The Treasury Department recently issued a series of FAQs in an effort to clarify when projects will be treated as having "begun construction" for purposes of the section 1603 grant. As you may be aware, a project that otherwise qualifies for the grant but is not placed in service before the end of 2010 may still be eligible for the grant if construction on the project is begun in 2009 or 2010 and the project is eventually placed in service before the applicable "credit termination date." The new FAQs address a number of the unanswered questions. However, the framework adopted by the Treasury Guidance and the new FAQs is complex, and there appears to be a considerable amount of confusion among developers about how the "beginning construction" requirement can be met. Therefore, we thought it important to issue this alert.
There are two distinct ways to begin construction pursuant to the Treasury Guidance: (1) actual physical activity; or (2) the expenditure of money. These tests are entirely separate, and what counts toward meeting one test generally will not affect qualification for the other.
- Physical Activity Test
Actual physical activity is the first test for beginning construction. The Treasury Guidance states that "[c]onstruction begins when physical work of a significant nature begins." FAQ 4 provides that even a small amount of physical activity will meet this requirement. However, FAQ 5 states that Treasury will scrutinize projects where the physical activity, once begun, does not involve a continuous program of construction. In other words, Treasury will evaluate whether work begun in 2009 or 2010 is carried on continuously and may disallow the section 1603 grant if it is not.
The Treasury Guidance and FAQs provide that both physical work done by the applicant itself and physical work done by others pursuant to a binding written contract may be taken into account. In addition, work done both on site and off site may count in meeting the physical activity test.
Importantly, there are specific requirements that must be met for a contract to be considered binding for purposes of section 1603, and only work done after the binding contract is entered into will count for purposes of this test.
On-site work may include excavation for foundations, pouring of concrete pads, building of certain roads, and assembly of machinery. Off-site work may include the manufacture of component parts, such as boilers or solar arrays, to be assembled or used on site. Preliminary work, such as planning and design, securing financing, researching, and site clearing, does not qualify. Physical work of a significant nature may begin even if a specific site for the facility has not been identified.
- Expenditure Test – The 5 Percent Safe Harbor
As an alternative to the physical activity test, the Treasury Guidance provides that construction begins if a safe harbor is satisfied. To qualify for the safe harbor, an applicant must have "paid or incurred" more than 5 percent of the total cost of the property on or before December 31, 2010. As with the physical activity test, these costs must be paid or incurred pursuant to a binding written contract. This is strictly an expenditure test; physical work is neither required nor relevant. There has been considerable confusion about this test.
The term "paid or incurred" has a specific meaning for tax purposes, based on whether the taxpayer is an accrual method or cash method taxpayer. For accrual method taxpayers, mere payment of an expense (e.g., making a nonrefundable deposit) generally is not sufficient for the expense to have been "incurred."
For purposes of the safe harbor, the general rule is that amounts are not treated as paid or incurred by an accrual method applicant until the property or services have actually been provided to the applicant by the contractor (or until the payment date, if the property or services are reasonably expected to be provided within three-and-a-half months of the payment date).
In addition, the Treasury Guidance provides that, if there is a binding written contract but the property or services have not yet been provided to the applicant, costs may be treated has having been paid or incurred by the applicant when costs have been paid or incurred by the contractor.
- Pros and Cons of the Two Tests
The 5 percent safe harbor is useful if physical work, either on site or off site, will not begin before 2011. Conversely, where it is possible for physical work of a significant nature to begin before the end of 2010, the 5 percent safe harbor has limited application. However, one advantage of meeting the 5 percent safe harbor, rather than the physical activity test, is that there is no requirement for the safe harbor that construction be continuous (see FAQ 22).
Planning and Drafting for Meeting the "Beginning Construction" Requirement
It is important that various agreements, such as EPC and BOP contracts and turbine and other equipment supply agreements, address how the "beginning construction requirement" is intended to be met. Where necessary, these agreements should be drafted to ensure they meet the requirements for "binding written contracts." It may also be appropriate for them to set specific performance and payment deadlines, and to obligate particular parties to provide reports, allocate costs, etc. in order that the application for the section 1603 grant can be completed. Finally, the agreements should address the question of allocation of risks if the various requirements for "beginning construction" are not met.
Developing and implementing a strategy for satisfying the "beginning of construction" requirement requires a thorough analysis of the particular transactions being considered. In addition, great care must be exercised in drafting the various agreements to ensure that they address the various requirements.