On June 22, the IRS released Notice 2018-59, guidance that provides rules to determine when a solar project begins construction for investment tax credit (ITC) purposes. The guidance was much-awaited by the solar industry because the date upon which construction begins governs the determination of the percentage level of the ITC, which is ratcheted down for projects that begin construction after 2019.
Overview of Beginning of Construction
The ITC percentage for a solar project is determined based on the year in which construction of the project begins – provided the solar project is also placed in service before Jan. 1, 2024 – as follows: (i) before Jan. 1, 2020, 30%; (ii) in 2020, 26%; (iii) in 2021, 22%; and (iv) any time thereafter (regardless of the year in which the solar project is placed in service), 10%.
The guidance is quite similar to existing guidance for utility-scale wind projects. As expected and consistent with the wind guidance, the guidance provides two means for establishing the beginning of construction of a solar project: (i) engaging in significant physical work either directly or by contract (the physical work method) or (ii) paying or incurring – depending on the taxpayer’s method of accounting – 5% of the ultimate tax basis of the project (the five percent method).
As is the case with wind, the guidance provides that the IRS will apply strict scrutiny of the facts and circumstances to determine if the project was continuously constructed from the deemed beginning of construction date through the date the project is placed in service.
Four-Year Placed-in-Service Window
The wind guidance provides a four-year window for the project to be completed and to avoid the scrutiny as to whether the construction was continuous. There had been speculation that the window for solar – or at least some classes of solar – would be shorter because the time to construct solar projects, especially rooftop solar, is generally shorter. In what is a relief to the solar industry, the guidance provides solar a four-year window, as well.
What the four-year window means in conjunction with the ITC’s ratcheting-down is that a developer could purchase $5 million of racking that is paid for on Dec. 31, 2019, and delivered to the developer on April 15, 2020. The developer could then use the $5 million of racking in the construction of $100 million of projects (assuming the 5/100 ratio is maintained in each project), none of which reach “notice to proceed” until 2023, so long as the projects are placed in service by the end of 2023. That $100 million of projects would qualify for the 30% ITC. (Note: The $100 million does not necessarily refer to the out-of-pocket construction costs. Rather, it refers to the “total cost” of the ITC-eligible property – i.e., the amount on which ITC is claimed. For instance, the out-of-pocket construction costs may be $90 million, but if the projects are subject to fair market value sales of $100 million, then to meet the safe harbor, the 5% is measured against the $100 million, not $90 million. The “total cost” does not include the cost of land because land is not “integral.”)
The Physical Work Method
As discussed above, the guidance provides two methods for establishing the beginning of construction. Under the physical work method, a taxpayer can establish that construction has begun by starting physical work of a significant nature.
The physical work method focuses on the nature of the work performed, not the amount or cost. The work must be performed with respect to property integral to the production of electricity (in contrast to the transmission thereof). Items that are not integral include fencing, most buildings, and roads that are not used to transport equipment that is used to operate and maintain the energy property.
The guidance provides that the physical work method can be satisfied by the manufacture of off-site components, mounting equipment, support structures such as racks and rails, inverters, step-up transformers and other power conditioning equipment. (Note: There is some ambiguity as to whether the manufacture of a transformer that steps up the voltage to 69 kV or more – as opposed to less than such amount – would satisfy the physical work method. In addition, it would appear that the IRS omitted storage from the list because it is the IRS’ view that storage is only “energy property” – i.e., ITC-eligible – if it is charged for its first five years of operations at least 75% a year by solar or another technology that qualifies for the ITC, including a wind project that has elected the ITC in lieu of the production tax credit. [See P.L.R. 201444025 (Oct. 31. 2014), which is discussed here.] At the time of starting construction, a taxpayer would not be certain that the storage would be so charged, so the IRS may have determined it appropriate to not include it in equipment that the manufacture of constitutes the start of construction.)
In terms of qualifying on-site work, the guidance provides a “non-exclusive list” that for solar includes the “installation of racks or other structures to affix photovoltaic panels, collectors or solar cells to a site.”
There are two important caveats with respect to satisfaction of the physical work method. First, the manufacture of items that are either in “inventory or are normally held in inventory by a vendor” does not satisfy the requirement. For instance, the manufacture of fasteners would not qualify, as fasteners are normally held in inventory by vendors. Likewise, the manufacture of most solar panels would appear to not qualify.
The second caveat is that the work not directly performed by the taxpayer must be performed pursuant to a “binding written contract” that is executed prior to the work being started. As related parties in many instances are separate taxpayers (e.g., a corporate parent and its wholly owned corporate subsidiary), project owners need to use care to ensure that work done by a related party that is a separate taxpayer is performed under a binding written contract. To be treated as binding, the contract has to be binding under state law (e.g., not an option agreement) and damages cannot be capped at less than 5% of the contract value.
The Five Percent Method
Under the five percent method, a taxpayer can establish that construction has begun by paying or incurring at least 5% of the total cost of the project. Whether an amount is treated as paid or incurred is determined under the code. Only costs included in the depreciable basis of the project are taken into account to determine whether the five percent method is satisfied, and, like the physical work method, only costs incurred with respect to property integral to the production of electricity are considered. Unlike the physical work method, costs paid or incurred with respect to property that is inventory or normally held in inventory by a vendor, such as solar panels, would count toward satisfaction of the five percent method.
The guidance includes a favorable modification of the cost overrun rules as applied to solar projects. For wind, if there is a cost overrun such that the amount incurred toward satisfaction of the five percent method with respect to a project comprising multiple turbines is less than 5%, but at least 3%, of the actual project spend, the taxpayer can opt to not claim tax credits with respect to some of the turbines of the project until the remaining turbines for which the tax credits are claimed have a “total cost” that is not more than 20 times the amount incurred toward satisfaction of the five percent method.
Under the guidance for solar projects, this reduction technique is likewise available to the extent the project can be segregated into “energy properties,” and then some of those energy properties are excluded from the tax credits until the remaining “energy properties” for which the tax credits are claimed satisfy the five percent method; however, there is no requirement that the costs incurred with respect to the project be equal to at least 3% of the total project spend. An “energy property” includes all components that must be placed in service at the same time in order to generate electricity.
For rooftop solar, all components “installed on a single rooftop” constitute a single energy property. This means for rooftop projects, developers need to be careful to not have the ultimate tax basis of the ITC-eligible property exceed 20 times what was spent under the five percent method, as such an excess disqualifies all of the project from relying on the five percent method. The guidance notes that if the five percent method is not available that the taxpayer could use the physical work method if the facts support it.
Multiple energy properties that are operated as part of a single project are treated as a single energy property for purposes of determining the beginning of construction. So if construction begins on one PV system in 2019 (e.g., physical work is performed, or costs are incurred, with respect to a PV system), all PV systems that are operated together with such PV system will have a 2019 beginning of construction date.
Whether multiple energy properties are operated as a single project is a factual determination that is made as of the date the project is placed in service. The nonexclusive factors in the guidance that indicate multiple energy properties are operated as part of a single project are (i) the energy properties are owned by a single legal entity; (ii) the energy properties are constructed on contiguous pieces of land; (iii) the energy properties are described in a common power purchase agreement or agreements; (iv) the energy properties have a common intertie; (v) the energy properties share a common substation; (vi) the energy properties are described in one or more common environmental or other regulatory permits; (vii) the energy properties were constructed pursuant to a single master construction contract; or (viii) the construction of the energy properties was financed pursuant to the same loan agreement.
The guidance contains the same transfer rules that apply to utility-scale wind projects. These rules are premised on the fact that there is no statutory requirement that the taxpayer that starts the construction of the project be the taxpayer that places it in service. However, although not addressed in the statute, the IRS has a policy to discourage “trafficking” in equipment that qualifies a project under the physical work method or the five percent method. Under these rules, a transfer of a “project” from one taxpayer to another does not cause a loss of begun construction status, so long as either (i) the transferred assets are more than equipment and contracts to acquire equipment (e.g., the transferred assets include a power contract and land rights) or (ii) the transferor before or after the transfer is more than 20% related to the transferee.
In a partnership context, this second prong can be satisfied with either a “profits” interest: i.e., a partner’s share of the profits, which may or may not be matched by current cash distributions, and losses or a “capital” interest (i.e., what a partner is entitled to in a liquidation). So, for instance, a transferor that receives a 20.1% capital interest and a 1% profits interest in the transferee would satisfy this requirement.
Overall, the guidance is favorable and will allow the solar industry to plan for project deployments through 2023. Nonetheless, the technical ambiguities and opportunities for foot faults in the guidance necessitate technical sophistication in applying it.
David K. Burton is a partner, Jeffrey G. Davis is a partner and Isaac L. Maron is an associate at law firm Mayer Brown. They can be reached at email@example.com, firstname.lastname@example.org and email@example.com.