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IRS Releases Additional Guidance on Beginning of Construction Requirements for Production Tax Credit and Investment Tax Credit Eligibility

On August 8, 2014, the Internal Revenue Service (the “IRS”) made available Notice 2014-46 (the “August Notice”),[1] which provides greater clarity in respect of the methods taxpayers may utilize to satisfy the “beginning of construction” requirement for the production tax credit (the “PTC”) under Section 45 of the Internal Revenue Code of 1986, as amended (the “Code”), and the investment tax credit (the “ITC”) under Code Section 48.[2] In particular, the August Notice provides the following:

1. clarifying guidance regarding satisfying the “physical work test” method (the “Physical Work Test”) related to the beginning of construction requirements, as originally set forth in Notice 2013-29 (the “April 2013 Notice”);[3]
2. clarifying guidance regarding the effect of certain transfers in respect of projects and project assets after certain project costs have been incurred or construction of a project has begun; and
3. a modification of the existing “5% of costs paid or incurred” safe harbor (the “5% Cost Safe Harbor”) originally described in the April 2013 Notice.

Together, this much anticipated guidance provides investors and developers with greater certainty in structuring and evaluating renewable energy projects intended to qualify for the PTC or ITC and provides a new rule with respect to cost overruns in connection with projects intended to qualify for the 5% Cost Safe Harbor.

I. Background

Prior to the enactment of the American Taxpayer Relief Act of 2012 (the “2012 Act”),[4] for purposes of claiming the PTC (or ITC in lieu of the PTC) a qualified facility was defined as a facility “placed in service” prior to January 1, 2014 (January 1, 2013, in the case of wind facilities) that was used to produce electricity from eligible resources. The 2012 Act revised this requirement such that a facility, including a wind facility, can qualify under these provisions if construction of the facility began prior to January 1, 2014.

In April 2013, the IRS released the April 2013 Notice, which set forth two methods taxpayers may use to satisfy the 2012 Act’s beginning of construction requirement:

1. by starting physical work of a significant nature prior to January 1, 2014 (i.e, the Physical Work Test); or
2. by paying or incurring 5% or more of the total cost of the facility and thereafter making continuous efforts to advance toward completion of the facility (i.e., the 5% Cost Safe Harbor).

The IRS noted in the April 2013 Notice that it would closely scrutinize a taxpayer seeking to utilize the Physical Work Test if the taxpayer did not maintain a “program of continuous construction.” Under the April 2013 Notice, the “program of continuous construction” and “continuous efforts” tests were based on a facts and circumstances analysis.

In September 2013, the IRS released additional guidance in the form of Notice 2013-60 (the “September 2013 Notice”),[5] clarifying the April 2013 Notice, which (i) provided a rule that treats a taxpayer as satisfying the “program of continuous construction” and “continuous efforts” requirements set forth in the April 2013 Notice if the qualified facility is placed in service prior to January 1, 2016, (ii) provided that a qualified facility transferred to another taxpayer is not required to be constructed by the transferee taxpayer claiming the PTC or ITC and (iii) provided that the “master contract rule” (a rule that allows taxpayers to include under the begun construction tests costs paid or incurred, or physical work completed, under a binding written contract that is assigned to an affiliated special purpose vehicle) articulated in the April 2013 Notice applies to the 5% Cost Safe Harbor as well as the Physical Work Test.

II. The August Notice

A. Satisfaction of the Physical Work Test
As noted above, the April 2013 Notice provided that a taxpayer may satisfy the begun construction requirements of Code Section 45 by beginning physical work of a significant nature with respect to a project prior to January 1, 2014 (i.e., the Physical Work Test). The April 2013 Notice set forth several examples of physical work that satisfy the Physical Work Test. These (non-exclusive examples) include: (i) in the case of wind turbines, beginning the excavation for the turbine’s foundation, setting anchor bolts into the ground, or pouring the concrete pads for the turbine’s foundation; (ii) beginning physical work on a custom-designed transformer that steps up the voltage of electricity produced at the facility that is needed to enable transmission of such electricity; and (iii) beginning physical work with respect to certain roads that are “integral” to the activity that will be performed by the facility. What was not clear in the April 2013 Notice was whether any one of these activities alone or whether a number of different physical work related activities would have to have been performed to satisfy the Physical Work Test.

The August Notice clarifies that each such activity (if such activity is “significant”), standing alone, constitutes physical work of a significant nature for purposes of satisfying the Physical Work Test. That is, a taxpayer need not begin each of the enumerated work activities in order to satisfy the Physical Work Test. The August Notice does not establish a bright line rule to address the question of the amount or extent of activity needed to be characterized as “significant” with respect to the above test and examples (e.g., starting the excavation of a wind turbine foundation and starting construction on certain “integral” roads).

However, the August Notice does imply that the amount of work needed in order to be characterized as significant is not extensive. In this regard, there are two helpful comments in the August Notice. First, the August Notice states that “beginning” work with respect to the examples will constitute work of a significant nature, which arguably implies that the amount of work that must be done before January 1, 2014, does not have to be extensive, and it seems clear from this language that such activities do not have to be completed before January 1, 2014. Second, the August Notice clarifies that an example set forth in the April 2013 Notice whereby a wind project consisting of 50 turbines was deemed to satisfy the beginning of construction requirement where the developer excavated the foundations and poured the concrete support pads for 10 of the turbines does not stand for the proposition that this example represents a minimum threshold in respect of the amount of work required to satisfy the Physical Work Test. Importantly, the August Notice states that “there is no fixed minimum amount of work or monetary or percentage threshold required to satisfy the Physical Work Test.”

Thus, this language provides very helpful guidance to renewable energy project investors and developers by clarifying points that raised a lot of uncertainty among practitioners as to the manner in which the examples set forth in the April 2013 Notice should be applied in respect of analyzing a project’s qualification under the Physical Work Test.

B. Transfers Relating to Facilities
As explicitly stated in the September 2013 Notice, eligibility under Code Section 45 does not require the taxpayer claiming the relevant tax credit be the same taxpayer that begins construction of the facility prior to January 1, 2014. That is, a facility could be transferred without fear that the facility might, post-transfer, be treated as not having satisfied the begun construction Physical Work Test or the 5% Cost Safe Harbor requirements. The August Notice adds some color with respect to “facility” transfers with what appear to be two separate rules, one for transfers between related parties and one for transfers between unrelated parties:

1. The first facility transfer rule provided in the August Notice appears to allow all transfers between parties that are related (generally a 20% related ownership requirement specifically defined in Code Section 197(f)(9)(C)).
2. The second facility transfer rule provided in the August Notice makes it clear that work performed or amounts paid or incurred prior to January 1, 2014 by an unrelated developer may be taken into account by an unrelated transferee for purposes of determining whether the facility qualifies under the Physical Work Test or the 5% Cost Safe Harbor only if such transfer involves the transfer of “more than just tangible personal property.”

With respect to the second facility transfer rule, the August Notice emphasizes that in the case of a transfer “consisting solely of tangible personal property (including contractual rights to such property under a binding written contract)” to a transferee not related to the transferor, the transferee may not take into account physical work performed or amounts paid or incurred by the transferor for purposes of the Physical Work Test or the 5% Cost Safe Harbor.

The two facility transfer rules appear to be squarely aimed at prohibiting taxpayers from “trafficking” in tangible personal facility property that was manufactured, or for which amounts were paid or incurred, prior to January 1, 2014 by a transferor selling such tangible personal facility property to an unrelated transferee. Unless such transfer also includes other intangible property (e.g., land, leases, options to acquire land, PPAs or permits) related to the transferred tangible personal facility property with respect to a facility that began construction prior to 2014, the work performed or cost incurred with respect to the transferred tangible personal property will not be taken into account in determining whether the Physical Work Test or the 5% Cost Safe Harbor has been satisfied.

Prior to the August Notice, another cause for great concern by many investors and tax advisors was uncertainty with respect to whether physical activities or costs incurred with respect to equipment or components had to be identified or allocated to a specific facility site prior to January 1, 2014. The August Notice squarely addresses this concern by stating that a taxpayer will not lose eligibility under the begun construction requirements of Code Section 45 if the taxpayer begins construction of a facility in 2013 with the intent to develop a facility at a particular site, but, thereafter, transfers equipment or components of the facility to a different site, completes the facility’s development and places the facility in service.[6]

C. Satisfaction of the 5% Cost Safe Harbor
Finally, the August Notice modifies the 5% Cost Safe Harbor with respect to situations involving cost overruns. The August Notice provides that for circumstances in which a taxpayer has paid or incurred less than 5% of the total costs of a “single project” (comprised of multiple facilities) prior to January 1, 2014, determined at the time the “single project” is placed in service (e.g., due to cost overruns), a taxpayer may still claim the PTC or ITC on any number of individual facilities (e.g., wind turbines) that comprise the project, provided that (i) the project consists of multiple facilities and (ii) the taxpayer has paid or incurred at least 3% of the “single project’s” total costs. Assuming the above requirements are satisfied, the August Notice permits PTCs or ITCs to be claimed on a portion of the “single project’s” facilities[7] (e.g., wind turbines) equal, in the aggregate, to twenty times the amounts paid or incurred prior to January 1, 2014.

This modification establishes what is arguably a new minimum cost “floor” with respect to the 5% Cost Safe Harbor in cost overrun situations that was not present in the April 2013 Notice. That is, under the April 2013 Notice, if a taxpayer failed to have paid or incurred 5% or more of the total cost of a project comprising multiple facilities because the total cost of the project was greater than anticipated (e.g., due to cost overruns), it appeared the taxpayer could still claim the PTC or ITC pro rata in respect of a portion of the facilities comprising the project, regardless of whether the taxpayer had paid or incurred 3% of the costs of the entire project prior to 2014.

* * *

The August Notice was much anticipated by sponsors that began construction of projects prior to January 1, 2014, and investors that are currently evaluating investments in such projects. In general, the August Notice provides welcome guidance to industry participants in respect of renewable energy investments by clarifying and expanding certain elements of prior “begun construction guidance” that may have chilled investment in certain renewable facility projects proposed to be PTC and ITC eligible. The August Notice should act as a catalyst to spur investment in renewable facilities that legitimately began construction in 2013.

[1] 2014-35 IRB 1. The August Notice is available here.
[2] The PTC (or ITC in lieu of the PTC) generally is available in respect of qualifying wind facilities, open-loop and closed loop biomass facilities, geothermal facilities, landfill gas facilities, trash facilities, hydropower facilities and marine and hydrokinetic facilities.
[3] 2013-29 IRB 1085. The April 2013 Notice is available here. Our prior client alert on this topic is available here.
[4] Pub. L. No. 112-240.
[5] 2013-42 IRB 1. The September 2013 Notice is available here. Our prior client alert on the September 2013 Notice is available here.
[6] We note that certain equipment and components may also be allocated by a taxpayer to a specific facility site pursuant to the “master contract” provisions described above.
[7] The August Notice makes clear that this modification to the 5% Cost Safe Harbor is inapplicable to a project that does not consist of “multiple facilities” (e.g., certain biomass facilities).

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Arthur Hazlitt, an O'Melveny partner licensed to practice law in New York, Mark Caterini, an O'Melveny partner licensed to practice law in New York, Junaid Chida, an O'Melveny partner licensed to practice law in California and New York, and Alexander Roberts, an O'Melveny associate licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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