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Ten Things to Remember about Begun Construction
We are getting to the end of 2020, and the annual reduction of the Internal Revenue Code (IRC) Section 48 investment tax credit for solar and certain other renewables. This all depends upon when the project “began construction,” so it is probably a good time to review best practices for getting the maximum credit. As you plan your year-end strategy, here are 10 things to remember.
1. The basic rules. As a refresher, I’ll note that projects that began construction in 2019 or earlier qualified for a 30 percent tax credit, projects that begin construction in 2020 qualify for a 26 percent tax credit, and projects that begin construction in 2021 will qualify for a 22 percent credit. Of course, these all require of the project to be completed and placed in service no later than Dec. 31, 2023, which is when some credits go to 10 percent, while others are ended altogether.
2. Have a strategy. Perhaps this is the most important rule of all. If you are a developer trying to qualify your project for the largest possible credit, familiarize yourself with the applicable rules and form a plan for complying with them. Don’t think that you can drop a pile of paperwork on your investor and expect them to figure out why your project qualifies for the highest possible credit. All this does is establish that you are not the sophisticated developer that the investor was hoping to work with.
3. Don’t plan to rely on the “public policy” argument. Similarly, developers should not “kind of” comply with the rules, planning to say, “Does it really matter that we didn’t get all the way to full compliance with the approval tests? Doesn’t the government want to see projects like ours built” Investors will respond to this “kinda/sorta” strategy by basing their investment on the lower credit rate that will apply to construction beginning in a later year. Similarly, investors will not give a pass to a developer who says “I did my best; I am sorry that I skipped a sentence in the IRS guidance that I didn’t think was important.”
4. Essentials of the two methods. As you know, there are two ways to establish that you began construction. One is the significant physical work test, and the other is the 5 percent safe harbor.
In broadest 50,000-foot-level terms, the 5 percent safe harbor provides the confidence of a mathematical test, the opportunity to sometimes have deliverables received 3½ months into next year and still qualify for this year’s rates and an easier path to “sprinkling” projects with grandfathered equipment in later years. Indeed, with the pandemic, the IRS extended the 3½-month period by several months, but only for 2020.
On the other hand, the significant physical work test offers a potentially far smaller current-year expenditure than 5 percent of the facility’s cost, but requires plans and specifications to build something that isn’t “inventory,” and it may require more care to treat physical work in the current year as grandfathered equipment that can be moved to other projects in later years (if desired).
Regardless of which rule you are relying on, remember that only items that are eligible for tax credits count toward meeting the begun-construction requirement; incurring the cost, or beginning physical work on high voltage interconnection equipment, which is not credit-eligible, will not help you pass the test. Next, the project must be placed in service by the end of 2023 or it won’t qualify for more than a 10 percent credit anyway, regardless of when construction began. Finally, it is no longer necessary to show that you were “continuously working” on a project that began in 2019 or later. The IRS provided a four-plus-year safe harbor in lieu of demonstrating continuous work, but under current law, the 2023 deadline will come first for such projects anyway. So, having begun construction, you can start and stop on the development of your project, provided you finish before 2024.
5. Each method has its own rules. The two methods are truly different ways to establish that you began construction. Each method has its own specific tests, and you can’t mix and match these special provisions. For example, the so-called 3½-month rule, which can allow you to begin construction this year, even though you take delivery of the grandfathering equipment next year only applies to the 5 percent safe harbor. Therefore, you can’t do physical work next year and expect it to establish the start of construction this year.
6. The 5 percent safe harbor and when to make payment. If you are using the 5 percent safe harbor strategy, then make sure that you can show that you got actual delivery of the items that you are counting toward the 5 percent requirement in accordance with the applicable rules.
Project developers are sometimes unsure about when to pay for these items while assuring that they comply with the 5 percent safe harbor. There are two possible timetables.
The first technique is to take delivery of the item in the current year, provided you have an unconditional obligation to pay for the item owed by someone who is good for that obligation, even if payment hasn’t yet been made. Many advisers will counsel you to actually pay at least 5 percent of the item’s cost. Assume a $10 million project and $500,000 of racking will be used to pass the 5 percent requirement. You can pass the test by getting the racking delivered in 2020, with 5 percent ($25,000) paid in 2020, provided the obligor owes the balance for the racking and is good for the obligation.
The second technique is to take delivery within 3½ months of actual payment, even if the 3½-month period runs into the following year. Here’s another illustration. Again, assume a $10 million project, and $500,000 of racking. Using the 3½-month rule, you can pay the entire $500,000 in late December 2020, and get delivery of the racking within 3½ months, say in March 2021. Note that the 3½-month period runs from payment, which is generally not the exact end of the year. For example, if you pay Dec. 10, you have until March 25. Also note that getting this extra 3½ months for delivery required $500,000 to be paid in 2020, and not just $25,000, as in my first example. It’s not cheap to buy a few months’ extension!
This is also a good example of how you cannot mix the requirements of these two techniques. Note that if you are relying on the first method, and you get delivery of the racking in 2020, it doesn’t help to pay more than 5 percent early, although it may make your business partners happy. It’s delivery of equipment constituting at least 5 percent of the facility in the current year that matters, not payment. On the other hand, if you know that you will not get delivery until next year and have to rely on the second technique, then payment in full in 2020 is crucial, as is delivery within 3½ months of that payment. When using the 3½-month rule, paying in 2021 is simply too late to qualify for begun construction in 2020. And don’t expect the IRS to consider waiving the payment deadline. Earlier this year, in response to COVID-19, it extended the 3½-month delivery date; it did not extend the before the end of last year payment date.
Finally, remember that we are only talking about a 5 percent test to begin construction. You do not have to acquire, or pay for, the entire project in order to begin construction. You just have to incur 5 percent of the project’s cost.
7. The significant physical work test. The IRS has conspicuously not imposed any percentage or similar requirement in order to pass the significant physical work test, other than to require that the work be “significant.” Of course, this gives this method great appeal to a developer who hopes to reduce the expenditures that might otherwise be required to pass the 5 percent safe harbor. At the same time, the no-inventory rule of the physical work test can make it somewhat harder to pass. Of course, it’s easiest to establish physical work by doing something on-site that is truly physical, like pouring a foundation. However there is a wide variety of equipment which a developer can start to construct (or, more typically, hire someone to construct, pursuant to a “written, binding contract”), so as to commence physical work. One of the most common is starting work on a radiator that will be part of a custom transformer. A good place to find a list of recommended items is Section 4.02 of IRS Notice 2018-59. Finally, remember that “preliminary activities,” such as planning, researching and getting permits, do not count toward the physical work test. See section 4.03 of IRS Notice 2018-59 for a useful list.
One new approach to the physical work method that we’ve seen proposed in the past many months is the “specially-design-something-that-resembles-inventory-but-isn’t” strategy. Here, a developer designs a component or part, even hardware, to its own specifications, ordering a large number of the special design that it plans to sprinkle across projects like the 5 percent safe harbor, but without having to meet the 5 percent requirement of that method. Obviously, crucial to reaching this conclusion is assuring that the part is not “either in existing inventory or ... normally held in inventory by a vendor,” because this would violate the IRS’s rules for the physical work test. Plainly, this approach requires acceptance from the investor, especially where the developer acquires hundreds or thousands of the specially designed component or part. On the one hand, the special design means that the item is not today in inventory or normally held in inventory by a vendor; on the other, can we really conclude that hundreds or thousands of something don’t become inventory once there are so many? At this point, it remains to be seen if this approach will catch on widely with the tax equity community.
8. Stepping into the shoes of a prior developer. Developers sometimes buy someone else’s project, and then “step into the shoe” of the seller’s begun construction strategy so as to qualify for a higher credit percentage. There are two ways to accomplish this. The first applies when only equipment is being transferred. Here, the buyer and the seller must be related in order for the equipment to keep its grandfathering. For this purpose, the IRS requires that the buyer and seller have at least a 20 percent profits or capital interest in common to be related. For example, assume the seller is M; if M sells grandfathered equipment to a buyer partnership in which M is a partner with at least a 20 percent interest in profits or capital, then the grandfathering would be maintained. The second method applies when the seller sells equipment along with permits, a power purchase agreement, or similar contractual rights that constitute more of a business. On these facts, the buyer can be entirely unrelated to the seller, and the equipment will still be grandfathered. Note that these same rules apply when a seller sells the interest in a single-member (disregarded) limited liability company (LLC) that owns grandfathered equipment. If the LLC is holder of only equipment (and no contracts), then the seller must have a 20 percent interest in the buying entity (or keep a 20 percent interest in the LLC) in order to maintain grandfathering. However, if the LLC has both contractual rights and equipment, then grandfathering will be preserved even if the buyer is entirely unrelated to the seller. Remember, this technique only works if the seller did its homework and properly grandfathered the project in the first place. Obviously, it’s important to have a good relationship with the seller, and get its documentation proving compliance with one of the two methods described above before you allow it to disappear following closing.
9. Technical questions. You have to be prepared for the technical questions that may come your way. I’ll describe a few and note that these issues are so fact-specific that it isn’t possible to give solutions until an actual situation is presented.
Are you permitted to use the 3½-month rule? Many advisers consider the 3½-month rule to be a method of accounting, that has to be consistent with how the developer otherwise conducts its business. This is sometimes hard to demonstrate.
Is a 5 percent down payment sufficient to create a binding written contract? Or does it look like an option to decide later whether you’ll go through with buying the property (or undertaking physical work)? Here, it can be important to have plans and specifications in the hands of the person providing engineering, procurement and construction (EPC) services before the end of the year. Having a provision in the documents that tells the EPC contractor to stop once it has done some basic physical work, and not resume unless and until the developer gives the go ahead sometime next year may be seen as more like an option that isn’t exercised until next year, thereby failing the begun construction test for the current year.
What does it take to show delivery? Is setting the item(s) aside in the seller’s factory sufficient? What about having the purchasing developer insure the goods? Does that demonstrate that the developer has accepted “risk of loss” and therefore, taken delivery? The more evidence of deliver the better, but there seems to be a fair amount of flexibility on this issue.
10. Work with your investor and their professional advisers. Don’t think that just because you are satisfied that you passed the tests that apply to one of the begun-construction tests that your investor will agree. A lot of investors and their counsel have particular issues that specially trouble them, and no amount of radiating confidence on the developer’s part will cause them to change their minds. With that in mind, it’s generally a good idea for the developer to get its begun-construction strategy and factual support out of the way early in the deal closing process. Yes, you can wait until later, figuring that the investor will have become so enamored with your project that it will happily buy into any begun construction strategy, but it’s more likely that if you delay, the investor will correspondingly delay or condition later capital contributions, buy insurance (at the developer’s expense) or simply assume that next year’s lower credit percentage applies.
Best of luck with qualifying for the maximum credit percentage.
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