Start of construction issues will take time to sort out

The Internal Revenue Service is still feeling its way on complicated fact patterns.

Many wind companies rushed to start physical work on projects at year end 2013 to qualify for federal tax credits on the projects. The American Wind Energy Association reported that 10,900 megawatts of new wind farms were under construction at year end.

The rush to start physical work at year end left issues around turbine pad excavations, roads, substations and transformers. Work must have started in 2013 on a significant task. It does not need to have been completed in 2013. The IRS does not have a threshold dollar amount for the value of physical work that had to be done in 2013, although a miniscule effort like $100 of work on a large project would call into question whether work really started.

Unless the work completed in 2013 is itself a significant task, the contractor should continue working into 2014 on the task until it is completed.

The view of the senior technical reviewer in Washington who will review disputes on audit is that turbine excavations alone are not enough. Tax counsel holding a contrary view point to a statement in IRS guidelines on starting construction that “physical work a significant nature begins with the beginning of the excavation for the foundation. . . .”

There are two ways to have started construction in 2013. One is to have started physical work of a significant nature, and the other is to have “incurred” at least 5% of the total project cost in 2013.

Projects that relied on the physical work test must complete the projects by 2015 or be able to show “continuous construction” after 2013 on the project. This may be hard to do for wind farms on land.

Developers who incurred at least 5% of the project cost by 2013 must show “continuous efforts” on any project that will not be completed until after 2015. This may be possible to do. The “continuous efforts” requirement contemplates that a project may still be under development. However, there is a misconception in the market that it is enough to do one task a month. This view is not shared by IRS officials in Washington. The IRS may also have a problem with artificially stretching out or “slow walking” the development process.

In general, the development team should ask every Monday what can be done to advance the project that week and keep logs showing what was done on a week-by-week basis. Delays are acceptable if due to events that are outside the developer’s control. For example, a developer may back up from when the interconnecting utility will be ready to start accepting power from the project to determine when to mobilize the construction crew on the site. This assumes the developer did not wait until 2015 to sign the interconnection agreement. It should work diligently in the meantime to put the project in a position to start work at the site.

The US Tax Court said in a case called Caltex Oil Services in early 2013 that costs for services are not “incurred” until the full service contract has been performed. The case involved a drilling contractor who signed a contract to drill wells. The costs of the wells were not considered incurred until the drilling contract was completed.

The IRS released a “field service advice” to an IRS agent in January that went in the other direction. The agent was auditing a company that claimed a 50% depreciation bonus on parts of a casino, hotel, restaurant and convention center project. A bonus could not be claimed if the developer “incurred” more than 10% of the project cost before 2008. The developer argued that none of the cost was incurred until the project was completed because the contractor it hired built the project under a turnkey contract where the contractor is responsible for turning over the project in ready-to-use condition. The IRS disagreed. The contract was not a turnkey contract, the IRS said, and costs were incurred as the developer made progress payments to the contractor. The contract said that title to the work in progress passed to the developer as such payments were made. The memo is Field Service Advice 20140202F.

Tax equity investors and lenders had shown a clear preference last year for projects that start work under the 5% test. However, they now appear willing to rely on the physical work test in cases with strong facts.

The IRS is willing to issue private letter rulings about construction-start issues, but only on purely legal questions. It has at least two ruling requests pending, and a third is expected to be filed in mid-February.

Grandfather rights to tax credits carry over where a developer sells a project on which it started construction in time to another developer. It is not clear they carry over where a developer with 2013 equipment buys a project in 2014 from another developer who did not start construction in time and uses the 2013 equipment in the project. Until the IRS rules on this fact pattern, the best approach in such cases is for the two developers to form a joint venture to own the project. Each would have an interest in the joint venture commensurate with the value it brings to the joint venture.

by Keith Martin