Tax Law Update
On June 22, the Internal Revenue Service ("IRS") issued Notice 2018-59 (the "Notice"), which provides guidance regarding qualification and construction timing for purposes of the investment tax credit ("ITC") provided by section 48 of the Internal Revenue Code of 1986, as amended (the "Code"), allowing taxpayers to take advantage of the credit based on when a project begins construction. The tax credit available under section 48 of the Code is the key tax benefit used by the solar energy industry.
Importantly, pursuant to recently updated timelines for construction, developers can now claim a tax credit of 30% of a solar project's cost if they can show they began construction by the end of 2019 and the project is placed in service by the end of 2023. For solar projects beginning construction during later periods, the amount of the ITC is reduced (to 26% for projects for which construction begins in 2020, to 22% for projects for which construction begins in 2021, and to 10% for projects for which construction begins after December 31, 2021). Additionally, to be eligible for the 30%, 26%, or 22% ITC, the solar project must be placed in service before January 1, 2024 (if not, the ITC is reduced to 10%). Because the precise timing of the beginning of construction is a threshold requirement for ITC qualification and has a direct relationship to the amount of ITC that can be claimed, guidance provided in the Notice gives needed guidance to developers and investors with respect to project qualification risk, and will bolster the demand for investment in such projects.
The Notice provides two methods for establishing when construction has begun on energy property that is eligible for the ITC; a continuity requirement for the two methods; and rules with respect to transferring energy property. This guidance provides greater certainty to solar energy developers and other taxpayers planning long-term project schedules and is largely consistent with the rules provided by the IRS in prior notices for taxpayers claiming the credit for electricity produced from certain renewable resources under section 45 of the Code (or the energy investment tax credit under section 48 of the Code in lieu of the section 45 credit) in connection with wind projects and certain other qualifying renewable energy projects.
Consistent with the prior PTC guidance and market solar practice, the Notice provides two methods for a taxpayer to establish that construction of solar energy property has begun for purposes of the ITC: (1) a taxpayer may establish the beginning of construction by starting physical work of a significant nature (the "Physical Work Test") or (2) a taxpayer may establish the beginning of construction by meeting a safe harbor based on having paid or incurred 5% or more of the total cost of the energy property (the "Five Percent Safe Harbor"). Both methods require that a taxpayer make continuous progress towards completion once construction has begun (the "Continuity Requirement").
The Notice provides other rules applicable to the Physical Work Test and Five Percent Safe Harbor, including definitions and descriptions of energy property, look-through rules, and the application of the 80/20 rule to retrofitted energy property similar to the guidance related to wind facilities.
Physical Work Test
Under this method, construction of energy property begins when physical work of a significant nature begins. Work performed by the taxpayer and work performed for the taxpayer by other persons under a binding written contract that is entered into prior to the manufacture, construction, or production of the energy property or components of energy property for use by the taxpayer in the taxpayer's trade or business (or for the taxpayer's production of income) is taken into account to determine whether construction has begun.
The Physical Work Test requires that a taxpayer begin physical work of a significant nature, which focuses on the nature of the work performed, not the amount or the cost. If the physical work performed is of a significant nature, there is no fixed minimum amount of work or monetary or percentage threshold required to satisfy the Physical Work Test. Both off-site and on-site work may be taken into account for purposes of demonstrating that physical work of a significant nature has begun. Generally, off-site physical work of a significant nature may include the manufacture of components, mounting equipment, support structures such as racks and rails, inverters, and certain transformers, and other power conditioning equipment. The Notice provides a list of examples to illustrate on-site physical work of a significant nature for different types of energy property.
Physical work of a significant nature does not include preliminary activities, even if the cost of those activities is properly included in the depreciable basis of the energy property. Generally, preliminary activities include, but are not limited to: planning or designing, securing financing, exploring, researching, conducting mapping and modeling to assess a resource, obtaining permits and licenses, conducting surveys, conducting environmental and engineering studies, performing activities to develop a geothermal deposit prior to valid discovery, clearing a site, conducting test drilling to determine soil condition, excavating to change the contour of the land, and removing existing foundations or components that will no longer be part of the energy property. Additionally, physical work of a significant nature does not include work to produce components of energy property that are either in existing inventory or are normally held in inventory by a vendor.
Five Percent Safe Harbor
Construction of energy property will be considered as having begun if a taxpayer pays or incurs 5% or more of the total cost of the solar energy property, and thereafter, the taxpayer makes continuous efforts to advance towards completion of the energy property. All costs properly included in the depreciable basis of the solar energy property are taken into account to determine whether the Five Percent Safe Harbor has been met. The total cost of the energy property does not include the cost of land or any property not integral to the production of electricity (e.g., property used for the transmission of electricity is not included).
Cost overruns, whether on a single project with multiple energy properties or on a single energy property that is not part of a single project composed of multiple energy properties and cannot be separated (or disaggregated) into multiple energy properties, are considered in determining whether the Five Percent Safe Harbor has been satisfied. If the total cost of an energy property exceeds its anticipated total cost, so that the amount a taxpayer actually paid or incurred turns out to be less than 5% of the total cost at the time it is placed in service, the Five Percent Safe Harbor may not be satisfied. However, the Five Percent Safe Harbor will be satisfied with respect to some, but not all, of the energy properties comprising the single project, as long as the total aggregate cost of those energy properties is not more than twenty times greater than the amount the taxpayer paid or incurred.
The Notice provides a Continuity Requirement for both the Physical Work Test (the "Continuous Construction Test") and the Five Percent Safe Harbor (the "Continuous Efforts Test"). The Continuity Requirement will generally be determined based on the relevant facts and circumstances unless the Continuity Safe Harbor described below is met.
Generally, if a taxpayer places energy property in service by the end of a calendar year that is no more than four calendar years after the calendar year during which construction of the energy property began the energy property will be considered to satisfy the "Continuity Safe Harbor." The Continuity Safe Harbor does not extend the deadlines by which certain energy property must be placed in service pursuant to section 48 of the Code.
The Notice provides that, except for a transfer of tangible personal property to an unrelated party, a fully or partially developed energy property may be transferred without losing its qualification under the Physical Work Test or the Five Percent Safe Harbor for purposes of the ITC. Additionally, the work performed or the amounts paid or incurred to develop energy property at a site before components of the energy property are transferred to a different site for completion and placing in service may be taken into account for purposes of determining when the energy property satisfies the Physical Work Test or the Five Percent Safe Harbor.
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 (within the meaning of Section 197(f)(9)(C) of the Code) to the transferor, any work performed or amounts paid or incurred by the transferor with respect to such transferred property will not be taken into account with respect to the transferee for purposes of the Physical Work Test or the Five Percent Safe Harbor.