Funding incentives under the U.S. Inflation Reduction Act of 2022 (IRA) to transition to a clean energy economy are unleashing opportunities for key U.S. allies and partners around the world. In particular, tax credits exceeding 10% of the price of average electric vehicle (EV) sold in the United States are leading to new investments in Mexico and Canada, and have triggered high-level political negotiations from U.S. partners such as the European Union and Japan.
IRA Tax Credits for EV Critical Minerals and Battery Components
Under the IRA, EVs and batteries produced in North America (including Mexico and Canada) may qualify for significant tax breaks. Partial tax breaks are also available for EVs with batteries utilizing critical minerals extracted or processed in countries with which the U.S. has a free trade agreement (FTA).
As we previously discussed in greater technical detail, the IRA amended the Clean Vehicle Credit under section 30D of the U.S. tax code to provide a $7,500 consumer tax credit for the purchase of a qualified vehicle such as an EV. This consists of $3,750 for vehicles meeting the “critical minerals” requirements and $3,750 for those meeting the “battery components” requirements.
- Under the critical minerals requirements, a share of critical minerals contained in the battery of a qualified vehicle must have beenextracted or processed in the U.S. or in a country with which the U.S. has an FTA, or recycled in North America. The applicable share is at least 40 percent for vehicles placed in service in 2023, and increasing by 10% per year until reaching 80% for vehicles placed in services after 2026.
- Under the battery components requirements, final assembly must have occurred in North America and the percentage of the value of the components contained in such battery that were manufactured or assembled in North America must be equal to or greater than the “applicable percentage,” i.e., “60% for 2024 and 2025 vehicles, and going up 10% per year till past 2028 at 100%.”
Some EVs, particularly those originating in FTA partner countries, may qualify for the $3,750 tax credit under the critical mineral requirements, but not for the additional credit under the battery component requirements. On March 31, 2023, the U.S. Department of Treasury issued for public inspection proposed regulations on the IRA’s EV tax credits, which we outlined here.
In particular interest for international firms, Treasury’s proposed regulations listed a range of FTA partner countries for purposes of the IRA: Australia, Bahrain, Canada, Chile, Colombia, Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, Israel, Jordan, Korea, Mexico, Morocco, Nicaragua, Oman, Panama, Peru, Singapore, and Japan. The inclusion of Japan comes because of a critical minerals agreement signed with the U.S. on March 28, 2023, leaves the door open for other countries or regions to follow the same path.
Mexico’s EV Potential Production Boom
As EV demand continues to increase around the world, production in Mexico is a clear option to explore, but Mexican policy toward the private sector and foreign investment in general may mute the country’s potential to capitalize on the opportunity. Several large EV manufacturers and EV component producers have already established their operations or announced new investments in Mexico. These developments build on favorable trends in Mexico over the past two decades, as it has become a significant site for global car production: the country is the seventh-largest manufacturer and fourth-largest vehicle exporter (with 80% of domestic production destined for the North American market). Mexico’s auto industry has expanded mainly because of its proximity to the United States (now also the largest EV market in the world), and because it is a major supplier network of vehicle parts and car components, has low labor costs, and has a skilled manufacturing workforce. In addition, Mexico has 13 FTAs, including with the United States, which makes it an attractive manufacturing hub for automakers that want to export vehicles tariff-free to major markets around the world.
Notwithstanding these favorable overall conditions, there are local headwinds due to President Lopez Obrador’s policy direction. Investors across many sectors in Mexico are concerned regarding government policies that prioritize state-owned entities over private investment. In the energy sector, these policies have called into question the potential supply of electricity to operate manufacturing plants, which would need to be supplied by the federal power utility Comisión Federal de Electricidad, whose generation capacity relies heavily on fossil fuels. Further, President Lopez Obrador’s overall policies in the energy sector have frozen investment in green energy sources, which has given many investors pause, including in the auto sector and those looking to meet ESG criteria in their global operations.
At the same time as the IRA tax credits and global trends make Mexico a potentially attractive investment option, the Mexican government is continuing to create uncertainty for private investors. The future of mining in general in Mexico came into question on March 28, when the government submitted a proposal that would increase risk and likely make some mining investments economically unviable. The government also has introduced uncertainty around lithium, a highly sought-after mineral that is used in the manufacturing of batteries. While Mexico has the potential to become a competitive producer of lithium, as discoveries have been made in several states in the country, the federal government recently introduced new regulations aimed at increasing state control over its extraction and distribution. These regulations, known as the Lithium Decrees, establish the creation of a new state-owned company called LitioMx (Litio para Mexico) with the intention of managing the exploration, mining exploitation, and refining of lithium throughout the national territory. The second decree hands over responsibility of the country’s lithium reserves to the Ministry of Energy (Sener) and the third decree creates a large lithium mining zone called Li-MX 1 in the northern state of Sonora, which encompasses one of the biggest lithium reserves, and limits the mining activity related to lithium in the area. Until the rules of the road for mining in Mexico and for the lithium sector are settled, it seems likely that Mexico will not realize its potential for foreign investment in these areas.
Dynamics in North America
The three governments of North America are working on developing EV infrastructure and regulations. During the North American Leaders Summit in January 2023, the U.S., Mexico and Canada agreed to develop a plan for operating standards and the installation of EV chargers along international borders to ensure a seamless EV charging transition from country to country.
The Mexican Ministry of Foreign Affairs, in collaboration with the University of California, created a multi-stakeholder working group for the electrification of transportation and published in January 2023 the results of the working group. These include diagnosis and recommendations for transition of the automotive industry in Mexico. Among the recommendations, the report focuses on circular economies, recycling, handling and battery disposal. In particular, they recommend the review of regulation, standards and proper management programs and disposal of electric vehicle batteries, adequate waste management, and the creation of databases and certification of companies authorized to handle, recycle and dispose of lithium-ion electric vehicle batteries.
Mexico still needs to update regulations and standards on EV manufacturing to become more competitive and take advantage of the regional integration. The Mexican government, through the Ministry of Economy, says it will publish additional regulations or NOMs (Norma Official Mexicana) related to batteries for EVs. In addition, the Mexican Ministry of Environment is drafting a National Electro Mobility Strategy, which is expected to include regulations on EVs and chargers and regulations aimed at the comprehensive management of waste generated by electrical units and their components including recycling of batteries.
Potential Critical Minerals Agreements as FTAs?
After months of concerns voiced by European officials regarding the IRA’s potential effects in shifting new EV investments from Europe to North America, President Biden and European Commission President von der Leyen launched talks in March 2023 on a new critical minerals agreement that would be deemed as an FTA for the purposes of the critical minerals tax breaks under the IRA. The two sides are also aiming to better coordinate the extensive subsidies that will be available for a variety of clean tech industries under the IRA and the EU’s Green Deal Industrial Plan.
As the U.S. and EU are apparently finalizing negotiations on a text and aiming to complete them by the time Treasury publishes the final guidelines on April 17, several questions arise. First, would the agreement explicitly refer to itself as an FTA or would this issue be left for interpretation under U.S. law and EU law (which may have different benchmarks and implications)? Second, who would need to approve the agreement, whether just the executive branch or also the Congress on the U.S. side, and whether the Commission, all EU institutions, or also EU Member States, on behalf of the EU? For instance, the U.S.-Japan critical minerals agreement was signed by the U.S. Trade Representative and her Japanese counterpart. Notably, the European Commission can enter into so-called non-binding agreements with other countries and, according to senior EU officials, is considering using this procedure for the critical minerals agreement with the U.S. Third, would the agreement be subject to judicial review to determine whether it qualifies for the IRA tax credits, and who would have standing to raise this issue?
Several law-makers have expressed their concerns on how the deal with Japan was negotiated and what is being negotiated with the EU, claiming that the U.S. administration overreached its trade policy jurisdiction when negotiating such deals.
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Covington’s Global Public Policy, Energy, and Tax teams are tracking these developments closely and can help advise companies on the incentives being developed in different areas of the world when planning new investments.