Solar developers that wish to maximize the federal tax incentives associated with their projects are looking beyond 2019 and planning for the phasedown of the Section 48 solar investment tax credit. By being proactive, these developers are grandfathering 2020-2023 projects at the current 30% credit level.This benefits both the developer and any tax credit investors participating in the financing of the project.
I. The Solar ITC – Qualifying for Tax Benefits at 2019 Levels
Section 48(a) of the Internal Revenue Code provides an investment tax credit (ITC) for solar energy property. The credit is typically based on a percentage of the cost of the property depending on the date that the project begins construction:
| If construction begins: | And is completed before: | The ITC percentage is: |
| Before 2020 | 2024 | 30% |
| During 2020 | 2024 | 26% |
| During 2021 | 2024 | 22% |
| After 2021 | No end date | 10% |
Tax credits like the ITC provide a dollar-for-dollar offset against current tax liability. This makes tax credits more valuable than depreciation or other business deductions.
The tax code does not provide guidance on what it means to “begin construction” for Section 48 purposes. However, in 2018, the Internal Revenue Service released administrative guidance in the form of IRS Notice 2018-59 (the Notice). This Notice closely follows prior IRS guidance released in interpretation of a similar start of construction requirement for demonstrating eligibility for the Section 45 production tax credit, which is similarly subject to phaseout over time.1 The Notice provides two methods for taxpayers to establish when construction begins for solar energy property. The taxpayer can (i) commence “physical work of a significant nature” (the Physical Work Test), or (ii) pay or incur at least five percent of the total cost of the eligible basis of the property (the 5% Safe Harbor). Both methods require that a taxpayer make continuous progress towards completion of the project once construction has begun, albeit using slightly different requirements. Construction will be deemed to have begun on the date the taxpayer first satisfies one of these two tests.
Leading solar developers are using these tests to qualify projects for the 30% ITC by beginning construction in 2019 in a manner that satisfies either the Physical Work Test or the 5% Safe Harbor, notwithstanding that such projects may not be placed in service until as late as 2023.
a. Physical Work Test
As provided in the Notice, construction of the project begins when physical work of a significant nature begins. The IRS focuses on the nature of the work performed, not the amount or the cost. There is no fixed minimum amount of work or monetary percentage threshold required under the Physical Work Test.
Physical work of a significant nature includes on-site work, such as the installation of racks or other structures to affix PV panels, collectors or solar cells, pouring foundations, and building maintenance roads, as well as off-site work, including the manufacturing of custom components, such as transformers, switchgear, and other custom power conditioning equipment. Actual physical construction must begin. Preconstruction and other preliminary activities—like planning or designing, clearing the site, or obtaining permits—will not be considered physical work for purposes of the Physical Work Test. Further, while physical work may include the manufacturing of equipment to be incorporated into a project, it does not include the manufacture of components that are either in existing inventory or are normally held in inventory by a vendor. As such, equipment that is custom-designed for the taxpayer may satisfy the Physical Work Test, but the manufacturing or assembly of “off-the-rack” items will not.
Physical work of a significant nature includes both work performed by the taxpayer and work performed for the taxpayer by third parties, in each case, whether on-site or off-site. If work is performed by third parties, it must be performed pursuant to a “binding written contract” that is entered into prior to the commencement of such work. The Notice is particular on what will be considered a binding written contract for this purpose. For example, it must not be drafted as an option and it must provide for damages in the event of breach or cancellation (although they can be limited to an amount not less than five percent of the total contract price). If the parties modify the contract after it is executed—depending on the extent and nature of these changes—the initial contract may be deemed to have been terminated and replaced with the modified contract. This will be problematic if the taxpayer intended to rely on equipment to be manufactured under the original contract for purposes of satisfying the Physical Work Test, assuming the contract is modified in a later calendar year.
Once the taxpayer commences physical work on the project, the Notice requires that the taxpayer maintain a continuous program of construction until completion of the project. Whether this requirement is satisfied depends on the taxpayer’s facts and circumstances. If physical, on-site construction is not actively taking place, other activities will demonstrate a continuous progress of construction, such as holding weekly meetings to discuss the development and plan of the site and finalizing the design of the site. Further, the Notice provides a lengthy non-exclusive list of permitted disruptions (Excusable Disruptions) that are beyond the taxpayer’s control. Examples include delays due to severe weather or natural disasters, delays in obtaining permits, interconnection-related delays, financing delays, and delays due to supply shortages.
The Notice also provides a safe harbor (the Continuity Safe Harbor), which, if satisfied, relieves the taxpayer of the requirement to demonstrate that it has maintained a continuous program of construction: if the taxpayer places the solar energy property in service by the end of the calendar year that is not more than four calendar years after the calendar year during which construction of the energy property began, then the energy property will be considered to satisfy the Continuity Safe Harbor. As applied, if a solar energy project commenced construction at any time during 2019, as long as the project is completed and placed in service by the end of 2023, it will satisfy the Continuity Safe Harbor, and thus the requirement that the taxpayer has maintained a continuous program of construction.
It is important to remember that neither the Excusable Disruptions nor the Continuity Safe Harbor extends the Section 48 statutory deadline that solar energy property must be placed in service before 2024 to qualify for anything higher than a 10% ITC.
b. 5% Safe Harbor
In addition to the Physical Work Test, the Notice provides an objective “5% Safe Harbor,” pursuant to which construction of solar energy property will be considered as having begun once the taxpayer “pays or incurs” five percent or more of the total cost of the solar energy property. This includes all costs included in the depreciable basis of the solar energy property, including any appropriate development fees allocable to ITC-eligible property. It does not include any costs associated with land or for equipment or property that is not considered integral to the solar energy property (and thus, not ITC-eligible). Unlike the Physical Work Test, the 5% Safe Harbor may be satisfied by purchasing equipment that is held in inventory.
As used in the Notice, the term “paid or incurred” has a specific meaning depending on whether the taxpayer is an accrual method or cash method taxpayer. Cash method taxpayers satisfy the 5% Safe Harbor based on payment: The payment of an expense generally is sufficient to establish that such expense has been paid for cash method taxpayers. Accrual method taxpayers satisfy the 5% Safe Harbor based on when the expense accrues for tax purposes: A cost is incurred under the accrual method of accounting in the taxable year during which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. While the first two prongs of this “all-events test” are self-explanatory, the third prong—economic performance—occurs only when the contracted-for service or the contracted-for property is provided to the taxpayer.
The all-events test does not require actual payment of the liability to incur an expense. That said, if an accrual method taxpayer pays for contracted-for services or property and reasonably expects that such services or property will be provided within 3 1/2months of the date of such payment, then the cost may be considered to have been incurred as of the date of payment, notwithstanding that economic performance has not yet occurred. This exception is a sub-method of accounting known as the “3½-month rule” and is available to accrual method taxpayers provided they employ the rule consistently.
Similar to the Physical Work Test, once the 5% Safe Harbor is satisfied, the taxpayer must demonstrate continuous efforts to advance towards completion of the energy property. The Notice provides the following facts and circumstances indicating continuous efforts: (i) paying or incurring additional amounts included in the total cost of the solar energy property, (ii) entering into binding written contracts for the manufacture, construction, or production of components of property or for future work to construct the property, (iii) obtaining required permits, and (iv) performing physical work of a significant nature that would satisfy the Physical Work Test.
The continuous efforts requirement under the 5% Safe Harbor benefits from the Excusable Disruptions in the same way as the Physical Work Test. More importantly, the requirement also benefits from the Continuity Safe Harbor. Specifically, as long as the project is completed by the end of the fourth calendar year after the calendar year during which construction begins, the taxpayer will satisfy the Continuity Safe Harbor and thus, will be deemed to have satisfied the continuous efforts prong of the 5% Safe Harbor.
c. Energy Property Requirement
The Physical Work Test and the 5% Safe Harbor may only be satisfied by starting physical work or purchasing tangible property that is considered energy property eligible for ITC under Section 48 of the code. Solar energy property for ITC purposes is comprised of all components of the solar farm that are functionally interdependent and necessary to generate electricity from solar. Such property includes PV panels, mounting equipment, support structures, tracking andmonitoring equipment, transformers, inverters, and other power conditioning equipment. It also includes related items necessary to operate the solar farm, like maintenance roads, but not roads used primarily for access to the site or for employee or visitor vehicles. Like other tangible property, batteries may be considered solar energy property if they are integrated into the solar farm and otherwise are integral to solar energy generation.2 Fencing, landscaping, and similar items arguably are not considered integral to electricity generation and thus will not likely be considered solar energy property.
d. Transfers of Energy Property
The Notice provides taxpayers with much flexibility in allocating ITC eligible equipment to projects, even if the placement of that equipment has not been determined definitively at the time the equipment is acquired. For example, the Notice permits a taxpayer to begin construction of solar energy property with the intent to develop such property at a certain site, and thereafter transfer components of such property to a different site, where it is eventually placed into service. In this case, the work performed or the amounts incurred prior to the transfer may be taken into account for purposes of satisfying the Physical Work Test or the 5% Safe Harbor. Further, a taxpayer may transfer ITC-eligible equipment to an affiliate (an entity in which the taxpayer maintains more than 20% ownership) while maintaining ITC eligibility.3 This flexibility allows, for example, a taxpayer to manufacture or acquire property in 2019 in a manner that satisfies either the Physical Work Test or the 5% Safe Harbor and then later combine that property with one or more projects acquired in the future through a special purpose subsidiary, thereby establishing 2019 ITC eligibility for those future acquired projects, assuming such projects will be placed in service before the end of 2023.
Solar energy property will lose its ITC eligibility if such property is transferred to an unrelated third party—the IRS refuses to support the trafficking in ITC-eligible property. That said, ITC eligibility will be preserved if the taxpayer transfers that property as part of a project (i.e., with project rights, such as site control, an interconnection, and a PPA). Put another way, the Notice prohibits a sale of equipment, but permits a sale of a project which includes that equipment.
II. Best Practices
Within each strategy, there are certain recommended best practices to ensure that the beginning construction requirement will be respected by tax equity investors and other financing partners.
a. Physical Work of a Significant Nature
While the Notice requires no minimum amount of work, tax equity investors typically will want to see a material amount of work performed. As a best practice, we recommend satisfying the Physical Work Test by performing multiple activities—any one of which could satisfy the minimum requirements set forth in the Notice—as this provides some level of assurance that the activities will be accepted by tax equity and financing partners.
In the case of on-site physical work, sponsors will typically start construction of maintenance roads. Such work must include more than simply bulldozing or site preparation. However, the roads do not need to be completed to demonstrate construction commencement. To satisfy tax equity’s imposed “materiality” requirement, we will typically see the entirety of the roads staked and bulldozed, with gravel or other road surface started over at least 15% of the linear road distance. For example, if upon completion the maintenance roads represent 1,000 linear feet, we will typically see gravel or other road surface started on at least 150 linear feet.
In the case of physical work performed off-site, while work started on any item of custom equipment should satisfy the Physical Work Test, we typically see sponsors commencing work on custom-designed transformers, which the Notice expressly mentions as energy property. That said, starting on other items of custom equipment, such as custom-designed switchgear, will also satisfy the Physical Work Test. What matters here is that the equipment could under no circumstances be considered as inventory. Once again, materiality will matter to a tax equity investor. Starting construction on a custom-designed subcomponent costing only a few thousand dollars is unlikely to satisfy tax equity investors, notwithstanding that such work may satisfy the Notice requirements.
As a best practice, the entirety of the item ordered under the contract should be completed in the ordinary course. In other words, if a transformer typically takes six months to complete, the transformer ordered under the contract should be completed in a similar timeline. However, this is not a Notice requirement and in fact is contrary to the existence of the Continuity Safe Harbor, which accepts work interruptions. Rather, this is a condition that has been imposed by some conservative tax equity investors. While we have seen many projects financed that have not satisfied this tax equity-imposed condition, we recommend preclearing with tax equity if work interruptions under the contract are desired.
b. 5% Safe Harbor
The cost to construct and/or purchase solar energy property will count towards satisfaction of the 5% Safe Harbor. We typically see sponsors purchase modules in bulk and then allocate them to projects in sufficient amount such that they represent at least 5% of the ITC-eligible basis of the projects into which they are incorporated. As a best practice, we recommend being overinclusive (at least 7%) to allow for unexpected cost overruns.
There is no reason that modules should be considered the only type of equipment available to satisfy the 5% Safe Harbor. For example, racking components and other ITC-eligible equipment may be purchased in bulk. That said, we do not recommend purchasing raw materials (like steel) even though it may eventually be incorporated into the project. While we are not aware of the IRS reviewing these types of purchases, because materials at this stage do not yet resemble ITC-eligible equipment, we believe it is unlikely that a 5% Safe Harbor strategy focused on raw materials purchases will be accepted by the IRS or tax equity.
As a best practice, we recommend satisfying the 5% Safe Harbor through purchases of equipment as opposed to payment for services performed, unless it is clear that the services will be completed during the year of payment (or within 3 1/2 months of payment, if relying on the 3½-month rule). We say this because contracted-for services are not considered as satisfying the all-events test until after the services are completed in their entirety.
c. Transferring Safe-Harbored Equipment (either by sale or through a tax equity transaction)
Whether it is selling a project to a third party or entering into a tax equity partnership, a developer will typically want to ensure that any transfer of property preserves ITC eligibility.
In the case of a sale to a third party, it is important to ensure that a “project” is transferred, as opposed to simply ITC-eligible property. The Notice does not identify the minimum requirements for something to be considered a project. As a best practice, we believe that a project should be considered as consisting of at least site control and an interconnection. Paired with these intangibles, the transfer of ITC-eligible property will preserve eligibility for the project.
In the case of a tax equity partnership, typically the timing of a tax equity investor coming in at mechanical completion obviates any concerns of preserving eligibility. That said, a sponsor should ensure that it maintains evidence of ITC eligibility and makes these records available on its data site, as this will be an important diligence item for tax equity to review. As a best practice, a sponsor may want to obtain a memorandum from its tax counsel confirming ITC eligibility. This memorandum would be included in the records made available to tax equity and will serve as a roadmap for tax equity’s diligence.
1 See IRS Notices 2013-29, 2013-60, 2014-46, 2015-25, 2016-31, 2017-14, and 2018-59. These notices developed start of construction rules over time primarily for wind development and provide excellent precedent for interpreting Notice 2018-59.
2 ITC eligibility for batteries is subject to special conditions, a discussion of which is beyond the scope of the memorandum.
3 Note that special “disguised sale” rules police affiliate transfers followed shortly thereafter by a sale of the sponsor’s interest in the affiliate.
