If You Build It, They Will Come: Satisfying the ITC’s Start of Construction Requirement
Although largely untouched by the Tax Cuts and Jobs Act (TCJA) (click here for more), renewable energy tax credits experienced some important developments in 2018, including the release of IRS Notice 2018-59 (the Notice) in June. The Notice clarified certain aspects of the Bipartisan Budget Act of 2018 (the BBA) affecting the Investment Tax Credit (ITC) and focused on the two methods taxpayers may use to satisfy the start of construction requirement found in Code Section 48(a)(5)(C) and modified by the BBA; these methods closely resemble those used to satisfy the same requirements necessary to qualify for the Production Tax Credit (PTC) under Code Section 45(b)(5)(A).
The ITC provides producers of certain types of alternative energy with a credit equal to a specified percentage of the tax basis in their “energy property” (discussed at greater length below). In 2015, the Protecting Americans from Tax Hikes Act (the PATH Act) extended the period of time for which certain technologies, including utility-scale wind, solar and geothermal, may claim the ITC. Certain “orphaned technologies” were excluded, including fiber-optic solar, qualified fuel cells, small wind (defined as having a nameplate capacity of 100 kilowatts or less), geothermal heat pumps and combined heat and power systems (CHP); as a result, affected taxpayers had to place energy property into service by January 1, 2016 (or 2017 in limited circumstances) to qualify for the ITC (click here for more). Subsequently, the BBA provided extensions to these orphaned technologies, creating an even playing field vis-à-vis their solar and geothermal counterparts — preventing any shift in business, and related research and development, away from these technologies that could have resulted from the inability to take advantage of the ITC.
Following the BBA’s passage, technologies utilizing the ITC fall into four categories. The first category, consisting of fiber-optic solar, qualified fuel cells and qualified small wind, must begin construction before January 1, 2022, and place the property into service before January 1, 2024. The Notice also provides for a phase-down of the credit for this category, allowing for a 30 percent credit if construction begins before January 1, 2020, but gradually phasing down to 10 percent if construction begins in the last year, between January 1, 2021 and December 31, 2021. The second category consists solely of solar energy (excluding fiber optic solar), which has the same timeline and phase-down applicable to those technologies in the first category, but also is eligible for a 10 percent ITC with respect to property the construction of which does not start until on or after January 1, 2022 and that is placed into service after January 1, 2024. A third category includes geothermal heat pump, qualified microturbine and CHP technologies. This category has no phase-down, with properties for which construction begins before January 1, 2022, eligible for a 10 percent ITC and no placed-in-service requirement. The final category consists solely of geothermal energy, which has a 10 percent ITC regardless as to when construction begins or the property is placed into service.
The Notice provides two methods that may be used to establish that construction has started by the date required to qualify for the ITC. These methods each consist of two prongs, in each case the first of which is intended to permit the taxpayer to demonstrate that enough progress has been made on the energy property in question so that the taxpayer may claim that construction has started (the Start of Construction Test). Each method also contains a second prong that, once the first prong is deemed to be satisfied, requires the taxpayer to demonstrate continuous progress towards the completion of the property’s construction (the Continuity Requirement). The Notice also defines energy property and describes how and when individual properties may be aggregated or disaggregated for the purpose of applying these tests.
Start of Construction
The first method, referred to as the Physical Work Test, requires (i) the taxpayer to begin physical work of a significant nature and (ii) for the construction to be continuous (discussed below). Notably, there is no set requirement in the first prong regarding the amount of work or the cost incurred. The Notice provides examples of work that would satisfy this first prong, such as installing racks or other structures that can be used to support photovoltaic panels for solar energy projects. Importantly, the Notice carves out both preliminary activities that do not satisfy this prong, such as exploring, securing financing, or obtaining the requisite permits and licenses, as well as the production of energy components to be held in inventory by a vendor instead of being included in the taxpayer’s energy property.
The second method, the Five Percent Safe Harbor, is satisfied if the taxpayer (i) incurs five percent or more of the total cost of the energy property and, once this threshold is crossed, (ii) makes continuous efforts to complete construction on the property (discussed below). When determining whether the five percent threshold in (i) has been met, the IRS will consider all costs properly included in the basis of the energy property, but will not include the cost of land or other property that is not integral to the functioning of the energy property. Importantly, a taxpayer might estimate that the five percent threshold is crossed in time to receive the desired credit percentage; however, if at the time the energy property is placed into service the actual total cost (i.e., the denominator) exceeds the estimated cost of completing construction on the property by an amount such that the five percent threshold was not crossed until a later date, the taxpayer will not be deemed to have satisfied the test.
The Continuity Requirement
As mentioned above, both the Physical Work Test and the Five Percent Safe Harbor include a second prong, the Continuity Requirement. The Continuity Requirement in each test closely resembles the other (thereby creating some confusion among taxpayers not familiar with the tests). In the case of the Physical Work Test, once the significant work has begun, construction must be continuous until the property is completed. In the case of the Five Percent Safe Harbor, the test is modified somewhat to require “continuous efforts” rather than specifically requiring construction. As this latter test is a bit more vague than the former, the Notice provides examples of what may be considered an “effort” in this context, including incurring additional costs, entering into binding contracts for the production of component parts for the property, and obtaining necessary permits. These requirements are not overly strident, however, and examples of permitted disruptions are provided. These include delays due to severe weather or natural disasters, supply shortages or an inability to obtain specialized equipment of limited availability.
Further, a taxpayer will be considered to have satisfied the Continuity Requirement of either test if the energy property in question is placed into service within four years of the start of construction (the Continuity Safe Harbor). If the taxpayer fails to do so, then whether they satisfy the Continuity Requirement will be determined by the relevant facts and circumstances.
Energy Property Defined
For the purposes of both the Physical Work Test and the Five Percent Safe Harbor, an “energy property” is a set of functionally interdependent component parts that independently can produce electricity and be operated and metered separately from other energy property. In the case of solar energy property, these component parts could include photovoltaic panels, support structures, monitoring equipment, transformers and other integral component parts. When determining whether physical work has begun or the five percent threshold has been met, one looks to whether this has occurred with respect to an individual energy property. However, certain facts and circumstances could cause the IRS to consider multiple individual properties to constitute a single energy project and aggregate such properties when determining whether the Start of Construction prong of either test is met. When making the determination to aggregate multiple properties into a single project, the IRS will look at factors such as whether the properties have a single owner, are on the same or contiguous parcels of land, are described in the same energy contracts or regulatory permits or financed or constructed pursuant to a single contract. This could have important implications for the taxpayer by making it more difficult to qualify for the ITC. For example, a taxpayer normally would satisfy the first prong of the Five Percent Safe Harbor once it has incurred five percent of the costs of constructing an energy property. However, if such property is aggregated with a neighboring property with a similar estimated total cost of construction, but with respect to which the taxpayer has only incurred one percent of the costs, then the taxpayer (as a result of averaging) will be deemed to have only incurred three percent of the cost of construction with respect to the aggregated project and thus fail to qualify for the ITC for either property.
Notably, and perhaps somewhat confusingly, multiple individual energy properties aggregated into a single project for purposes of determining when construction began under either the Physical Work Test or the Five Percent Safe Harbor may be disaggregated for purposes of determining whether the Continuity Requirement is met. For example, a taxpayer may own multiple solar energy properties that qualify individually, but due to facts and circumstances, these properties are aggregated into a single project for purposes of determining whether construction has begun. Assume that, unfortunately for the taxpayer, only some of the individual properties that comprise the aggregated project were completed within four years and thus eligible for the Continuity Safe Harbor. Instead of having the aggregated project fail to qualify for the Continuity Safe Harbor (and thereby having to withstand the scrutiny of the IRS’s facts and circumstances analysis), the taxpayer is allowed to disaggregate the properties, with the timely completed properties falling within the Continuity Safe Harbor and eligible for the ITC. The remaining energy properties (not completed within four years) ultimately may satisfy the Continuity Requirement, but will be subjected to the facts and circumstances analysis discussed above.
The Notice also provides further detail on other rules associated with the ITC, all of which serve to bring its treatment more in line with that of the PTC and thus offer greater clarity to energy producers and tax practitioners alike. However, other questions remain regarding the impact this and other recent developments may have on two other components of the renewable energy sector – namely, utility-scale wind and energy storage technology.