Emissions Free Trade: EV Tax Credit Sourcing Rules And The EU

Professor Kathleen Claussen of Georgetown Law discusses how the proposed regs for the new clean vehicle tax credit affect the EU and other countries without a free trade agreement.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: driving change.

When the Inflation Reduction Act was passed in August, it included a collection of measures aimed at reducing greenhouse gas emissions using tax credits. One of the measures requires electric vehicle batteries to have a significant percentage of critical minerals sourced in the United States or, crucially for today’s discussion, a country with which the United States has a free trade agreement. Naturally, this poses a problem for trading partners that don’t have a free trade agreement, especially the EU.

So what does the EU plan to do about this? Is a free trade agreement between the EU and United States possible?

Here to talk more about this is Tax Notes reporter Sarah Paez.

Sarah, welcome back to the podcast.

Sarah Paez: Dave, it’s great to be back.

David D. Stewart: I understand you recently spoke with someone about this. Could you tell us about your guest?

Sarah Paez: Yes, I spoke with professor Kathleen Claussen at Georgetown Law. She’s the former general counsel at the Office of the U.S. Trade Representative (USTR), and she’s an expert in international trade.

David D. Stewart: And what sort of things did you talk about?

Sarah Paez: We talked about a variety of things, but mostly we honed in on the trade issues that have arisen from the tax credits and subsidies offered in the Inflation Reduction Act, particularly the critical minerals requirement for the clean vehicle tax credit. We also touched on countries like Japan making a free trade agreement with the United States to take advantage of these tax credits and the potential for the EU to strike a similar deal with the United States. I should note that before we start the discussion, these rules are proposed, so they are still open for comment through the Federal Register notice.

David D. Stewart: All right, let’s go to that interview.

Sarah Paez: Kathleen, it is so great to have you on the podcast. Welcome. I’m so happy to be talking with you.

Kathleen Claussen: Thanks so much. It’s great to be here, Sarah.

Sarah Paez: I just wanted to start off by asking you, before we get into specifics, could you tell us a little bit about your background and areas of expertise?

Kathleen Claussen: Sure. I spend most of my time thinking about international economic law on the one side and foreign relations on the other side. So the topic we’re going to discuss today is sort of right at that intersection. That’s why I’m delighted to have the chance to chat.

On the international economic law side, I’m mostly focused on trade, trade agreements, international investment law, sustainability increasingly, and economic security as those issues have come to the fore. On the foreign relations side, I am thinking a lot about how we form agreements, treaties, executive agreements, and how those play out in the United States’ international relationships.

Sarah Paez: Great. Well, I’m really looking forward to hearing some of your views on these questions I have for you.

Let’s just get straight into it. We want to talk about the controversy that the U.S. Inflation Reduction Act has brought with the European Union, but also some of its other trading partners. Under section 30D of the act, which lays out a clean vehicle tax credit that’s worth up to $7,500 per purchase, the United States has instated this critical minerals requirement or a number of critical minerals requirements. Eligible taxpayers would be able to claim the credit if a significant percentage of critical minerals like lithium, copper, manganese used in a car’s battery were extracted or processed in the United States or in any country with which the United States has a free trade agreement.

So very specific, but maybe could you give us a little bit of background about the critical minerals requirements, section 30D of the clean vehicle tax credit, and how it’s structured, and then maybe talk a little bit about the controversy that’s arisen from that?

Kathleen Claussen: Sure. So the history of this change, of course, it connects back to incentives that were already in place and have been in place for some time that perhaps owners of EVs are already familiar with. These are incentives that were structured in a quite different way in past law.

What the IRA does is change how that incentive is structured or how it’s calculated with these new elements that you referred to. This is, of course, all connected to concerns about China, how China is very far ahead of the entire world on this issue that is having and mining and processing different types of critical minerals that will be critical, if I may say, to the future of the green energy environment in which we find ourselves and toward which the Biden administration is working. So internally in China and in China’s international relationships there, they’re so far ahead.

There are a few mines in other parts of the world, like Indonesia, Australia, the Democratic Republic of Congo; they’ve got mines going there and actively working away. But for the rest of the world, these are usually quite far out. There are some critical minerals in certain parts of Europe. We have some in the United States, but to get the permitting to be able to get to those minerals and then lead to their extraction and their processing [is] still quite a bit out.

So that’s the backdrop: How do we get the critical minerals we need, which are so important for batteries and beyond electric vehicles in other contexts of renewable energy? That’s really what’s motivating what’s happening here.

The structure of the IRA sets out these changes. As I mentioned, one of the key ones [is] already in place, which is the EV itself. The vehicle must be assembled in North America. That came into place last summer, but now we really zero in on the batteries, the battery structure, the battery components, every piece of the battery.

Now, I’m not a car expert, but my understanding is that we’re really looking at sort of four steps. There’s the extraction of the mineral, really where it all begins underground. Then there’s the processing of that mineral. Then the manufacturing of the battery components for which the minerals are inputs, and then finally the assembly of the battery. So everything we’re talking about in this tax credit has to do with just the battery, not the rest of the vehicle now, because we’re zooming in on that issue.

Some foreign companies, some American car companies, they’re still eligible for this because they are doing all this work, the extraction, the processing, the manufacturing, the assembling. They’re doing it in the United States or in other parts of North America. So it’s not an issue for them. But when we start to look more closely for some of these other auto assemblers or these other auto companies, they fall out in one part of the credit or another.

I want to come back to your point about there’s $7,500 on the line, right? A $7,500 tax credit for the consumer who’s buying the EV. It’s actually two separate credits. Each one is worth $3,750 each. Pretty easy to keep in mind so far, but then it gets complicated.

You highlighted how the critical minerals requirement — what you and I in our discussion take will refer to as the critical minerals requirement — that’s the one $3,750. And then there’s a separate thing we don’t need to talk about today that’s called the battery component requirement. That’s the other $3,750.

We’re going deeper and deeper into the weeds, but the first $3,750 credit is tied to whether those critical minerals — and you put it perfectly well — whether those critical minerals are extracted in the United States or in one of its trading partners or processed in the United States or one of its trading partners. A certain value of the critical minerals have to meet this threshold as it’s 40 percent — starting earlier on April 18, this 40 percent went into effect. But imagine that in three years is 2026; it’s going to be 80 percent. So this is a moving target on top of everything else.

We’re talking about those ones you said: lithium, graphite, cobalt. If the car you buy is going to get you that tax credit, the original lithium, graphite, and cobalt either need to be mined or processed in the United States or in any country with which the U.S. has a free trade agreement in effect. So some car manufacturers are out in the cold, which means some buyers are out in the cold; others get to still take advantage of this. It’s just a narrowing list. So that’s a quick overview of the requirements. Even for lawyers, it’s exhausting — pardon the pun, but it truly is.

It just takes you hours to just sort of understand what’s going on. Should I go then into the discussion of the disagreement, Sarah, would that be helpful?

Sarah Paez: Absolutely. That was a really great overview.

Kathleen Claussen: The difficulty begins with that language that you only get the benefit if these critical minerals are extracted or processed in a country with which the United States has a free trade agreement in effect. Free trade agreement, key phrase here. So what’s a free trade agreement? Maybe that’s a reasonable place to start.

The reason the EU and Japan are upset is because they don’t have one. We do not have a free trade agreement with the European Union. We don’t have one with Japan, which is a little surprising frankly, because they’re some of our biggest trading partners. But we don’t.

We have 20 different countries with whom we have a FTA — we’ll call it FTA in effect. And when I say that those 20 countries and the common use of the phrase FTA, it’s things that will be familiar to most people. Most importantly, the NAFTA (North American Free Trade Agreement), which is now USMCA (United States-Mexico-Canada Agreement), recently negotiated by the Trump administration, that’s the one that comes to mind for most people. But then there are another several countries that we could add to that list. Usually though, reasonably small trading partners like Chile would be one that’s important for critical minerals, but otherwise not a big economic partner.

When we say FTA out in trade land, in which I spend my time, we’re talking about massive deals that as the name suggests, free, it brings all the tariffs and other barriers to trade down to zero. It really says every movement of goods and services across our borders are not going to be subject to tariffs.

So that’s what we think of when we say FTA. But EU and Japan, we don’t have them. People may recall that years ago, we tried to do TTIP (Transatlantic Trade and Investment Partnership), right? This was going to be the big EU-U.S. FTA didn’t happen. All the politics, we’ll leave up for another day. So they felt left out.

When this discussion began, the IRA language became known. People might remember that [French President Emmanuel] Macron had this discussion with Biden. Biden tells him we’re going to fix this. So how do we fix it? How do we make sure that the EU and Japan get the benefits that all our other FTA partners will get? Well, one way to fix this is to make sure they get considered like FTA partners somehow. In the absence of this big comprehensive FTA, maybe there’s some other way that we can consider them FTA partners.

Now, can I just pause for one moment here, Sarah, because I want to highlight why Japan and the EU might care, apart from just feeling like “We are friends too and we want to be treated like friends.” Because we know, as I mentioned at the outset, this is really about China. And I said, there are other countries that have these critical minerals, Japan and EU not on that list. So what they care about is not extraction.

They’re not going to make it into the tax credit with their extraction, but I suspect that this has been pretty unclear frankly in the discussions. But it must be about the processing, that they’re doing some processing or they have plans more likely to do increased processing of critical minerals in their territories that would then allow their manufacturers to benefit from that. That has really been the sort of fuzziest part of the story. But they’re really interested in getting this done, and yet their current capacity to do the processing of critical minerals is really limited. There’s only a few companies, mostly in the Nordic countries that work on this area. So that’s just a footnote, but a not unimportant one that we should keep in mind.

So FTA, although we use it colloquially to talk about these big agreements, it’s actually not defined in statute. You can’t go look up in statutes that “This is what FTA means.” That seems to suggest that there’s a little wiggle room if we want to get Japan and the EU in. Treasury then has that opportunity. Treasury, IRS, they’re going to implement this law. They have to say, “OK, what does this language mean?” Even some of the big deals — NAFTA, USMCA — they don’t even use it in their title.

So really, there should be a good deal of flexibility in there. Well, back in December, we started to get a sense from Treasury and IRS as to what they were going to do with this, how they were going to think about what “free trade agreement” means in this context. And they said, “Well, we’re going to look at agreements that reduce or eliminate trade barriers. We’re going to look at agreements that commit the countries to not impose new trade barriers.”

They have a list of about four different criteria that get really broad, [a] set of criteria that you could think, “Well, man, we probably have other commercial agreements with a bunch of countries that could fall under these criteria.” And that’s actually true. We do. We have more than 1,200 mini-deals, is sort of my term for them. Sometimes people call them skinny deals — different sort of names — but these are smaller trade agreements. They have some capacity for regulating trade and usually on one item.

For example, we might think about deals that deal with steel or deals that deal with beef or poultry. We do these little deals all the time in past history of U.S. trade practice. So as I said, we’ve got over 1,200 of them with more than a hundred countries, here, including with Japan. And with the EU, they figure quite high in the list of those economies with whom we have these mini-deals.

So one possibility would have been for Treasury to point to those deals and say, “Aha, we’re going to count these deals as qualifying as FTAs. There is an existing universe of deals that we have with Japan, EU. Maybe they’re not the really big one that we’re used to, but we’re going to count those as FTAs.” And they could have done that. We know that’s not how they’ve decided to proceed.

Sarah Paez: It’s really fascinating to see the evolution of the EU and U.S. disagreement over this and also just with other countries that really want to be able to take advantage of these credits within the IRA.

When the IRA initially came out, the EU sort of responded pretty heavily with its own green deal industrial plan that kind of was designed to counteract the IRA because it was sort of mimicking many of these domestic component requirements to put together EV batteries and other solar, wind energy equipment. I wanted to ask, why did critical minerals become sort of the sticking point in this discussion, in this negotiation between the EU and the U.S. and also countries like Japan? Was that sort of the place that these countries felt that it would be easier for them to get in because they could make the argument? I wanted to know what your thoughts were on that.

Kathleen Claussen: Sure. A couple quick thoughts. Maybe the one piece of this you highlighted really importantly is that this does not exist in a vacuum, that this is in parallel with efforts, especially in the EU, but also surely in Japan, to do some of the same supply chain resilience measures that would protect them, forget even IRA, but to really get themselves shored up literally and figuratively when it comes to critical minerals. So that’s an important point I’m glad you raised.

Why this particular thing? Frankly, it’s in part because this is the only piece of the IRA that gives them that opening when you think about it. There are all these other requirements in there mostly having to do with assembly and manufacturing and so forth in North America.

This was the sort of last minute shift that, at least this is the rumor and how it was reported, with Senator [Joe] Manchin, D-W.Va, to say, “We’re going to add in this language of free trade agreement.” Or it came in there somewhere toward the end. And that provided an opening to get these allies, these friends, on board in some way to give them more access to the U.S. market, which of course is the most important car market in the world. So I suspect that’s why we’re spending most of our time on that. They see an opening for themselves to make up the lost space in some of these other areas where, frankly, they probably care more about the other areas, but there’s no opening for them to try to change the status quo now that the law’s in effect.

Sarah Paez: Going back to this language of free trade agreements and all this stuff surrounding it, basically, I wanted to know how would a deal between the EU and the U.S. on this subject be achieved? What might the language look like?

And also, we’ve read that negotiations to strike a critical minerals deal are ongoing. So where do you see that going?

Kathleen Claussen: Let me start with the Japan deal if I could, Sarah, because I think we’re going to get some lessons from that as we look to the EU. The Japan deal, we’ve got it already, right? This is a 10-page deal, not a big deal. Again, both senses of that expression, because it doesn’t do very much, at least on these 10 pages.

It’s available quite interestingly on the USTR website, if you go to free trade agreements. Before a month ago, it would only have those 20 countries listed. Now, very conveniently, they’ve added a sentence that says, “And we have a free trade agreement about critical minerals with Japan,” which for many people, that’s an oxymoron. You can’t have a free trade agreement about just one thing. That’s not a free trade agreement.

So that’s again — in trade land, people are very concerned about this. This language does not work, but it’s there. You can go read it. The 10 pages that they did negotiate very quickly — super quickly in such a way that it was clear that they blindsided members of Congress, that they were not consulting with Congress along the way, and that becomes a bigger issue as the story goes on. But the most important piece is it got done, so technically now, the Treasury has said in the IRS Federal Register notice that it acknowledges the deal is done.

They’re going to count this deal as one of the agreements under the definition in the code. So it’s done. And that’s all that matters at the end of the day. But if you look at it, it’s very basic. There aren’t a lot of binding obligations, but it’s not empty either.

Let me just read, if I may, one provision which says that “each party shall maintain its current practice not to impose export duties on critical minerals.” So they agree, there are no changes going to be made, but we agree we’re not going to change it. Now again, that may seem insignificant, but it actually is a little bit more significant than it may come across. And here’s why.

The Constitution, so Article I, and again, it depends on how much of a Constitution lover you are to know that in Article I, section 8 of the Constitution, it charges Congress with regulating commerce with foreign nations. This is critical because Congress then has the prerogative when it comes to regulating trade. It’s right there in Article I.

Over the years, Congress has typically delegated that authority to the executive. We can imagine that we do not want members of Congress out there negotiating our trade agreements. That is not a very fruitful way to proceed. And so they delegate that authority, and they have since the beginning, in different forms, to the executive. There, however, they did not do that. The IRA does not say Treasury can go out and negotiate a new deal. Here we’re now looking at a deal that has this binding obligation not to change tariffs on critical minerals.

So even though it says we’re not going to change them, that’s still an obligation into which the executive has entered without congressional approval. No delegation from Congress to do this, no approval from Congress on the other end. This is a trade executive agreement with an obligation in it that is probably contrary to what the Constitution requires.

So as I said before, Treasury had the option. They could have just used existing agreements, but as soon as they together with the U.S. trade representative — as soon as they decided to go out and negotiate new details, now they’re on less sound ground.

They do not have authority to do that. There’s nothing in the IRA. There’s nothing in the basic mandate of what either Treasury or USTR can do that says you can go negotiate a deal without anything more. All the other times we’ve done this, there’s something in a delegating authority or some statute out there that says, “Go forth and conquer, executive. You can do that deal. Or go forth, come back, bring it to us, we’ll approve it.” Didn’t happen here. So that’s why this Japan deal, and maybe subsequently very soon an EU deal, is raising a lot of concern on the Hill.

Let’s then turn to the EU deal. The EU deal, you mentioned it’s a work in progress. We don’t know exactly where things stand. We know that it’s probably not far out, although there’s some question as to what kind of deal it will be on the EU side.

I’ve just talked about the concerns about the U.S.-Japan deal on the U.S. side, and those concerns are repeated when it comes to the EU deal, but there’s also a very complex, very EU negotiating mechanism. Sometimes they have to go to the Parliament, to the Council, and then sometimes they have to go to national authorities.

And so I’m imagining that in Brussels, they’re working through all those pieces. What kind of deal is it going to be? How do we get it through our system? Whereas in Japan, that was simplified considerably by the processes that they have in place. So how close is this to done? Unclear as of the domestic process on really both sides of the Atlantic, but is it likely? Absolutely, yes. I think we are quite close. Will it look like the Japan deal? I’ve heard different things out and about.

I have heard that it’s similar in that it doesn’t seek to do very much. It’s not going to have extensive commitments and be much, much longer than this. Maybe it’ll be a little bit longer as the parties can find some additional spaces for agreement.

But I didn’t mention what else is in the Japan deal, that just for reference as we look to the EU as well, there are also environmental provisions in here. Maybe that’s not surprising because we’re talking about critical minerals and so there’s environmental concerns. There are also labor provisions in here. So they’re very basic. They don’t require either side to do very much, but it really is kind of a strange thing to see, I would say, in a deal like this. So I expect we’ll see it again in the EU, but just sort of flagging that that’s going on in these agreements.

Again, it doesn’t really matter what’s in there. So long as Treasury is out there saying, “We’re going to consider this as a qualifying agreement under the law,” then either economically we don’t really care what this does in a way. Secondarily in content, it doesn’t really matter what it says because you’re already over the point of saying, “This is something that we need to go to Congress for. Whatever. You’ve already crossed the threshold into content doesn’t matter. We’re just going to count this as being sufficient.”

So could there be a wrench thrown into this story at this point? Is there any sort of space left for this to fail? In theory, Congress could intervene and say, “We really didn’t like what you did with Japan.” They said that very loudly. “That was totally outside the scope of what you’re allowed to do. So we’re not going to let you do that on the EU side.” So they could theoretically intervene and, say, either pass a legislation or threaten some other measure that seems very unlikely to happen, as unhappy as they are on the process side and, frankly, as unhappy they seem to also be on the content side.

They said, “What did we get out of this?” When you go out there and negotiate, we should get something out of the deal. And they look at the Japan [deal] and they say, “This doesn’t look like it does anything for us.” So you’re hearing both the procedural concerns and the content concerns. Senator Manchin is not the only one who has raised that this was an opportunity for the U.S. anytime you go out and negotiate. “You blew it. And so we don’t want you to do this with the EU.” You could imagine they’re applying that pressure, and I know they’re applying that pressure behind the scenes and sometimes publicly as well.

But at the end of the day, this deal’s going to happen. I think there’s just no way around that. Where does that leave us? Well, marching forward on this is a very complicated legal structure, yes, but also I think there’s a risk out there for litigation, and it’s not an insignificant one.

And the way Treasury has gone about this, they had the option to stop with the existing deals. Now they’ve done the new deals. It’s a stretch anyway; that’s clearly not what was meant. We could walk through all the different legal theories under an Administrative Procedure Act styled claim; they could happen. To the extent there are aggrieved auto producers out there, I don’t think it’s too difficult to imagine a way to the courthouse.

Sarah Paez: Very interesting outlook on what this could mean, especially for the future of manufacturing. In terms of the supply of critical minerals, you even mentioned it before in your earlier remarks, there’s this fear that the U.S. cannot produce enough critical minerals because we don’t have the production capacity. Same with the EU, and same with a lot of our other trading partners.

So I’m wondering, once these deals are struck — the Japan deal, as you said, has already been struck. What does that mean for, I guess, the U.S. supply chain? Is this achieving the things that the IRA set out to achieve or do we still have ways to go to ensure, I guess, the security of the supply chain? As you said, a lot of it’s related to concerns about competition with China. So just wanted to know what you thought of that outlook.

Kathleen Claussen: Again, a super important question. I think you’ve sort of identified in your question this difficult, difficult, and long-standing tension in how we achieve our climate change goals versus how we deal with our competition with China. That is an issue we’ve seen for a long time in solar in particular, but increasingly in other areas as well, right? Because we’re getting all these solar cells from China, but we don’t want to support the Chinese industry, and we want to have them at home, but it’s too expensive to do at home.

This is a tried-and-true sort of trade story, one that is going on for some time. So it’s only heightened now. And I think that that’s right. To the extent that you’re asking, sort of putting it more facetiously than I know you intended, does this solve our problem? Surely not. And for the reasons we discussed that this is many years away, and it doesn’t matter really how many re-trade agreements you put on there.

When we’re getting 80 percent of our critical mineral supply from China, that’s very hard to make up. In the EU, it’s even worse. It’s 98 percent I’ve seen them say. So that takes a lot of work beyond just this lovely, small, very narrow tax credit to be able to make things happen. And there are a number of cars that are affected by this as you can go look it up. There’s a website — you can see, “Is my car affected? What do I get under this rule?”

The auto companies are going to move necessarily. The industry is too valuable for them not to. It’s a step; it’s going to take time; it’s going to be in motion. Presumably it’s not going to go away if there’s a change in administration given the complexities of the law. But as we’ve identified, there are still pieces that are unclear. There are moving parts, and I don’t just mean across borders. It remains to be seen just how this all plays out in implementation. The bottom line on supply chain resilience, I think, is very difficult to predict.

Sarah Paez: As you mentioned before, the tax credit is such a small part of it, and yet it’s the thing that’s sort of ignited this huge debate about our supply chains and trade. There are a lot of tax credits contained in the IRA, not just this electric vehicle clean energy tax credit. There’s a commercial vehicle credit. There’s [an] advanced manufacturing production credit.

So just kind of wondering, do these tax credits have the ability to make waves in the way that this legislation was intended? Did they really think that it would sort of hit this hard with U.S. trading partners, or does this seem like it’s sort of been a bit unexpected?

Kathleen Claussen: My sense is that the waves part was entirely intentional, but on the industry side, for the reasons we said that this is intended to move industry toward North America to do everything here, right?

On the trading partner side, I really think that was not as thoroughly vetted maybe is the way to put it, such that when this all came into place and it became known, I remember I was in Brussels and they were like, “Why didn’t we hear about this? Why didn’t you tell us this?” And so, obviously I was not representing the U.S. government, but they’re asking me these questions. And my feeling was that I don’t think that across the executive branch that was really a big part of the conversation.

Now, that could be wrong, but that’s been the way it’s been presented, and I think it may not be too far from what actually happened, the sort of remaining, the very last negotiation and among the senators to get it over the finish line.

So yes, waves were absolutely anticipated and very much intended as part of this broader reshoring, friend shoring concept. This little tiny slice among the many credits and the way that’s played out, maybe not so much.

Sarah Paez: Absolutely. Well, I really appreciate our conversation today. It’s absolutely fascinating. And I just wanted to give you a chance to, if there was anything that we didn’t cover on this topic — if you might want to say a few words.

Kathleen Claussen: No, I think we’ve covered everything, Sarah. Thanks. I, again, really appreciate the chance to come on and hang out with the tax crowd somewhat. This is only more sort of ancillary to how I spend my time, but I have learned a lot about the tax code and getting to know this particular provision, bringing together my free trade agreement fun to another set of fun folks. So thanks again for the opportunity.