorb sunlight and create hot liquids or air), storage tanks (to store hot liquids), rockbeds (to store hot air), thermostats (to activate pumps or fans which circulate the hot liquids or air), and heat exchangers (to utilize hot liquids or air to create hot air or water). Property that uses, as an energy source, fuel or energy derived indirectly from solar energy, such as ocean thermal energy, fossil fuel, or wood, is not considered solar energy property.

(2) PASSIVE SOLAR EXCLUDED -- (i) Solar energy property excludes the materials and components of "passive solar systems," even if combined with "active solar systems."

(ii) An active solar system is based on the use of mechanically forced energy transfer, such as the use of fans or pumps to circulate solar generated energy.

(iii) A passive system is based on the use of conductive, convective, or radiant energy transfer. Passive solar property includes greenhouses, solariums, roof ponds, glazing, and mass or water trombe walls.

(3) ELECTRIC GENERATION EQUIPMENT. Solar energy property includes equipment that uses solar energy to generate electricity, and includes storage devices, power conditioning equipment, transfer equipment, and parts related to the functioning of those items. In general, this process involves the transformation of sunlight into electricity through the use of such devices as solar cells or other collectors. However, solar energy property used to generate electricity includes only equipment up to (but not including) the stage that transmits or uses electricity.

(4) PIPES AND DUCTS. Pipes and ducts that are used exclusively to carry energy derived from solar energy are solar energy property. Pipes and ducts that are used to carry both energy derived from solar energy and energy derived from other sources are solar energy property (i) only if their use of energy other than solar energy does not exceed 25 percent of their total energy input in an annual measuring period and (ii) only to the extent of their basis or cost allocable to their use of solar energy during an annual measuring period. (See paragraph (d)(6) of this section for the definition of "annual measuring period" and for rules relating to the method of allocation.)

(5) SPECIALLY ADAPTED EQUIPMENT. Equipment that uses solar energy beyond the distribution stage is eligible only if specially adapted to use solar energy.

(6) AUXILIARY EQUIPMENT. Solar energy property does not include equipment (auxiliary equipment), such as furnaces and hot water heaters, that use a source of power other than solar or wind energy to provide usable energy. Solar energy property does include equipment, such as ducts and hot water tanks, which is utilized by both auxiliary equipment and solar energy equipment (dual use equipment). Such equipment is solar energy property (i) only if its use of energy from sources other than solar energy does not exceed 25 percent of its total energy input in an annual measuring period and (ii) only to the extent of its basis or cost allocable to its use of solar or wind energy during an annual measuring period. An "annual measuring period" for an item of dual use equipment is the 365 day period beginning with the day it is placed in service or a 365 day period beginning the day after the last day of the immediately preceding annual measuring period. The allocation of energy use required for purposes of paragraph (d)(6)(i) and (ii) of this section may be made by comparing, on a Btu basis, energy input to dual use equipment from solar energy with energy input from other sources. However, the Commissioner may accept any other method that, in his opinion, accurately establishes the relative annual use by dual use equipment of solar energy and energy derived from other sources.

(7) SOLAR PROCESS HEAT EQUIPMENT. Solar energy property does not include equipment that uses solar energy to generate steam at high temperatures for use in industrial or commercial processes (solar process heat).

(8) EXAMPLE. The following example illustrates this paragraph (d).

EXAMPLE. (a) In 1979, corporation X, a calendar year taxpayer, constructs an apartment building and purchases equipment to convert solar energy into heat for the building. Corporation X also installs an old-fired water heater and other equipment to provide a backup source of heat when the solar energy equipment cannot meet the energy needs of the building. For purposes of this example, all equipment is placed in service on October 1, 1979. On a Btu basis, eighty percent of the total energy input to the dual use equipment during the 365 day period beginning October 1, 1979, is from solar energy.

(b) The items purchased, in addition to the water heater, include a roof solar collector, a heat exchanger, a hot water tank, a control component, pumps, pipes, fan-coil units, and valves. Assume the fan-coil units could be used with energy derived from an oil or gas substance without significant modification. All items are depreciable and have a useful life of three years or more. The use of the equipment to heat the building is the first use to which the equipment has been put.

(c) Water is pumped from the basement through pipes to the roof solar collector. Heated water returns through pipes to a heat exchanger which transfers heat to the water in the hot water tank.

(d) The hot water tank and the oil-fired water heater utilize the same distribution pipe. Pumps and valves at the points of connection between the hot water tank, the oil-fired water heater, and the distribution pipe regulate the auxiliary energy supply use. They also prevent the oil-fired water heater from heating water in the hot water tank.

(e) An integrated control component determines whether hot water from the hot water tank or from the oil-fired water heater is distributed to fan-coil units located throughout the building.

(f) The roof solar collector is solar energy property. The pump that moves the water to the roof collector and the pipes between the roof collector and the hot water tank qualify because they are solely related to transporting solar heated water. The hot water tank qualifies because it stores water heated solely by solar radiation. The heat exchanger also qualifies.

(g) The oil-fired water heater does not qualify as solar energy property because it is auxiliary equipment.

(h) (i) Because the distribution pipe, the control component, and the pumps and valves serve the oil-fired water heater as well as the solar energy equipment, they qualify only to the extent of eighty percent of their cost or basis, the portion allocable to use of solar energy. If, in a subsequent taxable year, the basis or cost allocable to their use of solar energy falls below eighty percent, recapture may be required under section 47 and section 1.47-1(h). Thus, if, on a Btu basis, only 70 percent of the total energy input to that equipment for the 365 day period beginning October 1, 1980, is from solar energy, then there will be complete recapture of the credit during the 1980 taxable year. If, however, for that 365 day period, the portion of that equipment's total energy input that is from solar energy is less than 80 percent but greater than or equal to 75 percent, then only a proportional amount of credit will be recaptured during the 1980 taxable year. No additional credit is allowable for that equipment in a subsequent taxable year, however, if the portion of its basis or cost allocable to use of solar energy increases above what it was for a previous taxable year (see section 1.46-3(d)(4)(i)).

(ii) The fan-coil units do not qualify as solar energy property because they are not specially adapted to use energy derived from solar energy.

(e) WIND ENERGY PROPERTY -- (1) IN GENERAL. Energy property includes wind energy property. Wind energy property is equipment (and parts related to the functioning of that equipment) that performs a function described in paragraph (e)(2) of this section. In general, wind energy property consists of a windmill, wind-driven generator, storage devices, power conditioning equipment, transfer equipment, and parts related to the functioning of those items. Wind energy property does not include equipment that transmits or uses electricity derived from wind energy. In addition, limitations apply similar to those set forth in paragraph (d)(5), (6), and (8) of this section. For example, if equipment is used by both auxiliary equipment and wind energy equipment, such equipment is wind energy property only if its use of energy other than wind energy does not exceed 25 percent of its total energy input in an annual measuring period and only to the extent of its basis or cost allocable to its use of wind energy during an annual measuring period.

(2) ELIGIBLE FUNCTIONS. Wind energy property is limited to equipment (and parts related to the functioning of that equipment) that --

(i) Uses wind energy to heat or cool, or provide hot water for use in, a building or structure, or

(ii) Uses wind energy to generate electricity (but not mechanical forms of energy).

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