Treasury Grants in Lieu of Tax Credits: Beginning Construction Before January 1, 2011
Corporate & Finance Alert
September 28, 2010
I. INTRODUCTION: SOLAR ENERGY CREDITS
Under the investment tax credit provisions of Section 48 of the Internal Revenue Code (“IRC”), taxpayers are entitled to a federal income tax credit equal to 30 percent of certain energy property placed in service during a taxable year, including qualified fuel cell property, qualified small wind energy property, and certain solar energy property. Solar wind energy property is generally defined as equipment that uses solar energy to generate electricity, to heat or cool (or provide hot water for use in) a structure, or to provide solar process heat.
II. GRANTS IN LIEU OF TAX CREDITS
Critically, Section 1603(a) of the American Recovery and Reinvestment Act of 2009 (“ARRA”) provides that taxpayers may apply to the Treasury Department (“Treasury”) for a cash grant (the “Treasury Grants”) in lieu of certain energy investment tax credits or production tax credits, including those for most solar energy property. Congress enacted Section 1603(a) because the losses suffered by investors in the recession limited the ability of investors to use tax credits and depreciation, and the President and Congress wanted to encourage investment in alternative energy projects. Applicants for Treasury Grants cannot be a governmental organization or agency, cannot be an organization described in IRC Section 501(c), and cannot be a partnership, a limited liability company treated as a partnership, or a pass-thru entity with a partner, other equity holder, or holder of a profits interest that is such a governmental or exempt organization.
Program Guidelines for the Section 1603 Treasury Grants (the “General Program Guidance”) can be found on the Treasury’s webpage. A site that can be called the Treasury’s homepage for the Section 1603 Treasury Grant program can also be accessed.
Treasury Grants under Section 1603 are only available for specified energy property:
- placed in service in 2009 or 2010, or
- placed in service after 2010 but before the credit termination date with respect to such property (by January 1, 2017 for IRC Section 48 energy property), but only if the construction of such property began during 2009 or 2010.
III. APPLYING FOR TREASURY GRANTS
Under ARRA Section 1603(j), taxpayers must file an application for a grant in lieu of credit by October 1, 2011. The application can be found on the Treasury’s webpage.
For property placed in service after December 31, 2010, but before October 1, 2011, applicants need only submit a single application before October 1, 2011, documenting both that construction began on the property in 2009 or 2010, and that the property has been placed in service. For property that is placed in service on or after October 1, 2011, applicants must submit a preliminary application before October 1, 2011, demonstrating that construction on the property began in 2009 or 2010, and then supplement the application when the property is placed in service.
Treasury has posted a checklist to assist applicants as they complete their application.
Keep in mind that under ARRA Section 1603(c), Treasury must make payments of grants within 60 days of the later of (1) the date of the application for the grant, and (2) the date the specified energy property is placed in service. Under the General Program Guidance, if property is placed in service after 2010, applicants have 90 days after the property is placed in service to provide Treasury with the required information necessary to complete the application. Grants will then be paid within 60 days after the date that Treasury receives the supplemental information.
IV. SHOWING THAT CONSTRUCTION HAS BEGUN BEFORE JANUARY 1, 2011
Although the renewable energy industry has been seeking an extension of the Section 1603 Treasury Grant program, and a number of bills extending the program have been discussed and even introduced in Congress, until any such bill becomes law, applicants to the Treasury Grant program must comply with the program’s placed in service dates by showing that construction began before January 1, 2011. Treasury has issued guidance on this point in a set of frequently-asked questions and answers (the “FAQs”), which was substantially updated on June 25, 2010 and can be found on the Treasury’s webpage.
Critically, the FAQs provide that there are two ways to show that construction has begun before January 1, 2011. The first way is to show that physical work of a significant nature began before January 1, 2011. The second way is to meet a 5% safe harbor test.
A. Physical Work of a Significant Nature
To begin physical work of a significant nature means that any physical work on the specified energy property has started 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, as long as the contract is entered into prior to the work taking place. In general, any physical work on the specified energy property will be treated as the beginning of construction even if the work relates to only a small portion of the facility. So, for example, laying the foundation for one wind turbine that is part of a larger wind farm may be sufficient.
With respect to the question of how continuous work must be to satisfy the requirement that construction has begun, FAQ # 5 states that Treasury “will closely scrutinize any construction activity that does not involve a continuous program of construction or a contractual obligation to undertake and complete within a reasonable time, a continuous program of construction.” Treasury acknowledges that disruptions in the work schedule that are beyond the applicant’s control, such as unusual weather or a site at which work can only be performed during certain seasons, will be taken into account in determining whether an applicant has undertaken a continuous program of construction. Since the FAQ does not really answer the question, it creates a negative implication regarding whether the requirements have been met if a single foundation is laid in 2010, but no other physical work on a 50-turbine project takes place until 2012. FAQ #22, discussed below, provides guidance under the 5% safe harbor test in a similar situation.
The FAQs make clear that preliminary work such as clearing land and obtaining permits is not physical work of a significant nature on specified energy property. For example, erecting a fence, or beginning to erect a fence, is not the beginning of physical work of a significant nature because, generally, fencing is not an integral part of a qualified facility.
FAQ # 9 raises the question of whether construction at the site of a building that will be used for operations and maintenance constitutes physical work of a significant nature. Treasury’s response is that because a building is not specified energy property, its construction is not physical work of a significant nature. However, citing Treas. Reg.§ 1.48-1(e)(1), the FAQ states that the following structures are not treated as buildings for this purpose: “(1) a structure that is 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.”
FAQ # 11 raises the question of when a contract is binding. The response is that to be binding, a contract must be enforceable under state law. Also, the contract terms “cannot limit damages in the event of a breach to less than 5% of the total contract price.”
FAQ # 12 raises the important question of what is included in work performed under a binding written contract. Treasury’s full response is:
Work performed under the 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 who is manufacturing solar panels for a number of customers, physical work on the panels would only be considered work performed under the applicant’s binding written contract if the contractor can reasonably 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. Whether a method is reasonable depends on all the relevant facts and circumstances.
Finally, Treasury states that work performed under a contract does not include work to produce components or parts that are in existing inventory or are normally held in inventory by a manufacturer.
B. The 5% Safe Harbor
Treasury states that an applicant meets the 5% safe harbor “if the applicant pays or incurs 5.00% or more of the total cost of the specified energy property before the end of 2010.”
As to the definition of “paid or incurred,” FAQ # 16 states in part:
The term “paid or incurred” generally means paid or incurred within the meaning of Treas. Reg. §1.461-1(a)(1) and (2). That is, 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) the economic performance test (see Treas. Reg. §1.461-4) has been met with respect to such cost.
Under the economic performance rules of Treas. Reg. §1.461-4, for property manufactured, constructed, or produced for the applicant by another person under a binding written contract that is entered into prior to the manufacture, construction, or production of the property, the cost of such property is treated as “incurred” when the property is provided to the applicant. Critically, the 5% safe harbor described in both Treasury’s General Program Guidance and the FAQs provide an exception to this rule. For periods before the property is provided to the applicant, costs incurred with respect to the property by such other person are treated as costs of the property that are incurred by the applicant when the costs are incurred by that other person.
Separately, property is treated as provided to the applicant either when title to the property passes to the applicant, or when it is delivered to or accepted by the applicant, depending on the applicant’s method of accounting. In addition, consistent with the economic performance rule of Treas. Reg. §1.461-4(d)(6), property that the applicant reasonably expects to be provided within 3-1/2 months of the date of payment will be considered to be provided on the payment date.
Assuming that a supplier uses the accrual method of accounting for tax purposes, in the case of property manufactured, constructed, or produced for the applicant by another person (the supplier) under a binding written contract that is entered into prior to the manufacture, construction, or production of the property, FAQ # 18 raises the question of how does an applicant determine which costs have been paid or incurred on its behalf by the supplier. The response states that an applicant may rely on a statement by the supplier as to the amount incurred by the supplier with respect to the property to be manufactured, constructed, or produced for the applicant under the binding written contract. The supplier may use any reasonable, consistent method to allocate the costs incurred by the supplier among the units of property to be manufactured, constructed, or produced by the supplier, but including only those costs incurred after the binding written contract is entered into.
FAQ # 21 shows that Treasury will show some flexibility if an applicant’s total project costs turn out to be more than expected, in a manner that may initially appear to jeopardize satisfaction of the 5% safe harbor test. Specifically, the FAQ states:
If the applicant’s project includes multiple units of specified energy property, an applicant can opt to apply for a payment based on some, but not all, units of property. For example, if an applicant incurs $25,000 in costs in 2010 for specified energy property in a 5 turbine wind farm anticipating total costs for specified energy property of $500,000 but the actual total costs of specified energy property amount to $600,000, the safe harbor would not be satisfied. However, the applicant can opt to apply for a payment based on the costs of 3 turbines and would satisfy the safe harbor if the $25,000 of costs incurred in 2010 relates to the 3 turbines and their total cost does not exceed $500,000.
FAQ #22 states that if an applicant demonstrates that the applicant meets the 5% safe harbor as of December 31, 2010, with respect to a facility that will not be placed in service until 2012, the applicant need not continue to work at the site in 2011 to qualify for payment in 2012.
C. Documentation to Be Submitted to the Treasury Department to Show that Construction Began Prior to January 1, 2011
For projects relying on “physical work of a significant nature,” applicants must document the physical work. For example, to show 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; providing a detailed construction schedule; and providing an 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.
For projects relying on the 5% 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 (cash or accrual).
Finally, the FAQs include additional documentation requirements for applicants relying on the binding written contract rules related to the “physical work of a significant nature” test, as well as for both cash and accrual method applicants relying on the 5% safe harbor test.