The regulation aims to reduce overall greenhouse emissions in California to the 1990-level by 2020.  The 2020 goal represents a 15% reduction in emissions compared to expected emissions in 2020 if no plan had been enacted.  Reduction measures will be introduced in two phases; beginning in 2013, major industrial sources will be targeted and, beginning in 2015, distributors of transportation fuels, natural gas and other fuels will also be regulated.  In total, according to CARB, the regulation impacts 360 businesses and 600 facilities.

Companies regulated under the program will not be given a specific limit on the greenhouse gases they can emit but, rather, must provide sufficient allowances to cover their emissions.  One allowance is equal to one ton of carbon dioxide.  Each year, as the cap declines, the number of allowances will decrease as well.  Allowances will be awarded by CARB during the initial period of the program (2013-2014) to the most efficient companies.  Additional allowances may be purchased during CARB quarterly sales and on the market. Electric utilities will be given allowances to sell at auction to help achieve AB32 goals.  The first auctions are expected to take place in August and November 2012 (for 2013 allowances).

The regulations also provide for the use of offsets to meet emissions requirements.  Up to eight percent (8%) of a company’s emissions may be covered using credits from CARB-certified offset projects.  Offsets are reductions in greenhouse gas emissions from sources outside of the cap-and-trade program.  

CARB has indicated that the regulations are designed such that California may link with other programs in the Western Climate Initiative.  CARB has also approved an adaptive management plan to monitor the impact of the program on localized air quality and forests.

The final regulations must be filed with the California Office of Administrative Law by October 28, 2011.

Please contact John Leonti at (949) 622-2769 or john.leonti@troutmansanders.com with any questions.

Certain active solar energy systems are eligible for an exclusion from California property tax if they are “newly constructed” and have not undergone a “change in ownership.” The BOE takes the position that a sale-leaseback of property constitutes a change in ownership of that property.

Amendments to the legislation in August 2011 were intended to clarify that a sale-leaseback of a newly constructed solar project that is installed as an addition to an existing structure qualifies for the exclusion where the existing structure is not also sold and leased back. In response to the solar community’s call for confirmation of the legislative intent, the BOE on October 13, 2011, issued proposed guidelines on the application of the active solar energy system new construction exclusion.

The guidelines provide county assessors’ staff, assessment appeals board members, and taxpayers with information about the exclusion. The text of the guidelines is available here and the August 2011 legislative amendment is here.

Background 

All real and personal property is generally subject to ad valorem property taxation in California, unless a specific exemption applies. The tax is assessed annually, generally at 1% of assessed value. The valuation assessment rules vary depending on whether the  property is classified as real or personal property.

In the case of “real property,” increased assessments and the applicable rate are limited under Article XIII.A of the California state constitution. Real property generally cannot be reassessed above the year-of-acquisition valuation (plus an inflation factor) unless a “change in ownership” or “new construction” occurs with respect to the property. In the typical case of real estate, reassessment is triggered when the property changes hands (new owners) or when there is value added to existing property through new construction (e.g., an addition or renovation to an existing building or an improvement to land).  

For California property tax purposes, “real property” includes not only land and buildings, but also “fixtures.” “Personal property” generally means everything other than real property. In determining whether property is taxable as a fixture, courts generally look to its degree of “permanence” and the manner in which it is attached to the building.

It has been the BOE’s informal policy to treat PV solar installations as “real property,” and this position is formalized in the guidelines. As real property, PV systems generally were subject to assessment if they were “newly constructed” or a “change in ownership occurred.” In order to encourage the installation of newly constructed solar systems, the California legislature  adopted a specific exclusion from California real property tax for “active solar energy systems.” [1]

However, the exclusion was worded so that while “newly constructed” PV systems were protected from reassessment, they were still subject to reassessment upon a “change in ownership.” Questions immediately arose concerning whether a “change in ownership” occurs when a qualifying solar project is incorporated into a newly constructed building. Does the installation of qualified PV systems on newly constructed homes and buildings result in reassessment of the existing property when the builder sells the home to its first buyer? Similar questions arose in the context of newly constructed distributed generation projects that are financed upon completion with a sale-leaseback or partnership flip.  

In 2008, the California legislature adopted A.B. 1451, amending the statutory exclusion for solar projects. What prompted the change was this: home builders delivering newly built homes equipped with built-in PV solar systems that otherwise qualified for the exclusion were concerned that the original sale of the home to the first buyer would constitute a “change in ownership” of the PV system, and preclude the exclusion from applying to the portion of the home’s cost attributable to the PV system.  

The legislation provides that where an active solar energy system is incorporated by the owner-builder in the initial construction of a new building that the owner-builder does not intend to occupy or use, the sale of the building to the initial purchaser will not be treated as a “change in ownership” and the solar system qualifies for the exclusion from tax as new construction. The exclusion applies to the initial purchaser of the new building, so long as the owner-builder did not receive the exclusion for the same system. Similar rules were enacted for residential subdivisions. 

As is demonstrated by A.B. 1451, the change in ownership rules were not intended to apply to brand new property, but rather to property that has had the opportunity to appreciate in value without reassessment over a period of years. Thus, a new PV installation should not be subject to reassessment until the project or the underlying property changes ownership after the initial sale-leaseback or transfer in connection with a partnership flip. However, A.B. 1451 did not address the question about sale-leasebacks and partnership flips.      

Sale-Leasebacks and Partnership Flips

The industry sought clarification from the BOE that a new rooftop or ground-mounted PV system did not lose its eligibility for the new construction exclusion as a result of being financed with a sale-leaseback or a partnership flip. The industry also sought a clarifying amendment to the legislation. In August 2011, the California legislature adopted Assembly Bill ABX-1 15, the second amendment to the solar exclusion.

The bill provides that “…newly constructed active solar energy systems are often sold or transferred in sale leaseback arrangements, partnership flip structures, or other transactions to purchasers that may also be eligible for federal tax benefits” and “[a]s long as the active solar energy system is newly constructed or added and another taxpayer has not received an exclusion for the same active solar energy system, it is the intent of the Legislature that the purchaser of the active solar energy system in a transaction such as that described above receive an exclusion….” The new guidelines confirm, “this legislation ensures that newly constructed active solar energy systems transferred using sale-leaseback and similar arrangements that require the solar system itself, but not the real estate on which it is situated, to be sold or transferred to a third party, will continue to receive the property tax exclusion.” 

The bill clarifies that the exclusion remains in effect until there is a “subsequent” change in ownership. The guidelines identify several instances where a “change in ownership” will trigger a reassessment. In the context of equipment that is subject to a lease commencing at the time of installation, the system is excluded from the definition of new construction at the time of installation, and continues to be excluded from assessment until a change in ownership of the system occurs. At the end of the lease term, extension of the lease for an additional period will not trigger assessment. If the lessee purchases the system before or at the end of the lease term, such purchase terminates the new construction exclusion and makes the system assessable. If the lessee exercises no purchase option, the system is returned to the lessor at the end of the lease, and removed from the lessee’s property. The guidelines confirm that the removal will not result in any change to the assessed value of the “host” property.

The guidelines do address partnership flips as specifically as they do sale-leasebacks. In a sale-leaseback, the transfer to which the exclusion applies is the sale to the lessor (immediately before the property is leased back). In the partnership flip context, the transfer that the exclusion prevents from triggering reassessment is the transfer of an interest in the solar project by the developer to the newly created partnership with the “tax equity” investors. Presumably, the property continues to be excluded from assessment until a change in ownership of the system occurs.

To qualify for the exemption where a system is sold in a sale-leaseback or a partnership flip, the lessee (or developer in the case of a partnership) must not have been entitled to or received an exclusion from property tax for the system, because in that case the owner-lessor (or partnership) would not be entitled to a second exclusion. In the context of a partnership flip, the partnership would be ineligible for the exclusion if the developer has claimed it before transferring an interest in the system to the partnership. The bill does not specify any procedure for demonstrating that there is no “double dipping” except in the case of a newly constructed building that incorporates a solar system. In this context, the bill provides for the filing of a certificate by a new building contractor, indicating that it does not intend to own or occupy the property. 

However, the guidelines provide that a property owner who adds an active solar energy system to an existing structure is not required to file for the exclusion. The guidelines state that the exclusion should be automatically granted when the county assessor receives a copy of the building permit. Theoretically a notice may be appropriate in ground-mounted situations, including parking structures built on land, but, in all cases, a certificate from the lessee (or developer) to the effect that it has not and will not claim an exclusion should be sufficient to comply with the bill.

Leasehold Interests in Government Property

The guidelines clarify that systems installed on leased land or leased building rooftops are also eligible for the solar exclusion. However, when a lease involves a government-owned land or building, a taxable possessory interest in the real property is created and will be valued and assessed. In the context of a sale-leaseback, there may be government-owned land or building rooftop space leased to the solar project owner-lessor. If there is a corresponding lease of the land back to the solar project lessee, for a term and for rents that match those of the ground lease, there may be little or no value attributable to the possessory interest granted in the ground lease.

Retroactive Effect and Sunset

The solar system exclusion applies retroactively to all eligible projects completed on or after January 1, 2008. It is estimated that between 2008 and 2010, approximately $1.5 billion in value of new active solar systems were installed in California, and may be eligible for the exclusion. All solar systems eligible for exclusion on January 1, 2017, will continue to be excluded after that date until a change of ownership occurs. The bill’s provisions sunset prospectively on January 1, 2017. 

County or State Assessment

Only solar systems assessed at the county level can qualify for the solar exclusion. State-assessed property is not subject to the solar exclusion and is assessed at fair market value annually on the lien date. By law, state assessment is required if the facility has a generating capacity of 50 megawatts or more; and is owned by a company which is an “electrical corporation.” An electrical corporation does not include production of solar power for one’s own use, or the use of one’s tenants, or the sale to not more than two corporations or persons for use on the real property on which the power is generated, or, in some instances, the land immediately adjacent. Most distributed generation PV solar projects are such “behind the meter” projects, providing power to one “host” customer under a lease or a power purchase agreement, solely for the use by the host on the real property on which the power is generated (i.e., on a building rooftop or on land located on or near the building site.) Owners of these projects are not “electrical corporations” as defined in the statute and therefore are county assessed and may qualify for the solar exclusion.

Request for Comments 

The guidelines are issued in proposed form and the BOE has invited public comments. Suggested revisions or comments on the guidelines should be submitted to the BOE by November 23, 2011, to Mr. Michael McDade at PO Box 942879, Sacramento, CA 94279 or Michael.mcdade@boe.ca.gov. Comments received from interested parties will be posted to the BOE Web site on January 6, 2012. Final guidelines are expected shortly thereafter. All documents regarding the guidelines are available here.

[1]  Cal. Rev. & Tax Code § 73; Cal. Const., Art. XIIIA, § 2(a).  An “active solar energy system” is a system that uses solar devices, which are thermally isolated from living space or any other area where the energy is used, to provide for the collection, storage, or distribution of solar energy. The statute clarifies the definition to mean a system that, upon completion of the construction of the system as part of a new property or the addition of a system to an existing property, uses solar devices to provide for the collection, storage, or distribution of solar energy. Eligible systems do not include solar furnaces, hot water heaters, swimming pool heaters, hot tub heaters, passive energy systems, or wind energy systems. Only equipment used up to, but not including, the transmission stage is eligible for the exclusion.

Section 1603 of the American Recovery and Reinvestment Act of 2009, as amended (Section 1603), allows a taxpayer to elect to receive a cash grant payment, instead of claiming the 30% energy tax credit, with respect to an investment in certain renewable energy generation projects (so-called “specified energy property”). Generally, property qualifies as specified energy property if it would otherwise qualify for the Section 48 energy investment tax credit (ITC). The amount of the cash grant is 30% of the eligible basis of the property which qualifies for the ITC. The election to obtain the cash grant and forgo the ITC is made by application to Treasury. In general, Treasury is directed by the statute to pay out qualifying cash grants within 60 days after the application is complete and the project has been placed in service.

The amount of any Section 1603 cash grant payment is not includible in gross income. However, the tax basis of the property for purposes of depreciation deductions is reduced by one-half of the cash grant payment (as is also the case with the ITC). Like the ITC, all or a portion of the grant must be recaptured and paid back to Treasury in the event a specified disqualifying event occurs, such as a disposition of the project to an ineligible recipient or a change in the qualification or use of the property.

The Section 1603 cash grant program is available to applicants who place specified energy property in service during 2009, 2010 or 2011. Grant payments can be made for qualifying projects placed in service after 2011 if construction began during 2009, 2010 or 2011 and the property is placed in service by a specified date (December 31, 2016 for solar projects and December 31, 2012 for wind projects with respect to which the taxpayer has elected the ITC in lieu of the production tax credit). For more information about the cash grant program generally, see our summaries and alerts here and here.

Whether the taxpayer claims the ITC or elects the cash grant, the tax basis for the property determines the amount of the credit or grant. The Treasury Department has reviewed literally thousands of applications under the Section 1603 program and has paid out billions of dollars in grant money.  Congress encouraged a rapid application turn-around time and a 60-day payment deadline.  Due to the volume of applications, Treasury has had to evaluate whether a project is eligible for the grant, and whether the tax basis claimed by the taxpayer is accurate, in a much shorter period of time than is available to IRS auditors in the field examining returns on which the ITC has been claimed.

Most taxpayers and their advisors have been under the impression that once Treasury completes its review of a grant application and pays out a grant, the IRS does not have the authority to subsequently challenge on audit the qualification of the project as “specified energy property” or the amount of the tax basis on which the 30% grant was claimed. However, a recently issued IRS internal memorandum (available here) upsets this expectation. The IRS takes the position that the IRS may review in the course of an audit whether the amount of a Section 1603 payment was appropriate, and any portion of a Section 1603 payment that was “excessive” is required to be included in the grant recipient’s income.

In the memorandum, the IRS Chief Counsel responded to questions raised by IRS counsel and field agents concerning projects for which Section 1603 grant payments were made, but where the IRS determines on audit that all or a portion of the grant paid was not eligible for the grant. The key question raised was: “In the event the Service determines that a taxpayer’s project did not qualify for all or part of a section 1603 payment, is the excessive amount of the payment includible in the taxpayer’s gross income … notwithstanding … that section 1603 payments shall not be includible in the taxpayer’s gross income?” 

The IRS concluded that, notwithstanding the amount paid out by Treasury, only the portion of the grant claimed by the taxpayer that actually qualifies for the grant on the merits can be excluded from gross income. The excludable amount does not include the portion of any payment that a taxpayer receives under the Section 1603 program that exceeds the amount of the payment that applies to the cost of property that qualifies for the payment under section 1603. Thus, if the IRS determines, on examination, that a taxpayer’s property did not qualify for all or part of the payment that the taxpayer received under the Section 1603 program, the excess over the amount of the correctly determined Section 1603 payment is not excludible from the taxpayer’s gross income. The IRS also concluded that the excessive amount of a Section 1603 payment cannot be excluded from income under any other principle of tax law (e.g., as a non-taxable gift, contribution to capital).

As a corollary to the rule that “excessive” grant payments are income, the amount of the “excessive payment” that is includible in income does not reduce the taxpayer’s basis for the property for depreciation purposes.

For example, assume a taxpayer claims a grant payment of $300 on a project with a claimed tax basis of $1,000. Treasury pays the $300 grant to the taxpayer. Taxpayer’s basis for depreciation is reduced by one-half the grant amount, to $850. Absent a special disqualifying event, the grant money cannot be recaptured by Treasury. However, on the regular audit of the taxpayer’s return, the IRS examines and challenges the taxpayer’s claimed basis as excessive. The IRS determines that the taxpayer overstated its basis for the property and that the proper basis amount was $900, and the proper grant amount was $270. The taxpayer has an income inclusion of $30 (the “excessive payment”). In addition, the taxpayer’s basis re-adjusted: it is reduced from $1,000 to $865 ($1,000 less one-half of $270). Thus, the income inclusion is partially offset by a basis increase, but on a net basis, the economic loss caused by the adjustment on audit is still substantial.

What will surprise most taxpayers is not the IRS’ calculations, but the fact that the IRS has the authority on audit to challenge the amount of the taxpayer’s Section 1603 payment at all. By characterizing the portion of a grant payment that exceeds the allowable amount as an unreported item of gross income, the IRS essentially is asserting audit jurisdiction over every Section 1603 payment that Treasury has ever made. For taxpayers that have applied for and received a grant payment, the Treasury cannot recapture and require repayment of the grant money absent a disqualifying event. However, the IRS has another opportunity to review and challenge the taxpayer’s claim upon audit of the taxpayer’s return for the year the grant was paid. A significant portion of the economic benefit of the grant can be lost if the IRS determines on audit that all or a portion of the grant claimed exceeds the proper amount. 

One challenge that the IRS may make on audit is that the taxpayer’s project fails to qualify as “specified energy property.” Another more likely challenge is that the taxpayer has overstated the tax basis on which the 30% grant is calculated. Treasury apparently is concerned that taxpayers have attempted to game the Section 1603 system by claiming unrealistic and unsupported amounts as tax basis. Clearly, Treasury is concerned about potential taxpayer abuse in the Section 1603 program. This concern is reflected in the recently issued Treasury guidance describing how Treasury evaluates the tax basis for photovoltaic (PV) solar energy projects (discussed here). Treasury identified the opportunity to artificially step up basis through excessive developer premiums, transfers between related parties, sale-leasebacks, and in lessee “pass-through” lease transactions (also called “inverted leases”) where basis is deemed to be “fair market value.” Thus, if a lessor passes the Section 1603 payment through to a lessee and that payment to the lessee is based on an amount in excess of the true fair market value of the property, the lessee has received a partially excessive Section 1603 payment. These are the kinds of transactions which may be susceptible to greater IRS scrutiny on audit, with the potential for an unanticipated income inclusion and a reversal of a part of the overall economic benefit of the transaction.

Whether the taxpayer claims the ITC or the cash grant, the tax basis for the property determines the amount of the credit or grant. The Treasury Department is reviewing literally thousands of applications under the Section 1603 program and has to make a determination of tax basis in a much shorter period of time than is available to IRS auditors in the field. To assist taxpayers with preparing Section 1603 applications, Treasury has published and posted to its Section 1603 website an outline of the process used by the Section 1603 review team to evaluate basis and the principles that guide the process. Although these principles are published in the context of the cash grant, they are the same tax concepts used to determine tax basis for ITC purposes as well. Moreover, although the Treasury paper addresses solar PV properties, the guidance states that “the methods used to evaluate cost basis described herein apply to all types of properties.”

Basis

Basis is the amount of a taxpayer’s investment in property for tax purposes.  Basis is generally the cost of the property but also includes the capitalized portion of certain other costs related to buying or producing the property (e.g. permitting, engineering, and interest during construction). However, in certain circumstances, a taxpayer’s stated cost for an asset does not reflect the true economic cost of that asset to the taxpayer and will be ignored for purposes of determining the basis of the asset. For example, a stated cost may be inconsistent with the eligible property’s true basis “where a transaction is not conducted at arm’s-length by two economically self-interested parties or where a transaction is based upon ‘peculiar circumstances’ which influence the purchaser to agree to a price in excess of the property’s fair market value.”

In order to ensure that a taxpayer’s claimed cost basis reflects the eligible property’s fair market value, basis is more closely scrutinized in cases involving related parties, related transactions, or other unusual circumstances. Similar to the authority of the IRS in the context of the ITC, in making cash payments under Section 1603, the Treasury Department has authority to decide that “an applicant has miscalculated or misrepresented the basis of its property.” However, the Treasury cannot simply deny an application because it disagrees with the taxpayer’s claimed basis. The courts have held that Treasury must pay a cash grant based on the correct basis amount. See ARRA Energy Co. I v. United States, 97 Fed. Cl. 12 (Fed. Cl. 2011) and our discussion of the case here.

The first step the Treasury review team takes to evaluate the claimed basis for solar photovoltaic (PV) properties is to compare the claimed basis to certain benchmarks. The benchmarks used by Treasury for solar PV cost basis are predicated on an open-market, arm’s-length transaction between two entirely unrelated parties with adverse economic interests, specifically with respect to setting the eligible property’s price.
 
Benchmarks considered by the Treasury review team are drawn and updated based  on publicly available information and analyses by various experts, data from existing Section 1603 applications and other confidential sources, and Treasury’s experience with solar PV properties. As of the first quarter of 2011, benchmark solar PV market expectations are as follows:

These prices reflect a high quality of equipment (modules, inverters, racking) installed by reputable companies across the United States and include profit. 

These are merely benchmarks – they are not safe harbors and they are not ceilings. Each system is different and its cost will be affected by technology choice, regional market differences and differences in size within the above categories. A property may have specific characteristics that increase (or decrease) eligible costs. Such factors are considered in evaluating how a given application’s basis compares with benchmark prices. 

If claimed basis is deemed consistent with benchmark prices, the Section 1603 review team typically focuses the remainder of its cost review on examining line items provided in the detailed cost breakdown to ensure that only eligible items have been included and that no costs have been inappropriately attributed to the property. If there are no ineligible items, the basis reflects only items appropriately attributable to the eligible property, and if there is adequate documentation to support that the costs reflect actual costs, the cost basis is accepted. 

The review team may ask the applicant to provide additional detail if a cost breakdown line item is defined too generally. If ineligible items are identified, they are removed, and the payment is based on the corrected amount. For example, although a project may necessitate a fence for security or a building for operations and maintenance, such costs are not eligible. 

Applications with a claimed basis that is materially higher than benchmarks will receive closer scrutiny. In addition to ensuring that only eligible costs are included, the review team looks at whether there are related transactions, related party considerations, or other unusual circumstances, such as:

1. Owner/applicant is related to the developer, installer, or supplier (collectively referred to as the “developer”). The developer may be a separate, legally-organized business, but there is common ownership/control. In such a case, a sale of the property by one related party to the other may not reflect an arm’s-length price.
2. Owner/applicant is a party to one or more related transactions with the developer such that economic interests in the specific transaction determining basis may not be adverse. For example, the owner/applicant purchased the energy property from the developer and leased the property back to the developer (sale-leaseback).

Where such circumstances are present, the review team evaluates whether the claimed basis is consistent with the property’s fair market value. (Fair market value is also relevant in the context of applications by lessees of leased property, where the parties have elected to pass through the ITC or cash grant to the lessee.) In this context, original manufacturer’s invoices/costs to the developer should be provided for major equipment, subsequent markups by the developer should be enumerated, and any markups by the owner identified. The owner may also submit a detailed and credible third-party appraisal (discussed below) demonstrating that the claimed basis is consistent with a market transaction between unrelated parties with adverse economic interests.

Ultimately, if the Section 1603 review team determines that the basis was not properly calculated or represented, the review team may adjust the basis on which a Section 1603 payment is made to a level consistent with the review team’s view of the property’s true cost, as informed by documentation provided by the applicant and other relevant information and analysis. This is no different than what might take place upon examination by the IRS if the applicant elected the ITC rather than the Section 1603 payment.

Fair Market Value

The IRS generally defines fair market value (FMV) as “the price at which property would change hands between a buyer and a seller, neither having to buy or sell, and both having reasonable knowledge of all necessary facts.”

The review team does not prepare appraisals for energy property. Rather, the review team evaluates appraisals provided by applicants and prepared by independent, certified appraisers with expertise in solar PV properties. There are three broad and interrelated methods that are used in valuation efforts: the cost approach, market approach, and income approach.

Cost Approach. The cost approach is based on the actual cost to build the property. This approach should clearly show the cost buildup, including hard costs, soft costs, and profit. Because the Section 1603 program only applies to energy property placed in service after December 2008, properties are new, and the actual costs should be readily available.  As cost data for PV systems is increasingly timely and available, this approach tends to be the most concrete and supportable analysis and is favored by the review team. 

Treasury’s Section 1603 review team will accept a cost approach that includes only eligible property and a markup (“developer’s premium”) that is consistent with industry standards and with the scope of work for which the markup is received. While appropriate markups are case-specific and can depend on the ultimate transaction price, Treasury has found that appropriate markups typically fall in the range of 10 to 20 percent of actual cost to build. This 10 to 20 percent guideline is not a safe harbor or a ceiling. A cost approach that includes a markup should explicitly address the appropriateness of the selected markup in light of the activity, capital investment, and risk for which that markup is compensating.

Market Approach. The market approach is based on sales of comparable properties. The Treasury paper suggests that “thousands of solar PV properties have been installed in the last two years, and market data are readily available.” 

Income Approach. The income approach is based on the discounted value of future cash flows generated by and appropriately allocable to the eligible property. Numerous assumptions must be made, including forecasts of all relevant project revenue and cost streams, cost of capital (debt and equity), rates of inflation and taxes, number of periods of income, and residual value. Treasury has found this to be the “least reliable” method of valuation given the number of variables that are subject to speculation and open to debate. However, the reliability varies with the quality of the data and assumptions. Projects with contracted power purchase agreements (PPAs) and contracted sales of environmental attributes (e.g., SRECs) have concrete cash flows on which to base an income approach. Assumptions must still be made, however, about revenues expected to be generated after the PPA expires and residual value. For purposes of Section 1603, a credible income approach to valuation will consist of a detailed spreadsheet model showing annual revenue and expenses over the term of the contract with a reasonable residual value at contract termination.

• Inflation rates should be supported by credible sources.
• Discount rates should reflect an appropriate risk premium above the risk-free rate.
• Speculative revenue (i.e., revenue that is not specifically contracted and guaranteed by a credit-worthy customer) will be closely scrutinized and must be well-supported and documented. Projected revenue beyond contracted periods should be based on conservative, publicly-available data.
• All expenses must be included, both annual ordinary operating expenses and major maintenance (e.g., inverter replacement).
• All depreciation, taxes, and other considerations should be incorporated into the model.

These and all other assumptions should be well-reasoned and sufficiently documented, and should reflect market expectations. Moreover, the income approach should explicitly address the allocation of the estimated discounted cash flows to the eligible property.

Requirements for 100% Bonus Depreciation

Under the revenue procedure, “qualified property” is eligible for the 100% first year depreciation deduction if the property meets all of the following requirements:

Qualified Property. The property is “qualified property” – generally property eligible for MACRS depreciation deductions under section 168 of the Code that is acquired or constructed and placed in service in or after 2008, and was not subject to a written binding contract entered into before 2008 (i.e., the property would otherwise qualify for the 50% first year bonus depreciation deduction)

Acquisition. The property is “acquired” after September 8, 2010, and before January 1, 2012 (before January 1, 2013 in the case of certain long-lived property and certain aircraft). For 100% bonus purposes, a taxpayer “acquires” qualified property when the taxpayer pays or incurs the cost of the property. Qualified property that a taxpayer manufactures, constructs, or produces is treated as “acquired” for these purposes when the taxpayer begins constructing, manufacturing, or producing that property. As summarized in our prior alert on when construction begins, construction generally is considered to begin when physical work of a significant nature is first undertaken or the taxpayer has incurred a sufficient amount of project costs to satisfy a safe harbor. 

Thus, projects where construction began before September 9, 2010 are not eligible for 100% bonus depreciation. (Certain components of such projects may be eligible, as noted below.) Projects where construction began after September 8, 2010 satisfy the acquisition requirement (and can qualify for 100% bonus so long as there is no binding contract dated before 2008). Projects to acquire qualified property pursuant to written binding contracts entered into after September 8, 2010 are deemed to meet the acquisition requirement.

Placed In Service. The taxpayer places the qualified property in service after September 8, 2010, and before January 1, 2012 (before January 1, 2013 in the case of certain long-lived property and certain aircraft). Existing regulations apply to determine date the property is deemed “placed in service” for tax purposes.

Original Use. The original use of the qualified property commences with the taxpayer after September 8, 2010. Existing regulations apply to determine date the property is deemed “placed in service” for tax purposes. The lessor in sale-leaseback is treated as the original user of the property so long as the lessee sells and leases the property back within 90 days after the property becomes commercially operational (placed in service).

Election for Certain Components

Congress gave permission to Treasury to issue rules “similar to” (and not necessarily identical to) those in existing regulations. Many developers were hoping Treasury would take a more taxpayer-friendly position on the acquisition date for self-constructed property. 
For projects that were started before September 9, 2010, some advocated for allowing 100% bonus for at least those costs that were incurred after that date. The revenue procedure does not adopt that position, but does provide a limited exception for certain components.

If a taxpayer begins the manufacture, construction, or production of a project before September 9, 2010, the taxpayer may elect to treat any purchased or self-constructed component of the project as eligible for 100% bonus depreciation deduction, so long as the component is qualified property and is itself acquired or self-constructed by the taxpayer after September 8, 2010, and before January 1, 2012 (before January 1, 2013 in the case of certain long-lived property and certain aircraft).

50% Bonus Election

To minimize disputes regarding whether a taxpayer acquired or placed in service

qualified property after September 8, 2010, the revenue procedure allows a taxpayer to elect to claim the 50%, instead of the 100% first year bonus depreciation for all qualified property that is in the same class of property and placed in service by the taxpayer in its taxable year that includes September 9, 2010. For example, if a calendar-year taxpayer for its taxable year ending December 31, 2010, placed in service 5-year property before September 9, 2010, and other 5-year property after September 8, 2010, the taxpayer may elect to claim the 50% bonus for all of its 5-year property that is qualified property and placed in service during the 2010 taxable year.