CONSTRUCTION-START ISSUES continue to take up substantial IRS time.
Wind, geothermal, biomass, landfill gas, incremental hydroelectric and ocean energy projects must be under construction by year end to qualify for federal tax credits.
Developers were focused early in the year on “incurring” at least 5% of the project cost. This is one way for a project to be considered under construction in time. As the year draws to a close, attention has shifted to starting physical work of a significant nature on the project.
It is unclear to what extent tax equity investors and lenders will be willing to rely on the physical work test when it comes time to finance projects. Some tax equity investors have said they are uncomfortable relying on the test. However, a prominent lender-side law firm is advising lenders that it is comfortable with physical work.
Another issue is how much physical work is required in 2013. According to the Internal Revenue Service branch in Washington that handles construction-start issues, the key is the task must be significant. All the developer must do is start on it; the task does not have to be completed in 2013. Therefore, it would be a good idea to release the contractor to work on a meaningful task even if he does only a small part of it in 2013. He should continue working into 2014 on that task until it is completed.
The developer can give a limited notice to proceed on work under a larger contract, as long as what the contractor is released to do in the limited notice is significant.
Some tax equity investors and lenders appear to be adhering strictly to examples in the IRS guidance on starting construction. The guidance gives the example of a wind company that excavates and pours concrete pads above ground in 2013 for 10 turbines at a 50-turbine project, or 20% of the pads. The IRS has said the example has a typo. It intended to say one pad in 2013 based on a similar example that was posted under the Treasury cash grant program. Another example in the guidance suggests that the start of physical assembly of the main transformer for a project at a factory is enough to qualify the project for tax credits.
A developer hiring a contractor to start physical work this year must have a “binding” contract in place with the contractor before the contractor starts work. The contract can give the developer a right to terminate the contract for convenience. It can be silent about the damages to be paid after such a termination. However, many contracts specify liquidated damages to be paid in such cases and set the amount at 5% of the total contract price. Although not required, it would be a good idea to make the damages in such contracts the fixed amount, but not less than the actual costs the contractor incurred in performing the contract. Otherwise, the work beyond 5% of the project cost may not be considered binding.
The IRS has been answering many questions informally. These informal discussions have shed light on the following issues.
In 2012, the Treasury questioned whether some projects that started physical work in late 2011 before the deadline to qualify for Treasury cash grants were truly under construction if the projects lacked basic project contracts and permits needed for construction. The Treasury dropped these inquiries after concluding that since projects relying on physical work had to show a continuous pattern of construction, if a project still lacked basic contracts and permits at the end of 2011, it would need to have them fairly soon after to be under continuous construction. The IRS has said that projects that are completed in 2014 or 2015 will be considered automatically to have been under continuous construction. Does the IRS plan to revisit the amount of physical work required in 2013 after waiving the need to show continuous construction? The answer is no.
A developer can look through a contract with a prime contractor like a turbine manufacturer and count costs that the prime contractor incurs with subcontractors and suppliers for the 5% test. Is there similar look through for the physical work test? The answer is yes.
A developer who incurs costs in 2013 by taking delivery of equipment can decide later in which projects it had under development in 2013 to use the equipment. As long as the 2013 equipment accounts for at least 5% of the cost of the project at which it is used, the project qualifies for tax credits. Does the same principle apply to turbines or transformers on which the developer had the factory start physical work in 2013? The answer is yes.
Can a developer use stockpiled 2013 equipment in projects that it acquires in 2014 from other developers and claim tax credits on those projects? If the developer selling the project started construction independently on the project in 2013, then the project will remain qualified for tax credits after the sale. If the project was not under construction in 2013, then there is no consensus within the IRS construction-start branch. Until a consensus is reached, the only ways to qualify such a project for tax credits would be to acquire it in 2013 or, if that is not possible, for the developer taking over the project in 2014 not to buy it, but to enter into a joint venture with the original developer, and use the stockpiled 2013 equipment to qualify the project for tax credits. The original developer would have to retain an ownership interest commensurate with the value of the development rights he contributes.
The IRS is prepared to issue private letter rulings on construction-start issues. However, it will only rule on purely legal questions and not mixed questions of fact and law. An example of a legal question is the 2014 transfer issue about which the branch is currently undecided.