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The Current: Grandfathering Your Project for Section 1603 Grants Beyond 2011

Published by Forrest D. Milder on Tuesday, November 1, 2011

Journal cover November 2011   Download PDF

Yes, it’s “déjà vu all over again!” Perhaps Yogi Berra would have had the same reaction to our new annual ritual of worrying about how to grandfather renewables projects for Section 1603 grants. While some are still hoping that the Section 1603 program will be extended another year, it seems that grandfathering is a serious concern this year, so I thought it would be a good idea to provide an update to what you should be thinking about with respect to getting a Section 1603 grant next year and beyond.

Let’s start with a quick review of the program. The basic rule is that projects placed in service before the end of 2011 are eligible for Section 1603 grants equal to 30 percent of cost (or value in the case of lease pass throughs) for solar, wind, biomass, geothermal that generates electricity, municipal solid waste, landfill gas, qualified hydropower or marine and hydrokinetic, trash and fuel cell projects (the last is subject to a cap of $3 per watt). Combined heat and power (sometimes called cogeneration), microturbines (but not more than $200 per kW) and geothermal for heat qualify for a 10 percent grant. To date, Treasury has paid about $8.5 billion in connection with approximately 18,000 such projects.

That brings us to projects that won’t be placed in service by the end of 2011. Under the Section 1603 program, projects that “began construction” in 2009, 2010 or 2011, and which will be placed in service by the end of 2016 (solar), 2012 (wind), or 2013 (most other renewables, with geothermal for electricity declining from 30  to 10 percent if placed in service after 2013, and before the end of 2016) are also eligible for grants at the same rates described above.    

Section 1603 provides two ways that a grant applicant can show that construction has begun:  
There has been “physical work of a significant nature” in 2009, 2010 or 2011, or
5 percent of the cost of the project was incurred in 2009, 2010 or 2011.

Note that a project cannot have begun construction before 2009 and still qualify. I won’t go into the nuance of that rule here, but see the discussion of preliminary activities, below.

When reviewing these tests, it is a good idea to go to the Treasury’s web site and download the “Begun Construction Applicant Checklist,” which provides Treasury’s specific rules about passing these tests.

Here’s a quick summary of what you should remember:

  • A preliminary application must be submitted to Treasury before October 1, 2012, as a way to put Treasury on notice that the applicant plans to claim a grant. Treasury takes these preliminary applications seriously; in particular, an application generally must include a statement that has been signed under penalties of perjury, sometimes by a third-party engineer or contractor, depending on the particular facts of the project. Treasury says that it will notify applicants if they have submitted an application that reserves their place in line, although it doesn’t say when.
  • Regardless of which test is being passed, only those expenditures for qualifying equipment will count. For example, interconnection equipment, including the step-up transformer, generally counts. But transmission property does not.  Some roadways, say, for carrying biomass to the facility, count, but others do not.
  • The physical work of a significant nature test can be cheaper to pass in the near term. For example, an applicant can establish that it has begun construction for its project at a relatively low percentage of the project’s final cost by beginning the excavation for the foundation, the setting of anchor bolts into the ground, or the pouring of the concrete-pad foundations. The work does not have to be at the site, although it does have to be “physical.”  It does not include preliminary activities such as planning or designing, securing financing, exploring, researching, clearing a site, test drilling, or excavation to change the contour of the land, as distinguished from excavation for footings and foundations. Similarly, constructing a transmission tower, which is not eligible for the grant, is not considered qualifying “physical work.”
  • Physical work can be done by the applicant or by a contractor pursuant to a written, binding contract with at least a 5 percent damages provision, provided it is entered into before the work is undertaken. In general, the amount and design specifications of the property must be specified in the contract. A copy of the contract must be submitted to Treasury, so, to pass muster, be sure that it includes all the requirements. And, don’t forget to include provisions requiring the contractor to assist in making the 1603 application, which will likely include its statement under penalties of perjury.
  • The potential problem with the physical work test is this statement from Treasury: “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. Disruptions in the work schedule that are beyond the applicant’s control (for example, unusual weather or a site at which work can only be performed during certain seasons) will be taken into account in determining whether or not an applicant has undertaken a continuous program of construction.” Obviously, the concern is that even though the project met some minimal “begun construction” standard in 2011, an applicant’s failure to keep pushing ahead will cost it the Section 1603 grant based on  actions (or more likely, failures to act) after the end of 2011. Thus, while an applicant might save money in the near term by meeting the physical work test before the end of 2011, it will likely be burdened with making “continuous” expenditures thereafter, and it’s hard to know if any particular excuse for not going forward will placate Treasury. For this reason, it’s not surprising that most applicants and investors prefer the certainties of the 5 percent test instead.
  • Passing the 5 percent test requires the applicant to “incur” 5 percent of the project’s cost before the end of 2011. In particular, with the 5 percent test, there is no need for “continuity” as applies to the physical work test.  Although the cost of services can qualify, most applicants rely on the purchase of actual tangible assets from third parties due to Treasury’s close scrutiny of transactions with, and fees owed to, related parties. Nonetheless, Treasury’s FAQs do include an illustration of a contractor’s employees providing services necessary to design and plan for the production of a wind turbine and with services to manufacture or assemble the wind turbine as resulting in costs being incurred.  
  • Treasury relies primarily on tax regulations for determining when a cost has been incurred, whether for property or services. In the case of property, the cost is considered incurred when the property is “provided to the applicant.” Typically, this has been interpreted to require that an applicant purchase property costing at least 5 percent of the project’s cost, that the applicant pay or unconditionally owe at least 5 percent of the project’s cost in payment for that property, and that it take title to and delivery of the property before the end of 2011. Delivery can be on another’s site, and even overseas, but the applicant is best advised to have the property set aside, have serial numbers or other identifying information, and be responsible for insuring the property. A contractor can pass these tests on behalf of an applicant, if pursuant to a binding written contract entered into in advance. In this case, it is highly recommended that the applicant should still pay or unconditionally owe at least 5 percent of total project cost.
  • Treasury does not require the applicant to identify where the property will be used before the end of 2011, or even before October 1, 2012 when preliminary applications are due.
  • A tax regulation provides that property reasonably expected to be delivered within three and half months of payment can meet the “incurred” test, even if the three-and–a-half month period straddles two years. For example, an applicant could contract and pay for qualifying equipment on December 10, 2011, with a good faith contractual obligation to deliver the property by March 25, 2012. Three important things to remember: First, the test is measured from payment, which is not necessarily December 31. In other words, April 15 will generally not be the magic date. Second, actual payment in 2011 is required. Delivery of the purchaser’s note is not sufficient. Third, most investors are going to want to see actual delivery within three and a half months, and not rely on whether the applicant truly believed that the three-and-a-half month requirement would be met.
  • The 5 percent test is not an “intentions” test; it is an actual mathematical computation at the time that the project is completed. For this reason, many applicants are incurring more than 5 percent in 2011 in order to assure that they anticipate possible cost overruns.  All is generally not lost in this case; Treasury allows the project to be scaled back to match the 5 percent costs incurred, if possible.

Perhaps we’ll see another “fire drill” this year, and the program will be extended once again. However, given the lead time needed to undertake either of the two tests, and Congress’ penchant for extending grant and credit programs at the last possible moment, proponents of projects with post-2011 placed in service dates are well advised to get under way with their efforts to meet one of the two tests for grandfathering their project.

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