Lessons From the Last Rush to Start Construction
The Senate vote last night to let developers of wind, geothermal, biomass, landfill gas, incremental hydroelectric and ocean energy projects claim tax credits on projects on which they start construction by year end has four effects.
The expectation that the Senate would act set off a scramble starting earlier this month to take delivery of additional equipment from wind turbine manufacturers that might be used as a basis to treat more projects as under construction in time as well as a search for excavation and road contractors who can get to work on project sites before year end.
There are a number of lessons to take away from the last rush to start construction at the end of 2013.
The extension is part of a broader tax extenders bill that passed the House on December 3.
The Senate passed the identical bill shortly before adjourning for the year on December 16. President Obama is expected to sign it.
The bill will allow developers to claim 10 years of production tax credits on the electricity output from new projects that are under construction by December 31, 2014. (The previous deadline had been the end of 2013.)
The bill also preserves the option to claim a 30% investment tax credit on the project cost instead of production tax credits. Any investment credit is claimed in full in the year the project is put in service.
The bill extends a 50% depreciation bonus on new equipment put in service by December 31, 2014. (The bonus can also be claimed on some projects that are not completed until December 2015, but only on the tax basis built up through 2014.) The bonus is the ability to deduct 50% of the eligible basis in equipment immediately and deduct the other 50% over the normal depreciation period.
The bonus was originally conceived as a carrot to induce companies to buy more new equipment. It expired at the end of 2013. Extending it at the end of the year retroactively to January 1 makes it little more than a windfall for investments to which companies would already have had to have committed by now.
Congress folded a series of technical corrections to recent tax laws into the extenders bill. One technical correction is important to some renewable energy companies. Congress gave renewable energy developers the option during the period 2009 through 2011 (and longer for projects that were under construction in 2011) to be paid 30% of the project cost instead of claiming tax credits.
This was after the economy collapsed and the tax equity market shut down, making it hard to raise tax equity to finance new projects. The US Treasury acted essentially as the tax equity investor of last resort. Congress made clear that these “section 1603 payments” did not have to be reported as taxable income by recipients of the payments. However, there are two corporate income tax systems in the United States – corporations calculate their regular corporate income taxes and alternative minimum taxes and pay essentially whichever amount is greater – and the law creating the Treasury cash grant program failed to make clear that the section 1603 payments do not have to be reported as income by companies paying alternative minimum taxes.
The tax extenders bill fixes this retroactively as if it had been clear from the start. The Internal Revenue Service had gotten tired of waiting for Congress to fix the statute and was starting to collect taxes from AMT taxpayers.
The most significant effect of extending the deadline to start construction is it should make it easier to claim tax credits on wind, geothermal, biomass, landfill gas, incremental hydroelectric and ocean energy projects that are completed in 2016. Developers should be able to claim tax credits on projects that are completed in 2015 or 2016 without the need to prove that the developer worked continuously on the project.
There are two ways to start construction this year. One is by “incurring” at least 5% of the final project cost. Costs are not incurred merely by spending money. The developer must either take delivery of equipment this year or else pay this year and take delivery within 3 1/2 months after payment. Delivery can be at the factory. The IRS modified the 5% threshold in August 2014 to say that a wind developer who incurs at least 3% of the final project cost can claim tax credits on a fraction of the electricity output or project cost. At 3%, the project would qualify for 60% of the normal tax credits. At 4%, it would qualify for 80%.
The other way to start construction is to commence “physical work of a significant nature” at the project site or at a factory on equipment for the project. The IRS has interpreted the physical work test in a liberal manner so that not much must be done in 2014. However, many tax equity investors have not been as keen to finance projects that rely on physical work.
It is not enough merely to have started construction in time to qualify for tax credits. There must also be continuous work on the project after the construction start deadline. The IRS said in a notice in September 2013 that it will assume there was continuous work on any project that is completed by December 2015.
IRS and Treasury officials are talking about whether to issue a new notice extending the continuous-work presumption through 2016. A preliminary decision should be made shortly, although a new notice could take months.
The IRS takes the position currently that if one turbine at a 50-turbine wind farm slips into 2016, then the developer must prove continuous work on the entire project. The same principle should apply – assuming the IRS extends the continuous-work presumption through 2016 – if one turbine slips into 2017. The IRS gives the developer the benefit of treating the entire project as under construction in time based on incurring a fraction of the cost or starting physical work on a small piece of the project. Therefore, it also treats the project as a single project for assessing at the back end whether the project made it into service in time to benefit from the continuous-work presumption.
Another effect of the extension in the construction start deadline is some developers should be able to start construction of a few more projects by year end. Several larger developers began negotiating in early December to take delivery of more equipment from wind turbine manufacturers. Some manufacturers may have inventory or spare capacity that could be put to use quickly. A recent report by Navigant Research put worldwide demand for wind turbines in 2014 at 47,000 megawatts against a manufacturing capacity of 71,000 megawatts.
Some smaller developers who do not have the money to pay today for equipment are trying to mobilize excavation or road contractors to dig turbine foundations or put in roads on project sites before year end. Weather could be a factor at some sites.
The extension may put developers who relied on the physical work test to start construction of projects in 2013 in a stronger position to persuade tax equity investors and lenders that the physical work is significant if more work was done on the project in 2014 or can be done before year end. The American Wind Energy Association estimated that more than 12,000 megawatts of wind farms were under construction by the end of 2013. There were very rough estimates that at least 4,000 megawatts of these projects relied on the physical work test. The facts varied from one project to the next.
Some larger developers stockpiled equipment in 2013 that could be used in future projects. As long as the equipment actually used amounts to at least 5% of the final project cost and there was continuous work on the project after the construction start deadline, then the project qualifies for tax credits.
The IRS has been concerned about trafficking in 2013 stockpiled equipment. Under IRS rules, Developer A holding such equipment could transfer it to Developer B for use by Developer B as a basis for claiming tax credits, but only if Developer A contributes the equipment for more than a 20% interest in Developer B’s project. The short extension in the construction start deadline opens a very short window for developers holding 2013 equipment to sell it to other developers who can count the costs as incurred 2014 costs in their own right.
A number of lessons should be taken away from the last rush to start construction in 2013.
If at all possible, start construction by incurring costs rather than relying on physical work.
Developers with projects that are not completed until after 2016 will have to prove continuous work to claim tax credits. This is easier to do for projects that rely on the 5% test than for projects that rely on physical work.
A developer must show “continuous efforts” on any project that was under construction based on incurred costs. He or she must show “continuous construction” for any project that was under construction based on physical work. “Continuous efforts” contemplate that the project can still be merely under development; thus, development-type tasks like working to secure permits, a project site and an interconnection agreement and negotiating with vendors, financiers and construction contractors count as continuous efforts.
“Continuous construction” contemplates that a project is truly under construction. This may be hard to do for a wind farm on land with a normal construction period of six to eight months if the project is not completed until 2017 or later.
Anyone relying on continuous efforts should document the effort. The development team should come in every Monday morning and ask what it can do that week to advance the project, work at it, and keep detailed logs showing what was done from one day to the next on the project. It does not matter if the project is expected to be completed in time to benefit from the presumption that there was continuous work. The documentation is an insurance policy in the event the construction schedule slips.
If physical work is the only option, then it is better to dig turbine foundations or put in turbine string roads than to do minimal work on transformers or other equipment at a factory. If at all possible, dig at least 10% of the turbine foundations. Finish more than a mile of road to the permanent surface. If possible, clear or plot out the remaining roads. Access roads that allow entry on to the project site from the public highway do not count; what counts are string roads that connect one turbine to the next.
While the IRS declined in August to draw a bright line around what qualifies as “significant” physical work, it made clear that not much had to be done. However, the tax equity market has been less keen to finance projects that rely on minimal physical work. This is particularly important given that 2016 is expected to be a very busy year for tax equity due to competition from solar companies rushing to complete solar projects before the December 2016 deadline to qualify for a 30% investment tax credit.
Tax equity investors will have more projects from which to choose than there is available capacity. They will choose the ones that present the fewest tax risks; therefore, the stronger the physical work facts, the better.
The developer must have a binding contract in place with the construction contractor before physical work starts for the contractor to do the work and for the developer to pay for it. The contract does not have to be for the full job: for example, it can be for excavating just a fraction of the turbine foundations.
It is not a good idea for the developer to retain a right to terminate the contract for convenience. That may turn the contract into merely an option to have the work done, even if the developer is required to pay for the work that has been completed before cancellation. The safest course is to require payment of at least 5% of the total contract price in damages.
Anyone relying on physical work should document the work that was done before year end. Take photos of the site. Have an independent observer visit the site at year end and attest to what he or she saw.
The 3 1/2-month rule – where the developer pays in 2014 for equipment that will be delivered within 3 1/2 months of payment – is a “method of accounting.” Not every company can use it. A developer should confirm with its accountant that it can use this approach. Forming a partnership may help, as the partnership is allowed to choose a new method of accounting without having to get IRS permission to change its accounting method.
It does not work to give a turbine vendor a recourse note this year for equipment to be delivered within 3 1/2 months of payment. The IRS requires “payment” in 2014 if equipment is to be delivered in early 2015. It defines “payment” as “cash or cash equivalent.” What the IRS had in mind by a cash equivalent is a debt instrument for which there is an active market: for example, corporate debt traded on an exchange.
Case law suggests a note can be a cash equivalent, but only if four things are true about it. The note must bear an arm’s-length rate of interest, it must be freely transferable, it must be a kind for which there is an active market so that it is easily convertible into cash, and any discount at which it trades should only reflect changes in the cost of money rather than the likelihood of payment by the obligor.
When taking delivery at the factory, make sure that both title and risk of loss transfer. The developer should pay storage fees and buy casualty insurance while the equipment is being stored. Have a delivery certificate showing someone inspected the equipment on behalf of the developer.
If the vendor charged for future transportation to the project site as part of the equipment price, back it out of the 2014 incurred costs. Transportation is a service, and the cost of services is not incurred until the services are fully performed.
The same principle applies to a prepaid storage fee that is built into the price of the equipment. Make sure any sales taxes that must be paid after a real sale and delivery are paid. Segregate the equipment from other equipment belonging to the vendor, especially if the vendor is pulling the equipment out of inventory, and tag it as property of the developer. If the equipment is defective, it is better for the vendor to repair it under warranties rather than to reject the equipment so that the cost of the equipment continues to count as a 2014 cost.
Notice 2013-29, Notice 2013-60, Notice 2014-46
Additional Norton Rose Fulbright articles on "Start of construction PTC":
Additional Construction Starts Guidance - PTC
"Start of Construction" PTC: Lessons From The Last Rush to Start Construction
Tax credits for renewable energy remain in limbo in Congress - PTC ITC construction starts
The Camp Tax Reform Bill - corporate tax reform, PTCs, section 118