Many public utilities have entered into long-term power-purchase agreements for power produced by wind, solar, biomass and geothermal projects. Some utilities have embraced these technologies and taken on ownership and operation of renewable assets. Whether a utility is merely buying power from a third-party developer or has a stake in the facility, many renewable energy projects rely on federal tax incentives for financing. However, the economic downturn has dramatically reduced the profits (and tax liabilities) of the banks and life companies that historically have funded tax equity, severely limiting the availability of tax credits for renewable energy projects.
In response to the dearth of tax equity, the American Recovery and Reinvestment Act of 2009 (ARRA) created the Treasury grant program. The program was designed to allow the owner of commercial wind, solar or other qualifying renewable energy generation projects to receive a cash grant equal to 30 percent of the owner’s tax basis in the project (in lieu of taking the 30-percent solar investment tax credit (ITC), and the corresponding guidance which was released in July. Applicants are eligible for the Treasury grant only if they commence construction on projects by Dec. 31, 2010, and complete construction by Dec. 31, 2012 for wind, and by Dec. 31, 2016 for solar. The Treasury grant program has been very successful, supporting the deployment of 303 solar energy systems (283 solar electric systems and 20 solar thermal systems) as of the end of February 2010. Since guidance for the grant program was released in July of last year, the manufacture and construction of these systems has supported roughly 10,100 jobs—direct, indirect and induced.
In July, the Treasury issued new guidance in the form of questions and answers (FAQ) as to when “construction begins” for renewable energy projects that may be eligible for a cash grant in lieu of an ITC. The new guidance is important and timely because of the impending deadlines for the cash grant program. To qualify for a grant, qualified energy property must be placed in service in 2009 or 2010 or, if “construction begins” in 2009 or 2010, it must be placed in service by the applicable credit termination date—currently the end of 2012 for wind, the end of 2013 for biomass, geothermal and other resources, and the end of 2016 for solar. Because of the deadline and the uncertainty surrounding extension, many project developers will attempt to “begin construction” this year on those projects that have a practical chance of crossing that threshold in 2010.
There are two ways to show that construction has begun. One is to begin physical work of a significant nature. The other is to meet a 5-percent safe harbor.
To begin physical work of a significant nature means that physical work on the specified energy property has started. Physical work of a significant nature includes any physical work on the specified energy property at the site. Physical work of a significant nature also includes physical work that has taken place under a binding written contract for the manufacture, construction, or production of specified energy property for use by the applicant’s facility provided the contract is entered into prior to the work taking place. Some examples:
• Preliminary work such as planning or designing, exploring, researching, clearing land, building fences, obtaining permits or securing financing isn’t physical work of a significant nature. Excavation to change the contour of land isn’t physical work of a significant nature, but excavation for footings and foundations is.
• Generally, the cost of removal from the site of existing structures or property is associated with the property being removed or is capitalized to non-depreciable land. This is considered preliminary work and doesn’t constitute physical work of a significant nature on specified energy property.
• Roads on the site that are integral to the qualified facility are specified energy property; these include onsite roads that are used for moving materials to be processed (e.g., biomass) and roads for equipment to operate and maintain the facility. Starting construction on these roads constitutes the beginning of construction. But roads for access to the site, or roads used solely for employee or visitor vehicles aren’t specified energy property; starting construction on these roads isn’t starting physical work of a significant nature on specified energy property.
• Test drilling for a geothermal deposit is a preliminary activity and isn’t physical work of a significant nature.
• Because a building isn’t specified energy property, construction of a building isn’t physical work of a significant nature. However, the following structures aren’t treated as buildings for this purpose: 1) a structure that’s essentially an item of machinery or equipment; or 2) a structure that houses property used as an integral part of a qualified activity if the use of the structure is so closely related to the use of the housed property that the structure clearly can be expected to be replaced when the property it initially houses is replaced.
A qualified facility is defined as a specified energy property that includes property integral to the production of electricity, but doesn’t include property used for electrical transmission. Thus, physical work on a transmission tower located at the site isn’t physical work of a significant nature because the transmission tower isn’t part of the qualified facility. However, physical work on a transformer that steps up the voltage of electricity produced at the facility to the voltage needed for transmission is physical work of a significant nature because power conditioning equipment is part of the qualified facility.
In general, any physical work on the specified energy property will be treated as the beginning of construction even if such work relates to only a small part of the facility, but Treasury will closely scrutinize any construction activity that doesn’t involve a continuous program of construction or a contractual obligation to undertake and complete within a reasonable time a continuous program of construction. Disruptions in the work schedule that are beyond the applicant’s control—for example, unusual weather or a site—will be taken into account in determining whether or not an applicant has undertaken a continuous program of construction.
As noted, physical work of a significant nature also includes physical work that has taken place under a binding written contract for the manufacture, construction, or production of specified energy property for use by the applicant’s facility, provided the contract is entered into prior to the work taking place.
To be binding, a contract must be enforceable under state law. Additionally, the contract terms can’t limit damages in the event of a breach to less than 5 percent of the total contract price.
Work performed under a contract includes only work that takes place after the binding written contract is entered into. The work is treated as physical work of a significant nature only if it is work on property that will become specified energy property of the applicant. For example, if a contractor is manufacturing solar panels specifically for the applicant under a binding written contract, any physical work on those panels is physical work of a significant nature on specified energy property of the applicant. If an applicant has a binding written contract with a contractor that’s manufacturing solar panels for several different customers, physical work on the panels only would be considered work performed under the applicant’s binding written contract if the contractor reasonably can demonstrate that physical work has started on panels that will become specified energy property of the applicant. The contractor may use any reasonable, consistent method to allocate work it performs among its customers.
If an applicant purchases components or other parts from the inventory of a vendor under a binding written contract, physical work of a significant nature hasn’t begun because work performed under a contract doesn’t include work to produce components or parts that are in existing inventory or are normally held in inventory by a manufacturer.
If physical work takes place under a binding, written contract on property manufactured, constructed or produced for the applicant’s project, but the specific site for the project isn’t identified before the deadline for submitting initial applications (or the site changes after an initial application is submitted), the fact that the specific site of the project hasn’t been identified (or changes after the initial application) doesn’t affect the determination of whether construction has begun.
An applicant meets the 5-percent safe harbor if the applicant pays or incurs 5 percent or more of the total cost of the specified energy property before the end of 2010.
What does “paid or incurred” mean? Costs are taken into account when cash-method taxpayers “pay” them and when accrual-method taxpayers “incur” them. A cost is generally incurred for tax purposes when: 1) the fact of the liability is fixed; 2) the amount of the liability is determinable with reasonable accuracy; and 3) “economic performance” has occurred with respect to the liability. The 5-percent safe harbor includes a single exception to the foregoing general principles used to determine when amounts are incurred.
Under the general rules, when property is manufactured, constructed, or produced for the applicant by another person under a binding written contract, economic performance occurs, and the cost of such property is treated as incurred when the property finally is delivered or provided to the applicant. The exception is that, for periods before the property is provided to the applicant, costs incurred by another person, such as a contractor, are treated as costs of the property that are incurred by the applicant for purposes of the 5-percent safe harbor when those costs are incurred by the contractor.
Costs are deemed paid or incurred by the person providing property to the applicant (e.g., a contractor) as that person pays or incurs costs in connection with providing property to the applicant. Property is provided to the applicant when title to the property passes to the applicant or when the property is delivered to, or accepted by, the applicant, depending on the applicant’s method of accounting. In addition, property that the applicant reasonably expects to be provided within 3.5 months after the date of payment will be considered to be provided on the earlier payment date.
In the case of property manufactured, constructed, or produced for the applicant by another person (e.g., the contractor) under a binding written contract entered into before the manufacture, construction, or production of the property, the FAQ explains how the applicant determines what costs have been paid or incurred on its behalf by the contractor. If the contractor uses the accrual method of accounting, the applicant may rely on a statement by the contractor as to the amount incurred by the contractor with respect to the property to be manufactured, constructed, or produced for the applicant under the binding written contract. The contractor may use any reasonable, consistent method to allocate the costs incurred by the contractor among the units of property to be manufactured, constructed, or produced by the contractor. Only costs incurred by the contractor after the binding written contract is entered reasonably may be allocated to the property manufactured, constructed, or produced under that contract. The economic performance rules apply to determine when costs have been incurred by the contractor.
The exception that allows the applicant to take into account costs that are incurred by its contractor doesn’t apply to costs incurred by a subcontractor. Thus, if components are manufactured for the contractor by a subcontractor, the cost of those components is incurred only when the components are provided to the contractor and not as the subcontractor pays or incurs the costs of manufacturing the components. However, property that the contractor reasonably expects to receive from a subcontractor within 3.5 months of the date of the contractor’s payment to the subcontractor is considered to be provided by the payment date.
The FAQ addresses the effect of assignments of binding contracts between related entities. For example, a developer may enter into a binding written contract for multiple units of property to be manufactured for the developer by another person under a binding written contract (e.g., a master contract) entered into before the manufacture of the property. The developer then may assign its rights to certain units of property to an affiliated special purpose vehicle—generally, a limited liability company—that will own the project for which such property is to be used and will apply for the grant payment. Costs paid or incurred with respect to the master contract are considered to have been paid or incurred in 2009 or 2010 for purposes of determining whether construction has started. For purposes of determining whether construction has started, these costs are treated as costs of the property notwithstanding the assignment of all or a portion of the contract to the developer’s affiliate.
To satisfy the 5-percent safe harbor, applicants must demonstrate that costs paid or incurred before the end of 2010 are equal to, or greater than, 5 percent of the actual total costs of the specified energy property. However, if the applicant’s project includes multiple units of specified energy property, an applicant can opt to apply for a grant based on some, but not all, units of property.
All applications for section 1603 grants must be submitted by the statutory deadline of Oct. 1, 2011. For property that has been, or will be, placed in service in 2009 or 2010, an application demonstrating that construction has begun isn’t required. For property that’s placed in service after Dec. 31, 2010, but before Oct. 1, 2011, applicants need only submit a single application demonstrating both that construction began on the property in 2009 or 2010 and that the property has been placed in service. For property that’s placed in service on or after Oct. 1, 2011, applicants must submit a preliminary application by Oct. 1, 2011, demonstrating that construction on the property began in 2009 or 2010. Such applications then must be supplemented at the time the property is placed in service.
If an applicant submits an application demonstrating that construction has begun, the IRS will notify the applicant whether or not the work performed is physical work of a significant nature or, for applicants relying on the safe harbor, whether qualifying costs have been paid or incurred. However, the IRS can’t provide assurance that an applicant meets all the requirements for a payment until all facts and circumstances are known (i.e., at the time the facility is placed in service).
For projects relying on physical work of a significant nature, applicants must document the physical work. For example, to demonstrate that physical work of a significant nature has commenced at the site, applicants should submit a written report from the project engineer or installer, signed under penalties of perjury, describing the project’s eligibility; including a detailed construction schedule; estimated budget for the project; and a description of the work that has commenced, including any invoices for the work performed.
For projects with an anticipated cost basis of $1 million or more, the report must be from an independent engineer. To demonstrate that physical work of a significant nature has commenced under a binding written contract, applicants should submit a copy of the binding written contract and a statement from the contractor, signed under penalties of perjury, describing the work that has commenced and certifying that the work commenced pursuant to the binding written contract.
For projects relying on the 5-percent safe harbor, applicants must submit a statement from an authorized representative of the applicant signed under penalties of perjury, or for projects with an estimated eligible cost basis of $1 million or more, from an independent accountant, attesting to the method of accounting used by the applicant for federal tax purposes (e.g., cash or accrual). Applicants using the cash method of accounting must provide a statement that outlines the amount paid before the end of 2010; a detailed description of the costs that have been paid; and an estimate of the total cost of the specified energy property. Applicants also must include evidence of payment such as invoices or other financial records.
Applicants using the accrual method of accounting must provide a statement that illustrates the amount that has been incurred before the end of 2010; a detailed description of the costs incurred; and an estimate of the total cost of the specified energy property. Likewise, they must include evidence of the costs incurred such as invoices or other financial records. If an applicant is relying on costs paid or incurred by a contractor, it must include a copy of the binding written contract and a statement from the contractor, signed under penalty of perjury, of costs paid or incurred and allocated to applicant’s project.
The projects that utilities have undertaken to date under the Treasury grant program have been extraordinarily successful and have brought green generation technology to many populous areas. Utility companies must be proactive in securing funding before the Treasury grant program window expires, whether they own their facilities or are buying power from a third party. It’s still possible to reach the 5-percent safe harbor or to begin physical work of a significant nature in advance of the Dec. 31, 2010 deadline. Whether Congress will extend the deadline remains uncertain, so developers and utilities must act quickly to qualify for desired cash grants.