SEVERAL CONSTRUCTION-START ISSUES remain unsettled. Meanwhile, the market is feeling its way.
New wind, geothermal, biomass, landfill gas, small hydroelectric and ocean energy projects must be under construction by December 2013 to qualify for federal tax credits. Such projects qualify for a 30% investment tax credit or for production tax credits for 10 years on the electricity output.
There are two ways to start construction this year: by starting “significant” physical work on the project or by “incurring” at least 5% of the project cost.
However, the developer must also show that work on the project after this year is “continuous.”
The Internal Revenue Service said on September 20 that work on any project that is placed in service by December 2015 will automatically be considered to have been continuous. The IRS made the announcement in Notice 2013-60. Developers had been worried they will have trouble financing projects because lenders will be unable to tell at closing on the financing whether the project will qualify for tax credits.
Continuous work will remain an issue for projects that are not completed until 2016 or later.
The notice has caused developers to take another look at the physical work test rather than try to incur at least 5% of the project cost this year for projects that are expected to be completed in 2014 or 2015. It is not as expensive to start physical work at the project site or a factory, but many developers are asking how much work this year is enough.
According to the IRS national office, it is the start of significant physical work to put down a single turbine foundation or build a road around one or more turbine pads (as opposed to an access road to the main highway) or to have a factory start assembly of custom-made components for the project.
Rep. James Lankford (R.-Okla.) asked Curtis Wilson, the IRS associate chief counsel who handles energy tax credits, at a House subcommittee hearing in early October whether it is enough to put down turbine foundations for two turbines and put in a road this year to enable a 100-turbine wind farm to qualify for tax credits. Wilson suggested the entire project would qualify as long as the project functions as a single, integrated facility.
However, some developers remain uneasy. The IRS included an example of significant physical work in guidance it issued last spring on starting construction. That guidance had an example of a developer excavating foundations and pouring concrete for pads for 10 of 50 turbines, or 20% of foundations. IRS sources say the reference to 10 turbines was an error, and the intention was to refer to one turbine foundation like a similar example used in the Treasury cash grant program.
The IRS is following precedent under the section 1603 or Treasury cash grant program. The Treasury never required a minimum amount of work, but over time, it questioned whether some projects that lacked permits or other basic project contracts were truly under construction.
Many wind companies have spent the summer negotiating master turbine supply agreements with turbine vendors that require delivery of enough tower segments, blades, nacelles or other specially-made equipment to amount to at least 5% of the expected cost of their projects. The IRS has said informally that the projects at which the equipment will be used do not have to be identified this year. By extension, if the contract identifies four projects at which the equipment will be used and another project is later substituted for one of the four, components can be moved to that project and it should qualify for tax credits as long as the developer had been working steadily on it.
Some common issues are emerging in turbine contract negotiations. Costs are not considered “incurred” for purposes of the 5% test until there is delivery or transfer of title to equipment or services, with one exception. A payment in 2013 counts as a 2013 cost as long as delivery or title transfer is expected within 3 1/2 months of the payment.
Many developers are planning to pay in late 2013 for equipment to be delivered in early 2014. General milestone payments or down payments for a larger turbine order do not count for this purpose. The 2013 payment should be for the specific components. The 3 1/2-month rule appears to be a “method of accounting,” meaning that if the developer has used another method in the past to determine when costs are incurred, then the IRS must give permission to change. Some developers who are unsure whether they can use the 3 1/2-month rule are turning the entity that contracts with the turbine vendor into a partnership for tax purposes so that it has a clean slate to choose an accounting method.
Developers relying on the 3 1/2-month rule should make sure that the purchase order for the components is a “binding contract.” The contract cannot be merely an option to choose components later. Some contracts give the manufacturer the option to substitute different components in 2014 if the manufacturer is unable by the deadline to deliver exactly what was ordered. The IRS is still evaluating whether such a right for the manufacturer will prevent the contract from being considered a binding contract after indicating initially that such substitution clauses are okay.
Chadbourne has never felt comfortable relying on title transfer as opposed to delivery in 2013 (or within 3 1/2 months of a 2013 payment). Delivery can be at the factory. However, the parties must prove delivery occurred if the turbine vendor still remains in physical possession of the equipment. The developer should send a representative to inspect the equipment and sign a delivery certificate. It should have the right to remove the equipment at any time. It should pay for storage. It should have risk of loss. The equipment should be segregated from other inventory belonging to the vendor or, if the components are too large to do this, at least marked as property of the developer. Sales and other transfer taxes that are triggered by delivery should be paid. If the vendor is expected to re-deliver the equipment later to the project site, then there should not be anything in the later contract arrangements that calls into question whether the equipment was originally delivered at the factory. The equipment should not be of a kind that must be returned to the factory for further assembly.
Turbine vendors are agreeing to damages if they fail to make delivery deadlines, but the amounts vary from one contract to the next.
The ability to drop components into projects to be identified in the future gives an advantage to larger wind companies that are able to stockpile equipment. A common question is whether a company that has 2013 turbines can buy a project that a smaller developer has under development in 2014 and use the turbines to qualify for tax credits. The answer appears to be yes, provided the smaller developer has been working steadily on the project, but the IRS has yet to confirm this.
No further guidance is expected from the IRS on construction-start issues. The agency is still thinking about whether to entertain requests for private letter rulings. It does not rule on factual issues. Any rulings would have to present legal questions.
Before the IRS notice in September that dispenses with the need to show continuous work on projects that are completed by December 2015, many developers had been focusing on the 5% test. This remains the safer course for 2016 and later projects. For 2016 and later projects, physical work this year must be followed by “continuous construction,” while incurring 5% of the cost this year must be followed only by “continuous efforts.” The types of tasks that qualify as “continuous efforts” contemplate that a project may still be under development, while “continuous construction” seems to require a project to be farther along.
The IRS uses two principles to decide whether development efforts are continuous. First, it wants to see steady and diligent effort to finish developing the project and then build it. The development team should keep weekly logs showing what was done each week to advance the project. The team ought to ask itself every Monday what it can do that week to advance the project and then work at it. Second, interruptions in the work schedule that are outside the control of the developer are not a problem.
The IRS has said informally that it is not a problem to take the date when the utility to whose grid the project connects will have completed the substation improvements and network upgrades needed before the utility can start receiving electricity from the project and then work backwards from that date to determine when to start erecting turbines at the site.