Last week the Treasury issued new guidance in the form of questions and answers (FAQ) as to when “construction begins” for renewable energy projects that may be eligible for a cash grant in lieu of an investment tax credit under section 1603 of the American Recovery and Reinvestment Act of 2009. This alert summarizes the Treasury guidance to date on this issue, including the FAQ. You may access a copy of the new FAQ here, the Treasury Guidance document here and Treasury’s earlier FAQ here. Our prior report on the cash grant program is available here.
The new guidance is important and timely because of the impending deadlines for the cash grant program. To qualify for a grant, qualified energy property must be placed in service in 2009 or 2010 or, if “construction begins” in 2009 or 2010, it must be placed in service by the applicable credit termination date (currently the end of 2012 for wind, the end of 2013 for biomass, geothermal and other resources, and the end of 2016 for solar). Whether Congress will extend the cash grant program to projects commenced after 2010 is uncertain. While extensions have been proposed by legislators, the likelihood of passage this year remains unclear. Because of the deadline and the uncertainty surrounding extension, we expect project developers to attempt to “begin construction” this year on those projects that have a practical chance of crossing that threshold in 2010.
There are two ways to show that construction has begun. One is to begin physical work of a significant nature. The other is to meet a 5% safe harbor.
Physical Work of a Significant Nature
To begin physical work of a significant nature means that physical work on the specified energy property has started. Physical work of a significant nature includes any physical work on the specified energy property at the site. Physical work of a significant nature also includes physical work that has taken place under a binding written contract for the manufacture, construction, or production of specified energy property for use by the applicant’s facility provided the contract is entered into prior to the work taking place.
What Doesn’t Count. The following do not qualify as “physical work of a significant nature:”
- Preliminary work such as planning or designing, exploring, researching, clearing land, building fences, obtaining permits or securing financing is not physical work of a significant nature. Excavation to change the contour of land is not physical work of a significant nature, but excavation for footings and foundations is.
- Generally, the cost of removal from the site of existing structures or property is associated with the property being removed or is capitalized to non-depreciable land. This is considered preliminary work and does not constitute physical work of a significant nature on specified energy property.
- Roads on the site that are integral to the qualified facility are specified energy property; these include onsite roads that are used for moving materials to be processed (for example, biomass) and roads for equipment to operate and maintain the facility. Starting construction on these roads constitutes the beginning of construction. Roads for access to the site, or roads used solely for employee or visitor vehicles are not specified energy property; starting construction on these roads is not starting physical work of a significant nature on specified energy property.
- Test drilling for a geothermal deposit is a preliminary activity and is not physical work of a significant nature.
- Because a building is not specified energy property, construction of a building is not physical work of a significant nature. However, the following structures are not treated as buildings for this purpose: (1) a structure that is essentially an item of machinery or equipment, or (2) a structure that houses property used as an integral part of a qualified activity if the use of the structure is so closely related to the use of the housed property that the structure clearly can be expected to be replaced when the property it initially houses is replaced.
In the case of a qualified facility described in section 45, specified energy property includes property integral to the production of electricity, but does not include property used for electrical transmission. Thus, physical work on a transmission tower located at the site is not physical work of a significant nature because the transmission tower is not part of the qualified facility. However, physical work on a transformer that steps up the voltage of electricity produced at the facility to the voltage needed for transmission is physical work of a significant nature because power conditioning equipment is part of the qualified facility.
In general any physical work on the specified energy property will be treated as the beginning of construction even if such work relates to only a small part of the facility, but Treasury will closely scrutinize any construction activity that does not involve a continuous program of construction or a contractual obligation to undertake and complete within a reasonable time, a continuous program of construction. Disruptions in the work schedule that are beyond the applicant’s control (for example, unusual weather or a site) will be taken into account in determining whether or not an applicant has undertaken a continuous program of construction.
Work Performed by Contractors. As noted above, physical work of a significant nature also includes physical work that has taken place under a binding written contract for the manufacture, construction, or production of specified energy property for use by the applicant’s facility provided the contract is entered into prior to the work taking place.
To be binding, a contract must be enforceable under state law. Additionally, the contract terms cannot limit damages in the event of a breach to less than 5% of the total contract price.
Work performed under the contract includes only work that takes place after the binding written contract is entered into. The work is treated as physical work of a significant nature only if it is work on property that will become specified energy property of the applicant. For example, if a contractor is manufacturing solar panels specifically for the applicant under a binding written contract, any physical work on those panels is physical work of a significant nature on specified energy property of the applicant. If an applicant has a binding written contract with a contractor that is manufacturing solar panels for several different customers, physical work on the panels would only be considered work performed under the applicant’s binding written contract if the contractor can reasonably demonstrate that physical work has started on panels that will become specified energy property of the applicant. The contractor may use any reasonable, consistent method to allocate work it performs among its customers. Whether a method is reasonable depends on all the relevant facts and circumstances.
If an applicant purchases components or other parts from the inventory of a vendor under a binding written contract, physical work of a significant nature has not begun because work performed under a contract does not include work to produce components or parts that are in existing inventory or are normally held in inventory by a manufacturer.
If physical work takes place under to a binding written contract on property manufactured, constructed or produced for the applicant’s project but the specific site for the project is not identified before the deadline for submitting initial applications (or the site changes after an initial application is submitted), the fact that the specific site of the project has not been identified at the time of the initial application (or changes after the initial application) does not affect the determination of whether construction has begun.
5% Safe Harbor
An applicant meets the 5% safe harbor if the applicant pays or incurs 5% or more of the total cost of the specified energy property before the end of 2010.
What does “paid or incurred” mean? Costs are taken into account when cash-method taxpayers “pay” them and when accrual-method taxpayers “incur” them. A cost is generally “incurred” for tax purposes when (1) the fact of the liability is fixed, (2) the amount of the liability is determinable with reasonable accuracy, and (3) “economic performance” has occurred with respect to the liability. The 5% safe harbor includes a single exception to the foregoing general principles used to determine when amounts are “incurred.” Under the general rules, when property is manufactured, constructed, or produced for the applicant by another person under a binding written contract, economic performance occurs, and the cost of such property is treated as “incurred,” when the property is finally delivered or provided to the applicant. The exception is that, for periods before the property is provided to the applicant, costs incurred by such other person (contractor) are treated as costs of the property that are incurred by the applicant (for purposes of the 5% safe harbor) when the costs are incurred by the contractor.
Costs are deemed paid or incurred by the person providing property to the applicant (contractor) as that person pays or incurs costs in connection with providing property to the applicant. Property is provided to the applicant when title to the property passes to the applicant or when the property is delivered to or accepted by the applicant, depending on the applicant’s method of accounting. In addition, property that the applicant reasonably expects to be provided within 3-1/2 months after the date of payment will be considered to be provided on the earlier payment date.
Costs Incurred by Contractors. In the case of property manufactured, constructed, or produced for the applicant by another person (the contractor) under a binding written contract that is entered into prior to the manufacture, construction, or production of the property, the FAQ explains how the applicant determines what costs have been paid or incurred on its behalf by the contractor. Assuming that the contractor uses the accrual method of accounting, the applicant may rely on a statement by the contractor as to the amount incurred by the contractor with respect to the property to be manufactured, constructed, or produced for the applicant under the binding written contract. The contractor may use any reasonable, consistent method to allocate the costs incurred by the contractor among the units of property to be manufactured, constructed, or produced by the contractor. Only costs incurred by the contractor after the binding written contract is entered may be reasonably allocated to the property manufactured, constructed, or produced under that contract. The economic performance rules apply to determine when costs have been incurred by the contractor.
The exception that allows the applicant to take into account costs that are incurred by its contractor does not apply to costs incurred by a subcontractor. Thus, if components are manufactured for the contractor by a subcontractor, the cost of those components is incurred only when the components are provided to the contractor and not as the subcontractor pays or incurs the costs of manufacturing the components. However, property that the contractor reasonably expects to receive from a subcontractor within 3-1/2 months of the date of the contractor’s payment to the subcontractor is considered to be provided by the payment date.
The FAQ addresses the impact of assignments of binding contracts between related entities. For example, a developer may enter into a binding written contract for multiple units of property to be manufactured for the developer by another person under a binding written contract (a “master contract”) that is entered into prior to the manufacture of the property. The developer may then assign its rights to certain units of property to an affiliated special purpose vehicle (generally, a limited liability company) that will own the project for which such property is to be used and will apply for the grant payment. If costs paid or incurred with respect to the master contract are considered to have been paid or incurred in 2009 or 2010 for purposes of determining whether construction has started. For purposes of determining whether construction has started, these costs are treated as costs of the property notwithstanding the assignment of all or a portion of the contract to the developer’s affiliate.
To satisfy the 5% safe harbor applicants must demonstrate that costs paid or incurred before the end of 2010 are equal to or greater than 5% of the actual total costs of the specified energy property. However, if the applicant’s project includes multiple units of specified energy property, an applicant can opt to apply for a grant based on some, but not all, units of property. For example, if an applicant incurs $10,000 in costs in 2010 for specified energy property in a 5 turbine wind farm anticipating total costs for specified energy property of $500,000 but the actual total costs of specified energy property amount to $600,000, the safe harbor would not be satisfied. However, the applicant can opt to apply for a payment based on the costs of 3 turbines and would satisfy the safe harbor if the $10,000 of costs incurred in 2010 relates to the 3 turbines and their total cost does not exceed $500,000.
Process and Documentation
All applications for section 1603 grants must be submitted by the statutory deadline of October 1, 2011. For property that has been or will be placed in service in 2009 or 2010, an application demonstrating that construction has begun is not required. For property that is placed in service after December 31, 2010, but before October 1, 2011, applicants need only submit a single application demonstrating both that construction began on the property in 2009 or 2010 and that the property has been placed in service. For property that is placed in service on or after October 1, 2011, applicants must submit a preliminary application by October 1, 2011, demonstrating that construction on the property began in 2009 or 2010. Such applications must then be supplemented at the time the property is placed in service.
If an applicant submits an application demonstrating that construction has begun, the IRS will notify the applicant whether or not the work performed is physical work of a significant nature or, for applicants relying on the safe harbor, whether qualifying costs have been paid or incurred. However, the IRS cannot provide assurance that an applicant meets all the requirements for a payment until all facts and circumstances are known (at time the facility is placed in service).
For projects relying on “physical work of a significant nature” applicants must document the physical work. For example, to demonstrate that physical work of a significant nature has commenced at the site, applicants should submit a written report from the project engineer or installer, signed under penalties of perjury, describing the project’s eligibility; including a detailed construction schedule; estimated budget for the project and a description of the work that has commenced including any invoices for the work performed. For projects with an anticipated cost basis of $1 million or more, the report must be from an independent engineer. To demonstrate that physical work of a significant nature has commenced under a binding written contract, applicants should submit a copy of the binding written contract and a statement from the contractor, signed under penalties of perjury, describing the work that has commenced and certifying that the work commenced pursuant to the binding written contract.
For projects relying on the 5% safe harbor, applicants must submit a statement from an authorized representative of the applicant signed under penalties of perjury, or for projects with an estimated eligible cost basis of $1 million or more, from an independent accountant, attesting to the method of accounting used by the applicant for federal tax purposes (cash or accrual). For applicants that use the cash method of accounting, the statement should state the amount that has been paid before the end of 2010; a detailed description of the costs that have been paid; and an estimate of the total cost of the specified energy property and must include evidence of payment such as invoices or other financial records. For applicants that use the accrual method of accounting, the statement should state the amount that has been incurred before the end of 2010; a detailed description of the costs incurred; and an estimate of the total cost of the specified energy property and must include evidence of the costs incurred such as invoices or other financial records. If an applicant is relying on costs paid or incurred by a contractor, a copy of the binding written contract and a statement from the contractor, signed under penalty of perjury, of costs paid or incurred and allocated to applicant’s project must be included.
Additional documentation may also be required depending on the facts and circumstances. If additional documentation is required applicants will be notified.
Howard A. Cooper
Craig M. Kline
Project Development & Finance Practice
Todd R. Coles
Project Development & Finance Practice