Another race to start construction: Practical advice
The decision by Congress to extend expiring tax credits for renewable energy through 2019 for wind and 2021 for solar ― with phase outs ― could reduce the volume of new wind and solar construction in 2016, but bring lots of additional investment ultimately into the sector.
Congress may revisit whether to allow more time for fuel cell and combined heat and power projects.
Many renewable energy companies may turn to raising new capital to dive back into project development. Development pipelines had thinned as it looked like the tax credits were running out.
The key to qualifying for tax credits is to start construction of new projects by the new deadline and then be able to show continuous work on the projects after the construction-start deadline.
The IRS has not been making developers who finish projects within two years after the deadline prove continuous work. It hopes to issue a notice in March to explain how it will apply this policy now that a larger range of projects qualify potentially for tax credits if they are under construction by future deadlines and the amount of tax credits for which a project qualifies varies depending on when construction starts.
Many useful lessons can be drawn from the experience of wind companies with construction-start deadlines in 2013
Tax Credit Extensions
Tax credits for renewable energy projects were extended in December as follows.
Wind developers will have through December 2016 to start construction of new wind farms to qualify for 10 years of production tax credits at the full level. Production tax credits were $23 a megawatt hour for wind electricity in 2015. The credits are adjusted each year for inflation. The 2016 figure will not be announced until April. The tax credits run for 10 years after a project is first put in service.
Projects that start construction in 2017, 2018 or 2019 will qualify for 10 years of tax credits at reduced levels. The levels are 80% for projects starting construction in 2017, 60% in 2018 and 40% in 2019.
Developers will have the option to claim a 30% investment tax credit instead of PTCs during the same period and with the same phase down. Thus, for example, a developer who starts construction of a wind farm in 2018 could claim an 18% investment tax credit (30% x 60%).
Solar projects that are under construction by December 2019 will qualify for a 30% investment tax credit. The credit will fall to 26% for projects starting construction in 2020 and 22% for projects starting construction in 2021. The full investment tax credit is claimed in the year the project is put in service.
Projects that are under construction before these deadlines must be placed in service by December 2023 to qualify.
The investment credit will revert to its permanent 10% level after that. Thus, any project that is not under construction in time would still qualify for a 10% investment tax credit.
The tax extenders bill also extended the residential solar credit for homeowners who choose to buy solar rooftop systems or solar hot water heaters rather than enter into solar leases or power contracts with solar companies. They could claim a 30% tax credit on such equipment put in service through 2019. The credit drops to 26% in 2020 and 22% in 2021. It disappears after that.
Moving to other forms of renewable energy, geothermal, biomass, landfill gas, incremental hydroelectric and ocean energy projects will have until December 2016 to start construction to qualify for production tax credits. Developers of such projects will retain the option to claim a 30% investment tax credit instead of PTCs during the same period. Such projects were not given the same additional phase down as wind and solar.
The current 30% investment tax credit for fuel cells was not extended. Fuel cells must be in service by December 2016 to qualify under existing law.
Nancy Pelosi, the House Democratic leader, said as the tax extenders bill passed in December that she had a commitment from House Republican leaders to revisit in 2016 whether to extend expiring tax credits for fuel cells and CHP projects. She said tax credits for these types of equipment were not extended due to an oversight. Kevin Brady, the House tax committee chairman, said that his committee will take a look in 2016 at whether such tax credits should be extended. “The fuel cell and other breaks don’t expire until next year, and tax writers will likely work on the issue some time in 2016,” he said.
Congress extended a 50% “depreciation bonus” that expired at the end of 2014 retroactively to the start of 2015. Companies that put new equipment in service in 2015, 2016 or 2017 can deduct 50% of the tax basis in the equipment immediately and the other 50% using the normal depreciation table. New equipment put in service in 2018 will qualify for a 40% bonus. Equipment put in service in 2019 will qualify for a 30% bonus.
Assets, like transmission lines and gas-fired power plants that have longer depreciable lives, could qualify for the 50%, 40% or 30% bonus for an extra year. Thus, for example, a 50% bonus could still be claimed on the cost of transmission assets completed in 2018.
The bonus on longer-lived assets can only be claimed on the portion of the project cost incurred through 2019. Thus, a transmission line or gas-fired power plant completed in 2020 would qualify for a 30% bonus, but only on the basis built up in the asset through the end of 2019. Longer-lived assets put in service before 2020 would get whatever bonus applies to the full project cost.
The depreciation bonus is an acceleration of depreciation that would otherwise be claimed on a project. Thus, for example, wind farms in the United States are largely depreciated over five years. With a bonus, 50% of the project cost is taken as a depreciation deduction in year 1, and the remaining 50% of project cost is depreciated over five years, including partly in year 1.
Projects on Indian reservations can be depreciated more rapidly than projects in other parts of the United States. For example, a wind farm or solar project on an Indian reservation can be depreciated over three years rather than five years. This will remain true of any such projects that are completed by December 2016. The provision had expired at the end of 2014. The tax extenders bill extended it retroactively.
Solar companies will have to focus on what it means for a project to be under construction. Many solar companies had experience with construction-start rules under the Treasury cash grant program, but the tax rules are different.
Developers of wind, geothermal, biomass and other projects that qualify for production tax credits have had to live with the IRS construction-start rules since 2013.
There are two ways to start construction.
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 before the construction-start deadline or else pay before the deadline 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 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 before the deadline. 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 has not been making developers prove that there was continuous work on any project that is completed within two years after the deadline.
IRS and Treasury officials are talking about issuing a new notice explaining how they will apply this presumption now that the tax credits step down in amount over time. They are debating whether to spare companies from having to prove continuous work if a project is put in service within two years after the last construction-start deadline for any credit or to have separate two-year periods for each step down in the credits. Some counsel have suggested that, under this “vintaging” approach, a developer would also have to prove that construction of the project did not start too soon. It is unclear why this would be the case. The government hopes to issue a new notice on the two-year presumption in March.
Another issue under discussion is whether to have separate presumptions of varying lengths for different types of projects. For example, geothermal and offshore wind projects take more time to build than onshore wind farms. However, the IRS may decide this is more trouble than it is worth.
Another issue with which the government is wrestling is how the new rules apply to solar. It is not clear how they will work for rooftop solar installations. The US Treasury let rooftop solar companies stockpile solar panels and inverters and then claim grants on rooftop solar systems that use enough of this equipment to amount to more than 5% of the system cost. There was no continuous work requirement under the grant program.
It may also be harder for solar companies to start construction under the physical work test. Physical work at the factory on equipment for a project counts, but not if the factory starts manufacturing the equipment before there is a binding purchase order in place, and the equipment cannot be of a type that is kept in inventory. Solar panels and inverters are usually kept in inventory, unlike wind turbines that, even though the manufacturer has standard models, are not manufactured until a binding order is received.
The IRS is not expected to address the solar issues until later in the year.
The IRS takes the position currently that if one turbine at a 50-turbine wind farm slips past the two-year window, then the developer must prove continuous work on the entire project. 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.
The tax credit extensions are expected to take the pressure off developers and the tax equity market to close as many financings in 2016.
Larger wind developers who can afford it are expected to negotiate more contracts this year to buy “PTC components” on which they need to take delivery this year or in the first three and a half months of 2017. Developers had been stockpiling nacelles, blades and tower segments for use after the construction-start deadline in future projects.
Smaller developers who do not have the money to pay for equipment orders this year will end up late in the year 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 before 2014 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 2015 or can be done before year end 2016.
Some larger developers stockpiled equipment in 2013 and 2014 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, unless the IRS decides that any “vintaging” concept for proving continuous work also requires a developer to prove construction of the project did not start too soon.
The IRS has been concerned about trafficking in 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 extension in the construction start deadline opens a window for developers holding 2013 and 2014 equipment to sell it to other developers who can count the costs as incurred 2016 costs in their own right.
A number of lessons should be taken away from the push by wind developers to start construction in 2013 and 2014.
If at all possible, start construction by incurring costs rather than relying on physical work.
Developers with projects that are not completed until after whatever two-year presumption the IRS establishes 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 after the two-year window.
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. The IRS declined at the request of wind developers to draw a bright line around what qualifies as “significant” physical work, but it made clear in an August 2014 notice 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. Tax equity investors 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 remaining 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 before the construction-start deadline for equipment that will be delivered within 3 1/2 months after 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 by the construction-start deadline for equipment to be delivered within 3 1/2 months after payment. The IRS requires “payment” before the deadline if equipment is to be delivered early the following year. 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 costs considered incurred before the construction-start deadline. 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 fully incurred before the deadline.