Background
The eligibility to qualify for federal tax credits for facilities producing energy from wind, biomass, municipal solid waste, and certain other qualified energy sources changed at the end of 2012 with the passage of the American Taxpayer Relief Act of 2012 (ATRA). Prior to the enactment of ATRA, to qualify for PTC, an otherwise eligible facility was required to be “placed in service” (meaning, completed) before January 1, 2014, except for qualified wind facilities, which had to be placed in service before January 1, 2013. ATRA modified section 45 of the Tax Code to extend the PTC for wind facilities through 2013. This change also extended the ability of these projects to qualify for the energy investment tax credit (ITC) under section 48 of the Tax Code through an election to claim ITC as opposed to PTC. These changes do not implicate projects eligible for ITC that do not require an election.
As a nod to the lengthy development schedule for wind and other qualifying facilities, ATRA changed the eligibility criteria by replacing the placed-in-service standard with the requirement that the taxpayer must “begin construction” of its otherwise qualifying facility before January 1, 2014. Basing eligibility for PTC (and thus, ITC) on construction commencement for otherwise qualifying facilities is similar to the eligibility requirements that were relevant under the popular 1603 cash grant program that expired at the end of 2011. Under the 1603 program, the U.S. Department of Treasury issued comprehensive guidance regarding satisfying the beginning of construction requirement (1603 Guidance). Since ATRA changed the standard for eligibility, developers and their advisors familiar with the 1603 cash grant program have been left guessing whether the IRS would issue guidance that followed the 1603 Guidance or rather would adopt a new benchmark for eligibility.
Notice 2013-29 closely resembles the 1603 Guidance. However, it also includes certain deviations that will be important to developers and others seeking to ensure that otherwise qualified projects will be eligible for federal tax credits.
Methods for Establishing Construction Commencement
Similar to the 1603 Guidance, Notice 2013-29 provides two methods that a taxpayer may use to establish that construction of an otherwise qualified facility has begun. One (and only one) of the following must be satisfied:
(1) Actual Physical Activity. The taxpayer will satisfy the construction commencement requirement if “physical work of a significant nature” has started on the facility (Physical Work Method). Physical work of a significant nature includes any physical work on the project, whether performed on-site or off-site. It also includes physical work under a binding written contract with another person (for example, a vendor), provided the contract is entered into prior to the work taking place. While any physical work on the project will be treated as the beginning of construction (even if such work relates to only a small part of the facility), the IRS will closely scrutinize any construction activity that does not involve a continuous program of construction. In other words, once physical work begins on the subject project, it should continue through completion of construction. This method of satisfying construction commencement is similar to the physical work method as set forth in the 1603 Guidance.
In determining whether construction is continuing, Notice 2013-29 provides that events beyond the taxpayer’s control will be taken into account by the IRS, including: (i) severe weather conditions; (ii) natural disasters; (iii) licensing and permitting delays; (iv) delays at the written request of a state or federal agency regarding matters of safety, security, or similar concerns; (v) labor stoppages; (vi) inability to obtain specialized equipment of limited availability; (vii) the presence of endangered species; (viii) financing delays of less than six months; and (ix) supply shortages (Disruptive Factors). This Notice makes clear that these factors are not intended to encompass all possible Disruptive Factors that will be considered by the IRS and further, that the evaluation regarding whether a project’s construction is continuous is subject to an analysis of the relevant facts and circumstances. As such, we expect that the IRS will look at some of the Disruptive Factors and consider whether the taxpayer intentionally caused the delay of the project by, for example, failing to comply with the permit application process — a scenario that the IRS would obviously view as a negative factor in making its determination.
Consistent with the 1603 Guidance, Notice 2013-29 makes clear that to satisfy the Physical Work Method, only physical work performed with respect to tangible personal property and other tangible property used as an integral part of the qualifying energy project will be considered for purposes of determining whether a taxpayer has begun construction of a facility. This includes property integral to the production of electricity, but does not include property used for electrical transmission.
Notice 2013-29 provides the following clarifications that are helpful to taxpayers seeking to demonstrate construction commencement through the Physical Work Method. Most of these also were included in the 1603 Guidance:
- Physical work of a significant nature does not include preliminary activities such as planning or designing, securing financing, exploring, researching, obtaining permits, licensing, conducting surveys, environmental and engineering studies, clearing a site, test drilling of a geothermal deposit, test drilling to determine soil condition, or excavation to change the contour of the land (as distinguished from excavation for footings and foundations).
- Removal of existing turbines and towers is preliminary work and does not constitute physical work of a significant nature with respect to the facility.
- Starting work on roads on the site is physical work of a significant nature if such roads are integral to the qualified facility (such as roads used for equipment to operate and maintain the facility). Roads used primarily for access to the site, or roads used primarily for employee or visitor vehicles are not integral to the activity performed by the facility and thus do not demonstrate that construction has commenced.
- Physical work on a custom-designed transformer that steps up the voltage of electricity produced by the facility to the voltage needed for transmission is physical work of a significant nature with respect to the facility because power conditioning equipment is an integral part of the activity performed by the facility.
- Generally, buildings and fencing are not integral parts of the facility because they are not integral to the activity of the facility. As such, beginning the construction of buildings or fencing does not demonstrate that construction has commenced. However, the following are not treated as buildings for this purpose: (i) a structure that is essentially an item of machinery or equipment, or (ii) a structure that houses property that is integral to the activity of the facility if the use of the structure is so closely related to the use of the housed property that the structure clearly can be expected to be replaced when the property it initially houses is replaced. The construction of structures that are not treated as buildings under this standard may demonstrate that construction has commenced on the facility.
- As stated above, the taxpayer may rely on physical work performed by another person under a binding written contract to satisfy the Physical Work Method. However, work performed either by the taxpayer or by another person under a binding written contract does not include work to produce property that is either in existing inventory or is normally held in inventory by a vendor.
- Under a binding written contract, if a manufacturer produces components for multiple facilities, a reasonable method must be used to associate individual components with particular facilities.
- If a taxpayer enters into a binding written contract for a specific number of components to be manufactured (a master contract) and then through a new binding written contract (a project contract) the taxpayer assigns its rights to certain components to an affiliated special-purpose entity (like a new LLC) that will own the project for which such property is to be used, work performed with respect to the master contract may be taken into account in determining when physical work of a significant nature begins with respect to the facility. Similar to the 1603 Guidance, Notice 2013-29 fails to define the requisite common ownership or control necessary in order for a special-purpose entity to be considered “affiliated” to the taxpayer. We also note that Notice 2013-29 does not address how the IRS will treat entities disregarded for federal income tax purposes. We expect that transfers to disregarded entities would be ignored for purposes of satisfying the Physical Work Method.
(2) Actual Expenditure. Similar to the 1603 Guidance, Notice 2013-29 provides an alternative to demonstrating actual physical activity based on the taxpayer’s payment or incurrence of costs to construct the project. Specifically, a taxpayer may satisfy the construction commencement condition by demonstrating that it has paid or incurred five percent or more of the total cost of energy property included in the project prior to the end of 2013 (5% Safe Harbor). However, Notice 2013-29 includes a second condition not found in the 1603 Guidance that must be satisfied in order to meet the 5% Safe Harbor. In addition to paying or incurring a sufficient amount of costs to satisfy the 5% Safe Harbor, the taxpayer also must demonstrate that after such costs are paid or incurred, the taxpayer makes continuous efforts to advance towards completion of the facility. The inclusion of this second condition means that, unlike the five percent safe harbor under the 1603 Guidance, the 5% Safe Harbor under Notice 2013-29 includes a subjective component and as such, creates uncertainty for the taxpayer regarding whether the IRS will consider the 5% Safe Harbor satisfied.
Notice 2013-29 provides the following guidance to assist taxpayers in satisfying the 5% Safe Harbor:
- Only costs that are included in the eligible basis of the tangible property considered integral to the facility are taken into account in determining if the 5% Safe Harbor has been satisfied. The cost of land is not included in this determination.
- Whether a taxpayer has “paid” or “incurred” an expense depends on the method of accounting the taxpayer uses for tax purposes. Note that for cash method taxpayers, the payment of an expense (for example, making a nonrefundable deposit) generally is sufficient to establish that such expense has been “paid.” In contrast, for accrual method taxpayers, mere payment of an expense generally is insufficient for the expense to have been “incurred.” Rather, a cost is incurred for tax purposes when (1) the fact of the liability is fixed, (2) the amount of the liability is determinable with reasonable accuracy, and (3) economic performance has occurred; that is, the contracted-for services or property have been provided to the taxpayer. While not stated expressly in Notice 2013-29, cross-references to the Treasury Regulations describing the accrual method of accounting indicate that a taxpayer will be entitled to satisfy the economic performance requirement if the taxpayer pays for such services or property and reasonably expects such services or property to be provided within
3 ½ months of payment. To benefit from this 3 ½ month rule, the taxpayer must adopt it as a sub-method of accounting and consistently apply the rule. This is similar to the 1603 Guidance. - Notice 2013-29 provides a special rule for property that is manufactured, constructed, or produced for the taxpayer by another person under a binding written contract that is entered into prior to the manufacture of the property at issue. In this case, for periods before the property is delivered to the taxpayer, costs incurred by the other person with respect to the property are treated as costs that are incurred by the taxpayer at the time these costs are incurred by the other person. This is similar to a special rule included in the 1603 Guidance. However, unlike the 1603 Guidance, which allowed this rule to apply where such other person “paid” or “incurred” such costs, the look-through rule for economic performance included in Notice 2013-29 appears to be limited in application to accrual method taxpayers.
- Whether a taxpayer makes continuous efforts to advance towards completion of the facility will be determined by an analysis of the relevant facts and circumstances. Notice 2013-29 provides the following examples of facts and circumstances indicating continuous efforts to advance towards completion of the facility: (i) paying or incurring additional amounts included in the total cost of the facility; (ii) entering into binding written contracts for components or future work on construction of the facility; (iii) obtaining necessary permits; and (iv) performing physical work of a significant nature (as described under the Physical Work Method, above).
- The 5% Safe Harbor mirrors the language included in the Physical Work Method regarding disruptions to that taxpayer’s continuous efforts to advance towards completion of the facility that are beyond the taxpayer’s control. That is, Disruptive Factors will not be considered as indicating that a taxpayer has failed to make continuous efforts to advance towards completion of the facility.
- The 5% Safe Harbor contains a special rule regarding its application to a project comprising multiple facilities. In this scenario, if the total cost of the project exceeds its anticipated total cost, so that the amount a taxpayer actually paid or incurred with respect to the project before January 1, 2014 is less than five percent of the total cost of the project at the time it is placed in service, the taxpayer may nevertheless satisfy the 5% Safe Harbor with respect to some, but not all, of the individual facilities comprising the single project, as long as the total aggregate cost of those individual facilities is not more than 20 times greater than the amount the taxpayer paid or incurred before January 1, 2014. However, if the facility is not a single project comprising multiple facilities, and cannot be separated into smaller facilities, then the taxpayer will not satisfy the 5% Safe Harbor with respect to any portion of the facility. Notice 2013-29 provides helpful examples to better understand how cost overruns are considered under the 5% Safe Harbor.
Treatment of a Facility With Multiple Components as a Single Project
As is suggested in the discussion above regarding the handling of cost overruns when applying the 5% Safe Harbor, Notice 2013-29 provides detailed guidance regarding multiple facilities that are operated as a single project. This is similar to the treatment of these facilities under the 1603 Guidance.
It is important that Notice 2013-29 addresses the issue of a single project that includes multiple facilities because a “facility” for purposes of section 45 of the Tax Code generally includes all components of property that are functionally interdependent. As is indicated in Notice 2013-29 as well as in prior guidance, the IRS has interpreted this as meaning that each electricity-generating wind turbine, its tower, and its supporting pad together comprises a single facility for tax purposes, as it can be separately operated and metered and can begin producing electricity separately.
Notice 2013-29 provides that, solely for the purposes of determining whether construction of a facility has begun for purposes of PTC and ITC, multiple facilities that are operated as part of a single project will be treated as a single facility. For example, a wind farm that includes 50 wind turbines should constitute a single project for purposes of establishing construction commencement. That said, Notice 2013-29 makes clear that whether multiple facilities are operated as part of a single project will be subject to an analysis of the relevant facts and circumstances. As indicated in the Notice, factors indicating that multiple facilities are operated as part of a single project include, but are not limited to, the following: (i) the facilities are owned by a single legal entity, (ii) the facilities are constructed on contiguous pieces of land; (iii) the facilities are described in a common power purchase agreement (or agreements); (iv) the facilities have a common intertie; (v) the facilities share a common substation; (vi) the facilities are described in one or more common environmental or other regulatory permits; (vii) the facilities were constructed pursuant to a single master construction contract; and (viii) the construction of the facilities was financed pursuant to the same loan agreement.
By allowing a project comprising multiple facilities to be treated as a single project for purposes of construction commencement, Notice 2013-29 provides taxpayers with comfort on satisfying this standard. However, by making the application of this standard subject to a facts and circumstances analysis, taxpayers will remain exposed to the subjective determination of the IRS regarding the application of this rule. We expect that most wind developers will take comfort that a wind farm containing multiple turbines will be considered a single project for the purpose of demonstrating construction commencement. However, developers constructing projects utilizing other energy sources may be left with questions regarding how the IRS will make its determination.
Conclusion
The changes in eligibility for wind and other relevant alternative energy projects from a placed-in-service to a begin-construction standard provides developers the ability to pursue projects this year with the knowledge that such projects should qualify for PTC or ITC notwithstanding that the projects are completed after 2013. However, the end-of-the-year deadline also underscores the importance of taking actions today to ensure that an otherwise qualifying energy project will be eligible for these benefits. For projects currently on the drawing board, developers need to make sure that they are taking sufficient actions now in order to demonstrate that construction of their projects has begun in 2013, either by satisfying the Physical Work Method or the 5% Safe Harbor.
Both the Physical Work Method and the 5% Safe Harbor closely resemble the standards provided under the 1603 Guidance. However, the inclusion in the 5% Safe Harbor of a requirement that the taxpayer must make continuous efforts to advance towards completion of the facility imposes a subjective condition on an otherwise objective test. It also suggests that, unlike the 1603 cash grant program, taxpayers will not be able to stockpile energy property during 2013 in order to qualify future projects for the PTC or ITC without attracting the attention of the IRS.
By treating a project comprising multiple facilities as a single project for purposes of satisfying the continuous construction requirement, Notice 2013-29 provides a workable solution for wind farms. Taxpayers developing projects that include multiple components that rely on energy sources other than wind will have less comfort, as the determination regarding whether the project should be considered a single project for PTC and ITC is based on a facts and circumstances analysis.
Other than with respect to assigning components ordered under a master contract to an affiliated special-purpose entity, Notice 2013-29 does not include the extensive “successor-in-interest” rules that are an important component of the 1603 Guidance. This Notice does not indicate whether additional guidance will be released addressing this issue.
All that said, Notice 2013-29 provides taxpayers with the guidance necessary to move forward on otherwise qualified projects. By being attentive to the construction commencement requirements set forth in this Notice, taxpayers may qualify these projects for the PTC or ITC.
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED TO OR WRITTEN BY FOLEY AND LARDNER LLP TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax advisor.
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John A. Eliason
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