On April 15, 2013, the Internal Revenue Service (IRS) issued Notice 2013-29 (Notice) to provide guidance on what it means to begin construction with respect to a qualified facility for purposes of the production tax credit (PTC) under section 45(d) of the Internal Revenue Code of 1986, as amended (Code), and the investment tax credit (ITC) under section 48(a)(5) of the Code with respect to certain renewable energy. The guidance provides two methods for taxpayers to establish the beginning of construction—demonstrating physical work of a significant nature or satisfying a 5 percent safe harbor.
Section 407 of the American Taxpayer Relief Act of 2012 extended until January 1, 2014, the PTC and ITC for electricity produced from certain renewable resources provided in section 45(d) of the Code. In passing the extension, the U.S. Congress also changed the timing requirement for a qualified facility to be eligible to receive the PTC or ITC such that the qualified facility must begin construction of such facility before January 1, 2014.
Under the Notice, a taxpayer may establish that construction has begun either by demonstrating that physical work of a significant nature has begun or by satisfying a 5 percent safe harbor. As anticipated, these methods are similar to the guidance issued by the U.S. Department of Treasury with respect to the grant program under section 1603 of the American Recovery and Reinvestment Act of 2009 (Section 1603 Grant). However, there are a few distinctions, as discussed in more detail below. With respect to the safe harbor, the Notice provides that a taxpayer, in addition to satisfying the safe harbor amount, must make continuous efforts to advance completion of the qualified facility, a provision that was not required with respect to the Section 1603 Grant safe harbor. Additionally, the Notice has a different standard from the Section 1603 Grant program for the definition of binding contract for purposes of the safe harbor. The Notice also provides a favorable outcome for certain taxpayers in the event of cost overruns under the safe harbor such that taxpayers would still be eligible for a portion of the PTC or ITC.
Physical Work of a Significant Nature
Construction of a qualified facility begins when physical work of a significant nature begins. Whether physical work of a significant nature has begun will be determined based on the relevant facts and circumstances. Only physical work of a significant nature with respect to tangible property that is integral to the facility will be considered in determining whether construction has begun on a facility. Thus, property integral to the production of electricity is included, but not property used for the transmission of electricity. However, power conditioning equipment, such as a transformer that steps up the voltage of electricity produced at a facility to the voltage necessary for transmission, is an integral part of the facility. In addition, onsite roads used for moving materials for processing or for transporting equipment to operate and maintain the qualified facility are integral to the activity of the facility such that construction of such roads constitutes physical work of a significant nature with respect to the facility. However, access roads or roads used primarily by employee or visitor vehicles are not integral to the facility, and construction of these roads will not be treated as physical work of a significant nature. Fencing and buildings also generally are not treated as an integral part of the facility. However, a structure that is essentially an item of machinery or equipment, or a structure that houses property that is integral to the activity of the facility, will not be treated as a building for this purpose.
On- and Off-Site Work
Onsite and off-site work may be taken into account to demonstrate that physical work of a significant nature has begun. For example, with respect to a wind energy facility, onsite physical work of a significant nature begins with the beginning of the exaction for the foundation, the setting of anchor bolts into the ground or the pouring of the concrete pads of the foundation. If work is performed off-site, the work can be performed either by the taxpayer or by another person for the taxpayer pursuant to a binding written contract. If off-site work includes the manufacture of components for the taxpayer pursuant to a binding written contract, physical work of a significant nature begins off-site at the manufacturing location, provided the components are not normally held as inventory by the manufacturer.
In order for work performed off-site pursuant to a binding written contract to be taken into account, the contract must be entered into prior to the start of such work. A contract is binding only if it is enforceable under local law against the taxpayer (or a predecessor) and the contract does not limit damages to a specified amount (for example, by including a liquidated damages provision). In contrast, under the Section 1603 Grant, a contract is binding as long as the liquidated damages provision in the contract does not limit damages to less than 5 percent of the total contract price. The IRS is aware that there is an issue related to liquidated damages in the Notice and is actively discussing the matter. However, it is unclear whether this change was intentional and whether the IRS will make any changes to the Notice to remedy this issue.
Moreover, a taxpayer can assign such binding written contract to an affiliated special purpose entity that will own the qualified facility for which such property is to be used, and work performed under the contract may be taken into account in determining when physical work of a significant nature has begun.
Physical work of a significant nature, however, does not include preliminary activities, even if the cost of such activities is properly included in the depreciable basis of the facility. Such preliminary activities include planning or designing; securing financing; exploring; researching; obtaining permits; licensing; conducting surveys and environmental and engineering studies; clearing a site; test drilling a geothermal deposit; test drilling to determine soil condition; excavating to change the contour of the land (as distinguished from excavation for footings and foundations); and removing existing wind turbines and towers.
Multiple Facilities as a Single Project
Like the Section 1603 Grant, with respect to the qualified facility, the Notice provides that, solely for determining whether construction of a facility has begun for purposes of the PTC and the ITC, multiple facilities that are operated as part of a single project will be treated as a single facility. This distinction is important in the context of wind facilities so that taxpayers may begin work on part of a large project without beginning work on each individual facility and meet the requirements to begin construction. Whether multiple facilities are operated as part of a single project depends on the relevant facts and circumstances. Factors indicating operation as a single project include, but are not limited to, whether the facilities (i) are owned by a single legal entity, (ii) are constructed on contiguous pieces of land, (iii) are described in a common power purchase agreement or a common environmental or other regulatory permit, (iv) have a common intertie, (v) share a common substation, (vi) were constructed pursuant to a single master construction contract and (vii) were financed pursuant to the same loan agreement.
A taxpayer also must maintain a continuous program of construction that involves continuing physical work of a significant nature. However, certain disruptions in construction that are beyond the taxpayer’s control will not be considered as indicating that the taxpayer failed to maintain continuous construction. The Notice provides more detailed examples of such disruptions than were articulated in the Section 1603 Grant guidance. The disruptions that are considered beyond the taxpayer’s control include, but are not limited to, the following:
- Severe weather conditions
- Natural disasters
- Licensing and permitting delays
- Delays at the written request of a state or federal agency regarding safety, security or similar concerns
- Labor stoppages
- Inability to obtain specialized equipment of limited availability
- The presence of endangered species
- Financing delays of less than six months
- Supply shortages
Like the Section 1603 Grant, the Notice provides for a 5 percent safe harbor. Under the safe harbor, construction of a qualified facility will be considered as having begun before January 1, 2014, if a taxpayer pays or incurs (within the meaning of Treas. Reg. section 1.461-1(a)(1) and (2)) 5 percent or more of the total cost of the facility before such date, and thereafter the taxpayer makes continuous efforts to advance toward completion of the facility. However, unlike the grant program, the IRS imposed a continuous efforts requirement for the safe harbor and included a taxpayer-favorable provision related to cost overruns.
All costs properly included in the depreciable basis of the facility are taken into account to determine whether the safe harbor has been satisfied. However, the cost of land or any property not integral to the facility is not included. In addition, solely for purposes of applying the Notice, costs incurred with respect to property that is manufactured, constructed or produced for the taxpayer by another person pursuant to a binding written contract are deemed incurred by the taxpayer when the costs are incurred by the other person under the principles of section 461.
As noted previously, in contrast to the Section 1603 Grant, the Notice requires that in order to satisfy the 5 percent safe harbor, a taxpayer must make continuous efforts to advance toward completion of the facility. Whether a taxpayer makes continuous efforts will be determined under a facts-and-circumstances test. Facts and circumstances indicating such continuous efforts may include, but are not limited to, the following:
- Paying or incurring additional amounts included in the total cost of the facility
- Entering into binding written contracts for components or future work on construction of the facility
- Obtaining necessary permits
- Performing physical work of a significant nature
Certain disruptions that are beyond the taxpayer’s control will not be considered as indicating that a taxpayer has failed to make continuous efforts to advance toward completion of the facility. Examples of such disruptions are the same as the disruptions described previously with respect to the continuous construction requirement to demonstrate physical work of a significant nature.
With respect to a single project composed of multiple facilities, the Notice provides that if the actual cost of the project exceeds the anticipated cost such that the safe harbor amount is less than 5 percent of the total cost of the facility at the time the facility is placed in service, the safe harbor is not fully satisfied. However, the safe harbor will be satisfied, and the PTC or ITC may be claimed with respect to some, but not all, of the individual facilities comprising the single project, as long as the total aggregate cost of the individual facilities is not more than 20 times greater than the amount the taxpayer paid or incurred before January 1, 2014, under the safe harbor. This provision is a common-sense solution to cost overruns that gives taxpayers the benefit of the PTC and ITC to the extent of the 5 percent safe harbor rather than potentially causing the taxpayer to fail to meet the safe harbor standard with respect to the entire project. However, if the total cost of a single facility that is not a single project composed of multiple facilities exceeds the anticipated total cost such that the safe harbor amount is less than 5 percent of the total cost of the facility at the time the facility is placed in service, the taxpayer will not satisfy the safe harbor.
Two examples in the Notice illustrate this rule. In the first example, a taxpayer incurs $25,000 in 2013 to construct a five-turbine wind farm that will be operated as a single project, with an anticipated cost of $100,000 for each turbine, and a total cost for the facility of $500,000. The taxpayer makes continuous efforts to complete the facility. When the wind farm is placed in service, the actual total cost of the facility is $600,000, with each turbine costing $120,000. The example states that although the taxpayer did not pay or incur 5 percent of the actual cost of the facility before January 1, 2014, the taxpayer will be treated as satisfying the safe harbor with respect to four of the turbines, with an actual cost of $480,000. Thus, the taxpayer may claim the PTC for electricity produced from four of the turbines, or the ITC based on $480,000. However, if physical work of a significant nature began prior to January 1, 2014, with respect to the single project, the taxpayer can claim the PTC or the ITC on the full project (i.e., five turbines).
In the second example, a taxpayer incurs $25,000 in 2013 to construct an open-loop biomass facility. The taxpayer anticipates the total cost of the facility will be approximately $500,000. The taxpayer makes continuous efforts to advance toward completion of the facility. When the facility is placed in service, the actual total cost of the facility is $600,000. The example holds that because the facility is a single facility, the taxpayer cannot satisfy the safe harbor. However, if physical work of a significant nature began with respect to the facility before January 1, 2014, the taxpayer may be able to claim the PTC or the ITC with respect to the entire facility.
This IRS guidance was highly anticipated and generally will be considered favorable by many taxpayers, because it gives some certainty and answers many of the industry questions regarding whether projects will be able to meet the standards for beginning of construction. Additionally, since the Notice regarding beginning of construction is similar to guidance that was issued for the Section 1603 Grant, taxpayers generally will be familiar with the requirements, except for the distinctions noted previously. As noted previously, the IRS is aware of the issue in the Notice regarding liquidated damages in a binding contract and is actively discussing the matter. At this time, it is unclear whether the IRS will make any change to the Notice to remedy the issue. However, don’t expect this to be the end of the story—taxpayers will continue to have questions and will require additional details with respect to these rules.