IRS Guidance on When Construction Begins for Purposes of Production Tax Credit and Investment Tax Credit

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1 IRS Guidance on When Construction Begins for Purposes of Production Tax Credit and Investment Tax Credit October 28, 2013 Philip Tingle Martha Groves Pugh Gale E. Chan Madeline Chiampou Tully Boston Brussels Chicago Düsseldorf Frankfurt Houston London Los Angeles Miami Milan Munich New York Orange County Paris Rome Seoul Silicon Valley Washington, D.C. Strategic alliance with MWE China Law Offices (Shanghai) 2013 McDermott Will & Emery. The following legal entities are collectively referred to as "McDermott Will & Emery," "McDermott" or "the Firm": McDermott Will & Emery LLP, McDermott Will & Emery AARPI, McDermott Will & Emery Belgium LLP, McDermott Will & Emery Rechtsanwälte Steuerberater LLP, McDermott Will & Emery Studio Legale Associato and McDermott Will & Emery UK LLP. These entities coordinate their activities through service agreements. This communication may be considered attorney advertising. Previous results are not a guarantee of future outcome.

2 Agenda Background Extension of the production tax credit ( PTC ) and investment tax credit ( ITC ) for electricity produced from certain qualified facilities Liberalized timing requirement beginning construction Internal Revenue Service ( IRS ) Guidance Physical work of a significant nature and the 5% safe harbor Continuous construction and continuous efforts Transfers/changes of ownership of a qualified facility 2

3 Background Section 407 of the American Taxpayer Relief Act of 2012 extended until January 1, 2014, the PTC and the ITC for electricity produced from qualified facilities. Qualified facilities are wind, closed-loop biomass, open-loop biomass, geothermal, landfill gas, trash, hydropower, marine and hydrokinetic Congress also liberalized the timing requirement for a qualified facility so a taxpayer may meet the January 1, 2014 deadline by beginning construction on the facility by such date. Methods for demonstrating beginning construction are similar to those established under the 1603 Grant with some significant differences 3

4 Notice The IRS issued Notice on April 15, 2013 to provide guidance on what it means to begin construction. Notice provides that a taxpayer may establish that construction has begun either: By demonstrating that physical work of a significant nature has begun ( Physical Work Method ) or By satisfying the 5% safe harbor ( Safe Harbor ). 4

5 Notice The IRS issued Notice on September 20, 2013, to provide further guidance on meeting the beginning of construction requirements, addressing the requirements of continuous construction and continuous efforts, master contracts, and transfers of a qualified facility. 5

6 Significant Dates and Deadlines Prior to December 31, 2013 Satisfy one of the two begun construction tests (discussed in more detail below): Physical Work Method: perform physical work of a significant nature by end of this year Safe Harbor: incur 5% or more of project costs by end of this year Document work done or expenses incurred After December 31, 2013 and before being placed in service: Maintain continuous construction/efforts Document continuous construction/efforts And/or place project in service prior to January 1,

7 Physical Work Method Construction of a qualified facility begins when physical work of a significant nature begins. Determination is based on the relevant facts and circumstances. Only physical work of a significant nature with respect to tangible property that is integral to the facility will be considered in determining whether construction has begun on a facility. Examples include: Power conditioning equipment, such as a transformer that steps up the voltage of electricity produced at a facility to the voltage necessary for transmission; and Onsite roads used for moving materials for processing or transporting equipment to operate and maintain the qualified facility. 7

8 Physical Work Method However, construction on the following are not treated as physical work of a significant nature: Access roads or roads used primarily by employees or visitor vehicles are not considered integral to the facility; and Fencing and buildings. However, a structure that is essentially an item of machinery or equipment, or structure that houses property that is integral to the activity of the facility, will not be treated as a building for this purpose. 8

9 Physical Work Method: Onsite and Off-site Work Onsite and off-site work may be taken into account to demonstrate that physical work of a significant nature has begun. For wind energy facility, onsite physical work of a significant nature begins with the beginning of the exaction for the foundation, the setting of anchor bolts into the ground or the pouring of the concrete pads of the foundation. Off-site work can be performed either by the taxpayer or by another person for the taxpayer pursuant to a binding written contract. If off-site work includes the manufacture of components for the taxpayer pursuant to a binding written contract, physical work of a significant nature begins off-site at the manufacturing location, provided the components are not normally held as inventory by the manufacturer. 9

10 Physical Work Method: Onsite and Off-site Work To take into account work performed off-site pursuant to a binding written contract, the contract must be entered into prior to the start of such work. Such contract is binding only if it is enforceable under local law against the taxpayer (or a predecessor) and the contract does not limit damages to a specified amount (for example, by including a liquidated damages provision). If damages are at least 5% of the total contract price, the contract is not treated as limiting damages to a specified amount A contract for a number of components/equipment (a Master Contract ) can also be assigned to an affiliated special purpose entity that will own the facility for which such property is to be used, and work performed under the Master Contract may be taken into account in determining whether physical work of a significant nature has begun. 10

11 Physical Work Method: Preliminary Activities Physical work of a significant nature does not include preliminary activities, even if the cost of such activities is properly included in the depreciable basis of the facility. Examples of preliminary activities include: Planning or designing; securing financing; exploring; researching; obtaining permits; licensing; conducting surveys and environmental and engineering studies; clearing a site; test drilling a geothermal deposit; test drilling to determine soil condition; excavating to change the contour of the land (as distinguished from excavation for footings and foundations); and removing existing wind turbines and towers. 11

12 Physical Work Method: Multiple Facilities as Single Project In determining whether construction of a facility has begun for purposes of the PTC and the ITC, multiple facilities that are operated as part of a single project will be treated as a single facility. Whether multiple facilities are operated as part of a single project depends on the relevant facts and circumstances. Factors indicating operation as a single project include, but are not limited to, whether the facilities are owned by a single legal entity, are constructed on contiguous pieces of land, are described in a common power purchase agreement or a common environmental or other regulatory permit, have a common intertie, share a common substation, were constructed pursuant to a single master construction contract and were financed pursuant to the same loan agreement. 12

13 Physical Work Method: Continuous Construction Taxpayers also must maintain a continuous program of construction that involves continuing physical work of a significant nature ( Continuous Construction Test ). Certain disruptions in construction that are beyond the taxpayer s control will not be considered as indicating that the taxpayer failed to maintain continuous construction. Disruptions considered beyond the taxpayer s control include, but are not limited to, the following: Severe weather conditions; natural disasters; licensing and permitting delays; delays at the written request of a state or federal agency regarding safety, security or similar concerns; labor stoppages; inability to obtain specialized equipment of limited availability; presence of endangered species; financing delays of less than six months; and supply shortages. Searching for tax equity financing? Delays due to high demand? 13

14 Continuous Construction by Placing Project in Service Prior to January 1, 2016 Notice provides that, if a qualified facility is placed in service before January 1, 2016, the facility will be considered to satisfy the Continuous Construction Test and the Continuous Efforts Test. The continuous construction test discussed above caused industry participants and practitioners concern due to the many variables and uncertainties in meeting the continuous construction test. However, if a facility is not placed in service before January 1, 2016, the facility is not automatically deemed to have failed these tests. Whether the tests are met will be determined by the relevant facts and circumstances described in Notice

15 Physical Work Method: Practical Considerations/ Documentation in 2013 and Beyond Taxpayers should maintain records of all project construction performed in 2013: Construction timeline Engineering reports Invoices Notices to proceed Work completion certificates Pictures Documentation/Satisfaction of Continuous Construction Test: Continue collection of above documents plus documentation explaining any delays Documentation should be maintained even if project is expected to be placed in service prior to January 1, 2016 Project Identification/Changes in Site 15

16 Safe Harbor Construction of a qualified facility will be considered as having begun before January 1, 2014 if a taxpayer pays or incurs 5% or more of the total cost of the facility before such date, and thereafter the taxpayer makes continuous efforts to advance toward completion of the facility ( Continuous Efforts Test ). All costs properly included in the depreciable basis of the facility are taken into account to determine whether the Safe Harbor has been satisfied. However, the cost of land or any property not integral to the facility is not included. Costs incurred with respect to property that is manufactured, constructed or produced for the taxpayer by another person pursuant to a binding written contract are deemed incurred by the taxpayer when the costs are incurred by the other person under the principles of section 461, discussed below. 16

17 Safe Harbor: Incurring Costs When are costs incurred for Safe Harbor purposes? Treas. Reg. Section (a)(1) and (2) economic performance rules Costs are incurred as the services or property is provided A taxpayer is permitted to treat property as provided to the taxpayer when the property is delivered or accepted, or when title to the property passes, depending on taxpayer s method of accounting Actual payment in 2013 not always necessary if property or services are provided in 2013 In addition, property that the applicant reasonably expects to be provided within 3.5 months of the date of payment in 2013 will be considered to be provided on the payment date Delay liquidated damages provisions Taxpayers should determine whether they have already established a method of accounting for accruing costs of property or services 17

18 Safe Harbor: Continuous Efforts In order to satisfy the Safe Harbor, a taxpayer must make continuous efforts to advance toward completion of the facility. Whether a taxpayer makes continuous efforts will be determined under a facts-and-circumstances test. Facts and circumstances indicating such continuous efforts may include, but are not limited to, the following: Paying or incurring additional amounts included in the total cost of the facility; Entering into binding written contracts for components or future work on construction of the facility; Obtaining necessary permits; or Performing physical work of a significant nature. 18

19 Safe Harbor: Continuous Efforts Certain disruptions that are beyond the taxpayer s control will not be considered as indicating that a taxpayer has failed to make continuous efforts to advance toward completion of the facility. Examples of such disruptions are the same as the disruptions described previously with respect to the Continuous Construction Test under the Physical Work Method. Timing of identification of project 19

20 Safe Harbor: Cost Overruns Notice provides that if the actual cost of the project exceeds the anticipated cost such that the Safe Harbor amount is less than 5% of the total cost of the facility at the time the facility is placed in service, the Safe Harbor is not fully satisfied. However, the Safe Harbor will be satisfied, and the PTC or ITC may be claimed with respect to some, but not all, of the individual facilities comprising the single project, as long as the total aggregate cost of the individual facilities is not more than 20 times greater than the amount the taxpayer paid or incurred before January 1, 2014, under the Safe Harbor. Two examples in Notice illustrate this rule. 20

21 Master Contracts Notice clarified that the Master Contract provisions of Notice also apply for purposes of the Safe Harbor. 21

22 Safe Harbor: Practical Considerations and Establishing the Safe Harbor Assemble documentation establishing the costs incurred with respect to the Safe Harbored equipment in 2013: Contracts with third parties for the manufacture of component parts. Invoices showing payments due to third parties for Safe Harbor equipment Wire transfers, cancelled checks, or other proof of payment showing amounts paid to third parties and date of payment Evidence of date/location of delivery of component parts in 2013 or prior (e.g. shipment confirmations, warehousing confirmations, bills of lading) Maintain serial number lists that tie to invoices and payments and indicate date property was provided and location of equipment Segregate equipment from other equipment and establish a tracking procedure Maintain storage and warehousing records, as well as transportation records Equipment purchased from and services provided by third parties v. soft costs attributable to the manufacturing of the Safe Harbor Equipment, such as labor performed by employees 22

23 Transfers of a Qualified Facility Prior to Placed in Service Date Notice was silent as to the effect of a transfer of a facility after construction has begun but prior to the facility being placed in service. Notice permits a taxpayer to claim the PTC or ITC even if the taxpayer was not the owner of the facility on the date construction began. The Notice clarifies that the statute does not require construction to be begun by the taxpayer claiming the PTC or the ITC. Any ITC claimed on a facility is limited to the taxpayer s basis in the qualified property as defined in Section 48(a)(5)(D) of the Internal Revenue Code. 23

24 Transfer of a Qualified Facility As defined in that Section 48(a)(5)(D), qualified property means property that is tangible personal property or other tangible property (not including a building or its structural components), if such property is used as an integral part of the qualified investment credit facility; with respect to which depreciation (or amortization in lieu of depreciation) is allowable; which is constructed, reconstructed, erected or acquired by the taxpayer; and the original use of which commences with the taxpayer. 24

25 Transfer of a Qualified Facility Example Notice provides an example of a transfer meeting the above requirements. A developer contributed land to a single-member LLC that will own the facility. The developer incurred the appropriate Safe Harbor costs in November 2013 with respect to the facility. It is assumed that the developer maintains continuous efforts to advance towards completion of the facility. In April 2014, the developer sells 95% of the interests in the LLC to unrelated investors to finance development of the project. The developer keeps the proceeds of the sale of interests. 25

26 Transfer of a Qualified Facility Practical Considerations Document transfers and provide safe harbor documentation to transferee Ownership by foreign affiliates Purchases of Safe Harbor equipment entity v. assets? 26