A lot of talk at recent renewable energy conferences in the United States is about how much of a rush there will be to start construction of new projects by year end.
Wind, geothermal, biomass, landfill gas, incremental hydroelectric and ocean energy projects must be under construction by December 2013 to qualify for federal tax credits. The credits are worth at least 30% of the capital cost of such projects.
Large wind company CEOs attending the Global Windpower 2013 convention in Chicago in May all said they hope to have at least one or two new wind farms under construction by year end. Equipment manufacturers have been focusing on what they can do to help developers satisfy tests in the US tax rules for what it means to be under construction. However, unlike past years, few developers seemed to be using the wind convention to close turbine deals. Any new turbine orders seem unlikely to be placed until the fall.
The Internal Revenue Service explained in April what a developer must do to be considered to have started construction of a project this year. The IRS guidance is in Notice 2013-29.
There are two ways to start construction.
One is by starting "physical work of a significant nature" at the site or at a factory that is making equipment for the project. However, any work done by a contractor at the site or the factory counts only if done under a binding contract that is in place before the work starts.
The other way is by showing that the developer "incurred" at least 5% of the total project cost by year end. Costs are not usually “incurred” merely by spending money. The developer must ordinarily take delivery or title to services or equipment, but there are exceptions.
Projects that are under construction by December 2013 will qualify for 10 years of production tax credits on the electricity output or an investment tax credit upon project completion for 30% of the project cost.
Once construction starts, it must be continuous. This creates hindsight risk that a project that appeared under construction at the end of 2013 may not have been under construction after all.
Developers would do better to start under the 5% test rather than rely on physical work, although anyone who can should do both.
The problem with relying solely on physical work is that it will require proving later that there was "continuous construction." The US Treasury Department used the same two tests to administer a cash grant program for renewable energy projects that required projects to be under construction by 2011 to qualify. The Treasury came, over time, to feel that a project was not truly under construction based solely on a limited amount of physical work until it had all the permits and contracts in place to begin construction in earnest. Thus, for example, a developer who started work on roads or a foundation at the site, but who had no interconnection agreement, power contract, turbine supply agreement or balance-of-plant construction contract was not under construction even though another project with all the contracts that did the same road work would be viewed as underway. There is a risk that IRS agents auditing projects in the future will take the same position.
The 5% test requires "continuous efforts," but contemplates that a project may still be merely under development, as long as the developer works diligently after 2013 on rounding up permits, negotiating contracts and moving the project along. It would be a good idea to keep a log.
There is no deadline to complete construction.
Some in the IRS view the continuous work requirement as a soft deadline. However, the IRS guidance itself suggests that it is more a tool the IRS can invoke to prevent abuse. The IRS said it "will closely scrutinize a facility, and may determine that construction has not begun . . . if a taxpayer does not maintain a continuous program of construction." (Emphasis added.)
Developers have been asking a number of hard questions. One question is whether a project on which physical work starts in 2013 and that normally takes X months to build can qualify for tax credits if it takes three times that long to construct.
The answer is yes if the delays are due to factors beyond the control of the developer. The IRS published a list of examples of permitted delays. They are merely examples. There could be others. They include severe weather, natural disasters, licensing and permitting delays, inability to obtain specialized equipment due to limited availability and similar supply shortages and financing delays of less than six months.
What if there were no delays and the developer worked continuously, but at a much slower pace than normal? There is no clear answer.
What if there is a significant time lag between the start of work in 2013 and its later resumption that could have been avoided by not waiting as long to negotiate a key contract. For example, a developer relying on physical work in 2013 to start construction does not sign an interconnection agreement for the project until 2014 and there is an extended wait until the utility can have the intertie in place to allow electricity to reach the grid. The site work on the project is delayed to work backwards from when the intertie will be available. Such a project may have trouble qualifying under the physical work test, but seems to fit the pattern of a project still under development for which the 5% test is better suited.
The IRS had hoped not to publish any more guidance.
However, there is talk internally of possibly publishing examples to give the market a clearer indication of how the agency analyzes several common fact patterns. The talk is still at an early stage. Any such guidance would probably not be issued until the fall.
Physical work can be at the site or at a factory. It must be significant.
The IRS said examples of significant physical work at the site are "the beginning of the excavation for the foundation, the setting of anchor bolts in to the ground, or the pouring of the concrete pads of the foundation."
Preliminary activities like engineering, securing financing, doing environmental studies, negotiating contracts and obtaining permits are not physical work. Test drilling to determine soil conditions, "excavation to change the contour of the land (as distinguished from excavation for footings and foundations)" and tearing down existing turbines and towers are not yet significant physical work on the new facility. They precede the start of such work.
Test drilling at a geothermal field is not yet significant. Drilling is significant when it starts on production or reinjection wells.
An example in the IRS guidance deals with a wind farm that will have 50 turbines. Work starts in 2013 on 10 of the turbines. However, IRS and Treasury officials said there was no intention to suggest that at least 20% of the project had to be under construction in 2013. There is no minimum percentage threshold.
The work must start on the "facility" as defined for production tax credit purposes. For a wind farm, the "facility" includes any of the equipment through the point where the electricity moves into transmission. Electricity is not usually in transmission until it has been stepped up to transmission voltage. Thus, equipment through the step-up transformer is normally considered part of the facility, assuming the transformer is owned by the project, as are circuit breakers on the high side of the transformer whose function is to protect the transformer.
The IRS said that it will treat each wind farm as a single project so that work on any part of the project will qualify as the start of construction of the entire project when the facts point to one large project. This was good news for wind developers and was probably the largest open issue for that industry before April. The IRS has treated each turbine, pad and tower at a wind farm in the past as a separate power plant for production tax credit purposes. Facts that point to a single project are one company owns the entire project, all the electricity is sold under a single power contract, it moves to the grid through a single substation and intertie, the entire project is financed under a single loan agreement, all the turbines are on contiguous sites and they are being supplied under a single turbine supply agreement.
For a power plant that uses biomass as fuel, the "facility" includes all the equipment that is "necessary" for generating electricity. It does not include the fuel yard equipment. It does include integrated fuel handling equipment to move the fuel into the gasifier or boiler.
The IRS defines the "facility" at a geothermal project as including not only the power plant but also the geothermal wells and pipelines to bring steam to the site and return spent fluid for reinjection in the field.
Roads that will be used at the site to move fuel or spare parts or other equipment needed during the operating phase are part of the facility. However, roads that provide access to the main highway or that will be used primarily by employees or visitors are not. Fences are not. Most buildings are not, but not all structures are considered buildings for tax purposes. A structure that is basically a shell over a boiler or turbine is part of the equipment.
The physical work does not have to be at the site; it can be at the factory. However, the work at the factory must be assembly of equipment that is being custom made for the project as opposed to components that the manufacturer normally holds in inventory.
Alternatively, a developer can show construction started in time by "incurring" at least 5% of the total project cost by December 2013.
Costs are normally not incurred until the developer takes delivery or title to services or equipment. Chadbourne has never been comfortable relying solely on title transfer. It prefers to rely on delivery. During the cash grant program, developers would sometimes assert that title transferred to components like raw sheet metal that had to go back to the factory for further fabrication. It is hard to see how design services by a manufacturer are delivered before the product in which they are incorporated is delivered.
Delivery can be at the factory. However, the equipment should be segregated from other equipment belonging to the manufacturer. The developer should take risk of loss after delivery. It should buy insurance. It should pay any transfer taxes. An employee of the developer should inspect the equipment at the factory and sign an affidavit attesting to what he or she saw. Care should be taken to avoid provisions in the vendor contract that suggest that delivery did not really occur at the factory: for example, a provision that makes the vendor responsible for redelivering the equipment to the site and that leaves the vendor with legal title and control until such redelivery.
There are two exceptions where costs can be counted before delivery.
First, the developer can count spending in 2013 as a 2013 cost if the services or equipment are delivered within 3 1/2 months of the payment. This does not mean that an entire series of payments from September to December counts if delivery occurs by mid-April 2014. Only the last in the series of payments within 3 1/2 months before delivery counts potentially as a 2013 cost. For example, paying for turbine blades on December 31, 2013 counts if the blades are delivered by April 15. (The IRS requires that delivery be "reasonably expected" within 3 1/2 months. Therefore, the contract should make the deadline clear, but taking actual delivery in time avoids questions later about whether the missed deadline was realistic.) The payment should be for the particular equipment to be delivered as opposed to a general down payment or general milestone payment for performance of the entire contract.
The 3 1/2-month rule is a "method of accounting." If the developer has used a different approach in the past to determine when costs are incurred— for example, waiting until project acceptance to incur costs — then use of the 3 1/2-month rule would be considered a change in accounting method and require an IRS private ruling.
Second, the IRS made it easier than it appears at first glance to incur costs. The developer can "look through" any binding contract with a vendor or other contractor and count costs that the contractor incurs through December 2013 to perform the contract. Thus, for example, wages and benefits that the contractor accrues to its employees for work during 2013 to perform the contract count. An example is for design work on specially-ordered equipment. Costs incurred under binding purchase orders with subcontractors count if services or components are delivered to the contractor in 2013 (or, if the contractor is able to use the 3 1/2-month rule, within 3 1/2 months of a 2013 payment by the contractor to the subcontractor for them).
Any developer who plans to count costs incurred by a vendor directly or with its subcontractors should include a provision in the vendor contract requiring the vendor to deliver a certificate at year end, under penalties of perjury, attesting to the costs it incurred. The vendor should be required to help the developer respond to inquiries from the IRS.
The same costs cannot be counted twice.
The developer must incur at least 5% of the total project cost by December 2013. Put in both the numerator and the denominator of the fraction only costs that will be recovered through depreciation of the "facility." Thus, for example, legal fees to negotiate a power contract or interconnection agreement or the cost of land do not count. However, legal fees to negotiate a vendor contract or a construction loan and interest during construction do count (although a small portion of the construction loan legal fees and interest might not count due to partial allocation to buildings, fences, ineligible roads and similar items).
At the end of the day, most projects cost more than expected. Careful developers usually aim to incur at least 7% of the expected project cost to leave a safety margin. However, the IRS said that rather than disallow the entire project, where the project would normally be treated as multiple individual "facilities," like each turbine at a wind farm, tax credits can still be claimed on part of the project by shedding enough individual facilities to bring the costs incurred to at least 5% of the smaller project.
Wind companies often enter into frame agreements to buy turbines for multiple projects. They may not know in 2013 where the turbines will be used.
IRS officials said that the turbines do not have to be designated in 2013 for use in a particular project. The intention is to follow the practice under the Treasury cash grant program of allowing the developer to contribute equipment whose costs were incurred in 2013 (or on which physical work started) later to an affiliated project company. The project company can count the same 2013 costs as incurred (or physical work as having started) on its project. The vendor should enter into a "daughter contract" with the project company that mirrors the terms in the master frame agreement as a way of assigning the contract rights for the turbines to the project company.
What if a turbine contract was signed by a project company but the project is later cancelled? Until the IRS confirms that equipment can be transferred in such a case to another project company within the same developer group, it would be safest to follow the pattern in the IRS guidance of signing contracts at a parent level, at least where the developer wants to retain flexibility to reassign the equipment later.
The IRS has not addressed when grandfather rights to tax credits will carry over in cases where a project is sold before the project is completed. Early drafts of the construction-start guidance had rules similar to the Treasury cash grant program. However, they had to be dropped after they caused the draft to bog down in the internal approval process. It is possible additional guidance will be issued later this year on the issue, but no decision has been made.
Physical work in 2013 by a vendor or other contractor counts only if done after a binding contract is in place. Also, costs can only be incurred under binding contracts. "Binding" is a term of art. The contract must be binding under state law; the developer should not have a right to cancel the contract and get its money back. It should not be able to walk away from the contract without compensating the contractor for its work to date. The contract can be silent about damages, but any cap on damages cannot be less than 5% of the total contract price.
The contract should identify the equipment to be purchased. A contract that is merely an option to choose among different types of equipment is not yet a binding contract. A contract for a range of quantities is binding only for the minimum quantity.
Many contracts require that a notice to proceed be given by the developer before the contractor is authorized to start work. Such a contract can be a binding contract as long as it is a question of when and not whether the notice will be given.
Work done under a limited notice to proceed counts toward the physical work or 5% test.
A contract between related parties cannot be binding. However, the most sensible approach in such cases is to analyze the work as if done by the developer directly. Thus, any contractor profit could not be counted toward the 5% test.